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:
|Life||% Prob||Future Value||Net ARO|
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.