SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 8-K/A
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Amendment No. 1
Date of Report (Date of earliest event reported): August 25, 1999
WARRANTECH CORPORATION
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(Exact name of registrant as specified in its charter)
Delaware 0-13084 13-3178732
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(State or other juris- (Commission File Number) (IRS Employer
diction of incorporation) Identification No.)
300 Atlantic Street, Stamford, CT 06901
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(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code (203) 975-1100
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Item 4. Changes in Registrant's Certifying Accountant.
(a) (1) Former Independent Accountant.
(i) On August 25, 1999, the Board of Directors (the "Board of Directors")
of Warrantech Corporation (the "Registrant" or "Warrantech") authorized the
dismissal of Ernst & Young LLP ("Ernst & Young") as its independent accountant.
(ii) As previously reported by the Registrant on its Form 8-K dated July
15, 1999, Ernst & Young, which was retained to audit Warrantech's financial
statements for the fiscal year ended March 31, 1999 ("Fiscal 1999"), because of
its disagreement with the Registrant's revenue recognition policy, which
disagreement will be explained in detail below, has, as of the date of this Form
8-K, neither completed its audit (the "Audit") of the Registrant's financial
statements for Fiscal 1999, nor issued its report on the Registrant's financial
statements for Fiscal 1999. With respect to the Registrant's two most recently
audited annual financial statements, i.e. the fiscal years ended March 31, 1997
and March 31, 1998, the reports on those financial statements by the
Registrant's principal accountant neither contained any adverse opinion or
disclaimer of opinion, nor was modified as to uncertainty, audit scope or
accounting principles.
(iii) Each of the Board of Directors of the Registrant and its audit
committee (the "Audit Committee") participated in and approved the decision to
dismiss Ernst & Young as the independent accountant for the Registrant.
(iv) The Registrant believes that, in connection with the Audit for Fiscal
1999, there was and remains a disagreement with its former independent
accountant over the Registrant's revenue recognition policy, which disagreement,
if Ernst & Young had completed its Audit and delivered its report, would have
caused them to make reference thereto in their report on the financial
statements for Fiscal 1999.
(A) Disagreement with Ernst & Young over the Registrant's Revenue
Recognition Policy
Ernst & Young, which was retained to audit Warrantech's financial
statements for Fiscal 1999, has informed Warrantech that it believes that the
revenue recognition policy that Warrantech has followed since 1991 is not
correct, and that Warrantech should be following the straight line revenue
recognition method provided for in Technical Bulletin No. 90-1 ("TB 90-1") of
the Financial Accounting Standards Board ("FASB"). Ernst & Young informed
Warrantech's management of its view shortly before the anticipated filing of the
Registrant's Annual Report on Form 10-K for Fiscal 1999 (the "1999 Form 10-K")
was due for filing with the Securities and Exchange Commission (the "SEC"). Due
to the shortness of time available before the 1999 Form 10-K was due and because
Warrantech disagreed with Ernst & Young's view that
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TB 90-1 applied, Warrantech was not able to file its 1999 Form 10-K with
certified financial statements on July 14, 1999.
Background
Warrantech had originally requested the views of FASB and the SEC with
respect to the applicability of TB 90-1 in 1991. On August 23, 1991,
Warrantech's then independent accountant, Weinick Sanders Leventhal & Co., LLP
("WSL"), had a telephone conversation with a former staff member of FASB, Mr.
John Griffin, in which Mr. Griffin stated that FASB had reached an informal
opinion approximately one month earlier that TB 90-1 is not applicable to
entities that transfer their obligor risk under extended service contracts
("ESC"), if an ESC obligor transfers risk of loss through the purchase of
insurance. Mr. Griffin explained that this opinion was premised on the facts
that the full cost of the insurance must be known and fixed and all risk of loss
must be transferred to the carrier. Mr. Griffin further expressed the opinion
that entities that transfer their risk to insurance carriers in such a manner
should follow the revenue recognition guidelines in the American Institute of
Certified Public Accountant's Exposure Draft Proposed Industry Accounting Guide
for Insurance Agents and Brokers (the "Exposure Draft"). In a separate telephone
conversation between WSL and Mr. Wayne Kauth, one of the authors of the Exposure
Draft, Mr. Kauth stated that one of the major determining factors in the
applicability of the Exposure Draft was the transfer of risk of loss.
Based on Messrs. Griffin and Kauth's verbal opinions, Warrantech requested
a determination from the Division of Corporate Finance ("DCF") of the SEC. The
Registrant requested the agreement of the Staff of the DCF that TB 90-1 is not
applicable and its concurrence with Warrantech's proportional method of revenue
recognition as prescribed under the guidelines of the Exposure Draft. In a
letter dated November 15, 1991, Warrantech was informed that the Staff at the
DCF would not object to the conclusion of the Registrant and its independent
accountant that TB 90-1 is not applicable and that the revenue recognition in
the Exposure Draft is appropriate.
Ernst & Young's View
Ernst & Young has informed the Registrant that it believes that the
Registrant's revenue recognition policy should be changed because, in recent
years, the Registrant's subsidiaries have been classified as the obligors for a
portion of the service contracts which they administer, and as a result, the
Registrant should be required to straight line its revenues over the duration of
the service contracts in accordance with TB 90-1, as opposed to the current
method, in which the Registrant recognizes revenues in direct proportion to the
costs incurred.
The Registrant's management believes that Ernst & Young is not correct
because 100% of the risk related to the payment of claims under the service
contracts is, and since 1991 has been, covered by an unaffiliated insurance
company and, because of this transfer of risk, the Registrant
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and its subsidiaries are not exposed to any risk of payment for claims. This was
the basis of the opinions expressed by the FASB member and by the DCF Staff. All
of the insurance companies used by the Registrant to cover any claims made by
consumers under the service contracts are rated not less than "Excellent" by
A.M. Best & Company.
Fiscal 1999 was the first year in which the Registrant engaged Ernst &
Young to audit its financial statements. The previous auditing firms, each of
which have certified Warrantech's financial statements since 1991, issued
unqualified opinions with respect to Warrantech's financial statements, and
Warrantech did not follow TB 90-1 with respect to its revenue recognition policy
during any of those years.
Synopsis of Business Operations
The Registrant, through its wholly owned subsidiaries, designs, and
provides administration for ESC programs ("ESC Programs"), which are sold
through retailers, utility companies and financial institutions in conjunction
with their sale of consumer products such as televisions, VCR's, computers, home
office equipment, stereo equipment, refrigerators and other electronic and
household appliances, and dealers in automotive products such as automobiles,
trucks and recreational vehicles. In addition, the Registrant offers its program
development and administrative expertise and services to manufacturers and
insurance companies as an administrator of warranty programs.
An ESC Program provides the retailer's customer with an extension, for a
specified period of time (or mileage, in the case of automotive related
programs), of coverage similar to that provided by the manufacturer under the
terms of their product warranty(s). This coverage provides an insurance
arrangement for the repair or replacement of the product, or a component
thereof, in the event of a failure in workmanship or parts. Except for a small
deductible paid by the consumer in some of the programs, the repair or
replacement will be provided by the insurance company at no cost to the consumer
during the term of the contract.
The ESC is a transaction consummated by the retailer with the consumer.
Some of the transactions occur with the business being "Dealer Obligor", while
other transactions occur as "Administrator Obligor". In both cases, the
obligation is assumed in total by the insurer. The length of term of the ESC
ranges from one year to seven years, with an average of four years.
The payments made by the consumer for the ESC and the claims made by the
consumer under the ESC are handled in the same manner regardless of whether the
retailer or the Registrant is classified as the obligor under the ESC. In either
instance, the Registrant acts as the intermediary between the customer, who
receives the service contract, and the insurance company, which pays the claims
made under the service contract. The retailer receives payment from the consumer
and, after deducting a commission, forwards the balance to the Registrant as
trustee for the insurance company. The Registrant, in turn, retains a fee for
its Program
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Development, Marketing and Sales, Regulatory Compliance and Data Acquisition
efforts required in the installation of the ESC Program, and deposits the
balance of the amount received from the retailer or dealer into a trust account
for the benefit of the insurance company. The Registrant is designated by the
insurance carrier as the Administrator or Managing General Agent of the
insurance carrier that covers claims made under the service contracts
administered by the Registrant. Certain of the Registrant's subsidiaries are
licensed as insurance agents or brokers in most states. The monies deposited
into the trust account are deemed to be premiums under the agent/administrator
agreements between the Registrant and the insurance company.
When a claim for repair is made by a consumer under the ESC, the consumer
calls the Registrant. The Registrant evaluates the claim and, if it is covered,
the Registrant refers the consumer to an independent repair facility to make the
repair. The Registrant itself does not make the repair. After the repair is
made, the Registrant causes a check to be drawn from the insurance carrier's
trust account and arranges for payment to be made to the repair facility.
Whether the retailer or the Registrant is the seller/obligor under the ESC,
the risk of loss is borne 100% by the insurance company under a Contractual
Liability Insurance Policy in which the retailer or the Registrant, as the case
may be are named insureds. All of the ESCs marketed under the ESC Program
contain a provision which explains to the consumer that he has the express right
to directly assert a claim against the insurance carrier for the cost of the
repair. Some states have statutes or regulations which give the consumer this
"pass through" right as a matter of law. If the payments for claims under the
ESCs exceed the premium reserves maintained by the insurance company, the
insurance company incurs the loss and no portion of such loss may be charged to
Warrantech.
A more detailed description of the Registrant's current business operations
is set forth in the Registrant's Form 10-K for Fiscal 1999.
TB 90-1 is not Applicable
The correspondence which led to the SEC's approval of Warrantech's revenue
recognition policy shows that the issue, for the purposes of revenue recognition
by Warrantech, was not (and is not) who is the obligor under the service
contract, but, who bears the ultimate risk of loss. The business synopsis which
the SEC relied upon in issuing its approval of Warrantech's revenue recognition
policy pointed out that, on the consumer product side of Warrantech's business,
the insurance policy was issued directly to Warrantech rather than to the
retailer. Nevertheless, as explained to the SEC, "the risk of loss is still
borne by the insurer, as it has, by virtue of the terms of the insuring
agreement, assumed the risk of loss incurred under the terms of the extended
service contracts issued." Registrant believes that this was one of the key
facts which led to the SEC approval of the Registrant's revenue recognition
policy.
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Warrantech's letter to the SEC dated October 25, 1991 (the "October 1991
Letter") stated that the basis for the proposed change in the Registrant's
revenue recognition policy was that, prior to the change, the Registrant's
contract with its then insurer (Providence Washington) did not shift the entire
risk of loss to the insurer in the event that the premiums were not sufficient
to cover the claims. As explained in the October 1991 Letter, the new
relationship with Warrantech's insurer provided that, regardless of whether the
insurance reserves were sufficient to cover the claims, Warrantech would not be
required to use its own funds to cover the obligations. That arrangement
continues today. Under the agreements between Warrantech and its principal
insurers, CIGNA and AIG, Warrantech has no obligation to use its funds to cover
the claims under service contracts regardless of whether the claims exceed the
reserves. It is the insurance company which must ultimately bear any such loss.
It is significant to note that under the Providence Washington insurance
arrangement, regardless of the terms of the particular contracts which were
issued to the consumers, the fact that Warrantech had a risk of loss meant by
definition that it had some residual obligation under the contract. It was not,
however, this obligation that was relevant to the application of the revenue
recognition policy. Rather, the relevant question was whether the insurance
arrangement completely covered any obligation which Warrantech may have had. By
demonstrating, as it did in the October 1991 Letter, that any obligation of
Warrantech was completely covered under the new insurance arrangement, the
Registrant was able to satisfy the SEC that TB 90-1 did not apply. When the
October 1991 Letter provided that Warrantech "no longer had any risk of loss,"
that fact was not based upon a change in the relationship between Warrantech and
the consumer, but, upon a change in the relationship between Warrantech and the
insurer.
Based on the foregoing, Warrantech believes that there is no merit to Ernst
& Young's espoused position that, because Warrantech has become the obligor
under some of the service contracts, TB 90-1 is now applicable. As noted above,
the fact that Warrantech had an insurable obligation in 1991 did not cause the
SEC to conclude that TB 90-1 applied. Also, Warrantech did not first become the
obligor under its service contracts in Fiscal 1999; it has been the obligor for
several years, and each of its prior independent accountants has issued
unqualified opinions with respect to Warrantech's financial presentation.
It is Registrant's understanding that TB 90-1 contemplates the situation in
which the seller of a product is also selling a service contract relating to
such product and is responsible for the repair of the product. It does not
address the circumstance in which the obligation to repair the product is
assumed by an insurance company with no resultant or contingent obligation on
the part of the seller of the service contract. For example, paragraph 16 of TB
90-1 states that "it is the Seller's obligation to perform services . . . that
determines the appropriate financial reporting of the transactions. Because that
obligation extends over a period of time, immediate revenue recognition is
inappropriate".
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Registrant believes that the fact that Warrantech or the dealer may be a
party to, or even the seller of, the service contract has no bearing on the
obligation to pay the cost of repairing the product. This is not a situation,
for example, in which Warrantech or a dealer pays the cost of the repair of the
product out of its own funds and seeks reimbursement from the insurance company.
The premium for the coverage of the repairs is sent directly from the consumer
to the insurance company (after Warrantech and the dealer take their commission)
and the cost of the repair is paid in the first instance by the insurance
company. For this reason, the primary obligor is the insurance company and not
Warrantech or the dealer/retailer.
Paragraph 19 of TB 90-1 reflects that the focus of the Technical Bulletin
is on the assumption of risk under the service contract. In discussing whether
the straight-line method or another method of revenue recognition should be
applied, the Technical Bulletin referred to FAS 60 and noted that it:
permits the recognition of revenue in proportion to amount of risk
assumed by period. Therefore, proportionately higher revenue is
recognized in the period of greatest risk assumption as evidenced by
increased claims activity. The proposed Technical Bulletin's
requirement to recognize contract revenue on a straight-line basis was
revised accordingly to include this "period of risk" concept provided
sufficient historical evidence indicates a pattern of service costs
that is other than straight-line. [Emphasis added.]
Registrant interprets this statement to mean that TB 90-1 concerns the
entity which assumes the risk of paying the claims under the service contract.
As noted, Warrantech has no such obligation even where it is the seller of the
service contract. It does not assume the risk of the claim; the insurance
company does. Once again, the fact that Warrantech, following the change of its
insurance relationship from Providence Washington to American Hardware Mutual,
no longer assumed a risk of loss, was a key fact that Warrantech relied upon in
its position presented to the SEC to support the inapplicability of TB 90-1. As
stated in the October 1991 Letter, "the Company (Warrantech) no longer had any
risk of loss on contracts written in prior periods, nor would the Company have
any risk of loss on any future contracts written."
The Audit Committee requested WSL to compare the Registrant's present
business operations to those when WSL was the Registrant's independent public
accountants, and, given WSL's knowledge of the accounting pronouncements and the
background conversations with members of FASB and the SEC, asked WSL whether it
still concurs with management that TB 90-1 is currently inapplicable to the
Registrant's business operations. WSL's letter of concurrence is attached as
Exhibit 99-1.
Anticipated Impact of Changing the Registrant's Revenue Recognition Policy
If Warrantech were required to recognize its revenue in accordance with TB
90-1, it would have a drastically negative impact on its current and prior
years' reported results and
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subject the Registrant to potential delisting from the Nasdaq Stock Market.
Registrant's common stock was delisted from the Nasdaq Stock Market on September
2, 1999 pursuant to a decision by a Nasdaq Listing Qualifications Panel due to
the Registrant's inability to file its 1999 Form 10-K for Fiscal 1999 and its
Form 10-Q for the quarter ended June 30, 1999. The delay in filing these reports
was due to the unresolved issue concerning the Registrant's revenue recognition
policy. The Registrant is appealing the Nasdaq Panel's decision.
The accounting policy would also distort the presentation of the
Registrant's financial condition on an ongoing basis.
The Registrant believes that the revenue recognition policy which it has
followed over the past eight years correctly reflects the economic reality of
its business because it enables the Registrant to match revenues with expenses.
Under its present accounting policy, the Registrant includes in the revenue
which it recognizes the premiums which it receives from the dealers and
retailers because, pursuant to its agreements with the insurance companies, the
Registrant is required immediately to deposit those premiums into the insurance
companies' trust accounts for the payment of claims.
On the other hand, under TB 90-1, only with respect to those contracts in
which Registrant is the obligor, the Registrant would be required to defer a
substantial portion of the gross profit derived from the revenues over the life
of the service contracts even though the Registrant is not required to expend
any of its own assets for claims which are made. The effect would be to
substantially distort the results of operations and the Registrant's financial
condition because of the significant delay in recognizing revenues as an offset
to recognized expenses. The Registrant believes that such a presentation would
be materially misleading to shareholders and others with which the Registrant
does business.
If the Registrant is required to utilize TB 90-1, assuming that the results
of prior years are restated in conformity with such Technical Bulletin, it is
likely that shareholders' equity would be substantially adversely impacted and
would bear no relation to the Registrant's true financial condition.
Nevertheless, the negative impact on reported shareholder equity could cause the
Registrant to fail to satisfy Nasdaq's net equity listing criterion and
potentially result in delisting of the Registrant's common stock for that
reason.
It is the Registrant's understanding that its revenue recognition policy is
an industry-wide standard which is followed both by retailers (which are the
direct focus of TB 90-1) and by service contract administrators.
For example, a former principal customer of Registrant, CompUSA, is the
obligor under approximately forty-six percent of the service contracts which are
sold to CompUSA customers in certain states. Warrantech is identified as the
"obligor" under the remainder of the contracts. In either situation, Warrantech
administers the claims under the contracts and an insurance carrier is
responsible for the payment of the claims. In a conversation between the Chief
Financial Officer of the Registrant and the Chief Financial Officer of CompUSA
on August 19, 1999, the Chief Financial Officer of CompUSA informed the Chief
Financial Officer of the Registrant that CompUSA recognizes all revenue which it
receives from all of the service contracts which are administered by Warrantech.
CompUSA is a publicly held SEC reporting company and its financial statements
are certified by Ernst & Young. If, as it appears from the
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conversation between the Registrant's and CompUSA's Chief Financial Officers,
that TB 90-1 is not applicable to CompUSA's operations, then it would seem
logical that TB 90-1 should also not be applicable to Warrantech's operations.
It is the Registrant's understanding that several other major retail customers
that are clients of Ernst & Young take the view that TB 90-1 is not applicable
to their operations because the obligations of such retailer, under the service
contracts, are fully insured by third party carriers.
In light of the apparent inconsistency between different offices within
Ernst & Young itself with respect to the applicability of TB 90-1, Ernst &
Young's unwillingness to consider changing its view in light of this apparent
inconsistency and its unwillingness to even further discuss the issue with the
Registrant, the Audit Committee and the Board of Directors have reached the
conclusion that the independence of Ernst & Young has been compromised, that an
effective working relationship with Ernst & Young is no longer possible and
that, as a result, its engagement as the Registrant's independent accountant
should be terminated.
If the view espoused by the individuals at Ernst & Young who are
recommending the change in Warrantech's policy were to prevail, it would have an
impact far beyond the Registrant's operations. As reflected by the example of
CompUSA, the industry-wide practice appears to be that TB 90-1 does not apply to
service contracts for which all obligations are covered by insurance provided by
third party carriers. Thus, the numerous other companies involved in the service
contract business, including Sears, Ford (which recently acquired Automotive
Protection Corporation), General Motors Corporation, American International
Group, Inc., Best Buy Co. Inc., Circuit City Stores, Inc., CNA Financial Corp.,
American Bankers Insurance Group, Interstate National Dealer Services, and
others -- to the extent that their accounting policies are the same as that
followed by CompUSA -- could potentially be impacted by such a change in policy.
The Registrant believes that the industry practice is correct because it
provides the most realistic and faithful representation of operating results -
and it is far more meaningful to investors, shareholders, customers and vendors
than that which would result from recognition of revenue under the TB 90-1
guidelines. The Registrant had previously announced that it would seek the views
of FASB concerning its revenue recognition policy. Ernst & Young has informed
Registrant that it would not accept the position of FASB if FASB determined that
Registrant's revenue recognition policy was correct and that it would ask the
SEC to review FASB's determination before Ernst & Young would accept it. Given
the recently ascertained information which strongly indicates that the general
industry-wide practice is to follow the revenue recognition policy used by the
Registrant with respect to service contracts that are fully insured by third
party carriers, the Registrant has decided to address this matter directly with
the Chief Accountant's Office of the SEC's Division of Corporation Finance.
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(B) The Audit Committee has, independently and together, with the Board of
Directors, met with and discussed the subject matter of the above-mentioned
disagreement with the former independent accountants.
(C) The Registrant has authorized Ernst & Young to respond fully to the
inquiries of any successor accountant concerning the subject matter of the
above-mentioned disagreement.
(v) Reportable Events.
During an Audit Committee meeting held on July 13, 1999 (the "July 1999
Meeting"), Ernst & Young advised the Audit Committee that a "reportable
condition" existed, in that, significant accounting adjustments recorded by
management in connection with the Audit, involving, among other items,
allowances made for accounts receivable , insurance company claim receivables
and dealer related receivables, in the amount of $5 million were necessary in
order to bring these allowance balances to what Ernst & Young viewed as
acceptable amounts (the "Audit Adjustments").
The Audit Adjustments described by Ernst & Young, including a description
of the amounts and the reasons therefor, are set forth in Schedule A attached
hereto as Exhibit 99-2. Although all of the Audit Adjustments were recorded
prior to the filing of this Form 8-K, $5,027,014 of the Audit Adjustments were
not recorded prior to the Audit. As explained in Schedule A, $3,539,679 of the
Audit Adjustments were not recorded prior to the Audit, primarily because of the
termination of contracts with significant customers, which terminations neither
occurred nor were known to the Registrant until after the financial closing of
the Registrant's year end. Also as explained in Schedule A, of the remaining
$1,487,335 of the Audit Adjustments, $1,173,969 were judgmental differences
providing for an increase in the allowance for doubtful accounts. The remaining
$313,366 of the Audit Adjustments were made as a result of the audit process. In
management's opinion, the Audit Adjustments do not relate to prior periods
because they relate either to events occurring in the normal course of business
during the 4th Quarter or to events occurring subsequent to, but relating to,
the 4th Quarter.
The Registrant disagrees with Ernst & Young's conclusion that a material
weakness in internal control exists as a result of the significant Audit
Adjustments recorded because only $313,366 of the Audit Adjustments were made as
a the result of discrepancies; management does not view a $313,366 Audit
Adjustment to be an amount that is material in relation to the financial
statements being audited or to constitute an error. As noted, the majority of
the Audit Adjustments, i.e. $3,539,679, resulted from subsequent events, whereas
$1,173,969 resulted from judgmental differences.
It should be noted that Ernst & Young's report is the first instance in the
fifteen-year history of Warrantech in which material weaknesses in internal
controls were reported by its independent accountant to the Audit Committee.
Warrantech and the Audit Committee intend to
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take all necessary and appropriate measures to ensure that any material
weaknesses in internal controls which may exist are remedied.
The Registrant believes that the matters reported by Ernst & Young
concerning allowances made for accounts receivable involved judgments by
management, which are accounting estimate issues and not material weakness in
internal control issues. The accounting estimate nature of these matters is
evidenced by the fact that during the course of the Audit, Ernst & Young
proposed that the allowance of doubtful accounts be increased by $170,000
against an uncollected receivable of $680,000. The Registrant concurred with
this proposal and adjusted its books accordingly. As of the date of this Form
8-K, $492,420 of this $680,000 receivable has been either collected or is in the
process of being paid, and, management is currently taking actions necessary to
obtain all relevant underlying documentation from third parties necessary to
collect the remainder thereof.
Nonetheless, the Registrant and the Audit Committee have undertaken steps
to determine if Ernst & Young's allegations of the existence of material
weaknesses in the Registrant's internal controls based on the Audit Adjustments
are valid, or, if any other material weaknesses in internal controls exist and
what corrective actions should be instituted. The Registrant and the Audit
Committee also have instructed its new auditors - Weinick, Sanders, Leventhal &
Co., LLP ("Weinick") - to review the Audit Adjustments and Warrantech's
accounting policies and systems in their entirety in order to determine whether
there are any material weaknesses in internal controls. Weinick is currently
conducting the requested review of the Audit Adjustments and has reported to the
Registrant that, as of the date of this Form 8-K, nothing has come to Weinick's
attention that would lead it to believe that there are material weaknesses in
the Registrant's internal controls. In the course of Weinick's audit, it will as
noted review the Registrant's accounting policies and systems in their entirety,
present its findings to the Audit Committee and recommend and oversee the
implementation of any and all recommended changes.
During the July 1999 Meeting, Ernst & Young also communicated to the Audit
Committee a specific incident in which it asserted that an assistant controller
of the Registrant had told representatives of Ernst & Young during the Audit
that certain adjustments were made in connection with the closing of the
Registrant's 4th Quarter of Fiscal 1999 (the "4th Quarter") with which the
assistant controller did not agree and that the assistant controller suggested
to the auditors that they should review the 4th Quarter closing adjustments.
Ernst & Young further reported to the Audit Committee that when Ernst &
Young reviewed the 4th Quarter closing adjustments, it reversed a substantial
number of adjustments and that management consented to these reversals. Ernst &
Young further reported to the Audit Committee that when it first told management
of the information reported by the assistant controller, the Registrant's senior
management asked the assistant controller, in a meeting at which representatives
of Ernst & Young were present, whether he had in fact conveyed such
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information to Ernst & Young and the assistant controller vehemently denied that
he had made any such statements to Ernst & Young. Ernst & Young has not, either
during the July 1999 Meeting or at any time thereafter, provided any documentary
support for its statement. The Audit Committee was informed by the Chief
Financial Officer of the Registrant that there were no reversals of 4th Quarter
closing adjustments recommended by Ernst & Young, and that the only adjustments
recommended by Ernst & Young were the $5 million in Audit Adjustments discussed
above.
Because Ernst & Young has failed to provide management with an explanation
as to exactly which 4th Quarter closing adjustments it allegedly reversed, the
reasons for the discrepancy between Ernst & Young's statement that it reversed a
substantial number of these adjustments and the belief by the Registrant's Chief
Financial Officer that there were no reversals of 4th Quarter closing
adjustments recommended by Ernst & Young other than the Audit Adjustments
described above, is unknown to management at this time.
It is, however, the view of the Registrant's Chief Financial Officer that
there is no basis for that statement made by Ernst & Young. Management provided
to Ernst & Young, at the beginning of the Audit, the Registrant's financial
statements reflecting Income before Taxes of $4,440,904. The Registrant's Chief
Financial Officer maintains that there were no reversals of fourth quarter
adjustments made to change those financials. The only adjustments recorded were
those set forth in Schedule A attached as Exhibit 99-2, totaling $5,027,014, and
$555,545 of adjustments that the Company provided to Ernst & Young at the
beginning of the audit. This adjustment of $555,545 was calculated by the
Registrant subsequent to its closing process and it was provided to Ernst &
Young to be included as part of their post closing adjustments.
After recording these adjustments of $5,027,014 and $555,545 to Income
before Taxes of $4,440,904 as reflected in financial statements provided to
Ernst & Young, management arrives at Loss before Taxes of $1,141,655 which is
what the Registrant reported in its Form 8-K dated July 15, 1999.
While the Registrant believes that Ernst & Young's allegation relating to
the reversals of 4th Quarter closing adjustments are without substance,
management and the Audit Committee have commenced an investigation of the facts
and circumstances relating to the communications between Ernst & Young and the
assistant controller. The investigation will be conducted by independent outside
counsel under the direction of the Audit Committee.
(a) (2) New Independent Accountant
On August 25, 1999, the Registrant, as authorized by its Board of
Directors, engaged Weinick Sanders Leventhal & Co., LLP ("WSL") as its new
independent accountant to audit and report on the Registrant's financial
statements for Fiscal 1999, and to act, on a continuing basis, as the
Registrant's independent accountant, which engagement will include performing an
audit of the Registrant's financial statements for the fiscal year ended March
31, 2000.
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(A) As indicated above, the Registrant recently consulted WSL when the
Audit Committee requested WSL to compare the Registrant's present business
operations to those when WSL was the Registrant's independent accountant in
1991, and, given WSL's knowledge of the accounting pronouncements and the
background conversations with members of FASB and the SEC (as described above)
asked WSL whether it still concurs with management that TB 90-1 is currently
inapplicable to the Registrant's business operations.
(B) As reflected in WSL's letter of concurrence, attached hereto as Exhibit
99, WSL concurs with the view that TB 90-1 is inapplicable to the Registrant's
business operations.
(C) As indicated above, Ernst & Young has been consulted regarding the
applicability of TB 90-1 to the Registrant's business operations and disagrees
with the Registrant's position on this issue.
(D) WSL has had an opportunity to review this report.
(a)(3) Position of Former Independent Accountant
The Registrant has provided Ernst & Young with a copy of this Form 8-K and
has requested that Ernst & Young furnish it with a letter addressed to the
Commission stating whether it agrees with the statements made in this Form 8-K.
A copy of such letter shall be filed as an amendment to this Form 8-K within two
days of its receipt by the Registrant.
Safe Harbor Statement made pursuant to the Private Securities Litigation Reform
Act of 1995
The foregoing Form 8-K may contain statements which are forward looking in
nature. It should be understood that, at this time, the correct accounting
policy to apply or the potential impact of the accounting policy which is
ultimately adopted has not conclusively been determined. While management
believes that the revenue recognition policy which the Company has followed is
the proper policy, no assurance can be made that FASB or the SEC will continue
to concur with the Company's position. Many accounting policies are subject to
different interpretations by accountants and governing organizations.
Item 7. Financial Statements and Exhibits.
Exhibit 16. Letter from Ernst & Young regarding their dismissal as
independent accountant will be filed as an amendment at a later date.
Exhibit 99-1. Letter from Weinick Sanders Leventhal & Co., LLP, dated
August 11, 1999, concerning the Registrant's revenue recognition policy.
Exhibit 99-2. Warrantech 's summary of the Audit Adjustments for Fiscal
1999.
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<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
WARRANTECH CORPORATION
Date: September 10, 1999 By:
-------------------------------
Richard F. Gavino
Chief Financial Officer
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Exhibit Index
Exhibit No. Page
- ----------- ----
Exhibit 16 Letter from Ernst & Young regarding their dismissal as
independent accountant will be filed as an amendment at
a later date.
Exhibit 99-1 Letter from Weinick Sanders Leventhal & Co., LLP, dated 16
August 11, 1999, concerning the Registrant's revenue
recognition policy.
Exhibit 99-2 Warrantech's summary of the Audit Adjustments for 18
the Fiscal 1999.
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Exhibit 99-1
[Weinick Sanders Leventhal & Co., LLP letterhead]
August 11, 1999
The Audit Committee of
Board of Directors
Warrantech Corporation
300 Atlantic Street
Stamford, CT 06905
INTRODUCTION
We have been engaged by Warrantech Corporation ("Warrantech" or the "Company")
to report on the continued appropriateness of the accounting policy which the
Company utilizes for the recognition of revenue from the sale of extended
service contracts ("ESC") which the Company designs, markets and administers.
This report is being issued to Warrantech for assistance in evaluating
accounting principles for the specific transactions described below. Our
engagement has been conducted in accordance with standards established by the
American Institute of Certified Public Accountants.
BACKGROUND
We were engaged in 1991 to determine the appropriateness of the
non-applicability of Financial Accounting Standards Board ("FASB") Technical
Bulletin No. 90-1("TB 90-1") and to determine whether the Company should change
its accounting treatment to conform with guidelines contained in the Exposure
Draft of the American Institute of Certified Public Accountants ("AICPA")
entitled Proposed Industry Guidelines For Insurance Agents and Brokers.
According to members of FASB and the AICPA, and based upon the correspondence
with the staff of the Division of Corporation Finance of the Securities and
Exchange Commission, the transfer of risk was the crucial consideration in
determining whether an entity should use TB 90-1 or the Exposure Draft in
accounting for the ESC programs. In our letter to the Company's Board of
Directors dated October 25, 1991, we concluded that, based on management's
belief that all risk of loss for repair, replacement or other product loss is
covered by insurance and that the Company is not liable for any loss under any
insurance arrangement, management's adoption of the proportional performance
method of revenue recognition will more accurately conform to the Company's
business operations and properly match the incurrance of costs with revenues.
The Company has asked us whether, based upon the manner in which its business is
currently operated, it is still our opinion today that TB 90-1 does not apply
and that the Company should continue to follow the revenue recognition policy it
has followed over the past eight years.
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<PAGE>
DESCRIPTION OF TRANSACTION
We have relied upon the Synopsis of Business Operations, dated August 4, 1999,
for a description of the present facts, circumstances and assumptions relevant
to the specific transaction.
In sum, the Company is in the business of designing, marketing, and installing
ESC programs and thereafter performing claims administration for such ESC
programs. The Company also offers its program design and administrative
expertise to manufacturers of such products and as administrator of these
manufacturers' product warranty programs. Additionally, the Company sometimes
contracts with dealers to sell the ESC programs on their behalf directly through
mail or telephone. In some instances the dealer/retailer is the obligor under
the ESC and in other instances Warrantech is the obligor. In all instances,
Warrantech arranges for insurance coverage with a non-affiliated excellent-rated
insurance carrier, which is responsible for any and all costs, related to the
repair, replacement or other product loss. Except for a small deductible, which
in some programs the consumer may be required to pay, the carrier is responsible
or the costs.
APPROPRIATE ACCOUNTING PRINCIPLES
Based on the foregoing, the Company would be entitled to record revenues from
sales of its ESC programs at the time of sale by the retailer, dealer, utility,
financial institution, and the Company to the consumer since the Company's
earnings process has been substantially completed at the time and the insurance
carrier has assumed all risk of obligor loss under the contract. Since the
Company is responsible for the administration of claims during the ESC period, a
portion of revenues should be deferred in amount sufficient to meet the
Company's future costs and a reasonable profit thereon.
CONCLUDING COMMENTS
The ultimate responsibility for the appropriate application of generally
accepted accounting principles for an actual transaction rests with the
preparers of the financial statements. Our judgment on the appropriate
application of generally accepted accounting principles for the foregoing
transaction is based on the facts provided to us by management and the
communications with representatives of the FASB and AICPA that were involved in
the process of the formulation of TB 90-1 and the Exposure Draft. Should the
facts and circumstances as described above differ, our conclusion may change.
Very truly yours,
Weinick Sanders Leventhal & Co., LLP
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Exhibit 99-2
Schedule A
Warrantech Corporation
Summary of Audit Adjustments
Fiscal year Ended 3-31-99
Note # Audit Adjustments resulting from Events subsequent to Amount
year end:
1 Proteva ("PRO"), a manufacturer/seller of computers, $533,000
had an agreement with Warrantech ("WTEC") wherein WTEC
would administer on behalf of PRO the warranty provided
on each product. The agreement stipulated WTEC would
receive an administrative fee for each product shipped.
In January/February 1999, WTEC discovered that PRO had
underreported to WTEC the number of products shipped.
Based on admissions by Pro of the number of units sold,
WTEC accrued for the units underreported and recognized
revenue of $1,033,000. Litigation commenced in May
1999, resulting in a settlement agreement and mutual
release whereby WTEC would receive $500,000
necessitating an adjustment to increase allowance for
doubtful accounts for $533,000.
2 CompUSA, a retailer of computer products and customer $2,447,679
of WTEC acquired the Computer City stores. In
September/October 1998, WTEC, at the request of
CompUSA, converted the 50 acquired stores to begin
selling WTEC warranties. This required sales personnel
training, system review for data reporting, production
of supplies and store/salesperson performance
monitoring. In November/December WTEC and CompUSA
reached an agreement to administer the contracts sold
by Computer City prior to their acquisition. A draft
agreement was prepared effective December 1, 1998,
subject to approval of CompUSA's in house counsel. WTEC
recognized revenue of $2,448,000 in December 1998,
based on the services rendered. While the agreement was
under legal review, Cigna Property and Casualty
Insurance notified WTEC of a premium increase which
WTEC notified CompUSA on March 30,1999, in accordance
with its agreement. On June 22, 1999, CompUSA rejected
the premium increase imposed by Cigna Property and
Casualty Insurance Company with respect to the
insurance underlying the warranties administered by
WTEC. On June 30, 1999, CompUSA gave notice to WTEC
that it was terminating the Administration Agreement
dated August 18, 1995. As the $2,448,000 was not paid,
an adjustment to increase allowance for doubtful
accounts was required
In addition, based on the termination, an allowance for $ 559,000
doubtful accounts for other unpaid receivables from
CompUSA totaling $560,000 was required.
Audit Adjustments resulting from judgmental
differences:
3 Historically and for the fiscal year ended March 31, $1,018,969
1999,WTEC established its allowance for doubtful
accounts at year end by reserving 100% for any
receivables over 15 months. Ernst & Young recommended
that we provide for an additional reserve of $193,000
for receivables between 9 through 15 months and that we
provide an additional further reserve of $826,256 for
other specific potential uncollectable receivables. (To
date $489,333 of these receivables has been Collected.)
Write down of capitalized building costs $155,000
Other Miscellaneous Audit Adjustments:
4 Comprised of a payroll accrual reversal posted twice $313,366
for $158,894; a write off of an obsolete prepaid of
$135,000 and other sundry adjustments of $19,472.
Total Summary of Audit Adjustments $5,027,014
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