Accounting for decommissioning obligation

Decommissioning’ and ‘abandonment’ are two alternative terms which means: the final phase of the life of an oil and gas development; the obligation to remove and make safe a production site; and the obligation to restore suspended exploration/development sites.

The accounting for Decommissioning is well covered by the scope of IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ and management will need to apply care and judgment in applying this standard. The objective of IAS 37 “is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and to ensure that sufficient information is disclosed in the notes to enable users to understand their nature, timing and amount”. Decommissioning obligations have a financial impact as they necessitate cash costs in the future. Both the UK GAAP Financial Reporting Standard 12 and US GAAP Financial Reporting Standard 143 on decommissioning have the same principles with IAS 37 of fully providing for the total expected cost of meeting decommissioning obligation at any point in time.

IAS 37 requires recognition of a provision when there is: a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow will occur; and a reliable estimate can be made. The ‘present obligation as a result of a past event’ criterion means that only infrastructure that is currently in place will result in a provision. The liability will therefore exclude decommissioning costs of facilities yet to be installed. The need to come up with an estimate for what the decommissioning is going to cost, in order to provide for it, will involve detail engineering studies of work necessary to derive “Current Decommissioning Cost” in “today’s money”

For an event to be an obligating event, it is necessary that the entity has no realistic alternative to settling the obligation created by the event. This is the case only when: the settlement of the obligation can be enforced by law, or in the case of a constructive obligation where the event creates valid expectations in other parties that the entity will discharge the obligation.

A legal obligation derives from a contract, legislation or other operation of law. Changes in law should not be recognized until it is virtually certain that the legislation will be enacted as drafted, which is often not until it is enacted. Changes in legislation can result from instances where a provision was not initially required when the obligating event occurred, but is later required when it becomes virtually certain new legislation will pass. Changes in contracts become effective when the contract is executed.

A constructive obligation derives from an entity’s actions under which, by an established pattern of past practice, published policies or by a sufficiently specific current statement, the entity has indicated to other parties that it will accept certain responsibilities and, as a result, the entity has created a valid expectation on the part of those other parties that it will discharge those responsibilities.

With respect to the initial recognition of decommissioning liabilities: Provisions should only be recognized if the obligation arises from past events existing independently of an entity’s future actions; thus, if an entity can avoid an obligation by its future actions, no provision is required. The cost of dismantling and removing an asset associated with the construction of the asset should be apportioned in the original cost of the asset. Obligations to decommission an asset should be recognized during the exploration and evaluation and development or production phases, as appropriate, rather than at the time the asset begins commercial production. This is an important consideration for an asset that takes a substantial period of time to prepare for its intended use.

Decommissioning liabilities and the related capitalized costs are measured at the best estimate of the costs required to settle the decommissioning liability or to transfer to third party. Decommissioning liability provisions are discounted using pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability.

The standard requires that, in the event the time value of money is significant, the amount of a provision should be the present value of the expected expenditures necessary to discharge the obligation. It will be important for entities to be consistent in the choice and application of a discount rate, not only from period to period but also to situations in which discounting is required, e.g., impairment tests, cash flows from reserves, etc. IAS 37 explicitly prescribes that :

• The amount of the provision is the present value of the expenditure expected to be required to settle the obligation;

• The discount rate applied is a pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the liability; and

• The discount rate should not reflect risks for which future cash flow estimates have been adjusted.

The Decommissioning Asset is depleted (depreciated), in the same way as the other oil and gas assets, using the unit of production (UOP) basis. This means that the cost of decommissioning is expensed to profit and loss over the life of the field, rather than in one big hit after the field has stopped producing. The Decommissioning Provision is increased over time as it is unwound, which adjusts for the year’s worth of discount risk. The key idea is that by the time the field dries up, asset is down to 0 and provision is up to the full cost of decommissioning, in the money of the day when this takes place.

Costs estimates are based upon a number of assumptions and as a result changes in these estimates are almost inevitable over the life of a field, which will result in a change in the decommissioning asset and decommissioning provision. The decommissioning provision must be reviewed at each reporting date and adjusted to reflect management’s current best estimates. In addition, at each reporting date the decommissioning provision is to be recalculated for changes in the estimated timing or amount of future cash outflows.

Accounting for changes in provisions is outlined in IFRIC 1 ‘Changes in Existing Decommissioning, Restoration and Similar Liabilities’ and is applicable to decommissioning liabilities that have been both included in PP&E as part of an asset measured under IAS 16 and measured as a liability under IAS 37. It deals with the effect of the following three changes:

·A change in the estimated timing of outflow of resources necessary to discharge the decommission obligation

·A change in the current market based discount rate (changes in the time value of money and risks specific to the liability), and

·An increase that reflects the passage of time (also referred to as the unwinding of the discount or accretion of the discount).

For changes caused by items 1 and 2, the change is added to or deducted from the capitalized decommission cost of the asset to which it relates and the adjusted amount is amortized prospectively over the estimated life of the asset. A downward adjustment to the decommissioning and restoration asset cannot exceed the current carrying amount of the asset. Any excess should be recognized in the income statement in the current period.

The unwinding of the discount (item 3) arising from the passage of time is recognized as a financing cost in the income statement. It is not a borrowing cost as defined in IAS 23 “Borrowing Costs” and cannot be capitalized.

In conclusion, the following issues will require management’s consideration in conjunction with adoption of IFRS and IAS 37:

•Identification of all legal and constructive obligations for decommissioning liabilities.

•Determination of whether new decommissioning liabilities will need to be recognized at transition.

•Measurement of amounts and timing, including accounting for changes, of decommissioning cash flows.

•Selection of an appropriate discount rate and cost basis on which to calculate the decommissioning liabilities, which will require a choice between:

Using a risk free interest rate and risk adjusting the decommissioning cash flows or using a risk adjusted interest rate and un-risked decommissioning cash flows and

Using a nominal interest rate and inflation adjusted (future dollar) decommissioning cash flows or using a real interest rate and current dollar decommissioning cash flows.

·Determination of decommissioning liabilities, if any, for indefinite life assets based on management’s best estimates of amounts and timing.

Jide Onabajo & Femi Abegunde

Jide Onabajo and Femi Abegunde, Energy & Resources Industry Group, Akintola Williams Deloitte