Installation of fixed assets requires sincere work and incurs certain charges called commissioning costs for setting up and making a modification to the landscape for erecting the asset.
Similarly, the decommissioning cost is the cost incurred by the companies to reverse modifications that were made in setting up in the landscape.
This means the asset is used up and set for sale or salvage. Decommissioning costs are also popularly called asset retirement costs.
In this article, we will discuss detail on how to account for decommissioning costs
Industries where decommissioning is done.
The asset heavy industries such as metal industries and oil and other companies requiring large asset to be set for manufacturing incurs decommissioning cost.
These costs are usually very high in oil industries due to the nature of functioning. They have to keep and put drilling instruction in use so as to not let harmful gases leakage to earth.
Standards for Decommissioning costs
Decommissioning costs may require a provision in certain industries as per the prudent approach. IAS 37 on Provisions, contingent liabilities, and Contingent Assets require the creation of provision.
Similarly, IAS 16 Property, Plant and Equipment require including the initial estimate of the costs of dismantling and removing the item and restoring the site into the cost of an asset.
Further, IFRS has developed IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities to account for such decommissioning costs.
Computation of decommissioning costs
Since, these costs are future costs and likely, time value concept loops into the computation of decommissioning costs. The following are the steps in the calculation of the cost:
Compute decommissioning present cost using the time value of the asset assuming no improvement in decommissioning procedure.
Take into account the expected inflation to the time of actual decommissioning of the asset.
Use the discount rate and compute decommissioning liabilities or provisions to be included in the cost of the asset.
Unwind the discount on decommissioning assets that equal the opening balance of the decommissioning obligation. This will result in the period end balance of decommissioning liability.
Accounting treatment for decommissioning costs
Initial Recognition and Measurement
The retirement of production assets may be required by operating licenses or past practices. As per IAS 37, this ought to create an obligation and thus a liability.
Further, a corresponding asset is created as per IAS 16 on Property, Plant, and Equipment, which defines cost as an initial estimate of dismantling and removing the asset and restoring the site on which it is located.
The required accounting treatment in this scenario would be
Date
Particulars
Debit ($)
Credit ($)
Property, Plant and equipment
XXX
Provisioning for decommission
XXX
Such provisions are calculated by using present value concept
Subsequent Recognition and Measurement
When the asset is used up, unwind the discount and charge the interest on provisions to build up the required provisions over the life of the asset. This discount has to be recognized as a finance cost in the income statement.
Date
Particulars
Debit ($)
Credit ($)
Finance costs
XXX
Provisioning for decommission
XXX
Further, this cost of provision has to be depreciated over the useful life of fixed asset.
If changes to provision relate to removal of asset, then there is the case of decrease in value of asset as:
Date
Particulars
Debit ($)
Credit ($)
Provisioning for decommission
XXX
Property, Plant and Equipment
XXX
However, the asset cannot go below zero and neither can go above its recoverable amount . If the decrease in provision exceeds the carrying amount of the asset, the excess is recognized immediately in profit or loss.
At the end of useful life of asset, the company decommissions the asset and restores the site to required condition and all the expenses are charged against the provision. The entry to be made here is :
Exploration costs mean the cost incurred for the search of mineral resources including minerals, oils, natural gas, and other similar non-regenerative resources after the entity has obtained the rights to explore in specific areas by determining technical feasibility and commercial viability of extracting the mineral resource. (adapted from IFRS 6).
IFRS 6 allows the company to develop accounting policy for recognition of exploration and evaluation expenditures without adhering to much of the policy requirements of IAS 8 on Policies, changes in Accounting estimates, and errors. The evaluation phase is after the exploration but is dealt with likewise as one in IFRS.
Elements of cost of exploration and evaluation
After recognizing exploration cost as per IFRS 6, the following are the components that form part of the cost:
Acquisition of rights to explore.
Cost of exploratory drilling
Trenching and sampling
Cost of study towards topography and geology
Cost of activities related to technical feasibility and commercial viability of extracting mineral
However, expenditure related to the development of mineral resources shall not be recognized as exploration and evaluation costs. These are dealt in as per IAS 38 on intangible assets as development costs.
Accounting for exploration and evaluation.
An entity may have a past practice of deferring all exploration and evaluation expenditure as an asset even if the outcome is highly uncertain. Other entities may have a past practice of expensing all exploration and evaluation expenditure until the technical feasibility and commercial viability of extracting a mineral resource have been established.
An entity can change its accounting policy for E&E only if the change results in an accounting policy that is closer to the principles of the Framework.
Initial recognition
The entity should determine the unit to which exploration and evaluation cost will be allocated. The common method is to allocate between areas of interest.
This should involve determining areas to examine and track separately the costs incurred for each area. The area of interest contracts over time as work progresses.
Subsequent measurement of exploration and evaluation
There are two methods to determine the cost of exploration and evaluation. These methods are cost method and the revaluation method.
Whichever method is applied, it shall be consistent with the classification of the costs/assets. Depreciation and amortization of E&E assets usually do not commence until the assets are placed in service.
The revaluation method is applied to intangible assets only if there is an active market in relevant intangible assets.
However, such criteria are seldom met and cost method is used then. The ‘fair value as deemed cost’ exemption in IFRS only applies to tangible fixed assets and thus is not available for intangible assets.
Reclassification of Exploration and evaluation assets.
Exploration and evaluation assets are reclassified procedures that have been completed to recognize as such.
Those expenditures which are commercially viable have to reclassified to development cost viz. as development assets. The exploration and evaluation assets shall also be tested for impairment.
Impairment of Exploration and evaluation assets
There are various indicators to determine the impairment of exploration and evaluation assets as :
The right to explore in the geographical area has expired or about to expire with no option to renew.
Further exploration and evaluation are not planned.
There is sufficient data to conclude that exploration and evaluation will be discontinued due to a lack of commercial reserves.
Disclosure requirements
The disclosure requirements of exploration and evaluation assets generally include:
The accounting policy used for allocating exploration and evaluation assets cash-generating units for impairment purposes
The amount recognized in financial statement w.r.t. exploration and evaluation activities including the disclosure in operating cash flows and investing cash flows
Last but not least the reconciliation statement of amounts carried forward as exploration and evaluation assets at the beginning and closing of the accounting period. The reconciliation statement includes transfers to development, amounts written off, and impairments.
A tenant should recognize restoration cost as part of the right of use asset while incurring obligation for them. This shall be decided based on the circumstances, that it may start at the commencement date or can be a consequence of having used the asset for a particular period.
The obligation is covered under IAS 37 Provisions, Contingent Liabilities, and Contingent Assets. Regular wear and tear occur during the period of the lease which can increase the tenant’s hand-back obligation but it does not give rise to an asset.
Further, the tenant shall apply provisions of IAS 2 Inventories if the leased asset is used to manufacture inventories in the lease period.
Accounting
The legal owner of the asset may require the lessee/tenant to reinstate the leased space to its original state when the lease expires and the tenant decided not to renew the lease agreement.
Then, a provision for reinstatement cost/restoration cost needs to be recorded, as it is an existing obligation of the lessee/tenant.
This amount relates to the cost to be incurred to reinstate the lease space back to its original state. Such an amount is estimated with the help of a quotation from a renovator or building contractor.
Date
Particulars
Debit ($)
Credit ($)
XXXX
Reinstatement cost
XXX
XXXX
Provision for reinstatement
XXX
(To record reinstatement cost)
The amount capitalized above relates to the full cost to be incurred when the lease expires. For closing the account following entry shall be
The depreciation entry is to record the cost capitalized into P&L on a straight-line basis. The reinstatement or restoration cost has to be expensed off on a straight-line basis until the end of the lease period.
Impact of increase in lease term
In the initial period, the tenant measures the right of use of the asset and includes appropriate estimates of the cost to dismantle and remove the asset or restore the asset to the prior situation before the contract begins.
The obligation for these costs is recognized and measured in accordance with IAS 37. The changes to the best estimate of the settlement amount may result from changes in the amount or timing of the outflows or changes in discount rates.
A lease modification may result in a change to a tenant’s obligations to restore the underlying asset at the end of the lease. This may result in additional provisioning of restoration costs and should be provided immediately.
IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.
Depreciation expense is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.
Depreciation is computed using various methods. Popular methods include the straight-line method and accelerated depreciation methods.
Presentation in Financial Statement:
Income Statement: The asset cost less salvage value is spread over the useful life of the asset. The amount of depreciation needs to be calculated each year and is debited to Income Statement like any other operating expenses.
Balance Sheet: Depreciation reduces the value of assets over time. Depreciation cumulatively rises over the time and hits the cost less salvage value in the final year of useful life.
The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset. Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.
Implicit costs
These are the costs that have already been incurred. These are however not reported as separate expense. Implicit costs are opportunity costs that arise when a company use internal resources toward a project without any explicit compensation for the utilization of resources.
When a company allocates a resource, it has to forgo the ability to earn from other techniques or allocating elsewhere. In a nutshell, it comes from the use of assets but not from renting or buying it.
Example of implicit cost
When a tech company hires new tech employees, there are implicit costs to train that employee. If the senior manager takes the opportunity to train these new employees, he has to allocate some hours of his say 8 hours per week.
The implicit cost here in this scenario would be the hourly wage rate of senior managers multiplied by 8 hours. This is because the hours could have been allocated toward the senior manager’s current role in the top-level management
Are implicit costs shown in financial statements?
No implicit costs are not relevant to accounting as it does not involve the movement of money. These are just notional costs. Hence, these implicit costs are not recorded in financial statements.
Implicit vs Explicit
Explicit costs are defined costs in running the business. It includes expenses such as wage, rent, materials, depreciation, amongst others. Unlike implicit, these costs are real and presented in income statement in financial statements.
Conclusion
Depreciation is recognized expense. Although it has the feature of been incurred like implicit cost, however, depreciation represents the ongoing wear and tear of asset that has to be distributed over the number the years. In fact, depreciation is recognized as explicit cost and not implicit cost.
IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.
Depreciation expense is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.
Depreciation is computed using various methods. Popular methods include the straight-line method and accelerated depreciation methods. The amount of depreciation needs to be calculated each year and is debited to Income statement like any other operating expenses.
Depreciation cumulatively rises over time and hits the cost less salvage value in the final year of useful life. The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset.
Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.
Overhead costs
Overhead costs are residual costs after direct labor, direct expenses, and direct materials. Overhead costs are basically indirect costs. These cannot be directly traced back to the product and indirectly contributes to the value-added to the product. There are two types of overhead.
Manufacturing overhead termed as factory overhead: These costs relate to the factory where production is taking place. Manufacturing overhead includes expenses as the electricity used to operate the factory equipment, depreciation on the factory equipment and building, cost of security guard personnel.
Non-manufacturing overhead termed as administrative overhead: This overhead relates to administration cost of running a factory. These are basically office expenses that get added to the product in the cost sheet. Non-manufacturing costs include expenses related to maintenance, printing and stationery, depreciation of non-manufacturing equipment like vehicles to sell and distribute the products.
Direct costs vs overheads
Direct costs are easily traceable to the product. For example, a factory worker makes the product, so, direct labor is labor costs. Wood in the making of furniture attributes to direct material costs.
As can be seen, direct costs can be easily identified to product but not overheads. Overheads are indirectly related to the production and manufacturing of products.
Conclusion
Although depreciation has to be seen on case to case basis to decide whether it is direct cost or overhead, but a general parlance has been formed to classify it as overhead being part of factory overhead generally.
A Contrarian example would be turbine depreciation in the generation of electricity. This is the case of being directly related but is limited to only electricity or fewer industries.
Hence, depreciation expense is considered an indirect cost, since it is included in factory overhead and then allocated to the units manufactured during a reporting period. This is as per general parlance in businesses around globally.
IAS 16 defines depreciation as ‘the systematic allocation of the depreciable amount of an asset over its useful life’. The depreciable amount equals the purchase cost of the asset less the salvage value or other amount like revaluation amount of the asset. Depreciation amounts to distributing the cost of assets to the income statement over the useful life of the asset.
Depreciation is a non-cash operating activity which is the result of qualitative wear and tear in the use of asset but it has been quantified by the use of accounting principles and assumptions in line with the enterprise’s own accounting policies.
The amount of depreciation needs to be calculated each year and is debited to Income Statement like any other operating expenses. Depreciation cumulatively rises over the time and hits the cost less salvage value in the final year of useful life.
The historical value of the asset is reduced by this accumulated depreciation so as to arrive at the written down value of the asset. Written down value is computed after charging depreciation accumulated over the years to the initial cost i.e. historical cost.
Depreciation is computed using various methods as straight-line method, double declining method, units of production and sum of years digits method.
Operating expense
Operating expenses are normal business expenditures incurred daily. The operating expenses are incurred during the daily works of business operations. These expenses are however not directly associated with the production of goods or services. Examples of operating expenses include the following:
Insurance costs
Legal fees
Office supplies
Compensation and related payroll tax expenses
Advertising costs
Entertainment costs
Rent of production facilities
Depreciation.
Basically, there are two types of operating expenses viz administrative operating expenses and sales and marketing related operating expenses.
The administrative expenses relate to office-related expenses like legal fees and printing and stationery. Sales and marketing related operating expenses include advertising costs, travel costs, amongst others.
Is depreciation operating expense?
Depreciation replicates the period and scheduled conversion for a fixed asset into an expense as the asset is used during normal business operations. As the assets are used to generate operating income in the normal course of business, depreciation expense is considered as operating expense.
Depreciation depicts the scheduled conversion of the purchase cost and other associated costs into the expense during its useful life during the normal course of business operations.
Depreciation is however one of those operating expenses where cash movement is lacking. This is because the cash was already incurred for acquiring the asset and hence there is no requirement of spending the cash unless up-gradation of asset is required.
Therefore, depreciation is a non-cash component of operating expenses. The same treatment goes with the amortization of intangible assets.
Another way to look at it is to assume that all the fixed assets of business will ultimately be replaced in which case large cash outflow would be required for replacement asset. From this angle, there is better view to identify relationship between cash flow and amount of depreciation.
Hence. Depreciation will not be considered as part of operating expenses in the short term, but it should be considered as operating expense in the long term to provide for replacement cycles.
