Asset Retirement Obligation (ARO) means
- A commitment
- To restore the site where an asset is installed, constructed, or erected.
Establishing an asset can damage the Land.
So, this obligation can be for the removal of hazardous materials after asset retirement.
Why honor this obligation?
It’s legally binding.
That’s a future obligation.
So, entities prepare for it by accruing for the present value of such cost in the books of accounts.
How about an ARO practical example?
Think of a real-time scenario in which you are traveling on the road in a car and are involved in an accident due to the fault of another vehicle.
What are your first thoughts?
We generally look to see if this accident caused damage to us or our vehicle.
The other party is under obligation to fix the damages caused, which includes restoring your vehicle to its original condition and paying for the hospital charges, if any.
The same example applies when a site installs an asset.
What’s the relevance of ARO accounting here?
Restoration costs are not minimal.
These involve hefty amounts.
So, there is a high chance of these amounts distorting the financial position. So, entities record their present value of future obligations in the current year. Further, we need to add the accretion (increase in costs due to inflation) to the initial liability every year.
Asset Retirement Obligation Journal Entries
Accounting requires double entry, which balances debit and credit sides. In other words, any incoming benefits require outgoing benefits.
Say you purchase software through an e-commerce website for $30,000. Here, the software is the inflow, and bank payments are the outflow.
Let’s apply this principle to ARO.
ARO represents an outflow (future obligation) and does not associate with any inflow. So, to balance this equation, we create a fictitious asset (ARC Asset).
Now, let’s record the journal entries.
Recognition of Asset Retirement Obligation
ARC Asset A/c Dr. XXX
To ARO A/c XXX
We record the above entry at the present value of future obligation. Also, we revisit this obligation cost to reflect its current value at the end of each year. So, we increase the ARO balance to match the inflation
ARC Asset operates similarly to any other fixed asset, which results in yearly depreciation (Here, we record the annual charge of the asset cost in the statement of profit and loss as amortization). Such depreciation journal entries will be similar to any other asset. Refer to the entries below.
ARO Accretion Balance
ARO Accretion Expense A/c Dr. XXXX
To ARO A/c XXX
Entries to record the depreciation of the ARC Asset
ARC Depreciation A/c Dr. XXXX
To Accumulated ARC Depreciation A/c XXXX
Entries to record the settlement of the ARO obligation
Settlement refers to fulfilling the obligation to restore the site on which we install an asset. We best estimate the ARO obligation at the time we erect the plant and machinery or any asset. There can be additional expenses incurred with such decommission. Thus, we record it through retirement expenses, which hit the P&L account.
ARO A/c Dr XXXX
Retirement Expenses A/c XXXX
To Bank A/c XXXX
ARO liability is not a one-time process. It’s an iterative process to check each year if the liability value needs a revision, which can be attributed to subsequent developments in business, legislative requirements, and cost changes. There could be early or deferred retirement of assets, which might result in an upward or downward revision in the obligation balance.
