Financial Education

Certain assets result in obligations that must be filled at the end of the asset’s service life. For example, disposal of the asset may require environmental cleanup expenses. As soon as such obligations (asset retirement obligations or AROs) can be reasonably estimated they must be recognized in the company’s financial statements as follows:

1. The liability is estimated as the discounted value of the future expense.
2. The balancing offset to this liability is an increase in the carrying value of the asset.
3. The increase in asset value is depreciated on the income statement over the asset’s remaining service life, thus reducing equity through retained earnings.
4. The liability itself increases over time by the discount rate used in estimating the initial liability.
5. The increase in the liability is charged to the income statement as accretion expense.

Particularly in the case of regulated industries, companies facing asset retirement obligations often have funds set aside to cover the obligations. However, the size of the fund and timing of cash flows to the fund usually differ somewhat from the accounting accruals established regarding the liability.

For more information, see all articles on: Accounting, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis

See also:

Analyzing Asset Retirement Obligations

Asset Retirement Obligations – US Cellular Case Study

Postretirement Obligations

The Accounting Equation

Cumulative Effect of Accounting Changes