Refer below the extract from ONGC (Oil & Gas sector listed company) about the abandonment cost or decommissioning cost/ liability which are being capitalized with the related assets-
“Cost of temporary occupation of land, successful exploratory wells. all development wells, depreciation on related equipment. facilities and estimated Future abandonment costs are capitalised and reflected as Oil & Gas Assets.”
Certain assets that are being used in industries like Oil and Gas, Minerals extractions, Nuclear etc. (although the mentioned concept could be applicable to any industry) require through a contractual agreement to incur some expenditures (in future) relating to removal/ dismantle / re-surfacing the land/ or surface where these assets are used once it is handed back to the issuer.
These requirements to incur certain expenses are quite common across different industries and in the absence of any specific guidance under current accounting system there is some diversity in practice and as per our example of ONGC as mentioned above, these costs will be added to the related asset at its full value (total amount which is to be incurred in future). Reader can follow the link to download full report for their reference http://www.ongcindia.com/wps/wcm/PDF/AnnualReport/annual_report15-16.pdf
Now, after the applicability of Ind-As, there is some guidance available related to this concept and It will possibly change systems which are being kept currently to capture such transactions.
Firstly let us look at some relevant provisions of the standards related to the Decommissioning liability –
As per Ind-As- 37 – Provisions, Contingent Liabilities and Contingent Assets
Para 18 – “Financial statements deal with the financial position of an entity at the end of its reporting period and not its possible position in the future. Therefore, no provision is recognized for costs that need to be incurred to operate in the future. The only liabilities recognized in an entity’s balance sheet are those that exist at the end of the reporting period”
Para 19 -“It is only those obligations arising from past events existing independently of an entity’s future actions (ie the future conduct of its business) that are recognized as provisions. Examples of such obligations are penalties or clean-up costs for unlawful environmental damage, both of which would lead to an outflow of resources embodying economic benefits in settlement regardless of the future actions of the entity. Similarly, an entity recognizes a provision for the decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused……………..”
Para -14 – A provision shall be recognized when: (a) an entity has a present obligation (legal or constructive) as a result of a past event; (b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and (c) a reliable estimate can be made of the amount of the obligation. If these conditions are not met, no provision shall be recognized.
Ind-As- 16 – Property, Plant & Equipment’s
Para 16 – “………………………….(c) the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period.
Ind-As- 16, Appendix A– “Changes in existing decommissioning, restoration and similar liabilities”
Para -7 – The adjusted depreciable amount of the asset is depreciated over its useful life……………
Para -8 – The periodic unwinding of the discount shall be recognized in profit or loss as a finance cost as it occurs. Capitalization under Ind –AS- 23 is not permitted.
Let’s have a practical illustration to understand this whole requirement –
| Estimated Decommissioning liability | 10,000 | (per contractual agreement) | ||
| When to incur (how many years) | 20 | Years | ||
| Incremental borrowing rate (of entity) | 8.50% | p.a. | ||
| Present Value (discounted value) | 1,956 | (Using excel “PV” formula) | ||
| Initial recognition | ||||
| 1 | PPE (respective assets) | Dr. | 1,956 | |
| Decom. Liab. | Cr. | 1,956 | ||
| (Initial recognition at cost by using PV) | ||||
| Yearly Journal entries | ||||
| 2 | Depreciation | Dr. | 97.8 | |
| Accumulated dep. | Cr. | 97.8 | ||
| (Dep. Over 20 years i.e (INR 1,956)/20 years = INR 97.8) | ||||
| 3 | Finance exp. | Dr. | 166.27 | |
| Decom. Liab. | Cr. | 166.27 | ||
| (Decom. Liability to accrete by using borrowing rate) | ||||
Depreciation will then be calculated based on the useful life of the cost of asset capitalized i.e. INR 1,956 divided by 20 years = INR 97.81 p.a. Refer the table below-
| Years | Dep. (20 years) |
| 1 | 97.81 |
| 2 | 97.81 |
| 3 | 97.81 |
| 4 | 97.81 |
| — | —- |
| Till 20 | 97.81 |
| 1,956.16 |
And at the same time liability which has been recognized at its present value will be accreted (i.e. accumulation) each year by using Incremental rate of borrowing as per below table-
| Years | Opening | Finance exp | Closing bal. | |||
| 1 | 1,956 | 166 | 2,122.44 | |||
| 2 | 2,122 | 180 | 2,302.85 | |||
| 3 | 2,303 | 196 | 2,498.59 | |||
| 4 | 2,499 | 212 | 2,710.97 | |||
| — | — | — | — | |||
| Till 20 | 9,217 | 783 | 10,000.00 | Liability face value | ||
| Total finance exp | 8,044 | (To spread over the liability period) | ||||
Now,
There are some important aspects which are worth to be noted while dealing these kind of situations and it’s accounting accordingly-
- Standard is very clear about the decommissioning liability to be provided even though these are related to future action but because of the independence from any action of an entity, the said liability will be provided in the books at the inception only,
- Provision recognition criteria is already met , as entity has present obligation through a contractual agreement and money will outflow from the entity and amount is already mentioned in the agreement to be incurred at the end of the period mentioned, hence provision will be created,
- Now, as mentioned in the Appendix A of Ind-As -16, the cost of such assets will be recognized at the inception only by using equivalent amount of present value of liability/ prov. so created because of time value of money will be accreted over the period and only present value of liability will be recognized at the balance sheet and hence similar amount of asset will be recognized and will be depreciated accordingly,
- Appendix A talks about subsequent measurement of such liabilities and suggests that all changes in this liability will be adjusted towards the cost of assets (in case of cost modal of assets) and depreciate the new amount prospectively, however in case of revaluation modal it will be charged to PL/ OCI as per its previous upward/ downward treatments,
- Change in discount rate i.e. incremental borrowing rates will be also be used to reflect prospective adjustments,
- Accretion of liability will be charged to PL as finance cost and capitalization will not be allowed for such finance costs.
Reader can visualize that this will change the processes for recording/ recognizing such decommissioning costs and its accounting will require more general ledgers to be opened and calculation based working to align these adjustments. Materiality will always be considered by the management and accordingly such adjustments will be done.
A reader will appreciate about the main objective of the standard and an approach which one can follow while keeping in mind the basis of origin of such requirements. There could possibly be some specific situations or circumstances where the interpretation of any standard will be different as we should always keep in mind that IND-AS is principle based standards and lot more areas need management judgment in line with the standards relevant interpretation and best practices.
One has to look into all related facts and patterns before concluding this type of assessment based on this concept. Readers are requested not to take this article as any kind of advice (it is not exhaustive in nature) and should evaluate all relevant factors of each individual cases separately.
(Author of this article is an experienced chartered accountant who has specialization on various GAAP conversions assignments covering different industries around different part of the world including acting as IFRS advisor & corporate trainer. He can be reached via email at [email protected] or whatsapp +91-9634706933)
Author Bio
Many of our readers sent their requests to explore more accounting issues related to Oil & Gas sector like ONGC…I suggest to provide reader one accounting issue at a time so that it will be easier to remember and will be handy…all your suggestions are welcome..thanks