As I have mentioned before, my profession of auditing does not seem to be well respected. We do, however, serve a purpose, as was made dazzingly clear Friday:
Dell Inc. will restate its earnings for fiscal years 2003 through 2006 and the first quarter of 2007 after an internal audit found that certain employees had changed corporate account balances in order to meet quarterly financial targets, the company said Thursday.
I want to shed a little bit of light on this subject. I have seen this repeatedly throughout my audit career, and here’s how it works – in very broad terms.
Let’s say I am CFO Bob of the North American division of Massive Corporation. Part of Bob’s compensation is a bonus package that pays Bob $250,000 if he reaches or exceeds certain levels in a formula. The formula may have a half-dozen components – revenue, profits, units sold, whatever. The point is that if Bob reaches his goal he gets big money. He gets player money. If he misses it he may have to settle for the Jag instead of the Bentley, and Bob couldn’t bear that shame at Shady Hills Country Club.
Bob has to hit 8 out of 10 to reach his target in 2004. 2004 is a good year. Bob is confident he will make 9 out of 10 and get his $250,000 bonus. But Bob doesn’t get anything extra for that 9. 8 pays the same as 9. Bob leans back and thinks “well, maybe we should build up our reserves, just in case!” He increases a reserve in a well-funded account – maybe the accounts receivable reserve. This would be similar to you or me throwing another $1,000 in our car emergency account when our new car just passed every single inspection with flying colors.
So 2006 rolls around and Massive has a rough year. The North American division is not doing terribly, but Bob has not met any of his targets. He is at 7 out of 10 and unless he raises it to 8 before the end of the year he’s only going to get $50,000. Bob long ago burned through that 2004 bonus drinking his fine Scotch and keeping his mistress in furs. So Bob needs that 8. He needs it bad. One morning while his assistant is reading his email to him Bob suddenly remembers that reserve money he socked away. The accounts receivable are having a bad year, too. Massive is trying to collect their receivables but a lot of their customers are having troubles, too, and can’t pay Massive. Bob scratches his head and grimaces as a thought forms there. He thinks, “well, maybe I could claim it’s over-reserved.” He knows it isn’t – it was over-reserved in 2004 when times were good, but now that times are bad it’s probably just about right. But it’s a question of judgment and he’s a CFO, after all.
Bob grasps at his chance. He has his accounting staff transfer the reserve money into “extraordinary income” or something else that affects his score, and bingo! Bob makes his 8. Everyone is happy… at least until Bob gets found out by the internal auditors and gets fired. But don’t worry – no matter how much he ran his company into the ground he’ll do just fine.
Obviously, I cannot name names but I have seen this happen many, many times – sometimes blatantly, other times subtly. Once I ended up quitting out of frustration at this practice, because I realized I worked for a crooked company and could not keep working there and keep any self-respect. In Dell’s case, the auditors only gained traction when the SEC started investigating. Often, the auditors report to the CFO on a “functional” basis even though in theory they can go straight to the board (although the board members are probably going out for drinks with the CFO right after board meetings). So if the corruption occurs at the CFO level, it’s hard to fight it.
Think twice before you consider investing in any company that has exhibited this type of behavior. I would not assume, for example, that Dell has fixed the root problem of incentive-driven compensation, since that’s how most corporate employees are compensated in the US. It would be hard to say “no more bonuses – just do your job well!” If there is any type of incentive in the bonus plans – or in commissions or any other type of compensation – human nature will seek a way to make it benefit them. Invest with care!