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Accounting for Asset Retirement Obligation
[Updated as on Dec 31, 2019]
Asset retirement obligation is a legal or contractual obligation to dismantle and remove an asset and to restore the site in which it is located on retirement of a tangible asset. Usually this obligation arises when an asset is installed in a leased premise and the lessee is bound by the contract terms to dismantle and remove the same on expiry of the lease term. For instance, a Company A has installed a tower in a portion of land owned by Mr.B. A is required by the contract to dismantle and remove the asset and to restore the land on expiry of the lease term of 20 years. This obligation of A is termed as Asset Retirement Obligation.
Accounting for Asset Retirement Obligation (ARO)
As per para 16(c) of Ind AS 16, the cost of an item of property, plant and equipment includes the initial estimate of the costs of dismantling and removing the item and restoring the site on which it is located, the obligation for which an entity incurs either when the item is acquired or as a consequence of having used the item during a particular period for purposes other than to produce inventories during that period. Thus Ind AS requires that an entity shall arrive at an initial estimate of the expected cost for dismantling and removing the asset and restoration of the site and shall capitalise the same as part of the cost of the asset. However where an entity incurs ARO as a consequence of having used the item during a particular period to produce inventories during that period, such cost of obligation may be treated as per Ind AS 2- Inventories. But it may be noted that Ind AS 2 does not explicitly provide for the treatment of ARO incurred in producing inventories during that period. However IFRS allows ARO cost to be added to the carrying amount of inventories as is discussed in paragraph BC15 of IAS 16.
Recognition of ARO
The obligations for dismantling and restoration costs accounted for in accordance with Ind AS 2 or Ind AS 16 are recognised and measured in accordance with Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets.
As per para 14 of Ind AS 37, a provision shall be recognised when:
(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.
ARO is in the nature of a provision where the entity is having a present obligation as a result of past event. Here the obligation to dismantle and restore the asset may arise on having acquired the asset or as a result of using the asset over a period of time. For instance, where a building is constructed in a leased premise and the lease term requires the demolition of the building and restoration of the site on expiry of the lease term, the obligation arises upon construction of the building and as per Ind AS 16, the cost of meeting the obligation shall be capitalised as part of the cost of the building. In the case of an oil installation or nuclear power station, the entity shall recognise provision for the decommissioning costs of an oil installation or a nuclear power station to the extent that the entity is obliged to rectify damage already caused.
Under ARO, it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation. In the above example, demolition of building requires outflow of cash towards labour, equipments, transportation expenses etc.
A reliable estimate could also be made about the cost of obligation to be incurred later. Hence the ARO is recognised in the financial statements as a provision as at the date at which they are incurred at its measured value.
Measurement of ARO
As per para 36 of Ind AS 37, the amount recognised as a provision shall be the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. The estimate of the amount that an entity would rationally pay to settle or transfer the obligation to a third party gives the best estimate of the expenditure required to settle the present obligation at the end of the reporting period. Such estimates of outcome and financial effect are determined by the judgement of the management of the entity, supplemented by experience of similar transactions and, in some cases, reports from independent experts. The evidence considered includes any additional evidence provided by events after the reporting period also.
Under ARO, the entity weighs different options to carefully estimate the possible outflow of resources required to settle the obligation. The options include analysing any recent similar events that may have occurred and the expenditure incurred thereat. If no, then search for any similar past events and the related expenditure. In case there is significant time gap between the period of estimation and the occurrence of past event, adjustment should be made for the effect of inflation. If no similar activities could be traced, then reports from experts either within or outside may be sought.
In most cases of ARO, the timing of the obligation is a future date. Even if an estimate is arrived on the possible expenditure required to settle the obligation as at the date of incurrence of the obligation, due to the impact of inflation, the possible expenditure on the date of settlement may vary significantly. In such cases, such estimate arrived should be adjusted for appropriate inflation factor so that a best estimate of the amount required to settle the obligation at a future date is arrived.
As per para 45 of Ind AS 37, where the effect of the time value of money is material, the amount of a provision shall be the present value of the expenditures expected to be required to settle the obligation. Applying this provision, the estimated amount adjusted for inflation should be discounted to the date of incurrence of obligation by applying a suitable discount rate. As per para 47, 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. Such discount rates shall be the judgment of the management which in their opinion closely reflect current market assessment of the time value of money.
For instance, in estimating the expenditure required to demolish a building constructed in a lease land on expiry of the lease term, the entity may verify for any similar transactions done earlier, or may get report from independent experts engaged in similar activities etc. Suppose they have received an expert report on the expected expenditure if the demolition is done now, they have to inflate the amount to the date of expiry of the lease term which is the date of settlement of the obligation. This inflated amount has to be discounted back to the date of capitalisation of the building in the books of the entity since such ARO cost have to be capitalised as part of the cost of the asset as required by Ind AS 16.
ARO computation and recognition
The ARO amount to be recognised in the financial statement as on the date of incurrence of the obligation shall be calculated using the formula given below:
Where C is the expected cost at the time of obligation,
R is the rate of discount applied
n is the time required to settle the obligation
If an entity could estimate only the current cost of meeting the obligation, then such amount could be inflated to the time of fulfillment of the obligation using suitable inflation rate.
Estimated amount at time “n” shall be: Current estimated cost X [1+k]^n
Where k is the rate of inflation
For example, an entity has constructed a building in a leased property at a cost of Rs.300000. As per the terms of the lease, the entity has to demolish the building and restore the site at the end of the lease period of 12 years. The entity has received a report from its engineering wing about the current cost required to demolish a similar building and restore the site as
Rs.25250. The inflation rate is assumed as 5.876% and the discount rate used is 9%.
Current estimate= Rs.25200
Inflated cost of meeting the obligation= 25200 X [1+5.876%]^12 = Rs.50000
Journal entry for accounting of ARO is as follows:
Building A/c Dr Rs.17777
To ARO Liability A/c Cr Rs.17777
[Being ARO cost capitalised as part of cost of Building and ARO liability created for meeting the obligation later]
ARO liability GL shall be disclosed in the Balance Sheet under non- current liabilities
Expected disposal of assets
As per para 51 of Ind AS 37, gains from the expected disposal of assets shall not be taken into account in measuring a provision, even if the expected disposal is closely linked to the event giving rise to the provision. Hence while estimating the expenditure to be incurred for settlement of obligation, the possible realisation from the disposal of the assets or any components will not be considered.
Subsequent measurement
Depreciation
The ARO amount capitalised as part of the cost of the asset should be depreciated over the period of useful life of the related asset. As per para 56(d) of Ind AS, while considering the useful life of an asset, legal or similar limits on the use of the asset, such as the expiry dates of related leases shall be considered. In the case of ARO, the assets are to be retired upon expiry of the lease period. However it should be assessed whether the retired assets could be used further, in which case the assets shall be depreciated over its useful life. If the retired assets could not be used further, it shall be depreciated over the period of lease unless it is more than the useful life of the asset.
In the above example, since the building is to be demolished on expiry of the period of the lease, it shall be depreciated over the period of the lease which is 12 years.
If the value of the ARO asset is adjusted on account of revision of ARO provision, the adjusted depreciable amount of the such asset shall be depreciated prospectively over its remaining useful life or remaining period of lease as the case may be.
Finance cost
As per para 60 of Ind AS 37, where discounting is used, the carrying amount of a provision increases in each period to reflect the passage of time. This increase is recognised as borrowing cost. Thus in the case of ARO, the discounted ARO amount has to be periodically unwinded to reflect the passage of time and the difference amount is accounted as finance cost. Capitalisation under Ind AS 23 is not permitted.
Finance cost to be charged each year= ARO liability X discount rate
Since the ARO liability is created at the date of incurrence of the obligation, it has to be adjusted to reflect the present value at the date of reporting of the financial statement using the above formula. The difference is accounted as finance cost. Thereafter finance cost is to be charged on the new ARO balance for each accounting period till the date of obligation.
Journal entry shall be:
Finance Cost A/c Dr xxx
To ARO Laibility A/c Cr xxx
Review of ARO liability
As per para 59 of Ind AS 37, provisions shall be reviewed at the end of each reporting period and adjusted to reflect the current best estimate. The following events shall be expected to contribute to the change in measurement of an existing decommissioning, restoration or similar liability
(a) a change in the estimated outflow of resources embodying economic benefits (eg cash flows) required to settle the obligation;
(b) a change in the current market-based discount rate as defined in paragraph 47 of Ind AS 37 (this includes changes in the time value of money and the risks specific to the liability); and
(c) a change in the estimated timing of the settlement of obligation.
For instance in the example of demolition of building, in arriving at the ARO cost, the entity has made an estimate of the expected cost to dismantle and restore the site on expiry of the lease term and discounted the same using a suitable discount rate. These factors used to compute the ARO cost are subject to change. There can be variation in the discount rate used, or change in the estimate of the cost initially assessed or the lease period may vary.
The impact of such changes are to be made to the ARO amount recognised as part of the cost of the asset as well as the ARO amount recognised as a liability as follows:
If the related asset is measured using the cost model
If the related asset for which ARO is created was accounted using the cost model, the treatment should be as follows:
-
Any changes in the ARO liability shall be added to, or deducted from, the cost of the related asset in the current period.
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However the amount deducted from the cost of the asset shall not exceed its carrying amount. If a decrease in the liability exceeds the carrying amount of the asset, the excess shall be recognised immediately in profit or loss.
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if the adjustment results in an addition to the cost of an asset, the entity shall consider whether this is an indication that the new carrying amount of the asset may not be fully recoverable. If it is such an indication, the entity shall test the asset for impairment by estimating its recoverable amount, and shall account for any impairment loss, in accordance with Ind AS 36.
In the example discussed above, subsequent to creation of the ARO asset, they have charged depreciation on the asset and charged finance cost for each year. Period of 10 years have lapsed and the carrying amount of various GLs are as follows:
Original cost of the asset: Rs.317777
Accumulated depreciation: Rs.291599
Carrying amount of the asset: Rs.26178
ARO liability initially recognised: Rs.17777
Finance cost charged for 10 years: Rs.24307
ARO liability balance as on date: Rs.42084
We will consider the impact of changes in the ARO amount on account of change in each of the factors mentioned above:
-
Change in estimated amount required to settle the obligation which in this case is demolition of the building and restoration of the site.
The entity has re-estimated the amount required to demolish the Building owing to some technological changes and now expects to cost only Rs.30000.
Due to the re estimation, revised ARO amount is as follows:
Thus the ARO balance as on date is higher by Rs.16834 [42084-25250]
Hence such excess amount shall be adjusted by decreasing the liability amount as well as the carrying amount of the related asset.
The journal entry shall be as follows:
ARO Liability A/c Dr Rs.16834
To Building A/c Cr Rs.16834
The carrying amount after adjustment shall be:
Building- Rs.9344 [26178-16834]
ARO liability- Rs.25250 [42084-16834]
The adjusted carrying amount of the asset shall be depreciated over the remaining period of the contract.
If suppose the carrying amount of the asset had been Rs.15000, then the accounting treatment shall be as follows:
ARO Liability A/c Dr Rs.16834
To Building A/c Cr Rs.15000
To Excess provision Cr Rs. 1834
written back
If the revised estimate was Rs.60000 which is higher than the initial estimate, then the revised ARO amount would have been:
Since the revised ARO amount is higher by Rs.8417 [50501-42084], the ARO liability as well as the carrying amount of the asset shall be increased.
The journal entry in this case shall be:
Building A/c Dr Rs.8417
To ARO Liability A/c Cr Rs.8417
2. Change in the discount rate used
If in the above example after the lapse of 10 years, the entity realises that the discount rate being used was not adequate considering the market assessment of time value of money. The entity adopts 10% as the revised discount rate with other factors remaining unchanged. Revised calculation is as follows:
Since the revised ARO amount is lower by Rs.762 [42084-41322], the ARO liability as well as the carrying amount of the asset shall be decreased.
The journal entry in this case shall be:
ARO Liability A/c Dr Rs.762
To Building A/c Cr Rs.762
3. Change in timing of the event.
If in the above example after the lapse of 10 years, only the lease term is extended by 3 years and other things remaining same so that the timing of the fulfilment of the obligation i.e the demolition and restoration of the site stands postponed by 3 years. The revised calculation is as follows:
Since the revised ARO amount is lower by Rs.9587 [42084-32497], the ARO liability as well as the carrying amount of the asset shall be decreased.
The journal entry in this case shall be:
ARO Liability A/c Dr Rs.9587
To Building A/c Cr Rs.9587
If the related asset is measured using the revaluation model
Changes in the ARO liability affects the revaluation surplus or deficit already recognised as follows:
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any decrease in ARO liability shall increase the revaluation surplus created at the time of revaluation of the related asset except where there is a revaluation deficit in respect of the asset already recognised in profit and loss account in which case such decrease in ARO liability shall reverse the deficit so recognised in profit and loss account. However in case the decrease in the liability exceeds the carrying amount that would have been recognised had the asset been carried under the cost model, the excess shall be recognised immediately in profit or loss.
We may consider an example with particulars as on 31/03/2019 as follows:
Gross value of asset: Rs.60000
Accumulated Depreciation: Rs.54000
Carrying amount of asset:Rs.6000
ARO liability:Rs.8000
Revaluation surplus on the asset:Rs.6000
The entity has re-estimated the ARO liability as Rs.4000. The decrease of ARO liability of Rs.4000 shall be accounted as follows:
ARO Liability Dr 4000
To Revaluation Cr 4000
surplus
ARO liability balance becomes Rs.4000 and revaluation reserve balance becomes Rs.10000.
Suppose in the above example, instead of revaluation surplus, there was revaluation deficit of Rs.3000 and the ARO liability was to be reduced to Rs.1500. The entry will be as follows:
2. any increase in ARO liability shall be charged directly to profit and loss account unless adjusted to the extent credit balance exists in revaluation surplus in respect of the related asset.
If in the first example, ARO liability was to be increased to Rs.11000, the accounting entry shall be as follows:
Revaluation Surplus Dr 3000
To ARO Liability Cr 3000
3. the change in the ARO liability is an indication that the asset may have to be revalued in order to ensure that its carrying amount does not differ materially from its fair value at the end of the reporting period. Any such revaluation shall be taken into account in determining the amounts to be charged to revaluation deficit or revaluation surplus under (i) above. If a revaluation is necessary, all assets of that class shall be revalued.
Revision in ARO liability if the related asset has reached its useful life
Once the related asset has reached the end of its useful life, all subsequent changes in the ARO liability shall be recognised in profit or loss as they occur. This applies under both the cost model and the revaluation model
Disclosure of adjustment to Profit and Loss
Ind AS 1 requires disclosure in the statement of profit and loss of each component of other comprehensive income or expense. In complying with this requirement, the change in the revaluation surplus arising from a change in the liability shall be separately identified and disclosed as such.
Settlement of ARO
As per para 61 of Ind AS 37, a provision shall be used only for expenditures for which the provision was originally recognised. Hence at the time of the obligating event which is the actual dismantling of the asset and restoration of the site, the actual dismantling and restoration expenses incurred should be adjusted against the balance in the ARO account. For instance, if the actual dismantling expenses incurred was Rs.38000 and the balance in ARO GL was Rs.41500, then the journal entry will be as follows:
ARO liability Dr 41500
To Cash/Bank 38000
To Gain on dismantling 3500
However if the actual dismantling expenses was Rs.47000, then the entry will be:
ARO liability Dr 41500
Loss on dismantling Dr 5500
To Cash/Bank 47000
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