A lengthy internal investigation at Dell Inc. has finally concluded with the restatement of four years’ worth of financial statements. The company has admitted to manipulating financial statements in order to enhance quarterly earnings. The restatements will result in a reduction of net income by $92 million over the four-year period.
The investigation was huge. It reportedly involved 125 lawyers from Willkie Farr & Gallagher LLP and 250 accountants from KPMG LLP. The team evaluated over five million documents, conducted over 200 formal interviews, and examined over 2,600 journal entries flagged by specialized computer software. I can only imagine how many millions of dollars this cost.
The items under examination were largely related to Dell’s deferred revenue on software sales. These items were generally recorded in a way that would boost Dell’s earnings, when the actual operations did not meet specified targets. Also at issue was the way in which warranty revenue was booked, often accelerating the recognition to boost current earnings. Accounts were generally adjusted when closing a quarter, and many of the favorable (but improper) changes were initiated by senior executives.
The team of investigators determined that there were material weaknesses in Dell’s internal controls, and that remedial actions are in order. In other words, Dell needs to implement more checks and balances so that something like this does not happen again.
Management at Dell says that they have already started to correct the deficiencies by conducting more in-depth account reconciliations and reviews at quarter end. They believe that they now have a more complete review system in place.
Part of the problem at Dell (and at all other companies) is that there are accounts which require a great deal of judgment to be applied in calculating balances. This is especially true of accrual accounts, for which management will make certain estimates. A small change in these estimates can have a great impact on the financial statements. Users of the financial statements are relying on the good judgment of management, and there can be errors or fraud in putting that judgment to work.
The $92 million adjustment being made to Dell’s books is less than 1% of the company’s net income over the period affected. Although the dollars may not be significant when looking at the big picture, the problems associated with a lack of internal controls are serious. Had this problem not been detected, it could have gone one for many more years.
This case highlights just how easy it is for a company to head down a destructive path with its financial statements. Accounting manipulations that are small and are meant to be a one-time thing can easily snowball into a mess that spans years and costs millions of dollars to correct.