Question

Petrofac Co. operates an oil well in foreign country with environmental laws that require Petrocan Co. to restore the site to its original condition one the oil well ceases operations. Petrocan estimates two outcomes:

A. Either the restoration payment of $100,000 operations at the end of the 3rd year when the well will cease operations { which is 40% likely], or

B . The restoration payment of $150,000 instead at end of the 5th year when it will cease operations [ which is 60% likely].

The current three to five year risk free interest is 5 % a year.

Requirements: The company applies the two criteria of the proposed amendments to IAS 37 to determine whether recognition of a provision of appropriate.

Is the criterion 1, “ present obligation as a result of a past obligating event,”met? How? Or how not?

Determine whether Petrocan Co. should recognise a provision, if it can make a reliable estimate of the expected restoration. Yes ___ or No. ___. If yes, describe the recognition for what amount $_____, and in which financial schedules (s):

Answer 1

As per IAS 37, a provision for a liability is made "if and only if

a. a present obligation (legal or constructive) has arisen as a result of a past event (the obligating event)

b. payment is probable ('more likely than not'), and

c. the amount can be estimated reliably."

In the given case, there is an obligation to make a payment at a future date, the obligation is more than likely probable and it can be estimated reliably. Hence Petrofac co should recognize and provision.

Provisions for a one off event are measured at the most likely amount and the amount is discounted using the pre tax discount rate

The most likely amount in this case is $150,000, present value @5% after 5 years = 150,000*0.7835 = 117,525. This amount will be added to the cost of the asset and also shown as a liability. So the recognition is shown in the balance sheet.

Each year, the amount should be reviewed and adjusted to reflect the current best estimate.