Asset retirement obligation
Encyclopedia
Asset Retirement Obligations provide for future disposal of assets as required by SFAS 143 http://www.journalofaccountancy.com/Issues/2001/Dec/AccountingForAssetRetirementObligations.
Firms must recognize the ARO liability in the period it was acquired, generally acquisition. The liability equals the market value, and if that is not available the present value of cash flows that will be required to extinguish the liability. An asset equal to the initial liability is added to the Balance Sheet
, and depreciated over the life of the asset. The result is an increase in both assets and liabilities.
Consider a fixed asset that has a useful life of 7 years, a present value of cash flows equal to $15,000 and the present value of cleanup at the end of the 7th year equal to $5,000. Suppose the firm pays by cash the net present value, that is $10,000. Prior to SFAS 143, the firm would reduce cash by $10,000 and increase fixed assets by $10,000. No changes would result to the totals on either side of the balance sheet. By SFAS 143, the firm needs to also recognize the future liability of $5,000 and a corresponding asset of $5,000. Hence both sides of the balance sheet consequently increase by $5,000.
As the cash flows from the asset come in, the asset of $5,000 is depreciated down to zero in the seventh year. This makes sense as during the seven years the firm has received cash flows of $5,000 in excess of the present value of $10,000 it paid. And the firm uses these cash flows to meet its retirement obligation, and then extinguishes the liability of $5,000. The fixed asset of $10,000 is depreciated in the usual manner.
If the ARO is not recognized as per SFAS 143 then after the cash flows from the asset have been obtained but prior to its "retirement", the B/S assets will show an excess value of $5,000 that does not actually exist as it would have to be spent on clean up (retirement) costs. When the costs of retirement come in, the B/S assets (and equity on the right side) will drop by $5,000 at one go. Recognizing the ARO keeps the B/S more accurate through time.
The increase of assets and liabilities by $5,000 will affect financial ratios, for example return on assets will decline, debt equity ratio will increase, etc.
Firms must recognize the ARO liability in the period it was acquired, generally acquisition. The liability equals the market value, and if that is not available the present value of cash flows that will be required to extinguish the liability. An asset equal to the initial liability is added to the Balance Sheet
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...
, and depreciated over the life of the asset. The result is an increase in both assets and liabilities.
An ARO Example
All numbers in this example are in today's dollars.Consider a fixed asset that has a useful life of 7 years, a present value of cash flows equal to $15,000 and the present value of cleanup at the end of the 7th year equal to $5,000. Suppose the firm pays by cash the net present value, that is $10,000. Prior to SFAS 143, the firm would reduce cash by $10,000 and increase fixed assets by $10,000. No changes would result to the totals on either side of the balance sheet. By SFAS 143, the firm needs to also recognize the future liability of $5,000 and a corresponding asset of $5,000. Hence both sides of the balance sheet consequently increase by $5,000.
As the cash flows from the asset come in, the asset of $5,000 is depreciated down to zero in the seventh year. This makes sense as during the seven years the firm has received cash flows of $5,000 in excess of the present value of $10,000 it paid. And the firm uses these cash flows to meet its retirement obligation, and then extinguishes the liability of $5,000. The fixed asset of $10,000 is depreciated in the usual manner.
If the ARO is not recognized as per SFAS 143 then after the cash flows from the asset have been obtained but prior to its "retirement", the B/S assets will show an excess value of $5,000 that does not actually exist as it would have to be spent on clean up (retirement) costs. When the costs of retirement come in, the B/S assets (and equity on the right side) will drop by $5,000 at one go. Recognizing the ARO keeps the B/S more accurate through time.
The increase of assets and liabilities by $5,000 will affect financial ratios, for example return on assets will decline, debt equity ratio will increase, etc.