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There is a lot of debate amongst me and my classmates about Provisions and contingencies and when should something be classified as a provision and when a contingency.
Example: A Co. has a plant which will require Overhaul Costs every three years, now this Overhaul cost, should it be capitalised/expensed out/depreciated/written down/provided as a provision
But then my problem is that it can’t be a provision because the company can sell this plant later on and has no obligation to pay.
Another doubt is Environmental costs, do we again capitalise only and depreciate it with the asset / capitalise and do something else to it. . . . ?
Please help me, I did read the previous topic and there is still a debate and speculation aspect in it so I am still confused …. ( I might not have understood the previous discussion in the forum properly and I apologize for that )Sir if it’s going to take too long for you to explain the whole of provisions and the other questions above, could you kindly send me a link to some notes on it ? or videos ?
Thank You.you could try looking at the course notes! A provision is defined as a liability of uncertain timing or amount. A liability is also defined in the framework. A contingency is a possible liability which may arise dependent upon the outcome of some uncertai future event.
Apply these definitions to your overhaul situation and then see where you are up to.
Dear vedavyas,
Here is what I’ve found on these questions as they concerned me too a little while ago:
-according to BPP textbook you SHOULD NOT provide for any overhaul costs at all because the requirement of OBLIGATION is not satisfied, it’s mere INTENTION and, like you said, the management can sell the asset before the overhaul is due.
-Environmental costs are capitalized in your balance sheet instead of being expensed as they are normally quite substantial, so the entry is:
Environmental clean-up costs (asset) 10
Environmental provision (non-cur liab) 10Then you ‘depreciate’ these costs together with your main asset (oil rig etc) over the life of the oil rig. Your annual entries, say, are:
Environmental clean-up costs in I/S 1
Environmental clean-up costs in B/S 1At the end of the life of your oil rig you will have expensed the entire 10 and got rid of the asset on the balance sheet, thus leaving you only with the provision, which is a liability. Once you settle this liability, you credit cash and debit liability, thus bring everything to zero.
That’s all I’ve got, I hope it helps.
ValentinaThank you Mike, and Valentina,
I wanted to know if I add the environmental cost to my asset, I add it at the present value of the future obligation, and if I make the provision it should be for the whole amount, and not the present value right ? (or not the fair value of the provision/no. of years to incurr costs) ?And on warranties, suppose they have not given an estimate of the future cost to be incurred, or they have given that it might be 20% or so, but there is no proof that this cost will be incurred ( like experts opinion, or past performances..etc) then we don’t make the provision, right ?
Overhaul Cost:
Ex: Asset value 60m, life – 6years, Overhaul Cost 300k after 3 years this has to be incurred, then what do I use for calculating the depreciation on my asset ?
a. 60 m-(60m/6years)<--- Depreciation amount in brackets
or
b. FV(60m – 300k) – (60m-300k/6 years)<--- Depreciation amount in brackets
or
c. FV(60m – 300k) – (60m-300k/3 years, since overhaul is due after 3 years)<--- Depreciation amount in brackets
And what figure goes into my NCA in the SOFP
And there will not be any provision.. I got this. Thank you really for the repliesHi again,
Re: present value and liability
Please look at this example (BPP exam revision kit, Q56 Triangle, part (i).
I am simplifying here, ok?
so, a company bought a plant for 15 mln, 10 years of life. It is a legal requirement to decontaminate the area that plant started contaminating from day 1 of its operations. The present value of this decontamination is 5 mln at discount rate of 8%.Answer:
1.
Plant (plant 15+decontamination costs 5) 20
Cash or AP (for plant) 15
Provision: decont.costs (non-cur.liab) 5 (at PV!!!)2. One year later do depreciation as normal:
Depreciation expense (20/10) 2
Acc.depn-plant 2So, do you agree that after you do this entry for 1o years, you will put the expense of 5 mln decontamination through your income statement?
3. Next, unwind your discount (remember, 5 mln is at PV at discount rate of 8%, so this liability that is now sitting in your books at 5 mln must be gradually increased every year to the future obligation, the one they will actually have to pay out in 10 years):
Finance cost (5 mln x 8%) 400K (goes to I/S)
Finance cost 400 (goes to provision)So now, do you agree that your provision is 5,400?
So, next year we again unwind the discount, 5.400 X 8%=432 and so on, and eventually we bring our provision from 5 mln to the real future obligation amount.
Well, at least this is how I understand it…but I am not a tutor, I am fellow student who also gets confused all the time….
Re: your question about depreciation:
I am not 100% sure, but I think, according to IAS 16 PPE and the matching principle we must allocate the cost of the asset OVER ITS USEFUL LIFE irrespective of overhauls or not. Therefore, my answer would be 60/10=6.
The amount to be depreciated is normally either COST 60 or revalued amount. You don’t have the revalued amount yet. If the company does the revaluation in 3 years time and the asset is impaired due to 300 overhaul required, maybe then you use the revalued amount (60-300) for depreciation. I personally don’t see any other way around it, however, let’s wait for Mike, he knows everything!!! Thanks God 🙂My advice to you: do a lot of exam questions, you will learn all these delicate little things via the exam questions as the book does not cover a lot of things or covers them, but too briefly.
Cheers!
ValentinaHi
I think I answered this earlier in the ask the tutor chat session. however, we need to depreciate the asset over 6 years and the last overhaul costs ( now capitalised ) over three years. But we DO NOT PROVIDE for the overhaul ( we used to, in the “old days” but that stopped with the issue of the framework and the proper definition of a liability )
Hi,
Just to be clear: so do we need to capitalise the overhaul costs of 300 and then depreciate it over 3 years?
When we capitalise the overhaul costs, what’s the other side of the double entry please?
Many thanks,
ValentinaYou capitalize the 300k and add it to the value of the asset, then you depreciate the asset accordingly, (6m+300K x depreciation % or divided by the number of years, or whatever.)
Then in Finance Costs you unwind the Discount , suppose it’s 300k by a 5% discounting , then the finance cost of unwinding the discount is 300k x 5%, this finance cost is also added to the Provision amount stated in the SOFP….
That was what i understood from what Sir Mike had said in the Chat last night…I thought you depreciate the asset over 6 years and depreciate the overhauls costs separately over 3 years, that’s how I understood Mike…..
When we capitalise the overhaul costs, what’s the other side of the double entry please?
Many thanks,
ValentinaHey Valentina, you’re correct. Although the overhaul costs are capitalised into the asset, different depreciation rates apply, even though it is a single asset. A good example is in the course notes where we talk about an airplane. Different elements of the plane have different expected useful lives, so different depreciation rates are applied.
In the above example, depreciate the 6m over 6 years, but depreciate the capitalised overhaul costs over three years
good, and the amount to be added to the cost of the asset is the present value of the clean up costs. Similarly, the provision is the present value. Then, as each year goes by, we need to increase the provision by unrolling the discounted amount. the double entry is Dr Finance charges and Credit the provision
Sir your still replying to this topic ? thats great, and BTW I passed got 72 😀 Thank you very very much sir
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