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Hi Mr,
I come across a question from the ACCA FR study hub regarding IAS 37 Provision and not sure about the solution.
Here is the simplified scenario:
At the start of the year, company got an oil extraction license with clean up condition attached at the end of the license.
The license cost is $50M.
The present value of the clean up cost at the start of the year includes $20M fixed amount and $0.02 per barrel extracted variable amount.
During the year a total of 150M barrels were extracted by the company.
The relevant interest rate is 8%.In the solution:
1. The cost of license at the year start is: 50M+20M = $70M
2. The variable amount for the year is: $0.02 * 150M = $3M. This amount is charged to profit or loss.
3. The finance cost relating to the provision at the year end is: (20+3)*8% = $1.84M.My puzzle is this: if $3M forms part of the provision basis to calculate the $1.84M finance cost for the year, why is it not included as part of the license cost in the first calculation? Why the variable amount is expensed to profit or loss as the oil is extracted?
Thanks.
Hi Mr,
I did a consulting with ChatGPT and it provided a different and yet convincing explanation:
1. At initial recognition, only the fixed amount clean-up cost is recognised for the provision: $20M, which forms part of the license cost initial recognition, since $20M is a reliable estimate and arises from the license agreement obtained in the past.
2. The variable amount clean-up cost does not form part of the provision at initial recognition, because the extraction amount is not certain at year start and the extraction activity will only occur in the future during the year.
3. However, at the year end, the variable amount clean-up cost estimate becomes reliable since the information regarding extraction activity for the year is available. It now forms part of the carrying amount of the provision at the year end when it becomes an obligation.
4. The carrying amount of the variable clean-up provision is calculated as: $0.02 * 1.08 * 150 = $3.24M, with 1.08 being the factor to bring $0.02 per barrel to the current value at year end. $3.24M will be charged to P/L as extraction cost.
5. The carrying amount of the fix-ed clean-up provision is calculated as: $20 + $20*8% finance cost = $21.6M, with $1.6M being the finance cost for the year.
6. The total carrying amount of the provision at year end will be: $21.6 + $3.24 = $24.84M.Considering that ACCA’s study hub occassionally has errors, am I correct to think that the solution offered by ChatGPT is more reasonable? Or do we need to bring the $0.02 per barrel unit variable cost to the year end current value? Is $0.02 * 150 = $3M enough for the variable provision at year end?
Thanks.
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