An asset retirement obligation (ARO) is a legal obligation that is associated with the retirement of a tangible, long-term asset. It is generally applicable when a company is responsible for removing equipment or cleaning up hazardous materials at some agreed-upon future date.
An asset retirement obligation (ARO) is an obligation to retire an asset or changes to assets according to contractual stipulations, for example, a leasing contract that gives the temporary right to use and change the leased object and requires that any changes are retired at the end of the lease.
Under US GAAP, if a company enters into a lease for a building, constructs leasehold improvements, and determines based on the provisions of the lease that it is legally obligated to remove the leasehold improvements at the end of the lease, then the company has ARO.
Typical examples of an ARO are when a store builds out the leased space to their specific layout or a business paints and updates a space for their branding. If the lease agreement requires the lessee to remove shelving or repaint to a neutral color, the lessee has an ARO and should record the obligation to return to space to its original condition at the time the changes are made.
Similarly, when a company leases land and installs underground tanks on the property if the tanks must be removed at the end of the lease term, this is an ARO.
Initial measurement (AROs)
Asset retirement obligations are recognized at fair value in the period in which they are incurred if a reasonable estimate of fair value can be made. Fair value should be determined under ASC 820, Fair Value Measurements.
In the rare circumstances that a reasonable estimate of fair value cannot be determined, the liability should be recognized when a reasonable estimate can be made. A reporting entity asserting that a reasonable estimate of fair value cannot be determined should have sufficient evidence to support this conclusion. It would not be appropriate to delay the recognition of an ARO on the basis that management will not perform the related asset retirement activities in the foreseeable future.
If a reporting entity concludes that no obligation should be recognized because the fair value or timing of the obligation is indeterminate, the reporting entity should disclose the existence of the asset retirement obligation and the basis for not recognizing it. See FSP 11.6 for additional information relating to the presentation and disclosure of AROs.
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 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 the 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.
Asset Retirement Obligation: Calculating Expected Present Value
To calculate the expected present value of an ARO, companies should observe the following iterative steps:
- 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.
Purpose of Asset Retirement Obligations
The purpose of asset retirement obligations is to act as a fair value of a legal obligation that a company undertook when it installed infrastructure assets that must be dismantled in the future (along with remediation efforts to restore their original state). The fair value of the ARO must be recognized immediately, so the present financial position of the company is not distorted; however, it must be done reliably.
AROs ensure that known future problems are planned for and resolved. In the real world, they are utilized mainly by companies that typically use infrastructure in their operations. A good example is oil and gas companies.
An Example of an Asset Retirement Obligation
Consider an oil-drilling company that acquires a 40-year lease on a parcel of land. Five years into the lease, the company finishes constructing a drilling rig. This item must be removed, and the land must be cleaned up once the lease expires in 35 years.
Although the current cost for doing so is $15,000, an estimate for inflation for the removal and remediation work over the next 35 years is 2.5% per year. Consequently, for this ARO, the assumed future cost after inflation would be calculated as follows: 15,000 * (1 + 0.025) ^ 35 = 35,598.08.