The alleged under-accrual for warranties may be part of the US Securities Exchange Commission’s investigation into the computer maker, said Clay Sumner, an analyst at Friedman, Billings, Ramsey & Co Inc, in a new report.
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, Sumner said.
Warranty accruals are an expense counted during the quarter for the estimated future warranty costs of products sold in that quarter.
Dell’s warranty claims have been relatively stable and predictable, but the accrual rate – or the profit or loss expense recognized in a quarter – has tended to vary widely, which is a strong indicator of earnings management, Sumner said.
He pointed out that many companies tend to under-accrue when times are tough and over-accrue when business picks up, Dell appears to have under-accrued, and therefore overstate gross margins, since the third quarter of 2003.
Indeed, Dell’s warranty cash costs ran at 46% of the warranty reserve in its first fiscal 2007 quarter, compared to 27% for Hewlett-Packard Co and 13% for EMC, Sumner said.
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 since [2003], he said.
Round Rock, Texas-based Dell did not return a call for comment.
Dell’s warranty disclosure is unusual, possibly unique, making it difficult to identify Dell’s warranty accruals using only Dell’s SEC filings, Sumner said. For this reason, we believe this information is not in the consensus, and that restatements of earnings may be coming if this turns out to be one of the issues currently under SEC investigation.
While accounting rules differ for extended warranties, Dell counts its standard and extended warranty costs as one bundled figure. The effect is that it becomes difficult to actually separate the two to determine what Dell is really spending on either, Sumner said.
Extended warranties are supposed to be accounted for like service contracts, while standard warranties included with the product at no cost. Revenue for the latter is recognized up front, while for the former is partly deferred.
If one doesn’t know how large Dell’s extended warranty business is, it looks like Dell has a huge reserve for standard warranties, and hugely conservative standard warranty accruals, while precisely the opposite is true, Sumner said.
He claims this is especially tricky to decipher because Dell doesn’t break out deferred revenue on its balance sheet.
The analyst also pointed out that in Dell’s more recent quarterly results, the cost of actual claims as a percentage of product sales rose steadily up 30% year-over-year, which reduced cash margins. And costs may be heading higher, Sumner said.
