What Is an Asset Retirement Obligation?
Accounting for Assets That Eventually Will Be Removed
Although rare, sometimes you really do know what the future holds. If you’re a corporate accountant or business owner, then the future is clear for certain property you borrow or lease. And when that’s the case, business owners 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. Those rules come from Financial Accounting Standards Board Statement #143—also known as the Asset Retirement Obligation (ARO).
An Example: Fracking and AROs
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 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 amount to dismantle it when you’re done. That future obligation to tear down the machinery and perform any remediation required by government is described by your CPA as an ARO.
If you have a business that deals with asset retirement obligations, you most certainly 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. Nothing is coming out of the ground without 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. Hopefully you’ll pull so much crude oil and natural gas out of the ground that you and your investors will be rich, but you know that each of those wells has to be torn down once the 40 years is up.
Not only do you have to remove the equipment, but there might be environmental standards you have to meet as well. 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.
According to the FASB, in the past companies were not using standardized practices for retiring assets.
How Does an ARO Work?
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. But if we assume a 2.5% rate of inflation, the cost in 35 years will be somewhere around $36,000.
The good news is that you don’t have to show the entire amount on your books in the first year. There are some complex calculations using an accounting principle called present value to assign an initial value to the obligation but after the calculations are applied, your initial assumed retirement obligation is $2,407.
Adjustments to Make Over Time
Over those 35 years, the cost of taking the wells out of service will certainly change based on any number of market conditions. Maybe environmental standards change and closing down a well now comes with a much higher cost. On the other side, maybe the economy is 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.
FASB: "Statement of Financial Accounting Standards No. 143: Accounting for Asset Retirement Obligations," Accessed Oct. 31, 2019.
FASB: "Statement of Financial Accounting Standards No. 143: Accounting for Asset Retirement Obligations," Page 4. Accessed Oct. 31, 2019.