Print Сite this

Asset Retirement Obligations

Introduction

Asset retirement obligations imply liabilities to meet out the potential adverse effects on decommissioning and dismantling of long-lived assets upon the retirement of such assets. Such retirements may be at the end of the useful life of the asset or earlier following some contractual obligations. For example, in the automotive industry, infrastructural facilities like rail lines may be laid down from main transportation terminals up to the manufacturing hub in order to receive uninterrupted supplies of steel and other heavy raw materials, and also to deliver uninterruptedly the supplies manufactured from manufacturing hub up- to main terminals. The removal of such long-lived assets upon decommissioning, dismantling, or retirement often involves certain legal, contractual, and other compliances besides the costs of removing the facilities, and thus are known as Assets Retirement Obligations (AROs). Diverse accounting practices existed earlier for dealing with AROs. SFAS 143 has standardized the financial accounting and reporting practices for these asset’s retirement obligations. In this write, an in-depth study has been undertaken to analyze the dictums and recommendations of SFAS 143.

We will write a
custom essay
specifically for you

for only $16.05 $11/page
308 certified writers online
Learn More

Asset Retirement Obligations

Long-lived tangible assets involve costs and other obligations for the entity to meet at the end of their useful life or early retirements. These costs and other obligations are called Asset Retirement Obligations. Cheri Reither Mazza (2003) states that “Although a company may not pay cash until an asset is physically retired, it may nonetheless be committed to incur those costs prior to that time – sometime from the date of acquisition. In an accounting sense, such obligations are ‘real’ liabilities when they meet the definition in FASB Concepts Statement 6, Elements of Financial Statements:

Liabilities are probable future sacrifices of economic benefits arising from the present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events.

SFAS 143 applies to only enforceable retirement obligations that result from the acquisition, construction, development, or normal operation of a long-lived asset. Examples include a contractual obligation to tear down a manufacturing facility upon retirement or a legal obligation to decontaminate a nuclear power plant at the end of operating life. The former obligation would be incurred upon the construction of the manufacturing facility. The later obligation would be incurred throughout the operating life of the power plant as it is contaminated with nuclear waste.”

Objectives of SFAS 143

The most important objective of SFAS 143 is to seek uniformity in the application of accounting techniques used by different industries in dealing with assets retirement obligations. Prior to SFAS 143, diverse accounting practices were being used by different industries in dealing with AROs. One of those practices was depreciation-based accounting. Another accounting practice was not to recognize the liability for asset retirement obligations till the expiry of the useful life of long-lived assets.

Under depreciation-based accounting, the estimated undiscounted cash flows of AROs were added to the depreciation base (adjusted with salvage value) of the assets to be written off over the period of the useful life of the long-lived asset. The major defect of this deprecation-based accounting was that this system did not recognize timing differences as depreciation-based accounting brings in only the flat line recognition of asset retirement expenses.

SFAS 143 suggested liability-based accounting for dealing with assets retirement obligations. Liability-based accounting brings in an upward-trend expense line recognition of AROs. This is because liability-based accounting, as suggested by FASB 143, comprises straight-line depreciation and ever-increasing interest accretion using the passage of time technology, that is, the time value of money.

Get your
100% original paper
on any topic

done in as little as
3 hours
Learn More

The other objective of SFAS 143 is to make entities recognize the liabilities of asset retirement obligations as and when those liabilities are incurred. As stated earlier, most industries were not recognizing such liabilities till the expiry of the useful life of long-lived assets. The result of such practices was that the liabilities for AROs were not consistently measured and presented in the financial statements. The SFAS 143 sought measures to fill in this limitation of financial accounting in order to keep financial statements truly representative of transactions of the entity. In the language of SFAS 143

  • Retirement obligations will be recognized when they are incurred and displayed as liabilities. Thus more information on future cash outflows, leverage, and liquidity will be provided. Also, an initial measurement at fair value will provide relevant information about liabilities.
  • Because the asset retirement cost is capitalized as part of the assets carrying amount and subsequently allocated to expenses over the asset’s useful life, information about gross investments in long-lived assets will be provided.” (SFAS 143, page 143-2)

Modus operendi of SFAS 143

SFAS 143 is applicable to liabilities relating to Asset Retirement Obligations (AROs) of only long-lived tangible assets. Intangible assets are not affected as retirement costs are mainly attached with tangible long-lived assets.

The entities are required to recognize the liabilities for AROs as soon such liabilities are incurred in case of tangible long-lived assets. Those may be incurred at the inception of the assets and, in some cases, may also be incurred or continue to be incurred in subsequent reporting periods.

Fair value is the basis of measurement of AROs liabilities using information from markets available for discharging such costs, or at present values of estimated cash flows discounted using relevant adjusting factors and at a credit adjusted risk-free rate.

The recognition process is a liability- based. The carrying value of long-lived assets is enhanced with a fair value of AROs with the corresponding effect on liabilities for AROs in the period such liabilities are incurred. The estimates of such liabilities may be revised in subsequent periods on passage of time and/ or revision of original cash outflows basis.

Such capitalized costs of AROs are written off to income statement over the useful life of long-lived assets using some appropriate method, and changes resulting from the operation of the passage of time are written off to income statement in the same period with an increase in liability for AROs.

Liability-based recognition and measurement of AROs

The basic idea of the SFAS 143 pronouncement is that liability for asset retirement obligations should be recognized as and when those are incurred. AROs are incurred by different industries at different times. Some incur AROs at the inception of the asset, and others incur during the operating life of the asset. For example, in the mining industry, reclamation obligation is incurred as and when the land is dug, i.e., during the lifetime of the mining contract. On the other hand, the offshore oil and gas production industry incur such obligations at the inception of such a project.

We will write a custom
essays
specifically
for you!
Get your first paper with
15% OFF
Learn More

In this regard paragraph, 3 of SFAS 143 suggests that liability for ARO should be recognized in the period in which it is incurred only if the fair value of ARO is assessable at that time; otherwise, it should be recognized in the reporting period when the information for the fair value of ARO is made available.

The method suggested by SFAS 143 to recognize the liability for ARO at the inception of the asset is to capitalize the ARO cost by increasing the carrying value of the concerned asset and subsequently writing off this ARO cost as an expense over the period of the useful life of the asset (maybe starting from the period of recognition itself) using an appropriate allocation method.

However, when the liability of ARO is incurred in a later reporting period or in more than one reporting period after the inception of the long-lived asset, then as per SFAS 143, the same should be recognized in the reporting period or periods of its incurrence measured only at fair value. If such incurrence of AOR in subsequent years is in addition to earlier recognition of AOR, then such additional incurrence will be considered as an additional layer to the originally recognized liability.

During the subsequent period, the entity can make a revision to the initially recognized cost of ARO resulting either from the passage of time and/ or revision of original estimates made initially on the basis of undiscounted cash flows. The changes resulting from the passage of time shall be measured using credit- adjusted risk-free interest rate applicable at the initial recognition of ARO. The important thing to note is that this amount shall be recognized by increasing the carrying value of a liability for ARO and as an operating expense for the period called accretion expense.

But the changes resulting from the revision of original estimates of liability of ARO, made initially at undiscounted cash flow basis as stated above, shall be recognized by increasing or decreasing the carrying amount of liability for ARO with the corresponding effect on the carrying value of the concerned long-lived asset. If the revision is upward, then the undiscounted cash flow of estimates shall be discounted using the current credit-adjusted risk-free rate. However, if there is a downward revision, then undiscounted cash flow shall be discounted at a credit-adjusted risk-free rate that existed at the time of initial recognition of liability. In case the prior period to which downward revision relates cannot be identified, then the entity can use weighted average credit adjusted risk-free rate for discounting cash flows to estimate future cash flows. As a consequence, the entity will have to change the allocated retirement costs in the period or periods and future periods if the change affects more than one period.

Fair Values as the basis of measurement

Under SFAS 143, liabilities for AROs are measured on the basis of their fair values. When entities find it difficult to evaluate the liabilities of AROs at fair values, the recognition is deferred till the reporting period during which the fair values for liabilities of AROs are adequately measurable. But under the circumstances where the market for measuring the fair value of such liabilities does not exist, the estimation at present value basis has also been permitted.

In order to determine the fair value of a liability for AROs, SFAS 143 requires entities to make cash outflow estimates for settling assets retirement obligations and adjust those estimates with information and assumptions used in the market. But under no circumstances such cash flows are to be influenced by proprietary information and internal cost flow structures when such cash flows differ materially from the market valuation of cash flows.

The estimation of cash outflows to meet the asset’s retirement obligations is bound to be affected by timing differences, but the entities are also required to estimate such cash flows using all relevant information like inflation rates, technological advances, profit margins, and other factors that may offset the cash flows. The entities should discount cash flows using all assumptions, probabilities, and uncertainties envisaged by the entities. The rate of discounting has to be a credit adjusted risk-free credit rate.

Need a
100% original paper
written from scratch

by professional
specifically for you?
308 certified writers online
Learn More

Effects on financial statements

SFAS 143 will affect the financial statements of an entity in a number of following ways as described in the standard:

  • Total liabilities generally will increase because more retirement obligations will be recognized. For some entities, obligations will be recognized earlier, and they will be displayed as liabilities rather than contra- assets. In certain cases, the amount of a recognized liability may be lower than the recognized in current practice because a fair value measurement entails discounting.
  • The recognized costs of assets will increase because asset retirement costs will be added to the carrying amount of long-lived assets. Assets also will increase because assets acquired with an existing retirement obligation will be displayed on gross rather than on a net basis.
  • The amount of expense (accretion expense and depreciation expense) will be higher in later years of an asset’s life than in earlier years.” (SFAS 143 page 143-3).

Conclusion

The amended SFAS 143 is equipped well to bring uniformity in accounting practices of dealing with liabilities relating to asset retirement obligations. The main emphasis is that these liabilities should be recognized as and when those are incurred. The fair value method of measuring such liabilities has been suggested. But in the absence of a market to estimate fair values, the present value method of discounting cash flows can also be adopted. The discounting rate suggested is a credit-adjusted risk-free rate besides other factors affecting the discounting process. Application of SFAS 143 will provide financial statements true picture of liabilities relating to asset retirement obligations.

References

Cheri Reither Mazza, SFAS 143 on Asset Retirement Obligations, The CPA Journal, 2003. Web.

Statement of Financial Accounting Standards 143 as amended, Summary, page 143-2, viewed in 2008, Web.

ibid, page SFS 143-3.

Cite this paper

Select style

Reference

StudyCorgi. (2021, October 20). Asset Retirement Obligations. Retrieved from https://studycorgi.com/asset-retirement-obligations/

Reference

StudyCorgi. (2021, October 20). Asset Retirement Obligations. https://studycorgi.com/asset-retirement-obligations/

Work Cited

"Asset Retirement Obligations." StudyCorgi, 20 Oct. 2021, studycorgi.com/asset-retirement-obligations/.

1. StudyCorgi. "Asset Retirement Obligations." October 20, 2021. https://studycorgi.com/asset-retirement-obligations/.


Bibliography


StudyCorgi. "Asset Retirement Obligations." October 20, 2021. https://studycorgi.com/asset-retirement-obligations/.

References

StudyCorgi. 2021. "Asset Retirement Obligations." October 20, 2021. https://studycorgi.com/asset-retirement-obligations/.

References

StudyCorgi. (2021) 'Asset Retirement Obligations'. 20 October.

This paper was written and submitted to our database by a student to assist your with your own studies. You are free to use it to write your own assignment, however you must reference it properly.

If you are the original creator of this paper and no longer wish to have it published on StudyCorgi, request the removal.