If you have signed an operating lease for space, built leasehold improvements and agreed to remove those improvements at the end of the lease term, you may have an asset retirement obligation, also known as an ARO.
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.
Asset retirement obligation 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 accounting, an ARO usually applies when a company has a legal duty to retire an asset in the future and can reasonably estimate the cost of doing so. The obligation may come from a lease, contract, law, regulation or another legally enforceable requirement.
Common asset retirement obligation examples include:
For lease accounting, AROs often come up when a tenant makes changes to a leased space and is legally required to remove those improvements before returning the property to the landlord.
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:
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.
A law firm leases office space in a commercial building. The landlord agrees to build out offices and conference rooms based on the tenant’s approved plans. The landlord manages and pays for the construction, and the tenant does not record the improvements as its own leasehold improvement asset.
At the end of the lease, the tenant must return the space to its original condition.
In this case, the removal obligation may not be treated as an ARO because the tenant did not recognize the improvement as its own asset. Instead, the estimated removal cost may be treated as a lease payment and included in the lease liability and right-of-use asset.
A restaurant leases a retail space and installs kitchen equipment, branded finishes, signage and other leasehold improvements. The tenant pays the contractor and records the leasehold improvements on its balance sheet. The lease requires the tenant to remove those improvements at the end of the lease term.
In this case, the estimated cost to remove the leasehold improvements is generally treated as an asset retirement obligation. The tenant records the ARO liability and the related asset retirement cost when the obligation is incurred, assuming the cost can be reasonably estimated.
ARO treatment can vary depending on which accounting standard applies. ASC 410, IFRS 16, IAS 37, GASB 83 and GASB 87 all address parts of the issue, but they do not treat every lease-related obligation the same way.
Under U.S. GAAP, ASC 410 is the primary guidance for asset retirement obligations. ASC 842 also matters when the obligation is tied to a lease.
Under IFRS, IFRS 16 does not contain the same type of differentiation as ASC 842. An obligation to dismantle and remove an underlying asset, restore the site or restore the underlying asset is generally accounted for under IAS 37 and treated as an adjustment to the right-of-use asset.
Under GASB, GASB 87 does not specifically address AROs for lessees. GASB 83 goes further by requiring lessors to recognize AROs associated with leased property, while a lessee’s liability from obtaining the right to use an underlying asset would generally be incorporated into the lessee’s lease payments.
Under U.S. GAAP, ASC 410 provides guidance for asset retirement obligations. The initial measurement begins with the expected future costs to retire the asset.
The company estimates the future retirement cost, applies expected inflation or cost assumptions when needed, and discounts the future amount to present value using an appropriate rate. The resulting present value is recorded as the asset retirement obligation liability.
The offsetting debit is recorded as an asset retirement cost. This cost is added to the carrying amount of the related asset and then depreciated or amortized over the useful life of that asset.
Over time, the ARO liability increases through accretion expense. Accretion reflects the passage of time and moves the liability closer to the expected future settlement amount.
Under IFRS, asset retirement obligations related to leases are generally considered with IFRS 16 and IAS 37.
IAS 37 addresses provisions, contingent liabilities and contingent assets. When a company has an obligation to dismantle, remove or restore an asset or site, the estimated cost may be recognized as a provision if the recognition criteria are met.
For leases, the obligation may be included as part of the right-of-use asset. The related provision is measured based on the best estimate of the expenditure needed to settle the obligation, discounted when the effect of time value is material.
For government entities, GASB 83 addresses certain asset retirement obligations. GASB 87 covers lease accounting but does not address lessee AROs in the same way as ASC 410 or IFRS 16.
In many cases, a lessee’s obligation related to obtaining the right to use an underlying asset may be incorporated into lease payments. Because GASB treatment can depend on the specific facts, government entities should review GASB 83, GASB 87 and the lease terms carefully.
The initial asset retirement obligation journal entry records the present value of the expected future retirement cost.
| Account | Debit | Credit |
| Asset Retirement Cost | $XX | |
| Asset Retirement Obligation Liability | $XX |
The debit increases the cost basis of the related asset. The credit records the liability for the future retirement obligation.
For example, if the present value of the future retirement cost is $50,000, the entry would be:
| Account | Debit | Credit |
| Asset Retirement Cost | $50,000 | |
| Asset Retirement Obligation Liability | $50,000 |
This is the starting point for ARO accounting. After the initial entry, the company will also record accretion expense and depreciation or amortization over time.
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 re-measurements, as in ordinary lease accounting.
ARO accounting can become difficult when companies manage many leases, multiple locations and different types of end-of-term obligations.
Lease accounting software can help teams track:
For companies with complex lease portfolios, tracking AROs manually can increase the risk of missed obligations, inconsistent assumptions and inaccurate journal entries.
A centralized lease accounting system helps teams keep the lease data, accounting treatment and supporting documentation in one place. Request a demo!
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