Warranty claims: A hidden financial risk for auto suppliers

Product recalls by Toyota and GM for vehicle safety issues have dominated recent news headlines.  Underlying these (and all) recalls is the burden of a continuing vehicle problem, which can present itself in warranty claims to the OEM and component suppliers of the vehicle.  While warranty claims haven’t traditionally been the “hot” topic for discussion in the automotive industry, they’ll garner much more attention in the future.  On top of the current recalls, the automotive industry is scrambling to handle a record number of new vehicle launches over the next five years, with increasing risks of future product problems emerging in recalls and warranty claims.  For any supplier, these risks have the potential to result in significant financial liabilities that were unforeseen when the part was originally designed, produced, and sold.

Understanding the financial complexities of warranty data

Calculating the financial liabilities of recalls or warranties may involve thousands, even millions, of parts, sometimes from years earlier. Supplier financial responsibilities for each component affected become difficult to track to the root cause of the problem and, many times, accurate product data just isn’t available.  This difficulty in analyzing historical product information has resulted in many OEMs simplifying warranty cost and sharing as 50/50—even when it’s not clear that the supplier has any responsibility for the problem!

When assessing costs resulting from recalls and warranty claims, there are a multitude of charges that can result. Suppliers need to be aware of the potential “flow down” impact of OEM cost claims that may include:

• Repair costs incurred for non-eligible parts, as part of a “goodwill” response by the OEM or dealer to their customers.
• Conditional parts from other suppliers that are necessary to adequately complete repairs for the components under recall or warranty.
• Excessive labor and use of parts incurred in the repair, which may occur due to increased time or higher labor rates used for the recall or warranty repair (versus standard measures).
• Duplicate repairs for recall or warranties showing up in costs claimed by the OEM. These have typically been found in warranty and recall data due to duplicate data being entered in databases or when multiple repairs occur on multiple parts, creating confusion in the data being entered.

When cost inaccuracies show up in the recall or warranty claims, the simplifying cost-sharing agreements can become much more expensive than expected.  Compounding the difficulties in identifying accurate information on recalls and warranties is the inconsistency among OEMs in their procedures for tracking product information as well as inconsistencies in their supplier procedures and agreements.

Guidance for accounting & financial reporting

There’s significant debate among suppliers regarding the requirements for reporting potential costs of recalls and warranties.  At the time of production and sale, it may be recognized as a cost that may occur in the future.  Consequently, the following accounting standards apply to recall and warranty claims:

• For U.S. GAAP (generally accepted accounting principles), ASC 450 and ASC 460
• For IFRS (international financial reporting standards), Standard #37

When it comes to financial statement recognition, suppliers should record a warranty loss when (1) it’s probable a claim has been incurred as of the reporting date and (2) the amount of loss can be reasonably estimated. These costs are generally recorded at the time of sale based on historical defect rates; changes in estimates are recognized prospectively in future period results. 

All OEMs have established policies for warranty reserves based on the estimated future financial liability of the sale of current vehicles, typically based on statistical analysis of historical vehicle performance.  Because of the potential financial impact from an OEM recall or warranty, many suppliers have also begun to establish warranty reserves in current-year financial statements with the expressed concern about the risks from an OEM recall or warranty claim.

Warranty obligations of suppliers

When estimating your warranty obligations, the specific costs to be considered should include the replacement part or parts, shipping and handling, labor, testing, sorting and containment services, data analysis and tracking, and potentially other incremental costs. It’s important to recognize the “landscape” of your warranty obligations to cost effectively work through the recall or warranty, especially in the areas of:

• Understanding OEM (or supplier) contract terms and business practices.
• Accessing relevant product data, including the histories of vehicle and component performance, industrywide data and trends (including National Highway Traffic Safety Administration information as needed), internal product information, and the results of preproduction tests (OEM and supplier).
• Using information systems capabilities (especially for data segmentation). The information required includes tracking frequency and severity (cost) by product time in field, estimated time lag in occurrence, statistical analysis of product data, and actuarial (or arithmetic) calculations of future costs.
• Communicating frequently and effectively with your customer, whether OEM or supplier.

Evaluating your capabilities for capturing the required product and financial information to manage your warranty obligations is a critical internal work activity.  In working with suppliers, we’ve recognized warranty information management practices in three broad categories:

1. Basic
   Total accumulated losses by product type, in-service date, and warranty term.
2. Better
   Cost per unit by product type, in-service date, and warranty term.
3. Best
   Frequency of occurrence and cost by product type, in-service date, and warranty term.

The financial auditor perspective

There are a number of financial reporting items to consider when accounting for warranty claims including the timing of recognition, current versus noncurrent balance sheet classification, income statement classification, and accounting and presentation of cost recoveries from suppliers and insurance policies.  From an auditor’s perspective, it’s important for the company to:

• Know its information system capabilities, including product, business and financial reporting.
• Communicate frequently and consistently with customers, especially to establish processes, procedures, and expectations before issues may arise (i.e., coordination with quality, engineering, customer support, accounting, etc.). 
• Document the process and data used to ensure warranty obligations have been properly identified and quantified.

The extra effort expended by suppliers to be more disciplined in gathering and analyzing data regarding product issues will serve well in protecting the company’s financial interests during a recall or warranty claim process. Generally, it will lead to fewer surprises in reported results. 

In conclusion

Lack of accurate information is one of the biggest challenges in figuring out the “real” cost of product recalls and warranty claims.  They can be difficult to track, and it’s challenging to estimate the potential financial exposure.  There are so many complexities in the various company and product responsibilities, and such a large volume of information through which to sift, that suppliers often feel overwhelmed by the task.  Hence the widespread use of broad-cost sharing agreements that aren’t based on detailed claims analysis.

However, in today’s safety-conscious environment, the cost of warranties to suppliers is growing dramatically.  For more information on the financial considerations inherent in warranty claims and opportunities to improve the process, give us a call.