Provision, contingent liabilities
and contingent asset
Intermediate accounting
Asset with Significant Restoration
Costs at Retirement
• To illustrate the initial recognition of an asset
retirement obligation, assume that Bryan
Beach Company purchases and erects an oil
platform at a total cost of $750,000.
• At the end of ten years, the platform must be
dismantled and removed from the site at an
estimated cost of $100,000. Using an 8%
interest rate, the present value of $100,000
for ten years is $46,319.
(continued)
10-2
Asset with Significant Restoration
Costs at Retirement
The journal entries to record the purchase
and the asset retirement obligation follow:
Oil Platform
Cash
750,000
750,000
Oil Platform
Asset Retirement
Obligation
(continued)
46,319
46,319
10-3
Asset with Significant Restoration
Costs at Retirement
•
Homer Company constructs and
commences operation of a nuclear power
plant. Total construction cost is $400,000.
•
The cost of cleaning up the routine
contamination is estimated to be $500,000;
this cost will be incurred in 30 years when
the plant is decommissioned. Additional
annual contamination cleanup cost
$40,000. Assume an interest rate of 9%.
(continued)
10-4
Asset with Significant Restoration
Costs at Retirement
Initial Acquisition
Nuclear Plant
Cash
Nuclear Plant
Asset Retirement
Obligation
FV = $500,000; I = 9%; N =
30 years  $37,686
400,000
400,000
37,686
37,686
After One Year
Nuclear Plant
Asset Retirement
Obligation
3, 286
3,286
FV = $40,000; I = 9%; N =
29 years $3,286
10-5
Question 1
In which of the following circumstances must a provision be recognized?
(a) On 20 December 20X2 the board of an entity voted at a private
board meeting to close down a division. the accounting date of
the company is 31December. Before 30December 20X2 the
decision was not communicated to any of those affected and no
other steps were taken to implement the decision.
(b) The board met again and agree a detailed closure plan on
22December 20X2 and details were given to customers and
employees.
(c) A company is obliged to incur clean up costs for environmental
damage (that has already been caused).
(d) A company intends to carry out future expenditure to improve
their operating efficiency in the future.
Question 1: Answer
(a) Provision will not be recognized as no other steps were taken to
implement the decision. (Correct. Reason: no communication)
(b) Provision will not be recognized.
(Incorrect,
since board agreed the details before the reporting period,
classmates may misunderstand the case is disclosure, so they
categorized the provision is not recognized.)
(c) Provision will be recognized. (Correct)
(d) Provision will be recognized. (Incorrect, classmates misunderstand
that the contingent liability can be predicted even when no
obligation (future expenditure), so they categorized the provision is
recognized. Since no obligation is existed and under HKAS 37, no
provision would be appropriate, and the company is just intent to
do it.)
Question 2
Alice Co sells goods with a warranty under
which customers are covered for the cost of
repairs of any manufacturing defect that
becomes apparent within the first six months
of purchase.
The company's past experience and future
expectations indicate the following pattern of
likely repairs.
Question 2
Note the sales invoice price
% of goods sold
Defects
Cost of repairs
$m
75
None
-
20
Minor
1.0
5
Major
4.0
Question 2: Answer
Expected cost of repairs:
=75% x $0 m + 20% x $1.0 m + 5% x $4.0 m
=0.4 m (Correct)
(present obligation+reliable estimate+ probable)
Dr Expenses $0.4m
Cr Provision $0.4m
20%+5% =25% here does not mean the event not probable (>50%).
It do happens (>50%) as it has past experience. In this question,
it shows pattern of warranty.
It based on it 100% happens already.
Then it tells you that under100% happen How much $ the company need spend.
Question 3
Wiggle Co gives warranties at the time of
sale to purchasers of its products. Under
the terms of the warranty the company
undertakes to make good, by repair or
replacement, manufacturing defects that
become apparent within a period of two
years from the date of sale.
Should a provision be recognized?
Question 3: Answer
• Yes, a provision for warranties will be recognized at the best
estimate of the cost of warranty claims on products sold
before the financial position date. (Correct, the company
cannot avoid the cost of repairing or replacing all items of
products, and a provision for warranties should be made.)
• (The company has obligation within the entire warranty
period.)
Question 4: Repair
Cobo Co manufacture goods which are sold with a one
year warranty against defects.
(a) Should a provision be recognized for the cost of
repairing faulty goods?
(b) Cobo Co’s sales for the year are $40m. They anticipate
that 60% of goods will not be faulty, 30% will need
minor repairs costing $2m and 10% of goods will need
major repairs costing $4m. How much should be
provided for repairs?
Question 4: answer
(a)Yes, a provision should be recognized for the cost of repairing
faulty goods.(Correct, the company cannot avoid the
expenditure of repairing the faulty goods.)
(b) They anticipate 40% (1-60%) of goods will be faulty. So
$40m*40%= $16m
$16m+$2m+$4m=$22m
So $22m should be provided for repairs.
Dr. Expense
$22m
Cr. Provision
$22m
Question 4: answer
(b) (Incorrect, classmates misunderstood the
sales $40m as the repair cost, we only have to
calculate the repair cost.)
((60% x $0m)+ (30% x $2m (repair cost) )+ (10% x
$4m (repair cost) ) = $1m.
$1m should be provided for repairs.
Dr. Expense
$1m
Cr. Provision
$1m
Question
5:
Exam
Practice
Darren company Limited (DCL) is engaged in the manufacture of
batteries. On the unaudited as at 30June 20X8, It has recognized
the following provisions as current liabilities:
(a) A provision for late delivery penalty
In May 20X8 (within the period), DCL received a sales
order for 7m unites of rechargeable batteries for which
the agreed delivery date is 31 August 20X8 (after the
period).
It is expected that DCL would earn a gross profit of $1
per unit. Due to a shortage in the supply of raw materials,
at the reporting date(within the period), the
management realized that they could only supply the
goods at the earliest on 10 September 20X8 (after the
period).
According to the sales contract, DCL would compensate
the customer for late delivery at $0.01 per unit per day.
Expected GP:
$1 per unit
Contract:
Sales order
Year-end
7m
May
Contract:
Delivery Date
Aug
June
Penalty:
Late delivery$0.01 per unit per day
10th Sept
10 days
penalty
No 7m
stock
Realized:
no stock
At that date
For warranty topic:
Present Obligation:
Dr. Warranty expenses
Cr Provision for warranty
Expected
to have 7m
stock
For future operating loss:
No obligation
This is just the expectation
on future from June.
They may have stock
on Aug.
No present obligation on May.
future operating losses
Not happen now
Not a liability
obligation
Can avoid
expectation
Not a provision
Impairment
Indication
Asset (PPE)
Not under
HKAS 37
HKAS 36 Applied
Question 5
(b) A provision for annual safety inspection of the production line
The last inspection was carried out in June 20X7(last year).Due to a
large backlog存貨 of sales order, the management decided to
postpone the annual inspection until mid-September 20X8 (after
the period).
(C)A provision for the loss on sales of aged finished goods
the products were manufactured in late 20X6 with an expected
normal usage period of two years from the date of production
(should expire at late of 20x8). Due to short expiry period, they
were sold at a price below cost in July 20X8.(after the period)
(d) A provision for bonus payment to two executive directors
In accordance with the directors service contract, two executive
directors are entitiled to receive, in addition to monthly salaries, a
bonus of equivalent to 5 per cent of the profit before taxation and
the accrued bonus.
Year-end
May
June
No inspection
as usual.
Aug
Mid- Sept
Expected
to do inspection
This is just the expectation
on future action from June.
No present obligation on June.
Question 5: answer
(a) It is an onerous contract which the unavoidable costs of meeting the
obligations under the contract exceed the economic benefits expected to
be received under it.
If an entity has a contract that is onerous, the present obligation under the
contract shall be recognised and measured as a provision just like this case.
Dr. provision (I/S) 700,000
Cr. provision (FP-lib) 700,000
• ( Incorrect, classmates recognized the event is a kind of provision,
and they have included the loss.
• .However, the compensation will reduce the expected gross profit,
but will not result in an onerous contract for DCL.
• This is future operating loss.
• Accordingly, no provision is required for this late delivery penalty
as at 30 June 2008.
Question 5: answer
(b) It is a restructuring which did not obligation arises for the sale of an
operation until the entity is committed to the sale, ie there is a binding sale
agreement.
A restructuring provision shall include only the direct expenditures arising from
the restructuring, which are those that are both:
•(a) necessarily entailed by the restructuring; and
•(b) not associated with the ongoing activities of the entity.
(Incorrect, As at 30 June 2008, DCL has no obligation to perform the safety
inspection of the production line, accordingly no provision should be recognized.
The cost of inspection should be recognized as expense when incurred.)
Or
The information provided in the question has not stated whether DCL, by
an established pattern of past practice, published policies or a sufficiently
specific current statement, has indicated to other parties that it must carry
out the safety inspection on an annual basis and therefore, it has created
a valid expectation on the other parties in respect of this activity.
If there is evidence to prove the above, this can be considered as a
constructive obligation and therefore a provision should be provided.
Question 5: Answer
(c) A contingent liability is a possible obligation that arises from past events
and whose existence will be confirmed only by the occurrence or nonoccurrence of one or more uncertain future events not wholly within the
control of the entity; or a present obligation that arises from past events
but is not recognised because it is not probable that an outflow of
resources embodying economic benefits will be required to settle the
obligation; or the amount of the obligation cannot be measured with
sufficient reliability.
(Correct for no provision made already, this should be recognized as a
write down of inventories, and no separate provision should be recognized
in current liabilities.)
(It is internal company decision to cut the price)
Question 5: Answer
(c)(Correct, this should be recognized as a write down of inventories, and no
separate provision should be recognized in current liabilities.)
-Any future loss on sales of aged finished goods should be
considered in the measurement of the net realizable value of the
inventory under HKAS 2 instead of HKAS 37.
-The net realizable value is the estimated selling price in the ordinary
course of business less the estimated costs of completion and the
estimated costs necessary to make the sale.
-Sales of finished goods at a price below the cost immediately after
the financial position date (July 2008) is a strong indicator of the
amount of net realizable value at 30 June 2008.
-Accordingly, this should be recorded as a write down of inventories
and no separate provision should be recognized in the current
liabilities.
Question 5: Answer
(d) It is a contingent gains that circumstances
involving potential “gains ” that will not be
resolved until some future event occurs.
(Incorrect, they recognized the case as entitle (not
potential) payment (not gain) but the fact is DCL
has obligation to pay the bonus* and a provision
should be recognized, the amount should be
made a reliable estimate of provision amount.)
(*based on the amount of profit before tax and the accrued
bonus)