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In an impressive piece of accounting research, Freidman Billings Ramsey hardware analyst Clay Sumner asserts in a report this morning that Dell (DELL) has been manipulating its earnings reports by under-accruing for warranty costs. Sumner says his research finds that Dell’s under-accruals have caused per-share earnings to be over-stated by between 2 and 8 cents a share in five of the last 12 quarters. Sumner writes:

Our analysis of Dell’s warranty accruals points to at least three troubling conclusions. 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. Second, as of the last quarter for which a 10-Q is available, the cost of actual claims as a percentage of product sales was rising steadily - up 30% [year-over-year] in [fiscal 2006], reducing cash gross margins by 60 [basis points] - and costs may be heading higher. Third, Dell’s warranty disclosure is unusual, possibly unique, making it difficult to identify Dell’s warranty accruals using only Dell’s SEC filings. 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.

Sumner notes that while Dell’s warranty claim rate has been relatively stable, the accrual rate tends to vary widely, “a strong indicator of earnings management.” Sumner notes that Dell, like many companies, “tend to under-accrue when times are tough and over-accrue whebusiness gets better,” but that the overall trend since the third quarter of 2003 has been toward under-accrual, “and thus overstatement of gross margins.” He notes that Dell’s warranty costs were recently running at 46% of its warranty reserve, up from from 28% in the third quarter of 2003, and well above the 26% reporting by Hewlett-Packard (HPQ) and the 13% reported by EMC (EMC).

Sumner notes that Dell’s reserve should be higher than HP’s, since 85% of Dell’s PC customers are corporate buyers, who tend to get three-year warranties, while HP’s customer base is 80% consumers, who generally get one-year warranties. He thinks EMC is a better comparable than HP in this case; he notes that EMC is essentialy reserved for about 23 months of warranty expenses, versus 6.5 month for Dell.

One thing to remember is that warranty reserves are not simply a wise form of insurance against future claims; they are mandated by FASB accounting guidelines. “The key is that when a product’s revenue is recognized, so is the implicit revenue from the value of any standard warranty that is included at no extra cost to the buyer,” he explains. “This means that the total estimated cost to the vendor of servicing that warranty must also be recognizaed in the same period, to match the revenu with its associated expense.”

On page three of the report, Sumner really brings the point home:

As Dell notes in its filings, warranty claim rates tend to be very predctable, and since companies have a lot of actuarial experience with these rates, the accrual for them should be just as predictable. When the accural rates do not follow the claims rates, and specifically if a company significantly under-funds its warranty reserve, the company is really just sandbagging the estimated warranty expense, which is equivalent to overstating gross margins. If the company continues to overstate gross margin in this matter 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 [the third quarter of 2003].

Sumner also complains that Dell has a confusing approach to disclosing its warranty costs, lumping together both standard warranties - the kind that come with every PC at no extra charge - and extended warranties, for which customers pay extra. The two kinds of warranties are accounted for differently: costs for standard warranties are expensed up front, while for extended warranties they are spread our ratably over time, like a service contract. “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,” he explains.

Sumner concludes that there could be earnings restatements coming if this turns out to be one of the issues involved in the current formal SEC investigation of Dell’s accounting practices. He says it also means that “margins should not be expected to recover to former levels, even if all of Dell’s other problems went away.”

As for the stock, he concludes: “We do not recommend purchasing Dell shares.”

DELL 1-yr chart:

DELL 1-yr chart

Source: Dell Over-Stating Profits, FBR Analyst Says