Introduction:
In most cases when a company acquires certain types of long-term assets, it has an obligation to remove these assets after the end of their useful lives and restore the site. Most of these long term assets are constructed on leased land or premises, thus obligating the user to return it in the original condition at the end of the agreed term.
Typical example of such an asset is an oil rig, a nuclear power plant, a chemical unit, etc.
When an oil rig or a power plant fulfills its purpose and comes to the end of its useful life, it’s fair to our environment and people to remove it and restore the site as much as it can be.
In most of the countries, the legislation requires a company to remove the plant and restore the site after the end of its useful life making it inevitable for the company to incur the expenses to decommission its assets in future.
Page Contents
1. When to account for decommissioning expenses?
As per Ind AS 16, Property, Plant and Equipment, the cost of an item of property, plant and equipment includes among other things, an 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 37, ‘Provisions, Contingent Liabilities and Contingent Assets’, requires recognizing a provision when there is a liability – i.e. present obligation arising from past events.
As the liability to incur the decommissioning cost is incurred when an asset is build or constructed, it is an obligation that arise at the time of construction of an asset and needs to be recognized in the cost of the asset as per Ind AS 16.
2. How to measure decommissioning liability?
Estimation of decommissioning costs is a difficult task and involves significant judgement. The reason why the estimation of liability is difficult is because of the fact that we are trying to measure the expenses that are to be incurred at the end of the useful life of an asset which may be 30 years or 40 years or 50 years. As the period is really long, it necessitates few important steps:
a) Relying on experts to estimate future cost:
This estimation requires inputs from technical experts to evaluate various criteria like:
- Processes necessary to remove the asset or restore the sight
- Estimated cost likely to be incurred
- Timing of incurring the expenses, that is, the decommissioning expenses are to be incurred immediately on discontinuation of an asset/end of lease term or its going to take few years to remove the asset and restore the site.
Even though reliance can be placed on the report of the expert that are certain aspects which an accountant needs to consider, like:
- Whether estimated cost is at current price or adjusted for any future inflation?
- The above aspect is very important as the discounting rate used for arriving at the present value of the provision depends on the same
- Are the technologies used by the expert in his report currently available?
- What portion of the expenses relates to removal of assets or restoration and what portion relates to rectification of environmental and other damages caused on account of operations?
b) Use appropriate discount rate and arrive at the present value of the provision:
Para 47 of Ind AS 37, requires to select a “pre-tax rate(s) that reflect(s) current market assessment of the time value of money and the risks specific to liability”.
Not much guidance in available either in Ind AS or IFRS on selecting a discount rate and hence the same may vary from entity to entity depending on the type of approach used by each entity.
3. How to recognize decommissioning provision initially?
Once the measurement of decommissioning liability is done, the next step is to recognize it. As stated above, Ind AS 16 requires, recognizing initial estimates of decommissioning cost to the cost of an asset.
The journal entry is:
Property Plant and Equipment – Debit
Provision for decommissioning liability – Credit
While recognizing the liability be mindful of the liability that arises for rectifying the damages caused by operations of an asset. In this case the obligation arises only when the operations run and hence no provision is to be recognized at the time of construction of an asset. Moreover, this provision relates to operations and not to an asset and hence should be charged to the statement of profit and loss and should not be included in the cost of an asset.
4. How to recognize decommissioning provision subsequently?
Step 1: Unwind the discount each year: Which means charging an interest on the provision to build up the discounted liability to its future value.
The journal entry is:
Finance Cost – Debit
Provision for decommissioning liability – Credit
Step 2: Charge depreciation on the asset
The journal entry is:
Depreciation Expense – Debit
Accumulated Depreciation – Credit
Step 3: Revise the provision at the end of each reporting period, if required and recognize the changes in line with ‘Appendix A’ of Ind AS 16. The accounting for revision in provision depends on the model of accounting adopted for the assets.
- In case assets are accounted using the Cost Model, then any change in the provision is recognized in the cost of the asset.
- In case assets are accounted using the Revaluation Model, then any change in the provision is recognized in the revaluation surplus or deficit.
Example: Accounting for decommissioning provision
Let’s say that experts estimated the decommissioning expenses for a plant on 1 April 2020, as below:
| Year on incurring the expense | Amount of expense |
| 2030 | 400,000 |
| 2031 | 500,000 |
| Total | 900,000 |
Considering the appropriate discount rate at 12%, the present value of decommissioning provision to be recognized is:
| Particulars | Amount |
| 400,000*0.322 (Present value discounted at 12% at the end of 10 years) | 128,800 |
| 500,000*0.287 (Present value discounted at 12% at the end of 11 years) | 143,500 |
| Total decommissioning liability to be provided | 272,300 |
Amount of Rs. 272,300 is added to the cost of the property plant and equipment and depreciated over the useful life.
The company need to account finance cost on the decommissioning liability created using the rate of 12%.
The final word
Accounting for decommissioning is not easy as it involves a very degree of uncertainty and estimates. On top of that, accounting for something that will happen in the far future means lots of discounting and continuous re-estimation, reassessment and recalculation of a provision. Considering the complexities involved, decommissioning is not purely an accounting matter and it involves key role to be played by the decommissioning expert to help the accountant in estimating and re-estimating of the liability.
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