Section 1: Background
AS 29 and Ind AS 37 (Provisions, Contingent Liabilities and Contingent Assets) are accounting standards that deals with requirement of warranty valuation.
Manufacturing companies often give warranties at the time of sale to purchasers of its products. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within the pre-defined period of warranty from the date of sale. Example: Electronic manufacturing companies, mobile manufacturing industries etc.
Based on the past experience, it is often probable (i.e. more likely than not) that there will be some claims under the warranties in the future reporting periods. Further, since obligating event (i.e. the sale of the product with a warranty) is a past event, a provision is recognized for the best estimate of the costs of making good under the warranty products sold before the balance sheet date.
Companies often estimate the amount of provision using a frequency and severity approach. In many cases, companies also seek external support to determine the amount of provision required as well as to prepare the disclosures required in financial statements.
In this article, we will highlight the changes to the recognition, measurement and disclosure requirements for companies as they transition from AS 29 to Ind AS 37 (Provisions, Contingent Liabilities and Contingent Assets).
Section 2: Recognition of Warranty Provision
As per para 14 of Ind AS 37 Provisions, Contingent Liabilities and Contingent Assets:
“A provision shall be recognised when:
• an entity has a present obligation (legal or constructive) as a result of a past event;
• it is probable that an outflow of resources embodying economic benefits will be required to
settle the obligation; and
• a reliable estimate can be made of the amount of the obligation.”
The recognition requirements in respect of a provision in AS29 and Ind AS 37 remain the same. However, Ind AS 37 specifically requires provision to be created for constructive obligations if the other criteria for recognition of provision are met. It should be noted that AS 29 does not specifically recognise the concept of constructive obligation although some provisions may be required under AS29 in respect of obligations arising out of normal practice, custom or a desire to maintain good relations or to act in an equitable manner.
Ind AS 37 defines constructive obligation as “an obligation that derives from an entity’s own actions where:
• by an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities; and
• as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.”
Measurement: Ind AS 37 allows discounting, which can make significant difference!
As per para 35 of AS29, “the amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. The amount of a provision should not be discounted to its present value.”
Para 36 of Ind AS 37 also requires that “the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period”. However, para 45, which reads as under, allows the carrying amount of provision to be discounted to allow for the time value of money.
“Where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation.”
The discount rate to be used in determining the present value shall be a pre-tax rate that reflects current market assessment of the time value of money and the risks specific to the liability. The discount rate shall not reflect risks for which future cash flow estimates have been adjusted.
In our view, the major change between AS 29 and Ind AS 37 is the allowance of discounting in Ind AS 37. The same could materially bring down the liability for products with long-term warranties (more than one year) or in case of extended warranties.
Section 3: Disclosures
Majorly the disclosure requirements in both AS29 and Ind AS 37 are similar. However, Ind AS 37 requires that wherever discounting is used, the entity must disclose the increase in the liability amount arising from the passage of time and the effect of any change in the discount rate.
Para 84 of Ind AS 37, which deals with the disclosure requirements, reads as under: “For each class of provision, an entity shall disclose:
• the carrying amount at the beginning and end of the period;
• additional provisions made in the period, including increases to existing provisions;
• amounts used (i.e. incurred and charged against the provision) during the period;
• unused amounts reversed during the period; and
• the increase during the period in the discounted amount arising from the passage of time and
the effect of any change in the discount rate.”
Point (e) above is the additional disclosure requirement under Ind AS 37. Points (a) to (d) are the same
as in case of AS29.
The warranty valuation report includes:
• A brief description of the nature of the obligation and the expected timing of any resulting outflows of economic benefits;
• An indication of the uncertainties about the amount or timing of those outflows
• Claims data received from the company and analysis done on it
• Valuation Methodology
• Valuation results
Disclaimer: This above note is based on knowledge sharing information. The information should not be relied upon as advice on your specific circumstances. Neither Mithras Consultants nor any person connected with it accepts any liability arising from the use of this document. The above note is not providing any recommendations.
