BUS 20283

Unit 1 Tutorial Solution Provisions & Contingencies

Question 1)

(a) Refurbishment costs - no legislative requirement

.
Present obligation as a result of a past obligating event - There is no present
obligation.

Conclusion - No provision should be recognised. The cost of replacing the lining is not
recognised because, at the end of the reporting period, no obligation to replace the lining
exists and whether the expenditure incurred depends on the entity's future decision or
action - even though the entity has the intention to continue operate the furnace or to
replace the lining. Instead of a provision being recognized, the re-lining costs - if
incurred - should be capitalised and depreciated based on the consumption of the new
lining i.e. it should be depreciated over five years of useful life.

(b) Refurbishment costs - legislative requirement

Present obligation as a result of a past obligating event - There is no present

obligation.

Conclusion - No provision should be recognized. The costs of overhauling aircraft are

not recognised as a provision for the same reasons as situation (a) above. Even though
there is legal requirement to overhaul aircrafts does not make the costs of overhaul a
liability, no obligation exists to overhaul the aircraft independently of the entity's future
decision or action. The entity could avoid the future expenditure by its future decision or
action, for example, by selling the aircraft. Instead of a provision being recognised, the
maintenance costs - if incurred - should be capitalised and depreciated based on the legal
requirement of overhaul i.e. it should be depreciated over three years of useful life.

Question 2) (AFA: Ch 20 - Q 9 (situation 2 and 3 only)

May Wah Company

Situation 2:

There is a present obligation as a result of a past event the past event being the sale of
toy boxes with a coupon for a redeemable movie ticket.

There is also a probable outflow of resources from the issue of these coupons as 60% of
the coupons given out will be redeemed for movie tickets.

The conclusion is that a Provision for Coupon Redemptions is to be recognized for the
best estimate of the costs of movie ticket claims on products sold before the reporting

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date. This estimate would be 60% of the coupons given out during the year. The journal
entries are:

20X2
Dr Prepayment (tickets) 60%
Cr Bank 60%
Purchase of movie tickets in advance.

Dr Coupon redemption expense 40%

Cr Prepayment (tickets) 40%
Redemption of movie tickets this year.

Dr Coupon redemption expense 20%

Cr Provision for coupon redemptions 20%
Accrual of coupons this year (to be redeemed next year).

Situation 3:

The arguments that a Provision for Coupon Redemptions is to be recognized are similar
to situation 2 but the estimated amount of the provision would be 35% of the coupons
issued in 20X2. This is based on the past industry experience which should be considered
as appropriate basis for making best estimate. In 20X3, when the actual redemptions are
80% of coupons issued in 20X2, the under-provision must be recognised. The journal
entries are:

20X2
Dr Prepayment (tickets) 35%
Cr Bank 35%
Purchase of movie tickets in advance.

Dr Coupon redemption expense 35%

Cr Provision for coupon redemption 35%
Accrual of coupons this year (to be redeemed next year).

20X3
Dr Provision for coupon redemption 35%
Cr Prepayment (tickets) 35%
Reversal of coupons accrual made last year after redemption of tickets this year.

Dr Coupon redemption expense 45%

Cr Bank 45%
Further purchase of movie tickets this year to cope with additional redemption.

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Question 3) (AFA: Ch 20 - Q 10 (situation 1 and 3 only))

Situation 1:

The company has contaminated the harbour area, and this is the past event. Even though
there is no legislation requiring the company to clean up the contamination, however, the
company has widely published its environmental policy and it has a record of honouring
its published policy on commitment to environmental clean ups, as a result, a present
obligation in the nature of a constructive obligation exists.

Further, there is probable outflow of resources as the company needs to bear the
cleaning up costs. Also, the company is able to work out the approximate cost to be
incurred.

Therefore, a provision of $ 10m should be made in the accounts.

Journal entries:
Dr Expenditure for cleaning up contamination 10m
Cr Provision for cleaning up contamination 10m

Situation 3:

In view that the enterprises lawyers have advised that it is probable that the enterprise
would be found liable, there is a present obligation and this is a legal obligation.
However, as it is almost impossible to estimate the amount of damages the court might
award against the company, a provision cannot be made in the accounts. Therefore, this
is an unrecognized present obligation and should be disclosed as contingent liability in
notes to the accounts. The notes will include details including the nature of event and the
fact that it is impossible to estimate the amount of damages that the court may award
against the company.

Notes to the accounts

Contingent liability
A contingent liability exists concerning the death of employees from a plant explosion
which might be caused by the companys negligence. Lawyers opinion advised that it is
probable that the company would be found liable, although the company disputes the
liability. The financial effects to the company could be material because it pertains to
casualty. However, an estimate of the timing and amount of this possible obligation
cannot be determined reliably at this stage. Besides, the company has no insurance cover
for this contingent liability.