An article entitled Dells Warranty Accounting Questioned, which appeared in the December 4, 2006 issue of CFO magazine, claims that Dell, the computer manufacturing company, added up to 8 cents earnings per share by consistently under-accruing for warranty accruals. The actual amount of warranty claims as a percentage of revenues is increasing, but the warranty accruals are not keeping pace with actual warranty claims. The article claims that the company is under investigation by the U.S. Government for its accounting practices, and might have to restate its financial statements because of potential irregularities in its accounting treatment for warranties.

Required a. Discuss what is meant by under-accruing for warranty accruals in this context. Briefly explain how this can lead to an increase in a firms earnings per share.

b. As a result of consistently under-accruing for warranty accruals (over time), explain how warranty reserves (or warranty liability) can have a debit balance.

c. Explain how the restatement of Dells financial statements would reflect both moral hazard and adverse selection problems in the company.