Warranties – Example on recognising and measuring provisions
The Case: Product warranties
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On the basis of experience, it is probable (ie more likely than not) that there will be some claims under the warranties.
Considerations Product warranties
Present obligation as a result of a past obligating event—the obligating event is the sale of the product with a warranty, which gives rise to a legal obligation.
An outflow of resources embodying economic benefits in settlement—probable for the warranties as a whole.
Conclusion—the entity recognises a provision for the best estimate of the costs of making good under the warranty products sold before the reporting date.
Illustration of calculations:
In 20X0, goods are sold for CU1,000,000. Experience indicates that 90 per cent of products sold require no warranty repairs; 6 per cent of products sold require minor repairs costing 30 per cent of the sale price; and 4 per cent of products sold require major repairs or replacement costing 70 per cent of sale price. Consequently, estimated warranty costs are:
The expenditures for warranty repairs and replacements for products sold in 20X0 are expected to be made 60 per cent in 20X1, 30 per cent in 20X2, and 10 per cent in 20X3, in each case at the end of the period. Because the estimated cash flows already reflect the probabilities of the cash outflows, and assuming there are no other risks or uncertainties that must be reflected, to determine the present value of those cash flows the entity uses a ‘risk-free’ discount rate based on government bonds with the same term as the expected cash outflows (6 per cent for one-year bonds and 7 per cent for two-year and three-year bonds).
Calculation of the present value, at the end of 20X0, of the estimated cash flows related to the warranties for products sold in 20X0 is as follows:
The entity will recognise a warranty obligation of CU41,846 at the end of 20X0 for products sold in 20X0.
Just to provide the right frame for the case here is a short background of the key features of IAS 37 needed to understand the provisioning for a refunds policy.
Key definitions [IAS 37 10]
Provision: a liability of uncertain timing or amount. Refunds policy
- present obligation as a result of past events Refunds policy
- settlement is expected to result in an outflow of resources (payment) Refunds policy
- a possible obligation depending on whether some uncertain future event occurs, or Refunds policy
- a present obligation but payment is not probable or the amount cannot be measured reliably Refunds policy
Recognition of a provision
An entity must recognise a provision if, and only if: [IAS 37 14] Refunds policy
- a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event), Refunds policy
- payment is probable (‘more likely than not’), and Refunds policy
- the amount can be estimated reliably. Refunds policy
An obligating event is an event that creates a legal or constructive obligation and, therefore, results in an entity having no realistic alternative but to settle the obligation. [IAS 37 10]
A constructive obligation arises if past practice creates a valid expectation on the part of a third party, for example, a retail store that has a long-standing policy of allowing customers to return merchandise within, say, a 30-day period. [IAS 37 10] Refunds policy
A possible obligation (a contingent liability) is disclosed but not accrued. However, disclosure is not required if payment is remote. [IAS 37 86] Refunds policy
In rare cases, for example in a lawsuit, it may not be clear whether an entity has a present obligation. In those cases, a past event is deemed to give rise to a present obligation if, taking account of all available evidence, it is more likely than not that a present obligation exists at the balance sheet date. A provision should be recognised for that present obligation if the other recognition criteria described above are met. If it is more likely than not that no present obligation exists, the entity should disclose a contingent liability, unless the possibility of an outflow of resources is remote. [IAS 37 15]
All of the entities in the examples have 31 December as their reporting date. In all cases, it is assumed that a reliable estimate can be made of any outflows expected. In some examples the circumstances described may have resulted in impairment of the assets; this aspect is not dealt with in the examples. References to ‘best estimate’ are to the present value amount, when the effect of the time value of money is material.
See also: The IFRS Foundation