Accounting for Decommissioning Costs

Decommissioning Cost (also known as asset retirement obligation) is the cost that company spends to restore the production site and production equipment to the ecological condition before operation. It is the cost that company expected to pay at the end of asset’s useful life. This type of cost incurred in relation to only some assets such as offshore oil platforms, mining, and other production which impact the ecological condition.

The company needs to spend for decommissioning cost to restore the land and premises to the prior condition as it is required by the law. For example, oil production has a huge impact on the environment such as leaking which will destroy the sea creature around the area. The oil company has the obligation to restore the impact to the surrounding community. “Deepwater Horizon oil spill” is one of the disasters related to oil drilling production. It causes the company billion dollars to restore the damage and penalty from the government.

Accounting for Decommissioning Costs

As we can see, decommissioning cost is the future obligation which we expect to settle in the future. So it is part of the accounting estimation, management needs to make proper estimate base on experience, technical support, and their professional judgment.

Initial Recognition

  • Provisions for decommissioning: is the present value of the future obligation
  • Property, Plant & Equipment:

Subsequent Measurement

The provision cost will keep increasing over time as it is the debt that is discounted at the beginning of the period. It will create interest expense over the period. The interest rate equal to the discounted rate use in the initial recognition.

Dr. Finance Cost

Cr. Provision for Decommissioning

Depreciation Expense

Decommissioning costs that include the PPE must be depreciated too in addition to the cost of PPE.

Dr. Depreciation Expense

Cr. Accumulated Depreciation- Decommissioning cost

Example of Decommissioning Cost

ABC is an oil and gas company operating offshore drilling in the deep sea.  Management expects to spend 30 million dollars to clear the environmental impact at the end of production. The project is expected to last for 20 years. The interest rate is 5%.

Please calculate the decommissioning cost and journal entries.

Initial Recognition

The company needs to spend 30 million dollars in 20 years, so the present value would be:

Present Value of decommissioning cost = 30 / (1+5%)20 = 11.31 million

Journal Entry

Account Debit Credit
Property Plan & Equipment 11.31
Provision for Decommissioning 11.31

Subsequent Measurement

At the end of 1st year, we need to depreciate the PPE which arises due to decommissioning cost. This fixed asset will be depreciated over its useful life.

Depreciation expense = 11.31 million/20 = 0.565 million

Journal Entry

Account Debit Credit
Depreciation Expense 0.565
Accumulated Depreciation 0.565

Besides depreciation, the company needs to record financial cost and provision for decommissioning so the balance will increase and meet the management estimation.

Financial Cost = 11.31 * 5% = 0.5655 million

Journal Entry

Account Debit Credit
Financial Cost 0.5655
Provision for Decommissioning 0.5655