If you have signed an operating lease for space, built leasehold improvements, and determined that you are legally required to take out the leasehold improvement when the lease expires, then you have already encountered an asset retirement obligation or ARO for short.
What is Fixed Asset Retirement?
Asset retirement occurs when either capitalized goods or property is removed from service either because of disposal, sale, or any kind of removal. When the asset has been retired, then it no longer has the utility for which it was originally either constructed, acquired, or developed.
What is an Asset Retirement Obligation?
An ARO pertains to the legal obligation related to retiring a long-lived, tangible asset where the firm is responsible for either cleaning up the hazardous materials or removing equipment or structure at a later date. Companies must include AROs in their financial statement to reflect a holistic and more accurate picture of the enterprise’s overall value.
Some examples of ARO are when a shop constructs on the rented space according to a specific design or layout to suit the business’ needs or when the business updates and paints the rented space for their branding. If the lease contract requires the lessee to take out the improvements or repaint the space to its original color, then the lessee has an ARO and is required to return the rented asset to its original condition the lessee found it. Likewise, a firm that leases a lot and installs water tanks on the property and is required to remove such a tank after the lease ends also has an ARO.
Is Asset Retirement an Obligations Debt?
Asset retirement obligation is a liability, considered a common legal requirement to return an asset to its old condition according to asset retirement obligation accounting IFRS IAS 37 and the Accounting Standards Codification Statement No. 41- or FASB ASC 41.
What is the Accounting Entry for Asset Retirement?
Business must recognize the fair value of the ARO upon incurring the liability if it can obtain a realistic estimate of the ARO’s fair value. But if the fair value is initially unobtainable, then the ARO must be recognized at a later date when the fair market value is already available.
How Do You Calculate Asset Retirement Obligation?
A firm that acquires a fixed asset with an ARO already attached should recognize the ARO’s liability as of the fixed acquisition date. There’s a benefit to recognizing the liability immediately as possible since it provides the readers of the firm’s financial statements a more realistic grasp of the company’s actual state of obligations given that ARO liabilities can be quite big.
Generally, there’s only one way to identify the fair value of the ARO, which is by using an expected present value technique by using several possible outcomes. Those computing for the expected present value of the future cash flows must include the following into the calculation:
Probability distribution– When there are only two outcomes possible when determining the ARO’s expected present value, one must assign a 50 percent probability to each one until the additional information altering the initial probability distribution becomes available. If not, one must spread the probability across all the possible scenarios.
Discount rate– A risk-free, credit-adjusted rate must be used for discounting cash flows to their current value. Hence, the business’ credit standing will affect the discount rate to be used.
The following steps must be followed when calculating the expected present value of an ARO:
- Estimate the amount and timing of the cash flows related to the retirement activities
- Determine the risk-free, credit adjusted rate
- Record the period-to-period increase, if any, in the carrying amount of the ARO’s liability as an accretion expense. This can be done by multiplying the starting liability by the risk-free, credit-adjusted rate from when the liability was initially measured
- The upward liability revisions must be recognized as a new liability layer, then discount the reduction using the rate used for the first recognition of the related liability layer
When the ARO liability has been initially recognized, then the related asset retirement cost must be capitalized. It can be done by adding the related asset retirement cost and carrying amount of the related fixed asset.
If ARO liability changes over time
In many cases, the ARO liability will change over time. Thus, should the liability increase, then one must consider the incremental increase for every period so it becomes an additional layer of liability on top of any previous liability layers. The following points must be considered when recognizing these additional layers:
- Each layer must initially be recognized at its fair value
- Allocation of the ARO liability must be systematically be allocated to expense during the useful life of the asset
- The changes in the liability due to the passage of time must be measured using the risk-free, credit-adjusted rate when each layer was initially recognized. One must also record the cost of the liability’s increase. This should be classified as accretion expense when charged as an expense.
- When the ARO yet has to be realized and the time period has already shortened, then the amount, timing, and probabilities related to cash flows will improve. There might be changes in the ARO liability according to these changes in the estimate.
AROs are just a sample of the complex nature of the new lease accounting standards. Fortunately, there’s Visual Lease accounting software designed by seasoned accountants that can help any comply with various accounting standards. Our software can improve a company’s lease accounting to ensure compliance.