- 6 Marks
FR – L2 – Q44 – Provisions
Question
The following information relates to the financial statements of Kumasi Ltd for the year to 31 March 20X4.
The mining division of Kumasi Ltd has a 3 year operating licence from an overseas government. This allows it to mine and extract copper from a particular site. When the licence began on 1 April 20X3, Kumasi Ltd started to build on the site. The cost of the construction was GH¢500,000.
The overseas country has no particular environmental decommissioning laws. In response to the global sustainability agenda, Kumasi Ltd has developed its own policy for sustainable operations. It has made information about this policy public and has provided examples to demonstrate that it is a responsible company that believes in restoring mining sites at the end of the extraction period. The cost of removing the construction at the end of the three years is estimated to be GH¢100,000.
The cost of the site currently shown in the trial balance is GH¢500,000. The company has a cost of borrowing of 10%.
Required
Explain the correct accounting treatment for the above (with calculations if appropriate).
Answer
IAS 37 Provisions, Contingent Liabilities and Contingent Assets only permission to be made if three conditions are met:
(i) The company has a present obligation, either legally or constructively, as a result of a past event;
(ii) Probable outflow of resources is required to settle the obligation; and
(iii) A reliable estimate is available.
Although there is no legal requirement to restore the site, the company has established a constructive obligation by setting a valid expectation in the market, due to its published sustainability policy and past practice, from which it cannot realistically withdraw.
It therefore appears probable that Kumasi Ltd will have to pay money to improve the site and so a provision should be created for the expected amount. As the expected payment of GH¢100,000 will not be settled for three years, the provision should be discounted and entered at its net present value of GH¢75,131 (GH¢100,000/(1.1)^3). Over the three years, the discounting should be unwound and charged to profit or loss as finance costs, resulting in a provision of GH¢100,000 by the end of the third year.
The cost of the construction work has been correctly capitalised. The cost of the future decommissioning work should be added to this asset so that the total costs of the site can be matched to the revenue from the copper over the period of mining. This will result in an asset of GH¢575,131 which should be depreciated over the three year life in line with anticipated revenues.
- Tags: Decommissioning Costs, Financial Reporting, IAS 37, Non-current Assets, Provisions, Sustainability
- Level: Level 2
- Topic: Provisions
- Uploader: Samuel Duah