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This excerpt taken from the WDC 10-K filed Nov 20, 2006. Critical
Accounting Policies
We have prepared the accompanying consolidated financial
statements in conformity with accounting principles generally
accepted in the United States of America. The preparation of the
financial statements requires the use of judgment and estimates
that affect the reported amounts of revenues, expenses, assets,
liabilities and shareholders’ equity. We have adopted
accounting policies and practices that are generally accepted in
the industry in which we operate. We believe the following are
our most critical accounting policies that affect significant
areas and involve judgment and estimates made by us. If these
estimates differ significantly from actual results, the impact
to the consolidated financial statements may be material.
Revenue
and Accounts Receivable
In accordance with standard industry practice, we have
agreements with resellers that provide limited price protection
for inventories held by resellers at the time of published list
price reductions and other incentive programs. In accordance
with current accounting standards, we recognize revenue upon
delivery to OEMs and resellers and record a reduction to revenue
for estimated price protection and other programs in effect
until the resellers sell such inventory to their customers. We
base these adjustments on anticipated price decreases during the
reseller holding period, estimated amounts to be reimbursed to
qualifying customers, as well as historical pricing information.
If end-market demand for hard drives declines significantly, we
may have to increase sell-through incentive payments to
resellers, resulting in an increase in our allowances, which
could adversely impact operating results.
We record an allowance for doubtful accounts by analyzing
specific customer accounts and assessing the risk of loss based
on insolvency, disputes or other collection issues. In addition,
we routinely analyze the different receivable aging categories
and establish reserves based on a combination of past due
receivables and expected future losses based primarily
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on our historical levels of bad debt losses. If the financial
condition of a significant customer deteriorates resulting in
its inability to pay its accounts when due, or if our overall
loss history changes significantly, an adjustment in our
allowance for doubtful accounts would be required, which could
affect operating results.
We establish provisions against revenue and cost of revenue for
estimated sales returns in the same period that the related
revenue is recognized. We base these provisions on existing
product return notifications. If actual sales returns exceed
expectations, an increase in the sales return accrual would be
required, which could negatively affect operating results.
Warranty
We record an accrual for estimated warranty costs when revenue
is recognized. Warranty covers costs of repair or replacement of
the hard drive over the warranty period, which generally ranges
from one to five years. We have comprehensive processes with
which to estimate accruals for warranty, which include specific
detail on hard drive reliability, such as factory test data,
historical field return rates, and costs to repair by product
type. If actual product return trends or costs to repair
returned products demonstrate significant differences from
expectations, a change in the warranty provision is made. If
these estimates differ significantly from actual results, the
impact to the consolidated financial statements may be material.
For a summary of historical changes in estimates related to
pre-existing warranty provisions, refer to Part II,
Item 8, Note 6 of the Notes to Consolidated Financial
Statements, included in this Annual Report on
Form 10-K.
Inventory
We value inventories at the lower of cost
(first-in,
first-out basis) or net realizable value. We record inventory
write-downs for the valuation of inventory at the lower of cost
or net realizable value by analyzing market conditions and
estimates of future sales prices as compared to inventory costs
and inventory balances.
We evaluate inventory balances for excess quantities and
obsolescence on a regular basis by analyzing backlog, estimated
demand, inventory on hand, sales levels and other information,
and reduce inventory balances to net realizable value for excess
and obsolete inventory based on this analysis. Unanticipated
changes in technology or customer demand could result in a
decrease in demand for one or more of our products, which may
require an increase in inventory balance adjustments that could
negatively affect operating results.
Litigation
and Other Contingencies
We apply SFAS No. 5, “Accounting for
Contingencies,” to determine when and how much to accrue
for and disclose related to legal and other contingencies.
Accordingly, we disclose contingencies deemed to be reasonably
possible and accrue loss contingencies when, in consultation
with our legal advisors, we conclude that a loss is probable and
reasonably estimable (Refer to Part II, Item 8,
Note 7 of the Notes to Consolidated Financial Statements,
included in this Annual Report on
Form 10-K).
The ability to predict the ultimate outcome of such matters
involves judgments, estimates and inherent uncertainties. The
actual outcome of such matters could differ materially from
management’s estimates.
Income
Taxes
We account for income taxes under the asset and liability
method, which provides that deferred tax assets and liabilities
be recognized for temporary differences between the financial
reporting basis and the tax basis of our assets and liabilities
and expected benefits of utilizing net operating loss
(“NOL”) and tax credit carryforwards. We record a
valuation allowance where it is more likely than not that the
deferred tax assets will not be realized. Each period we
evaluate the need for a valuation allowance for our deferred tax
assets and we adjust the valuation allowance so that we record
net deferred tax assets only to the extent that we conclude it
is more likely than not that these deferred tax assets will be
realized.
We record estimated liabilities for tax uncertainties. To the
extent a tax position does not meet a probable level of
certainty, a liability is established based on the best estimate
of the amount that will not be sustained. However, the actual
liability in any such contingency may be materially different
from our estimates, which could result in the need to record
additional tax liabilities or potentially adjust previously
recorded tax liabilities.
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Stock-Based
Compensation
We account for all stock-based compensation in accordance with
the fair value recognition provisions of
SFAS No. 123-R,
“Share-Based Payment”. Under these provisions,
stock-based compensation cost is measured at the grant date
based on the value of the award and is recognized as expense
over the vesting period. Under
SFAS No. 123-R,
we are required to use judgment in estimating the amount of
stock-based awards that are expected to be forfeited. If actual
forfeitures differ significantly from the original estimate,
stock-based compensation expense and our results of operations
could be materially impacted.
Prior to the adoption of
SFAS No. 123-R,
we accounted for stock-based employee compensation plans
(including shares issued under our stock option plans and ESPP)
in accordance with Accounting Principles Board Opinion
No. 25, “Accounting for Stock Issued to
Employees” and its related interpretations (“APB
No. 25”), and followed the pro forma net income, pro
forma income per share, and stock-based compensation plan
disclosure requirements set forth in SFAS No. 123,
“Accounting for Stock-Based Compensation.” All other
types of equity awards were previously accounted for in
accordance with SFAS No. 123.
The fair values of all stock options granted subsequent to
April 1, 2005, were estimated using a binomial model and
the fair values of all options granted prior to April 1,
2005, and all ESPP shares were estimated using the
Black-Scholes-Merton option pricing model. Both the binomial and
the Black-Scholes-Merton models require the input of highly
subjective assumptions.
New
Accounting Standards
In July 2006, the FASB issued FASB Interpretation No. 48
(“FIN No. 48”), “Accounting for
Uncertainty in Income Taxes, an interpretation of Statement of
Financial Accounting Standards No. 109, Accounting for
Income Taxes.” FIN No. 48 clarifies the
accounting for income taxes by prescribing the minimum
recognition threshold a tax position is required to meet before
being recognized in the financial statements.
FIN No. 48 also provides guidance on derecognition,
measurement, classification, interest and penalties, accounting
in interim periods, disclosure and transition. The
interpretation applies to all tax positions related to income
taxes subject to SFAS No. 109. FIN No. 48 is
effective for fiscal years beginning after December 15,
2006. Differences between the amounts recognized in the
statements of financial position prior to the adoption of
FIN No. 48 and the amounts reported after adoption
should be accounted for as a cumulative-effect adjustment
recorded to the beginning balance of retained earnings. We are
currently evaluating the impact the adoption of
FIN No. 48 could have on our consolidated financial
statements.
In September 2006, the FASB issued SFAS No. 157,
“Fair Value Measurements.” SFAS No. 157
defines fair value, establishes a framework for measuring fair
value in U.S. generally accepted accounting principles
(GAAP), and expands disclosures about fair value measurements.
SFAS No. 157 is effective for financial statements
issued for fiscal years beginning after November 15, 2007,
and interim periods within those fiscal years. We are currently
evaluating the impact the adoption of SFAS No. 157
could have on our consolidated financial statements.
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