How to Account for Decommissioning Costs?

[How to Account for Decommissioning Costs?

If your business is in the oil and gas, mining, power and utilities, chemical and telecommunications industry, you will be familiar with decommissioning activities and its financial impacts. If you are not, hope this article simplify it.

What is Decommissioning ?

Decommissioning is the future dismantlement and removal of production equipment and facilities and the restoration and reclamation of the site to an ecological condition similar to that existing before operations began.

For example, toppling offshore production facilities involves removing the upper section of a platform (i.e., decks, jackets, and facilities) above a certain depth using either explosive or non-explosive cutting techniques.

The associated costs of remediation, restoration and environmental clean-up can be significant. Accordingly, energy companies have to park billions of dollars for decommissioning in their financial statements. Consider oil giant BP’s 2017 annual report, in which the company reported $16.1 billion in provision for decommissioning, down from $16.4 billion in the prior year. Thus, the accounting treatment for and audit of decommissioning costs are therefore critical.

Accounting Treatment for Decommissioning Costs

Initial Recognition and Measurement

Decommissioning of production assets may be required by law, the terms of operating licenses (Legal obligation) or an entity’s stated policy and past practice (Constructive obligation). All of these, according to Conceptual Framework and IAS 37 Provisions, Contingent Liabilities and Contingent Assets, create an obligation and thus a liability.

A corresponding asset is created as per IAS 16 Property, Plant and Equipment, which states that “the cost of an item of property, plant and equipment includes, among other things, Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the site on which it is located“.

The journal entry is therefore:

• Debit / Property, Plant and Equipment
• Credit / Provisions for decommissioning

Provisions for decommissioning are measured at the present value of the expected future cash flows (discounted cash flow) that will be required to perform the decommissioning (IAS 37).

Subsequent Recognition and Measurement

Subsequently, unwind the discount and charge the interest on provisions to build up the required provisions (future value of the discounted liability) over the life of asset. The accretion of the discount is recognized as part of finance costs in the statement of profit or loss.

Therefore, journal entry is:

• Debit / Finance Costs
• Credit / Provisions for Decommissioning

Remember to depreciate the cost of the provisions over the asset’s useful life (IAS 16).

In addition, changes to provisions that relate to the removal of an asset are added to or deducted from the carrying amount of the related asset in the current period.

Hence, the journal entry in case of decrease is:

• Debit / Provisions for Decommissioning
• Credit / Property, Plant and Equipment

However, the adjustments to the asset are restricted:

• The asset cannot decrease below zero and cannot increase above its recoverable amount.
• If the decrease in provision exceeds the carrying amount of the asset, the excess is recognized immediately in profit or loss.
• Adjustments that result in an addition to the cost of the asset are assessed to determine if the new carrying amount is fully recoverable or not. An impairment test is required if there is an indication that the asset may not be fully recoverable.

Finally, at the assets’ end-of-life date, the company decommissions the assets and restores the site to an ecological condition, so all expenses are charged against the provision:

• Debit / Provision for Decommissioning
• Credit / Cash

Illustrative Example:

X Co is involved in oil and gas production. On 1 January 2018, it constructed several platforms to drill wells and extract crude oil. The platforms were due to be productive for 8 years until 31 December 2025.  X Co, according to its stated policy and past practice, intends to decommission these platforms at the end of their useful life. At 1 January 2018, the costs of decommissioning the platform were estimated to be $80 million in 8 years’ time. To calculate the present value, the company considers that a discount rate of 5% is appropriate, and the discount factor at 5% for Year 8 is 0.677.

Assume that during 2018, the proven oil reserves are 40 million barrels and the annual production is 5 million barrels.

What is the accounting treatment in respect of the decommissioning for the year ended 31 December 2018?

Solution

In line with stated policy and past practice of X Co, it has a constructive obligation to decommission the platforms, and a reliable estimate for that liability can be made. The pay to decommissioning also enables X Co to acquire income from the extracted oil (economic benefits). Therefore, X Co must recognizes a provision as well as an asset, and depreciates this asset over its useful life.

The amount recognized for decommissioning costs is the present value of the expected future decommissioning costs. The present value is calculated as follows:

Future cost x discount factor (2025), which is $80 million × 0.677 = $54.160 million.

Therefore:

• Debit / Property, Plant and Equipment (platforms)            $54.160 million
• Credit / Provision for Decommissioning                                $54.160 million

Since the platforms are related to oil and gas production activities, the platforms are depreciated on unit of production basis over the proven oil reserves.

Accordingly, depreciation expense is $6.770 million {($54.160 million/40 million barrels) x 5 million barrels}.

Hence:

• Debit / Depreciation Expense $6.770 million
• Credit / Accumulated Depreciation $6.770 million

In addition, build up the provision for decommissioning costs to be $80 million by the end of year 8. This is done by unwinding the discounted decommissioning costs and making a finance costs each year. Hence, apply the cost of capital (5%) to the balance on the provision account. Thus, the finance costs for the year 31 December 2018 is 5% × $54.160 million = $2.708 million.

The entry is therefore:

• Debit / Finance Costs                                                 $2.708 million
• Credit / Provision for Decommissioning                $2.708 million

Statement of Financial Position at 31 December 2018 (Extracts)                              $million

Property, plant and equipment

Decommissioning Costs (Platforms)                                                                                          54.160

Depreciation                                                                                                                                     (6.770)

Provisions

Provision for Decommissioning at 1 January 2018                                                              54.160

Plus, Unwinding of Discount (54.160 x 5%)                                                                           2.708

Statement of Profit or Loss and Other Comprehensive Income for the Year Ended 31 December 2018 (Extracts)                                            $million

Depreciation Expense                                                                                                                    6.770

Finance Costs (Unwinding of Discount)                                                                                    2.708

To sum up, accounting for decommissioning is a challenge topic, because it involves significant areas of uncertainty and estimates.

In the next article we will demonstrate how to audit decommissioning costs.

I hope this article has been helpful in identifying the accounting issues of decommissioning activities.

Written by: Walid Yassin, ACCA

Section Head – Internal Audit – Gulf of Suez Petroleum Company

References

– ACCA Syllabus.

– PwC’s Inform INT.