Tesla's Warranty Reserve

[The Accountant]

If you don't have time to read this post in its entirety, skip to the Auditing the Warranty Reserve Section
I write this post to address allegations by Tesla bears that there is fraud with Tesla's Warranty Accounting.
The allegations are nonsense and I am confident that the Tesla's Warranty Reserve is fairly stated as audited by PwC
Warranty reserves are required for Tesla Autos and Energy products but in this post, I will use Tesla Auto in examples.

Background
Tesla provides a limited warranty on new vehicles of 4 years/50,000 miles and for the battery and drive unit - 8 years/100k-150k miles (depending on model), whichever comes first. When a vehicle is sold, Tesla needs to expense expected warranty costs upfront.

Computing the Warranty Reserve
To determine what amount to record as warranty expense at the time of sale, Tesla uses warranty claims history. These numbers are estimated and used for illustrative purposed only. Past Claims per Car may look as follows:

Although the repairs and cash outlay will occur over 8 years, Tesla records $1,500 per car at the time of the sale. They do this by setting up a reserve of $1,500. Since $1,500 has all been recorded in Year 1, future charges (e.g. $500 in year 2) does not impact the income statement in Year 2 as it is charged against the reserve that was set up in Year 1. So Tesla has a charge of $1,500 in year one and nothing thereafter (assuming the $1,500 estimate is good).

The Goodwill Allegation
If a repair does not fall under the warranty policy, a Service Center may do the work free of charge to keep a customer happy. This is a Goodwill repair. Although Goodwill repairs hit expense, they do so in the year incurred and not reserved for at the time of sale. This is proper accounting. The allegation from some claiming fraud is that Tesla is coding warranty work as goodwill to lower the reserve required at the date of sale.

Here is an example with amounts that are for illustrative purposes (not actual).
If the cash outlays in years 1-8 are as follows......

....then the impact to the income statement is as follows:

As you can see, Warranty expenses are all recorded in year 1 but the Goodwill expenses get recorded as incurred.
The people shouting fraud are stating that many of the Goodwill charges are really Warranty expenses (mis-coded) and should be charged in year 1 (thereby understating expenses in year 1).

Auditing the Warranty Reserve
There are a number of steps performed in auditing the Warranty Reserve but one audit step addresses the Goodwill claim. Auditors will review data to ensure all and only warranty claims data have been accounted for. Since there are thousands of transactions, it is not unlikely for there to be a few miscoding errors. If PwC found some repairs coded as goodwill rather than warranty, it is likely that it was addressed in one of the following ways:
- the miscoding was not material enough to change the reserve and allowed for a clean Audit Opinion to be issued.
- the miscoding was quantified and Tesla adjusted its warranty reserve in the published financial statements.
- the miscoding is already accounted for in Tesla's warranty reserve calculation (adding additional expense to account for miscoding).

The reason we can feel comfortable that PwC has done a thorough job at auditing the warranty reserve is because they told us. It is written right in their Audit Opinion Letter in the 2019 10K (see page 64 of 10K). They actually bring in professionals with specialized skills in this area to audit the Warranty Reserve.

They wrote something similar for Ford (who they also audit):

 

[ByeByeJohnny]

Great summary.

At what point could Tesla book some of that warranty money as profit or loss? Do they wait 8 years to see what the actual result is or is there a checkpoint every year? Using your example numbers would using only $500 instead of $700 the first year free up $200 after year 1 or would they need to wait until after year 8 and the car loosing warranty?

The 2012 model S should start coming out of warranty this year. Are there any indications of how those have done?

Would it be likely correct to assume that Tesla may have had a much larger $ value for warranties on earlier models and this is then lowered as they have some historical numbers? In the early years this would have included a lot of 'guesstimations' seeing that no one had historical numbers from electric cars. If that's the case there should be some 'profit' coming from this for years to come.

From the auditors notes Tesla has $1,089 million and Ford has $5,702 million set aside as of Dec 31, 2019. Ford has sold much more than 5x the number of cars over the last 8 years. This seems to indicate that Tesla is reserving a much higher number per car and might therefor have much higher warranty costs per car. Is there any other explanation?

Of course the warranty cost might also have gone up although that just seems less likely.

Has there been discussions about this anywhere? Any of the usual suspects including this in forecasts?

 

[AlMc]

This would be a good post to 'pin' @Right_Said_Fred

 

[The Accountant]

Great summary.

At what point could Tesla book some of that warranty money as profit or loss? Do they wait 8 years to see what the actual result is or is there a checkpoint every year? Using your example numbers would using only $500 instead of $700 the first year free up $200 after year 1 or would they need to wait until after year 8 and the car loosing warranty?

The 2012 model S should start coming out of warranty this year. Are there any indications of how those have done?

Would it be likely correct to assume that Tesla may have had a much larger $ value for warranties on earlier models and this is then lowered as they have some historical numbers? In the early years this would have including a lot of 'guesstimations' seeing that no one had historical numbers from electric cars. If that's the case there should be some 'profit' coming from this for years to come.

Of course the warranty cost might also have gone up although that just seems less likely.

Has there been discussions about this anywhere? Any of the usual suspects including this in forecasts?

I believe Tesla reexamines their claims history every year and makes adjustments. In 2019 they reduced the reserve by $36m (benefiting income) and in 2018 they increased expense $26m (reducing income ...maybe model 3 issues?).

The cost of warranty per vehicle has been dropping. This caculation is crude as it does not consider Tesla Energy, but if you take the warranty expense (provision) in each year and divide it by the number of cars sold, warranty expense dropped from $2,202 per car in 2018 to $1,511 iin 2019. This may be due to the fact that Model 3s have lower warranty costs than MS and MX and that quality is improving overall.

 

[traxila]

If you don't have time to read this post in its entirety, skip to the Auditing the Warranty Reserve Section
I write this post to address allegations by Tesla bears that there is fraud with Tesla's Warranty Accounting.
The allegations are nonsense and I am confident that the Tesla's Warranty Reserve is fairly stated as audited by PwC
Warranty reserves are required for Tesla Autos and Energy products but in this post, I will use Tesla Auto in examples.

Background
Tesla provides a limited warranty on new vehicles of 4 years/50,000 miles and for the battery and drive unit - 8 years/100k-150k miles (depending on model), whichever comes first. When a vehicle is sold, Tesla needs to expense expected warranty costs upfront.

Computing the Warranty Reserve
To determine what amount to record as warranty expense at the time of sale, Tesla uses warranty claims history. These numbers are estimated and used for illustrative purposed only. Past Claims per Car may look as follows:
View attachment 563329

Although the repairs and cash outlay will occur over 8 years, Tesla records $1,500 per car at the time of the sale. They do this by setting up a reserve of $1,500. Since $1,500 has all been recorded in Year 1, future charges (e.g. $500 in year 2) does not impact the income statement in Year 2 as it is charged against the reserve that was set up in Year 1. So Tesla has a charge of $1,500 in year one and nothing thereafter (assuming the $1,500 estimate is good).

The Goodwill Allegation
If a repair does not fall under the warranty policy, a Service Center may do the work free of charge to keep a customer happy. This is a Goodwill repair. Although Goodwill repairs hit expense, they do so in the year incurred and not reserved for at the time of sale. This is proper accounting. The allegation from some claiming fraud is that Tesla is coding warranty work as goodwill to lower the reserve required at the date of sale.

Here is an example with amounts that are for illustrative purposes (not actual).
If the cash outlays in years 1-8 are as follows......

View attachment 563338

....then the impact to the income statement is as follows:
View attachment 563331

As you can see, Warranty expenses are all recorded in year 1 but the Goodwill expenses get recorded as incurred.
The people shouting fraud are stating that many of the Goodwill charges are really Warranty expenses (mis-coded) and should be charged in year 1 (thereby understating expenses in year 1).

Auditing the Warranty Reserve
There are a number of steps performed in auditing the Warranty Reserve but one audit step addresses the Goodwill claim. Auditors will review data to ensure all and only warranty claims data have been accounted for. Since there are thousands of transactions, it is not unlikely for there to be a few miscoding errors. If PwC found some repairs coded as goodwill rather than warranty, it is likely that it was addressed in one of the following ways:
- the miscoding was not material enough to change the reserve and allowed for a clean Audit Opinion to be issued.
- the miscoding was quantified and Tesla adjusted its warranty reserve in the published financial statements.
- the miscoding is already accounted for in Tesla's warranty reserve calculation (adding additional expense to account for miscoding).

The reason we can feel comfortable that PwC has done a thorough job at auditing the warranty reserve is because they told us. It is written right in their Audit Opinion Letter in the 2019 10K (see page 64 of 10K). They actually bring in professionals with specialized skills in this area to audit the Warranty Reserve.
View attachment 563332
They wrote something similar for Ford (who they also audit):

View attachment 563334

You are great.

Thank you!

 

[kalefranz]

@The Accountant
Thanks so much for sharing and the time you put into this (and all of your other contributions here). Always so helpful and educational.

 

[mrbulk]

According to this article Tesla now has over a half $Billion$ in its warranty reserve which is multiple times more than other comparable car mfrs.

Tesla [TSLA] Has A Warranty Accounting Mystery

 

[The Accountant]

According to this article Tesla now has over a half $Billion$ in its warranty reserve which is multiple times more than other comparable car mfrs.

Tesla [TSLA] Has A Warranty Accounting Mystery

Yes, good point - the article actually states that Tesla has $1B in Warranty Reserves and if it is over-stated by 50%, it would bring $500m to profits.
It is possible the Reserve is overstated because Telsa does not have good 8 year claim data (too young of a company).
If the reserve is overstated, my guess is that Tesla brings it back to income a little at a time as they develop more claims experience. Maybe we will see $50m per year taken back to income over time.

 

[NoBeard]

And MAYBE, let's say you were in a quarter where you just needed a little push to get you into profitability to get you into the S&P500, you COULD do an audit and find that there's a spare lets say $1 more than what is needed to get into profitable territory in the reserves. One could pull a little cash out, ensuring S&P500 membership, which likely would push the shares into territory where a small release of new shares would allow one to return some money into the warranty reserve if required. My long TSLA shares would be just fine with that too. Just sayin' Elon, if you needed an idea.

 

[mrbulk]

And MAYBE, let's say you were in a quarter where you just needed a little push to get you into profitability to get you into the S&P500, you COULD do an audit and find that there's a spare lets say $1 more than what is needed to get into profitable territory in the reserves. One could pull a little cash out, ensuring S&P500 membership, which likely would push the shares into territory where a small release of new shares would allow one to return some money into the warranty reserve if required. My long TSLA shares would be just fine with that too. Just sayin' Elon, if you needed an idea.

My thoughts exactly.

 

[FrankSG]

Thanks so much for this! I learned a lot about a topic I knew very little about.

I assume warranty provisions are accounted for on the income statement as part of the CoGS of a vehicle?

 

[The Accountant]

Thanks so much for this! I learned a lot about a topic I knew very little about.

I assume warranty provisions are accounted for on the income statement as part of the CoGS of a vehicle?

Yes - that's correct.

 

[vikings123]

The cost of warranty per vehicle has been dropping. This caculation is crude as it does not consider Tesla Energy, but if you take the warranty expense (provision) in each year and divide it by the number of cars sold, warranty expense dropped from $2,202 per car in 2018 to $1,511 iin 2019. This may be due to the fact that Model 3s have lower warranty costs than MS and MX and that quality is improving overall.

Great informative post. It’s tough to deny that short sellers make important contributions to the market. I would never have learned about this topic if they had not brought it up even though in this case they are barking up the wrong tree.

Do you know if body shop repairs for paint issues or panel gap issues are covered as warranty? I do believe this was a major expense in 2019 for model 3 and likely a major expense for model Y in 2020. Like you said we should see warranty expense go down as overall quality improves. Thanks.

 

[byan1232]

If you don't have time to read this post in its entirety, skip to the Auditing the Warranty Reserve Section
I write this post to address allegations by Tesla bears that there is fraud with Tesla's Warranty Accounting.
The allegations are nonsense and I am confident that the Tesla's Warranty Reserve is fairly stated as audited by PwC
Warranty reserves are required for Tesla Autos and Energy products but in this post, I will use Tesla Auto in examples.

Background
Tesla provides a limited warranty on new vehicles of 4 years/50,000 miles and for the battery and drive unit - 8 years/100k-150k miles (depending on model), whichever comes first. When a vehicle is sold, Tesla needs to expense expected warranty costs upfront.

Computing the Warranty Reserve
To determine what amount to record as warranty expense at the time of sale, Tesla uses warranty claims history. These numbers are estimated and used for illustrative purposed only. Past Claims per Car may look as follows:
View attachment 563329

Although the repairs and cash outlay will occur over 8 years, Tesla records $1,500 per car at the time of the sale. They do this by setting up a reserve of $1,500. Since $1,500 has all been recorded in Year 1, future charges (e.g. $500 in year 2) does not impact the income statement in Year 2 as it is charged against the reserve that was set up in Year 1. So Tesla has a charge of $1,500 in year one and nothing thereafter (assuming the $1,500 estimate is good).

The Goodwill Allegation
If a repair does not fall under the warranty policy, a Service Center may do the work free of charge to keep a customer happy. This is a Goodwill repair. Although Goodwill repairs hit expense, they do so in the year incurred and not reserved for at the time of sale. This is proper accounting. The allegation from some claiming fraud is that Tesla is coding warranty work as goodwill to lower the reserve required at the date of sale.

Here is an example with amounts that are for illustrative purposes (not actual).
If the cash outlays in years 1-8 are as follows......

View attachment 563338

....then the impact to the income statement is as follows:
View attachment 563331

As you can see, Warranty expenses are all recorded in year 1 but the Goodwill expenses get recorded as incurred.
The people shouting fraud are stating that many of the Goodwill charges are really Warranty expenses (mis-coded) and should be charged in year 1 (thereby understating expenses in year 1).

Auditing the Warranty Reserve
There are a number of steps performed in auditing the Warranty Reserve but one audit step addresses the Goodwill claim. Auditors will review data to ensure all and only warranty claims data have been accounted for. Since there are thousands of transactions, it is not unlikely for there to be a few miscoding errors. If PwC found some repairs coded as goodwill rather than warranty, it is likely that it was addressed in one of the following ways:
- the miscoding was not material enough to change the reserve and allowed for a clean Audit Opinion to be issued.
- the miscoding was quantified and Tesla adjusted its warranty reserve in the published financial statements.
- the miscoding is already accounted for in Tesla's warranty reserve calculation (adding additional expense to account for miscoding).

The reason we can feel comfortable that PwC has done a thorough job at auditing the warranty reserve is because they told us. It is written right in their Audit Opinion Letter in the 2019 10K (see page 64 of 10K). They actually bring in professionals with specialized skills in this area to audit the Warranty Reserve.
View attachment 563332
They wrote something similar for Ford (who they also audit):

View attachment 563334

Thanks for the summary! Very helpful.

I do have one question. If the bears are saying Tesla has overstated its warranty reserves, wouldn't that mean Tesla's net income is actually understanding, meaning earnings per share should actually be higher than reported? That is a positive for the company...

Or are bears saying Tesla's actual true costs are higher therefore should be recording a greater upfront warranty expense. Ultimately, this means Tesla's net income is overstated (implying EPS is over stated as well)?

Thanks everyone!

 

[The Accountant]

Do you know if body shop repairs for paint issues or panel gap issues are covered as warranty? I do believe this was a major expense in 2019 for model 3 and likely a major expense for model Y in 2020

Yes - Paint issues and panel gaps would be covered in the warranty reserve.

 

[The Accountant]

Thanks for the summary! Very helpful.

I do have one question. If the bears are saying Tesla has overstated its warranty reserves, wouldn't that mean Tesla's net income is actually understanding, meaning earnings per share should actually be higher than reported? That is a positive for the company...

Or are bears saying Tesla's actual true costs are higher therefore should be recording a greater upfront warranty expense. Ultimately, this means Tesla's net income is overstated (implying EPS is over stated as well)?

Thanks everyone!

Your 2nd point is correct. The bears are saying that the warranty expense upfront should be higher and that net income in year 1 is overstated.

 

[jbcarioca]

To add a bit of context, there is an industry periodical named, oddly enough Warranty Week:
The link below is to their June 2020 Sola and EV report. That graphs the improving results of Tesla as @The Accountant has so usefully reported:
Solar & EV Warranty Report, 18 June 2020
In context this also demonstrates how the initial Tesla actuarial assumptions have been generally very conservative. FWIW, I have been told by authoritative sources that the initial Model S assumptions were built from the Mercedes S class as a base because so many Model S components (both A/C's, switchgear, suspension, both air and conventional, etc) came from the S Class. That happened because Tesla at that time could not independently source parts on attractive terms. Using that as a base the actuaries added for unique features such as batteries, BMS and deep software management systems. Since that had never before been done the actuaries were very concerned. They had no precedent, so assumed the worst. They really could not have done otherwise.

 

[jbcarioca]

Continuing Warranty Week data:
U.S. Auto Warranty Metrics, 5 March 2020
The most notable part is summarized in this chart:
American Auto Manufacturers
Warranty Claims Rates
(as a percentage of sales, 2003-2019)

Just for context, these data are the actual cost of claims, not accruals or adjustments. FWIW, by definition this category includes 'goodwill' and 'lemon law' items. Actual claims data is the only public category that is not subject to judgement or distinction between accounting treatment of reserves vs direct expense.

Just in case anybody anywhere represents Tesla quality control as generally deficient, these data prove otherwise. For all the bleating and complaining we all do here, these data are definitive proof that, in context to GM and Ford at minimum, Tesla is doing an outstanding job and is improving over time. When looking at this chart in context of known Tesla events one can see what might be Model S introduction woes with drivetrain and titanium shield for batteries and the FWD problems. Despite those events it is notable that since 2011Tesla had had better results than did Gm and Ford even though Tesla generally has been quite generous with warranty treatment.

For any of us who might be seriously anal compulsive, Warranty Week manufacturer databases are for sale cheaply, $25 each. That includes many suppliers also, so one can also see how many vehicle problems are actually paid by them. That is relevant because Tesla is the most integrated major vehicle manufacturer, so Tesla warranty costs cover more of the actual total warranty costs than they do for other OEMs. That point is almost always ignored but it can be, and often is, material. Think airbags, BMW early iDrive, ZF early 8-speed transmissions and many more, which ended out with very low actual direct costs to OEM's. Tesla has the airbag issue, the recent battery connector issue and a handful of others, probably, but fewer than have less integrated OEMs.

 

[The Accountant]

Continuing Warranty Week data:
U.S. Auto Warranty Metrics, 5 March 2020
The most notable part is summarized in this chart:
American Auto Manufacturers
Warranty Claims Rates
(as a percentage of sales, 2003-2019)

Just for context, these data are the actual cost of claims, not accruals or adjustments. FWIW, by definition this category includes 'goodwill' and 'lemon law' items. Actual claims data is the only public category that is not subject to judgement or distinction between accounting treatment of reserves vs direct expense.

Just in case anybody anywhere represents Tesla quality control as generally deficient, these data prove otherwise. For all the bleating and complaining we all do here, these data are definitive proof that, in context to GM and Ford at minimum, Tesla is doing an outstanding job and is improving over time. When looking at this chart in context of known Tesla events one can see what might be Model S introduction woes with drivetrain and titanium shield for batteries and the FWD problems. Despite those events it is notable that since 2011Tesla had had better results than did Gm and Ford even though Tesla generally has been quite generous with warranty treatment.

For any of us who might be seriously anal compulsive, Warranty Week manufacturer databases are for sale cheaply, $25 each. That includes many suppliers also, so one can also see how many vehicle problems are actually paid by them. That is relevant because Tesla is the most integrated major vehicle manufacturer, so Tesla warranty costs cover more of the actual total warranty costs than they do for other OEMs. That point is almost always ignored but it can be, and often is, material. Think airbags, BMW early iDrive, ZF early 8-speed transmissions and many more, which ended out with very low actual direct costs to OEM's. Tesla has the airbag issue, the recent battery connector issue and a handful of others, probably, but fewer than have less integrated OEMs.

@jbcarioca - with your knowledge of the OEM Dealership Network I would be interested to hear your comments about the potential benefits of Tesla's vertical integration on reducing warranty costs.

Two things come to mind:
- When an OEM dealership performs a warranty repair, they will charge the dealership's hourly rate for repairs (which I assume includes a profit mark-up) while Telsa just has the cost of labor. As an example, Telsa may incur $40/hr while Ford $50/hr. True?
- Also , I wonder how prevalent warranty fraud is within the dealership model. I have heard many times "while we're changing your oil, we'll be replacing xyz....don't worry, it's under warranty". In other words, Dealerships are on the lookout for warranty repairs (perhaps needed or not) to keep there shops busy whereas Tesla Service Centers have no incentive to do this. True?

 

[CyberShy]

It is true. dealerships make money on warranty repairs. It’s really no different than if the consumer paid. They don’t do it for no cost. The OEM pays for that work. Dealers LOVE warranty work.