Asset Retirement Obligations Requiring Recognition

When an entity acquires, constructs, and operates assets, it often incurs obligations that are unavoidable. Much of the discussion in ASC 410-20 pertains to specialized industry applications such as offshore oil platforms, nuclear power plants, mining operations, landfills, and underground storage tanks. However, the criteria for recognizing asset retirement obligations are intended to apply to situations encountered more frequently in practice, such as in the following examples.

Accounting Considerations

Several important accounting issues merit careful consideration.

Recognition and allocation. Upon initial recognition, the entity records an increase to the carrying amount of the related long-lived asset and an offsetting liability. The entity then depreciates the combined cost of the asset and the capitalized asset retirement obligation using a systematic and rational allocation method over the period during which the long-lived asset is expected to provide benefits, taking into consideration any expected salvage value. Conceptually, this accounting treatment is an application of the matching principle in that the total investment in the asset, including the cost of its eventual retirement, is charged to expense over the periods benefited. Depending on the pattern and timing of obligating events, an entity could, under these rules, capitalize an amount of asset retirement cost during a period and, in the same period, allocate an equal amount to depreciation expense. It is important to note that, for the purpose of capitalizing interest under ASC 835-20, these additions to the carrying amounts of long-lived assets are not considered expenditures.

Impairment. Retirement obligations added to the carrying amounts of long-lived assets must be included in those carrying amounts for the purpose of testing those assets for impairment. In estimating future cash flows under the impairment rules (ASC 360-10-35), the cash flows related to settling the liability for an asset retirement obligation are to be excluded from both the undiscounted cash flows used to assess the recoverability of the asset's carrying amount and the discounted cash flows used to measure the asset's fair value.

Measurement. Asset retirement obligations are initially measured at fair value. Fair value (as defined in ASC 820 and discussed in detail in the chapter on ASC 820) is the price that would be paid to transfer the liability in an orderly transaction between market participants at the measurement date. This measurement is not based on the amount that the reporting entity (the obligor) would be required to pay to settle the liability on the measurement date (which would be difficult, if not impossible, to estimate in the absence of a market for the transfer of such obligations). Rather, the measurement assumes that the reporting entity remains the obligor under the ARO and that the obligee has transferred its rights by selling them to a hypothetical market participant on the measurement date. In determining the price it would be willing to pay for the rights associated with the ARO, a third-party market participant would consider the risk of nonperformance of the reporting entity, since that entity will continue to be the obligor after the measurement date. Thus, the fair value measurement of the obligation, under ASC 820, takes into consideration the reporting entity's own risk of nonperformance that includes, but is not limited to, the effect of its own credit standing.

FASB conforms ASC 410-20 to its fair value guidance, but when it issued FAS 143 on AROs, acknowledged that:

Rarely, if ever, would there be an observable rate of interest for a liability that has cash flows similar to an asset retirement obligation being measured. In addition, an asset retirement obligation usually will have uncertainties in both timing and amount. In that circumstance, employing a discount rate adjustment technique, where uncertainty is incorporated into the rate, will be difficult, if not impossible.

This lack of observability means that management, in order to estimate the ARO, will be required to use an expected present value technique that uses its own assumptions regarding the necessary adjustment for market risk. These are referred to as “Level 3 inputs” by ASC 820.

Initially applying an expected present value method. ASC 820-10-55 provides two alternative methods for determining expected present value. To apply Method 1, management adjusts the expected cash flows for market risk by incorporating a cash risk premium in them and uses a risk-free interest rate to discount the risk-adjusted expected cash flows. To apply Method 2, management does not adjust the expected cash flows, but instead adjusts the risk-free interest rate by incorporating a risk premium in it.

As discussed later in this section, Method 1 cannot be used to estimate the expected present value of an ARO due to computational difficulties that cannot be overcome. As a result, the following discussion, adapted from ASC 410-20, uses Method 2 to illustrate the estimation of expected present value.

Management begins by estimating a series of cash flows that reflect its marketplace estimates of the cost and timing of performing the required retirement activities. Marketplace amounts are those amounts that would be expended by the entity to hire a third party to perform the work. Explicit assumptions are to be developed and incorporated in the estimates about all of the following matters:

1. The costs that a third party would incur in performing the necessary tasks associated with retiring the asset.
2. Additional amounts that the third party would include in pricing the work, related to such factors as inflation, overhead, equipment charges, profit margins, anticipated technological advances, and offsetting cash inflows, if any.
3. The extent to which the amount of the third party's costs or their timing might differ under various future scenarios and the relative probabilities of those scenarios actually occurring.
4. The price that the third party would demand and could expect to receive for bearing the uncertainties and unforeseeable circumstances inherent in the obligation. This is referred to as a market-risk premium.

If data is available regarding assumptions that marketplace participants would make that contradict management's own assumptions, management must adjust its assumptions accordingly. For example, if the costs of labor in the marketplace exceed those of the entity, the higher marketplace costs are to be used in the cash flow estimates. Even if the entity can and will retire the asset using internal resources, the obligation must be computed as if a third party will be retained to perform the work, including provisions for recovery of the contractor's overhead and profit.

The discount rate to be used in the present value calculations is the credit-adjusted risk-free rate that adjusts a risk-free rate of interest for the effects of the entity's own credit standing. The risk-free interest rate is the interest rate on monetary assets with maturity dates or durations that coincide with the period covered by the estimated cash flows associated with the ARO. When the measurement involves cash flows denominated in U.S. dollars, the yield curve for U.S. Treasury securities is used.

In adjusting the risk-free rate for the entity's credit standing, the entity takes into account the effects on the fair value estimate of all terms, collateral, and existing guarantees. In ASC 820, FASB indicated that it believed, when it issued ASC 410, that it would be more practical for management to reflect an estimate of its own credit standing as an adjustment to the risk-free rate rather than as an adjustment to the expected cash flows. In fact, based on the model FASB chose to account for subsequent upward and downward changes in the ARO, ASC 410 would not be operational unless the adjustment for credit standing was made to the risk-free interest rate.

As a practical matter, for companies whose debt is not rated by a bond-rating agency, the adjustment for credit standing may be difficult to establish. For such companies, the incremental borrowing rate used for lease testing may serve as an acceptable approximation of the credit-adjusted risk-free rate.

The ARO may be incurred in one or more of the entity's reporting periods. Each period's incremental liability incurred is recognized as a separate liability and is estimated using these principles based on market and interest rate assumptions existing in the period of recognition.

ASC 410-20 clarifies that an ARO is required to be recognized when incurred (or acquired), even if uncertainty exists regarding the timing and/or method of eventually settling the obligation. In effect, ASC 410-20 distinguishes between a contingency and an uncertainty. If the obligation to perform the retirement activities is unconditional, the fact that uncertainty exists regarding the timing and/or method of retirement does not relieve the reporting entity of the requirement to estimate and record the obligation if, in fact, it is reasonably estimable. The assumptions regarding the probabilities of the various outcomes used in the computation are to take into account that uncertainty. An ARO is considered reasonably estimable if:

1. It is evident that the obligation's fair value is included in an asset's acquisition price,
2. An active market exists for the transfer of the obligation, or
3. Sufficient information is available to enable the use of the CON 7 expected present value technique to estimate the obligation.

Sufficient information is considered to be available to reasonably estimate the obligation if either:

1. The settlement date and method of settlement have been specified by others (e.g., the end of a lease term or the end of a statutory period), or
2. Information is available to reasonably estimate:
   1. The settlement date or range of potential settlement dates
   2. The settlement method or potential settlement methods
   3. The probabilities of occurrence of the dates and methods in a. and b.

The information necessary to make these estimates can be based on the reporting entity's own historical experience, industry statistics or customary practices, management's own intent, or estimates of the asset's economic useful life.

The determination of fair value for an ARO may be difficult, especially if the volume and level of activity for the asset or liability have significantly decreased to the extent where there are few recent transactions or price quotations vary substantially. If so, it may be necessary to use multiple valuation techniques, and select a point within the derived range of values that is most representative of fair value.

Even if management concludes that sufficient information does not exist to record the obligation at inception, management is expected to continuously consider whether this remains true in future accounting periods, and to recognize the obligation in the first period when sufficient information becomes available to enable the fair value estimate.

Accounting in Subsequent Periods

After the initial period of ARO recognition, the liability will change as a result of either the passage of time or revisions to the original estimates of either the amounts of estimated cash flows or their timing. Such changes can arise due to the effects of inflation, changes in the probabilities used in the original estimate, changes in interest rates, changes in laws, regulations, statutes, and contracts.

ASC 410-20 does not require detailed cash flow estimates every reporting period, but rather allows the exercise of judgment as to when facts and circumstances indicate that the initial estimate requires updating.

If a change to the liability is deemed necessary, it is recognized by first adjusting its carrying amount for changes due to the passage of time (referred to as accretion and discussed in detail below) and then, if applicable, for changes due to revisions in either amounts or timing of estimated cash flows.

Changes due to the passage of time increase the carrying amount of the liability because there are fewer periods remaining from the initial measurement date until the settlement date; thus, the present value of the discounted future settlement amount increases. These changes are recorded as a period cost called accretion expense and classified separately in the operating section of the statement of income (or not-for-profit statement of activities). Accretion is computed using an interest method of allocation that results in periodic accretion expense that represents a level effective interest rate applied to the carrying amount of the liability at the beginning of each period. The effective interest rate used to calculate accretion is the credit-adjusted risk-free rate or rates (or incremental borrowing rate) applied when the liability or portion of the liability (as explained below) was initially measured and recognized. Accretion expense is not combined with interest expense, and is not considered interest cost for the purpose of applying the interest capitalization criteria of ASC 835-20.

Changes in the ARO that result from changes in the estimates of the timing or amounts of future cash flows are accounted for differently for increases and decreases. If the expected present value increases, the increase gives rise to a new obligation accounted for separately just as the ARO was originally measured but using current market value assumptions, and the current credit-adjusted risk-free rate. Thus, over time, a particular long-lived asset may have multiple layers of obligations associated with it that are based on different assumptions measured at different dates during the asset's useful life. The incremental obligation is recorded by increasing the recorded ARO and capitalizing the additional cost as a part of the carrying amount of the related long-lived asset. If multiple layers have been recorded and it is not practical to separately identify the period (or layer) to which subsequent revisions in estimated cash flows relate, management is permitted to use a weighted-average credit-adjusted risk-free rate to measure the change in the liability resulting from that revision.

If, however, the expected present value subsequently decreases, the difference between the remeasured amount and the carrying amount of the liability (after adjustment for inception-to-date accretion) is recorded as a gain in the current period. In this case, the previously recognized layers of liabilities are reduced pro rata so as not to affect the overall effective rate of accretion over the remaining life of the obligation.

For the purposes of measurement in subsequent periods, in the unlikely event that an entity originally determined its ARO based on available market prices rather than using the expected present value method, it would be required to determine the undiscounted cash flows embedded in that market price. This process is analogous to computing the rate of interest implicit in a lease.

If the increase in carrying amount of the affected long-lived asset resulting from the remeasurement of ARO in a subsequent period impacts only that period, then the increase is fully depreciated in that period. Otherwise, the increase is depreciated in the period of change and future periods as a change in estimate in accordance with ASC 250. Both depreciation and accretion are classified as operating expenses in the statement of income.

Other Provisions

Other provisions of ASC 410 affect the calculation of the credit-adjusted rate as well as how it is to be applied by rate-regulated entities.

Funding and assurance provisions. Factors such as laws, regulations, public policy, the entity's creditworthiness, or the sheer magnitude of the future obligation may cause an entity to be required to provide third parties with assurance that the entity will be able to satisfy its ARO in the future. Such assurance is provided using such instruments as surety bonds, insurance policies, letters of credit, guarantees by other entities, establishment of trust funds, or by custodial arrangements segregating other assets dedicated to satisfying the ARO. Although providing such means of assurance does not satisfy the underlying obligation, the credit-adjusted interest rate used in calculating the expected present value is adjusted for the effect on the entity's credit standing of employing one or more of these techniques.

Rate-regulated entities. Many rate-regulated entities (as defined in ASC 980 and discussed in the chapter on ASC 980) follow current specialized accounting that capitalizes costs not otherwise afforded that treatment under GAAP. These entities recover these additional costs in the rates that they charge their customers. These additional capitalized costs may or may not meet the definition of ARO under ASC 410. The differences in the amounts and timing of assets and liabilities between GAAP and regulatory accounting used for rate-making purposes give rise to temporary differences and the resultant deferred income tax accounting.

ASC 410 provides that, if the criteria in ASC 980 are met, the rate-regulated entity is to recognize a regulatory asset or liability for differences in the timing of recognition of the period costs associated with ARO for financial reporting and rate-making purposes. Accounting for the ARO arising from closed or abandoned long-lived assets of rate-regulated entities is covered by ASC 980-360.

Electronic Equipment Waste Obligations

ASC 720-40 prescribes the proper treatment of electronic equipment waste obligations. See the Chapter on ASC 720 for more information.

Environmental Remediation Liabilities

Obligations arising from pollution of the environment have become a major cost for businesses. ASC 410-30 sets forth a very detailed description of relevant laws, remediation provisions, and other pertinent information, which is useful to auditors as well as to reporting entities. In terms of accounting guidance, ASC 430-20 contains the principal rules with respect to accounting for environmental obligations (e.g., determining the threshold for accrual of a liability, etc.) and it sets “benchmarks” for liability recognition. The benchmarks for the accrual and evaluation of the estimated liability (i.e., the stages which are deemed to be important to ascertaining the existence and amount of the liability) are:

1. The identification and verification of an entity as a potentially responsible party (PRP), since ASC 410-30 stipulates that accrual is to be based on the premise that expected costs will be borne by only the “participating potentially responsible parties” and that the “recalcitrant, unproven and unidentified” PRP will not contribute to costs of remediation
2. The receipt of a “unilateral administrative order”
3. Participation, as a PRP, in the remedial investigation/feasibility study (RI/FS)
4. Completion of the feasibility study
5. Issuance of the Record of Decision (RoD)
6. The remedial design through operation and maintenance, including postremediation monitoring.

   (ASC 410-30-25-15)

The amount of the liability that is to be accrued is affected by the entity's allocable share of liability for a specific site and by its share of the amounts related to the site that will not be paid by the other PRP or the government. The categories of costs to be included in the accrued liability include incremental direct costs of the remediation effort itself, as well as the costs of compensation and benefits for employees directly involved in the remediation effort. Costs are to be estimated based on existing laws and technologies and are not to be discounted to estimated present values unless timing of cash payments is fixed or reliably determinable.

Incremental direct costs will include such items as fees paid to outside law firms for work related to the remediation effort, costs relating to completing the RI/FS, fees to outside consulting and engineering firms for site investigations and development of remedial action plans and remedial actions, costs of contractors performing remedial actions, government oversight costs and past costs, the cost of machinery and equipment dedicated to the remedial actions that do not have an alternative use, assessments by a PRP group covering costs incurred by the group in dealing with a site, and the costs of operation and maintenance of the remedial action, including costs of postremediation monitoring required by remedial action plan.

ASC 410-30 states that potential recoveries cannot be offset against the estimated liability, and further notes that any recovery recognized as an asset is to be reflected at fair value, which implies that only the present value of future recoveries can be recorded. It is presumed that the costs are operating in nature and thus cannot normally be included in the “other income and expense” category of the income statement, either. Disclosure of accounting policies regarding recognition of the liability and of any related asset (for recoveries from third parties) is also needed, where pertinent.