Define Asset Retirement Obligation

  

Asset Retirement Obligation

An asset retirement obligation (ARO) is a legal responsibility linked with the retirement of a physical, long-lived asset, in which a corporation is liable for removing equipment or cleaning up dangerous waste at a later period. AROs should be included in a company's financial statement to provide a more accurate and comprehensive picture of the company's total worth.

TAKEAWAYS FROM IKEY

• Asset retirement obligations (ARO) are legal requirements linked with the retirement of physical, long-lived assets, such as the removal of equipment or the cleanup of hazardous waste from a leased property.

• To effectively depict their total values, companies must include their AROs on their financial statements.

• The Financial Accounting Standards Board (FASB) governs ARO regulations, which are defined in Rule No. 143: Accounting for Asset Retirement.

Asset Retirement Obligations: What You Need to Know

Companies that build physical infrastructure that must be destroyed before a land lease ends, such as underground fuel storage tanks at petrol stations, are sometimes subject to asset retirement obligation accounting. AROs also apply to the removal of dangerous elements and/or waste items from the environment, such as the decontamination of nuclear power plants. Once the clean-up/removal effort is completed and the property is returned to its former condition, the asset is deemed retired.

An Asset Retirement Obligation Example

Consider an oil corporation that signs a 40-year lease on a piece of property. The business completes the construction of a drilling rig five years into the lease. When the lease expires in 35 years, this object must be removed, and the land must be cleaned up. Although the present cost is $15,000, inflation for the removal and cleanup work is expected to be 2.5 percent each year over the following 35 years. As a result, the estimated future cost after inflation for this ARO would be computed as follows: 15,000 * (1 + 0.025) 35 = 35,598.08.

Oversight of Asset Retirement Obligations

Because calculating asset retirement responsibilities can be difficult, organisations should obtain advice from a Certified Public Accountant to guarantee compliance with FASB Rule No. 143: Accounting for Asset Retirement Obligations. In order to make their balance sheets more accurate, public firms must identify the fair value of their AROs under this regulation. This is a shift from the income-statement technique that many companies previously adopted.

1  Calculating the Expected Present Value of an Asset Retirement Obligation

2  Companies should follow the iterative procedures below to calculate the estimated present value of an ARO:

3  Calculate the start and end dates of retirement activities, as well as the cash flows.

4  Calculate the risk-free rate after adjusting for credit.

5   Multiply the initial liability by the credit-adjusted risk-free rate for when the liability was originally measured to calculate any increase in the carrying amount of the ARO liability as an accretion expenditure.

6  If liability revisions are on the rise, discount them using the current credit-adjusted risk-free rate.

7   If liability revisions are heading lower, discount the decrease at the rate used for the corresponding liability year's original recognition.

IMPORTANT : Unanticipated cleaning expenditures originating from unplanned incidents, such as chemical spills and other mishaps, are not covered under Asset Retirement Obligations.