If you are required to remove assets related to a lease at the lease’s end (to restore the leased asset to its original condition before returning it to the Lessor), or anticipate other costs related to the retirement from service of an asset, an obligation is set up at the present value of the assumed future cost, and the ARO is accreted (increased by adding interest to the obligation) for the life of the lease. Simultaneously, the Asset Retirement Cost (the asset matching the initial obligation) is depreciated over the lease’s life. ARO accounting under US GAAP is specified in FAS 143, now labeled Topic 410 in the Accounting Standards Codification (ASC). ARO accounting for IFRS users is specified in IAS 37, where the obligations are called “provisions.”
In 2001, the Financial Accounting Standards Board (FASB), the organization charged with defining the standards for financial accounting for American business, issued Statement of Financial Accounting Standards No. 143, Accounting for Asset Retirement Obligations (generally known as FAS 143). It was issued to respond to diversity of practice in making provisions for expected and legally required future costs in decommissioning such varied assets as nuclear power plants, underground storage tanks, wells, mines, and leased property.
In this chapter, passages in quotation marks are taken directly from FAS 143, as amended (available on the FASB web site, www.fasb.org); the paragraph is shown in brackets. If another standard is referenced, its number is shown with its paragraph number in brackets. (The passages may also be found in the FASB’s new Accounting Standards Codification, primarily in topic 410.)
Entities complying with international financial reporting standards (IFRS) report AROs in accordance with the largely similar International Accounting Standard 37, Provisions, Contingent Liabilities and Contingent Assets. AROs are called “provisions” in that standard. Please see the section IAS 37 Differences, below, for the few differences.
FAS 143 applies to “legal obligations associated with the retirement of a tangible long-lived asset that result from the acquisition, construction, or development and (or) the normal operation of a long-lived asset...As used in this Statement, a legal obligation is an obligation that a party is required to settle as a result of an existing or enacted law, statute, ordinance, or written or oral contract or by legal construction of a contract under the doctrine of promissory estoppel.” It does not apply to obligations that arise from accidents and other “improper operation.” The existence of surety bonds, insurance policies, or other means of covering the obligation does not eliminate the liability, though it may affect determination of the credit- adjusted risk-free rate.
As an example, it is generally required legally that underground storage tanks used by service stations be dug up when either they reach the end of their useful life or the station is permanently closed, to reduce the risk of leaks which can contaminate groundwater and soil. Under FAS 143, the station owner (or Lessee, if the station is leased) recognizes an ARO liability when the tank is installed, along with a matching asset retirement cost (ARC) asset.
Uncertainty as to the size of the cost is not a reason to exclude an asset from ARO accounting. Nor is uncertainty about whether a legal requirement will actually be enforced. Instead, uncertainty is addressed through fair value and expected present value accounting, described later. If, however, it is not possible to make a reasonable estimate of the cost, or of the asset’s life, recognition is delayed until a reasonable estimate can be made.
The ARO liability is calculated by estimating the costs associated with retiring the asset, then present valuing the result. Most often, the estimated future cost is calculated by determining the current cost of the work to be done, then estimating an average inflation rate over the expected life of the asset. The present value is then calculated using a “credit-adjusted risk-free rate,” defined as “a risk-free interest rate adjusted for the effect of its credit standing. (Footnote: In determining the adjustment for the effect of its credit standing, an entity should consider the effects of all terms, collateral, and existing guarantees on the fair value of the liability.)” [¶A21, fn 18] The cost should be the cost that would be expended for a third party to do the work involved, even if the entity expects to do the work using internal resources.
Expected Present Value
Sometimes there is a range of possible outcomes, which may reflect either uncertainty of cost or uncertainty of settlement date (or both). In this situation, an expected present value approach to fair value accounting means that multiple outcome scenarios should be entered, with varying probabilities assigned to each.
Example: An underground storage tank is installed for a leased service station. The useful life of the tank is 40 years. The initial lease term is 20 years, with 4 5-year options. The Lessee judges that there is a 30% chance that it will vacate the property after the initial term, 40% chance that it will exercise all options, and 10% chance of ending the lease after each of the other options. In EZLease, you enter 5 AROs for the property record, one for each potential term, and list the appropriate probability for each.
If the current estimated cost is 15,000, inflation is 2%, and the credit-adjusted risk-free rate is 6%, the future cost at 20 years is 22,289.21. Enter 30% for the probability, and the future value is reduced to 6,686.76, with a Net ARO (present value) of 2,084.96. The full set of ARO layers is as follows:
The combined ARO (the sum of all the Net AROs) is thus 4,809.72, and this is set up as the initial ARO liability and ARC asset. Accretion is calculated separately for each piece of the estimate, with the first piece’s accretion ending after 20 years (optionally continuing based on inflation only). When the lease actually ends, or the tank is dug up, the ARO is terminated and the removal of the ARO liability is applied to the actual cost of tank removal and remediation.
The ARO liability increases by accretion, “applying an interest method of allocation to the amount of the liability at the beginning of the period.” The accretion expense is added to the liability, which is then used to calculate the next period’s accretion. Thus, each period the accretion expense increases. The ARC asset is normally depreciated straight-line over the life of the ARO.
Changes of Estimates
At some point after the initial setup of the ARO, you may conclude that the value needs to be changed, either because the estimated cost is incorrect, or the expected settlement (end) date of the ARO changes.
According to FAS 143, if the estimated cost decreases, the reduction should be recognized immediately, using the original risk-free rate to calculate the present value of the reduction. If the estimated cost increases, the current risk-free rate is used for the additional layer of cost.
If the end date changes, the future value is recalculated, then the present value at the current date is calculated, and the ARO liability and ARC asset are both adjusted by the difference between the new present value and the previously recognized ARO liability. If the change is a reduction greater than the ARC net asset (including accumulated depreciation), then the asset is written down to zero, and a gain is recognized for the excess.
To make such a change, click on the item in the ARO tree that represents the ARO layer that needs to be changed. The detailed information for that ARO displays. Click on Unlock Lease. Adjust the value or end date, as appropriate, and click Save Lease. EZLease generates a new revision to reflect the adjustment. If the change is to the value, a new layer is created. If the change is to the end date, a new revision is created.
Changing the cost this way results in a recalculated value based on inflating the cost from the original begin date of the ARO. To adjust the estimated cost to a specific current value, compared to one or more ARO layers, use Revise ARO Estimate on the ARO menu, described later in this chapter.
The prior information for the ARO is maintained, both for audit purposes and so that the activity up to the present is properly recorded in future reports. The modified information for the ARO is stored in a new layer. Balance sheet accounts are adjusted to reflect the new terms, and the ARO continues with the new values.
You may have an ARO for a property and settle the obligation on a portion of it. For instance, a quarry may complete work in one section, then close and remediate it while the rest of the quarry remains open.
Recognize the settlement payment for the portion using ARO Payment.
Reversal of an ARO
Sometimes, you discover that an ARO you entered on the system should never have been put on. You may discover that there is no legal responsibility to remediate, or you mistakenly entered the same information twice. If you simply delete the ARO from the database after running reports that included it, your future reports will not balance with those already run.
The solution is to terminate the ARO with a Reversal early termination type, dated in the current reporting period. This will cause all previously booked activity to be reversed, so that the life to date effect of the ARO is zero, but the beginning balances of your current reports will match the ending balances of the reports previously run. If, for example, you previously booked $100 in accretion and $50 in depreciation, the current report will show a $100 credit for accretion and $50 credit for depreciation, with similar reversing entries in all balance sheet accounts.
If your responsibility for the ARO terminates without being exercised, the process is called early termination. This is done by specifying a Term Type of Early and entering the date of termination in the Termination Date field. The undepreciated asset is removed along with the liability balance; a termination gain is reported.
Settlement of an ARO
The ARO accretes until it reaches its scheduled end date. You may choose, in System Options, whether liability should continue to accrue after the scheduled end date; if you set the option “Continue to accrue ARO after scheduled end date using inflation rate” on the ARO tab of System Options, the liability will increase using the ARO’s inflation rate until you terminate it. If the option is not selected, accretion stops, but the liability balance remains on the books until you terminate it.
Whenever you reach the date of settling your ARO, change the Termination Type to Normal and set the date. You may optionally enter a Payment record for the costs actually incurred. As of that date, any accretion (and depreciation, if the date is earlier than the ARO’s scheduled end date) ends, and the asset and liability are removed. EZ ARO reports (in the journal entries report) an ARO expense allowance for the difference between the liability and asset at termination. This is then applied to your actual costs, and any difference is recognized as a gain or loss.
IAS 37 Differences
The International Accounting Standards Board’s IAS 37 standard, Provisions, Contingent Liabilities, and Contingent Assets, covers AROs as part of its guidance for provisions. In general, the process is similar to account for an ARO under IAS 37. The primary difference has to do with the accretion rate.
The discount rate IAS 37 calls for is “a pre-tax rate (or rates) that reflect(s) current market assessments of the time value of money and the risks specific to the liability.” This is not defined exactly the same as FAS 143’s “credit-adjusted risk-free rate,” but the meaning is essentially the same to start with.
However, the reference to “current market assessments” means that regularly (at least yearly), the accretion rate must be updated to current values. To accomplish this, go to System Options, ARO tab, and check the box “Recalculate accretion when rate changes (IFRS),” then enter an updated accretion rate in the rates table above each time it needs to change.
Since the rate is changed regularly for all AROs, there is no need to differentiate the appropriate rate to use for revisions of the estimated cost.
Since provisions cover more than asset retirement obligations, the guidance provided is more general than that provided in FAS 143. In practice, preparers use similar methodologies for calculating estimated costs and making revisions.