Tesla Warranty Expense: A Case Of Goodwill By The Auditors

Dec. 23, 2019 11:18 AM ETTesla, Inc. (TSLA)725 Comments86 Likes
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Montana Skeptic
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Summary

  • Ask any accountant and you’ll learn that automobile warranty expense is properly categorized as part of the cost of selling the vehicle.
  • Yet since Q2 of 2018, Tesla in many instances has allocated warranty expense to “Goodwill” and other non-warranty expense categories.
  • Why does that matter? Because it inflates both Tesla’s claimed gross margin and its reported net income.
  • A trove of documentation from lawsuits against Tesla suggests the misallocation is pervasive.
  • How do I know so much about warranty? I don't. I've collaborated on this with Twitter's Luis Carruthers (@orthereaboot), who gathered the data and did the analysis.

Our Guest Author

Today’s piece is based on the research of Luis Carruthers (not his real name), who at Twitter posts as @orthereaboot. If you want to learn more about his education, background, and experience, tune in to Volume 2 of TC’s Chartcast, which you can easily find at Apple Podcasts, Spotify, PodBean, and several other podcast sites.

If you think Luis and I have made some errors on the warranty issues, feel free to let us know in the comments.

As I send this through the cyber tubes to Seeking Alpha, Bill Cunningham has written his own article about Tesla (NASDAQ:TSLA) warranty issues, focusing on some different facets than Luis and I cover here. Bill has allowed me to take a pre-publication peek, and as usual it’s superb and original work. I’ll link to Bill’s article as soon as I see it published. [Update: here it is.]

Warranty Costs and the Warranty Reserve

Perfection eludes most human activities, and manufacturing cars is no exception. Despite the remarkable improvement in the overall quality of automobiles in recent years, every automaker must deal with warranty issues from problems arising with flaws in design or manufacture.

For this reason, when selling a particular model, the automaker creates a warranty reserve equal to the automaker’s estimate of the average cost of the warranty work that car will require while under warranty. The automaker classifies the warranty reserve as a cost of making the car, which is sound and sensible because the cost of honoring the warranty, even if it will be incurred in future periods, is every bit as much a cost of the car as are parts and labor.

Like other automakers, and in accordance with sound accounting principles, Tesla books its warranty reserve against “Cost of revenues” on its income statement. Tesla’s SEC filings explain this process in clear terms:

We accrue a warranty reserve for the products sold by us, which includes our best estimate of the projected costs to repair or replace items under warranties and recalls when identified. These estimates are based on actual claims incurred to date and an estimate of the nature, frequency and costs of future claims. These estimates are inherently uncertain given our relatively short history of sales, and changes to our historical or projected warranty experience may cause material changes to the warranty reserve in the future.

(Source: Tesla’s 10-Q for Q3 2019)

As time marches forward and the automaker acquires actual warranty cost data, it can adjust the reserve upward or downward depending on the experience to date. Again, Tesla’s SEC filings provide a concise explanation:

We accrue a warranty reserve for the products sold by us, which includes our best estimate of the projected costs to repair or replace items under warranties and recalls when identified. These estimates are based on actual claims incurred to date and an estimate of the nature, frequency and costs of future claims. These estimates are inherently uncertain given our relatively short history of sales, and changes to our historical or projected warranty experience may cause material changes to the warranty reserve in the future.

(Tesla does not accrue a warranty reserve on its leased cars, but rather books the warranty costs as incurred. Bill Cunningham touched upon this in a recent – and superb – article on Tesla leasing. Like Bill, I find Tesla’s practice reasonable and appropriate.)

The question explored here is whether Tesla is accurately booking its warranty costs. Luis and I contend Tesla understates those warranty costs. It does so by classifying many expenses that should properly fall under warranty as, instead, goodwill. That has two important consequences. First, it exaggerates Tesla’s (already inflated) gross margin. Second, it results in Tesla overstating its net income in both the current quarter and in subsequent near-term quarters.

Let’s first touch upon Tesla reliability issues that create significant warranty expense. Then, we’ll explore how misclassifying warranty expenses results in inflating gross profit. After that, we’ll look at how the misclassification inflates net income. Finally, we’ll examine the evidence that Tesla is indeed misclassifying warranty expenses, and that such misclassification is pervasive.

Tesla’s Reliability Issues – “I love the car, but…”

While every automaker faces warranty problems resulting from defects, Tesla has had more such problems than most. For a while, Consumer Reports struck from its “Recommended” list the Tesla Model S and Model 3, citing issues including stuck latches, malfunctioning doors, paint and trim issues, and problems with power features such as cruise control, cameras, and warning lights.

As for the Model X:

Tesla’s other vehicle, the Model X SUV, still isn’t recommended. Model X owners reported numerous problems, ranging from its balky falcon-wing doors (that open vertically) to noises and leaks, and it has worse-than-average reliability,

In-car electronics continues to be a weakness in the Model X, as well as in the 3 and S. Tesla owners continue to report problems with the displays, including the screens freezing or suddenly going blank with the car in motion. Some owners report random rebooting of the systems…

So, while Tesla owners certainly love their cars, urgent pleas on social media from Tesla owners tweeting directly at Elon Musk for help with service issues show the downside of reliability issues – the cars’ need frequent repairs. Twitter and other social forums are replete with examples; this is a tiny sampling:

A ‘Goodwill’ Misclassification Inflates Gross Margin.

When a customer brings a car in for service or repairs, Tesla books the work primarily to either (1) customer pay (which becomes revenue in “Services and other” on the income statement), (2) warranty expense (which has no income statement effect, but is deducted from the existing warranty reserve on the balance sheet in either accrued liabilities or long-term liabilities), or (3) goodwill or some other marketing category under “Operating Expenses” on the income statement.

(In this context, “goodwill” means Tesla has performed the service free of charge; this type of goodwill expense has no relationship to balance sheet “goodwill,” which in simplest terms is an accounting entry for what’s left over after the determinable value of assets purchased is deducted from the purchase price.)

Given that Tesla frequently uses social media for marketing and understandably likes to cultivate influencers, it’s not unreasonable to expect that Tesla will from time to time repair, for no charge, problems that may not otherwise be covered under warranty. When that happens, the satisfied customer drives off with their detailed service record noting a so-called “goodwill” repair.

Tesla can perform all of the goodwill repair work it wants – that’s a business decision. But if the repair should have been covered under warranty, and is instead booked to an Operating Expenses category, then it becomes an accounting issue affecting gross margin.

Why is that? Let’s illustrate with an example. For simplicity, let’s assume every car a manufacturer makes is an “average” car needing exactly the average amount of warranty expense in the warranty reserve over its warranty lifetime.

Let’s assume that upon selling a car, the manufacturer creates a warranty reserve of $1,000 to cover estimated warranty expenses over a five-year warranty period. In each of Years 1 and 2, though, the car requires warranty repairs costing $500. If the manufacturer accounts for this as warranty work, its warranty reserve is exhausted with three years yet to run. The manufacturer must increase the warranty reserve. In other words, it must go back to the income statement to adjust upwards its “Cost of revenues” for “Automotive sales.” That results in a reduction of current period Gross Profit and, by definition, a lower gross margin.

What if the manufacturer instead decides to categorize all or part of the $1,000 repair as “goodwill?” That's still an expense, reducing current period income. However, because the expense now falls under “Operating expenses” rather than “Cost of revenues,” the “Gross profit” number remains the same, and gross margin is artificially inflated. (And, relative to the calculation used by other automakers, Tesla’s gross margin already is materially inflated for reasons that have been amply documented, including here and here.)

A "Goodwill" Misclassification Also Inflates Net Income.

A misclassification of warranty repair causes an overstatement not simply of gross margin but also of net income on the income statement’s bottom line.

At first blush, that seems counterintuitive: Whether classified under a Cost of Revenues or Operating Expenses, the cost falls to the bottom line. Here’s the catch, though.

If an auto manufacturer classifies half of what should be warranty expenses as goodwill, then the warranty reserve will equal the warranty expense, but the goodwill costs will be incurred over the warranty period instead of at the time of sale. In other words, the “Cost of revenues” will be understated during the current period and other near-term periods.

An example helps make this clear. For simplicity, let’s assume a five-year warranty period, with annual sales in Years 1 and 2 approximately equal to Tesla's 2018 and 2019 sales (but not leases), and annual sales in Years 3, 4, and 5 reflecting sales growth of 50,000 cars per year.

Let's also assume every sale happens on the final day of the year, total warranty expenses per car of $1,000, and total goodwill expenses per car of $1,000, both spread evenly over the warranty period. (Bill Cunningham hypothesizes there is actually a “bathtub” curve at work, with the highest warranty costs in the first and final warranty years, and I find his hypothesis plausible, but wish to keep our example simple.)

The table lays out the result. Both gross margin and net income are inflated by amounts that are, to say the least, material.

Are those the actual numbers at work with Tesla? No. We simply don't know the magnitude of the actual numbers. The point, though, is that allocating significant warranty costs to goodwill can easily result in a material inflation of both Gross Profit and Net Income.

Lemon Law Claims Furnish Evidence of Misclassifications

So, where's the evidence that Tesla is misclassifying some warranty expenses as goodwill? It's found in many of the pending lawsuits.

Tesla, its SolarCity subsidiary, and its CEO face hundreds of lawsuits. The Twitter site, www.PlainSite.org, compiles pleadings from some of those lawsuits:

The PlainSite compilation significantly understates the actual number of lawsuits because PlainSite lacks access to cases in many international courts and in some state courts in the U.S. as well.

Many of the pending lawsuits are so called “lemon law” claims by individual car purchasers. The pleadings and attachments reveal important information on internal Tesla accounting practices. (In some instances, the service records are not included in the legal pleadings, but are instead available on social media forums.)

The Tesla invoices often show warranty work being booked not as warranty, but rather under goodwill and other non-warranty categories that fall under Operating Expenses on Tesla’s income statement. We can determine that these vehicles were warranty eligible both because the lawsuit states the vehicle’s purchase date and because details about the service records show non-warranty repairs alongside repairs that the records describe as covered by warranty.

Let’s go through a few examples. In a New Jersey case called Salvage v. Tesla, the documentation records a mobile service visit for non-functioning keys and other problems, all of which would plainly appear to be covered by warranty. However, on the service record, all those charges are classified as goodwill:

Here’s an example from Henry v. Tesla, a lawsuit filed in California, where Tesla classified repairing problem windows, doors, and air-conditioning as goodwill rather than warranty.

A third example, from another New Jersey case, Belani v. Tesla, shows Tesla classifying the cost of fixing non-functional seatbelts as goodwill rather than warranty:

The Misclassifications Appears To Be Pervasive

What suggests that the misclassification of warranty expense as goodwill is pervasive?

There are seven cases available at the PlainSite that include the full service history for the vehicles that are the subjects of the lawsuits:

Each one of those seven service histories show instances of material misclassification of warranty expenses as goodwill. If that's a coincidence, it's an extraordinary coincidence.

Consider also the problem of the yellowing touchscreens. By last July, it had become evident that “Tesla's most unique feature continues to be one of its biggest headaches, as customers await touchscreen fixes.”

As Edward Niedermeyer’s article details, significant controversy exists about how the problem can be remedied. Tesla acknowledges the problem falls under its warranty and is offering a so-called ultraviolet light treatment as the fix. However, in several cases that have gone to arbitration, the arbitrators have ruled that Tesla’s warranty requires that it replace the defective screens, which is considerably more costly.

To date, how has Tesla classified the cost of fixing this widespread problem that it acknowledges is covered by warranty? The only available evidence indicates Tesla is billing the cost to goodwill:

(Screenshot of Tesla repair record posted on social media)

Indeed, there is evidence from a posting at the TMC forum that Tesla is fighting hard for the goodwill classification:

Tesla's explanation is a something of a dog chasing its tail. Tesla will perform its ultraviolet screen repair, but only if the car is still under warranty or under an Extended Service Agreement (ESA). However, the customer should regard the repair not as a warranty repair, but rather as a “goodwill gesture.” And yet, such goodwill gestures are unavailable to customers whose cars are out of warranty with no ESA.

Here in a complaint to the Attorney General of the State of Ohio (which you can find in its totality here) is another example of Tesla’s determination to book some warranty repairs as goodwill:

Let's close out the evidence with this remarkable exchange (both parts of which can be found here) that includes correspondence from a lawyer (in red type) for Tesla:

To my readers who are auditors and accountants, I ask this: Can you review this evidence, and see Tesla's stance about how to classify these repair expenses, and not develop more than a bit of heartburn? If Tesla were your audit client, would you not wish to pose some very hard questions to its management?

Implications and Notes

Tesla has been misclassifying warranty expense for nearly two years. The practice appears to be pervasive and may materially impact the financials by inflating the much-watched reported gross profit number (which also happens to be an important metric in Musk’s compensation award). It also may result in materially overstating net income.

Plainly, this is an issue on which Tesla’s auditors could fruitfully devote some attention. And, this topic would make for a useful line of inquiry during Tesla’s quarterly conference calls.

Of course, the fact that Tesla's very modest Q3 profit may well be, in large part, a mirage, simply does not matter right now. Two weeks ago, I warned that this stock was crazy dangerous to short right now. I hope you paid attention.

Why is the stock up so much in the past several months? To my way of thinking, there’s no good reason, though there are plenty of pumpalicious delicacies floating about, such as Jim Cramer’s recent paean. I thought what Cramer said was largely nonsense, but that’s for another day.

Right now, we’re seeing what’s become a Tesla tradition: An astonishing last-minute delivery push in the final days of the quarter. I expect Tesla to meet or slightly exceed its low-end guidance (360,000 deliveries). For any other auto company, meeting low-end guidance would be bearish. For Tesla fans, it likely will be a cause for celebration.

More from me soon about what to expect from the Q4 financials and in the year ahead. For now, though, the stock remains a hugely dangerous short.

A further note: There are more than 1,700 comments at my most recent article. Many were kind words of welcome back, which were much appreciated. Some were the usual flack and scorn from the usual suspects. But there also were some truly insightful comments from some bears. I appreciate those comments, even if I was unable to respond to all of them.

Finally, on Dec. 12, I was honored to be the inaugural guest on TC’s Chartcast. Tesla Charts and his engaging sidekick, Georgia Orwell, asked thoughtful questions, and I thought we had an interesting conversation. Largely about Tesla, of course. You can find that podcast at the first link in this article.

Correction & Comment (12/23/19)

In the article, I wrote that Tesla's gross profit number "also happens to be an important metric in Musk’s compensation award." As @doggydogworld has pointed out, that is wrong. Musk's compensation is in part based upon EBITDA, but not gross profit. I appreciate the correction and apologize for the error.

Also, as several commenters have pointed out, I have no proof that just because the Tesla service records indicate a repair is goodwill, the accountants book it as an Operating Expense instead of as warranty (Cost of Revenues).

It is possible the accountants ignore what is shown on service records when classifying the expenses, and it's plausible that the insistence on labeling some items as goodwill on service records may be to avoid setting a precedent that Tesla is obligated to cover certain issues (such as the yellowing screens) under warranty. But I wonder how the accountants are supposed to know how to book the expenses if not by reference to the service records. Tesla can, of course, clear this up by advising about its accounting policies, and if I hear from Tesla, I will post it here.

Further Note (later on 12/23/19)

I retract my correction. As @T-Rail Investor noted in the comments, Musk's compensation under the 2012 options grant is tied to gross margin. (Further, Jerome Guillen and J.B. Straubel have options tied to gross margin under a 2014 grant). Moreover, inflating net income would obviously bear directly on the EBITDA calculation, which is what governs some of Musk's options under the most recent grant.

Technical Correction (12/27/19)

After reviewing the comments of @Mark_A and @Bill Cunningham, I agree that, to be technically correct, first summary point should have said that the warranty reserve is part of the cost of "selling" rather than "making" an automobile. Elsewhere in the article, I made clear that the warranty reserve is a cost of selling ("For this reason, when selling a particular model, the automaker creates a warranty reserve equal to the automaker’s estimate of the average cost of the warranty work that car will require while under warranty.")

Whether called a cost of making the car or a cost of selling it, the warranty reserve is, for Tesla and other automakers, categorized under "Cost of revenues" (COGS) while goodwill is categorized as "Operating expenses" (SG&A) on the income statement. And that, of course, is the fundamental point.

This article was written by

Montana Skeptic profile picture
9.45K Followers
I have a J.D. degree from Yale Law School, practiced for 30 years as a trial lawyer in commercial cases, and in the decade that followed managed a $1B+ portfolio for a family office. I have recently retired and am free to write about whatever I want. And so I will.The fellow in my icon is Galileo Galilei, who famously said: Eppur si muove.I say, less famously: Time is the only reliable solvent of folly.
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Disclosure: I am/we are short TSLA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Montana Skeptic is short Tesla via long-dated call spreads. He regards shorting Tesla as exceptionally risky at this time.

Luis Carruthers, directly and via entities in whole or in part controlled by or beneficially owned by him, has a variety of Tesla equity, debt & derivative positions. He is overall net short Tesla and long SpaceX.

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