Warranty Valuations

Warranties are a common feature in many industries providing assurance to customers about the quality and reliability of products. As warranties involve future payments based on past commitments, an appropriate provisioning is necessary for business to account its effect. IFRS 37 (formally known as IAS37 Provisions, Contingent Liabilities and Contingent Assets) and its equivalent INDAS 37 set the guidelines for recognizing and measuring provisions for warranties. Companies should consider obtaining an independent assessment of these provisions by an actuary.

Provisions under IFRS 37

IFRS 37 (or INDAS 37) defines a provision as a liability of uncertain timing or amount. It requires that a provision be recognized when:

· Obligation (legal or constructive) is a result of past event.

· It is probable that an outflow of resources embodying economic benefits will be required to settle the provision.

· Reliable estimate of obligation can be made.

Types of Warranty

Warranties typically come in two types:

1. Assurance type – usually included in sale price of product.

2. Service type – usually sold separately as additional contract.

IFRS 37 deals with provisioning of assurance type of contracts.

Measurement of warranty provisions

Para 36 of IFRS 37 (same for INDAS) states

“The amount recognized as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period.”

This involves predicting future cash flows. The valuation of warranties can be divided into the following steps:

A. Identification and collection of data of eligible warranties

B. Assessment of past trends for setting assumptions.

C. Measure expected cost of fulfilling the warranty.

D. Discounting future cash flows

A. Identification and collection of data

Companies sell a portfolio of products, each with varying warranty policies. Products should be grouped into homogeneous categories based on factors such as sale period, warranty period, fault probability, claim severity, etc. For each group, collect information about the number of sales, sale prices, fault likelihood, repair or replacement costs, and other associated costs like labour and transportation.

When limited historical data is available, such as with new products or companies, internal test results or industry standard data can serve as proxies. As products mature, actual data should replace these initial estimates.

B. Assumption Setting

Setting assumptions is critical to the accuracy and reliability of financial estimates. Key assumptions include:

1. Historical claim rates – analyse past data to set a benchmark for future warranty events and claims. Adjust for outliers to avoid misrepresentation.

2. Product lifecycle - understand how the product's lifecycle affects failure likelihood, considering early life failures, normal wear and tear, and end-of-life issues. Similarly usage of product may have a seasonality which could impact timing of fault.

3. Claim frequency and severity – estimate the likelihood and average cost per claim using historical data. Different types of claims (minor, major, severe) should each have their own probabilities.

4. Product changes – technological enhancements may alter product reliability, impacting future probabilities and necessitating additional assumptions.

Other factors include compliance costs, litigation risks, economic trends, and the competitive landscape. Best practices include:

· Using comprehensive historical data.

· Regularly reviewing and adjusting assumptions.

· Testing various scenarios to understand the sensitivity of assumptions.

· Adjusting for interdependencies among assumptions.

C. Expected Cost of Fulfilling Warranty

Key components of warranty costs include:

1. Direct costs – parts, labour, logistics involved in servicing the product.

2. Indirect costs – claim management, documentation, and facility costs.

3. Unexpected costs – legal costs, and reputation management costs, if credible data is available.

Estimation methods involve:

· Analysing historical data and trends

· Employing statistical models such as regression or survival analysis

· Perform scenario analysis (best case, worst case) to determine range of impact

· Comparing costs with industry standards and peer analysis

· Building future cost trends into assumptions.

D. Discounting Future Cash Flows

IFRS 37 and IND AS 37 recommend discounting future cash flows to account for the time value of money, using a pre-tax rate that reflects current market assessments. However, AS 29 requires reporting expected expenditures without discounting. Companies should adhere to the applicable provisions.

Disclosure requirements

Para 84 of IFRS 37 (same for INDAS 37) outlines the disclosure requirements, which include:

· Carrying amount at the beginning of period

· Additional provisions made during the period (incl. additions in existing provisions)

· Amounts used, incurred, charged against provisions

· Unused amounts reversed during period

· Increase during period in the discounted amount due to passage of time and changes in discount rate

Comparative information is not required.

Para 85, specified additional disclosures, including:

· A brief description of nature of obligation

· Expected timing of resulting outflows

· An indication of uncertainties in timing and amount of cash flows

· Where necessary key assumptions used in estimation

· Disclose expected reimbursement amount

Conclusion

Accurate warranty valuations under IFRS 37 (INDAS 37) are essential for presenting a true and fair view of a company’s financial position. By systematically identifying obligations, estimating probabilities and costs, and adjusting for changes, companies can ensure compliance with the accounting standard and provide valuable information to stakeholders.

Companies must recognize the various scenarios that necessitate a valuation, from product launches to regulatory changes. Regular review and adjustment of warranty provisions are key to managing this complex yet critical aspect of financial accounting effectively.

Thank you for reading this note. We welcome any notes, comments on the topic. Feel free to reach to us at +91-9015388214 / neelesh@staconsultants.com.