why is warranty expenses considered as a provision and not a contingent liability?

Answer 1

Provisions for warranties are governed by IAS 37 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS

The key definitions are:
Provision: A liability of uncertain timing or amount.
Liability:
* Present obligation as a result of past events
* Settlement is expected to result in an outflow of resources (payment)
Contingent liability:
* a possible obligation depending on whether some uncertain future event occurs, or
* a present obligation but payment is not probable or the amount cannot be measured reliably

When a manufacturer gives a warranty, it satisfies the criteria for a liability - there is a legal obligation and settlement is expected to result in an outflow of resources (whether by payment to repair the defect or by using up of spare parts maintained for this purpose), so that's why a warranty is a provision and not merely a contingent liability. From history, the manufacturer would know that there will definitely be some claims for repairs or rectification, and he has to use either historical data or industry data as the best estimate (e.g. 2% of sales) for the provision.

Measurement of Provisions

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. [IAS 37.36] This means:

* Provisions for one-off events (restructuring, environmental clean-up, settlement of a lawsuit) are measured at the most likely amount. [IAS 37.40]
* Provisions for large populations of events (warranties, customer refunds) are measured at a probability-weighted expected value. [IAS 37.39]
* Both measurements are at discounted present value using a pre-tax discount rate that reflects the current market assessments of the time value of money and the risks specific to the liability. [IAS 37.45 and 37.47]
In reaching its best estimate, the enterprise should take into account the risks and uncertainties that surround the underlying events. Expected cash outflows should be discounted to their present values, where the effect of the time value of money is material. [IAS 37.42]

If you are governed by US GAAP, SFAS 5 Accounting for Contingencies is the authoritative pronouncement.

4. Examples of loss contingencies include:
a. Collectibility of receivables.
b. Obligations related to product warranties and product defects.

Accrual of Loss Contingencies
8. An estimated loss from a loss contingency (as defined in paragraph 1) shall be accrued by a charge to income if both of the following conditions are met:
a. Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
b. The amount of loss can be reasonably estimated.

Under both IAS and SFAS, a warranty provision has to be created as the event is hardly remote. History will tell the management that never a year goes by when there is NO claim for repair under the warranty given and it is industry practice to make the provision. If warranties are allowed to be treated as merely contingent liabilities, I'm sure lots of companies will only be too happy to not take up the provision.

Answer 2

Contingent Liability

Answer 3

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RE:
why is warranty expenses considered as a provision and not a contingent liability?

Answer 4

Technically, it is a contingent liability. Contingencies are possible economic events that may or may not occur in the future, and fall into 3 categories:

Highly Probable
Reasonably Probable
Remote

(the actual names used vary, but that's the gist of it).

If the loss is remote, it is ignored.
If the loss is Reasonably Probable, or Highly Probable but inestimable, the loss is disclosed in the footnotes.
If the loss is highly probable AND estimable, the amount is recorded on the balance sheet and income statement.

(Contingent gains, on the other hand, are never accrued on the financials)

Warranties meet the criteria of highly probable and estimable. we know that because we sell stuff with a warranty, we will be facing the future costs of meeting that warranty. Our engineers should be able to give us an error rate, and tell us roughly how much it will cost on average. So we have a highly probable future event that we can estimate. Book it.

It is also worth noting that revenue recognition rules require us to a) receive cash or a claim on cash (realized or realizable) and b) have completed the earning process, and be able to estimate remaining costs associated with the sale. For us to recognize any of the revenue associated with selling a product with a warranty, we HAVE to be able to estimate the warranty costs. Otherwise, we have to defer the profits on the sale until the warranty period has expired, and we have finally completed the earnings process.

Answer 5

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Answer: This would fell under contigency only. By definition given by the PAS, a provision is a liability of uncertain timing or amount. A provision should be recognised when, and only when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable (ie more likely than not) 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. The Standard notes that it is only in extremely rare cases that a reliable estimate will not be possible. A contingent liability is: (a) a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity; or (b) a present obligation that arises from past events but is not recognised because: (i) it is not probable that an outflow of resources embodying economic benefits will be required to settle the obligation; or (ii) the amount of the obligation cannot be measured with sufficient reliability. Source: Philippine Accounting Standard

Answer 6

Planned obsolescence. A manufacturer plans for it's product to fail at a given time and acts accordingly. Chance/probability dictates that a given percentage of unit will fail prematurely. This cannot be take as a contingent liability due to the inevitable nature of the outlay.

Answer 7

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Answer 8

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