Imagine playing a game of football on a hill. There's no doubt the team going downhill will win. This is hardly a level playing field. Now imagine that an auditor requests that a company book something that its competitor does not book. In fact, this is going on as we speak! Some warranty providers are required to book a warranty goodwill liability, whereas others are not.
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Warranty goodwill represents payments for claims that are not covered by a product's formal warranty coverage. This would include payments on perils specifically excluded from the warranty policy and payments made after the warranty expires. Warranty goodwill is often overlooked. In fact, some companies are unable to track whether a claim is in or out of warranty.
Warranty goodwill payments typically occur to maintain customer satisfaction and brand loyalty. Theoretically, this action offers the warranty provider a benefit in the form of increased future earnings, or franchise value, which is not captured in the balance sheet.
Many argue that warranty goodwill is discretionary and should not be booked. At any time, the warranty provider can pull the plug. Others argue that prior activity has set a precedent and warranty goodwill should be booked. Inclusion or exclusion of warranty goodwill could significantly affect financial statements, as it could represent 5 percent to 30 percent of the total warranty liability.
The inconsistency in treatment of warranty goodwill liability lies in the interpretation and application of U.S. GAAP. Accounting Standards Codification 450, Contingencies, from the Financial Accounting Standards Board, defines a warranty as "an obligation incurred in connection with the sale of goods or services that may require further performance by the seller after the sale has taken place." Given the definition of a warranty, what must be booked for this obligation?
U.S. GAAP defines a liability as a probable future sacrifice. Further, a firm would be constructively obliged if an established pattern of past practice exists that has created a valid expectation, and the practice does not have to be legally enforceable. This would seem to imply that warranty goodwill should be booked as a liability, but warranties are specifically identified as a contingency in ASC 450.
In ASC 450, contingencies are defined to involve uncertainty as to possible gain or loss when one or more future events either occur or fail to occur. An estimated loss from a contingency will be accrued as a charge to income if two conditions are met:
The liability has already occurred prior to issuance of the financial statements; and,
The amount of loss is estimable.
Given this U.S. GAAP guidance, the first condition is easily met, whereas the second condition is much more challenging. Is the amount of warranty goodwill loss estimable? And if so, how should it be estimated?
The warranty goodwill liability can be more difficult to estimate than the standard warranty liability. The first step in making any estimate is to understand the available data. Often, the data integrity for warranty goodwill is suspect. Some companies do not have a reliable process to identify claims as warranty goodwill.
Another complication is that a change in policy can drastically affect future payments. Estimating standard warranty liability can itself be complicated by a multitude of factors other than simple product failure, such as consumer behavior and seasonality. Warranty goodwill, though, is also affected by the behavior of the warranty provider.
Traditional actuarial methods rely on the past as a predictor of the future. If past behavior is expected to continue in the future, traditional triangular methods could be used. A change in behavior, though, would require a different approach.
For example, a provider may decide to reduce its grace period from six months to three months. A valid approach in this instance would be to estimate a payment pattern based on the historical warranty goodwill data and cut the pattern after three months, therefore reducing the amount of liability for warranty goodwill. Whatever the case, the actuary should use judgment as to whether the amount of goodwill is estimable.
In general, warranty goodwill will represent a greater portion of the total warranty unpaid claim liability than it does of the ultimate warranty costs. A majority of warranty goodwill payments are made after the standard warranty expires. If the warranty goodwill payments are made later than the standard warranty payments, the warranty goodwill will represent a greater portion of that unpaid amount than on a cost-per-unit basis.
Current accounting standards do not explicitly address warranty goodwill and have led to different interpretations. Definitive standards should be laid out. Is warranty goodwill a contingency? What is the standard by which losses are deemed estimable?
As indicated above, warranty goodwill can be 5-30 percent of the total warranty liability and could significantly impact financial statements. It is time to level the playing field. Uniform standards should be applied to enable sound decision-making.
Michael Paczolt, FCAS, MAAA, is a consulting actuary with the Chicago office of actuarial and consulting firm Milliman (www.milliman.com).