Asset retirement obligation under ASC 842, IFRS 16 and GASB 87

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. However, not all obligations at the end of the lease term are considered ARO.  Some of these differences are subtle, but they dramatically change the proper accounting treatment. A full, definitive explanation of the differences is beyond the scope of this document, but we can summarize some of the rules. As always, refer to your accounting advisors for final determinations.

What is Asset Retirement?

Asset retirement refers to the process of removing, disposing of, or decommissioning an asset that is no longer in use or has reached the end of its useful life. In many industries, asset retirement obligations (AROs) are recognized as a liability. These obligations represent the estimated future costs of retiring certain assets, especially in cases where environmental or safety considerations are involved.

When Is an End of Term Obligation an Asset Retirement Obligation?

The guidance of ASC 842, Leases, and ASC 410, Asset Retirement Obligations, can be somewhat circular and hard to follow.  Each standard refers to the other, and both discuss contract versus regulatory requirements, as well as a host of other considerations.  While these factors may impact the ultimate determination, ASC 842 gives us a simple rule of thumb:

• If the obligation is to remove an improvement to the underlying asset, and the asset has been recognized on the lessee’s balance sheet, the obligation to remove that asset should generally be accounted for as an ARO.
• If the asset is owned by the Lessor, then the cost to remove the asset would be considered a lease payment. It increases the lease liability and the right of use of assets. Amortization of this asset increase will then increase the lease expense.
  • Note that this “ownership” issue is based on accounting ownership, not legal ownership, which may be different.

There is a third subset of end of lease obligations which arise out of environmental considerations.  These are covered by a different section of ASC 410. 

Examples of Asset Retirement Obligation (ARO)

1. Biglaw, LLC, leases 40,000 square feet in a class A office building. The landlord agrees to build out offices and conference rooms to Biglaw’s specification, at a cost not to exceed $1 million. Biglaw approves the plans but is not involved in the construction.  They are obligated to return the space to its original condition at the end of the lease term.  Biglaw does not place a Tenant Improvement on their balance sheet.This end of lease obligation is not considered an ARO. Biglaw will estimate the cost to remove the improvements at the end of the lease and consider that a final lease payment. The lease liability and right of use asset include the cost to remove.
2. Justeatz, Inc. leases 4,000 square feet to use as one of their chain restaurants.  The space requires significant work to accommodate all their restaurant equipment, both general kitchen equipment and their signature finishes and signage. At the end of the term, Justeatz will remove their equipment and branded materials. Justeatz pays the contractor and puts a Leasehold Improvement on their balance sheet, then the landlord reimburses them. While the asset and liability are reduced by the amount of the incentive, the estimated cost to remove the leasehold improvements is handled as an ARO.

Differences ARO in Other Standards

IFRS 16 does not contain this sort of differentiation. Any obligation to dismantle and remove an underlying asset, the site or the underlying asset is accounted for under IAS 37 Provisions, Contingent Liabilities and Contingent Assets and is treated as an adjustment to the Right of Use Asset.

GASB 87 does not specifically address ARO for lessees. A clarifying statement in GASB 83, Certain Asset Retirement Obligations, goes further to require that lessors must recognize ARO’s associate with the leased property, but “a lessee’s liability as a result of obtaining the right to use an underlying asset generally would be incorporated into lessee’s lease payments”.

What is the Accounting Entry for Asset Retirement?

During ARO accounting, 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. 

Note that this does not apply if there is just uncertainty as to the amount of the obligation, only when the entity has insufficient information to estimate the present value. All three accounting standards contain similar provisions.

How Are Asset Retirement Obligations (AROs) Treated Under Different Accounting Standards?

ASC 410 (FASB, US GAAP)

Under ASC 410, the initial measurement starts with a recognition of the expected future costs to retire the asset. ASC 410 notes that using the expected cash flow technique is usually the only appropriate method for measuring the liability. This method calls for the entity to estimate the costs to meet the obligations today. If there are several possible scenarios or costs to estimate, the entity should establish a weighted average cost based on the probability of each being the correct value. This weighted average cost should then have an expected inflation factor applied to estimate the cost to be incurred at the time of remediation. 

Note that the time of remediation is not necessarily the end of the lease term. The expected date of remediation may occur before or after the lease expiration date.

This expected expenditure is then discounted using a risk-free interest rate, adjusted for the entity’s credit risk. This discounted value is the Asset Retirement Obligation, which is recorded as a liability on the balance sheet. Interest (at the discount rate) accretes to the obligation each period.

When recording the ARO, the offsetting debit entry is the Asset Retirement Cost. This cost is expensed “using a systematic and rational method over the useful life of the asset.” This is commonly amortized on a straight-line basis, although other methods may be used.

IFRS 16 (IASB)

IFRS 16 and IAS 37 work together to account for asset retirement obligations in leases.  IAS 37 starts with a best estimate of the expenditure to settle the obligation. The future obligation is discounted just as in ASC 410, except that the discount rate is a pre-tax rate that reflects current market assessments and the risks specific to the liability. The resulting value is called the Provision. Interest accretion is recognized as a borrowing cost.

The provision is then entered as an increase to the Right of Use Asset in the lease accounting schedule, with an offsetting credit against the IAS 37 provision. The Provision is therefore expensed in equal monthly installments as the ROU asset is amortized.

GASB 87

Recall that GASB 87 does not specifically address ARO for lessees. GASB 83, Certain Asset Retirement Obligations, states that “a lessee’s liability as a result of obtaining the right to use an underlying asset generally would be incorporated into lessee’s lease payments”. Therefore, the cost of satisfying the asset retirement obligation is merely considered a final payment during the lease term.

How Are ARO Changes Accounted For?

As ARO’s are always a forward projection of likely expenses, they are subject to change.  Inflation factors can change, technology can change the cost of accomplishing the work, and regulatory influences can change the scope, just to name a few factors.  Each of the standards provides for re-measuring the ARO as these conditions change.  

The factors to consider and thresholds for change are too many to consider here.  However, each standard calls for a periodic review, which may be supplemented when conditions are known to change. Changes which are material would be handled as remeasurements, as in ordinary lease accounting.

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