The Dilemma between Quality Reputation and Risk Prevention: Warranty Provisions of Car Manufacturers

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Chapter 2.3, Provision versus Accrual:

Outstanding obligations of a company which will have to be paid in the future mean a certain risk for the liquidity of a business if the amount or time of the obligation is unknown. Due to that reason a provision or accrual can be created which serves as a type of reserve for an obligation in a future period. But the important difference to an actual reserve is that the amount of the provision and the accrual become a part of the liabilities. The reserve is considered part of the assets.
In the annual report, the provision for warranty or guarantee is, according to the International Accounting Standards (IAS) 37.10, part of 'uncertain obligations' but accruals are shown in 'other liabilities' together with the accruals for pensions and tax payments. Literature shows that the definition of accrual and provision is not always easily discernable. According to IAS 37.11, an accrual is used for future debits, the occurrence of which is almost confirmed and is comparable to the Statement of Financial Accounting Standards (SFAS) 5 which requests a probability of 80 % - 90 %. An example for the accrual is the payment of personnel debits as vacation allowance or Christmas bonuses. Also, pending invoices for material already received from suppliers are mentioned as accruals because the uncertainty is very low.
Differing from the accrual, the provision is used for future obligations which are less probable in regards to period and amount. According to the International Financial Reporting Standards (IFRS) 'probable' means a probability of more than 50 %, 'possible' if the risk is lower or equal to 50 % and 'remote' if it is not very probable. IAS 37 says 'more likely than not' and means a mathematical-statistical probability of more than 50 %. The United States - Generally Accepted Accounting Principles (U.S.-GAAP) only mention 'probable' as required for the creation of a provision. The probability 'more likely than not' for provisions seems to be more adequate in regards to liabilities for warranty and guarantee due to the reason that it is very difficult to predict if a component in the car will fail during the period of warranty or guarantee. The prediction of a certain quality issue depends on statistical calculations under consideration of the technical specification of a component or system and a variety of other influences. Environmental influences like temperature or road conditions affect the reliability as well as influences of the individual driver and traffic situations. The Standard 3.2 of the German Association of the Automotive Industry (VDA) shows statistics of the usage which certain components in a car undergo during the lifetime of the car. For example, the standardized frequency a car´s driver door is used is double that of the passenger door usage. That the components of the driver´s door fail earlier than the components of the passenger´s doors can be statistically proven. But due to the reason that the failure statistics of components often show a stochastic behavior, that means failures occur randomly, long term experiences help to predict the expected warranty costs. Detailed explanations in regards to the statistical prediction of the reliability are shown in chapter 4.3.
In order to build a provision which reduces the profit and also the tax payments of a company, the probability of a warranty outflow of resources has to be calculated and documented. A stringent documentation of these calculations is of major importance because it can be reviewed by the tax authorities and auditors and has to be compliant with legal requirements. Building a provision is requested by local and international law and accounting standards and can differ from country to country in regards to the definitions.
If the provision is not completely used or the reason for the provision no longer exists, the provision has to be reversed partly or completely and will increase the profit of the company at this moment. This adaption of the provision has to be carried out frequently or at least at the change of the fiscal year which is the closing day of the annual report.
2.4 General Warranty Provision versus Specific Warranty Provision:

The general warranty provision is mainly based on historical data of the OEMs warranty payments and utilization of warranty provisions during the previous years. The general provision can be characterized as a short term provision which is created during the fiscal year, will be due in the actual fiscal year and was considered in the budget planning process. It is based on past experiences and reflects the calculated forecast of warranty and guarantee costs which will probably happen due to sporadic failures of components in the vehicles within the warranty or guarantee period. These general provisions are a feasible indicator for the quality level of the OEMs production processes and quality management performance and should show a decreasing trend which, in turn indicates improvement of the quality. According to ISO/TS 16949, which is the worldwide accepted quality management certification standard for car OEMs and automotive suppliers, one of the most important tasks of the company is to maintain a quality management system which assures a continuous improvement of the processes in order to guarantee customer satisfaction and to reduce costs.
Looking to the increasing trend of field recalls in Germany, it seems like the OEMs, which request a continuous improvement also from their tier one component suppliers, have problems increasing the quality level of the complete vehicle as a system of many components delivered by different suppliers. The peak of recalls in Germany was reached in 2011. Since 1998, recalls in Germany have increased from 55 documented recalls to 186 documented recalls in 2011. The worldwide number of car recalls also shows an increase in this time frame. The Center of Automotive Management (CAM) published in August 2013 that recalls increased by 230 % compared to the previous year.
The impact of these recalls on the warranty provisions is mainly considered in specific provisions due to the reason that major quality issues cannot be covered by the general provision due to the high unplanned cost risk. The specific provision is built immediately after the detection of the quality issue. These costs can be caused by recalls due to safety aspects or for the preventative protection of the quality reputation. In a recall, all vehicles which could be affected by a certain quality issue are called back to the dealers in order to repair or exchange the suspected faulty component. Also costs for potential law suits due to quality issues or safety related incidents can be considered in the specific warranty provision. The specific provision is not planned. The quality issue cannot be foreseen but the provision will remain accrued until the issue is solved or the potential risk is not probable anymore. If the risk will be present beyond the current fiscal year, a long term provision is created. Annual reports show that some OEMs separate the provision for recalls from the general warranty provision and some OEMs show them together. The analysis of annual reports in chapter 5 takes a deeper look at these practices.
IAS 37.39 also allows the combination of the general provision with the specific provision. Also § 240 HGB allows the estimation of different obligations into one group provision if they are considered similar in their reason.
General Provision and Specific Provision might be called differently in the companies analyzed. An average warranty cost level exists and has to be considered in the provisions, something both have in common. If major quality issues are detected which were not predictable, additional provisions are built within the fiscal year, which are related to the specific incidents. The cost risk of these incidents has to be evaluated and documented.
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