Recognition of a provision for warranty costs
A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On past experience, it is probable (i.e. more likely than not) that there will be some claims under the warranties.
In these circumstances the obligating event is the sale of the product with a warranty, which gives rise to a legal obligation. Because it is more likely than not that there will be an outflow of resources for some claims under the warranties as a whole, a provision is recognised for the best estimate of the costs of making good under the warranty for those products sold before the end of the reporting period.
The assessment of the probability of an outflow of resources is made across the population as a whole, and not using each potential claim as the unit of account. On past experience, it is probable that there will be some claims under the warranties, so a provision is recognised.
The assessment over the class of obligations as a whole makes it more likely that a provision will be recognised, because the probability criterion is considered in terms of whether at least one item in the population will give rise to a payment. Recognition then becomes a matter of reliable measurement and entities calculate an expected value of the estimated warranty costs. IAS 37 discusses this method of ‘expected value’ and illustrates how it is calculated in an example of a warranty provision.