- 15 Marks
Question
Roman Limited prepares its financial statements in accordance with International Accounting Standards. On March 16, 2017, Roman Limited made a public announcement of a decision to reduce the level of emission of harmful chemicals from its factories. The average useful life of the factories on March 31, 2017 was 25 years. The depreciation of the factories is computed on a straight-line basis and charged to cost of sales. The directors formulated the proposal for emission reduction following an agreement in principle earlier in the year.
The directors prepared detailed estimates of the costs of their proposals, showing the following expenditures:
- N60 million on March 31, 2018
- N60 million on March 31, 2019
- N80 million on March 31, 2020
All estimates were for actual anticipated cash payments. No contracts were entered into until after April 1, 2017. The estimate proved accurate regarding the expenditure due on March 31, 2018. When the directors decided to proceed with this project, they used discounted cash flow techniques to appraise the proposed investment, with an annual discount rate of 8%. The company has a reputation for fulfilling its financial commitments after it has publicly announced them. Roman Limited has made a provision for the expected costs of its proposal in the financial statements for the year ended March 31, 2017.
In accordance with the provisions of IAS 37 – Provisions, Contingent Liabilities, and Contingent Assets:
Required:
a. Explain the decision of the directors of Roman Limited to recognize the provision in the statement of financial position as at March 31, 2017.
(6 Marks)
b. Compute the appropriate provisions in the statement of financial position in respect of the proposed expenditure at March 31, 2017, and March 31, 2018.
(4 Marks)
Compute the TWO components of the charge to the statement of profit or loss in respect of the proposal for the year ended March 31, 2018. You should explain how each component arises and identify where in the statement of profit or loss each component is reported.
(5 Marks)
(Total 15 Marks)
Answer
Explanation of Provision Recognition (6 Marks)
Roman Limited’s decision to recognize the provision aligns with IAS 37 requirements. The criteria under IAS 37 for recognizing a provision include:
- Present Obligation: A present obligation from past events is created when the company publicly announces its commitment, establishing a constructive obligation.
- Probable Outflow of Resources: Given the company’s established reputation for fulfilling commitments, it is probable that Roman Limited will proceed with the planned expenditure.
- Reliable Estimate: The directors have provided a reliable estimate of costs for the emission reduction project using discounted cash flow techniques.
By meeting these criteria, Roman Limited appropriately recognized the provision as a liability in the financial statements as of March 31, 2017.
Part b: Calculation of Provisions for March 31, 2017, and March 31, 2018 (4 Marks)
Discounted Cash Flow Calculation (Discount rate = 8%):
| Year | Payment (N) | Discount Factor (8%) | Present Value (N) |
|---|---|---|---|
| 2018 | 60,000,000 | 0.92593 | 55,555,800 |
| 2019 | 60,000,000 | 0.85734 | 51,440,400 |
| 2020 | 80,000,000 | 0.79383 | 63,506,400 |
| Total Provision (2017) | 170,502,600 |
Provision at March 31, 2017: N170,502,600
Provision at March 31, 2018:
- Provision for 2018 expenditure is N60 million (actual payment).
- Adjust remaining provision balance for 2019 and 2020 costs, including interest unwind on remaining obligations.
Part b: Components of Profit or Loss Charge for March 31, 2018 (5 Marks)
- Unwinding of Discount: This represents the finance cost associated with the passage of time for the remaining provisions (interest expense on the outstanding liability).
- Reported as Finance Cost in the Profit or Loss statement.
- Depreciation of Provision: The actual expense of N60 million paid for emission reduction.
- Reported as Cost of Sales in the Profit or Loss statement, as it relates to the operational reduction in emissions.
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