Expert Answer:Accounting for the Intel Pentium Chip Flaw

  

Solved by verified expert:Consider the article “Accounting for the Intel Pentium Chip Flaw” (Miller & Narayanan, 2001). Next, using outside sources that you may seek and your professional experience, develop and write a 3 to 4 page paper concisely answering the following questions: 1) if you were an accountant for Intel, what specifically would be the relevant accounting research question with respect to the Intel Pentium chip flaw? 2) What constrains Intel’s decision about how to account for the Pentium chip flaw? 3) What do you need to know, estimate, and assume to answer the research question? 4) What would you recommend to Intel management with respect to accounting for the Intel Pentium chip flaw? Why?
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9-101-072
REV: OCTOBER 4, 2002
GREGORY S. MILLER
V.G. NARAYANAN
Accounting for the Intel Pentium Chip Flaw
What we view as an extremely minor technical problem has taken on a life of its own.
—Andrew S. Grove, Chief Executive Officer, Intel Corp.1
In December 1994 IBM stopped shipping personal computers containing the Intel Pentium
microprocessor. It supported this action with analysis provided by the IBM Research Division, which
indicated that “common spreadsheet programs, recalculating for 15 minutes a day, could produce
Pentium-related errors as often as once every 24 days. For a customer with 500 Pentium-based PCs,
this could result in as many as 20 mistakes a day….”2
Andrew Grove, Intel’s president and CEO retorted quickly: “[b]ased on the work of our scientists
analyzing real world applications, and the experience of millions of users of Pentium processor-based
systems, we have no evidence of increased probability of encountering the flaw…You can always
contrive situations that force this error. In other words, if you know where a meteor will land, you
can go there and get hit.”3
Although Mr. Grove’s opinion of the Pentium “bug” was clear, IBM’s action forced Intel’s top
management to address a tough question: Should Intel undertake a broad recall of Pentium Chips?
History
Microprocessing chips are the “brains” of computers sold for both home and business use. Intel
was the first, the biggest, and regarded by many as the best microprocessor-maker in the computer
industry. Intel’s 1993 gross margin of 63% and net margin of 26% were clear indications of the
strength of the company (see Exhibit 1 for Intel’s recent financial statements). Intel’s success was
based on constant innovation, huge spending in marketing, production and cycle-time improvement,
1Aaron Zitner, “Consumers get break on computer chip,” The Boston Globe, December 21, 1994, p. 1.
2Bart Ziegler, “IBM, Intel Continue Their Wrangling Over Liability for Pentium Repair Bill,” The Wall Street Journal, December
14, 1994, p .B6.
3[[Intel]] webmaster@www.intel.com, “Tell us what you think!,” Copyright (c) 1994, Intel Corporation. All rights reserved.
________________________________________________________________________________________________________________
Research Associate Lisa Brem prepared this case under the supervision of Professors Gregory S. Miller and V.G. Narayanan. This case draws on
material from “The Intel Pentium Chip Controversy (A) and (B), “HBS Nos. 196-091 and 196-092, prepared by Research Associate James Evans
under the supervision of Professor V.G. Narayanan. HBS cases are developed solely as the basis for class discussion. Cases are not intended to
serve as endorsements, sources of primary data, or illustrations of effective or ineffective management.
Copyright © 2001 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685,
write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be
reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical,
photocopying, recording, or otherwise—without the permission of Harvard Business School.
This document is authorized for use only in ANGELA MONTGOMERY’s EXPIRE-WAL ACCT 6140 Current Trends in Accounting Standards at Laureate Education – Baltimore from Apr 2017 to
Jun 2018.
101-072
Accounting for the Intel Pentium Chip Flaw
and relentless challenging of copycat competitors by “pummeling rivals in court.”4 Intel’s first
microprocessors for computers, the 8086 and 8088 (sold in the first IBM personal computer), were
followed by its 80186 (used primarily in controllers), 80286, 80386, and 80486 editions, each with
markedly more memory and processing speed than the previous generation (see Exhibit 2). By 1993,
when the first Pentium was introduced, a number of competitors—including AMD, Cyrix, and
NexGen—were already producing clones of Intel’s 486. These competitors were getting faster at
cloning Intel’s designs, and the 486 clones appeared on the market much faster than the clones of 386
and 286 chips.
The Pentium had been designed with more testing than any previously produced manufactured
product.5 “They ran the hell out of all the software they could find,” said Joseph Costello, CEO of a
chip-design software maker.6 A full year of testing involving trillions of random mathematical
processes was performed to detect any problems with the chip before and soon after it went on the
market; a quadrillion more were performed in the year after that. However, the rollout of any new
microprocessor was unavoidably risky since chip-testing technology was a generation behind chipmaking technology.
In addition to detailed testing, Intel had strategically prepared this new chip for market with the
increased trademark protection available to a name, the “Pentium,” rather than using the 80586
moniker. Intel began to steer the market toward this newer, faster chip—and away from competitors’
clones of prior models—by attempting to convince personal and corporate computer users that the
486 was outmoded. With an advertising blitz estimated at $150 million, the company advertised the
logo Intel Inside® and the name Pentium in every available type of media. By the end of September
1994, Intel had shipped nearly two million Pentium chips to computer producers (see Exhibit 3).
The Flaw Discovered
Early in the summer of 1994, mathematics professor Dr. Thomas Nicely of Lynchburg College in
Virginia discovered inconsistencies in his calculations performed on his Pentium-driven PC. Nicely
was trying to prove that PCs could do mathematical work heretofore only performed on larger
systems and thus was involved in intense and continuous number crunching far beyond that of a
typical user. Nicely discovered the division flaw occurred only with rare combinations of numbers,
and was not in his software, but in the processor of his Pentium.7
The problem arose in the floating-point processing unit of the chip, which handled numbers
expressed in scientific notation. At the end of October, Nicely published a note on the Internet
querying other users about the Pentium flaw. A discussion soon emerged at the Internet news group
“comp.sys.intel.” The tone quickly changed from a calm discussion of arcane technical tests to
flaming accusations and threats aimed at Intel.
4Don Clark, “Intel Balks at Replacing Pentium Chip Without Asking Owners Any Questions,” The Wall Street Journal,
December 14, 1994, p. A3.
5Jim Carlton and Stephen Kreider Yoder, “Computers: Humble Pie: Intel to Replace Its Pentium Chips,” The Wall Street Journal,
December 21, 1994, p. B1.
6Robert D. Hof, “The ‘Lurking Time Bomb’ of Silicon Valley,” Business Week, December 19, 1994, p. 118.
7As one example of the flaw, the solution to the following calculation, 4,195,835—( (4,195,835 / 3,145,727)) x 3,145,727, should
be zero, but a computer with the flawed Pentium chip provides an answer of 256: Walter S. Mossberg, “Intel Isn’t Serving
Millions Who Bought Its Pentium Campaign,” The Wall Street Journal, December 15, 1994, p. B1.
2
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Accounting for the Intel Pentium Chip Flaw
101-072
On November 7, 1994, an Electrical Engineering Times article by Alexander Wolfe, based on the
Internet discussions, prompted Intel’s response that it had uncovered the flaw during tests the
previous June. However, Intel had run a series of tests and concluded that an error would occur only
once every nine billion random calculations, or every 27,000 years for most users. Further, Intel had
remedied the problem for the next planned version of the Pentium, but had not informed customers
who had purchased a flawed processor. Following the article, Intel offered to replace the flawed
chips, but only on a limited basis: users first had to demonstrate that the flaw was likely to occur in
the work they performed on their computer. The Internet discussion group continued to “flame” the
company on-line and eventually attracted the attention of reporters. On November 22, 1994, CNN
broadcasted a story that revealed the chip flaw for the first time to the general public, Intel’s own
computer-making customers, and the rest of the media.
On November 24, the beginning of the Thanksgiving holiday weekend, the front-page of the New
York Times Business Section headlined “Flaw undermines the accuracy of Intel’s Pentium.”8 The
Boston Globe carried the same story on its front page, and the news continued to unfold over the next
month. By November 25 Intel’s stock had dropped two percentage points from its high in late
September.
The mounting consumer pressure to fix the Pentium flaw was hitting PC manufacturers as well as
Intel. But who would take responsibility for fixing the flaw? Dell, a computer manufacturer, began
advertising its Pentium with a built-in computer fix to remedy the latent flaw. On November 28,
Sequent, a mainframe manufacturer, stopped shipping Pentium machines until a software solution
could be installed.9 On November 30, IBM—a major Intel customer—announced that it would
replace the Pentium processor in any of its machines at the customer’s request. IBM, however, did
not have Intel’s support to fulfill such a promise and ran the risk of having to purchase replacements
on its own account.
As the second week of December passed, the media coverage began to abate and Pentium flaw
stories lost their front-page status. December Pentium sales continued to increase as planned, but
several thousand Pentium owners were calling Intel daily. Intel rallied over a thousand of its
employees to respond to these calls and carefully assess whether the users were performing functions
that would be at risk of engaging the flaw in the floating point unit.10
On December 12, 1994, IBM, without prior notice to Intel, dropped a bomb by halting shipments
of their Pentium PCs. News coverage and consumer fears re-ignited. IBM claimed that further
testing had revealed the bug to be more common than Intel had reported. On certain spreadsheet
programs, IBM researchers claimed the problematic number combinations were not random and
occurred much more frequently. Calculations for a continuous 15 minutes per day could produce an
error once every 24 days. Intel’s stock plummeted $2.50 within an hour of IBM’s announcement. (see
Exhibit 4).11
Intel had to decide how to respond to customer demands: should they offer to replace the
defective Pentium chips of all concerned users with no-questions-asked. In the week following IBM’s
announcement, an Intel crisis team assembled by Grove and made up of several dozen Intel
8John Markhoff, “Circuit Flaw Causes Pentium Chip to Miscalculate, Intel admits,” The New York Times, December 24, 1994, p.
B1.
9Don Clark, “Technology and Health: Intel Finds Pumped-Up Image Offers a Juicy Target in Pentium Brouhaha,” The Wall
Street Journal, December 5, 1994, p. B5.
10Robert D. Hof, “The Education of Andrew Grove,” Business Week, January 16, 1995, p. 31.
11Peter Lewis, “IBM Deals Blow to a Rival As It Suspends Pentium Sales,” The New York Times, December 13, 1994, p. A1.
3
This document is authorized for use only in ANGELA MONTGOMERY’s EXPIRE-WAL ACCT 6140 Current Trends in Accounting Standards at Laureate Education – Baltimore from Apr 2017 to
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101-072
Accounting for the Intel Pentium Chip Flaw
employees drawn from all parts of the company met before and after work each day to analyze and
resolve the consumer crisis on their hands.12 An all-day meeting instigated by Grove on Monday,
December 17, was “marked…by passionate discussion, the decision to change the policy on the
Pentium replacements was adopted and rescinded several times.”13
Costs of Replacement
Clearly, Intel was faced with the prospect of replacing some of the defective chips. Questions
remained as to how many of the chips would be replaced, how the replacement would be
accomplished, and whether Intel would pay for the labor costs to replace the chips, in addition to the
cost of the new chip itself.
Intel had to decide how wide a recall it would offer. It could continue its current policy of
providing replacement chips only to customers that demonstrated a need (which one analyst
estimated to be about 5% of chips sold),14 loosen these criteria but still require some demonstration of
need, or bow to public pressure and unconditionally replace chips on-demand. Of the approximately
six million flawed chips sold in 1993 and 1994, one-third were used in businesses.15 Presumably
these users would have a higher rate of return than personal users under almost any recall plan.
The actual cost of producing the replacement chip and the accompanying heat sinks (the devices
that release heat from operating chips) was estimated to be between $50 and $100 per chip. Other
replacement costs, which included the actual labor and incidental costs, were estimated to range from
$31 to $750 and average over $400 per chip replaced.16 The amount paid out by Intel depended on
what method it used to implement the repair. Intel could pay for the entire cost of accessing the unit,
the direct labor to replace the flawed chip, and any shipping or transportation costs incurred by
customers. Alternatively, Intel could send the replacement chip to the customers, leaving them to
decide how to replace the chip. Another possibility was to negotiate with computer manufacturers
and sellers to offer discounted or free replacement service to end-user customers. In any case, the
end user seeking replacement would have to bear some costs. One information technology
consultancy estimated that “[t]he amount borne by companies in a typical scenario will be $289 per
system, including administrative, labor, and downtime costs.”17
Other Potential Costs
Intel had other costs to account for as well. It had produced almost eight million flawed chips, so
in addition to the six million chips currently in computers it would need to account for the two
million chips in inventory.18
12John Markoff, “ Intel’s Crash Course on Consumers,” The New York Times, December 21, 1994, p. D1.
13Ibid.
14Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.
15Don Clark, “Intel Balks at Replacing Pentium Chip Without Asking Owners Any Questions,” The Wall Street Journal,
December 14, 1994, p. A3.
16Brian Gillooly, “The Real Cost—Intel’s ‘free’ Pentium replacement plan may end up costing large users a bundle,”
InformationWeek, January 9, 1995, p. 34.
17Ibid.
18Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.
4
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Accounting for the Intel Pentium Chip Flaw
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The potential of lawsuits from consumers, computer manufacturers, and shareholders loomed as
an imminent threat. The Wall Street Journal reported that “at least 10 suits in three states” accusing
Intel of securities fraud, false advertising, and violation of consumer protection laws, had been filed
seeking “hundreds of millions of dollars in damages.” Some suits also looked to force Intel to replace
the flawed chips. In addition, attorneys general of four states were in the process of filing suits
against Intel on the grounds that the company violated unfair-trade-practices laws. 19
Intel also had to assess the impact on its brand name. The company had spent $500 million from
1992 through 1994 on the “Intel Inside” campaign, which was designed to make the Pentium a
household name to personal computer consumers. The brand equity Intel had built through the
years was estimated by advertising industry analysts to be worth $6.4 billion. 20 Clearly the negative
publicity surrounding the flaw had damaged Intel’s reputation, but the extensive coverage in the
popular press had increased its name recognition substantially.21
Finally, Intel had projected 1995 Pentium sales of between 22 million and 25 million units,22 a
large increase over 1994 projections. Intel claimed that it could replace any defective chips while
continuing to meet demand for new orders. In fact, Intel’s new high production Fab 10 facility in
Leixlip, Ireland, could produce an estimated 12.5 million Pentium chips per year,23 more than twice
the approximately six million defective processors Intel sold in 1993 and 1994.24 Further, Intel had
opened or expanded five semiconductor facilities internationally in 1994. Unfortunately the reality of
Intel’s manufacturing and upgrading processes required some Intel plants to continue producing
defective chips through the first quarter of 1995.25 Thus, it was unclear whether the company could
change all production to the new chip and still meet the estimated demand.26
Accounting for the Loss Contingency
While Intel’s management struggled to determine a return policy, financial analysts were already
attempting to predict the impact on Intel’s financial statements. One analyst put the estimated costs
of a total recall at between $400 million and $800 million, assuming Intel replaced about 8 million
chips, including products sold and chips still in inventory.27 Another analyst suggested that about
one-quarter of Intel’s customers would respond to such a replacement-on-demand policy and that
this would cost the company about $50 million, not including labor.28 The financial community was
closely watching this issue, divided on its importance, and looking to Intel to provide some guidance
on the magnitude of the charge. Further, Intel’s management would have to determine whether this
19Richard B. Schmidt, “Flurry of Lawsuits Filed Against Intel Over Pentium Flaw,” The Wall Street Journal, December 16, 1994,
p. B8.
20Bill Snyder, “The Big Bad Brand; Intel Corp’s $80 million marketing campaign,” PC Week, September 12, 1994, p. A1.
21Laurie Flynn, “The Executive Computer; Intel Looks Beyond the Pentium,” The New York Times, February 26, 1995, p. 15.
22J.J. Lazlo, “Intel Corporation—Company Report,” PaineWebber Inc., January 26, 1995, pp. 7-9; G. Christian Hill, “Computers:
Despite Furor, Most Keep Their Pentium Chips,” The Wall Street Journal, April 13, 1995, p. B1.
23Fahnestock & Co. Inc., “Intel Corporation,” The Wall Street Journal Transcript, pp .113, 676.
24J.J. Lazlo, “Intel Corporation—Company Report,” PaineWebber Inc., January 26, 1995, pp. 7-9.
25Carlton and Kreider Yoder, The Wall Street Journal, December 21, 1994, p. B1
26Ibid.
27Aaron Zitner, “Pentium flaw not expected to damage Intel financially,” The Boston Globe, November 30, 1994, p. B1.
28Zitner, “Consumers get break on computer chip,” The Boston Globe, December 21, 1994, p. 62.
5
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101-072
Accounting for the Intel Pentium Chip Flaw
event was significant enough to warrant filing a form 8-K (frequently called a “current report”) with
the Securities and Exchange Commission.29
Intel’s senior management would have to combine their knowledge regarding Intel’s plans and
expectations with the provisions in Statement of Financial Accounting Standards No. 5 (see Exhibit
5). This standard requires that a charge be recognized in t …
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