When a company acquires certain types of long-term assets, it sometimes has an obligation to remove these assets after the end of their useful lives and restore the site.
Typical example of such an asset is an oil rig or a nuclear power plant.
When an oil rig, a power plant or similar construction fulfills its purpose and comes to the end of its useful life, it’s only fair to our environment and people to remove it and restore the site as much as it can be.
Now, here’s the problem:
When and how should you account for these expenses?
It would be clearly unfair to account for these expenses as they arise.
The reason is that the obligation to remove and restore the site arose right when the related assets were built and therefore, the company knew about these costs right from the start.
Users of the financial statements have the same right to know about such an obligation and the related expenses.
Therefore, IFRS contain several rules about so-called “decommissioning provisions”.
What do the rules say?
The standard IAS 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 I explained above, when you build an asset that requires removal after the end of its useful life and restoration of the site, then a present obligation arises at the time of its construction.
The obligation can result either from legislation (“legal obligation”) or from valid expectations of the third parties created by the company (“constructive obligation”).
Except for IAS 37, there’s the standard IAS 16 Property, Plant and Equipment that requires including the initial estimate of the costs of dismantling and removing the item and restoring the site into the cost of an asset.
It means that you do NOT recognize a decommissioning provision in profit or loss, but in your assets as a part of an item of PPE.
Finally, there’s a pronunciation IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities dealing with subsequent measurement of a provision and recognition of its changes.
How to measure decommissioning provision
Measurement of decommissioning provision is extremely demanding, difficult and there are a lot of uncertainties involved.
The main reason is that you try to measure the expenses to be incurred after the end of your asset’s useful life. That can happen 30, 40 or 50 years later (maybe even more).
It’s quite difficult to estimate what happens within the next 5 years… and what about 50 years?
I could write a separate article about measurement of provisions, but let me give you just a few points that you should bear in mind when measuring decommissioning provisions:
Involve experts to estimate future costs.
We, accountants, are very smart people, but we do not know everything. Therefore, technical experts in your business should be able to do the job. Please make sure that their report contains at least:
What types of processes and operations are necessary to remove/restore;
What their estimated cost with sufficient details is;
What the timing of estimated costs is (no, we can’t assume that a nuclear power plant or an oil rig will be removed within 1 year – it can take even 10 years to complete the job fully).
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Study the report and adjust it.
Technical experts are great, but they are not accountants. We are and therefore, we need to understand how the experts estimated costs (i.e. what they put in their report). You should ask questions like:
Are individual expenses estimated in today’s prices? Or, did experts include some inflation?
You should not include the same risk twice into your calculation and therefore, when your estimates are in current prices, then you should a real discount rate (excluding the effect of general inflation).
When the estimates are inflated, then use a nominal discount rate.
When I was dealing with my client’s decommissioning provision, our team selected a different approach.
We asked our experts to use the current year’s prices and then we adjusted them for the effect of inflation. The reason is that the cash flows are not centered in 1 year, but spread over more years and the estimate of inflation can be different for different years.
Did experts include any effect of technologies not yet available? Did they count on any technical development? Or, did they assume today’s technologies?
Hey, you should not count on any future developments that are not yet certain and available.
What portion of these expenses relates to the removal of the buildings and constructions? What portion relates to the rectification of environmental and other damages caused by the operations?
This is very important for decision on when and how to recognize your provision.
Select the discount rate and discount your cash flows.
IAS 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”.
There’s not much guidance in IFRS on selecting your discount rate in this particular case and indeed, there are many approaches to select your discount rate.
Let me describe just one of them.
You can select some publicly traded government bonds and plot them on the yield curve to extrapolate the yield for maturity in the period when your expenses for decommissioning are expected to arise.
Hmmm, sounds difficult, I know. But, decommissioning provisions are not easy! If you are interested, you can check out my IFRS Kit to learn how to do it.
How to recognize the decommissioning provision initially
When you measured your provision successfully, now it’s time to recognize it.
As written above, the standard IAS 16 requires recognizing initial estimate of decommissioning costs to the cost of an asset.
The journal entry is therefore:
Debit Property, Plant and Equipment (nuclear power plant, oil rig, whatever)
Credit Provision for Decommissioning
The question is when to recognize such a provision, because the nuclear power plant or similar assets are built within several years.
Well, you should recognize a provision when there’s a past event creating a present obligation.
In most cases, your obligation builds up together with your asset. Of course, you will have smaller expenses to remove semi-finished reactor than to remove completed reactor.
Therefore, I recommend splitting the creation of your provision into the individual years of constructing your asset. The more you construct, the bigger obligation you have.
Let me also warn you about a provision to rectify damages caused by the operations.
The obligating event happens when the operations run. Therefore, you do NOT recognize any provision to rectify damages caused by operations at the time of constructing your asset.
Moreover, this provision relates to the operations and not to an asset itself and therefore, it is recognized in profit or loss (not to the cost of an asset).