Asset retirement obligation involves the retirement of a tangible, long-lived asset that depends on a future event beyond the control of an obligated party. It is an accounting rule and legal obligation meant to account for the cost of returning a piece of property to its original condition. Asset retirement obligation (ARO) is an essential part of producing fair and accurate financial statements so those viewing them can have a better idea of a company's obligations, and therefore, its overall value.
Breaking Down Asset Retirement Obligation
Asset retirement obligation accounting is essential to renewal, remediation and restoration work performed on the property, such as cleaning up a brown field, removing hazardous infrastructure, or expensive dismantling of infrastructure improvements. It does not apply to work done for and costs associated with disaster or accident cleanup. An asset is considered retired when it is permanently taken out of service, such as through sale or disposal. Retirement obligations can be recognized either when the asset is placed in service or during its operating life at the point when its removal obligation is incurred.
ARO rules are established by the Financial Accounting Standards Board (FASB) and are outlined in Rule No. 143: Accounting for Asset Retirement Obligations. That rule requires public companies to recognize the fair value of retirement obligations for tangible, long-lived assets to make their balance sheets more accurate. This focus on the balance sheet represents a change from the income-statement approach many businesses previously used. Accounting for asset retirement obligations is a complex process that requires the assistance of a Certified Public Accountant (CPA).
Asset Retirement Obligation: Calculating Expected Present Value
- Estimate the timing and cash flows of retirement activities.
- Calculate the credit-adjusted risk-free rate.
- Note any increase in the carrying amount of the ARO liability as an accretion expense by multiplying the beginning liability by the credit-adjusted risk-free rate for when the liability was first measured.
- Note whether liability revisions are trending upward, then discount them at the current credit-adjusted risk-free rate.
- Note whether liability revisions are trending downward, then discount the reduction at the rate used for the initial recognition of the related liability year.
Asset Retirement Obligation Example
Consider the case of an oil-drilling site with a 40-year lease. After five years of holding the lease, a drilling platform is erected, and a well is created. The platform and well has an estimated useful life of 40 years. The current cost to remove the platform and well and clean up the site is $15,000. An estimate for inflation for that removal and remediation work over the next 40 years is 2.5% per year. Therefore the credit-adjusted risk-free borrowing rate is 8%.
Since the life of the drilling platform and well cannot extend past the life of the lease, you must assume retirement of the rig and well after 35 years. The assumed future cost (after inflation) of removing and cleaning up the rig and well in 35 years is 15,000 * (1 + 0.025) ^ 35 = 35,598.08. The present value of that is 35,598.08 / (1 + 0.08) ^ 35 = 2,407.66. This is the initial assumed retirement obligation.