Decommissioning costs provision meaning

The provision or costs for decommissioning is an estimate a company makes to determine the disbursements it must make in the future to restore a site or land.

Many entities that need to develop a specific economic activity incur a series of costs to adapt a site or place to the company’s needs.

For example, a company dedicated to wastewater treatment needs to build a plant to decontaminate a city’s river; this entity will incur costs to adapt the land according to the project specifications.  

On the other hand, in a contract of this nature, the parties agree that once the entity’s objective has been met, in this case, the river decontamination, the company will restore the place in which the activity was realized.

In this way, as  IAS 16 set out, the incurred costs for the company to restore the site will be recognized as a higher value of the plant; this is what we know as a provision for decommissioning costs.

Now, in large projects that can last several years, usually at the beginning of this, a company doesn’t know the costs it will have to incur once its activity ends.

These disbursements meet the provision definition under  IAS 37 because there is uncertainty about the number of resources incurred at the project’s end.

Therefore, the entity’s management must make the best estimate of this outflow of resources.

In other words, It must consider the value of money over time; that is, the entity must recognize the present value of resources that the company considers it must disburse in the future to restore the site.

Below, we will see two examples of decommissioning costs.

On the one hand, an example using the IAS 16 and another example from the point of view of IFRS 16.

In addition, an analysis will be carried out about the effect of a change in the estimate of decommissioning costs using the IFRIC 1.

Example and study case 1: provision for decommissioning IAS 16

In year 1, a chemicals’ company builds a plant.

The entity incurred 10,000,000.

According to the environmental regulations, in 10 years, the entity must dismantle the plant and restore the land affected by the construction of the asset.

The company’s management estimates it must disburse 2,000,000 once the project is complete, to restore the land and demolish the asset.

The entity determines a rate of 11% because this reflects the expectations regarding the present value of the decommissioning provision.

Proposed exercise solution 

The present value calculation of decommissioning costs is shown below:

decommissioning costs interest 3-min

The formula used to perform this calculation is as follows.

PV ((1 + 11%) ^ -10) X 2,000,000 = 704,369.

In this example, it is set out as an assumption that at the beginning of year 5, the entity considers it should change its estimate concerning the amount it will have to disburse at the end of the project, from 2,000,000 to 2,800,000.

It is essential to clarify that the variation in this calculation should be recognized as a change in an accounting estimate prospectively and not as a change in an accounting policy.

This is this way because the change in an estimate is the result of new information that the entity owns, information that the entity didn’t have at the time of making the initial estimate; for this reason, this change should not affect the financial statements of previous periods under IAS 8.

Next, we will perform the calculation of the following elements in the order shown below.

1. Property, plant, and equipment cost

2. Decommissioning costs provision.

3. The respective depreciation.

4. The interest expense of the provision.

5. The change in the estimate according to IFRIC 1.

Accounting recognition property plant and equipment and decommissioning provision.

Asset cost: 10,000,000.

Decommissioning costs: 704,369.

Total assets: 10,704,369.

decommissioning costs interest 3-min

Accumulated depreciation to year 4:

Accumulated depreciation = (10,704,369 / 10) x4 = 4,281,748)

decommissioning costs interest 3-min

As can be seen in the table, the interest calculation for year 4 amounts to 364,913.

Interest year 1: 77,481.

Interest year 2: 86,003.

Interest year 3: 95,464.

Interest year 4: 105,965.

Total: 364,913.

Thus, the provision at the end of year 4 is: 1,069,282 (704,369 + 364,913).

Change in the estimate according to IFRIC 1.

As we said before, the initial estimate went from 2,000,000 to 2,800,000; therefore, according to paragraph 5 of IFRIC 1, this change should be recognized as follows:

IFRIC 1-min

Since there was a change in the costs for dismantling, we must perform the table of interests again from year 5 to year 10; that is, we must bring to present value 2,800,000 to 6 years.

PV ((1 + 11%) ^ -6) X 2,800,000 = 1,496,994.

Adjustment = New provision at the beginning of year 5 – Initial provision balance.

Adjustment = 1,496,994 – 1,069,282 = 427,712

decommissioning costs interest 3-min

The new amortization table is as follows

decommissioning costs interest 3-min

The depreciation expense and the interest recognition are as follows:

Carrying amount asset at year 4: Cost less accumulated depreciation

Carrying amount asset at year 4: 10,704,369 – 4,281,748

Carrying amount asset at year 4: 6,422,621

Adjusted carrying amount: carrying amount + adjusted value of changes in decommissioning costs.

Adjusted carrying amount year 5: 6,422,621 + 427,712 = 6,850,333

Depreciation year 5: Adjusted carrying amount / remaining useful life

Depreciation year 5: 6,850,333 / 6 years

Depreciation year 5: 1,141,722

decommissioning costs interest 3-min

Thus, at the end of year 5, the property plant and equipment balance are as follows:

P.P.E. = Adjusted carrying amount less accumulated depreciation.

P.P.E. = 6,850,333 – 1,141,722 = 5,708,611.

On the other hand, the provision balance is as follows.

Provision for year 5: Adjusted provision value + reversal of interest expense.

Provision for year 5: 1.496.994 + 347.453 = 1.844.447.

If we proceed to compare the provision balance calculated with the new table of interests, we see that it exactly matches the initial balance in year 6

Example and study case 2: decommissioning costs IFRS 16

An entity agrees with a third party the lease of a warehouse for five years; an annual payment of 200,000 is set out for the asset’s rental.

In addition, the entity considers that it will need to carry out a series of modifications in the warehouse to operate correctly.

These disbursements amount to 500,000, and on the other hand, it is agreed with the owner asset that once it passes five years, the company will return the asset in the same conditions in which it was delivered.

For this, the company determines that it will have to pay 700,000 once this period passes.

The entity uses a 9% rate to recognize the present value of the lease payment and decommissioning costs.

According to IFRS 16, an entity that agrees with another company on the operating lease of an asset will have the right to use it for a certain period.

The asset right to use of use is made up of the following items :

  • Present value of lease payments

  • Present value of a decommissioning costs

  •  Directly attributable costs.

To calculate the present value of the asset by right of use, we will use a formula in Excel called PV.

PV = (9%, 5,200,000)

Present value of lease payments = 777,930

Regarding the provision, the calculation is as follows.

Present value decommissioning costs ((1 + 9%) ^ -5) x700,000 = 454,952

Directly attributable costs: 500,000

 Cost asset: 1,732,882

The table of lease payments and the table of decommissioning  provision  as follows:

Right of use asset-min
decommissioning costs interest 3-min

 Recognition for the first year is as follows.

Recognition right of use asset-min

As we can see, at the end of the first year, the depreciation calculation is equivalent to the asset cost divided by the useful life of the lease (1,732,882 / 5) = 346,576.

The value of 40,946 corresponds to decommissioning provision interests that must reverse until the amount the entity estimate must disburse once the lease agreement ends.

And finally, it is necessary to recognize the first-month payment lease corresponding to a principal payment for 129,986 and the other part of interest for 70,014, as shown in the payment table of the rental agreement.