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MGT401 GDB Fall 2019 Solution & Discussion Last Date: 27-01-2020

Total Marks 3
Starting Date Tuesday, January 21, 2020
Closing Date Monday, January 27, 2020
Status Open
Question Title IAS37
Question Description

GDB Question

An offshore oil exploration company is required by its license to remove the rig and restore the seabed. Management has estimated that 85% of the eventual cost will be incurred in removing the rig and 15% through the extraction of oil. The company’s practice on similar projects has been to account for the decommissioning costs using the ‘unit of production’ method whereby the amount required for decommissioning was built up year by year, in line with production levels, to reach the amount of the expected costs by the time production ceased. Keeping in mind the past experiences, the company has created the provision for this purpose.

Requirement:

Being a financial analyst, you are required to analyze the above decision of the company by answering following questions:

  1. Is there a present obligation as a result of a past event?
  2. Is there a probable transfer of economic benefits?
  3. Can the amount of the outflow be reasonably estimated?

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Solution Idea:

According to IAS 37, a company can recognize a provision against liability if it means the following conditions:

1. There is present obligation arises as a result of past event, in absence of past event; we follow the constructive obligation based on similar past practices.

2. Settlement of which results in probable transfer of economic benefits.

3. Estimation of the amount of the obligation is measurable.

Noted: Provision cannot be recognized if either of the condition is not met.

The following phrase, taken out from the last line of the paragraph, has helped me to answers the questions connected with IAS 37.

“The company has created the provision for this purpose”.

1. Is there is a present obligation as a result of a past event?

Ans: Yes, present obligation available in the form of constructive obligation resulted from the company’s practices on the similar projects.

2. Is there a probable transfer of economic benefit?

Ans: Yes, transfer of economic benefit is there, as decommissioning cost has been measured using the unit production method which is amount of extracted oil.

3. Can the amount of the outflow be reasonably estimated?

Ans: Yes, using historical data of similar projects of past, the reasonable amount of the outflow can be estimated.

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