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Companies use fixed assets to operate and generate revenues. Usually, these assets have a limited life beyond which companies don’t consider them useful. At this point, companies may either write it off or sell it for its scrap value. In some cases, companies may also be required to restore an asset or its location to its original condition. For these assets, companies must create an asset retirement obligation.
What is an Asset Retirement Obligation (ARO)?
Asset retirement obligation is a liability recorded for the provisions associated with retiring tangible assets. Accounting standards state that companies must create this liability for assets that require restoration of the site to its original condition. For example, it may occur when using a leased property for operations. At the end of these operations, the landlord may require the company to restore the property to its original condition.
An asset retirement obligation may also cover the cost of restoring an asset to its original condition. For example, lessors may require a company to restore their assets before returning them. Usually, companies estimate the costs associated with these restorations and create a liability for it at a discounted amount. With time, companies will adjust the obligation to reflect the expected cost.
How does an Asset Retirement Obligation work?
As stated above, companies may use fixed assets that incur costs after their useful life is over. These costs may include restoration, dismantling, demolishing, etc. In most cases, the agreement between the company and the asset owner will dictate whether these apply. If the contract requires them, companies must estimate those costs and create a liability.
Companies must use the expected present value method to determine the asset retirement obligation. This method requires using estimated retirement value, calculating cashflows, discount rates, and probability distribution. Once companies reach a reliable estimate, they record it as an asset retirement obligation. At the end of each period, companies recalculate the amount to adjust the present value.
What is the accounting for Asset Retirement Obligation?
Accounting for asset retirement obligations requires complex calculations. Once companies reach a retirement value, they must discount it to its present value. For example, if it takes $10,000 to retire an asset after 10 years with a 5% discount rate, the asset retirement obligation would be as given below.
Asset retirement obligation = $10,000 / (1 + 5%) ^ 10
Asset retirement obligation = $6,139.13
The company will record this amount in its balance sheet as an obligation. Similarly, this obligation will become a part of the acquired asset’s initial cost. After the end of each year, the company must recalculate the liability to reflect its present value. This process will also require a charge to the income statement. On the other hand, it may increase or decrease the asset retirement obligation on the balance sheet.
Asset retirement obligation is the liability associated with retiring a tangible fixed asset. It occurs when companies must remove an asset or restore its site to its original condition. Usually, it requires complex calculations to estimate this lability initially. Asset retirement obligation is a part of the balance sheet and can also impact the income statement.
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