Accounting for Decommissioning Provisions under IFRS
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If your business is in the oil and gas industry, it’s understandable that you’d like to stay focused on exciting new opportunities in the present, rather than obligations in the distant future. But it’s important to plan ahead and consider how decommissioning large-scale assets such as rigs will be carried out in years to come. Specifically, you need to work out how to account for the current value of what you’ll be spending in the future. With depleting oil prices since 2014 from their glory days of $100 plus and the resulting volatility and uncertainty that has brought to the industry, being able to meet and estimate that obligation has never been more critical.
In this post, we will look at your obligations under the International Financial Reporting Standards (IFRS) and share some wisdom on how to navigate this minefield.
What are your obligations?
When it comes to assets that need to be knocked down after they cease to be useful and the resulting environmental restoration work, companies are obliged to do their bit for the environment and society by putting the area the asset operated in as far back to normal as possible. But often, these assets have long lifespans lasting years or even several decades. How can you be expected to know what your decommissioning costs will be in, say, 30 years, before that phase of the project has even begun?
Consult the experts
Being prepared is key, and while the future can never be predicted with total accuracy, there’s no substitute for rigorous projections on how decommissioning will take place for your asset and how much it will cost. It can be tempting to rely on grand predictions for the future that are unrealistic, but this should be avoided. Your technical expert might strongly believe that in 2050 it will be possible to take down an oil rig in a day, but you can’t bank on it!
Measuring the future
Decommissioning provisions are measured at the present value of the expected future cash flows that will be required to perform the decommissioning. International Accounting Standard (IAS) 37, covering Provisions, Contingent Liabilities and Contingent Assets, requires you to pick a “pre-tax rate(s) that reflect(s) current market assessment of the time value of money and the risks specific to liability. The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted.” This means you need to incorporate macroeconomic effects like inflation to the estimates made by the technical experts and adjust the figures.
It’s important to make sure that you don’t expose yourself to the same risk more than once when it comes to picking a discount rate. If your estimated costs have been inflated, go for a nominal rate. But if you’re working with figures in current terms, choose a real discount rate.
Once you’ve worked out the current value of your expected expenditure, record this provision as a credit and the cost of construction as a debit. In accordance with IAS 16, the cost of the provision is recognised as part of the cost of the asset when it is put in place and depreciated over the asset’s useful life. The asset is depreciated on the basis that best reflects the consumption of the economic benefits of the asset. Typically this is based on the production as the numerator and the total estimated reserves as the denominator.
It will most likely take several years for your asset to be built, so it’s advisable to distribute the creation provision across the years allocated for construction.
IAS 37 Provisions, contingent liabilities and contingent assets paragraph 47 states that the discount rate (or rates) shall be a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability. The discount rate(s) shall not reflect risks for which future cash flow estimates have been adjusted. Many of the oil and gas upstream operators in the UK apply a risk free rate as a discount rate for such liabilities. The discount rate applied is disclosed in the financial statements and it will be an area easily picked up by regulators who will challenge the assumptions and rate used.
Upstreamly have found that the typical range of risk free rates used by operators varies between 2% and 5%. Using the interest rates offered by long term UK Government Bonds would be a benchmark to use.
Are you struggling with accounting for your decommissioning provisions? For a quality chartered accounting service in London and Aberdeen specialising in the upstream oil and gas industries, get in touch with Upstreamly today and speak to us to find out how we can help you. You can find out more about us and the services we provide via our website.