Here's A Simple Explanation Of How Tesla's New Warranty Policy Affects Earnings

Aug. 17, 2014 8:37 AM ETTesla, Inc. (TSLA)127 Comments
Chris Umiastowski profile picture
Chris Umiastowski
39 Followers

Summary

  • Tesla updated its Model S drive unit warranty.
  • I've estimated the cost impact of this for Q3 and in future quarters.
  • I believe the cost to be immaterial to the long term future of the company, and that Tesla has made the right decision for both customers and shareholders.

Friday afternoon Tesla (NASDAQ:TSLA) announced an improvement to the warranty it offers on the Model S electric sedan. All cars ever sold will retroactively get an 8-year warranty on the drive unit.

This is great for customers, but it does open the door to questions from shareholders. Is this an expensive extra perk going forward? How will this affect the next quarter's financials? Aside from the near-term financial impact, was this a smart move for Tesla?

Elon Musk, in his blog post revealing this change, has written, "This will have a moderately negative effect on Tesla earnings in the short term." While those with a solid accounting background will understand exactly what this means, the mainstream media does not. So I'd like to offer a simple explanation of what's happening and how it affects the financial statements.

Here's how the accounting works:

When Tesla sells a car to a customer they book revenue based upon the selling price. They also record expenses related to building, delivering and servicing the car during the warranty period. These expenses are charged to the "cost of good sold" (COGS) line on the income statement. Gross margin, measured in percent, is what is left over between the sale price and the COGS.

Most of the COGS line pertains to actually building the car. A smaller dollar amount represents Tesla's estimate of how much it will cost to service the car under warranty during the warranty period. Tesla charges this warranty amount to the income statement with each car sold, and simultaneously creates an accrued liability (warranty reserve) on the balance sheet.

In other words, some of Tesla's cash has been earmarked for warranty repairs. Based on 10Q filings from the first half of fiscal 2014, Tesla sets aside about $2,700 per car for future warranty work.

This article was written by

Chris Umiastowski profile picture
39 Followers
Chris Umiastowski spent over a decade as a sell-side technology analyst before leaving the industry in 2011. He was consistently ranked as a Top Gun analyst in Canada by Brendan Wood International. Mr. Umiastowski believes investors can earn market beating returns by thinking beyond next quarter and focusing on long term winners. He is also the growth investor for the Globe and Mail's Strategy Lab project.

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