An asset retirement obligation is a type of legal obligation that applies to businesses that have long-lived assets that will someday be retired. The asset retirement obligation ensures that investors are aware of the costs that will be spent on removing those assets and cleaning up any damage to the surrounding property. It most often applies to companies that deal with hazardous materials, such as companies in the oil and gas industry.
Here's how asset retirement obligations work.
What Is an Asset Retirement Obligation?
If you’re a corporate accountant or business owner that owns or leases certain type of assets, you may have to apply complicated bookkeeping rules set forth by the Financial Accounting Standards Board (FASB) that account for the cost of returning that property to its original condition. These rules are known collectively as the asset retirement obligation.
In other words, how much will it cost for your business to remove heavy equipment in the future? Those costs need to be accounted for as a liability, so investors are aware of a major cost that will occur at some point.
- Acronym: ARO
How Does an Asset Retirement Obligation Work?
Put simply, these rules impose a legal obligation on a company to eventually remove certain assets. While the assets are in use, an accountant will account for future asset retirement obligations as a liability.
For example, let's assume that you want to start a company that engages in fracking. You start your company by leasing three pieces of land. Each is a 40-year lease. The next step is to place equipment on each of those sites and start pumping. You probably won’t bring all three of your sites into service at the same time. Instead, you’ll stagger their in-service dates.
Your certified public accountant (CPA) has to account for the fact that you will have to pay to remove the equipment from each of your three sites when the 40-year leases end. It took a lot of money to transport and assemble the equipment and it will be a significant expense to dismantle it when you’re done. That future obligation to tear down the machinery and perform any remediation required by the government is described by your CPA as an ARO.
If you have a business that deals with asset retirement obligations, you most likely have other financial reporting complexities and probably already have an accountant who is taking these advanced concepts into consideration. Seek advice from your CPA if you have concerns about accounting for your business’s future obligations.
Why the ARO Rule Exists
Your fracking business has a lot of startup costs. You can't extract anything without the help of some expensive equipment. Because of the high startup costs, you are going to need investors and those investors will want to know exactly where you stand financially—now and in the future. As your company grows, the investors’ CPAs will ask for accurate reporting of the financial health of your fracking company, and this reporting should account for the expected costs of retiring your fracking equipment once your lease on the land is up.
The FASB created ARO rules because reporting on future liabilities related to retired assets were not previously standardized. This made it difficult to accurately assess and compare the financial wellbeing of companies with these types of assets.
Not only do you have to pay to remove the equipment, but there might be environmental standards you have to meet, as well. You may have to spend extra resources to clean up or reduce the environmental impact of your assets. Because you know these costs are coming, you have known liabilities that have to be reported from the time you put the wells into service.
Your fracking wells have a useful life of about 40 years, but let’s say that you waited five years to bring one of your wells into service. That means that you have 35 years left on your lease and 35 years of useful life. Your accountant did some research and found that it would cost about $15,000 per well to take it out of service in today’s dollars. However, you also need to account for inflation with AROs, so the true cost in 35 years could be well above $30,000.
Accounting principles like present value may allow you to delay the impact these liabilities have on your balance sheet.
Adjustments to Make Over Time
Inflation isn't the only thing that will impact the actual cost of removing assets in 35 years. Any number of market conditions could impact the cost of taking the wells out. Maybe environmental standards change and closing down a well now comes with a much higher cost. On the other side, maybe the economy will be in a slump and the labor cost is lower because more people are looking for jobs and are willing to work for less. Either way, the asset retirement obligation will change over time. The accountant is required to adjust the balance sheet to reflect these changes.
- An asset retirement obligation is an aspect of accounting that attempts to predict the cost of removing an asset in the future.
- AROs are a liability—it's a cost that will occur in the future.
- AROs most often apply to assets in hazardous industries, such as oil and gas extraction equipment.