Decommissioning liability

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Jonny
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Decommissioning liability

Post by Jonny »

Hi
I'm referring to the example 11 of IFRS 13 that states that it is needed to calculate the:

1) risk of non-performance
2) Market risk premium

to estimate the fair value of the Decommissioning liability

How can I calculate the correct risk of non-performance?

How can I calculate the correct Market risk premium in case I want to adjust the rate used to discount the future cash flows to their present values (ie as a reduction in the discount rate)

Thanks

Regards
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

re. risk of non-performance - I would use the credit risk only and ignore other aspects unless you have something specific in mind
re. risk premium - it's explained as the uncertainty in cash flow estimation, so it will depend on the specifics of your case, highly judgmental for sure

what exactly is your decommissioning liability for?
Jonny
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Re: Decommissioning liability

Post by Jonny »

It is for the decommissioning cost also known as asset retirement obligation: is the cost incurred by companies in reversing the modifications made to landscape when a fixed asset is used up.
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

I know what a decommissioning liability is in general :lol: I asked about your specifc case
JRSB
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Re: Decommissioning liability

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:lol:
Jonny
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Re: Decommissioning liability

Post by Jonny »

:D
ok I wasn’t sure about the question. sorry!

I'm referring to decommission costs related to a company that has a plant that produces copper wire.

The estimate of the costs has embedded a contingency (15%). We always used the risk free to calculate the NPV. But, we never considered risk of non-performance. For the auditors is ok. The risk of non-performance is zero as it is a legal obligation. What is your experience?
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Marek Muc
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Re: Decommissioning liability

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are you measuring the provision for initial recognition under IAS 37 or the fair value under IFRS 13 for the purpose of e.g. business combination accounting?

it's true that for the IAS 37 accounting, risk free rate is often used, see this research by IASB:
IAS 37 discounting.PNG
https://cdn.ifrs.org/-/media/project/di ... ummary.pdf
Jonny
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Re: Decommissioning liability

Post by Jonny »

Very interesting! thanks!

We are expiring both cases.

I understand that “non-financial liabilities are generally accounted for under IAS 37. IAS 37 does not require or permit fair value measurement. Non-financial liabilities are measured at fair value under IFRS 13 only when they are assumed in a business combination”. Manual of accounting Pwc

Example 11 IFRS 13 above refers to a business combination. I cannot find an example under IAS 37.

Do I have to use a different discount rate for the same obligation? I do not understand why the amount should be different if I am or not in a business combination.
What happens in a year time when I must estimate again the discount rate? Do I have to keep different approach depending if the asset was acquired or not under a business combination?
Can you help me understand?
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

in general, the amount can be different for a liability acquired in a business combination, because business combination accounting requires fair value measurement (as opposed to other measurement basis e.g. amortised cost for most financial liabilities) - this is how the business combination accounting works, you can read BC paragraphs to IFRS 3 (BC22+) if you want to dig deeper as to why

for subsequent measurement, you use standard approach defined in a specific IFRS (there are certain exceptions), so a subsequent measurement of a decommissioning liability will be the same irrespective of whether it was assumed through a business combination or not

Obviously you can use simplifications in your approach and not remeasure every single item to fair value if you conclude that the amount in acquiree's books is reasonably close to fair value
Jonny
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Re: Decommissioning liability

Post by Jonny »

Thanks!
JRSB
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Re: Decommissioning liability

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Thanks I hadn't appreciated the distinction for provisions - practice being application of WACC in most cases.
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

Interesting, because I would say that WACC is not the right discount rate for a liability. WACC takes into account risks specific to assets, and will be generally higher than a discount rate applied to liabilities
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Re: Decommissioning liability

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Yes agree not right but in practice a lot of smaller reporters will use one company discount rate for everything.
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Marek Muc
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Re: Decommissioning liability

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The simplified approach that I've seen in practice is to used risk free rate for provisions, which makes more sense to me than WACC and is still simple :)
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Re: Decommissioning liability

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What's a standard risk free rate in Poland? We would normally have 0 - 0.25% depending on gilt term . Central bank base rate is 0.1%
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

in Poland short-term rates are close to zero as well, but it only indicates what's the current time value or money :)

besides, decommissioning liability is usually of long- term nature, I see that the yield on 15Y UK gov bonds is still a healthy 0.5% ;)
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Re: Decommissioning liability

Post by JRSB »

Marek Muc wrote: 07 Jan 2021, 11:04 Interesting, because I would say that WACC is not the right discount rate for a liability. WACC takes into account risks specific to assets, and will be generally higher than a discount rate applied to liabilities
What's the 'common in practice' (rather than theory) approach to the discount rate for liabilities, in your experience?
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Marek Muc
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Re: Decommissioning liability

Post by Marek Muc »

In my experience, a risk-free rate is used if the entity looks for a simple solution. E.g. for decommissioning liability you can say that the risk and uncertainty is built into the cash flow part. Whereas in WACC you have expected return on equity built in, so it's harder to reconcile WACC with conceptual basis for measuring a liability

PS. I see that you caught up with latest topics yesterday :) and I'm very happy that you did, January felt a bit lonely, exIFRS seems to be buried with some work too
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