4.6 Subsequent Measurement of AROs and ARCs
The subsequent measurement guidance in ASC 410-20-35-1 through 35-8 is reproduced below.
ASC 410-20
Allocation of Asset Retirement Cost
35-1 A liability for an asset retirement obligation may be incurred over more than one reporting period if the
events that create the obligation occur over more than one reporting period. Any incremental liability incurred
in a subsequent reporting period shall be considered to be an additional layer of the original liability. Each layer
shall be initially measured at fair value. For example, the liability for decommissioning a nuclear power plant is
incurred as contamination occurs. Each period, as contamination increases, a separate layer shall be measured
and recognized. Paragraph 410-20-30-1 provides guidance on using that technique.
35-2 An entity shall subsequently allocate that asset retirement cost to expense using a systematic and rational
method over its useful life. Application of a systematic and rational allocation method does not preclude an
entity from capitalizing an amount of asset retirement cost and allocating an equal amount to expense in the
same accounting period. For example, assume an entity acquires a long-lived asset with an estimated life of
10 years. As that asset is operated, the entity incurs one-tenth of the liability for an asset retirement obligation
each year. Application of a systematic and rational allocation method would not preclude that entity from
capitalizing and then expensing one-tenth of the asset retirement costs each year.
35-3 In periods subsequent to initial measurement, an entity shall recognize period-to-period changes in the
liability for an asset retirement obligation resulting from the following:
- The passage of time
- Revisions to either the timing or the amount of the original estimate of undiscounted cash flows.
35-4 An entity shall measure and incorporate changes due to the passage of time into the carrying amount of
the liability before measuring changes resulting from a revision to either the timing or the amount of estimated
cash flows.
35-5 An entity shall measure changes in the liability for an asset retirement obligation due to passage of time
by applying an interest method of allocation to the amount of the liability at the beginning of the period. The
interest rate used to measure that change shall be the credit-adjusted risk-free rate that existed when the
liability, or portion thereof, was initially measured. That amount shall be recognized as an increase in the
carrying amount of the liability and as an expense classified as accretion expense. Paragraph 835-20-15-7
states that accretion expense related to exit costs and asset retirement obligations shall not be considered to
be interest cost for purposes of applying Subtopic 835-20.
35-6 The subsequent measurement provisions require an entity to identify undiscounted estimated cash flows
associated with the initial measurement of a liability. Therefore, an entity that obtains an initial measurement
of fair value from a market price or from a technique other than an expected present value technique must
determine the undiscounted cash flows and estimated timing of those cash flows that are embodied in that fair
value amount for purposes of applying the subsequent measurement provisions. Example 1 (see paragraph
410-20-55-31) provides an illustration of the subsequent measurement of a liability that is initially obtained
from a market price. (See paragraph 410-20-25-14 for a discussion on conditional outcomes.)
35-7 Paragraph 410-20-25-14 explains how uncertainty surrounding conditional performance of a retirement
obligation is factored into its measurement by assessing the likelihood that performance will be required. As
the time for notification approaches, more information and a better perspective about the ultimate outcome
will likely be obtained. Consequently, reassessment of the timing, amount, and probabilities associated with the
expected cash flows may change the amount of the liability recognized. See paragraphs 410-20-55-18 through
55-19.
Change in Estimate
35-8 Changes resulting from revisions to the timing or the amount of the original estimate of undiscounted cash flows shall be recognized as an increase or a decrease in the carrying amount of the liability for an asset retirement obligation and the related asset retirement cost capitalized as part of the carrying amount of the related long-lived asset. Upward revisions in the amount of undiscounted estimated cash flows shall be discounted using the current credit-adjusted risk-free rate. Downward revisions in the amount of undiscounted estimated cash flows shall be discounted using the credit-adjusted risk-free rate that existed when the original liability was recognized. If an entity cannot identify the prior period to which the downward revision relates, it may use a weighted-average credit-adjusted risk-free rate to discount the downward revision to estimated future cash flows. When asset retirement costs change as a result of a revision to estimated cash flows, an entity shall adjust the amount of asset retirement cost allocated to expense in the period of change if the change affects that period only or in the period of change and future periods if the change affects more than one period as required by paragraphs 250-10-45-17 through 45-20 for a change in estimate.
4.6.1 Capitalized ARCs
In subsequently accounting for the ARC capitalized as part of the tangible
long-lived asset to which the ARO is related, an
entity is required under ASC 410-20-35-2 to
allocate that ARC to expense by using a systematic
and rational method over the asset’s useful life,
which generally means that the ARC should be
depreciated along with the related long-lived
asset over the remaining economic useful life of
the asset. However, this guidance does not
preclude an entity from capitalizing an ARC and,
depending on the facts and circumstances related
to the ARO, allocating an equal amount to expense
in the same accounting period.
The examples below illustrate the subsequent recognition of ARCs as an expense
over future periods.
Example 4-2
Company P owns several forests that are used in its production of paper. The company is under legal obligation to plant a tree for each tree it cuts down as part of retiring the asset (i.e., the forest). It plants a replacement tree concurrently with cutting down a tree.
The obligating event (cutting down trees) occurs in the current period
regardless of whether the company plants the new
trees immediately or waits until the end of the
entire forest’s useful life. If the company elects
to plant the replacement tree immediately, the ARO
will equal the current cost of planting the
replacement tree. Since the company elects to
plant the replacement tree in the same period in
which it cuts down a tree, it is appropriate for
the company to allocate an equal amount of the ARC
to expense in the same accounting period.
Example 4-3
A limited-life partnership has been formed to mine minerals for the next 20
years. The partnership is legally responsible for
the reclamation of the mine and the land upon
termination of the partnership (i.e., in 20
years). In accordance with its legal obligation,
the partnership has recorded an ARO and
corresponding ARC for the present value (using 20
years) of the reclamation costs. The useful life
of the mine is expected to extend for 50
years.
Expensing reclamation costs over the life of the partnership is appropriate in this situation. Before the guidance in ASC 410-20 became effective, industry practice for coal mines was to accrue reclamation costs over the life of the mine. In this case, the reclamation costs are required at the end of the partnership agreement. The useful life of the mine is expected to extend beyond the life of the partnership; however, since the partnership is required to perform the reclamation of the mine at the termination of the partnership agreement, the amortization period of the reclamation costs would be limited to the term of the agreement.
Connecting the Dots
In accordance with ASC 360-10-35-17 (which addresses accounting for the
impairment of long-lived assets), an asset
impairment loss is recorded only when the carrying
amount of an asset is not recoverable and exceeds
the asset’s fair value. The carrying amount of a
long-lived asset is not recoverable if it exceeds
the sum of the undiscounted cash flows expected to
result from the use and eventual disposition of
the asset. An impairment loss should be measured
as the amount by which the carrying amount of a
long-lived asset exceeds its fair value. When
performing the impairment calculation, an entity
should include capitalized ARCs in the evaluation
of the asset. However, the estimated future cash
flows related to the ARO should be excluded from
(1) the undiscounted cash flows used to test the
asset for recoverability and (2) the discounted
cash flows used to measure the asset’s fair
value.
Further, in allocating the purchase price to a long-lived asset acquired and the related ARO
assumed in a business combination transaction accounted for under ASC 805, an entity should
measure and record both of the following:
- The ARO based on the fair value of the liability by using the credit-adjusted risk-free rate as of the acquisition date.
- The associated long-lived asset at fair value without considering any future cash outflows associated with the asset retirement activities and without adjustment to add the amount of the ARO.
4.6.2 Changes in an ARO Due to the Passage of Time
An entity is required to measure changes in an ARO due to the passage of time by using the interest
method of allocation. The interest method of allocation requires an entity to use the credit-adjusted
risk-free interest rate it used on the initial measurement date when it recognizes subsequent changes
in the ARO. The amount is recognized as an increase (i.e., a credit) to the ARO, with the offsetting entry
recorded in the income statement. The amount recorded in the income statement must be classified as
an operating item and cannot be classified as interest expense. ASC 410-20-35-5 refers to this expense
as accretion expense.
To calculate the accretion expense, an entity multiplies the ARO balance at the
beginning of the period by the credit-adjusted risk-free rate that existed when
the ARO was initially recognized and, to the extent relevant, the
credit-adjusted risk-free rate(s) from subsequent remeasurements. If an ARO is
to be adjusted for both the passage of time and a revision of the estimated cash
flows, the accretion expense due to the passage of time must be recognized
first.
4.6.3 Changes in the Timing or Amount of Expected Cash Flows
When there is a change in the estimated timing or amount of expected cash flows
of the retirement activity, the carrying amount of
the liability should be adjusted either upward (as
an increase in the ARO) or downward (as a decrease
in the ARO), with the offset recorded as an
increase or decrease in the related capitalized
ARC. To calculate changes in the estimated timing
or amount of expected cash flows that result in
upward revisions to an ARO, an entity should use
its then-current credit-adjusted risk-free
interest rate. That is, the credit-adjusted
risk-free rate in effect when the change occurs
would be used to discount the revised estimate of
the incremental expected cash flows of the
retirement activity. However, if a change in the
estimated timing or amount of expected cash flows
results in a downward revision of an ARO, an
entity should discount the undiscounted revised
estimate of expected cash flows by using the
credit-adjusted risk-free rate that was in effect
on the date of initial measurement and recognition
of the original ARO and, to the extent relevant,
the credit-adjusted risk-free rate(s) from
subsequent remeasurements. The examples below
illustrate this concept.
Example 4-4
Assume that the undiscounted cost to perform a retirement activity 10 years from now is $100 and that the current credit-adjusted discount rate is 5 percent. The present value of the ARO would be accreted at 5 percent per year until year 10. In year 4, on the basis of updated information, the undiscounted cost to perform the retirement activity has increased by $5. The present value of the $5 would become a new cost layer that would be accreted at the then-current credit-adjusted discount rate (i.e., the credit-adjusted discount rate in year 4) until year 10.
Example 4-5
Assume the same facts as in the example above, except that in year 4, the
estimated undiscounted cost to perform the
retirement activity has decreased by $5. The $5
reduction in undiscounted cash flows is simply
deducted from the original year 1 layer of
undiscounted cash flows. The original 5 percent
credit-adjusted discount rate is used for the one
single layer.
Determining the appropriate unit of account for the ARO is essential to ensuring that increases and decreases
in undiscounted cash flows or timing of cash flows are appropriately reflected in new layers or deducted from
the appropriate existing layers. It is important for an entity to carefully define the ARO unit of account in the
year the ARO is incurred to properly account for subsequent changes in estimates.
When an entity is unable to identify the appropriate prior period to which downward adjustments of an ARO are related, it would be appropriate for that entity to use a weighted-average credit-adjusted risk-free rate to discount the revised estimated expected cash flows.
Connecting the Dots
There is no explicit guidance in ASC 410-20 on the frequency with which an ARO should be reassessed to determine whether there have been changes in the estimated amount or timing of cash flows. In the absence of specific guidance, an entity should evaluate whether there are any indicators that would suggest that a change in the estimate of the ARO is necessary. Events or changes in circumstances that may indicate a need for reassessment include the following:
- A change in the law, regulation, or contract giving rise to the ARO that results in a change to either the timing of settlement or the expected retirement costs.
- A change in management’s intended use of the asset, including a change in plans for maintaining the asset to extend its useful life or to abandon the asset earlier than previously expected.
- Advancements in technology that result in new methods of settlement or changes to existing methods of settlement.
- A change in economic assumptions, such as inflation rates.
An entity should analyze its specific facts and circumstances to determine whether the estimate of the ARO needs to be reassessed.
There may be situations in which the reduction of an ARO due to a revision of
the original estimate of the timing or amount of
the obligation exceeds the remaining associated
unamortized ARC. In these circumstances, questions
may arise about whether the difference should be
recorded as a credit to the income statement or as
a reduction of the carrying value of the related
asset. The accounting will depend on whether the
ARC and the related asset are viewed as a single
asset or two discrete assets.
ASC 410-20-25-5 states, in part:
Upon initial recognition of a liability for an asset retirement obligation, an entity shall capitalize an asset retirement cost by increasing the carrying amount of the related long-lived asset by the same amount as the liability.
ASC 410-20-35-2 states, in part:
An entity shall subsequently allocate that asset retirement cost to expense using a systematic and rational method over its useful life.
ASC 410-20-25-5 appears to support a single-asset approach; however, ASC
410-20-35-2 could be interpreted to support a
two-asset approach. If the ARC and related asset
are viewed as a single asset, any downward
adjustment of an ARO in excess of the related ARC
should be recorded as a reduction of the carrying
value of the related asset (although we believe
that if the downward adjustment of the ARO results
in a reduction of the carrying amount of the
single asset to below zero, any excess should be
recorded as a credit to the income statement). If
the two-asset approach is applied, the downward
adjustment of an ARO in excess of the ARC cost
should be recorded as a credit to the income
statement.
Connecting the Dots
We believe that the single-asset approach is preferable to the two-asset approach since it appears to be the one intended by the FASB given the following excerpt from paragraph B42 of the Background Information and Basis for Conclusions of FASB Statement 143:
The Board believes that asset retirement costs are integral to or are a prerequisite for operating
the long-lived asset and noted that current accounting practice includes in the historical-cost basis
of an asset all costs that are necessary to prepare the asset for its intended use. Capitalized asset
retirement costs are not a separate asset because there is no specific and separate future economic
benefit that results from those costs. In other words, the future economic benefit of those costs lies in
the productive asset that is used in the entity’s operations.
Further, ASC 410-20-55-20 states:
Revisions to the asset retirement obligation result in adjustments of capitalized asset retirement costs
and will affect subsequent depreciation of the related asset. Such adjustments are depreciated on a
prospective basis.
As previously noted, since an ARO is required to be initially measured at fair value incorporating
marketplace assumptions, differences between estimated future costs used in the measurement of
the fair value of an entity’s ARO and actual expenditures incurred by that entity to settle the ARO may
occur, resulting in a gain or loss. For example, a gain would most likely result when an entity elects to
settle an ARO by using internal resources because the entity’s internal costs are most likely less than the
costs reflected in the fair value measurement of the ARO, which would be a function of the costs, profit
margin, and market risk premium of a third party.
A gain or loss resulting from settlement of an ARO should be recognized in the period in which the asset
retirement activities are performed. When asset retirement activities are performed over more than one
reporting period, gains or losses should be recognized pro rata in accordance with the costs incurred
during the period as compared with the total costs that the entity expects to incur to settle the ARO.
Example 4-6
Assume that (1) an entity recognized a liability for an ARO in the amount of $600,000 (based on a third-party
estimate), (2) the entity expects to incur total costs of $400,000 to settle the ARO by using internal resources,
and (3) the entity incurred $200,000 of costs during the current period. No costs were incurred by the entity
before the current period. Ignoring the effects of discounting and other changes, the entity would reduce the
ARO by $300,000 and recognize a gain of $100,000 during the current period.
Further assume that the remaining $200,000 of costs were incurred during the next reporting period. The
entity would reduce the ARO by $300,000 (the ARO would be reduced to zero) and recognize a gain of
$100,000 during the next reporting period.
It would be inappropriate to defer recognition of the entire gain or loss to the period in which the asset
retirement activities are completed and the ARO is settled. Doing so would result in overstating or
understating the ARO because the amount recognized would not be representative of the amount that
the entity would have to pay a third party to assume the costs of settling the ARO.
This approach is supported by paragraph B41 of the Background Information and Basis for Conclusions of FASB Statement 143, which states, in part:
The real issue is which period or periods should reflect the efficiencies of incurring lower costs than the costs that would be required by the market to settle the liability. The Board believes it is those periods in which the activities necessary to settle the liability are incurred.