Estimated liability to discharge obligations under product guarantee or warranty may be allowed as per recent judgment of the Supreme court.

[C.A. DEV KUMAR KOTHARI]

Relevant links:

Rotork Controls India (P) Ltd. v. CIT CIVIL APPEAL NOS. 3506-3510 OF 2009 [2009 -TMI - 33420 - SUPREME COURT OF INDIA]

BHARAT EARTH MOVERS v. CIT [2008 -TMI - 5816 - SUPREME Court]

A.P.S. Cold Storage and Ice Factory v. CIT [1979] 119 ITR 709 (All).

Calcutta Co. Ltd. v. CIT [1959] 37 ITR 1 (SC).

Coles Myer Finance Ltd. v. Federal Commissioner of Taxation [1993] 176 CLR 640.

Commercial Union Assurance Co. of Australia Ltd. v. Federal Commissioner of Taxation [1977] 14 ALR 651.

CIT v. Pretty Cycle Industries 1980 -TMI - 36882 - (PUNJAB AND HARYANA High Court)

Federal Commissioner of Taxation v. James Flood Pty Ltd. [1953] 88 CLR 492.

Indian Molasses Co. (Pvt.) Ltd. v. CIT 1959 -TMI - 49589 - (SUPREME Court).

RC v. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 (PC).

Shree Sajjan Mills Ltd. v. CIT [2008 -TMI - 5911 - SUPREME Court]

CIT vs. Vinitec Corpn. (P.) Ltd. 2005 -TMI - 10672 - (DELHI High Court)

CIT v. Indian Transformers Ltd. reported in 2003 -TMI - 10914 - (KERALA High Court) Business aspects relating to guarantee / warranty:

Guarantee on products:

In case of durable products the manufacturer provide guarantee about product for certain period of time after sale or after installation. The guarantee may be for replacement of the product or some parts of product in certain circumstances. There are also some circumstances prescribed in which guarantee is not valid or it loses the contractual force in relation to guarantee. For example if a machine is dismantled by unauthorized person, the manufacturer can deny his obligations under guarantee and warranty.

Warranty on products

When a manufacturer sells a durable item he carrying and/ or warranty for the product sold. The period of guarantee/ warranty depends on the nature of the product, its total useful life and the practices followed by different manufacturers of similar products. Sometimes, on payment of certain extra amount extended warranty is also provided.

Purpose of guarantee/ warranty

The purpose of providing guarantee and / or warranty is to gain confidence of the customers, to provide standard services in relation to the product so that its useful life is maintained. Furthermore, guarantee and/ or warranty also to be provided because the competitors are also providing the same.

There is consideration for guarantee/ warranty

There is definitely a consideration received for providing guarantee and/ or warranty. It is in nature of insurance premium for ensuring free service or replacement of equipment or its parts during the period of warranty. We can also find instances where flexible prices over depending on the period of guarantee/ warranty offered by the manufacturer and accepted by the customer, for example in case of motor cars generally one year's warranty is provided by the manufacturer. However, on payment of consideration for extended warranty, the manufacturer may provide warranty for a longer duration.

Warranty vs. annual maintenance contract (A.M.C.)

During certain period the manufacturers provide free warranty and during that period manufacturer arranges for periodical inspection, cleaning, repairing, maintenance of the equipment. After the warranty period is over the customer can enter into A.M.C. (Annual Maintenance Contract) in force the manufacturers provide free service, sometimes, the A.MC. is including for cost of spare parts etc. sometimes, it may be without spare parts etc, it depends on the terms of A.M.C. What is provided under A.M.C. is similar to what is provided under warranty for A.M.C. certain specific charges are levied whereas in case of warranty some consideration is embedded in the sale value of the product. This comparison of A.M.C. and warranty is made to b ring out the fact that when a product is sold with warranty certain consideration is received in form of sale price and in consideration thereof certain commitments are made.

Accounting for consideration for warranty or obligation under warranty

One can adopt two types of approach as follows:-

A certain part of sale price can be considered as consideration for warranty and that consideration can be spread over the period of warranty at the time of sale such consideration will be considered as in nature of advance. The other method can be to provide for estimated expenses for meeting obligation of manufacturer during the period of warranty. Let us take an example. A machine is priced at Rs.1 lakh. The machine is offered without any warranty for Rs.1 lakh and a price of Rs. 1,10,000/- with one year's warranty, Rs.1,17,000/- for two year's warranty and at Rs.1,35,000/- for three year's warranty. Thus, we find that the consideration for warranty is as follows:-

For one year Rs.10,000/-, for two years Rs.17,000/-, for three years Rs.30,000/-. It can be seen from the above that the warranty charges are not uniform. This is for the reason that the entire amount is received in advance and therefore, there is certain element of interest which the manufacturer gain during the period of warranty. In case of three years, the warranty consideration is higher because the third year may involve more cost in meeting warranty obligation.

Accounting methods in the above example

The manufacturer can credit Rs.1 lakh to sales account and the excess amount as advance for warranty which will be adjusted over the period of warranty as income after considering the possibility of higher cost required to meet warranty obligation.

If the entire amount is taken into sales account then the manufacturer is required to make provision for expenses likely to be incurred over the period of warranty.

Provision for warranty obligation

Estimated liability to meet obligations under warranty during warranty period can be reasonably estimated and that must be estimated and provided if the entire sale value is taken as revenue otherwise in the year of sale the higher amount of income will be shown and in the subsequent period there will be expenses for meeting warranty obligation but there will be no corresponding revenue. Therefore, to ascertain true profit it is essential that either a part of sale value should be taken as advance for warranty obligation or liability for meeting warranty obligation should be provided.

Liability for warranty obligation can be scientifically estimated

During the warranty period periodical visit is made for inspection, cleaning, repair, maintenance etc. for which cost can be reasonably estimated. Cost of special parts likely to be the same can also be reasonably estimated on average basis. For example, a manufacturer of computer can reasonably estimate that certain number of hard discs are likely to crash and the manufacturer will have to replace them. By experience manufacturer can estimate the likely expenditure in replacement of parts during warranty period. Therefore, a properly estimated liability is ascertained liability and it can be allowed. Of course, in due course of time it can be found that in some cases more expenses have been incurred than estimated and in some other cases lower expenses have been incurred because it depends on the intensity with which the customer uses the permit under warranty and also the degree of care adopted by the customer. However, on an average reasonable estimate can be made by the manufacturer.

Guarantee and warrantee obligations arises due to sale of product:

Obligations as to guarantee and warranty arises because sale of a product has taken place with certain assurances about quality, functionality and suitability and durability etc. of the product and its components. Therefore, as soon as sales ( or installation in some cases) take place, the obligations towards guarantee and warrantee starts. Therefore, it can be said that the obligation is arising because of the event of sale of product which has resulted into earning of revenue. Therefore, expenses for meeting obligations under guarantee and warrantee are in relation to sale of product.

Guarantee and warrantee on single product or tailor made products:

In case of tailor made products specifically designed, developed, and manufactured/ fabricated for customers also provision for guarantee / warranty will be allowable. In such cases also the manufacturer can reasonably estimate expenses to be incurred to meet such obligations. This is so because the manufacturer can very well estimate which parts require replacement at certain frequency, how many visits of technicians are required on regular basis and on special calls from customers, what is contingency of break-downs and normal engineering oriented accidents or lapses which may require incurring costs to repair/ replace parts etc. Furthermore, general engineering rules about preventive maintenance and repair and maintenance can be applied even for a new product manufactured for the first time. However, in such cases it is possible and so it is also advisable to negotiate with the customer and fix separately guarantee/ warrantee charges for future years to avoid disputes because based on some observations of the Supreme Court in recent judgment the A.O. may try to say that this decision is applicable only when large number of products are sold and there is long drawn precedence of such expenses having been incurred in past.

Care required:

The estimate should be made on reasonable and scientific basis. All relevant factors like remaining period of guarantee / warranty, distance of customers which may affect costs in discharging such liability, estimated expenses depending on use to which assets are put- like industrial use, commercial use and domestic use, and present value of expenses should be considered while estimating liability. If past data for the same product are available they can be used otherwise data for other similar products can be used. If possible certain published reports in relation to these aspects can also be used. In overall it can be said that the exercise for estimation should be such that any reasonable person can be satisfied about the same.

Excess expenses:

In case in future it is found that the estimate was lower and in fact higher amount has been spent, then such excess spent amount shall be allowed in that year. If in subsequent year events so turn that suggest that for the remaining period of guarantee/ warrantee larger expenses are estimated then what has been provided so far, then a revised estimate can be made and additional provision can be made.

Excessive liability will be income on write back:

In future if it is found that excess provision has been allowed in past and now such excess provision is not required, the same shall be written back and offered as income. 

Recent Judgment of the Supreme Court:

In case of Rotork Controls India (P) Ltd. v. CIT CIVIL APPEAL NOS. 3506-3510 OF 2009 [2009 -TMI - 33420 - SUPREME COURT OF INDIA] decided on MAY 12, 2009 the Supreme court considered and allowed liability for warranty which was estimated in a reasonable basis considering past experience. The Supreme Court considered various aspects including some of those discussed earlier in this article.

Supreme court also considered as to what is a provision? And held that a provision is a liability which can be measured only by using a substantial degree of estimation. A provision is recognized when: (a) an enterprise has a present obligation as a result of a past event; (b) it is probable that an outflow of resources will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision can be recognized.

On issue of liability the Court held that " liability is defined as a present obligation arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

Obligating events leading to liability: The court observed and held on the following lines:

a. A past event that leads to a present obligation is called as an obligating event.

b. The obligating event is an event that creates an obligation which results in an outflow of resources. It is only those obligations arising from past events existing independently of the future conduct of the business of the enterprise that is recognized as provision.

c. there must be not only present obligation but also the probability of an outflow of resources to settle that obligation to make a liability to qualify for recognition as an expenditure or provision fro expenditure.

d. When there are a number of obligations (e.g. product warranties or similar contracts) the probability that an outflow will be required in settlement of those obligations, is determined by considering the said obligations as a whole. In this connection, it may be noted that in the case of a manufacture and sale of one single item the provision for warranty could constitute a contingent liability not entitled to deduction under Section 37 of the said Act. However, when there is manufacture and sale of an army of items running into thousands of units of sophisticated goods, the past event of defects being detected in some of such items leads to a present obligation which results in an enterprise having no alternative to settling that obligation.

e. The appellant assessee has been manufacturing and selling Valve Actuators. They are in the business from assessment years 1983- 84 onwards. Valve Actuators are sophisticated goods. Over the years appellant has been manufacturing Valve Actuators in large numbers. The statistical data indicates that every year some of these manufactured Actuators are found to be defective. The statistical data over the years also indicates that being sophisticated item no customer is prepared to buy Valve Actuator without a warranty. Therefore, warranty became integral part of the sale price of the Valve Actuator(s). In other words, warranty stood attached to the sale price of the product. These aspects are important.

f. Obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the present case, therefore, warranty provision needs to be recognized because the appellant is an enterprise having a present obligation as a result of past events resulting in an outflow of resources.

g. A reliable estimate can be made of the amount of the obligation.

h. In short, in the case of assessee/ appellant all three conditions for recognition of a provision stood satisfied.

i. Product Warranties are subject matter for consideration.

j. Examples of warranty and accounting treatments - the court considered some examples like in case of computers manufacturer or dealer gives warranty for a period of 36 months from the date of supply. The said company considers following options : (a) account for warranty expense in the year in which it is incurred; (b) it makes a provision for warranty only when the customer makes a claim; and (c) it provides for warranty at 2% of turnover of the company based on past experience (historical trend). The first option is unsustainable since it would tantamount to accounting for warranty expenses on cash basis, which is prohibited both under the Companies Act as well as by the Accounting Standards which require accrual concept to be followed. In the present case, the Department is insisting on the first option which, as stated above, is erroneous as it rules out the accrual concept. The second option is also inappropriate since it does not reflect the expected warranty costs in respect of revenue already recognized (accrued). In other words, it is not based on matching concept. Under the matching concept, if revenue is recognized the cost incurred to earn that revenue including warranty costs has to be fully provided for.

k. When Valve Actuators are sold and the warranty costs are an integral part of that sale price then the appellant has to provide for such warranty costs in its account for the relevant year, otherwise the matching concept fails. In such a case the second option is also inappropriate. Under the circumstances, the third option is most appropriate because it fulfills accrual concept as well as the matching concept. For determining an appropriate historical trend, it is important that the company has a proper accounting system for capturing relationship between the nature of the sales, the warranty provisions made and the actual expenses incurred against it subsequently. Thus, the decision on the warranty provision should be based on past experience of the company. A detailed assessment of the warranty provisioning policy is required particularly if the experience suggests that warranty provisions are generally reversed if they remained unutilized at the end of the period prescribed in the warranty. Therefore, the company should scrutinize the historical trend of warranty provisions made and the actual expenses incurred against it. On this basis a sensible estimate should be made. The warranty provision for the products should be based on the estimate at year end of future warranty expenses. Such estimates need reassessment every year. As one reaches close to the end of the warranty period, the probability that the warranty expenses will be incurred is considerably reduced and that should be reflected in the estimation amount. Whether this should be done through a pro rata reversal or otherwise would require assessment of historical trend. If warranty provisions are based on experience and historical trend(s) and if the working is robust then the question of reversal in the subsequent two years, in the above example, may not arise in a significant way. In our view, on the facts and circumstances of this case, provision for warranty is rightly made by the appellant-enterprise because it has incurred a present obligation as a result of past events. There is also an outflow of resources. A reliable estimate of the obligation was also possible. Therefore, the appellant has incurred a liability, on the facts and circumstances of this case, during the relevant assessment year which was entitled to deduction under Section 37 of the 1961 Act. Therefore, all the three conditions for recognizing a liability for the purposes of provisioning stands satisfied in this case. It is important to note that there are four important aspects of provisioning. They are - provisioning which relates to present obligation, it arises out of obligating events, it involves outflow of resources and lastly it involves reliable estimation of obligation. Keeping in mind all the four aspects, we are of the view that the High Court should not have interfered with the decision of the Tribunal in this case.

l. the present value of the contingent liability like the warranty expense, if properly ascertained and discounted on accrued basis, could be an item of deduction under Section 37 of the said Act. As stated above, the principle of estimation of the contingent liability is not the normal rule. As stated above, it would depend on the nature of business, the nature of sales, the nature of the product manufactured and sold and the scientific method of accounting being adopted by the assessee. It will also depend upon the historical trend. It would also depend upon the number of articles produced. As stated above, if it is a case of single item being produced then the principle of estimation of contingent liability on pro rata basis may not apply.

m. In the present case, we have the situation of large number of items being produced. They are sophisticated goods. They are supported by the historical trend, namely, defects being detected in some of the items. The data also indicates that the warranty cost(s) is embedded in the sale price. The data also indicates that the warranty is attached to the sale price. In the circumstances, we hold that the principle laid down by this Court in the case of Metal Box Company of India (supra) will apply. In that case this Court held that contingent liabilities discounted and valued as out-of- necessity could be taken into account as trading expenses if these were capable of being valued. It was further held that an estimated liability even under a gratuity scheme even if it was a contingent liability if properly ascertainable and if its present value stood fairly discounted, was deductible from the gross profits while preparing the P & L Account. In view of this decision it became permissible for an assessee to provide, in his P & L Account,

Present obligation- the court considered and held that we once again reiterate that a liability is a present obligation arising from past events, the settlement of which is expected to result in an outflow of resources and in respect of which a reliable estimate is possible of the amount of obligation.

Thus the Supreme court allowed the appeal of the assessee and its claim for allowability of estimated liability for warranty.

Some other earlier decided cases:

CIT vs. Vinitec Corpn. (P.) Ltd. 2005 -TMI - 10672 - (DELHI High Court)

In this case the assessee made provision for future warranty expenses and claimed the same under mercantile method of accounting. The department considered the same as contingent liability. The Tribunal allowed the provision as ascertained liability against business income. The department challenged the same before the High Court. The High Court dismissed the appeal with the following observations.   

It was not disputed that the warranty clause was part of the sale document and imposed a liability upon the assessee to discharge the obligations under that clause for the period of warranty. It was a liability which was capable of being construed in definite terms which had arisen in the accounting year even though the actual quantification and discharge was deferred to a future date. Once and assessee is maintaining his accounts on the mercantile system, a liability is accrued, though to be discharged at a future date, which would be a proper deduction while working out the profits and gains of his business, regard being had to the accepted principles of commercial practice and accountancy.

There was nothing on record which even could remotely suggest that a change in accountancy system was motivated or was improper. There was also nothing on record to suggest that the provisions made on the accounting year and deduction claimed as business expenditure were unduly exhaustive and were intended to evade taxation.

Therefore, no question of law, much less a substantial question and law, arose for determination in the instant appeal. The appeal of the revenue, thus, was to be dismissed.

The court referred to several judgments on the related aspects including the following:

Mysore Lamp Works Ltd. v. CIT 1990 -TMI - 23300 - (KARNATAKA High Court)

CIT v. Gemini Cashew Sales Corpn. [2008 -TMI - 5019 - SUPREME Court]

 Sheraton Apparels v. Assistant Commissioner 2002 -TMI - 12569 - (BOMBAY High Court)

Shree Sajjan Mills Ltd. v. CIT [2008 -TMI - 5911 - SUPREME Court].

BHARAT EARTH MOVERS v. CIT [2008 -TMI - 5816 - SUPREME Court].

 IRC v. Mitsubishi Motors News Zealand Ltd. [1996] 222 ITR 697 (PC)

While considering the Tribunals order the court found that the Tribunal allowed the assessee's claim for liability against warranty by holding as follows:-

when the assessee sells his goods the warranty clause is part of the sale transaction and therefore is a committed liability by the assessee at the very initial stage of sale. But for prescription of such a warranty clause, the customer may not even buy the product of the assessee. In order to substantiate his claim for the assessment year 2000-01, the assessee had given figures of last five years of warranty liability provided and vis-a-vis to the expenditure incurred.

CIT v. Indian Transformers Ltd. reported in 2003 -TMI - 10914 - (KERALA High Court)

The Supreme Court in BHARAT EARTH MOVERS v. CIT [2008 -TMI - 5816 - SUPREME Court] considered the general principles regarding allowance of business expenditure and the difference between accrued and contingent liabilities. It was held that "if a business liability has definitely arisen in the accounting year, the deduction should be allowed although the liability may have to be quantified and discharged at a future date. What should be certain is the incurring of the liability. It should also be capable of being estimated with reasonable certainty though the actual quantification may not be possible. If these requirements are satisfied the liability is not a contingent one. The liability is in presenti though it will be discharged at a future date. It does not make any difference if the future date on which the liability shall have to be discharged is not certain."

The assessee was a company engaged in the business of manufacture and sale of electrical transformers. In the assessment for the years 1991-92, 1992-93 and 1993-94, the assessee claimed deduction of Rs.3,50,000, Rs.4,01,000 and Rs.4,78,000, respectively, representing provision for after sales services based on the warranty issued at the time of sale of the transformers. The Assessing Officer disallowed the claim and added back the provision mainly on the ground that the provision was made in respect of a contingent liability and not in respect of a definite and ascertained liability. However, the said claim was allowed by the first appellate authority in appeal. The same was confirmed by the Tribunal. The first appellate author8ty noted that during the accounting period relevant to the assessment year 1991-92 itself defects in the transformers supplied were brought to the notice of the assessee and that the second transaction referred to in the appellate order was in respect of ten transformers which failed within a year of operation and which resulted in serious dislocation of production. The BHEL one of the assessee's customers itself had brought this fact to the notice of the chairman of the assessee and requested him to give serious attention to the quality. The Tribunal considered the further fact that the actual expenses incurred for the assessment year 1991-92 was Rs.7,98,958 as against the provision made for Rs.3,50,000. The Tribunal had also noted that the amount of Rs.12,23,381 written back as the provision did not relate to the warranty claim. On appeal to the High Court :

Held, dismissing the appeal, that the two instances of defects came to the notice of the assessee of which one was with respect to ten numbers of transformers sold to BHEL and as per the complaint all the transformers failed within one year of such purchase. This gave a clear picture that a major portion of the transformers sold were defective and therefore a reasonable provision had to be made. The assessee had made a provision of Rs.3,50,000 but the actual expenses incurred for that year was Rs.7,98,958. These circumstances clearly showed that the provision was made on a reasonable basis. The Tribunal had rightly held that the provision made for the three years was based on an ascertained liability and that it could not be treated as a contingent liability.

BHARAT EARTH MOVERS v. CIT [2008 -TMI - 5816 - SUPREME Court] applied.

Cases referred to :

A.P.S. Cold Storage and Ice Factory v. CIT [1979] 119 ITR 709 (All).

Calcutta Co. Ltd. v. CIT [1959] 37 ITR 1 (SC).

Coles Myer Finance Ltd. v. Federal Commissioner of Taxation [1993] 176 CLR 640.

Commercial Union Assurance Co. of Australia Ltd. v. Federal Commissioner of Taxation [1977] 14 ALR 651.

CIT v. Pretty Cycle Industries 1980 -TMI - 36882 - (PUNJAB AND HARYANA High Court).

Federal Commissioner of Taxation v. James Flood Pty Ltd. [1953] 88 CLR 492.

Indian Molasses Co. (Pvt.) Ltd. v. CIT 1959 -TMI - 49589 - (SUPREME Court).

IRC v. Mitsubishi Motors New Zealand Ltd. [1996] 222 ITR 697 (PC).

Shree Sajjan Mills Ltd. v. CIT [2008 -TMI - 5911 - SUPREME Court].

Discussions to this article

[N.C Prabhakar]

The above article is one of the several landmark judgment given by the Apex court and the CBDT should enhance the scope of Sec.37 of the Act by suggesting a suitable amendment either in the ensuing Budget or in the next year's Budget.