Asset Retirement Obligation
Installation of a fixed asset often requires significant modification to the landscape in which the asset is erected. Such modifications affect the communities in which the assets are installed. It is the responsibility of the companies to reverse those modifications and protect the communities from their hazardous effects when the asset runs out of its useful life. Decommissioning cost (also known as asset retirement obligation) is the cost incurred by companies in reversing the modifications made to landscape when a fixed asset is used up.
An oil well offers a good example of asset that carries significant decommissioning cost. Drilling an oil well requires drilling holes in the ground in pursuit of oil. An oil well (regardless of whether it is successful or not) must be plugged when oil or gas is not being extracted from it, so as to stop any leakages of hazardous gases or fluids.
Accounting for Asset Retirement Obligations
Asset retirement obligation/decommissioning cost broadly refers to the amount that a company expects to incur in disposing of the asset and reversing modifications made to the installation site. Generally-accepted accounting standards (GAAP) require the company to include the present value of the expected (face value of) future decommissioning cost in the total acquisition cost of the asset. This involve making the following journal entry:
|Asset retirement obligation||XXXXX|
In the above journal entry, the asset retirement obligation is a liability account which increases over time on account of unwinding of discount. The asset retirement obligation is effectively a sort of debt that incurs interest expense over the period. The amount of interest expense booked equals the product of beginning balance in the asset retirement obligation account (or decommissioning liability account) and the discount rate used to find the present value of the asset retirement obligation account.
|Asset retirement obligation||XXXXX|
Interest expense is recorded such that the balance in the decommissioning cost liability at the time of actual uninstallation of the asset equals the actual expenditure made. Once the asset is decommissioned, the following journal entry is passed.
|Asset retirement obligation expense||XXXXX|
Calculating Decommissioning Cost
Decommissioning cost accounting requires some time value of money calculations that involve the following steps:
- Calculating the expected expense in today’s dollars on decommissioning of the asset assuming no improvement in decommissioning technology.
- Projecting the amount estimated above using the expected inflation rate to find the amount the company expect to expend at the time of actual decommissioning of the asset.
- Discounting the future expected decommissioning cost figure obtained above using the effective discount rate. This gives us the beginning value of the decommissioning liability (or provision for decommissioning cost or asset retirement obligation) as included in the cost of the asset.
- Unwinding the discount on asset retirement obligation by adding an amount equal to the product of opening balance of the asset retirement obligation and the relevant discount rate to the mentioned opening balance. This leaves us with period-end balance of the decommissioning liability. This unwinding of discount adjustment is made for each period.
The following example will walk you through all the calculations and journal entries needed to account for a typical asset-retirement obligation.
You are an accounting analyst at Petrocars, Inc., a company engaged in oil and gas exploration in central Asian republics (CARs). On 31 December 2012, the chief accounting officer requested you to estimate the provision for decommissioning cost for a recently commissioned gas field in Azerbaijan. You obtained the following information from other relevant departments:
- The installations cost $300 million and are expected to last for 15 years.
- The company uses straight-line depreciation method.
- The company will have to incur $10 million if it decommissions the plant today.
- Relevant inflation rate is 5%.
- The relevant discount rate is 8%
The opening balance in decommissioning liability account is calculated by compounding the $10 million at the inflation rate and discounting the future value obtained at the relevant discount rate.
Expected expenditure in 15 years = $10 million × (1 + 3%)15 = $15.6 million
Present value of expected expenditure = $15.6 M ÷ (1 + 8%)15 = $4.9 M
You should pass the following journal entry to record the installation of the plant and provision for decommissioning cost.
|Gas Installation—Azerbaijan||$304.9 M|
|Accounts Payable/Cash||$300 M|
|Asset retirement obligation||$4.9 M|
You can see that the present value of the decommissioning cost/asset retirement obligation is included in the cost of the relevant installation and it will be depreciated over the period.
On 31 December 2013, you will pass the following journal entry to record depreciation.
|Depreciation expense ($304.9M ÷ 15)||$20.33 M|
|Accumulated depreciation—gas installation||$20.33 M|
You will also record the increase in decommissioning liability/asset retirement obligation due to the fact that we are 1 year closer to the actual expenditure. This effect is the unwinding of discount, which is recorded as follows:
|Finance cost ($4.9 million × 8%)||$0.393 M|
|Asset retirement obligation||$0.393 M|
The balance of the decommissioning liability/asset retirement obligation account will be $5.3 million as at 31 December 2013 and it will increase over the next 14 years such that it will be exactly $15.6 at the time of actual decommissioning of the plant.