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ACCT2110
Topic 4: Provisions and Contingencies
Question 1
ABC Ltd enters into a supply agreement with Buyer Ltd on 1 January 2020. The agreement
states that:
• ABC Ltd must supply Buyers Ltd with 100 chairs at a price of $150 per chair.
• If ABC Ltd cannot deliver the chairs on time and under the terms of the contract it must pay
Buyers Ltd a penalty of $12 000.
• The delivery date is 31 March 2020.
ABC Ltd begins manufacturing the chairs on 1 March 2020, but experiences a series of
production problems that result in the production cost of each chair totalling $200 as at 31
March 2020. Assuming the end of ABC Ltd’s reporting period is 31 March.
Required: Briefly explain how ABC Ltd should account for the contract.
Question 2
In each of the following scenarios, explain whether or not ABC Ltd would be required to
recognise a provision.
a) As a result of its plastics operations, ABC Ltd has contaminated the land on which it
operates. There is no legal requirement to clean up the land, and ABC Ltd has no record of
cleaning up the land that it has contaminated.
b) As a result of its plastic operations, ABC Ltd has contaminated the land on which it operates.
There is a legal requirement to clean up the land.
c) As a result of its plastics operation, ABC Ltd has contaminated the land on which it operates.
There is no legal requirement to clean up the land, but ABC Ltd has a long record of cleaning
up land that it has contaminated.
Question 3
Below are three independent situations.
1. In August 2020, a worker was injured in the factory in an accident partially the result of his
own negligence. The worker has sued Wesley Co. for $800,000. Counsel believes it is
reasonably possible that the outcome of the suit will be unfavorable and that the settlement
would cost the company from $250,000 to $500,000.
ACCT2110 Semester 2/2023
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2. A suit for breach of contract seeking damages of $2,400,000 was filed by an author against
Greer Co. on October 4, 2020. Greer's legal counsel believes that an unfavorable outcome
is probable. A reasonable estimate of the award to the plaintiff is between $600,000 and
$1,800,000. No amount within this range is a better estimate of potential damages than any
other amount.
3. Quinn Ltd is involved in a pending court case and lawyers believe it is probable that Quinn
Ltd will be awarded damages of $1,000,000.
Required
Discuss the proper accounting treatment, including any required disclosures, for each situation.
Give the rationale for your answers.
Problem 1
On 30 June (the reporting day) 2020, ABC Ltd estimates that it will be required to
pay $100 000 in 3 years’ time (30 June 2023) to settle a warranty obligation. The risk‐free
discount rate applied is 5.5%. The probability of cash outflows has been assessed (i.e. adjusted
for risk) in determining the $100 000.
Required
1. How is the provision accounted for at 30 June 2020 and 30 June 2021? Prepare the journal
entries.
2. At 30 June 2022, ABC Ltd re‐estimates the amount to be paid to settle the obligation at the
end June 2023 to be $90 000. The appropriate discount rate remains at 5.5%. How is the re‐
estimation accounted for? Prepare the journal entries.
Problem 2
LMI Ltd is a lawnmower manufacturer. Its reporting period ends 30 June. Following is an
extract from its financial statements at 30 June 2023.
Current liabilities
Provisions
Provision for warranties
$525 000
Non‐current liabilities
Provisions
Provision for warranties
131 004
Note 37 — contingent liabilities
LMI signed an agreement with BankSouth on 3 April 2023 to the effect that LMI guarantees a loan
made by BankSouth to LMI’s subsidiary, LSS Ltd. LSS’s loan with BankSouth was $56 million as at
30 June 2023. LSS was in a strong financial position at 30 June 2023 and accordingly LMI believes
that it is not probable that the guarantee will be called (AASB 137/IAS 37 paragraph 86).
ACCT2110 Semester 2/2023
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The provision for warranties at 30 June 2023 was calculated using the following assumptions (there
was no balance carried forward from the prior year).
Estimated cost of repairs — products with minor defects $2 000 000
Estimated cost of repairs — products with major defects $5 500 000
Expected % of products sold during FY 2023 having no defects in FY 2024 75%
Expected % of products sold during FY 2023 having minor defects in FY 2024 20%
Expected % of products sold during FY 2023 having major defects in FY 2024 5%
Expected timing of settlement of warranty payments — those with minor defects 90% in FY 2024,
10% in FY 2025
Expected timing of settlement of warranty payments — those with major defects 60% in FY 2024,
40% in FY 2025
Discount rate 7%. The effect of
discounting for
FY 2024 is
considered to be
immaterial.
During the year ended 30 June 2024, the following occurred.
• In relation to the warranty provision of $656 004 at 30 June 2023, $420 000 was paid
out of the provision. Of the amount paid, $360 000 was for products with minor defects
and $60 000 was for products with major defects, all of which related to amounts that
had been expected to be paid in the 2024 financial year.
• In calculating its warranty provision for 30 June 2024, LMI made the following
adjustments to the assumptions used for products sold during FY 2024.
Estimated cost of repairs — products with minor defects $2 500 000
Estimated cost of repairs — products with major defects $6 000 000
Expected % of products sold during FY 2024 having no defects in FY 2025 80%
Expected % of products sold during FY 2024 having minor defects in FY 2025 17%
Expected % of products sold during FY 2024 having major defects in FY 2025 3%
Expected timing of settlement of warranty payments — those with minor defects All in FY 2025
Expected timing of settlement of warranty payments — those with major defects 50% in FY 2025,
50% in FY 2026
Discount rate No change. The
effect of
discounting for
FY 2025 is
considered to be
immaterial.
• The subsidiary of LMI, LSS Ltd, was in a strong financial position at 30 June 2024.
However, LSS was sued by one of its competitors for patent infringement in April 2024.
ACCT2110 Semester 2/2023
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The compensation claimed in relation to the patent infringement is $87 million. The
hearing for the dispute had not been scheduled as at the date the financial statements for
2024 were authorised for issue. The legal adviser of LSS was of opinion that there was a
30% chance that LSS would be found guilty. If found guilty, there was a 60% chance
that LSS would need to pay $50 million as compensation to the plaintiff, and a 40%
chance it would have to pay $30 million compensation.
Required
(a) Calculate the warranty provision as at 30 June 2023. This should agree with the financial
statements provided in the question.
(b) Calculate the warranty provision for products sold during FY 2024 as at 30 June 2024.
(c) Determine whether the bank guarantee meets the definition of a provision or a contingent
liability for the year ended 30 June 2024 given the patent infringement action against LSS.