BURLEY QUESTION 3 DEC 2009

The reference to the question is in the title. Here’s the question reproduced (just part a) that I have an issue with:

Burley and Slite, a public limited company, jointly control an oilfi eld. Burley has a 60% interest and Slite a 40% interest and the companies are entitled to extract oil in these proportions. An agreement was signed on 1 December 2008, which allowed for the net cash settlement of any over/under extraction by one company. The net cash settlement would be at the market price of oil at the date of settlement. Both parties have used this method of settlement before. 200,000 barrels of oil were produced up to 1 October 2009 but none were produced after this up to 30 November 2009 due to production difficulties. The oil was all sold to third parties at $100 per barrel. Burley has extracted 10,000 barrels more than the company’s quota and Slite has under extracted by the
same amount. The market price of oil at the year-end of 30 November 2009 was $105 per barrel. The excess oil extracted by Burley was settled on 12 December 2009 under the terms of the agreement at $95 per barrel.
Burley had purchased oil from another supplier because of the production difficulties at $98 per barrel and has oil inventory of 5,000 barrels at the year-end, purchased from this source. Slite had no inventory of oil. Neither company had oil inventory at 1 December 2008. Selling costs are $2 per barrel.
Burley wishes to know how to account for the recognition of revenue, the excess oil extracted and the oil inventory at the year-end

Now everything is okay but I don’t get why the answer keeps revaluing the liability every time (basically I don’t get the double entries). This isn’t share based payment or financial instruments that we need to keep revaluing the liability so why revalue the liability every now and then. I reproduce the answer below from my BPP revision kit. Here it is:

Excess oil extracted
Burley has over-extracted and Slite under-extracted by 10,000 barrels of oil. The substance of the transaction is that Burley has purchased the oil from Slite at the point of production at the market value ruling at that point, namely $100 per barrel. Burley should therefore recognise a purchasefrom Slite in the amount of 10,000 × $100 = $1m.
The accounting entries would be:
DEBIT Purchases $1m
CREDIT Slite – financial liability $1m
The amount payable to Slite at the year endwill change with the movement in the price of oil and therefore the financial liability recorded at the year end should reflect the best estimate of the cash payable.
By the year end the price of oil has risen to $105 per barrel, so the financial liability will be 10,000 × $105 = $1,050,000, an increase of $50,000. The accounting entries to reflect this increase in liability and expense to profit or loss at the year end will be:
DEBIT Expense (P/L) $50,000
CREDIT Slite – financial liability $50,000
After the year end the price of oil changes again, and the transaction is settled at $95 per barrel. The cash paid by Burley to Slite on 12 December 20X9 is 10,000 × $95 = $950,000. This means that a gain arises after the year end of $1,050,000 – $950,000 = $100,000. This gain will be taken to profit or loss in the following accounting period:
DEBIT Slite – financial liability $100,000
CREDIT Profit or loss $100,000
The gain arising is an event after the reporting period.These are defined by IAS 10 Events after the reporting period as events, both favourable and unfavourable, that occur between the end of the reporting period and the date that the financial statements are authorized for issue.
The question arises of whether this is an adjusting or non adjusting event. An adjusting event is an event after the reporting period that provides further evidence of conditions that existed at the end of the reporting period. A non-adjusting event is an event after the reporting period that is indicative of a condition that arose after the end of the reporting period. The price of oil changes frequently in response to a number of factors, reflecting events that arose after the year end.It would therefore not be appropriate to adjust the financial statements in response to the decline in the price of oil. The gain is therefore a non-adjusting event after the reporting period.”

We are clearly told that we need to pay at the price of oil which prevails the day we make the payment (i.e. if we, Burley, over extracts) so why first recognize a purchase? What’s purchased and what’s the significance of debiting purchases at first?

Also, even if I agree we purchased the oil from our partner why not just show it at (10000*95) = 950,000 straight away, why go in circles and recognize gains/losses in the I/S for no use when it’s clear that the oil was over extracted in this year (30.Nov.2009) so what’s the use of all those entries? Please explain to me the logic behind all those double entries and why at first we use the market rate at the date of purchase and then the rate at the year end and then finally recognize it at the above value?

Thanks,

ME…