What is an Asset Retirement Obligation?

Explanation

Companies in several industries have to bring an asset back to its original state after the asset is taken out of service. It may involve 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 must be removed like in oil drills. The expected expenses to be incurred on such restoration are taken care of by Asset Retirement Obligations.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Asset Retirement Obligation (wallstreetmojo.com)

How Does it Work?

The restoration expenses are incurred at the end of the asset’s useful life. However, a discounted liability is created on the balance sheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more and a corresponding asset right after construction or initiation of the project; or on the determination of the fair value of restoration. This liability is then gradually increased at a fixed rate to match the expected obligation at the end of the asset’s life.

The recognition and accounting of asset retirement obligations are published by the Financial Accounting Standards Board (FASB) in the United States and 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 liability’s fair value when it incurs it. If the fair value of the liability cannot be determined, the liability should be recognized later when the fair value becomes available. Prompt recognition of the liability can benefit stakeholders as these liabilities are high-value liabilities, and their recognition shows a better picture of the liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.read more.

Accounting for Asset Retirement Obligation

Accounting for Asset Retirement obligation requires recognizing the present value of the expected retirement expenses to be recognized as a liability and fixed asset. The liability is then increased every year at the risk-free rate and measured at subsequent periods for the change in expected cost. The interest rate used for discounting is the risk-free rate adjusted for the effect of the entity’s credit standing.

The asset recognized on the balance sheet is depreciated, and the expense is recorded on the income statement. The increase in liability is recognized as an accretion expense on theThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more income statementIncome StatementThe income statement is one of the company’s financial reports that summarizes all of the company’s revenues and expenses over time in order to determine the company’s profit or loss and measure its business activity over time based on user requirements.read more 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.

Differences in Accounting Treatment of Asset Retirement Obligations in US GAAP and IFRS

Example

Assume a power company builds a power plant with a 50-year lease at a site. The asset takes three 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, detoxifying the site, and cleaning the site is $50,000 in today’s dollars. Because retirement has to be done after 47 years, this cost will be higher at that time. Consider that the retirement cost will increase at the rate of inflationRate Of InflationThe rate of inflation formula helps understand how much the price of goods and services in an economy has increased in a year. It is calculated by dividing the difference between two Consumer Price Indexes(CPI) by previous CPI and multiplying it by 100.read more. 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.

Benefits

  • The obligation will be a real and significant expense; it makes sense to provide for the expense as soon as the liability’s fair value 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 statementsFinancial StatementsFinancial statements are written reports prepared by a company’s management to present the company’s financial affairs over a given period (quarter, six monthly or yearly). These statements, which include the Balance Sheet, Income Statement, Cash Flows, and Shareholders Equity Statement, must be prepared in accordance with prescribed and standardized accounting standards to ensure uniformity in reporting at all levels.read more.

Drawbacks

  • 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.)

Conclusion

Asset Retirement Obligations are essential from an accounting point of view. Had it not been the regulatory requirement, businesses would have used their discretion in disclosing these costs. It could have hurt the stakeholders badly as these costs could cause a severe drain on the company’s cash balances 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 article has been a guide to what is an asset retirement obligation. Here we discuss how Asset Retirement Obligation works along with an example, benefits, and drawbacks. You may learn more about Financing from the following articles –

  • Limitations of Financial AccountingAccounting TerminologyAssets RevaluationFully Depreciated Assets