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Chapter 7

Q. 7.10

The following transactions and events have affected Sharp Technologies S.A. pior to December 31st, 20X7. The management of the company authorizes the financial statements for issue on March 15th, 20X8.

a) The company has accidentally polluted a neighbouring property. The management estimates clean-up costs at 300,000 lei. Current legislation requires immediate clean-up of polluted sites. The company holds an insurance policy covering such incidents for up to 80% of actual costs, but the company is aware that the recovery of their value from the insurer is laborious.

b) The company sells industrial equipment with a warranty period of 12 months. Estimated warranty costs in 2018 amount to 200,000 lei.

c) On February 15th, 20X5 the Office for Patents and Trademarks has granted the company the patent for its new aluminium casting technology. Some potential customers have already shown their interest in this breakthrough in the defence industry. The company estimates revenues of 800,000 lei in the coming year.

e) The company is a defendant in two court cases concerning product defaults. The plaintiffs, General S.R.L. and KUT S.A., seek damages of 50,000 lei and 100,000 lei respectively. The company’s legal advisors estimate that there is a high probability to lose the case against General S.R.L., but a strong chance to win against KUT S.A.

 

Step-by-Step

Verified Solution

a) The company has a legal obligation to clean up the neighbouring property and an outflow of economic benefits is probable. Therefore, a provision should be recognized for the amount of 300,000 lei. The amount receivable from the insurer should be treated as a contingent asset (explained later), as its receipt is uncertain. The journal entry is as follows:


300,000 lei                 Expense with provision         =       Provision for Clean-up Costs                      300,000 lei


 

b) At the end of the year, the company has a legal obligation to repair the equipment sold during the year. Although not every item sold will require repairs, there is a high probability that some warranty costs will be incurred. A provision should then be recognized for the best estimate of these costs, that is, for 200,000 lei.


200,000 lei           Expense with provision           =         Provision for warranties                 200,000 lei


 

c) This grant from the Office for Patents and Trademarks is material; therefore, the company should disclose a contingent asset in the notes. Future revenues are not allowed in the financial statements, but such an event is considered a contingent asset and disclosed in the notes, which informs the stakeholders.

d) On a meeting held in November, 20X7, the Board of Directors has decided to discontinue the chemical division of the company. In the following month, the company terminated contracts with suppliers of chemical materials and sent a letter to every employee in the division announcing the close-down scheduled for March 1st of the following year. Compensations payable to employees and other restructuring costs amount to 500,000 lei. At the end of the financial year 20X7, the company has a constructive obligation towards its personnel and third parties as it has begun to implement the restructuring plan. It is highly probable that resources will leave the enterprise to settle this obligation and thus the company should recognize a provision for restructuring of 500,000 lei.


500,000 lei         Expense with provision      =          Provision for discontinued operations                        500,000 lei


 

e)Based on existing evidence, the company has a legal obligation in the General S.A. case, but has no obligation in the KUT S.R.L case. The probability to pay damages in the first case is high, in the second case remote. The company will recognize a provision of 50,000 lei in the first case; it will neither recognize a provision, nor disclose a contingent liability in the second case, as there is a remote probability that it will have to pay damages to KUT S.A.


50,000 lei          Expense with provision           =           Provision for litigations              50,000 lei


 

Provisions are in place until either the risk event takes place or the timing (for warranties for instance) is off. Consequently, the provisions are reversed/cancelled.
In Example a) above, the company should set up a provision for clean-up costs at the end of the year 20X7 for the estimated amount of 300,000 lei.
Now, assume that in 20X8, the company pays 310,000 lei plus 19% VAT to a business specialized in decontamination. The disclosure of the service bought is:


368,900 lei            %                                             =        Other payables               368,900 lei

310,000 lei           Other Services Expense
58,900 lei             VAT Deductible


 

The provision previous recognized is reversed/cancelled:


300,000 lei             Provision for Clean-up Costs         =          Revenue from Provisions                      300,000 lei


 

When the insurer announces to the company that it will reimburse the clean-up costs, the company recognizes an asset (a receivable) and the corresponding revenue (248,000 lei = 310,000 lei * 80%):


248,000 lei           Other Debtors          =          Other Operating Revenue                 248,000 lei


Provisions and contingent liabilities are often misunderstood and used as synonyms. This is an error and should be better understood by looking at the following example.