Is Dell going to Heck?

Dell Inc. announced that its 10-K, due April 3, 2007 extended to April 18, would not be filed on time. Dell has also failed to meet NASDAQ requirements for continued listing as a result of its delinquent periodic report filings.

This delay was based on evidence of unspecified misconduct, and has involved prior quarters as well. In August 2006, the Dell announced that it was under informal investigation by the SEC on revenue recognition.

The resolution of these issues, have been long in coming, and still it is not clear how high in the organization the issues reach, though there have been firings, but also in what they entail.

Even with all the delays, there is really no clear picture of what has gone wrong.

There are two issues in the Dell story. First the problems have hung on for a long time, and further, it is not clear exactly what is wrong, or how high the problems go. Of greater interest the market has not reacted strongly to this news, nor has NASDAQ. If internal control and accurate financial statements necessary to the market, why hasn’t the stock foundered given the circumstances?

As to the first part of the question, the best place to start is with a review of SAS (Statement of Auditing Standards) No. 31 Evidential Matterwhich define the assertions made in the financial statements. These assertions cover everything in the financial statements and how Dell might be deficient.

The first is existence: "Assertions about existence or occurrence deal with whether assets or liabilities of the entity exist at a given date and whether recorded transactions have occurred during a given period." Revenue recognition is part of this one because it turns on the existence of receivables. That in turn relates to passage of ownership. SAS No. 99 because of the prevalence of revenue recognition issues in cases of fraud, requires specific tests on revenue with the objective of identifying indications of material misstatements due to fraudulent financial reporting.

Completeness deals with whether all transactions and accounts that should be presented in the financial statements are so included. It would seem that assertion is not an issue. If it were, we would note a degree of inventory shrinkage, or missing liens against assets.

Valuation is one of the most important covering: "Assertions about valuation or allocation deal with whether asset, liability, revenue, and expense components have been included in the financial statements at appropriate amounts." It does not seem that classical valuations items related to inventory are a problem. The question of accounts receivable and warranties clearly are. Warranties in this case are not just, what is commonly considered, but also the pre-paid service plans and how their sales and associated expenses are matched.

SAS No. 31 states that: "assertions about rights and obligations deal with whether assets are the rights of the entity and liabilities are the obligations of the entity at a given date." This issue ties back to the assertion of existence. In this instance, we can ask if ownership has passed, at a given time or under a given set of circumstances. Bill Fleckenstein was also uncomfortable with the size of the "long-term investments and long-term receivables" and "long-term liabilities" line items. It was a balance sheet, Mr. Fleckenstein wrote at the time that "looks more like that of a financial institution than the box maker that it is."As well it should, having an independent financing arm.

The last are: "assertions about presentation and disclosure deal with whether particular components of the financial statements are properly classified, described, and disclosed."

For now, I believe that Dell has the ability to write the financials, but it appears that there are weakness in information collection..

For the five assertions it appears that valuation and rights and obligations are the areas of concern. There are going to be others that tie to it, but those two weaknesses would explain why it has taken so long to resolve the issues. The issues are technical and resolution may require a large amount of transaction testing.

The next step is to determine why there are problems, and the best way is to examine the COSO framework for relevant items.

There appear to be weakness in the control environment, probably in the area of authority and responsibility, and perhaps organizational structure. The sign of trouble is how slow Dell has been in even finding out if restatements are required. Share price has not been hurt, which shows that the system does work, though management may not know what is happening at any given time. Note that the founder stepped back in when trouble came.

For Risk Assessment, the company probably has no problems in the sense that they are protecting assets and can be said to be doing that properly. If that were not so, then gross margins would have fallen drastically. In any event word would have gotten around.

Control Activities are another area of mixed signals. First it is hard judge, policies and procedures, but as it relates to valuation of warranties, it is clearly lacking. This area is one where information should exist with sufficient historical detail to value the reserves be it uncollected account expense or others. Problems in those areas point to trouble at the top, simply because of the nature of the work. Other problems may emerge with options and that would be much the same. If these problems are in the production cycle too, then Dell will find it very costly to fix and maintain these controls.

Information and Communication appears not to be a problem related to these issues, but the amount of time spent on them shows that at response times are not very good or effective. Again the key task is getting product out the door, which is happening, but more than that, it is hard to tell if management reigns but doesn’t rule.

Monitoring is key to internal control system and the Audit Committee is doing the investigating of the current problems. One area of concern is other current assets, according to Bill Fleckstein

(seehttp://online.wsj.com/article/SB117530196851655338search.html?KEYWORDS=dell&COLLECTION=wsjie/6month

In 2004, the Other Current Asset doubled, while sales only grew by about 21%. This sort of red flag is what monitoring is supposed to prevent. Management might not know either, though it was a long time back.

The previously noted Fleckenstein comment how certain long term assets and liabilities made it look like a financial institution. Well, he describing the harm GAAP can do to financial analysis. In this case, as with many companies, like Cisco, Dell has a financing arm, which is consolidated. The problem is that financing entities are asset driven and the parent is sales driven. Many analysts consider self-financing a red flag because of the level of manipulation possible on the issue of revenue recognition.

Based on admittedly sparse information, it would appear that the company has control problems. The troubles are not sufficient to impact operations, but rather prevent accurate estimates such as reserves, and more importantly timely feed back and correction.

The question despite all the fanfare about GAAP and Internal Control, why is it that Dell is still going strong, if those two things were so important? Certainly, there has been a decline in shareholder value from a high in the low 40’s in December 2005 to about $25.00 now. The decline more or less followed absence of financial statements. 2006 was a bad year, but it wasn’t like Enron or Calpine for instance.

Why no crash? The market adjusted their forecasts to the max downside for warranties and possibly sales. There may have been other issues relating to the financing arm which makes these statements much less transparent. On the other hand, analysts also believed that sales were increasing, and that the management controls were effective.

These flaws have cost stakeholders money, but as the issues resolve, there will be considerable upside. Analysts employ far broader sources than most people believe, and are able to compensate for a lack of financial statement information. GAAP financials are nice to have but are not the sole means available to test performance or value.