When a company sets up a long-term asset such as an oil rig or a processing plant, it assumes an obligation that it will dismantle and restore the sight after the useful life of the asset. In most of the cases, it is a legal obligation of the company. However, where there is no environmental law governing site restoration, companies often assume this liability as a goodwill gesture to the community. In such cases, the obligation to dismantle and restore the site becomes a constructive obligation.
At the time of initial recognition of the long-term asset, an estimate of the dismantling cost is made. As an oil rig, power plant or any other similar long-term asset is constructed to be used for many years, like 20-30 years, so the dismantling cost which will be incurred at the end of the asset’s useful life needs to be discounted.
Present value of estimated dismantling costs is included in the cost of the asset with the corresponding effect recognized as a provision for dismantling costs. In subsequent periods, unwinding of discount will increase the provision so that at the end of the useful life of the asset, provision for dismantling becomes equal to the actual cost required for dismantling.
Let’s assume that dismantling cost is estimated to be $500,000 which will be incurred after 10 years. Considering the inflation and uncertainty of cashflows, the appropriate rate to be used for discounting is determined to be 6%.
Present value of dismantling costs will be calculated as follows:
PV of dismantling costs = $500,000 / (1.06)^10 = $279,200
Following journal entry is made to record the provision for dismantling costs:
Dr. — Property, plant and equipment — $279,200
Cr. — Provision for dismantling costs — $279,200
Subsequently, unwinding of discount is added in the provision every year using the following journal entry:
Dr. — Unwinding of discount (finance cost in income statement)
Cr. — Provision for dismantling cost