Accounting - AROs (Asset Retirement Obligations) logic, understand

hanvinh

Anybody understand why the asset is depreciated and what the logic is behind accretion expense?

draz

I can email you a nice explanation on it. I'll need your email ID though

scr879

luke@kerrasset.com

thanks!

cchang

Mailing it in half an hour. Let me know what you think

johnnyBuz

supersunny138@gmail.com

Thanks in advance betthecfa

invic

I have a spreadsheet which shows how the ARO is accounted for over the life of the asset. I'll send it on to the above addresses after work.

I have the same thing done for Par/Premium/Discount Bonds and also leases, so I'll send them all on.

dmar

Ive left out the example and the summary table. Wasnt sure how to paste it in here...

Hope this helps

AROs

For many types of long-lived assets, ownership involves an obligation that must be fulfilled at the end of the asset’s service life. These obligations are called asset retirement obligations (AROs). For example, assume that a firm obtains permission from the government to dispose of its waste at a landfill site, as long as it undertakes reasonable procedures to cap and close the landfill after a few years. SFAS 143 requires that this obligation (to cap and close the landfill) be reflected on the firm’s financial statements. The following steps illustrate the accounting for this ARO.

Step 1: Recognize an asset and a liability equal to the present value of the expenses that will be incurred eventually.

Effect: Fixed assets and LT liabilities increase by the present value of the expenses required. There is no change in equity at this stage.

Step 2: Depreciate the asset every year so that it is completely written off by the time capping procedures have to be undertaken.

Effect: Fixed assets decrease, net income falls, and retained earnings and equity decrease every year till the asset has been fully written off.

Step 3: The liability increases every year as it is based on the present value of expected future expenses. As the point in time that capping procedures need to be performed nears, the present value of the expense rises because the number of discounting periods falls. This increase in the liability (known as accretion expense) is included in operating expenses.

Effect: The value of the liability increases every year, operating income falls, net income and equity decrease.


Overall result: At the time when the actual expenses to restore the land to its original condition need to be undertaken, the asset related to the ARO will be fully written off, and the liability amount will equal the amount that needs to be spend at that point in time to remedy the damage.


Analysis

For the purpose of analysis, adjustments are necessary to reflect the debt-like nature of AROs. The ARO liability adjusted for the following items must be included in debt in the calculation of a company’s leverage ratios:
? Funds already set aside is trust funds or escrow accounts to meet the liability.
? Tax savings that will be realized when the ARO is paid.

Further, accretion expense should be reclassified as interest expense, and treated as a non-operating item. This adjustment results in an increase in interest expense and an increase in operating income (EBIT) by the amount of annual accretion expense.

waldziuchna

The asset is depreciated, because there is no real asset. It's an expense, but in order to balance the accounting equation, you have to recognize an Asset and a Liability. At the end, the Liability acreets (increases upwards), the 'asset' is no longer there.

shootingstar

Any questions? There must be!

evolsteevol

why is the accretion treated as an operating expense? Shouldn't it be treated as an non-operating item?

And why do you increase the asset only to depreciate it every year? Is it simply to balance the accounting equation?