Fair value of decommissioning obligation

Fair value of decommissioning obligation is about a nice example of decommissioning a large oil platform.

In the oil and gas industry, it is 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, the obligations under the International Financial Reporting Standards (IFRS) will be discussed and hopefully some wisdom will be shared on how to navigate this minefield.

What are the IFRS 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! Fair Value of decommissioning obligation

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. IAS 37 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.

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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.

Discount rates

IAS 37 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.

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.

EXAMPLE calculation decommissioning provision

On 1 January 20X1 Entity A assumes a decommissioning (i.e., asset retirement) liability in a business combination. The entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is estimated to be 10 years. On the basis of IFRS 13, Entity A uses the expected present value technique to measure the fair value of the decommissioning liability. Entity A was contractually allowed to transfer its decommissioning liability to a market participant, and in this regard Entity A concludes that a market participant would use all the following inputs, probability-weighted as appropriate, when estimating the price it would expect to receive:

Fair Value of Decommissioning Obligation

  1. Labor costs;
  2. Allocation of overhead costs;
  3. The compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset. Such compensation includes both of the following:
    1. Profit on labor and overhead costs; and
    2. The risk that the actual cash outflows might differ from those expected, excluding inflation;
  4. The effect of inflation on estimated costs and profits;
  5. The time value of money, represented by the risk-free rate; and
  6. The non-performance risk relating to the risk that Entity A will not fulfill the obligation, including Entity A’s own credit risk.
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The significant assumptions used by Entity A to measure fair value are as follows:

(a) Labor costs are developed on the basis of current marketplace wages, adjusted for expectations of future wage increases, required to hire contractors to dismantle and remove offshore oil platforms.

Entity A assigns probability assessments to a range of cash flow estimates as follows:

Cash flow estimate (€)

Probability assessment

Expected cash flow (€)

100,000

25%

25,000

125,000

50%

62,500

175,000

25%

43,750

Fair Value of decommissioning obligation

131,250

The probability assessments are developed on the basis of Entity A’s experience with fulfilling obligations of this type and its knowledge of the market.

(b) Entity A estimates allocated overhead and equipment operating costs using the rate it applies to labor costs (80% of expected labor costs). This is consistent with the cost structure of market participants.

(c) Entity A estimates the compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset as follows:

  1. A third-party contractor typically adds a mark-up on labor and allocated internal costs to provide a profit margin on the job. The profit margin used (20%) represents Entity A’s understanding of the operating profit that contractors in the industry generally earn to dismantle and remove offshore oil platforms. Entity A concludes that this rate is consistent with the rate that a market participant would require as compensation for undertaking the activity.
  2. A contractor would typically require compensation for the risk that the actual cash outflows might differ from those expected because of the uncertainty inherent in locking in today’s price for a project that will not occur for 10 years. Entity A estimates the amount of that premium to be 5 per cent of the expected cash flows, including the effect of inflation.

(d) Entity A assumes a rate of inflation of 4% over the 10-year period on the basis of available market data. Fair Value of decommissioning obligation

(e) The risk-free rate of interest for a 10-year maturity on 1 January 20X1 is 5%. Entity A adjusts that rate by 3.5% to reflect its risk of non-performance (i.e., the risk that it will not fulfill the obligation), including its credit risk. Therefore, the discount rate used to compute the present value of the cash flows is 8.5%. Entity A concludes that its assumptions would be used by market participants.

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Fair Value of Decommissioning Obligation

In addition, Entity A does not adjust its fair value measurement for the existence of a restriction preventing it from transferring the liability. As illustrated in the following table, Entity A measures the fair value of its decommissioning liability as €194,879. Fair Value of decommissioning obligation

Expected cash flows

(€) 1 January 20X1

Expected labor costs Fair Value of Decommissioning Obligation

131,250

Allocated overhead and operating equipment costs (0.80 x €131,250 =)

105,000

Contractor’s profit mark-up [0.20 x (€131,250 + €105,000) =] Fair Value of Decommissioning Obligation

47,250

Expected cash flows before inflation adjustment

283,500

Inflation factor (4% for 10 years) Fair Value of Decommissioning Obligation

X 1.4802

Expected cash flows adjusted for inflation

419,638

Market risk premium (0.05 x €419,637 =) Fair Value of Decommissioning Obligation

20,982

Expected cash flows adjusted for market risk

440,619

Expected present value using discount rate of 8.5% for 10 years

194,879

Fair Value of Decommissioning Obligation

Annualreporting provides financial reporting narratives using IFRS keywords and terminology for free to students and others interested in financial reporting. The information provided on this website is for general information and educational purposes only and should not be used as a substitute for professional advice. Use at your own risk. Annualreporting is an independent website and it is not affiliated with, endorsed by, or in any other way associated with the IFRS Foundation. For official information concerning IFRS Standards, visit IFRS.org or the local representative in your jurisdiction.

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