Accounting for Asset Retirement Obligations
Asset retirement obligations are tested on the FAR section of the CPA exam. Candidates can expect to see multiple choice questions and/or a simulation on the topic.
Asset retirement obligations (ARO) are a legal obligation associated with the retirement of a tangible long-lived asset in which the timing or method of settlement may be conditional on a future event, the occurrence of which may not be within the control of the entity burdened by the obligation. Common examples of ARO’s include:
Criteria to recognize ARO liability:
Under U.S. GAAP, a company is required to recognize an ARO liability on the balance sheet if the company has a duty or responsibility upon retirement of the asset. In other words, if the company is using an asset and it is damaging the land/property, then the company will incur some level of cost to return the land back to its previous condition.
For example, if you borrowed a friend’s car, and you damaged the car, you would fix the car before you returned it to your friend. Unless you aren’t a loyal friend, you have the duty or responsibility to return the car to its original condition when you are finished using the car and give it back to your friend.
Mental Map for ARO (4 steps):
The mental map will help you remember the four key steps to solving questions related to asset retirement obligations. The four steps touch on the initial measurement, recording accretion expense, depreciation expense, and the entry for when the liability is removed or decommissioned:
Applying the 4 steps of ARO:
Let’s go through the example below to learn how to apply the 4 steps of the ARO mental map that are listed above:
Step 1) Record Initial Liability at Present Value
The company will record an initial liability for the expected retirement costs of the tangible long-lived asset (i.e., fixed asset). In other words, the company will estimate how much it will cost in the future to remove the fixed asset and return the site back to its previous condition. The company will capitalize this liability at the present value of the future expected cost.
The company will use the credit-adjusted risk-free rate to measure the initial liability. This rate factors in the credit rating of the company. This rate will often be given, so look for it in a question or simulation. The same rate will be used to record accretion expense (step #2).
Based on the ARO example, the company estimates the remediation cost will be $250,000, however, that is the future cost (undiscounted). The liability is recorded at the present value, so we would take $250,000 x 0.68058, which equals $170,146 (rounded). The company would debit asset retirement cost, which is a type of fixed asset account, for $170,146. The credit will be to asset retirement obligation for $170,146, which record the liability on the balance sheet.
Step 2) Record accretion expense and increase ARO liability
The company will record accretion expense on an annual basis over the life of the asset. We record accretion expense to increase the liability on the balance sheet to the estimate cost to remediate when the useful life is up. For this example, the estimated cost at the end of Year 5 is $250,000, but the liability was initially recorded for $170,146. So, this step focuses on how the company will increase the liability from $170,146 to $250,000 by Year 5.
All we need to do is multiply the carrying amount of the ARO liability at the end of each period by the accretion rate. For Grant, the credit-adjusted risk-free rate, which is also the accretion rate, is 8%. To calculate the annual accretion expense, you would multiply the beginning ARO balance by 8%. The accretion expense is then added to the beginning balance to get the ending ARO balance for the period.
If you take a look at the example journal entry for Year 1, the debit is to accretion expense and the credit is to asset retirement obligation. The credit will increase the ARO liability each year until it reaches $250,000 at the end of Year 5. This is your final check to make sure your accretion expense schedule is correct!
Step 3) Record depreciation expense and accumulated ARC.
The company must also record depreciation expense and build up the accumulated asset retirement cost account, which is a contra-asset. The accumulated asset retirement cost account is similar to any other fixed asset that has accumulated depreciation. By the end of the useful life, the accumulated asset retirement cost would equal the initial asset retirement cost that was recorded (i.e., full depreciated).
In our example for Grant, the initial asset retirement cost was recorded at $170,146. The useful life was 5 years and depreciation expense is calculated using the straight-line method. Therefore, annual depreciation expense would be $170,146 divided by 5 years, which equals $34,029.
The journal entry that would be recorded each year would be a debit to depreciation expense for $34,029 and a credit to accumulated depreciation for $34,029. At the end of the useful life, which occurs at the end of Year 5, total accumulated depreciation should equal the asset retirement cost, which was $170,146 in the initial entry (step #1). This your final check to make sure that your depreciation schedule is correct!
Step 4) Record entry when asset is retired or decommissioned
At the end of the useful life, the company must retire or decommission the asset, which is when the cash outflow occurs. The actual cash cost should come close to the initial cost, but it is rarely exactly the same. The company will either spend more or less than the initial cost estimate.
In our example, Grant estimated it would cost $250,000 to plug the oil well before abandoning the facility. The example states the actual cost was $275,000, which is $25,000 more than the initial estimate. When this occurs, the company records additional expense.
The journal entry that would be recorded by Grant would be a debit to asset retirement obligation for $250,000 (removes the ARO liability), a debit to oil remediation expense (or similar expense account) for $25,000, and then a credit to cash (or accounts payable) for the actual cost to remediate or decommission.
Multiple outcomes of expected cost:
What happens if the company cannot reasonable estimate the future expected cost of an asset retirement obligation? When that is the case, the company develops different estimates and applies a percentage probability of the event occurring. The example below illustrates two different cost estimates with a probability of 50% occurring:
Changes in Estimates:
If the company increases or decreases the original cost estimate, then the company would also need to adjust the asset retirement obligation liability on the balance sheet.
- Recognize upward liability revisions – The company would add the discounted effect of any costs that was underestimated when the liability was initially recorded.
- Recognize downward liability revisions – The company would remove the discounted effect of any costs that was overestimated when the liability was initially recorded.
Disclosure of ARO:
According to U.S. GAAP, the company needs to disclose the following:
- A general description of the asset retirement obligations and the associated long-lived assets
- The fair value of assets that are legally restricted for purposes of settling asset retirement obligation
- A reconciliation of the beginning and ending aggregate carrying amount of asset retirement obligations showing separately the changes attributable to the following components, whenever there is a significant change in any of these components during the reporting period:
- Liabilities incurred in the current period
- Liabilities settled in the current period
- Accretion expense
- Revisions in estimated cash flows
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