How to Account for Decommissioning Costs?

What are Decommissioning Costs?

Decommissioning costs are incurred by the company when they need to spend reserves to restore the production site and the production equipment to the desired ecological condition before the operation.

In other words, this is the cost that the company is expected to pay at the end of the useful life of a given asset.

This type of cost is incurred in relation to certain assets, including offshore oil platforms, mining, as well as other production, which greatly impacts the ecological condition.

Normally, decommissioning expenses are supposed to be spent by the company in order to restore land and premises to prior conditions, as required by the law.

For instance, oil production from the sea might have a huge impact on the environment, such as leaking, which is likely to deplete the condition of the sea.

Hence, decommissioning costs are incurred in order to reduce the environmental footprint as undertaken by the companies.

How are Decommissioning Costs Computed?

Decommissioning costs are future costs, and therefore, when recording these costs, it is important to incorporate the time value of money.

The following steps are undertaken to calculate decommissioning costs from the company’s perspective. The steps are as follows:

  • There is a need to compute decommissioning present costs using the asset’s time value, assuming that there is no improvement in the decommissioning procedure.
  • The depleted costs also consider the expected inflation rate to the time when the actual decommissioning of the asset takes place.
  • There is a need to use the discounted rate, and subsequently compute decommissioning liabilities or provisions that are supposed to be included in the asset’s cost.
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Keeping all these factors in mind, it is important to calculate decommissioning costs accurately to avoid any litigations from the relevant authorities.

When are decommissioning costs capitalized?

When an entity purchases or constructs an asset, it takes on a statutory or contractual obligation to decommission the asset or restore the site. These costs are then capitalized on the date on which the entity is obligated to incur them or settle them off.

The amount that is capitalized as part of the asset is the amount that is estimated to be paid and subsequently discounted at the date of the initial recognition.

The corresponding credit is recognized in the form of provisions (as mentioned in the forthcoming sections).

What is the difference between decommissioned assets and decommissioning liabilities?

The retirement of an asset from service, which may or may not include the actual physical removal of the asset from the premises is referred to as a decommissioned asset.

On the other hand, decommissioning liabilities are any costs, charges, expenses, and liabilities incurred in abandoning or decommissioning any asset or property.

The costs that are associated with decommissioning (regardless of assets or liabilities) need to be accounted for in the financial statements.   

Accounting for Decommissioning Costs

Decommissioning costs are regarded as future obligations that need to be settled in the future by the company. It is categorized as part of the accounting estimation, where management needs to make proper estimates based on judgment, reflecting experience, technical support, and professional judgment.

Initial Recognition of Decommissioning Costs

Decommissioning costs can be regarded into two parts:

  • Provision for decommissioning is referred to as the present value of future obligations.
  • Property, Plant, and Equipment: Decommissioning costs pertaining to property, plant, and equipment should also be recognized as provisions that need to be paid for purposes of initial recognition.
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Subsequent Measurement of Decommissioning Costs

The provision associated with decommissioning costs keeps increasing over time, as it is the debt that is discounted at the beginning of the period.

It also eventually creates interest expense over the period. The interest rate that is used is equivalent to the discounted rates used in the initial recognition process.

The journal entries that are used to record this are as follows:

Finance Cost  xxx
   Provision for Decommissioningxxx

On the other hand, as far as Property, Plant and Equipment are concerned, decommissioning costs should be adjusted for in the cost of the Property, Plant, and Equipment.

Depreciation Expense   xxx
   Accumulated Depreciation – decommissioning costsxxx

Lastly, once the asset or the project reaches the end of its useful life, the company then decommissions the asset and restores the site to the required condition.

All the recorded expenses are then duly charged against the provision. The journal entry that is required in this case is as follows:

Provision for Decommissioning   $3.78 Million
   Cash  $3.78 Million

Example of Decommissioning Costs

Lora Inc. is an oil or gas company that operates offshore drilling in the deep sea. Management expects to spend an amount of $10 Million to make up for the environmental impact caused in the region due to oil extraction. The project is expected to last for around 20 years. The applicable interest rate that is applicable is around 5%.

The accounting treatment of the example mentioned above is given below:

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Since the company needs to spend a sum of $10 Million across a period of 20 years. Since this sum is spread across a large time frame, the present value of the decommissioning cost needs to be calculated. The present value of the decommissioning cost is as follows:  

Present Value of Decommissioning Costs:

Present Value = 10/ (1+0.05) ^20 = $3.78 Million

Journal Entries of Decommissioning Costs

The transaction above is depicted in the following journal entry:

Property, Plant, and Equipment   $3.78 Million
   Provision for Decommissioning  $3.78 Million

Subsequent Measurement of Decommissioning Costs

At the end of the 1st year of operations, there is a need to depreciate the Property, Plant, and Equipment, which primarily arises as a result of decommissioning costs. The fixed asset is depreciated over its useful life.

Depreciation expense incurred = $3.78 Million / 20 = 0.189 Million

Journal Entry to record Decommissioning Costs

The following journal entries are required to record decommissioning costs for Property, Plant, and Equipment:

Depreciation Expense  $0.189 Million
   Accumulated Depreciation  $0.189 Million

Besides Depreciation, Lora Inc. also needs to record the financial cost and provision for decommissioning so that the balance increases and meets the management estimation.

The financial cost in this regard is calculated as follows:

Financial Cost = $3.78 Million * 5% = 0.189 Million

The journal entry to record this financial cost is as follows:

Financial Cost  $0.565 Million
   Provision for Decommissioning  $0.565 Million