Question

The following items pertain to possible provisions: A company uses a part manufactured in Germany in its automobile manufacturing plant. There has been a concern about the failure of this part in cars manufactured in Germany. No failures have occurred to date in Canada. The company decided to do a voluntary recall of all cars manufactured with this part. The recall is 40% complete and has cost $1,220,000 to date. A company self-insures for floods. That is, it pays no insurance but is liable to replace assets lost through flood damage. No losses have been incurred this year, but there have been $210,000 of losses in most other years, and the company is concerned that there might well be $420,000 of losses next year, evening out the pattern. A company offers a three-year guarantee over parts and labour for products sold to ensure that parts work as expected. There were no payments this year, and only 5% of products sold this year are expected to need repairs in the next year. The cost of this work would be in the range of $110,000. A company has been sued by a customer for $1,020,000. The customer slipped on ice coming out of the store and claims the store did not put salt down or clear the stairs properly. The company’s lawyer has indicated that there is a 10% chance that the company will lose the lawsuit based on past history. The company, though, has decided to settle to avoid negative publicity. The costs of settling are estimated to range between $260,000 and $520,000. A company is required by legislation to undertake environmental remediation for a mining site that is currently active. The site will not be cleaned up until the mine closes, which is now scheduled for 2032. It is not certain how much the cleanup will cost at that time, or how long it will take.

Answer 1

1. As the company has opted for voluntary recall and the recall is 40% complete, the company needs to take provision for the remaining 60% as the recall will defintely be executed. The amount of provision will be =($1,220,000/40%)*60% =$1,830,000

2. As per the trend the flood loss amounts to $210,000 per year. Though there is no expense for flood loss this year, as per company estimate , next the the amount may be double. On a conservative note a Provision for Flood loss for $210,000 for current year should be taken to avoid double expense impact in next year.

3. As $ 110,000 is  expected cost of repair of the units sold this year , that will be incurred next year, there needs to be a provision this year for $110,000 to satisfy matching concept of revenue and cost.

4. As the company has decided to settle the lawsuit of $1,020,000 , a provision needs to be recorded . The cost of settlement can be taken as average of upper and lower limits =($260000+$520000)/2= $390,000

So the total amount of provision required is $1,410,000

5. The compnay needs to take prpoportionate yealy provision for environmental remedial actions. As the amount can not be ascertained, the company can take the estimates from similar activities taken up by other companies of similar nature and take yearly approximate provision. As the time progresses, it can fine tune the provision amount based on more accurates estimates that comes up in later years.