They Break It, You Buy It

Recent impacts of accounting for warranties on industrial company earnings

Companies typically issue warranties with new products under which they agree to fix or replace a product in the event it fails before the end of the warranty period. This leaves the company with a potential future obligation which it must account for at the time of the sale.  The company must estimate the amount of any potential future obligation by taking into consideration how likely it is the item will need repair/replacement. It must also estimate the total cost of honoring the warranty which will include labor, material, and part costs. These estimates may change over time as actual product performance proves to be different than expected or costs to replace are impacted by items such as unanticipated inflation. Often, if a company has an unexpected problem with a product (think Ford Pinto), the company may treat the increase in expected costs as a one-time event and present adjusted earnings without it.

Factors impacting warranties can be complex and require close examination of footnote details to look for any unusual trends in expenses, claims, or sudden adjustments to previously established accruals. Expenses that don’t track sales growth, payments on claims regularly exceeding expenses for new warranties, or unexplained reductions in previously established warranty accruals should be questioned.

Johnson Controls (JCI) is a good example of how changes in warranty assumptions can have a material impact on results. The following table shows the provision for new warranties, settlements paid, and changes in assumptions on existing warranties for the last eight quarters:

Assumption changes are netted with provisions for new warranties to determine warranty expense in a given quarter. The last quarter saw an $11 million reduction in the reserve from changes in estimates for existing warranties after the prior quarter had a $10 million increase from estimate changes. That looks very odd to us because they both represent the largest recent moves the company has made from changing estimates. Sequentially, total warranty expense dropped from $40 million to $24 million – which added 1.8 cents to EPS. On a y/y basis, it was the same- a drop from $40 million. JCI hit earnings forecasts in June 2023 even with the $40 million in expense. However, the company missed estimates in the last quarter by 2 cents and the miss would have been twice as large without the tailwind from the unusually low warranty expense.

We looked at the warranty disclosures of 70 industrial companies in search of similar impacts. In most cases, movement in accruals expense was less than a penny per share. However, we noted four cases where recent earnings were either materially boosted or penalized by unusual changes in warranty-related items.

Let’s get Behind the Numbers…