Dell: Prolonging the Agony

Mar 30, 10:17 AM

Current Headlines: No news may be good news, but a sliver of news can be excruciating--at least when you re Dell (DELL) and mired in an internal investigation of accounting practices. That s what transpired Mar. 29 when Dell provided yet another update--its fifth--on the probe that began in August. The company said it will miss an already extended deadline of Apr. 18 for filing its annual report. That s on top of the fact that it has not officially released financial results from the second and third quarters of its fiscal year, which ended on Feb. 2.

What s more, the company said for the first time that the audit committee of its board had uncovered "evidence of misconduct." The revelations add to the uncertainty that s shrouded Dell since the company first announced it received inquiries from the Securities & Exchange Commission about financial controls. The picture has slowly darkened.

At one point, Dell said the focus was on how it accounted for "accruals, reserves, and other balance-sheet items." Some have suggested this might relate to how the company booked revenue related to service offerings and product warranties. In September, the company received federal subpoenas from the U.S. Attorney for the Southern District of New York. But the most recent announcement was the first time the company had suggested someone had knowingly acted improperly. One possibility is that the company manipulated how much money it set aside to provide warranty-related customer service, so as to manage earnings to help it meet or beat Wall Street s quarterly expectations--though Dell isn t commenting beyond its terse, three-paragraph press release.

Dell has not yet decided if it will need to restate past earnings. But insiders are already questioning the role of former Chief Financial Officer James Schneider, who was replaced by board member Don Carty on Dec. 20. Schneider did not return phone calls seeking comment. Also cause for concern: The company did not take the opportunity to lay the blame on Schneider and other former staffers, such as CEO Kevin Rollins, who was pushed out on Jan. 31. Contrast Dell s silence, for example, with how Apple (AAPL) eased investors fears over its options-backdating problem. In the Dec. 29 report of its audit committee, Apple said it "found no misconduct by current management." Investors pushed Dell s already depressed shares down more than 2% in extended trading.

Whoever is to blame, the lack of resolution only extends the time Dell is forced to operate under the cloud of federal investigation. Observers see similarities to the behavior of companies caught up in the options-backdating scandal. In many of those cases, outside lawyers and accountants hired by the board found insufficient internal processes and controls in the way options were doled out--and ended up looking to make sure that wasn t the case in other parts of the company. In the end, such probes can take months and chew up tens of millions of dollars and create internal strife as insiders worry about their legal vulnerability--not to mention sagging stock prices as investors fret as well.

That s what happened at Mercury Interactive. Before it was sold to Hewlett-Packard (HPQ) last November, the software maker ended up spending about $70 million as investigators looked into how it did everything from controlling expenses to booking revenue. "The feeling is, If the company is rotten around stock options, is it rotten completely? " says Joseph Costello, who joined Mercury s board in the midst of the several-months-long probe. Also, when errors crop up, investigators are unlikely to shrug it off as paperwork mistakes. Rather, they demand proof that errors were not the result of deliberate fraud--which requires weeks or months of exhaustive investigative research.

And as new bits of controversy crop up, directors level of concern increases. To limit any charges that the company [and they themselves] may face, directors become even more motivated to root out all potential problems. In the end, says Costello, only 20% of the money spent on the investigation at Mercury was spent on options accounting. "It can spiral out of control," says Costello, who notes that such extensive probes are also great money makers for the law firms and accountants involved.

To be sure, Dell hasn t said anything to suggest this is happening at the company, but at least one insider believes the Dell probe has expanded beyond the initial area of concern: how it recognized warranty-related earnings. Now, says the source, the investigation has leaked into a number of other areas, including whether the company may have improperly booked payments it received from chipmaker Intel (INTC).

A lawsuit filed in February claimed that Dell had received $250 million per quarter in payments from Intel in exchange for exclusively using its chips--but buried the payments as a cost of goods sold. "Dell was trying to pretend its business model was more efficient and profitable than it really was," lawyer William Lerach, whose firm, Lerach Coughlin Stoia Geller Rudman & Robbins, brought the suit, told in February. "Had analysts known that 25% of the operating profit per quarter was from a discretionary rebate or kickback, they d have thought very differently about the company." Dell spokesman Bob Pearson would not comment on which issues or areas of the company were being investigated.

"There could be different reasons for a company not to be more chatty about the investigation s initial findings--such as a concern about not stepping on regulators toes, or about resolving disagreements between the company and its outside auditors regarding the significance of any accounting problems," says George Stamboulidis, head of corporate investigations and the white-collar defense practice for Baker Hofstetler. It may well take months before Dell finally can disclose its findings. Until then, it may have to maintain its painful silence, leaving investors to wonder.

Editor s note: Burrows is one of the reporters whose phone records were sought by Hewlett-Packard as part of an investigation into board leaks.