Ind AS 2 – Inventory Valuation Treatment of Warranty | Rectification | Royalty Costs

1. Question

Omega Limited, hereinafter referred to as “the company,”is engaged in the manufacturing of premium home appliances. The company produces a new line of smart air purifiers called “Airclean”. The product is sold with a 2-year warranty covering repair and replacement of parts, as well as rectification of any manufacturing defects discovered after sale.

During the quality check, for a batch of 5,000 units ready for dispatch, the company identifies a fan motor alignment defect in 1,000 units and incurs Rs. 10 lakh in replacement components and Rs. 2 lakh in additional labour to rectify the issue before the units are transferred to finished goods inventory. Further, based on experience, the company estimates that approximately 2% of total units sold will require warranty repairs during the 2-year post-sale warranty period, for which it establishes a warranty provision of Rs. 5 lakh.

The company is also contractually obligated to pay two types of royalty: a 3% royalty on sales revenue to an institutional investor under a revenue-sharing arrangement, and a 2% production-based royalty to Tech Private Limited for the technical know-how used in manufacturing Airclean. The royalty shall be payable for each unit produced. The company expects to incur 10 lakh of royalty expense, wherein 6 lakhs shall be paid to the investor, and 4 lakhs shall be paid for availing technical know-how.

At the year-end, when the company carries out inventory valuation in accordance with Ind AS 2, the management faces uncertainty regarding the appropriate treatment of certain costs. Specifically, the management is unsure whether the pre-dispatch defect rectification costs, the provision for expected post-sale warranty repairs, the sales-based royalty payable to the investor, and the production-based technical know-how royalty should be included as part of the cost of inventory or excluded from it.

2. Relevant Provisions

Ind AS 2 – Inventories

Para 9 of Ind AS 2

Inventories shall be measured at the lower of cost and net realisable value.

Para 10 of Ind AS 2

The cost of inventories shall comprise all costs of purchase, costs of conversion, and other costs incurred in bringing the inventories to their present location and condition.

Para 11 of Ind AS 2

The costs of purchase of inventories comprise the purchase price, import duties and other taxes (other than those subsequently recoverable by the entity from the taxing authorities), and transport, handling, and other costs directly attributable to the acquisition of finished goods, materials, and services. Trade discounts, rebates, and other similar items are deducted in determining the costs of purchase.

Para 16 of Ind AS 2

Examples of costs excluded from the cost of inventories and recognised as expenses in the period in which they are incurred are:

(a) abnormal amounts of wasted materials, labour or other production costs

(b) storage costs, unless those costs are necessary in the production process before a further production stage

(c) administrative overheads that do not contribute to bringing inventories to their present location and condition

(d) selling costs

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