1.

The article states that the US standard setter FASB requires companies to record
provision in relation to environmental costs of retiring an asset (to reserve
environmental liabilities) if its fair value could be reasonably estimated. How do you
think companies would go about estimating such a provision?

To estimate a provision for the cost of retiring an asset the company would engage
suitably qualified personnel to estimate the cost of removing and disposing the materials
of which the asset was constructed. Next they would estimate the costs involved in
restoring the land on which the asset was based. The date that the costs are expected
to be incurred would be determined. Cost accountants would work with these predicted
future expenses to estimate the present value of the outflows and to arrive at the
amount of the provision to be recognised in the accounts.

2. What aspects of the requirements were used by US companies to defer recognition

of a liability? Why would companies want to do this?

The US requirement stated that a provision was to be recorded in the accounts if its
amount could be reliably estimated. Some companies responded by stating that they
could not reliably estimate costs and therefore they avoided recognition of the provision.

A reduction in profit and an increase in liabilities which result from recognising a

provision may not be viewed favourably by managers because of the impact on share
price, financial ratios and remuneration. Students should consider the incentives at play
behind decisions to record (recognise) an item in the accounts or to disclose
information.

3. In what ways does the recognition of the liability in relation to future restoration
activity affect (a) net profit and cash flow in the current year and future years; and (b)
liabilities in the current and future years?

A provision for restoration involves the following journal entry to initially raised the
provision

(1) Year 1 Dr Restoration expense

(2) Year 1 Cr Provision for restoration

It reduces profit (by creating a restoration expense) but not cash flow in the year it is
recorded. It increases liabilities in the year it is recorded. In the future when the liability
is settled, the following journal entry is recorded

(1) Year X Dr Provision for restoration

(2) Year X Cr Cash

There is no effect on profit but there is an outflow of cash for the amount of the
restoration expense. At this time the liability is reduced. The entries are basic accrual
accounting. Students should refer to discussion in the chapter about IAS 37 and the
limitations on the use of provisions.

4. The article refers to changes in disclosure requirements relating to environmental

liabilities in many countries around the world. How important is it that companies
recognise the liability? To what extent is disclosure about the liability sufficient?

Ideally, accounting measures transactions and reports information which is useful for
decision making. One argument is that as long as information is disclosed, users can
factor it into their decision making. That is, disclosure is sufficient for competent users.
As long as they are aware of the amount and timing of the expected outflow of future
economic benefits they can include it in their models predicting cash flows and profit
and make informed decisions. Recognition of the amount in the accounts is not
necessary.

However, the counter argument is that less attention is given to note disclosure by users
and auditors compared to when items are recognised. Potentially, users could miss the
information if it is not recognised in the accounts and they focus on amount recognised
in the accounts. One view is that companies may give lower importance to amounts
which are disclosed (not recognised). When an amount must be recognised, it has
economic consequences which will ensure that managers give close attention to the
management of the underlying item. That is, if amounts are included in the accounts,
managers will endeavour to make accurate assessments of these amounts. Remember
that accounting is a means of holding managers accountable and recognition of
liabilities is a more effective way of doing this than simply disclosing an item. In addition,
research shows that auditors apply stricter tests and closer scrutiny to amounts which
are recognised compared to those which are disclosed.