Asset Retirement Obligation
An asset retirement obligation (ARO) is a liability associated with the eventual retirement of a fixed asset. The liability is commonly a legal requirement to return a site to its previous condition. A business should recognize the fair value of an ARO when it incurs the liability and if it can make a reasonable estimate of the fair value of the ARO. If a fair value is not initially obtainable, recognize the ARO at a later date, when the fair value becomes available. If a company acquires a fixed asset to which an ARO is attached, recognize a liability for the ARO as of the fixed asset acquisition date. Recognizing this liability as soon as possible gives the readers of a company's financial statements a better grasp of the true state of its obligations, especially since ARO liabilities can be quite large.
Initial Accounting for an Asset Retirement Obligation
In most cases, the only way to determine the fair value of an ARO is to use an expected present value technique, where the probabilities of several possible outcomes are used. When constructing an expected present value of future cash flows, incorporate the following points into the calculation:
- Discount rate. Use a credit-adjusted risk-free rate to discount cash flows to their present value. Thus, the credit standing of a business may impact the discount rate used.
- Probability distribution. When calculating the expected present value of an ARO, and there are only two possible outcomes, assign a 50 percent probability to each one until you have additional information that alters the initial probability distribution. Otherwise, spread the probability across the full set of possible scenarios.
Follow these steps in calculating the expected present value of an ARO:
- Estimate the timing and amount of the cash flows associated with the retirement activities.
- Determine the credit-adjusted risk-free rate.
- Recognize any period-to-period increase in the carrying amount of the ARO liability as accretion expense. To do so, multiply the beginning liability by the credit-adjusted risk-free rate derived when the liability was first measured.
- Recognize upward liability revisions as a new liability layer, and discount them at the current credit-adjusted risk-free rate.
- Recognize downward liability revisions by reducing the appropriate liability layer, and discount the reduction at the rate used for the initial recognition of the related liability layer.
When you initially recognize an ARO liability, also capitalize the related asset retirement cost by adding it to the carrying amount of the related fixed asset.
Subsequent Measurement of an Asset Retirement Obligation
It is possible that an ARO liability may change over time. If the liability increases, consider the incremental increase in each period to be an additional layer of liability, in addition to any previous liability layers. The following points will assist in your recognition of these additional layers:
- Initially recognize each layer at its fair value.
- Systematically allocate the ARO liability to expense over the useful life of the underlying asset.
- Measure changes in the liability due to the passage of time, using the credit-adjusted risk-free rate when each layer of liability was first recognized. You should recognize this cost as an increase in the liability. When charged to expense, this is classified as accretion expense (which is not the same as interest expense).
- As the time period shortens before an ARO is realized, your assessment of the timing, amount, and probabilities associated with cash flows will improve. You will likely need to alter the ARO liability based on these changes in estimate. If you make an upward revision in the ARO liability, then discount it using the current credit-adjusted risk-free rate. If you make a downward revision in the ARO liability, then discount it using the original credit-adjusted risk-free rate when the liability layer was first recognized. If you cannot identify the liability layer to which the downward adjustment relates, then use a weighted-average credit-adjusted risk-free rate to discount it.
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. If it becomes apparent that no expenses will be required as part of the retirement of an asset, then reverse any remaining unamortized ARO to zero.