FAS 143: Accounting for Asset Retirement Obligations

Specific accounting standards govern how companies report future costs to retire long-lived assets. The Financial Accounting Standards Board (FASB) issued this guidance as Statement No. 143, now known as Accounting Standards Codification (ASC) 410-20. This framework requires a company to recognize a liability for these future costs when the obligation is incurred, not when the asset is actually retired.

Identifying an Asset Retirement Obligation

An Asset Retirement Obligation (ARO) is a liability recognized for a legal obligation associated with the retirement of a tangible, long-lived asset. An obligation is considered “legal” if it results from an existing law, a statute, a written or oral contract, or if it is legally enforceable under the doctrine of promissory estoppel. The requirement to record an ARO is triggered when a company acquires, constructs, develops, or begins normal operation of an asset that carries a future retirement duty.

Common examples include the obligation to decommission a nuclear power plant, dismantle an offshore oil rig, or remove underground fuel storage tanks at a gas station. It also frequently applies to leased assets, where a contract requires the lessee to restore a property to its original condition before the end of the lease term. For instance, a retailer leasing a store in a mall may have a contractual duty to remove all custom fixtures, signage, and flooring upon vacating the premises.

Uncertainty about the exact timing or amount of the final settlement cost does not eliminate the need to recognize the obligation. Instead, such uncertainties are factored into the measurement of the liability through probability-weighted estimates. If it is genuinely impossible to make a reasonable estimate of the fair value, recognition is delayed only until the point at which a reasonable estimate can be made.

Initial Measurement of the Liability

The initial measurement of an ARO is based on its fair value at the time the obligation is incurred. Fair value is the amount at which the liability could be settled in a current transaction between willing parties. Since a ready market for settling such obligations rarely exists, companies estimate fair value by calculating the present value of the expected future cash outflows needed to satisfy the retirement duty.

The first step is to estimate all potential future cash flows required to retire the asset. These estimates should be comprehensive, including costs for labor, materials, contractor fees, and any allocated overhead directly related to the retirement activities. Companies should also consider the potential for different outcomes by assigning probabilities to various cash flow scenarios. For example, a company might estimate a 40% chance that decommissioning costs will be $500,000 and a 60% chance they will be $600,000, leading to an expected cash flow of $560,000.

Once the expected cash flows are determined, the company must select an appropriate discount rate to calculate their present value. The standard specifies the use of a credit-adjusted risk-free rate. This rate begins with a risk-free rate, such as the rate for U.S. Treasury securities with a maturity similar to the timing of the retirement obligation, and then adjusts it for the company’s own credit standing.

The resulting present value is recorded as the initial ARO liability on the balance sheet. Simultaneously, the company capitalizes this same amount as an Asset Retirement Cost (ARC) by increasing the carrying value of the related long-lived asset. For example, if the present value of the retirement obligation is calculated to be $100,000, the company records a $100,000 ARO liability and increases the book value of the associated plant or equipment by $100,000.

Accounting After Initial Recognition

After the initial recording of the asset retirement obligation and the corresponding asset retirement cost, the accounting process continues throughout the life of the asset. Two distinct activities occur concurrently in the periods following initial recognition: the gradual increase of the liability and the systematic depreciation of the capitalized cost.

The ARO liability increases over time through a process called accretion. Accretion expense represents the increase in the present value of the liability due to the passage of time, effectively functioning like interest expense. It is calculated by multiplying the ARO liability at the beginning of the period by the same credit-adjusted risk-free rate used for the initial measurement. This expense is recognized in the income statement and increases the carrying amount of the ARO liability on the balance sheet.

While the liability accretes, the capitalized Asset Retirement Cost (ARC) is depreciated. The ARC, which was added to the value of the related tangible asset, is allocated to expense over that asset’s useful life. This depreciation is calculated using the company’s standard depreciation method for similar assets.

Financial Statement Disclosures

Specific disclosures in the footnotes are required to provide a clear understanding of a company’s asset retirement obligations. A company must provide a general description of its AROs and the associated long-lived assets. The disclosures should also include the fair value of any assets that are legally restricted for the specific purpose of settling the ARO liability, such as funds placed in a trust.

A central component of the disclosure is a reconciliation of the beginning and ending carrying amount of the ARO liability. This schedule must separately show:

• Liabilities incurred in the current period
• Liabilities settled during the period
• Accretion expense
• Any revisions made to the estimated cash flows