Semester 1 Week 11 Tutorial 9 Flashcards
Outline the “big bath” provision and the problems which existed before IAS 37.
Before IAS 37 there was a problem with companies putting through provisions for
inappropriate reasons. In particular there was a problem with “big bath” provisions
where company would deliberately put through inappropriate provisions in good
years to reduce profits and release them in bad years to increase profits – thus
smoothing profits.
Before IAS 37 there was no clear guidance on how provisions should be treated
therefore situations such as this arose.
- Woodford Ltd. are an electrical contractor, they have provided guarantees on certain projects. As at the year end of 31 December 20X5 they expected that they would pay out £145,000 over the coming year as a result of these guarantees.
Prepare the appropriate journal as at 31 December 20X5.
Dr
Cost of sales (or other appropriate account) 145000
Cr Provision for guarantees 145000
Being provision for guarantee costs
- In the 20X6 year they find they only spend £85,000 on these guarantee payments.
Prepare the appropriate journal(s) for 20X6.
Dr Provision for guarantees 85000
Cr bank/creditors 85000
Being utilisation of provision
Dr Provision for guarantees 60,000
Cr cost of sales (or other appropriate account if used in 3) 60,000
Being write back of provision
Note: These two journals could also be combined.
- Ubicore Plc. are a vehicle manufacturer. Recently they have discovered that one of their biggest selling vehicles has a fault and a warranty payout will be required.
Their product engineers estimate that there is a 40% chance that £2,000,000 will be paid out, a 30% chance that £2,500,000 will be paid out, a 20% chance that £3,200,000 will be paid out and a 10% chance that £4,000,000 will be paid out.
Prepare the appropriate journal as at the year end date.
This situation requires a weighted average approach.
40% x £2,000,000 = 800,000
30% x £2,500,000 = 750,000
20% x £3,200,000 = 640,000
10% x £4,000,000 = 400,000
Total = 2,590,000
Dr cost of sales (other appropriate account) 2,590,000 Cr provision for warranty repairs 2,590,000
Being provision for warranty repairs
- Watton Plc. are an oil company, they are required to pay the decommissioning costs of any oil wells that become redundant. Watton have two oil wells that will require to be decommissioned in 5 years at a cost of £15,000,000. The underlying interest rate is 3.8%.
Prepare the journal to account for this transaction.
First calculate the required provision.
15,000,000/1.038^5 = 12,448,140
Dr environmental costs (or other suitable account) 12,448,140
Cr provision for decommissioning 12,448,140
Being required provision for decommissioning
- Coinfire Ltd. have sued a competitor over a copyright infringement. Coinfire’s lawyers believe that they have a very strong case and estimate that compensation of £4,000,000 will be received.
Advise the directors of Coinfire how this should be treated.
As it is likely that this money will be received this should be treated as a contingent
asset. This means that no journal entry is required and no figure is entered in the P&L
or statement of financial position, instead a note is added describing this situation.
- Advise why financial statements are required to be published.
Companies are owned by shareholders, but run on a day-to-day basis by directors.
Quite often the directors and shareholders are different people. While the directors
have knowledge of how the company is being run on a day-to-day basis and any
important information related to the company the shareholders and other
stakeholders do not have this information. This is called the information gap.
In order to eliminate this information gap, the directors are required to publish the
financial statements of the company on an annual basis. This allows the shareholders
and other users of the accounts to judge the financial performance of the company,
and thereby the performance of the directors.
