IAS 37, Provisions, Contingent Liabilities and Contingent Assets, was issued in 1998. The Standard sets out the principles of accounting for these items and clarifies when provisions should and should not be made. Prior to its issue, the inappropriate use of provisions had been an area where companies had been accused of manipulating the financial statements and of creative accounting.
Required:
(a) Describe the nature of provisions and the accounting requirements for them contained in IAS 37.
(b) Explain why there is a need for an accounting standard in this area. Illustrate your answer with three practical examples of how the Standard addresses controversial issues.
(c) Bodyline sells sports goods and clothing through a chain of retail outlets. It offers customers a full refund facility for any goods returned within 28 days of their purchase provided they are unused and in their original packaging. In addition, all goods carry a warranty against manufacturing defects for 12 months from their date of purchase. For most goods the manufacturer underwrites this warranty such that Bodyline is credited with the cost of the goods that are returned as faulty. Goods purchased from one manufacturer, Header, are sold to Bodyline at a negotiated discount which is designed to compensate Bodyline for manufacturing defects. No refunds are given by Header, thus Bodyline has to bear the cost of any manufacturing faults of these goods.
Bodyline makes a uniform mark-up on cost of 25% on all goods it sells, except for those supplied from Header on which it makes a mark-up on cost of 40%. Sales of goods manufactured by Header consistently account for 20% of all Bodyline's sales.
Sales in the last 28 days of the trading year to 30 September 2003 were $1 750 000. Past trends reliably indicate that 10% of all goods are returned under the 28-day return facility. These are not faulty goods. Of these, 70% are later resold at the normal selling price and the remaining 30% are sold as 'sale' items at half the normal retail price.
In addition to the above expected returns, an estimated $160 000 (at selling price) of the goods sold during the year will have manufacturing defects and have yet to be returned by customers. Goods returned as faulty have no resale value.
Required:
Describe the nature of the above warranty/return facilities and calculate the provision Bodyline is required to make at 30 September 2003:
(i) For goods subject to the 28-day returns policy, and
(ii) For goods that are likely to be faulty.
(d) Rockbuster has recently purchased an item of earth moving plant at a total cost of $24 million. The plant has an estimated life of 10 years with no residual value, however its engine will need replacing after every 5000 hours of use at an estimated cost of $7.5 million. The directors of Rockbuster intend to depreciate the plant at $2.4 million ($24 million/10 years) p.a. and make a provision of $1500 ($7.5 million/5000 hours) per hour of use for the replacement of the engine.
Required:
Explain how the plant should be treated in accordance with International Accounting Standards and comment on the directors' proposed treatment.