Financial Reporting

Topic: Provisions and contingent liabilities Level of difficulty: High Haeffner PLC is an accounting firm. Some of its clients face the following situations. For each, it is assumed that a reliable estimate can be made of any outflows expected:

1 Acme Manufacturing Enterprises Ltd. (AME) provides a warranty on its products at the time of sale. Under the terms of the warranty contract, AME undertakes to make good, by repair or replacement, any manufacturing defect that becomes apparent within three years from the date of sale. Based on past experience, it is probable that there will be some claims under the warranties.

2 Stone Oil Industries Co. (SOI) has been a medium-size oil producer and refiner for the past 50 years. It operates in many parts of the world. On occasions, SOI units have incurred spills of crude or refined products that have contaminated land and water. It is SOI’s management philosophy that clean-up should be organized only when the firm is required to do so under the laws of the country in which the spill took place. One country in which SOI operates has, until now, not had any legislation requiring cleaning-up. SOI has been contaminating land and water in that country for several years without taking any corrective action. On 31 December X1 it becomes virtually certain that a draft law mandating retroactive cleaning-up of land and waterways already contaminated will be enacted shortly after the year-end.

3 Sudstrom AB is a large upscale retail store established in most major consumer market areas. It has built its reputation on selection and quality of its products and on a well-advertised policy of refunding purchases to dissatisfied customers without asking any question as long as Sudstrom carries the product, even in cases where the store may not be under any legal obligation to do so.

4 On 18 December X1, the board of Zygafuss Agglomerated Enterprises Co. (ZAE) decided to close down one of its industrial divisions. By closing date (31 December) the decision had not yet been communicated to any of those affected (not even to the Works Council), and no other steps had been taken to implement the decision.

5 During X1 Mutter GmbH had provided a loan guarantee for the benefit of Scout AG, a trading partner (in which Mutter does not hold any share interest) opening the market for Mutter products in Transmoldavia (a fictitious country). Scout’s financial condition at that time is considered to be sound and its economic prospects bright. Bankers have, however, requested a loan guarantee because of the short history of Scout in this market and the possible instability of the Transmoldavian market. During X2 the market in Transmoldavia experiences a serious economic downturn and Scout’s financial condition deteriorates. On 30 June X2 Scout AG actually files for protection from its creditors.


Analyze each of these five situations and make a recommendation for each as to the necessity of recording (and reporting) or not an appropriate provision.

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