[ Rotork Controls India P. Ltd. v. CIT, (2009) 314
ITR 62 (SC)]
The appellant-company sold valve actuators. The bulk of the
sales was to BHEL. At the time of sale, the appellant (assessee) provided a
standard warranty whereby in the event of any beacon rotork actuator or part
thereof becoming defective within 12 months from the date of commencing or 18
months from the date of dispatch, whichever was earlier, the company undertook
to rectify or replace the defective part free of charge. This warranty was
given under certain conditions stipulated in the warranty clause. For the A.Y.
1991-92, the asessee made a provision for warranty at Rs.10,18,800 at the rate
of 1.5% of the turnover. This provision was made by the assessee on account of
warranty claims likely to arise on the sale of effected by the appellant and
to cover up that expenditure. Since the provision made was for Rs.10,18,800
which exceeded the actual expenditure, the appellant revised Rs.5,00,246 as
reversal of excess provision. Consequently, the assessee claimed deduction in
respect of the net provision of Rs.5,18,554 which was disallowed by the
Assessing Officer on the ground that the liability was merely a contingent
liability not allowable as a deduction u/s.37 of the Act. This decision was
upheld by the Commissioner of Income-tax (Appeals). The matter was carried in
appeal to the Tribunal by the appellant. It was held by the Tribunal that
right from the A.Y. 1983-84 the Commissioner of Income-tax (Appeals) as well
as the Tribunal had allowed the warranty claim(s) on the ground that valve
actuators are sophisticated equipment; that in the course of manufacture and
sale of valve actuators a reasonable warranty was given to the purchases; that
every item of sale was covered by the warranty scheme; that no purchaser was
ready and willing to buy valve actuators without warranty and consequently
every item sold had a corresponding obligation under the warranty clause(s)
attached to such sales. All through this period between the A.Y. 1983-84 and
the A.Y. 1991-92, the Tribunal took the view that the provision made by the
appellant was realistic. Applying the rule of consistency, the Tribunal held
that the assessee on the facts and circumstances of the case was entitled to
deduction u/s.37 of the 1961 Act in respect of the provision for warranty
amounting to Rs. 5,18,554. Aggrieved by the decision of the Tribunal, the
Department carried the matter in appeal to the Madras High Court.
The High Court held that the assessee was not entitled to
deduction in respect of the provision made for warranty claims. It was held
that no obligation was ever cast on the date of the sale and consequently
there was no accrued liability. According to the High Court, the warranty
provision was made against the liability which had not crystallised against
the appellant and consequently it was a provision made for an unascertained
liability and, therefore, the appellant was not entitled to claim deduction
u/s.37 of the 1961 Act.
On appeal, the Supreme Court held that in the case of
manufacture and sale of one single item, the provision for warranty could
constitute a contingent liability not entitled to deduction u/s.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 events of defects
being detected in some of such items lead to a present obligation which
results in an enterprise having no alternative to settling that obligation in
the present case.
The appellant has been manufacturing valve actuators in
large numbers. The statistical data indicated that every year some of these
manufactured actuators are found to be defective. The statistical data over
the years also indicated that being sophisticated item no customer is prepared
to buy a valve actuator without a warranty. Therefore, the warranty became
integral part of the sale price of the valve actuators. In other words, the
warranty stood attached to the sale price of the product. Therefore, the
warranty provision was needed to be recognised because the appellant was an
enterprise having a present obligation as a result of past events resulting in
an outflow of resources. Also, a reliable estimate could be made of the amount
of the obligation.
The Supreme Court observed that there are following options
for accounting the warranty expense :
(a) account warranty expense in the year in which it is
incurred;
(b) to make a provision for warranty only when the
customer makes a claim; and
(c) to provide for warranty at certain percentage of
turnover of the company based on past experience (historical trend).
According to the Supreme Court, the first opinion 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 recognised (accrued). In other words, it is not
based on the matching concept. Under the matching concept, if revenue is
recognised the cost incurred to earn that revenue including warranty costs
has to be fully provided for. 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 the most
appropriate because it fulfils accrual concept as well as the matching
concept.
