IAS 37 Homework Solution

Part 1

Accounting for the oil rig and the related decommissioning liability

The oil rig should be impaired to nil as it has been totally destroyed and has no salvage value.

The impairment should be recognised as a revaluation decrease to the extent of any credit balance
existing in the revaluation surplus in respect of the oil rig; the balance would be recognised in profit
or loss.

With regard to the decommissioning liability, a new assessment should be made regarding the
timing and amount of the decommissioning costs. The timing is likely to have been brought forward
and the costs increased due to the exigent containment and clean-up activities following the oil leak.
Care must be taken not to double count the clean-up costs by including them in the provision as well
as in this decommissioning liability (see discussion below).

Any increase in the liability should be charged to profit or loss as the revaluation surplus in respect of
the oil rig has been fully depleted after the impairment of the oil rig (IFRIC 1.6(a)(ii)).

Insurance payments

The receipt of $400million should be recognised as income separately from the impairment loss.

It can be recognised in the financial statement as the money has already been received

(the ‘virtually certain’ criterion per IAS37.33 is met).

The additional $150million insurance pay-out should be disclosed as a contingent asset in the notes
to the financial statement if it is probable that economic benefits will flow to OilCo as the receipt
thereof depends on the result of investigations which have not yet finalised. Thus the receipt is not
virtually certain.

Containment and clean-up costs as well as legal claims

To the extent that the $76million incurred to date relate to activities that would have been carried
out in the normal course of decommissioning the unit and restoring the drilling site, they should be
deducted from the decommissioning liability when they are paid.

Other containment and clean-up costs are expensed as they are incurred.

These expenses, to the extent that they remain unpaid at year end, should be recognised as a
liability and not a provision as their timing and amount are certain.
(The decommissioning provision could also be reversed in full against revaluation surplus then P&L
and a new liability raised for the clean-up activities if the latter is viewed as a separate event from
the original decommissioning obligation. 2 marks.)

As to the balance of the estimated clean-up costs and legal compensations (10 000 mil – 76 mil = 9
924mil), a provision should be raised to the extent that OilCo has a present obligation arising from a
past event and it is probable that future economic benefits will flow out of the company on
settlement and the amount can be estimated reliably.

Present obligation as a result of a past event (the obligating event) and outflow of economic benefits

The public announcement made by OilCo before year end has created valid expectations in the
general public that the entity will discharge the obligation for the clean-up costs and OilCo has no
realistic alternative to settling the obligation created by the announcement (IAS 37.17(b)) which will
lead to an outflow of economic benefits regardless of the future actions of the entity. This past event
gave rise to a present constructive obligation on OilCo to discharge those responsibilities at year
end.

Reliable estimates

The use of estimates is an essential part of the preparation of financial statements and does not
undermine their reliability. Except in extremely rare cases, an entity will be able to determine a
range of possible outcomes and can therefore make an estimate of the obligation that is sufficiently
reliable to use in recognising a provision (IAS37.25).

In this case, the $10 billion estimated by financial experts could be regarded as a reliable estimate
for the obligation.

As the definition and recognition criteria of a provision are met, the balance of the clean- up and
containment costs should be recognised as a provision at year end.

Lawsuits that have been filed against OilCo at year end should be assessed for their likely outcomes
with the help of experts. Legitimate cases with outcomes that are likely to favour the plaintiffs
should be provided for.

A contingent liability should be disclosed for law suits that are not recognized as a provision based
on the criteria in IAS37.

Part 2
Supply contract

The contract to purchase is an executory contract, because before the cooling agent is delivered,
neither party has performed its obligations for the month in question (IAS 37.3).

Thus no amount should be recognised in respect of this contract until the cooling agent is delivered
and is paid for on a monthly basis.

When the litres of cooling agent are delivered to OilCo, they must be recognised as inventory,
because this cooling agent is a material or supply to be consumed in the production process (IAS
2.6). The corresponding credit will be recognised as a liability for accounts payable, until the end of
the month when the purchase price is actually paid.

Per IAS 2, inventory should be initially recognised at cost. Owing to the fact that $10 of each litre of
cooling agent is for the repayment of a loan (see below), the cost of the inventory is $90 per litre
(until 3 April 2011 – see below). At year end, the inventory is required to be remeasured to the lower
of cost and net realisable value. Given the fact that the inventory is to be resold after purchase, at a
price not exceeding $75, it is likely that a write-down is required.

Incentive to enter into the supply agreement

According to the Conceptual Framework for Financial Reporting, financial statements must faithfully
reflect the economic phenomena they purport to represent (para. QC12). A faithful representation
of this incentive agreement is the following: the third party has lent money to OilCo ($3 million) and
OilCo is paying the loan back in monthly instalments over 7 years (in the form of above market
payments for the cooling agent, of $50 000 [(100-$90) x 5 000] per month).

Accordingly, OilCo has a financial liability to repay this “incentive” (which is actually a loan), because
the fixed term supply contract has created a contractual obligation to pay this excess amount which
represents a repayment of principal and interest.

Assuming that $3 million represents the fair value of the loan, this is the amount at which it should
be initially measured, and this should be used (along with payments of $50 000 per month) to
determine an effective interest rate for the loan, which is the rate that exactly discounts the
payments to be made in the future to the fair value at the date of initial recognition. This should
then be used to accrue an annual interest expense in respect of the loan until the incentive has been
fully repaid. At the end of each month, OilCo should recognise a decrease in the loan for the $50 000
payment.

Onerous contract
On the 3rd of April 2011, the supply agreement becomes onerous, because the unavoidable costs of
fulfilling the contract ($90 per litre) exceed the benefits expected to be received as a result of the
contract (there is no other use for the cooling agent other than to sell it at the market price of $80
and then $75, which is less than the $90 cost). Accordingly, a provision for the onerous contract
must be recognised.

The onerous contract must be recognised at the best estimate (IAS 37.36) of the least net cost of
exiting from the contract (IAS 37.68), being the lower of the net cost of completing the contract (see
below) and the cancellation fee for terminating the contract (which is $20 million).

The contract costs are $450 000 per month, but the contract benefits are $400 000 per month to the
end of June and then $375 000 per month thereafter. The net cost must be discounted using a
market related rate to find a present value at 3 April 2011. Since this is likely to be lower than the
$20 million penalty cost, this amount must be recognised as the provision for the onerous contract
on 3 April 2011.

The next issue to resolve is what the contra account to this onerous provision entry should be on 3
April 2011. The supply contract is in respect of inventory (see above); however, the only reason that
the contract is onerous is because the inventory resale value is below the contract price. Thus it is
submitted that the debit side of this entry should go to profit or loss, as the inventory would be
immediately written down to its net realisable value.

To the end of the 2011 financial year, OilCo should unwind the discount on the provision and
recognise an interest expense in profit or loss. When OilCo makes payment for the inventory in
2011, $80 worth of this payment is in respect of inventory, and $10 of this payment reduces the
onerous contract provision, which was raised in respect of the differential between the market rate
and the contract rate (IAS 37.62 states that only expenditures that relate to the original provision are
set against it).