You are the audit manager in charge of the audit of OilCo Ltd, a crude oil extraction company

involved in offshore drillings in the Gulf of Mexico. OilCo is listed on the JSE and has a 30 June
year end.

1. Deepwater oil rig

OilCo owns and operates a deepwater offshore oil rig built at a cost of R560 million. This cost
includes R24 million being the present value of the related decommissioning liability
discounted at 10% per annum. The rig was first brought into use on 1 st July 2002 and has an
expected useful life of 12 years with no residual value. The decommissioning costs are
expected to be incurred at the end of the rig’s useful life.

OilCo had always measured its property, plant and equipment under the cost model in IAS 16.
Nevertheless, in order to reflect more truly the future economic benefits expected to be
derived from its assets, OilCo’s directors decided to change the accounting policy from 1st
January 2010 to measure all its property, plant and equipment under the revaluation model
and elects not to transfer the realised portion of revaluation surplus to retained income.
The company eliminated the accumulated depreciation as at the date of revaluation against
the gross carrying amount of the asset.

The first revaluation of the oil rig occurred on 1st January 2010 where a professional valuer
estimated its fair value at R230million, using a discounted cash flow model after deducting
the expected decommissioning costs, which has remained the same since 1st July 2002.

On 3rd April 2010 an explosion occurred at the rig in the Gulf of Mexico and the rig was
completely destroyed, causing oil to leak uncontrollably into the ocean. According to a panel
of government and academic scientists on 16th June, oil was gushing at a rate of 35,000 to
60,000 barrels per day into the sea after numerous failed attempts to contain the leak. The
spill has caused extensive damage to the ecosystem of the gulf coast and at a meeting held
in June, financial experts estimated that the containment and cleanup costs as well as the
settlement of legal claims are expected to amount to R10 billion. R76 million of the total R10
billion has been incurred at year end. In a press release in early June 2010, OilCo has accepted
full responsibility to pay for these costs and any valid legal claims.

Shortly after the explosion, OilCo lodged a claim with its insurance company for a R550
million compensation for the destruction of the oil rig. As partial settlement of the claim R400
million was received on 5th May 2010 and the insurance company indicated that the payment
of the balance of the claim is dependent on the outcome of federal investigations as to the
cause of the explosion.

The oil rig has never been impaired. The useful life, residual value and discount rate remain
unchanged throughout all the years under review.

The managing director of OilCo has recognised a provision for the full estimated R10billion in
cleanup costs and legal claims in its 2010 financial statements. The financial director,
however, disagrees with the treatment on the ground that the recognition of a provision of
such magnitude using estimated amounts would distort the financial performance and
position of the company.

After reading the scenario, you be thinking about what was processed and what you believe
should have been processed as follows:
What was done?
Dr Dep; Cr Accum depr (oil rig)
Dr finance charges, Cr Provision for decommissioning
Dr P/L; Cr Provision R10 bn

What should have been done?

1. Impair the asset to zero: First reverse reval surplus and the expense the rest of the
impairment
2. De-recognise the asset (i.e. get rid of its presentation totally by Dr Accum dep & imp
and Cr Asset)
3. Recognise a provision for the present value of the full R10bn because the full amount
is a constructive obligation regardless of what has been incurred in the current year.
4. Provision for decommissioning costs (i.e. dismantling costs) are probably not included
in the R10bn (clean up and legal claim), so keep this, but will be required to dismantle
sooner than expected, therefore recalculate the PV.
5. Recognise income for the R400 m already received. The other R150 m must be
assessed for virtual certainty/probability.

2. Aftermath of the explosion

On 1 July 2008, OilCo entered into a long-term supply contract with an unrelated third party.
Under this contract, OilCo agreed to buy 5 000 litres of a special cooling agent per month for
a period of 7 years. The price per litre was R100, and the full purchase price for a month’s
worth of purchases (R500 000) is payable monthly in arrears. The parties agreed that the
contract could be cancelled by either party at any time, provided that a fee of R20 million be
paid for the cancellation. As the price of R100 was, at the time of the contract being signed,
above the market price of R90 per litre, the supplier paid OilCo R3 000 000 in cash to make
funds available for the higher contract price and act as an incentive to enter into the
agreement.

Accounting interpretation: Journal entries should have been:

Dr bank
Cr liability R3m

When inventory was purchased:

Dr liability R10 x z units
Dr inventory R90 x z units
Cr Bank R100 x z units
If price of inventory subsequently decreased:
Dr cost of sales (with inventory write-down to NRV)
Cr inventory

Following the explosion in the Gulf of Mexico, OilCo had no use for the litres of cooling agent
being purchased under this contract, because it had sufficient supplies for its other oil rigs
from other supply agreements. Thus, management decided to resell the litres of special
cooling agent it was purchasing on the open market as from 1 May 2011. At year end, the
market value of the cooling agent was R80 per litre, and this was expected to decline to R75
per litre after June 2011 and remain at that level for the foreseeable future.

REQUIRED Marks

A Discuss whether the discounted cash flow calculation performed by the

professional valuer on 1st January 2010 is correct for the determination of
the oil rig’s fair value for accounting purposes on that date.
2
This is referring specifically to the fact that the “provision for
decommissioning costs” i.e, the eventual cash outflow on dismantling of
the oil rig was included in the value of the asset.

Discuss how the explosion of the oil rig will affect the 2010 financial
statements of OilCo. Your answer should address the recognition and
measurement of the following:

• The oil rig and the related decommissioning liability;

• The insurance payments; and
B
• The provision for the cleanup costs and legal claims.
16

Limit your discussion to issues described in section 1 ‘deepwater oil rig’.

If you have read the question from an “Accounting perspective” from the
beginning, you should already have the answer to this part of the
question without too much extra effort.