Fasb 143 – Asset Retirement Obligations




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Lecture Notes for Acct 592 Prof. Teresa Gordon

FASB 143 – Asset Retirement Obligations


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

Acquisition

Construction, or development

Normal operation


Legal obligation:
Based on existing or enacted law, statute or ordinance
Based on written or oral contract
Based on 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
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.]
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


Events that give rise to ARO may occur over multiple reporting periods

Examples: 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
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

Subsequent Recognition and Measurement


Period-to-period changes in ARO are recognized differently:
1. related to the passage of time
2. related to revisions in assumption about timing or amount of cash flows

First step:


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.

Note that it is computed like interest expense and is based on the discount rate used when the ARO was established

Second step:


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

Downward revisions may also use a weighted-average credit-adjusted risk-free discount rate

Recognize as an increase in the carrying value of the related long-lived asset {the debit} and an increase in the ARO {the credit}.

Note that this 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

EXAMPLE 1 – Asset Retirement Obligation
A waste management company opens a landfill on January 1, 2003. It is legally required to properly cap and close the landfill and restore the surface of the land for alternative use. The estimated useful life of the landfill is 12 years. The land was purchased in 2001 for $600,000. Upon closure, the land will be donated to the country for a park. The estimated value of the tax deduction related to the gift is $200,000. The cost incurred during 2002 to ready the property for use as a landfill was $800,000. The estimated capacity of the landfill is 120,000 tons of garbage. Level of usage is expected to be constant over the life of the landfill.
The company uses the following assumptions to compute the fair value:

1. Labor costs based on current marketplace wages:



Estimated Cash Flows

Probability Assessment

Expected Cash Flows

$300,000

25%




$375,000

50%




$450,000

25%













2. Expected overhead rate = 80% of direct labor costs

3. Expected cost of materials for closure = $85,000

4. Normal profit margin for contractors in this industry = 20%

5. Risk premium that a contractor would demand for bearing the uncertainty of a commitment this far into the future = 7% of the estimated inflation-adjusted cash flows

6. The risk-free rate of interest on January 1, 2003 is 4%. The credit standing adjustment is 8% for a total discount rate of 12%

7. Assumed inflation rate = 3%



Initial ARO Liability at January 1, 2003


Expected labor and material costs




$ 460,000

Allocated overhead

$ 375,000

* 80%

300,000










760,000

Markup on direct costs

$760,000

* 20%

152,000

Expected cash outflow before inflation




912,000

Inflation factor




3% for 12 periods

1.425761

Inflation adjusted cashflow




1,300,294

Market risk premium

1,300,294

* 7%

91,021

Expected future cash outflow at closure of landfill =

1,391,315













Present value




12% for 12 periods

$ 357,116



Computing depreciation or depletion expense:


Historical cost of land







$ 600,000

Preparation costs







$ 800,000

Residual value







$ (200,000)

Asset retirement obligation capitalized






Depreciation base
























Estimated capacity in tons of garbage




120,000

Depletion or depreciation rate per ton






$

Accretion expense is based on the ARO capitalized. Multiply the beginning of the year balance in the ARO liability by the credit-adjusted risk-free rate (the same rate used to discount the future cash flows).


The following schedule of expenses assumes that there is no need to revise any of the assumptions that affect anticipated future cash flows.











12%

$ 12.98




Year

ARO - BOY

ARO - EOY

Accretion Expense

Depreciation Expense

Total Expense

2003

357,116

399,970

42,854

129,760

172,614

2004

399,970

447,966

47,996

129,760

177,756

2005

447,966

501,722

53,756

129,760

183,516

2006

501,722

561,929

60,207

129,760

189,966

2007

561,929

629,360

67,431

129,760

197,191

2008

629,360

704,883

75,523

129,760

205,283

2009

704,883

789,469

84,586

129,760

214,346

2010

789,469

884,206

94,736

129,760

224,496

2011

884,206

990,310

106,105

129,760

235,864

2012

990,310

1,109,147

118,837

129,760

248,597

2013

1,109,147

1,242,245

133,098

129,760

262,857

2014

1,242,245

1,391,315

149,069

129,760

278,829










1,034,199

1,557,116

2,591,315


Example 2 – Same facts as Example 1 EXCEPT:
New regulations are announced in early 2008. The projected costs are consequently expected to increase by the following amounts. All other assumptions remain the same.

Labor increases by




15%

$ 56,250

Materials increase by




50%

$ 42,500

Credit-adjusted risk-free rate

10%



Since this is an UPWARD adjustment in the ARO, the increase is computed using the current credit-adjusted risk-free rate.




Expected increase in labor and material costs







Allocated overhead on direct labor




* 80%
















Markup on direct costs




* 20%




Expected cash outflow before inflation







Inflation factor




3% for 7 periods




Inflation adjusted cashflow







Market risk premium










Expected future cash outflow at closure of landfill =
















Present value




10% for 7 periods



The accretion cost on this new ARO will use the discount rate from 2008 (not the original one from 2003). Consequently, it is probably easier to compute the additional accretion expense in a new set of columns.


For the depreciation expense, we first have to determine the carrying value of the landfill BEFORE the change in the assumptions – at the end of 2007. Then we re-compute the depreciation rate over the remaining useful life.


Historical cost







1,400,000

Initial ARO recognized







357,116










1,757,116

Less accumulated depreciation







Carrying value at end of 2007







Upward adjustment to ARO



















Less salvage value







(200,000)




Depreciation base




Remaining capacity in tons of garbage







Revised rate per ton










Upward Revision of Cash Flows for Landfill Example




Initial ARO

Upward Revision in ARO
















12%







10%










ARO - BOY

ARO - EOY

Accretion Expense

ARO - BOY

ARO - EOY

Accretion Expense

Depreciation Expense

Total Expense

2003

357,116

399,970

42,854










129,760

172,614

2004

399,970

447,966

47,996










129,760

177,756

2005

447,966

501,722

53,756










129,760

183,516

2006

501,722

561,929

60,207










129,760

189,966

2007

561,929

629,360

67,431










129,760

197,191

2008

629,360

704,883

75,523
















2009

704,883

789,469

84,586
















2010

789,469

884,206

94,736
















2011

884,206

990,310

106,105
















2012

990,310

1,109,147

118,837
















2013

1,109,147

1,242,245

133,098
















2014

1,242,245

1,391,315

149,069

























1,034,199















Homework Exercises:


1. 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. Relevant cost information follows:
Land ................................................. $9,000,000

Asset retirement obligation (asset).... 1,500,000


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

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?

c. What is the balance in the ARO liability account at 12/31/02?
2. A Fairfax Inc. is legally responsible for decontamination procedures associated with operating a chemical plant it acquired on January 1, 2001 for $50,000,000. The acquisition cost was attributed as follows: $48,000,000 for the plant and $2,000,000 for the land. The future cash flows for decontamination were analyzed and discounted back to the present using a 5% credit-adjusted risk-free rate. The asset retirement obligation was initially recognized at $2,000,000. The expected useful life of the plant is 25 years. At the end of its useful life and after decontamination, the plant should be worth $4,000,000 (not including the value of the land). Fairfax uses the straight-line method to depreciate buildings and related manufacturing facilities.
1. What amount of depreciation expense should be recognized for 2001?

2. What amount will be recognized as accretion expense for 2001?


3. What amount will be recognized as accretion expense for 2002 assuming that no revisions in assumptions regarding the asset retirement obligation are considered necessary?


4. What is the ending balance in the asset retirement obligation on 12-31-02?




Asset retirement obligation – Example 1 – year 2


Measurement of change in cashflows













Labor increases by




15%

$ 56,250







Materials increase by




50%

$ 42,500







Expected labor and material costs




98,750







Allocated overhead

$ 56,250

80%

45,000







Expected increase







143,750







Markup




20%

28,750







Expected cash outflow before inflation




172,500







Inflation factor




3%

1.229874

7

periods

Inflation adjusted cashflow







212,153







Market risk premium




7%

14,851







Expected future cash outflow at closure of landfill =

227,004

























Remaining useful life:
















Present value




10%

116,489

7

periods



















Revised depreciation expense (current and prospective method)







Historical cost







1,400,000







Initial ARO recognized







357,116
















1,757,116







Less accumulated depreciation




(648,798)







Carrying value at end of 2007




1,108,318







Upward adjustment to ARO




116,489
















1,224,806







Less salvage value







(200,000)










Depreciation base

1,024,806







Remaining capacity in tons of garbage




70,000







Revised rate per ton







$ 14.64







Revised Schedule of Expenses






















and assuming that no adjustments of assumptions need to be made

























12%







10%

$ 14.64







Initial ARO

Upward Revision in ARO







Year

ARO - BOY

ARO - EOY

Accretion Expense

ARO - BOY

ARO - EOY

Accretion Expense

Depreciation Expense

Total Expense

2003

357,116

399,970

42,854










129,760

172,614

2004

399,970

447,966

47,996










129,760

177,756

2005

447,966

501,722

53,756










129,760

183,516

2006

501,722

561,929

60,207










129,760

189,966

2007

561,929

629,360

67,431










129,760

197,191

2008

629,360

704,883

75,523

116,489

128,138

11,649

146,401

233,573

2009

704,883

789,469

84,586

128,138

140,952

12,814

146,401

243,801

2010

789,469

884,206

94,736

140,952

155,047

14,095

146,401

255,232

2011

884,206

990,310

106,105

155,047

170,551

15,505

146,401

268,010

2012

990,310

1,109,147

118,837

170,551

187,607

17,055

146,401

282,293

2013

1,109,147

1,242,245

133,098

187,607

206,367

18,761

146,401

298,259

2014

1,242,245

1,391,315

149,069

206,367

227,004

20,637

146,401

316,107










1,034,199







110,515

1,673,605

2,818,318






















ok

ok













Check:

























Historical cost:







$ 1,400,000
















ARO initial







357,116
















ARO adjustment







116,489
















Salvage







(200,000)

























$ 1,673,605






Homework Exercise – Solution, Problem 1
1. Asset Retirement Obligation and Depletion – Joseph Co.

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

(9,000,000 cost + 1,500,000 ARO – 1,000,000 RV)/2,500,000 tons = 3.80

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

For 2002: (1,500,000 + 120,000) * .08 = $129,600 accretion expense

c. What is the balance in the ARO liability account at 12/31/02?

1,500,000 + 120,000 + 129,600 = $1,749,600



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