The following case study was originally presented at Stock Market Beat.
As accounting geeks, we are always on the lookout for examples of misleading company financial reports. In particular, it is a neat find when a company has beaten earnings by a penny or two for several consecutive quarters due to accounting items over which management has discretion. Examples of such discretionary items include the allowance for doubtful accounts and warranty reserves.
Accounting rules require companies to recognize sales and the related expenses in the same period. However, if a product is warrantied for three years after the sale (as DELL products often are) this can be difficult. In such cases, management is required to estimate the future warranty expense and charge the estimated amount when the sale is made. The charge is accounted for as a warranty reserve, and future actual warranty costs act as a reduction to the reserve rather than showing up on the income statement directly. If management’s estimate turns out to be incorrect (intentionally or unintentionally) the amount reserved will be adjusted in the future periods when necessary.
Because management has a good deal of discretion when estimating the costs (especially during quarterly reports – which are not audited as are the annual ones) skeptical investors call reserve accounts “piggy banks.” If management has a good quarter and beats earnings by several cents they could estimate higher than normal warranty expenses, and smooth out the earnings by reporting less in the good time. Then, in a bad quarter they could estimate a lower warranty expense to take some of it back. Which leads us to the following article we found regarding DELL.
Research Firm: Dell Warranty Accounting ‘Troubling’ – Warranty Accruals – CRN
New questions are being raised about the way Dell accounts for its warranty accruals.Friedman, Billings, Ramsey Research (FBR), an Arlington, Va.-based research firm, on Friday said its study of Dell’s books “points to at least three troubling conclusions” in the way that the computer hardware giant has handled warranty accruals in its financial reports.
FBR said in its report that Dell’s accounting for warranty accruals “has caused [earnings per share] overstatement of 2 cents to 8 cents in five of the last 12 quarters for which data is available.” The study comes as Dell faces investigations by the U.S. Securities and Exchange Commission, the U.S. Attorney for the Southern District of New York and the audit committee of its board of directors.
“First, it appears that Dell regularly uses warranty accruals to materially manage margins and earnings, rendering the reported results less useful for gauging actual margin trends,” FBR said in the study. “Second, as of the last quarter for which a 10-Q [report with the SEC] is available, the cost of actual claims as a percentage of products sales was rising steadily — up 30 percent [year over year in Dell's 2006 fiscal year] and costs may be heading higher.
“FBR also said Dell’s way of disclosing how it manages the money it collects from product warranties, the money it sets aside in reserve for warranty expenses and how much it accrues in warranty funds, is unusual, making it difficult to identify the Round Rock, Texas-based company’s warranty accruals based on public financial reports alone. The research firm said Dell could be headed for a restatement of earnings if the SEC probe includes a focus on warranties.
Since that would be pretty serious manipulation, we decided to check things out for ourselves. We come away unconvinced.
We’ll take the last point first. In its reports DELL discloses its warranty costs and reserves using a table very similar to this one:
“Revenue deferred and costs accrued for new warranties” is the line management estimates. The obligations honored represent actual warranty expenses while the amortization of deferred revenue represents amounts DELL has collected for service agreements that it recognizes over the term of the agreement.
As FBR notes, by lumping deferred revenue and warranty estimates into a single line it is difficult to tell which is which. This can be important, as the warranty reserves are recognized as a product-related expense while the deferred revenues are recognized as service revenue. So we looked at several quarters of management estimates as a percentage of both total revenue and service revenue, which we condensed to the following chart:
Other than the big spike up in Q306 (the quarter that ended in October 2005) there isn’t too much of a trend in either ratio. As a percentage of total revenue the accruals are rising over time, which actually means that the company is reporting lower profits than they would if the accruals were held constant. As a percentage of service revenue there may be a very mild case that the company is being more aggressive.
Still, there doesn’t have to be a trend in order for the quarterly fluctuations to affect earnings. So we took the average ratio of our nine quarters reported as a “normal” percentage of sales that should be accrued. We see that the fluctuations in accruals were indeed enough to affect EPS. Further, there were more quarters in which the adjustment would have reduced EPS than those in which it would have increased EPS. If the company beat estimates in those quarters by a smaller amount than the warranty accrual, there would be some cause for concern. For example, in the April 06 quarter (Q107) the company reported earnings that met consensus estimates, but normalizing warranty accruals to service revenue they would have missed by $0.02.
However, Friedman’s second point (about the rising actual warranty expenses) seems somewhat frivolous. We noted that the reserve spiked in the October 2005 quarter. Looking at that filing, we learn that:
During the quarter, Dell recognized a product charge of $307 million for estimated warranty costs of servicing or replacing certain OptiPlextm systems that include a vendor part that failed to perform to Dell’s specifications. At October 28, 2005, $274 million of the accrued warranty obligation remains outstanding for servicing or replacing additional OptiPlextm systems.
Having a $307 million expected warranty expense is certainly unfortunate. However, as per the accounting requirements DELL recognized the charge as soon as the problem was discovered, and the higher current expenses at least partly relate to the remaining expenses associated with servicing and replacing those systems as needed. It is hard to argue that this is anything more than the accounting system functioning as it was intended to (matching the expenses to the associated revenues as much as possible.) The charge was taken in October 2005 and disclosed at the time as a way of covering the future expenses. Now, as the expenses are recognized they come out of the reserve rather than the income statement (since they were already charged to the income statement in October.) No big deal. In fact it seems to confirm that management is using the process appropriately. (It would be inappropriate for them to put a big deposit in the piggy bank if they weren’t going to have higher actual expenses.)
Furthermore, since the most recent cases of adjusted earnings falling below reported earnings are due to the timing of recognizing this specific issue, we are less concerned about the adjusted-earnings miss in the April quarter.