Accounting for Toyotas Recalls* According to the U.S. Transportation Department, over the past decade through the end of February,

the number of deaths linked to sudden acceleration in Toyota vehicles has increased to 52.1

Despite a long-term strategy of building quality into their vehicles (Exhibit 1), Toyota ended the first decade of the twenty-first century mired in controversy and legal claims related to allegations of unintended sudden acceleration. In mid-September 2009, Toyota Motor Sales USA ordered its dealers in the United States to inspect floormats in all of their cars after a high- speed traffic accident in late August 2009 killed a California Highway Patrol Officer and three members of his family (Exhibit 2). Unintended acceleration caused by an incorrect or misaligned floormat was suspected. Exhibit 3 summarizes subsequent events. By late September, Toyota urged approximately 4 million Toyota and Lexus owners to remove the drivers side floor mat. About a month later, investigators turned their attention to the design of the accelerator pedal. In a press briefing on November 2, 2009 Toyota Group Vice President and General Manager Bob Carter categorically denied claims like those in [an] ABC News investigation into the situation wherein owners are claiming electrical or mechanical faults led to unintended acceleration.2

On November 16, 2009, Japanese media reported that Toyota had made a deal with the U.S. National Highway Traffic Safety Administration (NHTSA) over a recall. Toyota denied any agreement had been reached, but the company admitted it had already set aside $5.6 billion to deal with the issue.3 By late November 2009, Toyota had recalled over four million vehicles in the U.S. to address the risk that floormats could come loose and trap the accelerator pedal (Exhibit 4).

On January 16, 2010, Toyota notified the NHTSA that accelerator pedals made by its supplier CTS Corp might have a dangerous "sticking" defect. Five days later, Toyota announced a recall of over 2 million vehicles related to sticking pedals (Exhibit 5). Days later, at the urging of the NTHSA, Toyota (i) halted U.S. sales of eight models involved in the recall, including its best- selling Camry and Corolla sedans, and (ii) recalled an additional 1.1 million vehicles due to the

risk that a loose floormat could trap the accelerator in an open position. This added to the recall of 4.2 million vehicles announced in late November 2009.

Financial impact of the recalls

On January 27, 2010, Automotive News estimated that Toyota dealers could lose as much as $1.5 million in profit every week of the sales freeze. Toyota notified NHTSA late in the day that it would expand its late November recall to cover an additional 1.1 million vehicles.

Largely as a result of weeks of bad press, Toyota sales in January 2010 fell 16% from the year earlier to levels not experienced in the prior decade. Toyotas stock price fell approximately 10% overall and about 30% relative to the S&P 500 over the period from early September 2009 through April 2010 (Exhibit 6). In contrast, Ford Motor Companys stock price grew 80% over the same period, suggesting that at least some competitors benefited from Toyotas problems (Exhibit 7).

On March 9, 2010, The Wall Street Journal reported that the financial impact on Toyota could exceed $5 billion over the next fiscal year, including litigation costs, warranty costs, increased marketing and incentive campaigns to countervail the negative publicity surrounding the claims of unintended acceleration. For example, in early 2010, Toyota featured a 0% interest five-year loan offer, competitive lease prices and free maintenance across 80% of its vehicle line-up.4 While Toyota had already estimated a recall cost of about $2 billion (180 billion yen) for the current fiscal year, analysts estimated future costs to be much higher, including J.P. Morgans estimate of $5.5 billion (500 billion yen). Despite having an approximate $29 billion in cash and little debt, ratings agency Fitch placed the company's 'A+' rating on negative watch. Fitch said the recall and sales suspension casts a negative light on Toyota's reputation for quality. A reduction in a company's credit rating can make it more expensive for it to raise money in the debt market.5

On April 19, 2010, Toyota confirmed it would pay a $16.4 million fine by the NHTSA related to delaying the recall of vehicles experiencing sticking accelerator pedals. Toyota denied any wrongdoing but elected to pay the fine, the largest amount allowed under U.S. federal law.

On May 11, 2010, Toyota reported a $1.2 billion profit for the fourth fiscal quarter and $2.2 billion for the fiscal year ended March 31, 2010, despite revealing that it had spent $1.1 billion on recalling 8 million vehicles and had lost about $800 million in sales worldwide. Toyota reported a $233 million operating loss for its North America region down from a $1.9 billion loss in the same quarter of 2009. Management expressed optimism and forecasted net income of $3.4 billion for fiscal 2011.6

Accounting for warranty provisions and contingent liabilities

Throughout the recall crisis, the financial community looked to Toyota management for guidance on the magnitude and duration of its effects. However, Toyotas May 11 announcement of fiscal 2010 financial results was thin on details.

A difficult challenge for any accounting system is reporting events that have important but uncertain outcomes such as the events surrounding the ultimate recall of millions of Toyota and Lexus vehicles in late 2009 and early 2010. Uncertainty related to the recalls included current and future warranty costs, as well as potential litigation settlement costs. Of these costs, past warranty costs are observable and future warranty costs were likely relatively straightforward to forecast. Toyota management knew the number of recalled vehicles, the approximate cost to repair each vehicle and the number of vehicles yet to be repaired. With this information, management estimated incremental warranty expense and the associated liability related to the recalls.

The accounting entry increased warranty expense, which lowered net income for the period, and increased liabilities for the estimated future warranty work. The liability is reduced as repairs are completed.

More difficult to predict were future costs to settle litigation surrounding the accidents and events leading to the recalls. Such predictions tend to be highly subjective and only result in a reported (contingent) liability under certain conditions. Further complicating the situation was that accounting for contingencies under U.S. GAAP was in a state of flux at yearend 2009 and both the U.S. and Japan were discussing the transition to International Financial Reporting Standards (IFRS) and its materially different approach to reporting contingent liabilities (summarized in Exhibit 8).7

At stake was how to report the estimated future implications of Toyotas recalls on the Companys financial statements (or whether to report anything at all). Not surprisingly, different constituencies tended to hold different positions on what the best accounting should be. Preparers and auditors tended to support current U.S. GAAP while consumers of financial data (investors and analysts) tended to be critical of current U.S. GAAP and preferred more disclosure and recognition of uncertain contingent liabilities.

Managements dilemma

As fiscal yearend 2010 approached, Toyota management had an expensive recall campaign under way and was dealing aggressively with public relations challenges.

Toyota and its president, Akio Toyoda, have embarked on a media offensive, after being criticized for its slow response to the burgeoning crisis. Mr. Toyoda last week aimed to rally the troops by speaking in front of thousands of Toyota dealers, suppliers and management. On Monday, he met with Yukio Hatoyama, Japan's prime minister, to discuss his testimony before U.S. Congress and his visit to China.

The car maker also lashed out against ABC News, alleging the broadcaster staged part of a report on Feb. 22 that purported to show electronic problems could cause Toyota vehicles to accelerate unexpectedly.

The attack on ABC was part of what the Japanese car maker has called a broader push to rebut critics and win support for its view that the electronics in its vehicles are not defective.

In addition to the public relations offensive, management had to (i) decide how to report the events of the past six months in its annual report to the companys shareholders, and (ii) determine how reporting might differ if IFRS were used instead of U.S. GAAP,8 and (iii) address the lingering question was how they could have done a better job of responding to the events surrounding the allegations of sudden acceleration.

5. Would investors want Toyota's management to disclose and estimate contingent liabilities associated with sudden acceleration claims? Why or why not