What is Asset Retirement Obligation?
Asset Retirement Obligation is a legal and accounting requirement, in which a company needs to make provisions for the retirement of a tangible long-lived asset in order to bring the asset back to its original condition after the business is done using the asset.
Companies in several industries have to bring an asset back to its original state after the asset is taken out of service. This may involve industries like oil drilling, power plants, mining, and many other industries. It also applies to the properties taken on lease where the properties have to be brought back to their original shape. After the use, the asset may have to detoxicate like in nuclear plants or machinery have to be removed like in oil drills. The expected expenses to be incurred on such restoration are taken care of by Asset Retirement Obligations.
How Does it Work?
The restorations expenses are incurred at the end of the useful life of the asset but a discounted liability is created on the balance sheet along with a corresponding asset right after the construction or initiation of the project or when the fair value of the restoration can be determined. This liability is then increased at a fixed rate gradually to match the expected obligation at the end of the life of the asset.
The recognition and accounting of asset retirement obligations are published by the Financial Accounting Standards Board (FASB) in the United States and by the International Financial Reporting Standards in the rest of the world. These institutions provide detailed guidelines on the treatment of Asset Retirement Obligations.
For the right measurement of the liability, the company must determine the fair value of the liability when it incurs it and if the fair value of the liability cannot be determined, the liability should be recognized at a later date when the fair value becomes available. Prompt recognition of the liability can be very useful for stakeholders as these liabilities are high-value liabilities and their recognition shows a better picture of the liabilities.
Accounting for Asset Retirement Obligation
Accounting for Asset Retirement obligation requires to recognize the present value of the expected retirement expenses to be recognized as a liability and fixed asset. The interest rate used for discounting is the risk-free rate adjusted for the effect of the entity’s credit standing. The liability is then increased every year at the risk-free rate and measured at subsequent periods for the change in expected cost.
The increase in liability is recognized as accretion expense on the income statement and is calculated by multiplying the liability amount by the risk-free rate. Any change in the expected expense is adjusted to the liability balance after every revision. The asset recognized on the balance sheet is depreciated and the expense is recorded on the income statement.
Differences in Accounting Treatment of Asset Retirement Obligations in US GAAP and IFRS
|Initial Measurement of Asset Retirement Obligation (ARO) Liability||The fair value is recognized as a liability as and when it becomes available. The discount rate used is the risk-free rate.||The liability is measured as the best estimate of the expenditure to settle the obligation discounted at the pre-tax rate.|
|Asset recognition from ARO||ARO amount is added to fixed assets at the time of the estimate.||Generally included in property plant and equipment. Recognized in inventory if incurred during a period when the property was used to produce an inventory.|
|Subsequent Measurements||Revision is done from time to time to either the amount or timing of cash flows. Upward and downward revisions are discounted using current and original risk-free rates, respectively.||Checked for change on every balance sheet date. Both the expected cash flow and the rate of discount can be changed and adjusted liability can be shown on the basis of new assumptions.|
Assume a power company builds a power plant at a site with a 50-year lease. The asset takes 3 years to be built and has to be necessarily retired at the end of 47 years after it was built. The cost of dismantling the equipment, detoxification of the site and cleaning of the site is $50,000 in today’s dollars. Because retirement has to be done after 47 years, this cost will definitely be higher at that time. To take that into consideration the retirement cost will increase at the rate of inflation. Assuming an inflation rate of 3%, the cost of retirement at the end of 47 years will be $200,595. Assuming a risk-free rate of 7% the present value of this obligation comes out to be $8.342. See the illustration below for details.
- The obligation will be a real and big expense, it makes sense to provide for the expense as soon as the fair value of the liability can be determined.
- It helps pre-plan the restoration of the property to its original state.
- It shows the fairness and accuracy of the financial statements.
- Asset retirement obligations are based on estimates and are prone to errors of judgment.
- Liability changes frequently.
- The rates used while recognizing the liability may change going forward and may lead to a change in the liability.
- These obligations do not cover work done after other events that affect the assets like natural calamities (earthquakes, floods, etc.)
Asset Retirement Obligations are important from an accounting point of view. Had it not been the regulatory requirement businesses would have used their discretion in disclosing these costs, which could have hurt the stakeholders badly as these costs could cause a severe drain in the cash balances of the company and may adversely impact the business. Accounting for the obligation well in advance gives the business the time to plan and set aside resources for the event.
This has been a guide to what is asset retirement obligation. Here we discuss how does Asset Retirement Obligation works along with an example, benefits and drawbacks. You may learn more about Financing from the following articles –