THE ALLEGATIONS WERE shocking: For years, Microsoft has systematically distorted its profit figures in an effort to consistently beat Wall Street expectations and keep its stock price steadily rising. The false reports would violate SEC regulations, and amount to outright fraud.

More shocking was the source of the allegations: Microsoft's chief of internal audits, Charlie Pancerzewski, who reported directly to the company's chief financial officer.

Most shocking of all was what happened to Pancerzewski when he reported the suspicious bookkeeping to his supervisors, Microsoft CFO Mike Brown and chief operating officer Bob Herbold, in the spring of 1995. Soon afterward, Pancerzewski—who for nearly five years had received stellar performance evaluations—received his first-ever unsatisfactory one, and was eventually forced to resign.

Two months ago, Microsoft quietly settled a lawsuit containing these allegations, filed in 1997 by Pancerzewski under the Whistleblowers Protection Act. The auditor claimed he was wrongfully terminated after telling his supervisors that Microsoft might be breaking securities and tax laws. The lawsuit made its tortuous way through several rounds of pretrial motions until last fall, when US District Judge Carolyn Dimmick denied Microsoft's final plea for summary judgment, finding credible evidence that Microsoft may have violated SEC rules, as Pancerzewski alleged. Shortly thereafter, Microsoft and Pancerzewski settled out of court. Terms of the agreement were sealed, but one source who claims familiarity with the case says that Microsoft paid Pancerzewski $4 million.

Microsoft and Pancerzewski are barred by the settlement from discussing its terms, but court records, in detailing the accuser's allegations, tell a scandalous story. Before coming to Microsoft in 1991, Pancerzewski was a partner at Deloitte, Haskins & Sells (now Deloitte & Touche), one of the nation's Big Five accounting firms. ThenMicrosoft CFO Mike Brown recruited him to create and lead a new department at Microsoft in charge of internal audits. Court documents show that Pancerzewski received highly favorable evaluations throughout his first four years in Redmond. In one letter to Pancerzewski, COO Herbold writes, "Your relatively small audit group had a significant, positive impact on Microsoft's operations, which was observed and recognized at the company's highest levels." In 1995, Pancerzewski was promoted to job level 13—near the top of the company's employment ladder—and given the title of general auditor. Later that year, Pancerzewski claims, he uncovered potentially illegal "monkey business" in Microsoft's bookkeeping, and was later asked to destroy copies of a consultant's report about potential company tax liabilities in Europe.

Judge Dimmick threw out most of Pancerzewski's allegations (including the European tax issue and a separate age discrimination claim) for lack of evidence, but left it for the trial to determine the truth of his charge that Microsoft fraudulently "borrowed" from its cash reserves in relatively lean reporting periods and hoarded cash in the reserves during fatter times, in order to give a more orderly appearance to its earning pattern. "To grossly oversimplify," Pancerzewski's complaint reads, "the setting of a reserve removes the amount of the reserve from Microsoft's reported income. Similarly, when the reserve is reversed it has the effect of increasing reported income. By setting and canceling reserves, Microsoft is able to control its reported profit and to keep its reported earnings on a smoother upward trend."

Known as a "cookie jar" reserve policy, the practice would violate Generally Accepted Accounting Practices (GAAP) and SEC regulations.

Pancerzewski reported his concerns to his supervisors by e-mail in March 1995. As Microsoft has learned the hard way, electronic correspondence creates a surprisingly indelible paper trail, and copies of the ensuing exchange in the court file show that Brown was worried that Pancerzewski might have been compromising company secrets: "[I]f you disclose any confidential issues in a non privileged context, you will be doing the Company a great disservice," the CFO wrote. "All of the audit reports you have created so far would generally be discoverable in the US . . . and could be fertile ground for an astute litigator."

Shortly after this exchange, Brown gave Pancerzewski a surprise evaluation—the only one, Microsoft concedes, given outside the company's regular annual rotation. Pancerzewski received his first unsatisfactory grade in the report, which cited poor communication skills. Five months later, in January 1996, Pancerzewski was invited by his boss to a local lunch spot near Microsoft's main campus, and was given the choice of resigning or being fired.

THE WHISTLEBLOWERS PROTECTION Act covers terminated employees who "sought to protect the public good, and not merely private or proprietary interests, in reporting . . . alleged wrongdoing." In other words, in order to qualify for protection under the act, an accuser who claims to have been fired for uncovering illegal activity has first of all to prove that the activity actually took place. In the court filings, Microsoft maintains that its practices were legal, and that Pancerzewski was not terminated for raising alarms about them. But Dimmick's refusal to throw out the "cookie jar" allegations signals that there was credible evidence—in her mind, at least—that Pancerzewski's allegations might prove true.