Accounting for Asset Retirement Obligations
By Eugene G. Chewning Jr. and Anita McKie
Recently, FASB issued SFAS 143, Accounting for Asset Retirement Obligations,
effective for years beginning after December 15, 2002. This project was placed
on the agenda in mid-1994 and, as originally conceived, concerned the accounting
for electric utilities nuclear decommissioning costs. After deliberating
the issue, FASB extended its conclusions to other industries with similar
liabilities arising from the development and early operations of some long-lived
assets. Their deliberations resulted in the issuance of a 1996 exposure draft,
Accounting for Certain Liabilities Related to Closure or Removal of Long-Lived
Assets. After a comment period and further deliberations, the board issued
a revised exposure draft, Accounting for Obligations Associated with the
Retirement of Long-Lived Assets, in 2000. The revised exposure draft further
extended the scope of the project to include obligations arising at any time
during the life of the asset.
The scope of SFAS 143 includes legal obligations resulting from the acquisition, construction, or development and (or) the normal operation of a long-lived asset (para. 2). Legal obligations result from law, statute, ordinance, or contract, or arise from promissory estoppel. A contractual obligation normally requires an exchange of consideration. For obligations arising from promissory estoppel, a party cannot use the absence of consideration as a defense; that is, a valid contract may exist without the exchange of consideration if one party relied on a promise made by another and was harmed because of that reliance. Thus, SFAS 143 applies to legal and other obligations for which the entity has little or no ability to avoid future costs in performing retirement activities.
Examples of obligations covered by SFAS 143 include obligations arising from
Because the new standard requires that retirement obligations be recognized as they occur, many companies may report asset retirement obligations that consist of layers of liabilities. For example, the retirement obligation of a landfill operator would increase incrementally as new portions of the landfill site are opened, with each new layer measured at fair value.
On the other hand, retirement obligations are not to be confused with obligations that arise from the improper operation of a long-lived asset: for example, a liability that may result from an environmental discharge or an industrial accident.
The retirement liability arises from the obligation to remove or mitigate the impact of the potentially adverse effects of the operation of certain long-lived assets or the very asset itself. In the waste management industry, these costs include the final capping of the site, site inspections, groundwater monitoring, methane gas control, and maintenance costs. In the investor-owned utility industry, they include the actual removal and disposal of the activated (hot) equipment and facilities of nuclear reactors. The removal process includes engineering schedules, actual dismantlement of facilities, and concurrent and future security. The mining industry faces costs not only of reclamation of the actual mining site but also of removal of roads, preparation plants, and other facilities. Future expenditures for these obligations may be extensive. For example, in the investor-owned utility industry, the average cost per utility to close nuclear facilitiesthe nuclear decommissioning costswas estimated to be about $615 million in 1995, with some costs reaching over $4 billion.
Current Accounting Practices
Current disclosures regarding these costs lack uniformity. An inspection of sample disclosures, however, suggests that most entities accrue such costs ratably over the life of the asset as a component of depreciation or depletion. For example, many oil companies include in unit of production depletion rates an allowance for estimated future abandonment and removal costs associated with offshore production platforms. Similarly, most investor-owned utilities recognize nuclear decommissioning costs in depreciation rates. This practice treats closure costs as a negative element of salvage value that requires the recognition of additional costs of depreciation or depletion.
FASB has decided that many other obligations in other industries, such as closure, removal, site reclamation, or remediation related to long-lived assets, create situations sufficiently similar to nuclear decommissioning that they should be accounted for in the same way.
Because nuclear decommissioning costs (NDC) have been considered a removal cost, most utilities have recognized NDC as a component of net salvage value when determining depreciation expense. Total expected decommissioning and other salvage costs are subtracted from the total expected salvage recovery yielding a result that is usually negative. This negative net salvage value indicates that additional costs will be incurred at the time the nuclear facility is decommissioned. The general practice has been to accrue the negative salvage value over the life of the facility as part of depreciation expense and to accrue the corresponding liability as a reduction in assets through accumulated depreciation. In essence, this means that the amount of NDC recognized annually is reflected as depreciation expense with a corresponding credit to accumulated depreciation rather than as a liability account. Most public utilities that operate nuclear facilities have followed this practice, which recognizes total estimated NDC neither as a liability nor as accumulated depreciation.
As rates that include a provision for decommissioning are collected, monies have been held internally or deposited in external trust funds. These fund balances have been, for the most part, reported as assets on the balance sheet.
Assume that Investor-Owned Utility Inc. (IOU) has the balance sheet seen in Exhibit 1 before accounting for decommissioning costs.
Based on a site-specific study, IOU expects decommissioning to cost $1,000 million in current dollars. The decommissioning costs collected in rates this year are $50 million. IOU expects the nuclear plant to have no salvage value at the end of its useful life.
Given the historical practice of most utilities, the NDC of $1,000 million is subtracted from salvage value. Because actual salvage value in this example is expected to be zero, a negative salvage value of $1,000 million is used for the purposes of computing depreciation. In other words, depreciation is based on the $15,000 million cost of the nuclear plant plus NDC, or $16,000 million. Thus, if this practice continued to the end of the facilitys useful life, the net plant asset account would actually carry a credit balance of $1,000 million.
To continue the example, assume that NDC is recognized over a remaining useful life of 20 years and the decommissioning funds collected in rates are placed in trust. The accounting in the current period would include the following entries:
Depreciation Exp. $50,000,000
Acc. Depreciation $50,000,000
To record that portion of total NDC recognized in the current periods depreciation adjustment
NDC Trust Fund $50,000,000
To record a transfer of $50 million to the NDC Trust Fund
After accounting for decommissioning costs, the balance sheet would look like Exhibit 2.
Note that in this example, amounts collected for decommissioning are included as an asset, but the related liability for decommissioning is not shown separately on the balance sheet because it is partially included in the accumulated depreciation total.
SFAS 143 requires immediate recognition of a liability for such costs, measured at fair value (the amount at which the liability could be settled currently). On the asset side, the estimated cost of retirement must be capitalized to the related asset account at the time the liability is recognized, and future depreciation amounts must be revised accordingly. This means that for utilities with nuclear facilities, for example, plant costs increase by the amount of estimated NDC. This may or may not result in an increase in depreciation expense, as NDC is currently included in depreciation rates but not capitalized. Differences between previously recorded expenses and expenses that would have been recorded had SFAS 143 been followed in prior years require a cumulative-effect adjustment. External trust funds established to defray retirement costs of long-lived assets cannot be offset against the liability.
SFAS 143 requires a discussion of the nature of these costs, the fair value of the assets set aside to settle the liability, and a reconciliation of the beginning and ending balance of the asset retirement liability. The reconciliation must include disclosure of additional retirement liabilities arising in the current period, settlements of retirement liabilities, accretion, and the effects of changes in cash flow estimates.
Under SFAS 143, IOUs balance sheet would look like Exhibit 3. (Note that the balances are based on the simplifying assumption that the net effect of all adjustments is zero and that the decommissioning cost estimate of $1,000 million approximates the amount that would be obtained through the required measurement method.) The plant account now carries a balance of $16,000 million and reflects the requirement to capitalize the cost of decommissioning. An NDC liability accrual of $1,000 million also appears.
Changes in Financial Reporting
Under SFAS 143, requirements for reporting of assets and liabilities are sharply defined. FASB focuses on liability recognition and explicitly disconnects the method of allocating retirement costs to expense from liability recognition. Historically, many utilities have recognized a decommissioning liability ratably over the life of a nuclear facility as a component of periodic depreciation expense. Others have not provided for costs on an accrual basis or have discounted the obligation. Oil companies have typically accrued the costs of abandonment and removal of offshore oilrigs by including these costs in depletion rates. Waste management companies have accrued estimates of closure and postclosure costs of landfills based on their consumption of airspace. SFAS 143 ends this practice of recognition through charges to depreciation or depletion and accrual via accumulated depreciation or accumulated depletion by requiring immediate recognition of the liability at fair value. The requirement to measure the liability at fair value does not preclude estimates obtained through present value techniques as described in FASB Concepts Statement 7. The amount charged to income includes depreciation on the capitalized cost and the change in the present value of the liability (accretion). The difference between the costs recognized as expenses to date and the costs that would have been recognized had this standard been in effect in prior periods must be reported as a cumulative-effect adjustment as required by APB Opinion 20, Accounting Changes.
Obligations for retirement of long-lived assets can be substantial. FASBs proposed immediate recognition of the liability for these costs will have a material impact on the financial statements of many companies. The reasonableness of cost estimates, as well as the adequacy of disclosures related to closure and removal costs, should be carefully evaluated. In addition, the potential impact of SFAS 143 on bond covenants and other debt-related contracts could pose technical default problems for some businesses.
Robert H. Colson, PhD, CPA
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