Q Bluebell – provision

The scenario states that three hotels which were severely damaged by a flood during the year “need extensive repairs and refurbishment at an estimated cost of £100 million, which has been provided in full. All of the buildings are insured for damage caused by flooding.”

What ACCA’s answer then says is:
“The provisions for repairing flood damage should only be recognised if Bluebell Co has an obligation to perform the repairs at the year end. There is unlikely to be any legal or constructive obligation attached to this situation so a provision should not have been recognised in this accounting period. Operating expenses (and PPE if any portion of the provision relating to refurbishment has been capitalised) and liabilities are therefore overstated.
“In addition, it is important to consider that the buildings are covered by an insurance policy, which will pay out for repair and refurbishment costs to the assets. The fact that Bluebell Co has recognised a repair expense of $100 million indicates that either the buildings were not covered by adequate insurance (a business risk), or that the accounting implication of the reimbursement has been ignored.
“Tutorial note: Credit will be awarded for alternative interpretations as to whether an obligation exists at the year end for the property repairs to be carried out.”

So in answer to your Q – a provision should be recognised, regardless of any insurance, BUT ONLY IF there is a legal/constructive obligation – this is the first consideration in the answer. The model answer suggests that Bluebell has made a provision for FUTURE repairs. This is contrary to IAS 37. However, you could have suggested that Bluebell had entered into a contract for the repairs (i.e. Bluebell cannot just walk away from them or take some other action like simply sell them in their damaged condition) – in which case a provision would be legitimate. The insurance recovery would then be recognised separately as a contingent asset (cannot be offset because the contracts are with different parties and because the accounting treatments of contingent liabilities and assets do not “match”).

I don’t know why the BPP answer has been “turned round” but as restated I agree that it is misleading.

I am less inclined to state that this statement which is looking at the expense (in profit or loss) is wrong. If material you certainly wouldn’t offset asset against liability (unless there was a legal right of set-off – which there isn’t in these situations) – this would affect ratio calculations. But at the end of the day, profit is just the current year residual. So if we assume the recovery of insurance is virtually certain (“will pay”) and recognise the contingent asset the “income” would not be revenue and would most likely be offset against the cost in profit or loss.

There are numerous examples of offset in profit or loss – e.g. gains/losses on disposals of assets are often subsumed within depreciation expense – or recovery of a bad debt is offset against bad debt expense, etc, etc. So in this case profit or loss would just show next expense of the flood – which would be nothing if fully recovered.

You’re welcome!