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How to Audit Decommissioning Costs?
The previous article highlighted and addressed the accounting treatment of decommissioning costs. This article is to demonstrate the key risks in this area and how to audit it.
Assessing the Risks
ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and Its Environment, requires auditors “to identify and assess the risks of material misstatement, whether due to fraud or error, at the financial statement and assertion levels”.
Assessing engagement risks early at the planning stage should result in an efficient audit. The team will only focus their time and effort on higher risk audits and high risk balances. The following is a gist of the relevant risks in respect of decommissioning costs that should draw the auditor’s attention:
- Risk that inappropriate assumptions have been used in determining the initial decommissioning costs.
Estimation of decommissioning costs is not an exact science. It is a significant area of judgment and inherently subjective and complex. It involves estimations of the expected decommissioning cost, the estimated life of assets and appropriate discount factor to calculate the present value of the expected costs.
- Risk that an inappropriate interest rate and discount factor have been used.
Decommissioning will often take place far away in the future. Therefore, the effect of discounting is generally material and will have a significant impact on the size of the provision and the equivalent asset recognized. 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”. Hence, the interest rate used in discounting the cash flows should be reviewed annually. Using the interest rates offered by long term US Government Bonds would be a benchmark to use.
- Risk that decommissioning provisions are not updated at each statement of financial position date.
Decommissioning costs should be reviewed annually to reflect changes in laws and regulations, public expectations, prices, future impact of climate change and changes in clean-up technology.
- Risk that the value of the provision has not increased since last year.
The value of the provision should be normally increased over time, as the provision is unwound each year to increase its present value. If the provision has not increased in value, this could indicate that management has changed one or more of the assumptions used in the measurement of the provision (e.g. using a higher interest rate).
- Risk that insufficient disclosure has been made in the notes to the financial statements.
IAS 37 requires that the notes should contain narrative information including a brief description of the nature of,the obligation and the expected timing of any outflows of economic benefits, and an indication of the uncertainties about the amount or timing of those outflows. In addition, the notes should disclose the major assumptions made concerning future events. The notes should also contain numerical disclosures, namely a reconciliation of the opening and closing provision, analyzing the movement in the year.
ISA 330 The Auditor’s Response to Assessed Risks, state that auditors should “obtain sufficient appropriate audit evidence regarding the assessed risks of material misstatement, through designing and implementing appropriate responses to those risks”.
Therefore, in respect of decommissioning cost the auditors should:
- Obtain a written representation from management indicating that management,consider that significant assumptions used in making the accounting estimate are reasonable.
- Review any agreement/operating licenses issued by government to,confirm that there is an obligation to decommission.
- Recalculate the management’s calculations used to measure the provision to assure that,the calculation is based on assumptions in line with your understanding of the entity.
- Discuss with management whether there has been a change from the prior year,in the methods for making the estimates or assumptions used in the measurement of the provision, and challenge these management’s assumptions to ensure its reasonableness.
- Assess the controls in place over the estimate of the provision (e.g., the assumptions used in calculations,are periodically reviewed and whether there is review and approval of the calculations).
- Review the notes to the draft financial statements to confirm sufficiency of narrative and numerical disclosures provided in compliance with IAS 37.
To conclude, accounting for and auditing of decommissioning is a challenge topic, because it involves significant areas of uncertainty and estimates.
In addition, it is not completely matter of accounting. It is essentially an engineering matter. Then it is a matter of quantifying those engineering outcomes. Thereby, you should consider the industry’s experts to reach a reasonable conclusion.
I hope that you find this article interesting and informative.
Written By: Walid Yassin, ACCA
Section Head – Internal Audit – Gulf of Suez Petroleum Company
– ACCA Syllabus.