ExpertMedium2 marksMultiple Choice
ACCA · Question 17 · Provisions and Contingencies
HeavyMachinery Co sells industrial equipment with a one-year warranty. Based on past experience, 5% of equipment sold will have major defects costing $1,000 each to repair, and 15% will have minor defects costing $200 each to repair. During the year, 1,000 units were sold. What is the expected value of the warranty provision required at year-end?
HeavyMachinery Co sells industrial equipment with a one-year warranty. Based on past experience, 5% of equipment sold will have major defects costing $1,000 each to repair, and 15% will have minor defects costing $200 each to repair. During the year, 1,000 units were sold. What is the expected value of the warranty provision required at year-end?
Answer options:
A.
$50,000
B.
$30,000
C.
$80,000
D.
$1,200,000
How to approach this question
Use the expected value method. Calculate the cost of major defects and add it to the cost of minor defects based on the probabilities.
Full Answer
C.$80,000✓ Correct
Under IAS 37, when a provision involves a large population of items, the obligation is estimated by weighting all possible outcomes by their associated probabilities (expected value method).
Major defects: 5% of 1,000 units = 50 units. Cost = 50 * $1,000 = $50,000.
Minor defects: 15% of 1,000 units = 150 units. Cost = 150 * $200 = $30,000.
Total expected cost = $50,000 + $30,000 = $80,000.
Common mistakes
Only calculating the provision for the most likely outcome, rather than the expected value of all outcomes.
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