Friedman, Billings, Ramsey Research (FBR), an Arlington-based research firm, recently came to "troubling conclusions" about the way warranty provisions are accounted for at DELL. FBR reports that DELL's accounting for warranty accruals "has caused [earnings per share] overstatement of [on average 5] cents in five of the last 12 quarters [ending in 2006]." To understand the impact of this information on DELL's financial statements, you should consider the information from the 10-Q form (quarterly report) of DELL in year 2005 (see Exhibit 1). Required Q3a: Assuming that DELL maintains the quality of its products, then the "true" amount of warranty provisions (i.e., costs accrued for new warranties) can be seen as a constant percentage of current revenues. Historically the ratio of warranty provisions to revenues from product licenses was 2.1%. Provide your estimate of the amount by which DELL may have overstated its earnings in 2004 and 2005. Show all calculation steps. Note: the income statement for DELL can be found in Exhibit 2. (6 marks) Q3b: Consider the information on revenue recognition in Exhibits 1, 2 and 3. DELL generates revenues from the sale of product licenses and revenues from product support and other services, which include revenues from extended warranty and service contracts. Is there evidence that DELL might accelerate sales from product support and other services? What financial statement items will you adjust to reverse the accelerated recognition of revenue from the extended warranty and service contracts? (7 marks) Exhibit 1: Critical Accounting Policies: DELL offers extended warranty and service contracts to customers that extend and/or enhance the technical support, parts, and labor coverage offered as part of the base warranty included with the product. Revenue from extended warranty and service contracts, for which DELL is obligated to perform, is recorded as deferred revenue and subsequently recognized over the term of the contract or when the service is completed. Revenue from sales of third-party extended warranty and service contracts, for which DELL is not obligated to perform, is recognized on a net basis at the time of sale. Warranty - DELL records warranty liabilities at the time of sale for the estimated costs that may be incurred under its basic limited warranty. The anticipated rate of warranty claims is the primary factor impacting DELL's estimated warranty obligation. Warranty claims are relatively predictable based on historical experience of failure rates. Each quarter, DELL reevaluates its estimates to assess the adequacy of its recorded warranty liabilities and adjusts the amounts as necessary. Revisions of the estimates affect the gross margin. Deferred Revenue and Warranty Liability (Note 7): Revenue from extended warranty and service contracts, for which DELL is obligated to perform, is recorded as deferred revenue and subsequently recognized over the term of the contract or when the service is completed. (Please turn over) 7 DELL records warranty liabilities at the time of sale for the estimated costs that may be incurred under its basic limited warranty. Changes in DELL's aggregate deferred revenue and warranty liability (basic and extended warranties), which are included in other current and non-current liabilities on DELL's consolidated statement of financial position, are presented in the following table: January 28, January 30, 2004 2005 (in thousands $) Aggregate deferred revenue and warranty 2,694 2,042 liability at beginning of period Revenue deferred from extended warranty and service contracts 2,104 1,216 1,331 1,329 Costs accrued for new warranties Service obligations honored Amortization of deferred revenue (1,176) (983) (1,359) (912) 3,594 2,694 Aggregate deferred revenue and warranty liability at end of period Revenues: Cost of revenues: Product licenses... Product support and other services Total revenues Product licenses... Product support and other services Total cost of revenues Sales and marketing Research and development General and administrative Restructuring and impairment charges Amortization of intangible assets Total operating expenses. Income from operations Financing and other income (expense): Interest income Interest expense, including discount amortization expense of $2,137 in 2003 Loss on investments... Loss on early extinguishment of notes payable Other income (expense), net Total financing and other income (expense) Income (loss) from continuing operations before income taxes Provision (benefit) for income taxes. Net income (loss) from continuing operations Discontinued operations: Gain from abandonment Income from discontinued operations Net income (loss) Basic earnings (loss) per share: Continuing operations Discontinued operations Net income (loss) attributable to common stockholders. Weighted average shares outstanding used in computing basic earnings (loss) per share Diluted earnings (loss) per share: Continuing operations Discontinued operations Net income (loss) attributable to common stockholders. Weighted average shares outstanding used in computing diluted earnings (loss) per share Exhibit 2: CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share data) Years Ended December 31, 2005 2004 $ 99,926 $ 96,995 168,736 134,213 268,662 231,208 3,886 3,875 32.565 28,996 36,451 32,871 232,211 198,337 70,420 31,471 36,382 138,344 93,867 Gross profit Operating expenses 2003 $77.221 98,356 175,577 3,240 24,745 27,985 147,592 69,924 57,475 24,915 27,684 34,977 32,580 1,699 182 129,887 119,620 68,450 27,972 1,221 644 (53) (5,109) (83) (31,069) 1,550 (215) 307 4,303 870 (35,227) 98,170 69,320 (7255) 33,427 (98,993) (2,587) 64,743 168,313 (4,668) 765 765 $ 64,743 $168,313 $ (3,903) 4.38 $ 10.48 $ (0.31) 0.05 4.38 $10.48 $ (0.26) 16,055 14,804 4.19 $9.83 $ (0.31) 0.05 4.19 $ 9.83 $ (0.26) 17,119 14,804 (94) (127) '' :' 14,768 15,436 Assets Exhibit 3: CONSOLIDATED BALANCE SHEETS (in thousands, except per share data) 2005 2004 Cash and cash equivalents $ 42,318 $ 68,314 5,076 1,210 53,761 37,816 Restricted cash and investments Short-term investments. Accounts receivable, net..... Prepaid expenses and other current assets Deferred tax assets, net 43,052 40,917 6,209 6,337 22,971 20,583 Total current assets..... 173,387 175,177 Property and equipment, net...... 12,031 16,096 3,669 5,479 Capitalized software development costs, net Long-term investments... 26,365 2,293 3,021 Deposits and other assets Deferred tax assets, net 86,393 110,818 Total assets $ 277,773 $336,956 Liabilities and Stockholders' Equity Current liabilities: $19,550 $20,668 Accounts payable and accrued expenses Accrued compensation and employee benefits... Deferred revenue and advance payments.... 27,258 25,292 45,874 43,674 Total current liabilities.. 92,682 89,634 1,554 1,681 Deferred revenue and advance payments Other long-term liabilities 2,815 5,063 Total liabilities 97,051 96,378 Commitments and Contingencies Stockholders' Equity: Preferred stock undesignated; $0.001 par value; 5,000 shares authorized; no shares issued or outstanding... Class A common stock; $0.001 par value; 330,000 shares authorized; 13,270 shares issued and 10,595 shares outstanding, and 12,841 shares issued and 12,773 shares outstanding, respectively 13 13 Class B common stock; $0.001 par value; 165,000 shares authorized; 3,258 and 3,394 shares issued and outstanding, respectively 3 3 Additional paid-in capital... 428,062 417,287 (2,331) Treasury stock, at cost; 2,675 and 68 shares, respectively Accumulated other comprehensive income 3,206 Accumulated deficit (136,817) 2,318 (112,857) (177,600) 180,722 240,578 Total stockholders' equity Total liabilities and stockholders' equity $ 277,773 $336,956 Number of ordinary (common) shares in issue at 31 December, 2005 is 16,528,000 (note that this is the total figure - the figure in thousands is 16,528) Current assets: December 31