Hamilton Corporation (the Company) is a multinational auto parts supplier headquartered in the Midwest. Hamilton began its operations as a wholly owned subsidiary of Motor Company (MC), and was ultimately spun off and incorporated in 1998. As an auto parts supplier, one of the challenges for Hamilton in preparing their financial statements was the development of their warranty reserve. Management had a policy for accruing warranty expenses at a consistent 3% of sales each year. The controller and CFO at Hamilton worked diligently each year to develop an accurate estimate using this policy as a starting point and by reviewing the claims information for the year (captured in the AIS system) as well as prior history with warranty claims vis-à-vis their estimate. At the same time, Hamilton’s CEO exerted significant pressure to show consistent positive results for the Company overall and believed that estimate accounts should reflect accuracy without being too conservative. The BOD and Audit Committee trusted management’s approach and calculations without asking for details on how estimates were calculated or what assumptions were used.

Shortly after the spin-off, in early 2000, MC informed Hamilton that the Company might possibly owe MC an estimated $350 to $800 million for potential warranty claims related to auto parts sales that had occurred prior to the separation in 1999. Hamilton’s management team believed that any warranty claims related to sales prior to the separation should be limited to the reserve amount that was agreed to at the time of separation. However, because MC remained Hamilton’s largest client, the management team was motivated to find a solution that would appease MC.

As a direct result, the management team at Hamilton worked hard to convince MC to cap warranty claims related to prior auto parts sales at $100 million. Unfortunately, MC rejected the idea and instead continued to assert the full warranty claim against Hamilton. Recognizing that the Company could not afford to make any adjustments to their warranty reserve in excess of $100 million without a significant reduction in operating income, management had significant incentives to mask the true level of warranty expense in order to meet analysts’ forecasts.

Marketplace Challenges

The management team at Hamilton fully understood that the Company’s performance in its first several quarters was vital to the long-term success of the Company. Because the marketplace often views spin-offs as “damaged goods” in the early stages, the demonstration of impressive financial results, right away, was believed to be imperative to the Company’s ability to raise future capital.

Management quickly realized that a series of challenges existed that were likely to prevent the Company from reporting favorable results in its first several quarters of operation as a stand-alone entity. To start, management believed that the warranty claims asserted by MC had the potential to cripple the Company. In addition, management had to address a sharp and unexpected drop in automotive demand that affected its sales volume during the same time period. Unwilling to report adverse results and risk the Company’s ability to continue as a going concern, management made the decision to report favorable results, no matter what.

Warranty Claims

Faced with mounting pressure from the warranty claims asserted by MC, management increased Hamilton’s warranty reserve by $112 million during the second quarter of 2000. The increase in warranty reserve should have been charged as an expense under GAAP since the company Hamilton did not have a written agreement stating that the claims reflected a correction to its 1999 spin-off agreement with MC. However, in an effort to limit the effect on reported net income, management booked the entry directly to retained earnings as a net adjustment to the spin-off transaction. In so doing, management failed to reveal the true nature of the charge to investors.

Case Questions

1. Using the information provided in the case, and with reference to the components of the COSO framework, what is your preliminary assessment of Hamilton’s controls over the warranty estimate? What additional information do you need regarding the internal controls over the process?
2. Ignoring MC’s claims, and given what you know about the inputs, factors & assumptions used by Hamilton in calculating their warranty reserve, how would you substantively test the warranty reserve estimate account?
3. What additional factors should be considered by the auditor in their evaluation of the warranty estimate?