Question

Assuming a year end of 31 December 2021, state, with reasons, how you would account for the following items:

1. A furnace has a lining that needs to be replaced every five years for technical reasons. At the reporting date, the lining has been in use for three years.

2. An airline is required by law to overhaul its aircraft once every three years.

3. 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 (more likely than not) that there will be some claims under the warranties.

4. A retail store has a policy of refunding purchases by dissatisfied customers, even though it is under no legal obligation to do so. Its policy of making refunds is generally known.

5.The directors of a company have discovered a painting in a cupboard and have sent it to an auction house, who has confirmed that it should sell for €1.5 million in the following month’s auction.

6. A claim has been made against a company for injury suffered by a pedestrian in connection with building work by the company. Legal advisers have confirmed that the company will probably have to pay damages of €200,000 but that a claim can be made against the building sub-contractors for €90,000.

7. An entity in the oil industry causes contamination but cleans up only when required to do so under the laws of the particular country in which it operates. One country in which it operates has no legislation requiring cleaning up and the entity has been contaminating land in that country for several years. At 31 December 2021, it is virtually certain that a draft law requiring a clean-up of land already contaminated will be enacted shortly after the year-end.

8. Explain how a contingent liability is different to a provision and how a contingent liability should be dealt with in the financial statements.

9. An entity has guaranteed a loan taken out by one of its subsidiary entities. In October 2021, the subsidiary placed itself in liquidation and there would appear to be insufficient funds to repay the loan.

10. Fault plc sells goods under warranty. Past experience indicates that 80% of the goods sold will have no defects, 15% will have minor defects and 5% will have major defects. If minor defects occurred in all goods sold, the cost of fixing would be €5,000 and for major defects €10,000.

11. On 12 December 2021, the board of an entity decided to close down a division. Before the reporting date, 31 December 2021, the decision was not communicated to any of those affected and no other steps were taken to implement the decision.

12. On 14 December 2021, the board of an entity decided to close down a division making a particular product. On 20 December 2021, a detailed plan for closing down the division was agreed by the board. Letters were sent to customers advising them to seek an alternative source of supply and redundancy notices were sent to the staff of the division.

13. After a wedding in 2020, 10 people became ill, as a result of food poisoning from caviar served by Union plc. Legal proceedings were started seeking damages from Union plc, who dispute liability. Up to the date of authorisation of the financial statements for the year to 31 December 2021, Union plc’s lawyers advise that it is probable that it will not be found liable. However, when Union plc prepares its financial statements for the year to 31 December 2021, its lawyers advise that, owing to developments in the case, it is probable that Union plc will be found liable.

14. What is the required accounting treatment?

At 31 December 2020?

At 31 December 2021?

15.An entity operates profitably from a factory that it has leased under a lease. During December 2021, the entity relocates its operations to a new factory. The lease on the old factory continues for the next four years, it cannot be cancelled and the factory cannot be sub-let.

Answer 1

1. This is a case of a provision for a future expense. An entity recognizes a provision for the replacement cost of the lining as an expense gradually over the five years based on its usage. This is because the need for replacement is a result of regular use and wear, and is predictable.

2. Similar to the first case, an airline should recognize a provision for the costs of the required overhaul. The cost should be spread evenly over the three years between overhauls, reflecting the fact that the plane is incurring the obligation to be overhauled through its usage.

3. This is a case for recognizing a provision for warranties. The entity should estimate the costs of repairing or replacing the items likely to be returned based on past experience, and should recognize this amount as a provision and an expense in the financial statements at the time of sale.

4. The retail store should recognize a provision for refunds to customers. The amount can be estimated based on past experience.

5. The painting discovered is an asset not previously recognized. It should be recognized at its fair value of €1.5 million.

6. The entity should recognize a liability for the expected damages of €200,000. Concurrently, it should recognize a receivable for the expected recovery from the sub-contractors of €90,000.

7. The entity should recognize a provision for the expected costs of the cleanup required by the imminent legislation. This should be based on the best estimate of these costs at the reporting date.

8. A contingent liability is a possible obligation that arises from past events and whose existence will be confirmed only by the occurrence or non-occurrence of one or more uncertain future events not wholly within the control of the entity. A provision, on the other hand, is a liability of uncertain timing or amount. While provisions are recognized on the balance sheet, contingent liabilities are not recognized but disclosed in the notes unless the possibility of an outflow of resources is remote.

9. The entity should recognize a liability for the amount of the loan guarantee that it expects to pay on behalf of the liquidated subsidiary.

10. Fault plc should recognize a provision for warranties based on past experience. If experience shows that 15% of goods will have minor defects and 5% will have major defects, the provision should be calculated as 15% of €5,000 plus 5% of €10,000.

11. As no steps have been taken to implement the decision to close the division, the entity should not recognize any provision related to the closure as of 31 December 2021.

12. Since the decision to close the division was communicated to those affected and steps were taken to implement it before the reporting date, the entity should recognize a provision for the costs associated with the closure.

13. At 31 December 2020, no provision should be recognized because the probability of outflow was assessed as low. But at 31 December 2021, a provision should be recognized because it is now probable that Union plc will be found liable.

14. Required accounting treatment:

At 31 December 2020: Union Plc should not recognize any provision for the liability since it is probable that it won't be found liable.

At 31 December 2021: Union Plc should recognize a provision for the liability since it is now probable that it will be found liable.

15. The entity should recognize a provision for onerous contracts, which is the lower of the cost of fulfilling it and any compensation or penalties arising from failure to fulfill it. In this case, it is the present value of the unavoidable costs of meeting the obligations under the contract i.e., the remaining lease payments.