Once upon a time, oil and gas-producing companies would look at estimated salvage value from production equipment as compared to estimated costs to plug and abandon a property, typically determine that the future costs would be offset from proceeds received, perhaps make a footnote disclosure in their financial statements to that effect and move on. In practice, many companies continue with that time-honored tradition. The Financial Accounting Standards Board (FASB) requires a very different approach for companies presenting their financial statements in accordance with generally accepted accounting principles. While the requirements of Section 410, Asset Retirement and Environmental Obligations, formerly known as FASB Statement 143, are not new, it seems as though many E&P companies continue to use outdated accounting practices.
While the guidance regarding Accounting for Asset Retirement and Environmental Obligations applies to all entities, the oil and gas industry is specifically impacted by the requirement that “Obligations for dismantlement, restoration, and abandonment costs shall be accounted for in accordance with the guidance.” Some key aspects of the requirements are as follows:
• A legal retirement obligation must exist that results from the acquisition, construction or development of a long-lived asset. Retirement refers to a sale, abandonment or disposal of the asset.
• A liability is established, at fair value, for the asset retirement obligation in the period in which it was incurred. This means when the asset was acquired, constructed or developed, not when the asset is retired.
• The asset retirement cost is capitalized at the time the liability is established and charged to expense using a systematic and rational method.
• Salvage value is not considered when establishing the liability but is considered when determining the amortization and depreciation rates.
• The liability is annually adjusted upward to reflect the passage of time and adjusted up or down to reflect changes to the originally estimated timing or amount of undiscounted cash flows.
The overall impact of adopting the requirements of this standard is to gross up assets and liabilities of entities that have the legal obligation to incur asset retirement costs at the time the asset is acquired and to reflect the changes to the carrying value of the asset and liability in operations of the entity until such time as the asset is retired. In a perfect world, the liability will match the required cash outlay for dismantlement, removal and restoration costs when the asset is ultimately retired.
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This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.