Provision for environmental costs

When a company sets up a long-term asset such as an oil rig, a power plant or a large processing plant, its running usually damages the environment in one way or the other. For instance, deforestation, emission of carbon dioxide and other toxic gases, release of waste materials etc. effect the environment adversely. If there is a legal or constructive obligation on the company to restrict the environmental damages or restore it to its original condition to some extent, for example, by re-plantation of trees or by recycling waste materials etc., the company would have to incur significant costs.

Environmental experts are required to make an estimate of the costs. 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, and most of the cleaning and environment restoration costs will be incurred at the end of the asset’s useful life, therefore discounting becomes significant.

Present value of estimated environmental costs is included in the cost of the asset with the corresponding effect recognized as a provision for environmental costs. If the environmental damage was not expected at the start and later it was recognized, then the present value of estimated environmental costs is recorded in the income statement with the corresponding effect recognized as a provision for environmental 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 environment costs becomes equal to the actual cost required for cleaning and restoration of the environment.

Let’s take a look at the following example.

Example – Environmental provision

A company has set up a large coal mine in Country X. There is no legislation regarding protection of the environment. However, the company has a reputation of environment friendly policies, and therefore, it has announced that at the end of the expected useful life of 15 years, the coal mine will be abandoned and the company will do significant replantation to restore the environment. Expected cost of replantation and cleaning is estimated to be $600,000. Considering the inflation and uncertainty of cashflows, the appropriate rate to be used for discounting is determined to be 5%.

Present value of environmental costs will be calculated as follows:

PV of environmental costs = $600,000 / (1.05)^15 = $288,610

Following journal entry is made to record the provision for environmental costs:

Dr. — Property, plant and equipment — $288,610
Cr. — Provision for environmental costs — $288,610

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 environmental costs

Following is the calculation of finance cost (unwinding of interest):