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ACT B332F Company Accounting II

HKAS 37 Provisions, Contingent Liabilities and Contingent Assets

Tutorial Exercises

Question 1

Distinguish contingent liabilities from provisions.  Support your answer with one simple example.

Question 2

Presented below are 5 independent situations relating to the recognition and/or disclosure of liabilities, provisions and contingent liabilities as at the various companies’ financial statement reporting date of 31 December Year 1:

(i) Magazine Ltd sold 500 annual subscriptions on 31 December Year 1 for $580 each. 

(ii) Justice Ltd was involved in a lawsuit on 31 December Year 1.  Lawyers determined that it was probable that Justice Ltd would lose the case and the amount of damages to be paid by Justice Ltd could be 50% of chance paying $50,000 and 50% of chance paying $5,000,000.

(iii) Drillers Ltd erected and placed into service an off-shore oil platform on 31 December Year 1.  Drillers Ltd was legally required to dismantle and remove the platform at the end of its useful life in 10 years.  The estimated present value of the dismantling and removal costs at 31 December Year 1 was $500,000.

(iv) As a result of its plastics operations, Polymer Ltd had, on 31 December Year 1, contaminated the land on which it operated.  There was no legal requirement to clean up the land, but Polymer Ltd had a long record of cleaning up land that it had contaminated.  If the land was to be cleaned up, it would cost Polymer ltd $87,000.

(v) Kobe Ltd estimated that it will cost $45,000 to overhaul a machine.  The overhaul is needed every 5 years and the machine was 5 years old as at 31 December Year 1.

Required:

Discuss, with reasons, in each of the above independent situations (i) to (v), whether they require the recognition and/or disclosure of a liability, a provision or a contingent liability, or none of them, in the financial statements of the company concerned as at its financial reporting date at 31 December Year 1.  Identify also in your discussion the past obligating event, if any, in each situation.

Question 3 (HKICPA Module A Sept 2006)

Mini Automobile Limited (“MAL”) signed a firm sale contract with Car Trading Inc. (“CTI”) on 1 May Year 1.  The contract specifies that 300 units of Mini Wagon II (“MWII”) have to be delivered before 28 February Year 2 at a fixed price of HK$ 380,000 per unit.  If the delivery is late for more than one month, MAL will grant CTI a discount of 30% on each delayed unit.  The cost of production is HK$288,000 per unit.  Up to 31 December Year 1 MAL was only able to deliver 260 units. MAL will only be able to deliver another 20 units before 28 February Year 2.  The unexpected delay is due to strike on one of the production plants.

MAL signed an agreement to lease premises for show room for three years.  According to the lease agreement, MAL is responsible for restoration of the premises to the original condition at the expiry of the lease term.  As at 31 December Year1, MAL had already incurred HK$ 10m in renovating and decorating the showroom.  MAL estimates that it will incur HK$0.8m to restore the premises to the original position.

At 31 December Year1, MAL was a defendant in a patent infringement lawsuit of its driving control system (“DCS”) that has a high probability of making loss of HK$120m.  If MAL loses the case, the management will take legal action to claim the loss from the DCS developer.  The Company’s lawyers advise that it is also highly probably that MAL will be successful in recovery of HK$100m from the DCS developer.

Required:

For each of the situations, determine (i) whether a provision should be made; (ii) the amount of the provision, if any, in MAL’s statement of financial position at 31 December Year 1. (iii) the required disclosure by reference to the relevant accounting standards.

Question 4

Sea Limited, a public company, purchased a coal mine and its related plant on 1 January 2014. During the year to 31 December 2014, a new Environmental Legislation had been passed and enforced with immediate effect. This Legislation requires Sea Limited to landscape the area affected by the mining activities during the estimated life of the coal mine. At 31 December 2014, the estimated economic life of the coal mine is ten years. At the same time, the future costs of the landscape, which have been estimated by a professional surveyor with sufficient experience to be $162,000, have to be discounted at 8% to the present value as of 1 January 2014.

Required:

Discuss and explain the appropriate accounting treatments for the year ended 31 December 2014 of the event given in the question. In your answers, you have to address the following areas:

(HKIAAT Paper 7 Advanced Accounting June 2008)

Question 5

Darren Company Limited (“DCL”) is engaged in the manufacture of batteries. On the unaudited statement of financial position as at 30 June 2014, it has recognized the following provisions as current liabilities:

(a) A provision for late delivery penalty

In May 2014, DCL received a sales order for 7,000,000 units of rechargeable batteries for which the agreed delivery date is 31 August 2014. It is expected that DCL would earn a gross profit of HK$1 per unit. Due to a shortage in the supply of raw materials, at the reporting date, the management realized that they could only supply the goods at the earliest on 10 September 2014. According to the sales contract, DCL would compensate the customer for late delivery at HK$0.01 per unit per day.

(b) A provision for annual safety inspection of the production line

The last inspection was carried out in June 2013. Due to a large backlog of sales orders, the management decided to postpone the annual inspection until mid-September 2014.

(c) A provision for the loss on sales of aged finished goods

The products were manufactured in late 2012 with an expected normal usage period of 2 years from the date of production. Due to the short expiry period, they were sold at a price below cost in July 2014.

(d) A provision for bonus payments to two executive directors

In accordance with the directors’ service contract, two executive directors are entitled to receive, in addition to monthly salaries, a bonus of equivalent to 5% of the profit before taxation and the accrued bonus.

Required:

Discuss the appropriateness of the provisions recognized by DCL.

(HKICPA Module A Feb 2008)

Question 6

AKB Limited has two factories in the Mainland, one in Shenzhen and one in Dongguan. AKB has started an internal restructuring by downsizing its Shenzhen factory and shifting manufacturing operations to its factory in Dongguan. In early 2010, the management considered selling or leasing the Shenzhen factory in order to limit operation expenses and, more importantly, to look for a larger cash cushion and prepare for even harder times in the future.

AKB’s directors decided on 8 February 2010 to restructure the company’s operations. On 28 February 2010, the Shenzhen factory was shut down. An offer of HK$40 million has been received for the Shenzhen factory though there is no binding sales agreement. One thousand retrenched factory workers have already left and their accumulated entitlements have been paid, except an amount of HK$3 million, representing a compensation of two months’ wages for the retrenched factory workers, which has not yet been paid. It is expected that costs of HK$350,000 will be incurred in transferring 250 workers to their new jobs in the Dongguan factory. The transfer is planned for 8 April 2010.

Meanwhile, all office staff of the Shenzhen factory, except one, have been retrenched and have had their accumulated entitlements paid. One office staff member, Gary Wong, remains in order to complete tasks relating to the closure of the Shenzhen factory and the transfer of workers to the Dongguan factory. Wong will stay until 31 May 2010. His salary will be HK$8,000 per month and his retrenchment package will be HK$26,000, all of which will be paid on the day he leaves. It is estimated that he spends 70% of his time handling the closure of the Shenzhen factory, 25% on handling the transfer of workers to the Dongguan factory, and the remaining 5% on general administration.

Required:

Determine, with explanations, the amount of the provision for restructuring costs to be recognised in AKB’s statement of financial position as at 31 March 2010.

(HKICPA QP FE Dec 2010 Paper II)