Case 14-38 Fraud

Fraud

Focus: Contemporary and Historical Cases

14-38

Fraud

Professional Skepticism

Dell, Inc. LO 1, 3 In July 2010, the SEC issued a complaint against senior management at Dell, Inc., including the company’s chairman, CEO, and CFO. The complaint includes allegations that Dell engaged in fraud during the period 2002–2006 by failing to disclose a significant relationship with its major vendor (Intel) that led to Intel’s making payments back to Dell. According to the complaint, Intel agreed to make cash payments to Dell in exchange for Dell’s promise that it would not purchase microprocessors from Intel’s archrival, Advanced Micro Devices (AMD). The cash payments were very large, ranging from 10 to 76% of operating income over the period of the fraud. In March 2006, Dell announced that it would begin using AMD as a vendor and Intel immediately retaliated by ceasing to make its usual cash payments to Dell, thereby resulting in a 36% drop in Dell’s quarterly income. In the quarterly earnings conference call, Michael Dell attributed the drop to pricing pressures in the face of slowing demand and to component costs that declined less than expected; of course, these statements were false.

Consider the difficulty that this scheme posed for Dell’s auditors, PricewaterhouseCoopers (PwC). The most senior members of the management team were actively involved in this deception and not intending to make full and fair disclosures to investors or the auditors. However, should the auditors have otherwise known of the payments? This question is at the heart of a continuing debate about auditing versus forensic accounting (looking for fraud). The auditors, heretofore, had not seen any reason to question management’s integrity, but economic situations and motivations change. Furthermore, instituting a standard audit procedure in which audit software is used to search for cash receipts from major vendors (where only cash disbursements are expected) would have likely uncovered the cash received from Intel. Should such procedures—even when fraud is not expected—be performed on every audit, simply because such fraud can occur? Perhaps so, but this would also mean that audit firms would have to systematically think about a host of situations that may occur with all clients and add the standard software analysis to the audits, thereby driving up audit costs (maybe without an increase in audit fees).

This example illustrates the difficulty that auditors sometimes face in their obligation to review the adequacy of disclosures—when auditors encounter fraud, intentional concealment, and collusion among the perpetrators, it is very difficult for the auditors to reach an accurate conclusion regarding their audit work. Critics of PwC might say that PwC conducted the audit in a low-quality manner, thereby resulting in a failure to detect the fraud.

Why were Dell’s recording and disclosure of the payments from Intel materially false and misleading?

What changes in the economic environment, or in the management culture of Dell, might have led PwC to become more skeptical of the company and therefore to expand audit procedures?

Should using data-analytical tools to identify significant cash receipts from vendors be a required part of every audit engagement? Explain your rationale and consider such things as audit cost and user expectations.

Assume that instead of negotiating payments from Intel, Dell would have negotiated a long-term supply contract with Intel that resulted in lower prices for Intel chips as long as Dell agreed not to use a competitor’s chips in its products. Should the amount of the price reduction be disclosed as a separate item in the financial statements under GAAP? Why or why not?

Assume the company negotiated lower prices with Intel as described in Part d. How would the auditor become aware of the lower prices? Consider that, especially in tougher economic times, many companies were negotiating lower prices from their suppliers.

Assume the role of the engagement quality review partner. What reviews and analyses might have alerted you to the size and nature of the Intel payments?

Considering this case and the many ways in which the payments (or price reductions) from Intel could have occurred, how would you decide when the judgments and decisions made by management moves from aggressive accounting to outright fraud?