Summary of ASPE 3110 Asset Retirement Obligations

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2 Purpose and Scope This Section establishes standards for the recognition, measurement and disclosure of liabilities for asset retirement obligations (AROs) and the associated asset retirement costs. What the Section applies to Legal obligations associated with the retirement of a tangible long-lived asset that results from its acquisition, construction, development or normal operation [Note 1]. Obligations of both lessors and lessees in connection with leased assets, whether imposed by a lease agreement or by a party other than the lessor, except for those obligations of a lessee that meet the definition of either minimum lease payments or contingent rentals, which are accounted for in Section 3065, Leases [Note 2]. Obligations arising in connection with leasing and other agreements concerning the rights to explore for or exploit natural resources. What the section does not apply to Obligations arising solely from a plan to sell or otherwise dispose of a long-lived asset. These are accounted for in terms of Section 3475, Disposal of Long-lived assets and discontinued operations. Obligations that result from the improper use of an asset [Note 3]. Note 1: Acquisition/Development: For example, drilling rig/oil lease - from the moment the lease site is developed there is an obligation to perform environmental remediation activities to restore the land to its original state at the termination of the operations on that site. Normal operations: These are predictable and likely to occur, for example a nuclear plant entity has a legal obligation to decontaminate when operations cease, contamination is predictable and likely to occur and unavoidable as a result of operating the plant. Note 2: An operating lease on a plant, an entity may have a obligation to remediate environmental damage upon termination of the lease, the ARC and ARO are recognized even though the asset itself is not recognized. Note 3: A remediation liability resulting from improper operations does not fall within the scope of this Section, for example, a fuel storage facility - a certain amount of spillage may be inherent in normal operations however, a large accident caused by non-compliance with safety procedures is not. The obligation to clean up after the accident is not within the scope of this Section. 2

3 Definitions Asset retirement obligation (ARO) is a legal obligation associated with the retirement of a tangible long-lived asset that an entity is required to settle as a result of an existing or exacted law, statute, ordinance or written or oral contract or by legal construction of a contract under the doctrine of promissory estoppel. Retirement is the other-than-temporary removal from service of a long-lived asset including its sale, abandonment, recycling or disposal in some manner but NOT its temporary idling. Asset retirement cost (ARC) is the amount that is capitalized and increases the carrying amount of a long-lived asset when a liability for an ARO is recognized. Accretion expense is the increase in the carrying amount of an ARO due to the passage of time. Promissory estoppel is the legal principle that a promise or assurance made without consideration may nonetheless be enforced to prevent injustice when: The promise or assurance was intended to affect a contract or other legal relationship between the promisor and the promisee, and to be acted on; and The promisee acted on the promise or assurance, or in some way changed its position. Example: Assume that a company operates a manufacturing facility on land subject to a 99-year lease. The lease requires the company to restore the land but the obligation is enforceable only if the company ceases to operate the facility before the end of the 25th year of the lease. In the 23rd year of the lease, the company's chief executive officer announces publicly that it plans to retire the facility in five years. In that case, under the terms of the lease, the company would not be required to restore the land. If the announcement also states that the company intends nevertheless to demolish the facility and restore the land, and it is reasonable to expect that the lessor would be aware of the announcement, the Canadian courts might conclude that there has been a promissory estoppel. A promissory estoppel may exist even though no one had relied on the announcement to their detriment. The promissory estoppel would prevent the company later from standing on the letter of the lease by which its obligation would have expired at the end of the 25th year of the lease Recognition An entity shall recognize a liability for an ARO in the period in which it is incurred when a reasonable estimate of the amount of the obligation can be made. If a reasonable estimate of the amount of the obligation cannot be made in the period the ARO is incurred, the liability shall be recognized when a reasonable estimate of the amount of the obligation can be made. Liabilities have three essential characteristics: They embody a duty or responsibility to others that entails settlement by future transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand; The duty or responsibility obligates the entity, leaving it little or no discretion to avoid it; and The transaction or event obligating the entity has already occurred. 3

4 Only a legal obligation associated with the retirement of a tangible long-lived asset, including an obligation created by promissory estoppel, establishes a clear duty or responsibility to another party that justifies recognition of a liability. When a tangible long-lived asset with an existing ARO is acquired, a liability for the obligation is recognized at the asset s acquisition date as if that obligation were incurred on that date. Measurement The amount recognized as an ARO shall be the best estimate of the expenditure required to settle the present obligation at the balance sheet date. The best estimate is the amount that an entity would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party at that time. It is determined by entity s management s judgment, supplemented by experience of similar transactions and, in some cases, reports from independent experts. Factors impacting best estimate: Future events that may affect the amount required to settle an obligation are reflected in its measurement when there is sufficient objective evidence that they will occur. These events may be particularly important in measuring an ARO. For example, an entity may believe that the cost of cleaning up a site at the end of its life will be reduced by future changes in technology. The effect of possible new legislation is taken into consideration in measuring an existing obligation when sufficient objective evidence exists that the legislation is virtually certain to be enacted. A present value technique is often the best available technique with which to estimate the expenditure required to settle the present obligation at the balance sheet date. When a present value technique is used, an entity estimates future cash flows used in that technique on a basis consistent with the objective of measuring the ARO. Recognition and Allocation of an Asset Retirement Cost Initial Recognition *Any impairment of asset retirement costs is accounted for in accordance with IMPAIRMENT OF LONG- LIVED ASSETS, s

5 Subsequent to initial measurement ARO s are to be reviewed at each balance sheet date and adjusted to reflect the current best estimate. Changes in the liability for an ARO that an entity shall recognize from period-to-period result from: a) The passage of time; and b) Revisions to either the timing, the amount of the original estimate of undiscounted cash flows or the discount rate. Note: An entity shall measure and incorporate changes due to the passage of time into the carrying amount of the liability before measuring changes resulting from a revision to either the timing or the amount of estimated cash flows. a) Changes resulting from the passage of time Measured by applying an interest method of allocation to the amount of the liability at the beginning of the period. The interest rate used to measure that change is the discount rate applied to measure the liability at the beginning of the period. Accounting treatment: Dr Expense Cr Liability The amount being recognized is an increase in the carrying amount of the liability and an expense. The expense is classified as an operating item in the income statement and not as an interest expense. This can be described as an accretion expense or any other description conveying the underlying nature of the expense. b) Changes resulting from revisions to the timing or the amount of the original estimate of undiscounted cash flows or revisions to the discount rate Recognized as an increase or a decrease in the carrying amount of the liability for an ARO, and the related asset retirement cost capitalized as part of the carrying amount of the related long-lived asset. When asset retirement costs change as a result of a revision to estimated cash flows, an entity adjusts the amount of asset retirement cost allocated to expense: in the period of change if the change affects that period only; or in the period of change and future periods if the change affects more than one period (as required by ACCOUNTING CHANGES, Section 1506, for a change in estimate). Changes in asset retirement costs that affect future periods will result in adjustments of capitalized asset retirement costs and will affect subsequent depreciation of the related asset. Such adjustments are depreciated on a prospective basis. 5

6 Effects of funding and assurance provisions Providing assurance that an entity will be able to satisfy its ARO does not satisfy or extinguish the related liability. Methods of providing assurance include surety bonds, insurance policies, letters of credit, guarantees by other entities and establishment of trust funds or identification of other assets dedicated to satisfy the ARO. Setting assets aside to satisfy an ARO does not satisfy the criteria for offsetting the assets and the liability on the balance sheet. For a previously recognized ARO, changes in funding and assurance provisions have no effect on the measurement of that liability. Costs associated with complying with funding or assurance provisions are accounted for separately from the ARO. Disclosure An entity shall disclose the following information about its asset retirement obligations: a general description of the asset retirement obligations and the associated long-lived assets; the amount of the asset retirement obligation at the end of the year; the total amount paid towards the liability during the year; and if readily determinable, the fair value of assets that are legally restricted for purposes of settling asset retirement obligations. If this is not readily determinable, the carrying amount of assets legally restricted for purposes of settling asset retirement obligations. When a reasonable estimate of the amount of an asset retirement obligation cannot be made, that fact and the reasons therefore shall be disclosed. Uncertainties affecting the measurement of a liability for asset retirement obligations are disclosed in accordance with MEASUREMENT UNCERTAINTY, s Application guidance The appendix to this Section provides further guidance on the application of certain aspects of this Section. This includes guidance related to: Asset retirement obligations with indeterminate settlement dates; Asset retirement obligations related to component parts of larger systems; Obligations associated with an unrecognized tangible long-lived asset; Conditional obligations; Obligations created by new statutory or regulatory requirements; Recoveries of asset retirement costs; and Further guidance relating to measurement and subsequent recognition of asset retirement obligations. 6

7 Illustrative example Offshore Drilling Inc. Background January 1, acquires offshore drilling rig at a cost of $50 million Life = 4 years Legislation requires that it be removed Current market rate of interest on Government of Canada 4 year bonds = 8% Recognition The entity: has acquired a long-lived tangible asset (drilling rig); has a legal obligation which it is required to settle (removal of the drilling rig); and the obligation resulted from the assets acquisition and is associated with its retirement. The entity will recognize an ARO in the period in which it is incurred (period of drilling rig acquisition), when a reasonable estimate of the amount of the obligation can be made, and recognize an ARC by increasing the carrying amount of the related long-lived asset (drilling rig) by the same amount as the ARO. Measurement The ARO (and related ARC) is measured at the best estimate of the expenditure required to settle the present obligation at the balance sheet date using a present value technique including: all expected costs that will be incurred in performing the tasks necessary to retire the asset (i.e., overhead, equipment charges); probabilities assigned to expected future cash flows; and a discount rate applied which represents the current market risk-free rate of interest for maturity dates that coincide with the expected cash flows. The following table illustrates the estimate of labour cash flow required to remove the drilling rig: CF Estimate Labour Cost Labour Cost Estimate Probability Expected CF $4,500,000 10% $450,000 $5,000,000 50% $2,500,000 $6,000,000 40% $2,400,000 Total Expected Value - Labour $5,350,000 The following table illustrates the estimate of total cash flows required to remove the drilling rig = "undiscounted expected value of the ARO": Total Expected Value Estimate Expected Value of Labour Costs $5,350,000 Allocated Overhead (80% of Labour) $4,280,000 Contractor s Mark-up (20% of Labour) $1,070,000 Total Cash Outflows $10,700,000 Contractor s Market Risk Premium (20% of total) $2,140,000 Expected Value of ARO $12,840,000 7

8 The following table illustrates the discounting of the expected cash flows using the current market risk-free rate of interest for maturity dates that coincide with the expected cash flows: Total Expected Value PV of ARO Expected Value of ARO $12,840,000 Multiplied by: 8% of $1 in four years Expected PV of ARO $9,437,784 The following table illustrates the journal entry for the initial recognition of: ARO (discounted expected value of the cash flows); and Asset (cost + ARC equal to the ARO) January 1, 2011 Dr Drilling Rig $59,437,784 Cr Cash $50,000,000 Cr ARO $9,437,784 To record initial acquisition of drilling rig Allocation of Asset Retirement Cost The following table illustrates the journal entry to record the amortization charge for the asset cost and the ARC added to the asset. Note that straight-line is used for simplicity, even though in practice we would likely use the units-of-production method: December 31, 2011 Dr Amortization Expense ($59,437,784/4) $14,859,446 Cr Drilling Rig Accumulated Amortization $14,859,446 To record amortization expense The following table illustrates the interest method of allocation to account for changes in the ARO due to the passage of time (accretion expense). Note that rounding is the cause of the extra $2 in the closing balance at the end of 2014: Passage of Time Changes Accretion Expense Year Opening balance Expense (at 8%) Closing balance 2011 $9, $755,023 $10,192, $11,192,807 $815,425 $11,008, $11,008,232 $880,659 $11,888, $11,888,891 $951,111 $12,840,002 The following table illustrates the journal entry to record accretion expense at the end of year 1 (i.e. 2011). Note that the journal entry remains the same for all years using each year s calculated amount under Expense (at 8%) from the table above: December 31, 2011 Dr Accretion expense $755,023 Cr ARO $755,023 To record amortization expense 8

9 Changes to the Amount of Estimated Cash Flows and the Discount Rate Additional information Date December 31, 2012 Estimated labour costs have increased (see revised table below) Market interest rates have changed - current market rate of interest on Government of Canada 2 year bonds = 7% Recall removal required at end of 2014 Note: The liability is adjusted for accretion expense prior to adjusting for revisions in estimated cash flows, thus as the change in estimate occurs on December 31, 2012, the accretion expense for the 2012 year is recorded prior to the change in estimate. Also, the change in the expected cash flows and discount rate are a change in estimate and accounted for on a prospective basis, thus, the accretion expense and amortization expense recorded for 2011 and 2012 are unaffected, however, the accretion expense and amortization expense in 2013 and 2014 will both change based on the new estimate of the ARO. The following table illustrates the revised estimate of labour cash flow required to remove the drilling rig: Revised CF Estimate Labour Cost Labour Cost Estimate Probability Expected CF $4,800,000 20% $960,000 $5,900,000 30% $1,770,000 $6,500,000 50% $3,250,000 Total Expected Value - Labour $5,980,000 The following table illustrates the revised expected PV of the ARO: Revised Expected PV of ARO Expected Value of Labour Costs $5,980,000 Allocated Overhead (80% of Labour) $4,784,000 Contractor s Mark-up (20% of Labour) $1,196,000 Total Cash Outflows $11,960,000 Contractor s Market Risk Premium (20% of total) $2,392,000 Expected Value of ARO $14,352,000 Multiplied by: 7% of $1 in two years Revised Expected PV of ARO $12,535,593 ARO at December 31, 2012 $11,008,232 Adjustment required $1,527,361 The following table illustrates the ARO and accretion expense recorded to December 31, 2012, the required adjustment from the change in estimate, and the accretion expense which will be recorded in the 2013 and 2014 years: Passage of Time Changes Accretion Expense Year Opening balance Expense (at 8%) Adjustment Closing balance 2011 $9, $755,023 - *$10,192, $11,192,807 $815,425 - *$11,008,232 Adjustment $11,008,232 - $1,527,361 $12,535, $12,535,593 $877,491 - **$13,413, $13,413,084 $938,916 - **$14,352,000 * Accretion expense calculated at 8%. ** Accretion expense calculated at 7%. 9

10 The following table illustrates the carrying value of the drilling rig plus the ARC and the amortization expense recorded to December 31, 2012, the required adjustment from the change in estimate, and the amortization expense which will be recorded in the 2013 and 2014 years: Drilling Rig + ARC Amortization Expense Year Opening balance Expense (at 8%) Adjustment Closing balance 2011 $59,437,784 $14,589,446 - $44,578, $44, $14,589,446 - $29,718,892 Adjustment $29,718,892 - $1,527,361 $31,246, $31,246,253 $15,623,127 - $15,623, $15,623,127 $15,623, The change in the amortization expense each year for the 2 remaining years is equal to the increase in ARO/ARC divided by 2. The following table illustrates the journal entries required at December 31, 2012 (end of year 2): December 31, 2012 Dr Amortization Expense $14,859,446 Cr Drilling Rig Accumulated Amortization $14,859,446 To record amortization expense based on original measurement Dr Accretion expense $755,023 Cr ARO $755,023 To record accretion expense (based on original measurement) Dr Drilling Rig $1,527,361 Cr ARO $1,527,361 To record change in estimate The following table illustrates subsequent journal entries in 2013 and 2014 (years 3 & 4) for amortization and accretion expense, which would follow the format as in years 1 and 2, however would be recorded at the amounts as calculated based on the revised estimate of the ARO: December 31, 2013 Dr Amortization Expense $15,623,127 Cr Drilling Rig Accumulated Amortization $15,623,127 To record amortization expense based on revised measurement Dr Accretion expense $877,491 Cr ARO $877,491 To record accretion expense (based on revised measurement) 10

11 December 31, 2014 Dr Amortization Expense $15,623,126 Cr Drilling Rig Accumulated Amortization $15,623,126 To record amortization expense based on revised measurement Dr Accretion expense $938,916 Cr ARO $938,916 To record accretion expense based on revised measurement The following table illustrates the balance sheet balances as at December 31, 2014 (i.e. removal date, just prior to asset removal) including: Drilling Rig Carrying Cost equal to the sum of: + $50,000,000 (original cost) + $ 9,437,784 (ARC based on initial PV estimate) + $ 1,527,361 (increase to ARC based on revised PV estimate) ARO equal to the sum of $14,352,000 (revised Expected Value of the ARO) Balance Sheet Balances December 31, 2014 Drilling Rig $ 60,965,145) Drilling Rig (accumulated Amortization) $(60,965,145) Net Asset $Nil ARO $ 14,352,000 Settlement A salvage company was contracted to remove the drilling rig at a cost of $14.5 million. The following table illustrates the journal entry required to recognize the settlement of the ARO and retirement of the asset. Note that it is unlikely that a settlement amount will ever equal the ARO and as such a gain or loss on settlement will be recognized. Dr Drilling Rig accumulated amortization $60,965,145 Cr Drilling Rig $60,965,145 Dr ARO $14,352,000 Cr Payable to Salvage Company $14,500,000 Dr Loss on settlement of AR $ 148,000 Dr Payable to Salvage Company $14,500,000 Cr Cash $14,500,000 To record settlement of ARO Cash payments made to settle an ARO are classified as operating cash flows in the statement of cash flows. 11

12 Disclosure The disclosure requirements regarding AROs for the 4 years would be as follows: Accounting Policy Note (included in all years) An asset retirement obligation is recognized at the best estimate of the expenditure required to settle the present obligation at the balance sheet date when the liability for an asset retirement obligation is incurred and a reasonable estimate of the obligation is determinable. The best estimate of the asset retirement obligation is the present value of the amount the Company would rationally pay to settle the obligation, or transfer it to a third party, at the balance sheet date. When a liability is recognized, a corresponding asset retirement cost is capitalized to the carrying amount of the related asset. The asset retirement cost is amortized over the estimated useful life of the related asset. The Company recognizes changes to the liability due to the passage of time in operating expenses, as accretion. Changes due to passage of time are calculated by applying an interest method of allocation using the discount rate used in the original calculation of the asset retirement obligation. The Company recognizes changes to the liability arising from revisions to the timing, amount of expected undiscounted cash flows or discount rate as an increase or decrease to the carrying amounts of the asset retirement obligation and the related asset retirement capitalized cost. Asset Retirement Obligation - December 31, 2011 As the Company acquired an offshore oil platform on January 1, 2011, it is legally required to dismantle and remove the platform at the end of its useful life, which is estimated to be 4 years. As of December 31, 2011, the Company has accrued $10,192,807 (20010 $nil) reflecting the liability for the asset retirement obligation. A corresponding amount has been capitalized as an asset retirement cost and added to the carrying value of drilling rigs. Asset Retirement Obligation - December 31, 2012 As the Company acquired an offshore oil platform on January 1, 2011, it is legally required to dismantle and remove the platform at the end of its useful life, which is estimated to be 4 years. As of December 31, 2012, the Company has accrued $12,535,593 (2011 $10,192,807) reflecting the liability for the asset retirement obligation. A corresponding amount has been capitalized as an asset retirement cost and added to the carrying value of drilling rigs. Asset Retirement Obligation - December 31, 2013 As the Company acquired an offshore oil platform on January 1, 2011, it is legally required to dismantle and remove the platform at the end of its useful life, which is estimated to be 4 years. As of December 31, 2013, the Company has accrued $13,414,084 (2012 $12,535,593) reflecting the liability for the asset retirement obligation. A corresponding amount has been capitalized as an asset retirement cost and added to the carrying value of drilling rigs. Asset Retirement Obligation - December 31, 2014 As the Company acquired an offshore oil platform on January 1, 2011, it is legally required to dismantle and remove the platform at the end of its useful life, which is estimated to be 4 years. As of December 31, 2014, the Company has accrued $nil (2013 $13,413,084) reflecting the liability for the asset retirement obligation. A corresponding amount has been capitalized as an asset retirement cost and added to the carrying value of drilling rigs. During the year, the Company paid $14,500,000 (2013 $nil) towards the asset retirement obligation. 12

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