Diagnosed for importance decommissioning liability IFRS – IAS 36 – Impact of a decommissioning liability in determining the recoverable amount of a Cash generating unit.
At a glance
Most liabilities are ignored when calculating recoverable amounts in impairment testing. However certain liabilities, such as decommissioning and restoration liabilities, cannot be separated from the related assets. This presents challenges when applying both the ‘fair value less costs of disposal’ approach and the ‘value in use’ approach. The IFRS Interpretations Committee (IC) considered how to apply the current guidance to a value in use calculation. The IC declined to take the issue on to the agenda as the guidance on value in use is clear, therefore neither an Interpretation nor an amendment to IAS 36 was necessary.
The scope of the IC agenda decision is limited to value in use calculations and particularly to the guidance in IAS 36 Impairment of Assets, paragraph 78. The standard requires the carrying amount of a recognised liability to be deducted from both the carrying amount of a CGU and the amount determined under value in use without the cash outflows associated with the liability. The IC observed this approach makes the comparison of the carrying amount and the recoverable amount meaningful.
The agenda decision does not address how to incorporate the decommissioning obligation in a fair value less costs of disposal approach. We look at the challenges that arise in practice under value in use and fair value less costs of disposal below. Diagnosed for importance decommissioning liability IFRS
How does it work in practice in value in use?
The recoverable amount of the asset is determined under the value in use cash flow model approach described in IAS 36 Impairment of Assets in paragraphs 30 through 57. The value in use cash flow model excludes the cash outflows for decommissioning provision. The recorded amount of the provision is deducted from the amount determined in the value in use model to produce a net recoverable amount. The net recoverable amount is then compared to the carrying amount of the cash generating unit including the decommissioning provision under IAS 37.
It is not appropriate to include the cash outflows for the decommissioning obligation in the value in use cash flow model. The model uses a discount rate that is specific to the assets being tested, reflects the time value of money and the return investors would require to invest in the asset. The performance of the asset will have a number of uncertainties associated with it; demand, price and operational risk, among others. Diagnosed for importance decommissioning liability IFRS
The cash outflows associated with the decommissioning obligation have different uncertainties associated with them, but these are more around amount and timing rather than occurrence or performance risk. Future sales might be uncertain but the need to restore at the end of the asset’s life is not. The effect of discounting these cash outflows using the asset rate rather than the risk free rate required by IAS 37 is likely to materially decrease the amount of the liability; this effect is known as the ‘discount rate cushion’.
How does it work in practice in fair value less costs of disposal?
The impairment standard has little specific guidance on determining fair value less costs of disposal generally and none on using how to use fair value less costs of disposal as the recoverable amount for a cash generating unit with a non-separable liability. Fair value is almost always developed using a cash flow model to produce an enterprise value unless there is a binding offer in place to sell the relevant asset or business. Diagnosed for importance decommissioning liability IFRS
Fair value is defined in IAS 36 as the price that would be paid to sell an asset or assume a liability. The challenge arises both from the different approaches that might be taken to measure assets and liabilities at fair value as well as the practical approach often used by valuers. Diagnosed for importance decommissioning liability IFRS
Valuation practice is to produce a single cash flow model that produces a fair value for the business (cash generating unit) that includes the cash outflows for the liability. This approach is consistent with how a market participant would think about determining the fair value of the business. The core asset may have a very long life and decommissioning or restoration is many years in the future. Cash outflows for an obligation that will commence in twenty years in the future would seldom be specifically modelled, even by a party looking to buy the assets, but would be incorporated in a terminal value in the cash flow model. Diagnosed for importance decommissioning liability IFRS
However, if the mine or power plant is coming to the end of its life and the cash flows are imminent (say expected to begin within the next five years or the period covered by the specific projections) then a market participant may take a different approach to consider at what price it is willing to transact for the assets and the non-separable liabilities. Diagnosed for importance decommissioning liability IFRS
An alternative approach would be to calculate the fair value of the asset excluding the cash outflows to satisfy the liability and discount those using a market participant discount rate. Separately, the liability would be calculated using market participant assumptions, rather than an IAS 37 approach.
IFRS 13 requires fair value measurement of the liability to reflect the amount the entity would need to pay a third party to assume the obligation; this would include a profit margin to the third party, plus a margin for estimation risk (that it might be underestimated) and similar market participant type assumptions. This is likely to produce a higher value for the liability than under IAS 37. The amount determined for the liability would then be deducted from the amount determined for the asset to produce a ‘net’ fair value. Diagnosed for importance decommissioning liability IFRS Diagnosed for importance decommissioning liability IFRS
The recoverable amount determined under fair value less costs of disposal under either of the valuation approaches described is then compared to the carrying amount of the CGU including the decommissioning obligation measured under IAS 37. Diagnosed for importance decommissioning liability IFRS
See also: The IFRS Foundation
Diagnosed for importance decommissioning liability IFRS