An asset retirement obligation, or ARO, is a legal obligation associated with the retirement of a tangible long-lived asset that results from the acquisition, construction, or development and (or) the normal operation of that asset. Under US generally accepted accounting principles an entity recognizes the fair value of that liability in the period in which it is incurred, if a reasonable estimate of fair value can be made, and on initial recognition capitalizes an equal amount as an asset retirement cost by increasing the carrying amount of the related long-lived asset (FASB Statement No. 143, paragraphs 2, 3 and 11).
Statement No. 143 is codified into FASB Accounting Standards Codification Subtopic 410-20 (GASB Statement No. 83, paragraph A2).
Legal obligation is a defined term here, and it is narrower than it sounds. It means an obligation 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 (FASB Statement No. 143, paragraph 2). A cleanup a client intends to do, or has budgeted for, is not one.
What Makes an ARO Behave Unlike an Accrued Liability
The asset retirement cost sits inside the asset, and the entity allocates it to expense using a systematic and rational method over the asset’s useful life (FASB Statement No. 143, paragraph 11).
The liability then grows on its own. In periods after initial measurement, an entity measures the change due to the passage of time by applying an interest method to the liability at the beginning of the period, using the credit-adjusted risk-free rate that existed when the liability was initially measured, and recognizes that increase as accretion expense, an operating item in the statement of income and not interest cost for purposes of Statement No. 34 (FASB Statement No. 143, paragraph 14).
Recognition also does not run through the probability test that governs an ordinary accrual, because the measurement objective is fair value, and Statement No. 5 and Interpretation No. 14 are not applicable to a liability measured on that objective (FASB Statement No. 143, paragraph 6).
The Obligation Is Unconditional Even When the Timing Is Not
A conditional asset retirement obligation is a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the entity’s control. The obligation to perform the activity is unconditional even though that uncertainty exists, so an entity recognizes a liability for its fair value once that fair value can be reasonably estimated (FASB Interpretation No. 47, paragraph 3). An unambiguous requirement coupled with a low likelihood of required performance therefore still requires a liability, because uncertainty about the conditional outcome is incorporated into the measurement of fair value rather than into the recognition decision (FASB Statement No. 143, paragraph A24).
A Worked Example
Say a client holds a permit that requires the client to remove a fuel storage tank when the tank comes out of service. The client estimates the removal outlay and discounts it at the credit-adjusted risk-free rate.
Estimated removal outlay at retirement 100,000
Years to retirement, and the asset's useful life 10
Credit-adjusted risk-free rate 5%
Initial ARO liability 100,000 / 1.05^10 61,391.33
Asset retirement cost capitalized, same amount 61,391.33
Year 1 accretion expense 61,391.33 x 5% 3,069.57
ARO liability at end of year 1 64,460.90
Year 1 asset retirement cost, allocated straight line 6,139.13The opening entry debits the asset retirement cost and credits the ARO liability, which is why an ARO raises the gross carrying amount of the asset and not only the liability side of the balance sheet.
What an ARO Is Not
An Environmental Remediation Liability Under ASC 410-30
An obligation that results from the improper operation of an asset is outside ARO accounting, and may instead fall under the environmental remediation guidance first issued as AICPA Statement of Position 96-1 (FASB Statement No. 143, paragraph 2). Normal operation puts a retirement cost in the first bucket. A spill puts it in the second.
A Lease Restoration Obligation Under ASC 842
The ARO standard does not apply to a lessee obligation in connection with leased property, whether imposed by the lease agreement or by a party other than the lessor, that meets the definition of minimum lease payments or contingent rentals under the lease standard then in force; only a lessee obligation that fails that definition is accounted for as an ARO (FASB Statement No. 143, paragraph 17).
A Governmental Client Applies GASB 83, Not ASC 410-20
For a state or local government the term is defined by a different board and behaves differently. An ARO there is a legally enforceable liability associated with the retirement of a tangible capital asset, and it is recognized when the liability is both incurred and reasonably estimable. Two events have to occur together. An external obligating event is the approval of a law or regulation, the creation of a legally binding contract or the issuance of a court judgment, and an internal obligating event is one that results from normal operations (GASB Statement No. 83, paragraphs 4, 8, 9 and 10).
Three differences change the working papers. The government recognizes a corresponding deferred outflow of resources instead of capitalizing a cost into the asset, and reduces that deferred outflow over the capital asset’s estimated useful life, or over its remaining useful life when the deferred outflow is first reported after the asset is already in operation. Measurement is the best estimate of the current value of outlays expected to be incurred, adjusted at least annually for the effects of general inflation or deflation, rather than a discounted fair value that accretes. And conditional obligations to perform asset retirement activities are excluded from the scope of that Statement outright (GASB Statement No. 83, paragraphs 6, 12, 15, 19 and 23), which is the opposite of the treatment on the commercial side.
Common Questions
Decommissioning a nuclear power plant is the standard’s own illustration, and the liability is incurred as contamination occurs, so each period a separate layer is measured and recognized as an addition to the original liability (FASB Statement No. 143, paragraph 10). Governmental examples run the same way, including decommissioning nuclear reactors and dismantling and removing sewage treatment plants (GASB Statement No. 83, paragraph 1).
The opening entry records the liability and an equal asset retirement cost, and each later period adds accretion to the liability. A revision to the timing or the amount of the original estimate of undiscounted cash flows then adjusts both the liability and the capitalized asset retirement cost, with upward revisions discounted at the current credit-adjusted risk-free rate and downward revisions at the rate that existed when the original liability was recognized (FASB Statement No. 143, paragraph 15).
No IFRS standard carries that name. A decommissioning or restoration obligation is a provision, which IAS 37 defines as a liability of uncertain timing or amount, measured at the amount the entity would rationally pay to settle the obligation at the end of the reporting period and discounted to its present value, with later changes in an existing decommissioning, restoration or similar liability dealt with by IFRIC 1 (IFRS Foundation, IAS 37). The cost side sits in the asset, because cost includes the estimated costs of dismantling and removing the item and restoring the site on which it is located (IFRS Foundation, IAS 16).
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