Warranty Fraud

Ask any accountant and you’ll learn that an automobile warranty expense is properly categorized as part of the cost of making the vehicle.

• Yet since at least 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.
• Tesla’s own legal counsel admits the company has a policy of classifying warranty-covered repairs as goodwill.

Despite the marked improvement in the overall quality of automobile manufacture 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.  Like other automakers, and in accordance with sound accounting principles, Tesla (TSLA) books its warranty reserve against “Cost of Revenues.”

The question explored here is whether Tesla is accurately booking its warranty costs. Our contention is that, no, it is understating 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.

When a customer brings a car in for service or repairs, Tesla books the work primarily to either (A) customer pay (which becomes revenue in “Services and other” on the income statement); (B) 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 (C) a marketing category under the income statement’s “Operating expenses”.

Now for an example:

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 is 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. In Tesla’s case, the inflation of gross margin is on top of other accounting practices that significantly inflate Tesla’s claimed gross margins.

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. The issue is in the timing of when those costs get allocated.  Manufacturers are supposed to reserve for the whole warranty expense upfront, but because Tesla misclassifies warranty expenses as goodwill they are able to push those expenses out to the time of repair.   As long as they are growing, current period income is overstated, and at all times, cumulative net income is overstated.

So, what is the evidence that Tesla is misclassifying some warranty expenses as goodwill? That evidence found in many of the pending lawsuits.

Tesla Inc. (TSLA), its SolarCity subsidiary, and its CEO face hundreds of lawsuits. The legal research website, 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.

Most 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 evidence in all the instances cited later in this article is publicly available.)

The Tesla invoices often show warranty work being booked not as “warranty,” but rather under “goodwill” and other non-warranty expense categories that fall into the “Operating expenses” category on the 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 shows that a mobile service visit for non-functioning keys & 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 where Tesla classified repairing problem windows, doors, and air-conditioning as goodwill rather than warranty.

A third example, in a case called Belani v. Tesla, we see Tesla classifying the cost of fixing non-functional seatbelts as goodwill rather than warranty:

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

There are seven cases available at the PlainSite that include a 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 is a coincidence, it is an extraordinary coincidence.

Consider also the problem of the yellowing touchscreens. By July 2019, it had become evident that “Tesla’s most unique feature continues to be one of its biggest headaches, as customers await touchscreen fixes”.

Customers Revolt As Fix For Tesla’s Touchscreen “Yellow Band” Problem Remains Elusive

In the conclusion to my upcoming book LUDICROUS: The Unvarnished Story Of Tesla Motors, I note that Tesla’s giant touchscreen symbolizes the divergent perspectives on the most fought-over automaker in recent memory.

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