Chapter 4 — Accounting for Asset Retirement Obligations

4.5 Initial Measurement of AROs and ARCs

ASC 410-20

30-1 An expected present value technique will usually be the only appropriate technique with which to estimate the fair value of a liability for an asset retirement obligation. An entity, when using that technique, shall discount the expected cash flows using a credit-adjusted risk-free rate. Thus, the effect of an entity’s credit standing is reflected in the discount rate rather than in the expected cash flows. Proper application of a discount rate adjustment technique entails analysis of at least two liabilities — the liability that exists in the marketplace and has an observable interest rate and the liability being measured. The appropriate rate of interest for the cash flows being measured shall be inferred from the observable rate of interest of some other liability, and to draw that inference the characteristics of the cash flows shall be similar to those of the liability being measured. 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. See paragraphs 410-20-55-13 through 55-17 and Example 2 (paragraph 410-20-55-35). For further information on present value techniques, see the guidance beginning in paragraph 820-10-55-4.

AROs are initially measured at fair value. Given the lack of active markets for the transfer of such obligations, an expected present value technique will usually be the only appropriate technique with which to estimate the fair value of an ARO, which entails first estimating probability-weighted expected cash flows and then discounting such expected cash flows by using a credit-adjusted risk-free interest rate. ASC 410-20-55-13 provides the following implementation guidance related to the use of an expected present value technique:

ASC 410-20

55-13 This implementation guidance illustrates paragraph 410-20-30-1. In estimating the fair value of a liability for an asset retirement obligation using an expected present value technique, an entity shall begin by estimating the expected cash flows that reflect, to the extent possible, a marketplace assessment of the cost and timing of performing the required retirement activities. Considerations in estimating those expected cash flows include developing and incorporating explicit assumptions, to the extent possible, about all of the following:

The costs that a third party would incur in performing the tasks necessary to retire the asset
Other amounts that a third party would include in determining the price of the transfer, including, for example, inflation, overhead, equipment charges, profit margin, and advances in technology
The extent to which the amount of a third party’s costs or the timing of its costs would vary under different future scenarios and the relative probabilities of those scenarios
The price that a third party would demand and could expect to receive for bearing the uncertainties and unforeseeable circumstances inherent in the obligation, sometimes referred to as a market-risk premium.

Since 2021, there has been a trend of increasing inflation. Although the effects of inflation vary by company, recent inflationary trends should be considered in the measurement of AROs and environmental remediation liabilities.

Measuring the fair value of an ARO requires many significant management estimates and judgments and poses several practical challenges for preparers of financial statements. The next section and Section 4.5.2 highlight a few of these challenges and provide guidance to help preparers address these challenges.

4.5.1 Determining an Appropriate Discount Rate

The credit-adjusted risk-free rate referred to in ASC 410-20-30-1 (reproduced in Section 4.5) represents a risk-free interest rate adjusted for the effect of an entity’s credit standing, taking into consideration the effects of all terms, collateral, and existing guarantees on the fair value of the liability. Generally, the yield curve for U.S. Treasury securities, with a maturity matched to the expected timing of settlement of the ARO, is used to establish the appropriate risk-free rate for determining the credit-adjusted risk-free rate, even in periods when yields on U.S. Treasury notes are unusually low. For subsidiaries within a consolidated group, the discount rate (credit adjustment to the risk-free rate) should be specific to the entity that owns the long-lived asset to which the ARO is related and that is legally obligated for the asset retirement activity. However, the credit adjustment should take into consideration not only the credit standing of the entity that is legally obligated but also any other relevant facts, such as parent or brother/sister company guarantees of the entity’s obligations and other methods of providing assurance that the entity’s obligations will be paid, such as surety bonds, insurance policies, letters of credit, guarantees by other (unrelated) entities, or the establishment of trust funds or identification of other assets dedicated to satisfying the ARO.

When determining the credit adjustment to the risk-free rate, nonpublic entities should use the same sources of information for determining discount rates that they use for mark-to-market calculations or determining the incremental borrowing rates for lease accounting or other purposes. Appropriate sources of this information for nonpublic entities might include financial institutions, other lenders, or comparable public companies.

4.5.2 Estimating Cash Flows and Applying an Expected Present Value Technique

The guidance in ASC 410-20-55-13 (reproduced in Section 4.5) includes consideration of a market risk premium when an expected present value technique is applied. Accordingly, when an entity performs a marketplace assessment of the cost of conducting required retirement activities, it must consider and determine a market risk premium that would be required for a third party to assume the retirement cost obligations — that is, the premium that a market participant would demand for bearing the uncertainty associated with the cash flows. If the entity is currently unable to obtain third-party quotes for the market risk premium for the specific retirement obligation (e.g., nuclear decommissioning), it should determine the premium for similar obligations (e.g., fossil plant dismantlement) and use that market risk premium as a minimum or increase that minimum to reflect the increased risk associated with the entity’s specific retirement obligation. Predetermined percentage adjustments to retirement costs related to contingencies for unspecified additional costs or changes in estimated costs, which may commonly be used in ARO cost studies, would not be considered an acceptable third-party market risk premium estimate. Contingency adjustments should be specific to individual cost components of the estimate and not universally applied to the overall cost estimate.

Entities often incorporate the use of internal resources into their remediation plans. As previously noted, the guidance in ASC 410-20-55-13 requires the amounts included in the ARO cash flow estimate to reflect the costs that a third party would incur to conduct the retirement activities. Therefore, in addition to internal resources, entities need to consider incremental costs (e.g., overhead, equipment charges, profit margin) to ensure that the amounts included in the ARO cash flow estimate reflect the costs that a third party would incur.

Further, estimates for the demolition costs of a long-lived asset may include salvage credits for materials that can be sold. However, it is not appropriate for an entity to include estimated salvage credits when estimating expected cash flows to initially measure an ARO. ASC 410-20 applies only to “retirement” costs. Any estimated salvage value should be considered in connection with the calculation of depreciation of the related long-lived asset. The asset should be depreciated to reduce the net asset value so that it equals the estimated salvage value at the end of the asset’s useful life.

In applying an expected present value technique, entities develop cash flow assumptions on the basis of the various costs that are necessary to achieve the required level of remediation, which will most likely take into consideration several possible outcomes in terms of total remediation costs required. They then multiply those outcomes by assigned probabilities, which reflect the estimated likelihood of occurrence of each potential outcome, to calculate the estimated expected cash flows; the sum of these estimated expected cash flows constitutes the (undiscounted) ARO under an expected present value technique. Entities need to use significant judgment in both estimating costs (cash flows) for various possible outcomes and assigning probabilities to the various outcomes. For a rate-regulated entity (such as a public utility), there may be a single estimate used to calculate the retirement costs that is based on a level of effort agreed to by a governing body, such as a state utility commission or the Federal Energy Regulatory Commission.

When an expected present value technique is used, applying the probability weighting method to several possible cash flow scenarios in the application of an expected present value technique will almost certainly result in differences between actual asset retirement cash flows or their timing and the cash flows or timing incorporated into the initial measurement of an ARO. Further, incorporating third-party and marketplace assumptions into the estimate of ARO cash flows and the initial measurement of the ARO will most likely result in the recognition of gains upon the settlement of the ARO if the entity settles the obligation by using its own resources. These issues are addressed by the guidance in ASC 410-20 on subsequent recognition, subsequent measurement, and derecognition and are further discussed in Sections 4.6.1 through 4.6.3.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.