View 1
Paragraph
11 and 14 of Accounting Standard (AS) 29, ‘Provisions, Contingent
Liabilities and Contingent Assets’, states as follows:
“11. An
obligation is a duty or responsibility to act or perform in a certain
way. Obligations may be legally enforceable as a consequence of a
binding contract or statutory requirement. Obligations also arise from
normal business practice, custom and a desire to maintain good business
relations or act in an equitable manner.”
“14. A provision should be recognised when:
(a) an enterprise has a present obligation as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits 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 should be recognised.”
In
the extant case, let us further assume that the contractor is bound to
rectify, rework and compensate any defects, short supplies, operational
problems of the individual equipment already supplied/ work already done
under construction contracts. In other words, the contractual
obligation in respect of warranty coexists from the date of first supply
and not from the date of completion of contract. Thus, there exists a
contractual/customary present obligation in respect of warranty service,
which will require out-flow of resources embodying economic benefits to
settle the obligation. Therefore a provision in respect of warranty
service should be recognised.
As far as timing of recognition of
provision is concerned, the following relevant paragraphs 15, 16 and 21
of AS 7, are reproduced below:
“15. Contract costs should comprise:
(a) costs that relate directly to the specific contract; …
16. Costs that relate directly to a specific contract include: …
(g) the estimated costs of rectification and guarantee work, including expected warranty costs; and …”
“21.
When the outcome of a construction contract can be estimated reliably,
contract revenue and contract costs associated with the construction
contract should be recognised as revenue and expenses respectively by
reference to the stage of completion of the contract activity at the
reporting date. …”
Based on the above, it may be argued that the
estimated warranty cost is a contract cost which is directly related to
the specific contract. When the outcome of a construction contract can
be estimated reliably, contract revenue and contract costs associated
with the construction contract should be recognised as revenue and
expenses respectively by reference to the stage of completion of the
contract activity at the balance sheet date. Accordingly, following the
percentage of completion method, the contract costs, including provision
for expected warranty costs should be recognised by reference to stage
of completion of the contract activity at the reporting date. Thus, the
present obligation in respect of contractual warranty as per the
provisions of AS 29 arises from the performance of a contract activity
in respect of which contract cost is recognised even during the progress
of the contract and as such, the proportionate warranty cost can be
included as ‘cost incurred’ to determine the stage of completion for
recognition of revenue as per the principles of AS 7.
This view
is also aligned to the current practice with respect to sale of goods
which contains a warranty obligation. The current practice is to
recognise the entire revenue when the goods are sold, and make a
provision with respect to warranty costs.
View 2
It
is questionable whether the warranty on the project commences as each
equipment in the project is installed. Generally the warranty is on the
entire project, and it commences on the handover of the project to the
customer. The activities involved in ensuring that the equipments are in
working condition during the construction of the project are more in
the nature of a project activity rather than a warranty activity. If
this be the case, then the warranty provisions and the corresponding
revenue would be recognised at the end of Year 2. Therefore the only
difference in view 1 and 2 is the timing of the recognition of the
warranty provisions and the corresponding revenue.
View 3
Paragraph
26 of AS 7 states as follows, “A contractor may have incurred contract
costs that relate to future activity on the contract. Such contract
costs are recognised as an asset provided it is probable that they will
be recovered. Such costs represent an amount due from the customer and
are often classified as contract work in progress”.
Since the
warranty activity is a future activity, any provision for the
contractual obligation on the warranty should also be correspondingly
recognised as an asset. However, no revenues/costs are recognised when
the contract is in progress with regards to warranty. Once the project
is commissioned and the warranty commences, revenue and cost with
respect to warranty is recognised. For sake of simplicity, the margins
on the contract activity and warranty activity in the above example have
been maintained at the same level. However, in practice the margins may
differ.
Conclusion
The author believes that each of the above views may be tenable under current Indian accounting standards.
