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The Present value of the future cost totalling 15000 comprises of 90% – dismantling costs (13500) and 10% – damage caused by electricity generation (1500).
The company has estimated these costs to arise when they constructed the station.
Sir I am clear on the following:-
– The cost of dismantling (13500) will be added to value of asset and will be depreciated over the useful life of the power station.
– The costs related to damages will be spread over the useful life of the power station (1500/10=150 per year)
– Both of these will be unwound and the will be charged to finance costs.
What I am unclear about is:-
1) How will we unwind the discount for the damages? wont it create complications?
2) As you mentioned in the last post, the damage related costs should not be provided for, but then the company has already made a reliable estimate and calculated the present value of this cost then wont this also be recognised as a provision (as it fulfils the criteria of the provision)?
Thanks
I will ask my professor to give me the details of the question as he had asked this in a revision class.
I will let you know tomorrow.
Thank you sir
Sir, it is a part of a question in P2 Electron (which was given for practice purposes),
Electron has recently constructed an ecologically efficient power station. A condition of being granted the operating licence by the government is that the power station be dismantled at the end of its life which is estimated to be 20 years. The power station cost $100 million and began production on 1 July 2005. Depreciation is charged on the power station using the straight line method. Electron has estimated at 30 June 2006, it will cost $15 million (net present value) to restore the site to its original condition using a discount rate of five per cent. Ninety-five per cent of these costs relate to the removal of the power station and five per cent relates to the damage caused through generating energy.
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I did go through the answer and was able to understand most of the things.
But, I noticed that there was a provision for the damage caused but the calculation was (0.7/20=0.1 million). I didn’t understand this calculation. Does this include the the discount being unwound for damages? (They have not shown any unwinding of the discount for the damage costs of 0.7 million)
Thanks
I thought I recognised the question!
This extract from the answer explains some of the problems
“The costs to be incurred will be treated as part of the cost of the facility to be depreciated over its production life.
However, the costs relating to the damage caused by the generation of energy should not be included in the provision, until the power is generated which in this case would be 5% of the total discounted provision”
We are given the present value of the restoration provision requirement as at 1 complete year after the project started so we need to go back a full year to find what the discounted provision estimate was on day 1 of the project
That calculation is $15,000,000 discounted for 1 year at 5% = $14,285,714
And we’re told that the damage repair element is estimated at 5% of the total so that’s $714,286
And that damage repair is a one off cost that we shall face in 20 years time so we need to allocate that $714,285 over the next 20 years at the rate of $714,285 / 20 = $35,714 per annum and that has been rounded up to $1 (million)
Here’s a further extract from the answer:
“A simple straight line basis has been used to calculate the required provision for damage. A more complex method could be used whereby the present value of the expected cost of the provision is provided for over 20 years and the discount thereon is unwound over its life.”
It’s an awful question that your tutor has set … as he has told you, it’s P2 level!!
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