on 1 january 20×1 entity a assumes a decommissioning liability in a business combina 612326

Decommissioning Liability [IFRS 13.IE35-39]

On 1 January 20X1 Entity A assumes a decommissioning liability in a business combination. The entity is legally required to dismantle and remove an offshore oil platform at the end of its useful life, which is estimated to be 10 years. Entity A uses the expected present value technique to measure the fair value of the decommissioning liability.

If Entity A were contractually allowed to transfer its decommissioning liability to a market participant, Entity A would conclude that a market participant would use all the following inputs, probability-weighted as appropriate, when estimating the price it would expect to receive:

(a) labour costs;

(b) allocation of overhead costs;

(c) the compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset. Such compensation includes both of the following:

(i) profit on labour and overhead costs; and

(ii) the risk that the actual cash outflows might differ from those expected, excluding inflation;

(d) effect of inflation on estimated costs and profits;

(e) time value of money, represented by the risk-free rate; and

(f) non-performance risk relating to the risk that Entity A will not fulfil the obligation, including Entity A”s own credit risk.

The significant assumptions used by Entity A to measure fair value are as follows:

(a) Labour costs are developed on the basis of current marketplace wages, adjusted for expectations of future wage increases and a requirement to hire contractors to dismantle and remove offshore oil platforms. Entity A assigns probability assessments to a range of cash flow estimates as follows:

Cash flow estimate CU	Probability assessment	Expected cash flows CU
100,000	25%	25,000
125,000	50%	62,500
175,000	25%	43,750
		131,250

The probability assessments are developed on the basis of Entity A”s experience with fulfilling obligations of this type and its knowledge of the market.

(b) Entity A estimates allocated overhead and equipment operating costs using the rate it applies to labour costs (80% of expected labour costs). This is consistent with the cost structure of market participants.

(c) Entity A estimates the compensation that a market participant would require for undertaking the activity and for assuming the risk associated with the obligation to dismantle and remove the asset as follows:

(i) A third-party contractor typically adds a mark-up on labour and allocated internal costs to provide a profit margin on the job. The profit margin used (20%) represents Entity A”s understanding of the operating profit that contractors in the industry generally earn to dismantle and remove offshore oil platforms. Entity A concludes that this rate is consistent with the rate that a market participant would require as compensation for undertaking the activity.

(ii) A contractor would typically require compensation for the risk that the actual cash outflows might differ from those expected because of the uncertainty inherent in locking in today”s price for a project that will not occur for 10 years. Entity A estimates the amount of that premium to be 5% of the expected cash flows, including the effect of inflation.

(d) Entity A assumes a rate of inflation of 4% over the 10-year period on the basis of available market data.

(e) The risk-free rate of interest for a 10-year maturity on 1 January 20X1 is 5%. Entity A adjusts that rate by 3.5% to reflect its risk of non-performance (i.e. the risk that it will not fulfil the obligation), including its credit risk. Therefore, the discount rate used to compute the present value of the cash flows is 8.5%.

Entity A concludes that its assumptions would be used by market participants. In addition, Entity A does not adjust its fair value measurement for the existence of a restriction preventing it from transferring the liability even if such a restriction exists. As illustrated in the following table, Entity A measures the fair value of its decommissioning liability as CU194,879.

		Expected cash flows CU
Expected labour costs		131,250
Allocated overhead and equipment costs (0.80 x CU131,250)	105,000
Contractor”s profit mark-up[0.20 x (CU131,250 + CU105,000)1	47,250
Expected cash flows before inflation adjustment		283,500
Inflation factor (4% for 10 years)		1.4802
Expected cash flows adjusted for inflation		419,637
Market risk premium (0.05 x CU419,637)		20,982
Expected cash flows adjusted for market risk		440,619
Expected present value using discount rate of 8.5% for 10 years		194,879