Asset Retirement Obligations
FASB 143
FASB 143 Scope
• Applies to legal obligations associated
with the retirement of a tangible longlived asset resulting from
• Acquisition
Construction, or development
Normal operation
Legal obligation based on
• Existing or enacted law, statute or ordinance
• Written or oral contract
• Legal construction under the doctrine of
promissory estoppel
– Promissory estoppel: a promise made without
consideration may be enforced to prevent injustice
if the promisor should have reasonably expected
the promisee to rely on the promise and the
promisee did actually rely on the promise to his or
her detriment
Examples
• Landfill that must be capped and closed
• Off-shore oil rig that must be dismantled
and removed
• Decontamination activities for nuclear
power plant
• Asbestos remediation required when
buildings are remodeled
Measurement at Fair Value
• Fair value of ARO is the amount at
which that liability could be settled in a
current transaction between willing
parties
– In other words, NOT based on a forced
liquidation transaction price
Measurement at Fair Value
• Quoted market values are best if
available
• Present value analysis may be the best
technique available to determine fair
value
– Note: the expected cash flow approach
will probably be the only appropriate
technique for most AROs. [See Concept
Statement No. 7, Para. 44 for description.]
Present Value Computations
• Uncertainties in the amount and timing are
incorporated into the fair value calculation
• The entity’s credit standing is reflected in the
discount rate used [credit-adjusted risk-free
rate]
• If a range is estimated for the timing or
amount of the estimated cash flows,
probabilities associated with possible
outcomes are explicitly considered in an
expected value computation
May affect many periods
• Events that give rise to ARO may occur over
multiple reporting periods
– Liability for decommissioning a nuclear power
plant is incurred as contamination occurs.
– Liability associated with PAST operation of an
newly acquired operating landfill would be
recognized at acquisition.
– Additional obligations would be recognized each
year as a result of operating the landfill.
• During each period, a new, separate layer of
ARO is measured and recognized
Improper Operation or
Catastrophic Accident
• Environmental remediation liabilities that
result from improper operation of a longlived asset are not AROs.
– Example: A certain amount of normal spillage
might be anticipated as part of ARO. A major spill
caused by failure to comply with company’s safety
procedures is not part of an ARO.
• Presumably, a loss would be recognized for a
catastrophe during the period it occurred although FASB
143 does not discuss this point.
Initial Recognition
• The period in which an asset retirement
obligation (ARO) is recognized:
– If a reasonable estimate can be made -- when it is
incurred
– If a reasonable estimate cannot be made initially –
when it becomes possible to make a reasonable
estimate of the fair value of the liability
Debit P P & E
• To offset the liability, the entity will
increase {debit} the carrying amount of
the related long-lived asset by the same
amount as the ARO liability recorded
PP&E
$100,000
Asset Retirement
Obligation
$100,000
Subsequent Recognition and
Measurement
Period-to-period changes in ARO are
recognized differently:
 related to the passage of time
– Accretion expense (discount rate times balance
forward in ARO)
 related to revisions in assumption about
timing or amount of cash flows
– Changes impact PP&E and ARO rather than an
expense account.
– Revised PP&E amount will affect future
depreciation expense
First step – time passing effect
• Measure and incorporate changes in
liability due to passage of time to arrive
at a new carrying value
– Use an interest rate method applied to
beginning balance using the original
credit-adjusted risk-free discount rate
– The change is called an accretion
expense and is classified as an operating
expense on the income statement.
Second step – revisions effect
• Measure changes resulting from
revisions to assumptions
– Upward revisions: use current creditadjusted risk-free discount rate
– Downward revisions: use original creditadjusted risk-free discount rate
• Or a weighted-average historical discount rate
Accounting for revised
estimate of clean-up cost
Estimated
Estimated
costs increase costs decrease
(use new rate) (use orig. rate)
Long-lived
asset account
Asset
retirement
obligation
Debit
Credit
Credit
Debit
Revised estimates:
• In other words, recognize change in the
carrying value of the related long-lived
assets and a corresponding change in
the asset retirement obligation
There is no immediate impact
• The revision in ARO does not
immediately affect the income
statement.
• But the amount of ARO asset
depreciated in the current and future
years will be increased or decreased
accordingly
Clarification – FIN 47
• FAS 143 required companies to retroactively
recognize ARO assets and liabilities with a
cumulative effect of a change in accounting
principle on income statement
• FIN 47 (March 2005) is effective for fiscal
years ending after Dec 15, 2005
• Clarifies “conditional ARO” as used in FAS
143
FIN 47 (March 2005)
• Objective: To clarify that an
unconditional legal obligation
associated with the retirement of a
tangible long-lived asset should be
recognized even if the timing and/or
method of the settlement of that
obligation is conditioned on a future
event, provided that the liability's fair
value can be reasonably estimated.
Conditional AROs - Defined
• A legal obligation to perform an asset
retirement activity but the timing and/or
method may not be within the control of the
company
• The obligation is unconditional even though
uncertainty exists about timing and/or method
• Liability must be recognized if an expected
present value technique could be used
(among other valuation techniques)
Utility Poles Example
• The act of purchasing treated poles triggers
recognition of a liability to dispose of the poles using
special procedures.
• The ownership of the treated poles creates the
obligation to dispose of them in the proper manner.
• If the entity sold the poles instead of installing them,
the buyer would assume the obligation of disposal,
which would affect the exchange price.
• The legal requirement relates only to the disposal of
the poles, therefore the cost to remove the poles is
not included in the asset retirement obligation.
• If, however, the law required the entity to remove the
treated poles, the cost of removal would be included
in the retirement obligation.
Go to Asbestos Example
• An Implementation of FIN 47 for a
university
ARO Example 1
• This is an example based on FASB 143
that shows how complicated it will be to
project the asset retirement obligation.
• It involves both analysis of probabilities
and the use of present value techniques
ARO Example 1
Labor Cost –
estimated cash
flows
$300,000
Probability
assessment
25%
$375,000
50%
$450,000
25%
Expected
Cash Flows
ARO Example 1
Labor Cost –
estimated cash
flows
$300,000
Probability
assessment
Expected
Cash Flows
25%
75,000
$375,000
50%
187,500
$450,000
25%
112,500
375,000
ARO Example 1
$375,000 labor +
$85,000 materials
Expected labor & material costs
$
Allocated overhead
Direct costs
Markup on direct costs
Expected CF before inflation
This amount is in today’s dollars. We
need to allow for inflation. We can use a
PV calculator to do it.
460,000
300,000
760,000
152,000
912,000
ARO Example 1
•
•
•
•
•
PV = 912,000
n=12 years
i= 3% (expected inflation rate)
FV = ?
$1,300,294
FASB’s examples also include putting in
an additional amount for the risk
premium a contractor would demand
because the contract is far in the
future
ARO Example 1
Inflation adjusted cash flow
Market risk premium (7%)
Expected CF at closure of landfill
This amount is now in
future dollars, an estimate
of what we will actually
have to pay to restore the
landfill.
1,300,294
91,021
1,391,315
ARO Example 1
• To get our liability, we have to discount the
future estimated cash flow back to the
present using the “credit-adjusted risk free
rate.”
• Initial ARO Liability at 1/1/03
–
–
–
–
FV = $1,391,315
n=12 years
i = 12% (credit-adjusted risk free rate)
PV = $357,116
ARO Example 1
• Now, we can compute the “historical
cost” of the landfill – including all costs
necessary to get the landfill ready to
use PLUS costs to restore the property
at the end of its useful life.
• Cost = $600,000 land + $800,000 prep
+ 357,117 retirement cost = $1,757,116
ARO Example 1
• Depreciation Base = cost less residual value:
• $1,757,116 – 200,000 = $1,557,116
• Using an activity method, we would divide by
120,000 tons of garbage to get
• $12.98 per ton
• To keep things simple, we’ll assume even
production over the years or $129,760 per
year. [Equivalent to SL: $1557116 ÷ 12
years]
ARO Example 1
• Expenses for 2003:
• Depreciation
129,760
Acc’d Depreciation
129,760
• Accretion expense
42,854
Asset Retirement Obligation
42,854
[357,116 * 12%]
Why do we need to increase the
liability account?
ARO Example 1
399,970 * 12%
ARO –
Accretion Depreciation
Expense
beginning Expense
2003
357,116
42,854
129,760
Year
2004
2005
399,970
357,116 + 42,854
OR find PV for
2006
FV=1,391,315
n=11,
i=12%, pmt=0
47,996
129,760
129,760
129,760
ARO Example 1
• So accretion expense is really
• INTEREST EXPENSE!
– It is what it takes to make the liability
correct because we are one year
closer to the end of the asset’s useful
life
– Note that FASB says we should not treat
accretion expense like interest when it
comes to interest capitalization
ARO Example 1
Year
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
Accretion
Depreciation
Total
ARO - BOY Expense
Expense
Expense
357,116
42,854
129,760
172,614
399,970
47,996
129,760
177,756
447,966
53,756
129,760
183,516
Note60,207
that when 129,760
we get to 189,966
501,722
1/1/2015,
the129,760
liability
561,929
67,431
197,191
account
the
629,360
75,523 will equal
129,760
205,283
expected
cash
704,883
84,586 future
129,760
214,346
we predicted
when 224,496
789,469 flows
94,736
129,760
884,206 we106,105
acquired the129,760
land fill 235,864
990,310
118,837
129,760
248,597
1,109,147
133,098
129,760
262,857
1,242,245
149,069
129,760
278,829
1,391,315
1,034,199
1,557,116
2,591,315
ARO Example 1
• The example continued on the next
page. It illustrates what happens if we
need to revise our estimates.
• Solution is in the back – I’ll leave it for
homework.
Example 2 is much shorter
• Do it for practice and check answer
against the solution at end of notes file
• Do the 3rd problem for homework – to
be submitted next class
• Very short – 15-20 minutes
Impairment of Long-lived
Assets
FASB 121
Now FASB 144
Impairment or Disposal of
Long-lived Assets - FASB 144
• A departure from transaction-based
Historical Cost Model
For assets to be held and used:
Carrying value is written down to fair
value when projected future cash flows
(undiscounted) are less than carrying
value
Application (Scope)
•
•
•
•
•
Land
Building
Equipment
Natural resources
Intangible assets
– FASB 147 says FAS144 covers long-term
customer-relation intangible assets in the
banking industry
Goodwill Impairment
• Remember, we are to test goodwill for
impairment at least annually
• FASB 144 evaluations may include
goodwill but this analysis happens only
when there is a “triggering event” and
not on an annual basis
Assets held for use
See flow chart
Note that FASB 144 has different rules for assets
to be sold or abandoned that are NOT on this
flow chart
Assets held for use
• When should impairment be
recognized?
– Testing each asset each period would be
too costly
– We wait for a “triggering event”
Impairment test when
• Events or changes in circumstances
indicate that the carrying amount may not be
recoverable
• Decline in market value
• Change in way asset is used or physical
change in asset
• Adverse changes in legal factors or business
climate
• Probable sale of asset before end of useful life
• Current period losses with history of operating
or cash flow losses associated with asset
To apply impairment tests
• A long-lived asset shall be grouped with
other assets and liabilities at the lowest
level for which identifiable cash flows
are largely independent of the cash
flows of other assets and liabilities.
This is referred to as a
“primary asset” approach –
because we need to have a
group of assets that generates
cash flows
An impairment loss is recognized if
• Carrying amount of asset (book value) is
greater than undiscounted future cash flows
related to use and disposal of asset
• The asset is written down to fair value
• The fair value becomes the new carrying
value (book value) and depreciation is
recorded over remaining useful life
– Restoration of a previously recognized impairment
loss is prohibited.
Triggering
Event
Events
indicate possible
impairment?
Yes
Is BV >
undiscounted
future CFs?
Yes
Quoted
market prices
available
for FV?
Yes
No
No
No
Can FV be
estimated based on
MV of similar
assets?
No impairment
recorded. Use
carrying value.
FASB 144 - Impairment of
Assets To Be Held and Used
Yes
No
Find FV by
discounting
future cash
flows (CFs)
Impairment
loss = excess
of BV over FV
Determining fair value
• FASB 144 describes a probabilityweighted cash flow estimation
approach to deal with situations in
which
– alternative courses of action to recover the
carrying amount of a long-lived asset are
under consideration, or
– a range is estimated for the amount of
possible future cash flows
Long-lived assets to be
disposed of and NOT held for
use
These rules are substantially
different from FASB 121 and NOT
covered on the flow chart
Long-lived assets to be
disposed of by sale
•
Classified as “held for sale” in period
in which all of the following criteria are
met:
1. Management commits to a plan to sell the
asset
2. Asset is available for immediate sale in
its present condition
3. Active program to locate a buyer has
been initiated
Long-lived assets to be
disposed of by sale
•
Classified as “held for sale” in period
in which all of the following criteria are
met:
4. Sale is probable within one year
5. Asset is being actively marketed for a
reasonable price
6. It is unlikely that the plan to sell will be
changed
Measurement
• Write asset down to the LOWER of
– Carrying amount
– Fair value less cost to sell
• Stop depreciating the asset
Assets to be disposed of other
means
• Situations include:
– Abandonment
– Exchange for similar productive asset
– Distribution to owners in a spinoff
• The asset shall continue to be classified
as “held and used” until it is disposed of
Assets to be disposed of other
means
• Asset stays in PP&E
– Depreciation estimates should be revised
to reflect shortened life
• Depreciation ends and a gain or loss is
recorded when the property is “disposed
of”
The “disposed of” date:
• Abandoned
– The date it
ceases to be
used
• Exchanged or
distributed to
owners
through a
spinoff
– The date when
it is exchanged
or distributed
Impairment Example 1
• Johnson Company purchased equipment 8
years ago for $1,000,000. The equipment has
been depreciated using the straight-line
method with a 20-year useful life and 10%
residual value.
• Johnson's operations have experienced
significant losses for the past 2 years and, as
a result, the company has decided that the
equipment should be evaluated for possible
impairment.
Impairment Example 1
• The management of Johnson Company
estimates that the equipment has a
remaining useful life of 7 years. Net
cash inflow from the equipment will be
$80,000 per year. The fair value of the
equipment is $240,000. No goodwill
was associated with the purchase of the
equipment.
Example 1 - a
• Determine if an impairment loss should be
recognized.
– Annual depreciation for the equipment has been
$45,000 ($1,000,000 - $100,000)/20 years.
Current book value of the equipment is:
•
•
Original cost
Accumulated depreciation
($45,000 * 8 years)
• Book value
$1,000,000
360,000
$ 640,000
Example 1 - a
• Determine if an impairment loss
should be recognized.
• Anticipated future cash flows $ 560,000
•
(7 years * $80,000 per year)
• Look at the flow chart – should we recognize
an impairment?
The fair value is lower, so an impairment
loss should be recognized.
Example 1 - b
• Determine the amount of the loss and
prepare the journal entry to record the
loss.
– The impairment loss is equal to the $400,000
($640,000 - $240,000) difference between the
book value of the equipment and its fair value. The
impairment loss would be recorded as follows:
•
• Acc’d Depreciation
• Loss on Impairment
• Equipment
360,000
400,000
760,000
Example 1 - c
• What journal entry should Johnson Company
make if future cash flows related to the
equipment were $980,000 in total?
– Since the future cash flows (undiscounted)
equal $980,000 and this amount is greater
than the book value of $640,000, Johnson
Company will not do anything.
• No impairment is recognized and no upward
revaluation is recorded.
• No journal entry needed.
Example 2
• Here is a problem to do for homework
• Also, there are more examples on old
exam files on my Acct 315 web page