Dell: It’s All Over But The Shoutin’

And the shoutin’ about Dell will be heard for quite a while.

What’s “over” is Dell’s accounting investigation that began in August 2005 with the SEC’s Division of Enforcement. What the shoutin’ will be about will be materiality and earnings management. The findings of independent legal counsel Wilkie Farr and forensic accountants from KPMG are best summarized in this single sentence in the non-reliance 8-K filed yesterday afternoon:

The investigation raised questions relating to numerous accounting issues, most of which involved adjustments to various reserve and accrued liability accounts, and identified evidence that certain adjustments appear to have been motivated by the objective of attaining financial targets.

Dell is planting the non-reliance black flag on its annual reports for fiscal 2003, 2004, 2005 and 2006 (including the quarterlies within those years), and the first quarter of fiscal 2007 because of those “adjustments to various reserve and accrued liability accounts.” Notice that this period restatement period is well after the “anything goes technology bubble era,” which ended around 2001.

Notice also that during the period, Section 404 of the Sarbanes-Oxley Act was effective.

What was going on? After reviewing thousands of transactions, the forensic team “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 revenue of between $35 billion and $56 billion and annual net income of between $2.1 billion and $3.6 billion for the periods in question.”

So, materiality for adjustments that were known to be improper - “an acceptable device to compensate for earnings shortfalls” - apparently were justified by putting them into the wrong context of materiality. Instead of evaluating the adjustments for what they meant qualitatively to investors, they were probably rationalized as immaterial strictly on a quantitative basis.

Indeed, the adjustments seem almost piddly in sheer quantitative terms. From the 8-K:

• Net revenue for each annual period is expected to be reduced by an amount that is less than 1% of the amount previously reported for that annual period … The largest percentage changes in quarterly net revenue are expected to be in the fourth quarter of fiscal 2003 and the second quarter of fiscal 2004, each with expected reductions of 2% or less. All other quarterly net revenue changes are expected to be less than 1% of the amount previously reported.

However, even minor changes in revenue can have mammoth effects on operating earnings - it’s the laws of operating leverage at work. Dell had significant fluctuations in earnings effects as a result of its revenue adjustments; keep in mind the cliche’ that “timing is everything.” From the 8-K:

• The cumulative change to net income for the Restatement Period is expected to be a reduction of between $50 million and $150 million (compared to previously reported net income of over $12 billion for the Restatement Period), and the cumulative change to EPS for the Restatement Period is expected to be a reduction of $0.02 to $0.07 (compared to previously reported EPS of $4.78 over the Restatement Period)…

You’re probably thinking, “Peanuts, quantitatively. What’s the big deal?” Read on: back to the 8-K.

Most of these reductions relate to the timing of net income that would or will be recognized in periods before and after the Restatement Period. Net income and EPS for three of the four annual periods are expected to be reduced by amounts ranging from approximately 0.5% to 5% of the amounts previously reported, while net income and EPS for the remaining annual period (fiscal 2006) are expected to be increased by approximately 1%. The changes to net income and EPS for the quarterly periods will vary, with the adjustments expected to increase net income and EPS in some quarters and reduce net income and EPS in others. The largest percentage changes in quarterly net income and EPS are expected to be in the first quarter of fiscal 2003 and the second quarter of fiscal 2004, each with expected reductions of between 10% and 13%; the fourth quarter of fiscal 2005, with an expected reduction of approximately 7%; and the second quarter of fiscal 2005 and the third and fourth quarters of fiscal 2006, each with an expected increase ranging from approximately 5% to 7%. Net income and EPS for each of the other quarters are expected to change by 5% or less.

Those are some very wide intra-year earnings swings that would have occurred without the “acceptable device[s] to compensate for earnings shortfalls.” The “acceptable devices” mattered little to the balance sheet: correcting them will “increase total assets by 1% or less and increase total liabilities by approximately 1%.” So much for all the financial gumshoeing of the balance sheet for evidence of earnings management.

The cash flow statement didn’t change much either, according to the 8-K. Only the income statement, for the purpose of meeting Wall Street expectations.

Next big question (not addressed in the 8-K): How much stock was management buying and selling during this period where earnings were being managed - and when did transactions occur? Far from “aligning managers with the shareholder interests,” this may be one of those examples where the equity-denominated compensation will prove a distraction for managers who now have to defend how they were aligning their interests with those of stockholders. Stay tuned.

DELL 1-yr chart: