Section 37 of the Income-tax Act, 1961 - Business expenditure Allowability of Where standard warranty was required to be given during sell and assessee made provision for warranty which exceeded actual expenditure and excess amount was reversed, claim for deduction under section 37 of said excess amount could not be denied .
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.
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.
A past event that leads to a present obligation is called as an obligating event. 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. For a liability to qualify for recognition there must be not only present obligation but also the probability of an outflow of resources to settle that obligation.
Where there are a number of obligations (e.g. product warranties or similar contracts) the probability that an outflow will be required in settlement, 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. 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.
The assessee-company had been manufacturing and selling Valve Actuators. At the time of sale the assessee provided a Standard Warranty for a period and undertook to rectify or replace the defective part free of charge. This warranty is given under certain conditions stipulated in the warranty clause.
The assessee made a provision for warranty 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 sales effected by the appellant and to cover up that expenditure. During the assessment year 1991-92, since the provision made was for Rs.10,18,800/- which exceeded the actual expenditure, the assessee reversed 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 revenue on the ground that the liability was merely a contingent liability not allowable as a deduction under Section 37. The Supreme Court held that Valve Actuators are sophisticated goods. Over the years appellant had been manufacturing Valve Actuators in large numbers. The statistical data indicated that every year some of these manufactured Actuators were found to be defective. The statistical data over the years also indicated that being sophisticated item no customer was 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 were important. Obligations arising from past events have to be recognized as provisions. These past events are known as obligating events. In the instant case, therefore, warranty provision needed to be recognized because the appellant was an enterprise having a present obligation as a result of past events resulting in an outflow of resources.
Lastly, a reliable estimate could be made of the amount of the obligation. In short, all conditions for recognition of a provision were satisfied in this case.
When Valve Actuators were sold and the warranty costs were an integral part of that sale price then the appellant had to provide for such warranty costs in its account for the relevant year, otherwise the matching concept would fail. In such a case the option of making a provision for warranty only when the customer would make a claim was also inappropriate. Under the circumstances, the option of providing for warranty at 2% of turnover of the company based on past experience (historical trend) was most appropriate because it fulfilled 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, one 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 years, may not arise in a significant way.
On the facts and circumstances of this case, provision for warranty was rightly made by the appellantenterprise because it had incurred a present obligation as a result of past events. There was also an outflow of resources. A reliable estimate of the obligation was also possible. The appellant had incurred a liability, during the relevant assessment year which was entitled to deduction under Section 37. Therefore, all conditions for recognizing a liability for the purposes of provisioning stood 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.
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. The principle of estimation of the contingent liability is not the normal rule. 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. 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. However, in the instant case, it was not so. In the instant case large number of items being produced. They were sophisticated goods. They were supported by the historical trend, namely, defects being detected in some of the items. The data also indicated that the warranty cost(s) was embedded in the sale price. The data also indicated that the warranty was attached to the sale price.
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.
If the historical trend indicates that large number of sophisticated goods were being manufactured in the past and in the past if the facts established show that defects existed in some of the items manufactured and sold, then the provision made for warranty in respect of the army of such sophisticated goods would be entitled to deduction from the gross receipts under section 37. It would all depend on the data systematically maintained by the assessee. In view of the above, the assessee succeeded.
These cases is compiled by Mr. Susanta K. Sahu, Secretary, Committee on Economic and Commercial Laws.
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