Asset Retirement Obligations

FASB 143

FASB 143 Scope

• Applies to legal obligations associated with the retirement of a tangible long-lived asset resulting from

• Acquisition Construction, or developmentNormal 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

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 long-lived 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&EAsset

Retirement Obligation

$100,000$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 credit-

adjusted risk-free discount rate– Downward revisions: use original credit-

adjusted risk-free discount rate• Or a weighted-average historical discount rate

Accounting for revised estimate of clean-up cost

Estimated costs increase (use new rate)

Estimated costs decrease(use orig. rate)

Long-lived asset account Debit Credit

Asset retirement obligation

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

Transition

• Effective for fiscal years beginning AFTER June 15, 2002

• Companies will have to retroactively recognize ARO assets and liabilities.

• The effect on current year will be included in operating income

• The effect on prior years will be presented net of tax as a cumulative effect of a change in accounting principle

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

Probability assessment

Expected Cash Flows

$300,000 25%

$375,000 50%

$450,000 25%

ARO Example 1

Labor Cost – estimated cash

flows

Probability assessment

Expected Cash Flows

$300,000 25% 75,000

$375,000 50% 187,500

$450,000 25% 112,500

375,000

ARO Example 1

Expected labor & material costs $ 460,000 Allocated overhead 300,000

Direct costs 760,000 Markup on direct costs 152,000 Expected CF before inflation 912,000

This amount is in today’s dollars. We need to allow for inflation. We can

use a PV calculator to do it.

$375,000 labor + $85,000 materials

ARO Example 1

• PV = 912,000

• n=12 years

• i= 3% (expected inflation rate)

• FV = ?

• $1,300,294

ARO Example 1

Inflation adjusted cash flow 1,300,294 Market risk premium (7%) 91,021 Expected CF at closure of landfill 1,391,315

This amount is now in future dollars, an estimate of what we will actually have to pay to restore the landfill.

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

• 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

Year ARO – beginning

Accretion Expense

Depreciation Expense

2003 357,116 42,854 129,760

2004 129,760

2005 129,760

2006 129,760

399,970 47,996

357,116 + 42,854OR find PV for

FV=1,391,315 n=11, i=12%, pmt=0

399,970 * 12%

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 1Year ARO - BOY

Accretion Expense

Depreciation Expense

Total Expense

2003 357,116 42,854 129,760 172,614 2004 399,970 47,996 129,760 177,756 2005 447,966 53,756 129,760 183,516 2006 501,722 60,207 129,760 189,966 2007 561,929 67,431 129,760 197,191 2008 629,360 75,523 129,760 205,283 2009 704,883 84,586 129,760 214,346 2010 789,469 94,736 129,760 224,496 2011 884,206 106,105 129,760 235,864 2012 990,310 118,837 129,760 248,597 2013 1,109,147 133,098 129,760 262,857 2014 1,242,245 149,069 129,760 278,829 2015 1,391,315 1,034,199 1,557,116 2,591,315

Note that when we get to 1/1/2015, the

liability account will equal the expected

future cash flows we predicted when we

acquired the land fill

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.

ARO Example 2

• Joseph Company acquired a tract of land containing an extractable natural resource. Joseph is required by the purchase contract to restore the land to a condition suitable for recreational use after it has extracted the natural resource. Geological surveys estimate that the recoverable reserves will be 2,500,000 tons and that the land will have a value of $1,000,000 after restoration.

ARO Example 2

• Relevant cost information follows:– Land $9,000,000– Asset retirement obligation

1,500,000

• a. What should be the depletion charge per ton of extracted material?

• 9,000,000 + 1,500,000 ARO – 1,000,000 RV 2,500,000 tons

• = 3.80 per ton

ARO Example 2

• b. If the beginning balance in the asset retirement obligation (liability) account is $1,500,000 at 1/1/01 and the credit-adjusted risk-free discount rate used to determine the ARO was 8%, what accretion expense be for 2001 and 2002?

•  For 2001: 1,500,000 * .08 = $120,000 accretion expense

• Accretion expense would INCREASE the liability account

ARO Example 2

• A schedule would look like this:

•  

DateAccretion Expense

(8%)

ARO Liability

Balance fwd 1,500,000

12/31/2001 120,000 1,620,000

12/31/2002 129,600 1,749,600

ARO Example 3

• Here is one more practice problem.

• Please do the solution for homework

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. 

Impairmentloss = excessof BV over FV

No impairmentrecorded. Usecarrying value.

FASB 144 - Impairment ofAssets To Be Held and Used

No

Yes

Yes

Eventsindicate possible

impairment?

Is BV >undiscountedfuture CFs?

Yes Yes

No

Can FV beestimated based on

MV of similarassets?

Find FV bydiscountingfuture cashflows (CFs)

No

No

Quoted market prices

availablefor FV?

Triggering Event

Determining fair value

• FASB 144 describes a probability-weighted 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 year5. Asset is being actively marketed for a

reasonable price6. 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 $1,000,000• Accumulated depreciation 360,000

($45,000 * 8 years) • Book value $ 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 360,000•  Loss on Impairment 400,000•    Equipment 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