Question

Problem 3: Provisions/Contingent Liabilities On 1 October 2017, Promoil acquired a newly constructed oil platform at a cost of $30 million together with the right to extract oil from an offshore oilfield under a government licence. The terms of the licence are that Promoil will have to remove the platform (which will then have no value) and restore the sea bed to an environmentally satisfactory condition in 10 years’ time when the oil reserves have been exhausted. The estimated cost of this on 30 September 2027 will be $15 million. The present value of $1 receivable in 10 years at the appropriate discount rate for Promoil of 8% is $0·46. Required: (i) Explain and quantify how the oil platform should be treated in the financial statements of Promoil for the year ended 30 September 2018; (ii) Describe how your answer to (b)(i) would change if the government licence did not require an environmental clean up.

Answer 1

A provision is created because present obligation as a result of past events and settlement is expected to result in an outflow of resources (payment).

Hence An entity must recognise a provision if, and only if

• a present obligation (legal or constructive) has arisen as a result of a past event
• payment is probable and
• the amount can be estimated reliably

The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date.

Hence Promoil needs to create the provision as it is satisfying all the condition as follows:

A present obligation - It is extracting oil and will need to restore the sea bed

Payment is probable - Amount will be spent to restore the sea bed to environment friendly conditions

Amount can be estimated - $ 15m will be spent

Now the treatment for the provision

Promoil will create provision today in books of accounts using present value as follows

Oil Platform account ... Dr 6.9 m

to provision for restoration a/c 6.9 m

(being provision created 15m x 0.46 = 6.9m)

(0.46 is the present value of $1 at 8%)

II) If the license did not require to restore the sea bed, then no provision will be created in the books as the very first condition would have missed out i.e., present obligation.

Hence in this case no provision will be required.