Question

Newark Ltd is a manufacturing company that operates a production facility in the Sydney suburb of Blacktown. In January 2020 residents living adjacent to the production facility complained that the ground around their homes was being contaminated by waste discharged from Newark Ltd's production facility. In May 2020, environmental officers from the City of Sydney Council confirmed that the ground was contaminated although they did not regard the contamination as posing a health risk. Although Newark Ltd is not legally required to restore the contaminated ground, Newark Ltd immediately responded by implementing new procedures for the storage and disposal of waste material to prevent any further contamination from occurring and then then made a series of public announcements that it would undertake to restore the contaminated ground in two years' time.

As at 30 June 2020, Newark Ltd estimates the cost of restoring the contaminated ground as follows:

Cost Probability

$1,500,000 5%

900,000 5%

500,000 30%

350,000 60%

On 30 June 2020, the risk-free discount rate, based on two-year government bonds, is 6%. However, Newark Ltd believes that a discount rate of 4% is appropriate to adjust for the risks specific to this liability.

Required

Determine the amount that, in your judgement, Newark Ltd should recognise as a provision as at 30 June 2020. Justify the approach that you used to calculate the amount. You should note that the marks for this question are for the approach that you take and the justification rather than the calculation.

Answer 1

The above question can be taken in 2 perspectives -

1. accounting perspective

2. management & risk perspective

As mentioned the marks are based on the approach taken to get to the solution , we need to go ahead with the management & risk perspective here.

First we consider that the restoration of contaminated ground will be done by the company , irrespective of health risks due to the contamination. Hence the provision to be made for the same should be done immediately.

As , the cost probablity schedule is given , we take a weighted average of all probablities i.e. [ COST 1 x Probablity+ COST 2 x probablity +...]and so on. we arrive at the value of 480000. Now this value is the future of the liability, the actual payment will be made after 2yrs,i.e. the time value of money can be considered by the company

Now the given question states that there are 2 discount factors given viz. 4% & 6 %. If we discount this future liability we will arrive at the present value to be provisioned.

But, practically speaking the liability will have to be mandatorily paid off at the end of 2 years. When a company invests its capital into its core business , it usually gets more return on capital employed than any govt. security, also the provision made is on the books of the company rather than actuality.

Hence my opinion will be that the provision to be made should be equal to the future value itself i.e. 480000. It also gives the company a cushion of safety if the cost increases over the period of 2 years. To justify the non usage of time value of money , we can say that the same amount could be put to use in day to day operations so that to reap benefits out of the same.