This is one of a series of articles, Covering Financials, focused on financial accounting disclosures and how you as a journalist can interpret and report on them. The first four articles (see related links) introduce the financial accounting concepts utilized in this and future articles. If you have a topic you are interested in, post your request in the comments or email me at email@example.com.
Recent SEC Actions
Last week (April 19, 2016) the Securities and Exchange Commission issued press release 2016-74. One purpose of the press release was announcing settlement of financial accounting fraud charges against several Logitech International executives. The press release also announced complaints against other Logitech executives for different financial accounting fraud issues. The settlement with Logitech executives stemmed from violations of generally accepted accounting principles for warranty costs.
Possible Investigative Reporting Opportunities
In this week’s article let’s explore the GAAP accounting for warranty costs. This will help develop your background knowledge in order to improve your interviews with company executives and experts.
Many people think that GAAP accounting is a set rule book of dos and don’ts; however, GAAP accounting is more a set of principles containing best practices and a few rules. Many judgments need to be made to record financial transactions in accordance with GAAP. Many judgments are particularly pervasive with GAAP accounting for warranty costs. For example, consider the driving rule dictating we don’t exceed 30 mph. “Do not drive over the speed limit.” GAAP has a number of rules. But more pervasively, GAAP consists of principles. A principle is, “drive safely,” which may mean driving less than the speed limit, or in certain situations it could mean exceeding the speed limit. But GAAP is also generally accepted, so most GAAP is akin to “Drive safely. A generally accepted agreement is that about 30 mph is safe on a normal driving day. It could be less than 30 mph on unusual weather days or for many other reasons (e.g. lots of kids playing near the street).” In other words, judgment is a necessary and pervasive feature of GAAP accounting.
Why All the Judgments in GAAP Accounting?
Recall from our introductory articles (see related links at the end of this article) that GAAP financial statements measure wealth created and that measuring wealth activities is inherently judgmental. Occasionally, I’ll ask my students how much wealth they are creating for themselves during school. Most believe it is positive and a substantial amount. Any measurements necessarily require judgments. If I then ask them about their cash flows for the school term, they can all measure that. After all, cash is rather easy to count. But my students are investing in their college education in large part because of their assessments of possible wealth flows, not just current cash flows. Similarly, investors want financial statements that measure wealth flows in addition to cash flows.
GAAP Accounting for Warranty Costs
Logitech offers a warranty when it sells goods to customers. According to GAAP, in the accounting period in which Logitech records sales revenue from sales to customers (wealth inflows) it needs to record warranty expense (a wealth outflow). These related events should make sense when you remember that GAAP measures wealth created. Selling goods with a warranty creates a rather visible wealth inflow (sales revenue) and a less visible wealth outflow due to the warranty promise that facilitates sales. However, estimating warranty costs requires judgments–when any entity provides a warranty it can’t preempt its future warranty costs. But to ignore the warranty costs in the financial statements would yield a misleading report on wealth created during the accounting period. Notice that none of this discussion mentions cash flows. Cash flows will occur when the warranty promises are honored, probably several years away.
GAAP requires entities such as Logitech to estimate the warranty expense for an accounting period and record (accrue) an estimated warranty liability on the balance sheet. To do so, all reasonable evidence and management judgment should be utilized. Management must make estimates faithfully and not ignore reasonable evidence or fail to develop it (thus ignoring it). Nor can management interpret evidence with bias to suit its own objectives or motivations.
To develop warranty expense and warranty liability amounts, managers should use history including the warranty repairs on products sold previously, both same or similar products. For example, if a corporation sold lawn mowers and history, over say the last 10 years, indicates that there will be $2.50 of warranty repairs per lawn mower sold. The $2.50 is steady across all 10 years, therefore, the company can easily calculate the warranty costs for lawn mowers sold in the current year. But if current evidence would cause management to either raise or lower its historical experience of $2.50 per lawn mower sold, then management needs to faithfully include that in their estimates. Current evidence might be a manufacturing glitch this year that management knows will cause more warranty repairs on products currently sold than the $2.50 that history indicates.
What Did Logitech Do?
With an understanding that accounting for warranty costs necessarily entails judgments and estimates, we can hopefully interpret Logitech’s actions more easily. Fortunately the SEC’s Logitech cease-and-desist proceedings document describes the chain of events within Logitech leading to its warranty cost fraudulent financial statement amounts. The proceedings are publicly available, and if you start at paragraph 28 (through 54) you’ll find several SEC observations:
• Para. 29. Logitech estimated warranty costs for only one quarter into the future but the company offered warranties to customers for one, two or five years after purchase. Logitech had no basis to estimate for only one quarter. This judgment biased warranty costs down in a way that was not GAAP compliant. Even if all warranty repairs were made within one quarter after sales, the analysis should extend through the full warranty period in order to demonstrate that point.
• Para. 30. Estimated warranty costs were not based on the total number of products under warranty. Not including all products under warranty would bias warranty costs downward and not be GAAP compliant.
• Para. 32. A senior accountant at Logitech reviewed the model or approach that Logitech used to estimate warranty costs, concluding that it was not in compliance with GAAP and the estimated warranty liability was too low by $3.4 million. She presented her findings to the comptroller and others but nothing happened. At this point Logitech was ignoring reasonable evidence and was clearly not GAAP compliant.
• Para. 34. Worse, Logitech kept a list of accounting adjustments that represented risks to the financial statements but never shared that list with auditors.
• Para. 43. Eventually the warranty liability was understated by an estimated $4.2 million. Managers including the CFO knew about it. Instead of fixing the error, Logitech decided to gradually increase the “reserve” (reserve is a word often used for either “liability” or “expense”…in this case liability) so the fix was less obvious in the financial statements. This was a very poor decision by upper management and not GAAP compliant.
• Para. 45. No one on Logitech’s accounting and finance team told the external auditors about the warranty issues. Auditors inquire about any such issues, per standard practice, and in paragraph 50, the SEC discloses that Logitech management simply failed to inform the external auditors about the warranty cost issues. We don’t know why the auditors did not catch the warranty errors during their audits.
• Para. 48. The warranty liability understatement grew to $17.2 million and eventually to over $21 million when Logitech’s net income was $71.5 million.
A Growing Problem
As often happens with these types of events, the problem grew. Eventually Logitech needed to record a one-time expense of over $21 million, about 30 percent of its net income. I’d like to know if they excluded this expense from their pro-forma, non-GAAP income measures.
Understanding that GAAP is not just a set of rules, and instead requires substantial judgments, faithfully applied, can help you develop interesting articles out of scenarios such as Logitech’s. Using SEC press releases can help you obtain the facts. Consider the following interesting angles for articles:
- Why did Logitech’s management choose not to follow GAAP?
- Were management motivated to meet analyst earnings forecasts? Bonus objectives? Perhaps a strong-willed CFO or CEO influenced them? Perhaps they were just in denial, or was this a “group-think” gone wrong?
- How did the SEC learn of the warranty problems?
- Was there an internal whistle blower to the SEC? If so, what happened to the individuals involved?
- Did any analysts question the low warranty costs Logitech recorded?
- Did Logitech competitors have similar warranty problems, and how did they handle them?
Steven Orpurt is a professor teaching corporate governance and sustainability in the W.P. Carey School of Business at Arizona State University.