Asset-Based Finance: How This Lending Model Works
An asset retirement obligation (ARO) is a term used in accounting to refer to a corporation’s legal responsibility to remove equipment or clean up hazardous chemicals when a physical, long-lived asset is retired. AROs must be included in a company’s financial statements to provide a more precise and comprehensive view of the entire worth of the business.
Acquiring Knowledge of Asset Retirement Obligations
Companies that build physical infrastructure that must be taken down before a land lease ends, such as underground fuel storage tanks at petrol stations, are sometimes subject to asset retirement obligation accounting. AROs also apply to removing dangerous substances and waste from the environment, such as decontaminating nuclear power plants. The asset is regarded as retired once the cleanup and removal process is over and the property has been returned to its original state.
An illustration of a retirement obligation for assets
Take the case of an oil drilling business that purchases a 40-year lease on a property. The business completes the drilling rig’s construction five years into the lease. When the lease expires in 35 years, this object must be removed, and the land must be cleaned up. Although doing so now costs $15,000, the cost of removal and cleanup is projected to increase by 2.5% over the following 35 years. Consequently, for this ARO, the projected future cost after inflation would be computed as follows: 15,000 * (1 + 0.025) ^ 35 = 35,598.08.
Oversight of Asset Retirement Obligations
Since determining asset retirement obligations can be difficult, businesses should obtain advice from Certified Public Accountants to guarantee compliance with the Financial Accounting Standards Board’s Rule No. 143: Accounting for Asset Retirement Obligations. To make their balance sheets more accurate, public firms must disclose the fair value of their AROs. This is a change from the traditional income-statement strategy that many firms previously employed.
How to Determine Expected Present Value for Asset Retirement Obligation
Companies should follow the iterative procedures below to calculate the estimated present value of an ARO:
- Calculate the cash flows and timing of retirement-related activities.
- Determine the risk-free rate adjusted for credit.
- Multiply the initial liability by the credit-adjusted risk-free rate applicable at the time the obligation was initially measured to account for
- Any rise in the carrying amount of the ARO liability as an accretion expenditure.
- Note any increasing trends in liability revisions and discount them at the current credit-adjusted risk-free rate.
- If liability revisions are heading lower, note this and discount the reduction at the rate used when the corresponding liability year was first recognized.
Conclusion
- It is required by contract that when long-lasting, tangible assets are retired, hazardous chemicals must be cleaned up or machinery must be taken away. This is called an asset retirement obligation (ARO).
- To reflect their total values appropriately, businesses must fully disclose their AROs on their financial accounts.
- The Financial Accounting Standards Board (FASB) regulates ARO regulations, as stated in Rule No. 143: Accounting for Asset Retirement.
