PPE Decommissioning

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Mr. Arth, CFO of Peace Ltd, a Phase I company, asked me “What is the difference between Ind AS and existing Accounting Standards for Fixed Assets? If the asset continues to be an asset, the cost I incur for the asset continues to be the same, the life and usage of an asset is also the same, why would the accounting for it change? Why is there such a fuss about migration from existing accounting standards to Ind AS?”

He went on to narrate a situation. Peace Ltd was setting up a new plant at Site A. Site A was very close to a river and surrounded by dense forest. In the initial years of setting up the plant, one of the machines to be installed may cause some damage to the local environment. Environmental laws require Peace Ltd to restore the site of the machine after such machine is retired from use.

The accountants of Peace Ltd had informed Mr. Arth that there would be some increase in cost of asset, creation of new provisions, discounting rates to be determined in respect to these machines.

Mr. Arth said, “Being a CFO of a Company like Peace Ltd, I have to look after several activities. If I start micro-managing the accounting function, how would I work efficiently? Having said that, I cannot ignore any changes that impact my Balance Sheet and bottom line. Would you help me understand the crux of this change?”

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My first step was to explain Mr. Arth meaning of decommissioning costs.

Many times, entities have obligations to dismantle, remove and restore items of Property, Plant and Equipment (PPE). In a case of Peace Ltd, environmental laws required Peace Ltd to restore an area of the Site A after certain machines are retired from use. Thus, Peace Ltd had a legal obligation to restore the environment. Peace Ltd would also incur significant costs for restoration. Such costs for restoration of an environment are called decommissioning costs.

On understanding the concept, Mr. Arth asked, “Why have (future expenses) costs to be incurred at the time of retirement of an asset suddenly become significant at the time of purchase of that asset (present record keeping)?”

This is where the change lies. As we know, an entity recognises PPE (previously fixed asset) at its cost. Under Ind AS 16, decommissioning costs are included in the scope of ‘cost of PPE’. Therefore, decommissioning costs of the machine are to be recognised at initial recognition of PPE.

Also, Peace Ltd has a legal obligation to restore the site of machine. This legal obligation is created as a result of installation of machine at site, even though cost will be incurred on date of retirement. Thus, in accordance with Ind AS 37, there is a present obligation as a result of past event, and a provision should be created for such liability.

On understanding the concept, Mr. Arth asked, “Why are (future expenses) costs to be incurred at the time of retirement of an asset have suddenly become significant at the time of purchase of that asset (present record keeping)?”

Why are (future expenses) costs to be incurred at the time of retirement of an asset have suddenly become significant at the time of purchase of that asset (present record keeping)?

This is where the change lies. As we know, an entity recognises PPE (previously fixed asset) at its cost. Under Ind AS 16, decommissioning costs are included in the scope of ‘cost of PPE’. Therefore, decommissioning costs of the machine are to be recognised at initial recognition of PPE.

Also, Peace Ltd has a legal obligation to restore the site of machine. This legal obligation is created as a result of installation of machine at site, even though cost will be incurred on date of retirement. Thus, in accordance with Ind AS 37, there is a present obligation as a result of past event, and a provision should be created for such liability.

Mr Arth then asked, “How would I estimate the decommissioning costs? Do we account for time value of money?

For this, we refer to Ind AS 37. Since the asset is expected to be retired after a substantial period of use, the cost of restoration cannot be determined accurately and is ‘best estimate’ by taking in account the prevailing conditions.

The time value of money will also be accounted for.

So, Peace Ltd should create a provision equivalent to the present value of expected decommissioning costs.

On each reporting date thereafter, Peace Ltd will unwind the discount on provision.

Thus, we zeroed in on three aspects of the issue:

  1. Recognition and measurement of the decommissioning costs expected to be incurred
  2. Recognition and measurement of decommissioning liabilities
  3. Unwinding of discount on Provision for decommissioning liabilities

Let us try to understand each of these three aspects through the example of Peace Ltd.

Facts of the case:

Peace Ltd has purchased Machine A for Rs. 500,000. The useful life of this machine is 5 years. The residual value at end of 5 years is NIL and machine is depreciated using straight-line method.

Peace Ltd has legal obligation to restore the site of a machine when the asset is retired from use. It is estimated that the cost of restoration, at end of 5 years, will be Rs. 100,000.

The discount rate is 10% p.a. (We will be writing separate article on Discount Rates – stay tuned)

Initial recognition of PPE

Ind AS 16 requires entities to recognise the restoration costs as part of the cost of PPE at initial recognition of PPE. Therefore, Peace Ltd will have to include the cost of restoration in the cost of machine.

However, the cost of Rs. 100,000 is to be incurred at end of Year 5. So we need to discount the decommissioning liability to its present value. The present value of such liability will be included in the cost of Machine A at initial recognition.

Computation for the same will be as follows:

Present Value = Future Value/ (1+r)^n

(Rs. 100,000 X 1)/ (1+0.10)^5 = Rs. 100,000 X 0.6209213 = Rs. 62,092.13

Cost of Machine A = Cost of Purchase + PV of Decommissioning costs

= Rs. 500,000 + Rs. 62,092.13

= Rs. 562,092.13

Journal entry for initial recognition

Date

Particulars

Debit Amount

Credit Amount

Day 0

Machine A (PPE) A/c

562,062.13

To Bank A/c

500,000.00

To Provision for Decommissioning liability A/c

62,062.13

(Being Machine A recognised as PPE and present value of cost of decommissioning included in cost of asset, corresponding liability created)

Depreciation over life of asset

Since Machine A is to be depreciated over the useful life of 5 years on straight-line basis, the depreciation charge for each year will be computed as follows:

Rs. 562,092.13/ 5 years = Rs. 112,418.43

The depreciation schedule will be as follows:

Year

Carrying amount at beginning of year

Depreciation Carrying amount at end of year

1

 562,092.13  112,418.43  449,673.71

2

 449,673.71  112,418.43  337,255.28

3

 337,255.28  112,418.43  224,836.85

4

 224,836.85  112,418.43  112,418.43

5

 112,418.43  112,418.43

NIL

Unwinding of discount

On each reporting date, Peace Ltd will be required to re-measure the decommissioning liability at its present value. This is known as “unwinding of discount”.

The computation for unwinding of discount is as follows:

Year Calculation Decommissioning Liability Finance Cost
Day 0 100,000 X (1+0.10)^5 = 100,000 X 0.6209 62,092.13 0
Year 1 100,000 X (1+0.10)^4 = 100,000 X 0.6830 68,301.35 6,209.21
Year 2 100,000 X (1+0.10)^3 = 100,000 X 0.7513 75,131.48 6,830.13
Year 3 100,000 X (1+0.10)^2 = 100,000 X 0.8264 82,644.63 7,513.15
Year 4 100,000 X (1+0.10)^1 = 100,000 X 0.9091 90,909.09 8,264.46
Year 5 100,000 X (1+0.10)^0 = 100,000 X 1.0000 100,000.00 9,090.91

 

If it is difficult for you to interpret above table, you may find below similar calculation in different structure: Provision for Decomissioning Liability

Year Opening Int. @10% Closing
1  62,092.13  6,209.21  68,301.34
2  68,301.34  6,830.13  75,131.48
3  75,131.48  7,513.15  82,644.63
4  82,644.63  8,264.46  90,909.09
5  90,909.09  9,090.91  1,00,000.00

 

At the end of each year, an entity accounts for the unwinding of discount on provision for decommissioning cost.

Journal entry for unwinding of discount on provision for decommissioning cost

Date Particulars Debit Amount Credit Amount
End of Year X Interest Expense A/c Finance Cost
To Decommissioning liability A/c Finance Cost
(Being unwinding of discount on provision for decommissioning liability)

Remember : At the end of each reporting period, an entity has to record journal entries for:

  1. Depreciation on PPE (where PPE Cost includes Present Value of Cost of future decommissioning/ dismantling/ site restoration)
  2. Finance Cost due to an unwinding of discount.

Retirement of Asset

On the retirement of Machine A at end of its useful life of 5 years, the carrying value of Machine A will be NIL, because residual value is 0.

The site of Machine A will have to be restored, and decommissioning costs will be paid.

If the restoration expenditure is less than/ more than the decommissioning liability created, the difference will be credited/ debited to the Profit or Loss account

Journal entry for payment of decommissioning costs

Date Particulars Debit Amount Credit Amount
End of Year 5

Decommissioning liability A/c

100,000
To Bank A/c 100,000

(Being decommissioning cost paid)

Extract of Balance Sheet and Statement of Profit or Loss (SOPL)

Extract of Balance Sheet as on Day 0 End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5
ASSETS
PPEMachine A 562,092.13 449,673.71 337,255.28 224,836.85 112,418.43 NIL
 
LIABILITIES
Non-current Liabilities:Decommissioning Liability 62,092.13 68,301.35 75,131.48 82,644.63
Current Liabilities:Decommissioning Liability 90,909.09
Extract of SOPL Year 1 Year 2 Year 3 Year 4 Year 5
EXPENSES
Finance Cost:Interest Expense 6,209.21 6,830.13 7,513.15 8,264.46 9,090.91
Depreciation 112,418.43 112,418.43 112,418.43 112,418.43 112,418.43

After I had explained the basics of accounting to Mr. Arth, he asked said “is it possible that over the course of life of an asset, the estimate regarding the decommissioning liabilities may change. How would we account for such change in liability?”

His concern is well-founded. Since the decommissioning costs are to be estimated at initial recognition of the corresponding item of PPE, it is possible that there may be an increase/ decrease in estimated decommissioning liabilities.

Such increase/ decrease may be on account of factors like:

  • Change in estimated cost of restoration
  • Change in discounting rate to be applied

Accounting for change in existing decommissioning liabilities will depend on whether the entity follows cost model or revaluation model for measurement of relevant class of PPE.

Let us understand this concept by continuing with our example.

Peace Ltd values machines by following cost model. At end of Year 3, it is estimated that due to technological improvements, the cost of restoration, at end of 5 years, is estimated to be Rs. 80,000.

In such a scenario, the decommissioning liabilities and unwinding of discount will be recalculated as follows:

 Year Calculation Decommissioning Liability Finance Cost
Year 3 80,000 X (1+0.10)^2 = 80,000 X 0.8264 66,115.70*
Year 4 80,000 X (1+0.10)^1 = 80,000 X 0.9091 72,727.27 6,611.57
Year 5 80,000 X (1+0.10)^0 = 80,000 X 1.0000 80,000.00 7,272.73

*Liability at end of Year 2 Rs. 75,131.48 Less Rs. 9,015.78

Journal entry for reduction in decommissioning liability

Date Particulars Debit Amount Credit Amount
End of Year 3 Decommissioning liability A/c 9,015.78
To Machine A (PPE) A/c 9,015.78
(Being reduction in estimated decommissioning liability)
End of Year 4 Interest Expense/ Finance Cost A/c 6,611.57
To Decommissioning liability A/c 6,611.57
(Being unwinding of discount on provision for decommissioning liability)
End of Year 5 Interest Expense/ Finance Cost A/c 7,272.73
To Decommissioning liability A/c 7,272.73
(Being unwinding of discount on provision for decommissioning liability)

The reduction in carrying amount of Machine A, will also impact the depreciation schedule for Year 4 and Year 5.

The revised depreciation calculation will be as follows:

Carrying amount at end of year 3 will be reduced by Rs. 9,015.78. Therefore, carrying amount at beginning of Year 4 = Rs. 224,836.85 – Rs. 9,015.78 = Rs. 215,821.08. This amount will be depreciated over the remaining useful life of 2 years on straight-line basis

Year Carrying amount at beginning of year Depreciation Carrying amount at end of year
4 215,821.08 107,910.54 107,910.54
5 107,910.54 107,910.54 NIL

In this situation:

  • A decrease in estimated cost of restoration, and resultant reduction in carrying amount of Machine A has led to a decrease in depreciation charge for subsequent years
  • The carrying amount of Machine A and balance of Decommissioning liability will decrease by Rs. 9,015.78 for Balance Sheet as on End of Year 3.
  • Interest expense will not be charged to SOPL for Year 3.

Similarly, there can be situations where:

  • There is an increase in estimated decommissioning liability due an increase in expected restoration costs
  • The decommissioning liability increases/ decreases due to change in discounting rate applied

Appendix A to Ind AS 16 deals with accounting for all such changes in measurement of existing decommissioning, restoration and similar liabilities.

By now, Mr. Arth had understood the difference between AS 10 and Ind AS 16 in respect to decommissioning costs. But what are the takeaways for him?

Mr. Arth realised that

  • Including decommissioning costs in cost of PPE would increase his asset base
  • There would be a corresponding increase in liabilities by way of provision for decommissioning liabilities
  • Unwinding of discount would lead to increase in expense over the life of asset
  • The depreciation charge for such asset would also increase

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