When a Microsoft auditor alerted chief operating officer Bob Herbold and then-chief financial officer Mike Brown to the practice, he was urged to destroy copies of his report and ultimately was fired, court papers on file in Seattle federal court alleged.
The allegations are part of a probe by the Securities and Exchange Commission announced by Microsoft last week. The agency in recent months has vowed to crack down on the practice, which is known as keeping "cookie jar reserves" because companies can dip into them to conceal slow business during lean quarters. A violation can result in a fines or an order requiring a company to restate its earnings.
The software giant, for its part, says its accounting practices are regarded as among the most conservative in the industry.
"Microsoft financial statements are prepared in accordance with generally accepted accounting principles and are reviewed and audited regularly by independent public auditors," a Microsoft spokesman said.
But briefs filed here in the former Microsoft employee's 1996 lawsuit tell a far different story. The documents, reviewed by CNET News.com a day after the probe was announced, claim that Microsoft illegally retaliated against Charles Pancerzewski after his corporate auditing department in 1995 reported the alleged improprieties to the company's top brass.
"Corporate audit started reporting on and finding some matters that embarrassed perhaps Mike Brown or others in the company because they were fairly serious problems," Pancerzewski, a partner at accounting giant Deloitte & Touch before coming to work at Microsoft, testified in deposition taken in the case.
Within a few months, performance evaluations for Pancerzewski turned sour despite a recent promotion to general auditor, court records allege. In January 1996, Microsoft allegedly issued Pancerzewski an ultimatum: resign or be fired.
The suit alleges age discrimination, breach of contract, and retaliation for blowing the whistle on accounting improprieties. Last year, U.S. District Judge Carolyn Dimmick dismissed most of the charges but let allegations concerning the SEC laws go forward.
Within months, Microsoft and Pancerzewski settled the case on undisclosed terms. Both sides declined to discuss the settlement or the original allegations. Most of the court briefs concerning the accusations are sealed.
But a surviving transcript of a June 1998 hearing quotes Pancerzewski's attorney as saying that Microsoft "systematically and deliberately excluded hundreds of millions of dollars from their publicly reported financial statements in order to smooth income and conceal volatility." The practice violated the Securities Exchange Act, the Federal Foreign Corrupt Practices Act, and European tax laws, argued Pete Vial, Pancerzewski's lawyer.
Vial went on to allege that Brown, then Microsoft's CFO, wrote in an email to chief executive Bill Gates that "we should do all we can to smooth our earnings and keep a steady state earnings model." After Pancerzewski reported the alleged reserves to Herbold and Brown, "what they did was isolate him, demote, him," Vial argued.
But Tom Kelly, an attorney for Microsoft, argued that there was no evidence that Pancerzewski ever reported any alleged accounting improprieties to anyone at Microsoft. The lawyer referred to an email exchange in August 1995 in which Herbold asked Pancerzewski: "Are there serious problems that you...are concerned about?" Pancerzewski never brought up the alleged violations.
"The real issue is an employee who wanted to have a different scope of work, was not satisfied with what he was doing, wanted to do someone else's job," Kelly told the court.