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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Oct 31

Written by: Jack Ciesielski
10/31/2007 9:37 AM 

Yesterday, Dell released its long-simmering fiscal year 2007 10-K , including restated information for prior years. The table below, culled from the 10-K, summarizes the adjustments made by category.

 
                                 
    February 3,
    January 28,
    January 30,
    January 31,
 
    2006     2005     2004     2003  
    (in millions)  
 
Beginning retained earnings as reported
  $ 9,174     $ 6,131     $ 3,486     $ 1,364  
Revenue Recognition:
                               
Software
    (21 )     (9 )     (7 )     (2 )
Other
    (216 )     (217 )     (102 )     (64 )
                                 
Revenue Recognition
    (237 )     (226 )     (109 )     (66 )
                                 
Warranty Liabilities
    202       223       129       31  
Restructuring Reserves
    (18 )     (18 )     (14 )     80  
Other
    (45 )     (35 )     (49 )     32  
(Provision) benefit for income taxes
    21       4       11       (18 )
                                 
Cumulative adjustments to beginning R.E.
    (77 )     (52 )     (32 )     59  
                                 
Beginning retained earnings as restated
  $ 9,097     $ 6,079     $ 3,454     $ 1,423  
                                 

 


The cumulative adjustments in each year may seem minor. Yet the improper accounting was significant enough to matter to the results, when results absolutely, positively had to "happen." Check this excerpt:

"The investigation ... identified evidence that certain adjustments appear to have been motivated by the objective of attaining financial targets. According to the investigation, these activities typically occurred in the days immediately following the end of a quarter, when the accounting books were being closed and the results of the quarter were being compiled. The investigation found evidence that, in that timeframe , account balances were reviewed, sometimes at the request or with the knowledge of senior executives, with the goal of seeking adjustments so that quarterly performance objectives could be met. The investigation concluded that a number of these adjustments were improper, including the creation and release of accruals and reserves that appear to have been made for the purpose of enhancing internal performance measures or reported results, as well as the transfer of excess accruals from one liability account to another and the use of the excess balances to offset unrelated expenses in later periods. The investigation found that sometimes business unit personnel did not provide complete information to corporate headquarters and, in a number of instances, purposefully incorrect or incomplete information about these activities was provided to internal or external auditors.

 

The investigation identified evidence that accounting adjustments were viewed at times as an acceptable device to compensate for earnings shortfalls that could not be closed through operational means . Often, these adjustments were several hundred thousand or several million dollars, in the context of a company with annual revenues ranging from $35.3 billion to $55.8 billion and annual net income ranging from $2.0 billion to $3.6 billion for the periods in question..."

Sorry to get carried away with the bolding - but this is the kind of stuff that's long passed for "creating shareholder value" when in fact, it's creating value forthe guys who come in and clean up afterwards, namely, the special committees and forensic accountants.

Apparently, Dell managers believed that they were doing the right thing as long as they put the materiality of their actions into a context large enough to swamp their significance. Quantity, not quality, was their yardstick of choice.

Slight irony: Dell's a hardware seller, and you'd expect that foibles in revenue recognition would have to do with hardware. But it was the software revenue recognition that got them in the soup. Apparently, the post-contract support for software sales was getting recognized too soon: according to the 10-K, "high volume, lower dollar value software products has historically been assessed as a group and the post-contract support revenue was deferred based on an estimate of average “Vendor Specific Objective Evidence” (“VSOE ”)." In the end, there was no supportable VSOE , and in the restatement, the revenues were deferred and recognized "over the post-contract support period." In the table above, that's the software revenue recognition line.

The "other" revenue recognition restatement line relates to early revenue recognition on shipments to customers before title and risk transferred to them; deferred warranty revenue "being recognized over a shorter time period than the actual contract durations;" overstated rebate accruals; fictitious sales by a Japanese affiliate; and sales recognized as reductions of cost of sales.

The warranty liabilities related to certain vendor reimbursement agreements that were applied to the balance of warranty liabilities to reduce them, along with instances of excessive warranty reserves being held on the balance sheet and not revised when it would have been correct to lower them.

Lots of stuff, and lots of time to repair them. Given the disclosure that many of these adjustments took place to "enhance internal performance measures or reported results," you have to expect that there will be some pretty big lawsuits coming. And you also wonder if this will be a test case for the SEC to apply Section 304 of the Sarbanes-Oxley Act. From the Act:

Section 304 -- Forfeiture of Certain Bonuses and Profits

Additional Compensation Prior to Noncompliance With Commission Financial Reporting Requirements. If an issuer is required to prepare an accounting restatement due to the material noncompliance of the issuer, as a result of misconduct, with any financial reporting requirement under the securities laws, the chief executive officer and chief financial officer of the issuer shall reimburse the issuer for--

    1. any bonus or other incentive-based or equity-based compensation received by that person from the issuer during the 12-month period following the first public issuance or filing with the Commission (whichever first occurs) of the financial document embodying such financial reporting requirement; and
    2. any profits realized from the sale of securities of the issuer during that 12-month period.
  1. Commission Exemption Authority. The Commission may exempt any person from the application of subsection (a), as it deems necessary and appropriate.


There's plenty of evidence of noncompliance with commission financial reporting requirements; misconduct, well, that might be the province of hair-splitting lawyers, but there seems to be some grounds in that the noncompliance was willful. Seems like there should be something at stake for the top officers under this provision - but there's always that Section b, the exemption authority. What'll it be?

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