Asset Retirement Obligation Example How Does It Work?

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. Because the circumstances surrounding a business and its major assets will vary widely, the effect of adopting Statement no. 143 also will vary. The interplay of the factors involved—particularly the credit-adjusted, risk-free discount rate, the age of the asset relative to its overall useful life, cash flow estimates and the adequacy of prior provisions for retirement costs—means each situation requires CPAs to do careful analysis. EXECUTIVE SUMMARY TO PROVIDE BUSINESSES WITH GUIDANCE ON WHEN and how to recognize a liability for asset retirement obligations, FASB issued Statement no. 143, Accounting for Asset Retirement Obligations. The statement applies to retirement obligations for tangible long-lived assets.

The weight assigned to this probability should consider all relevant facts and circumstances, such as management’s past success in obtaining similar licenses and the economics of the asset. A change in the expectation of renewal may impact the depreciable life or expected salvage value of the asset.

Adjustments to the Liability

The journal entry that would be recorded by Grant would be a debit to asset retirement obligation for $250,000 , a debit to oil remediation expense for $25,000, and then a credit to cash for the actual cost to remediate or decommission. This reduction is a downward adjustment, and the existing ARO liability and asset must be adjusted to represent the reduction in expected costs. Cat’s Clothing applies the original credit-adjusted risk-free rate applicable at the time of the initial ARO measurement in this calculation, which was 5%. Once an ARO is identified, it is recorded as a liability, measured at the present value of the future total estimated cost, , of removal or clean up as of the date the initial obligation is incurred. For example, if it will cost a tenant an estimated $20,000 to remove tenant improvements made to a building in five years, the ARO is initially measured at the present value of $20,000 over 5 years, using an applicable discount rate.

Any differences between the https://intuit-payroll.org/ retirement liability balance and the actual retirement costs would flow through the income statement as a gain or loss on retirement. An entity must estimate the cash flows required to settle a retirement liability and make those estimates consistent with information and assumptions “marketplace participants” would use. Companies should not allow proprietary information and internal cost structures to influence the cash flow estimates if they differ materially from market conditions. Under Statement no. 143, an entity must recognize an asset retirement obligation at its fair value—the amount at which an informed willing party would agree to assume the obligation.

CFR § 367.22 – Accounting for asset retirement obligations.

It is calculated by dividing the difference between two Consumer Price Indexes by previous CPI and multiplying it by 100. Risk-free RateA risk-free rate is the minimum rate of return expected on investment with zero risks by the investor.

• Methods of providing assurance include surety bonds, insurance policies, letters of credit, guarantees by other entities, and establishment of trust funds or other assets dedicated to satisfying the ARO.
• You normally settle an ARO only when the underlying fixed asset is retired, though it is possible that some portion of an ARO will be settled prior to asset retirement.
• Publicly-traded companies are required by federal laws under the jurisdiction of the Securities and Exchange Commission to disclose certain operating and financial information on an ongoing basis.
• PPE Corp estimates the present value of the legal obligation to be $1,000,000.

A liquid, solvent, relatively unleveraged company—one with a strong credit standing—would have a smaller adjustment than an entity that is less creditworthy. In order to determine the value of the new ARO, calculate the present value of the $10,000 increase over the periods remaining until removal is required. The change occurred at the beginning of the third year so the additional estimate is discounted over the six years remaining using the current 6% credit-adjusted risk-free rate to arrive at its present value. In other words, the increase is added to the ARO balance but maintains a separate amortization table from the original ARO as a result of the new discount rate.

Example: Accounting for an ARO using a real estate lease

A past history of nonenforcement of an unambiguous Asset Retirement Obligation Definition does not defer recognition of a liability, but its measurement is affected by the uncertainty over the requirement to perform retirement activities. If the amount of the original estimate for the cost does not change and neither does the company’s discount rate, the carrying amount of the asset retirement obligation after 7 years will be $2,500,000 due to the annual accreditation expense adjustments. Again, considering the same facts and circumstances noted above, let’s assume at the beginning of year three a change in estimate decreases the expected settlement costs to $75,000. The $8,000 ($83,000 – $75,000) decrease, discounted at the 7% initial credit adjusted risk-free rate, reduces the carrying amount of the ARO liability at the effective date of the change. Agencies should also annually evaluate the values of AROs to determine if there are any factors that would significantly increase or decrease estimated outlays. Relevant factors to consider include price increases/decreases ; technological changes; changes in legal or regulatory requirements; and changes in the type of equipment, facilities, or services that will be used to retire the tangible capital asset.

• On December 31, 20X1, Oil Co determines that the ARO will require $100,000 more than the original estimate of $800,000.
• Spending should not exceed this level without prior approval of the governing body.
• The change will allow governments to analyze and compare costs much more effectively.
• Assuming a risk-free rate of 7%, the present value of this obligation comes out to be $8.342.
• The appropriated budget is still used to set tax levies and some budget statutes still require balanced budgets, but it is more generally used to authorize a specific amount of expenditures regardless of whether estimated resources meet or exceed that amount.
• The asset retirement obligation liability should be adjusted for the passage of time by accreting the balance using the interest method over the period from initial measurement to the expected timing of settlement.
• In other words, the increase is added to the ARO balance but maintains a separate amortization table from the original ARO as a result of the new discount rate.