|
|
|
|
CFA Level 1 - SFAS 143 Requirements SFAS 143 REQUIREMENTS
SFAS 143 was developed to account for the future obligation that will arise once an asset is sold. This is best understood through an example. A company buys a plot of land that will be used for the treatment of lumber. Over time, the chemicals used to treat the lumber will contaminate the land. The federal government requires these companies to decontaminate the soil before it can be sold. This soil decontamination costs money and represents a future liability for the company. That is precisely why SFAS 143 was developed.
Requirements of SFAS 143 or Asset Retirement Obligation (ARO) to be recognized:
- Legal requirements to remove an asset or component part must exist before any ARO is recognized for removal costs. However, if there is no legal obligation to remove a component, then no ARO is required.
- A legal obligation may exist to dispose of a component part of an asset: "Any legal obligations that require disposal of the replaced part are within the scope of this Statement".
- All ARO liabilities must meet the liability criteria in FAS Concepts Statement Number 6, "Elements of Financial Statements." Only present (current) obligations meet these criteria.
The Standard identifies examples of potential AROs, including landfill closure and nuclear decommissioning.
Accounting Implications of SFAS 143
At initiation:
- The present value (PV) of the total future cash flow obligation must be added to the balance value of the acquired asset.
- The discount rate used in the PV calculation in the current risk-free rate plus adjustments for the credit risk of the company.
- The present value obligation is also added in the long-term liability section of the company's balance sheet.
After initiation (subsequent years):
- The liability portion is accreted using the rate-based accretion method. This means that each year the liability section increases at the same rate at which it was discounted. This enables the liability section to equal its total future value at the end of the estimated useful life of the asset.
- The annual accreted portion is expensed on the income statement and in most cases is included in the reported interest-expense portion of the income statement.
- Since the value of the asset has increased at initiation, the depreciation will be higher than it otherwise would have been.
- Changes in estimated liability are accounted prospectively, so prior periods are not restated.
- Disclosures required: a description of ARO and asset, reconciliation of liability, show effect of new liabilities incurred and liabilities extinguished.
Likely effects on financial statements and ratios:
- Since depreciation expense is higher, net income will be lower.
- Net interest will most likely be higher since the accreted portion is reported in this consolidated account.
- Cash flow will be unaffected.
- Value of assets will be higher since ARO will be included.
- Long-term liability portion will be higher.
- Stockholders' equity will be lower due to lower net income.
- The debt-to-equity ratio will be higher because long-term liability increases, and stockholders' equity will be lower.
- Asset turnover will be lower (higher asset value).
- Solvency ratios will be negatively affected (times interest earned, lower EBIT).
|
|
|
