Regulation

Dell’s Warranty Accounting Questioned

A research firm calls Dell's accounting for warranty accruals "troubling" and its warranty disclosure "unusual."
Sarah JohnsonDecember 4, 2006

Since Dell’s announcement three weeks ago that it was under formal investigation by the Securities and Exchange Commission, the company has been mum about what accounting issues are being scrutinized. In the meantime, a Virginia research firm is criticizing how the computer giant accounts for warranty accruals. And the firm—Friedman, Billings, Ramsey & Co.—speculates that if that is one of the matters involved in the SEC’s investigation, Dell may have to restate some of its past earnings.

The firm’s analysis of warranty accruals turned up “at least three troubling conclusions,” wrote the report’s author, Clay Sumner. The most significant is his claim that Dell’s reported results cannot be relied on to gauge margin trends because the company regularly uses warranty accruals to materially manage margins and earnings. By under-accruing for warranties, Dell has overstated its earnings per share by two to eight cents in five quarters over the past three years, FBR claims.

Sumner also noted that Dell may be facing financial trouble because its actual cost of warranty claims as a percentage of product sales has been rising and could go higher. Further, he said, investors relying solely on Dell’s SEC filings are not getting an accurate picture of the company’s warranty accruals because how its disclosures are misleading.

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Nearly three weeks ago, Dell admitted that an SEC informal probe into certain accounting and financial reporting matters had been upgraded to a formal investigation. The company would not elaborate further, but confirmed to CFO.com that the issues were not related to stock option granting practices.

The U.S. Attorney for the Southern District of New York, which subpoenaed documents related to financial reporting from 2002 to the present, and Dell’s audit committee have also launched investigations into possible misstatements made in prior financial reports. Dell has not yet filed its second or third quarterly results, which were originally scheduled for release on November 16, although it did announce preliminary earnings in a press release. Dell did not respond to CFO.com’s request for comment on this story.

For the FBR report, Sumner analyzed Dell’s standard and extended warranties for several months. When accounting for both types of warranties, Dell lumps them together, creating disclosure issues because accounting rules differ for extended warranties, the author said. Dell’s warranty disclosure is “unusual, possibly unique,” Sumner wrote. An unenlightened observer could interpret Dell’s books as showing a huge reserve for standard warranties and very conservative standard warranty accruals even though the opposite is true, Sumner added.

Dell has also underfunded its reserves for standard warranties, according to FBR. Generally accepted accounting practices require that revenue from a warranty and the estimated cost of servicing the warranty must be recognized at the same time. Those costs to the vendor, which may not occur until much later, are included in a “warranty reserve,” which is later reduced by actual costs if the warranty is tapped. The reserve generally stays stable, since actual costs go out and accruals from warranties come in.

“When the accrual rates do not follow the claims rates, and specifically if a company significantly under-funds its ‘warranty reserve,’ the company is really just sandbagging the estimated warranty expense, which is equivalent to overstating gross margin,” Sumner wrote. “If the company continues to overstate gross margin in this manner for a sustained number of quarters, claims costs will increasingly represent a larger portion of the reserve, which is what has been happening at Dell.”

Sumner wrote that many companies using warranty accruals “tend to under-accrue when times are tough and over-accrue when business gets better.” But Dell has been inclined toward under-accrual for the past three years, leading to what FBR says has been an overstatement of gross margins.

Jay Goldberg, principal at accounting firm Friedman LLP, disagrees that an under-accrual, or over-accrual, of a liability for warranty costs is a common occurrence. To do so would be misleading. “If a company under-accrues a warranty liability, the effect on its gross margin is to overstate the margin and net income,” Goldberg told CFO.com. “This will also have the effect of overstating its working capital and shareholders’ equity.”