Does Your Lease Contain an Asset Retirement Obligation?
Asset retirement obligations (AROs) are oftentimes overlooked, but are in fact critical considerations for companies, especially manufacturers, who deal with long-term leases of specialized equipment or facilities. Understanding the accounting for AROs is essential for accurate financial reporting and compliance. This article outlines the key aspects of AROs in the context of lease accounting and explains why all companies, and manufacturers in particular, should pay close attention to these obligations.
AROs represent the expected costs associated with the future retirement of a fixed asset. This typically includes activities such as decommissioning, dismantling, and remediation. For manufacturers, these obligations often arise from leased facilities or equipment that require specific end-of-lease restoration or removal activities.
Accounting for AROs
1. Identify Obligations
Companies will first need to identify any legal or contractual obligations to retire leased assets. In order to do this, companies should thoroughly review all lease agreements, environmental regulations, and internal policies to identify potential AROs. Typically, companies identify an ARO by finding a clause in the lease agreement that contains language such as the “lessee is required to restore the leased property to its original condition.”
An easy way to spot potential AROs is by considering if the company has significant leasehold improvements on the balance sheet. If so, that is a good reason to carefully inspect the corresponding lease agreements for potential AROs, as it is common for lessors to include a clause in the lease agreement, such as the one previously mentioned, when there are significant leasehold improvements.
LEASE INGREDIENTS:
Commencement Date, End Date, Renewal Option, Deposit, Monthly Payments, Discount Rate.
MAY CONTAIN ASSET RETIREMENT OBLIGATION
2. Initial Recognition
The initial entry to bring an ARO onto the books is debit the asset retirement cost (ARC) as part of the cost basis of the related asset and credit an ARO liability account. The ARO is measured at fair value, typically the present value of the estimated future retirement costs.
Estimating those future retirement costs has proven to be more of a challenge than many might expect. We recommend developing a detailed breakout of the costs required to retire the asset and then regularly updating the estimates, as there are significant changes in inflation, regulations, or other relevant cost drivers. While using data from similar projects may be ideal, such data is not easily accessible. Discussing future costs with a contractor or another expert familiar with the cost of restoring the asset is oftentimes the best way to estimate significant AROs.
3. Subsequent Measurement
Over time, the ARC asset is reduced on the balance sheet and depreciation expense is recognized on the income statement. The ARO liability is adjusted through accretion expense as the present value of the future obligations change. If there are adjustments to the expected future cash flows relating to an ARO, both the ARO and the corresponding ARC would be adjusted.
At the end of the lease term, when it is time to pay for the restoration of the leased property, there should be little impact on the income statement as the expense would have already been incurred over the term of the lease. The final entry, then, will be to debit the liability and credit cash to pay the costs of restoring the property.
Why AROs Matter
AROs can significantly impact both the balance sheet and income statement, not to mention the various ratios that are based on elements of those statements. If a company has an ARO clause but does not account for the ARO correctly, they will end up recording the entire cost of restoring the asset in one period (i.e. at the end of the lease) instead of spreading out the expense over the term of the lease.
Understanding and planning for AROs allows manufacturers to manage costs effectively. By estimating future retirement costs, companies can set aside appropriate funds and avoid unexpected financial burdens at the end of the lease term.
Awareness of ARO implications can influence lease negotiations. Manufacturers can negotiate lease terms that minimize or clarify end-of-lease obligations, potentially reducing future costs.
Accurate accounting for AROs ensures compliance with accounting standards and provides a true and fair view of the company’s financial position. Non-compliance results in misstated financial reports.
Transparent reporting of AROs builds investor confidence. Investors seek assurance that the company manages its obligations prudently and has a clear understanding of future financial commitments. Going back to the second point, if investors find that an ARO was missed and the entire cost is absorbed in one period, they may lose confidence in other financial reporting performed by management.
Conclusion
Asset retirement obligations are a crucial aspect of lease accounting, particularly for manufacturers with significant leasehold improvements. By accurately identifying, recognizing, and measuring AROs, companies enhance accuracy of financial reporting, add visibility to significant future costs, maintain investor confidence, and ultimately contribute to the company’s long-term financial health.
Please reach out to a member of our Manufacturing & Distribution team for more information on the topic outlined above. For more information regarding our Manufacturing & Distribution experience, visit our Manufacturing & Distribution industry page.
About the Author
Brett joined McKonly & Asbury in 2011 and is currently a Director with the firm. As a member of the firm’s Audit & Assurance Segment, he serves clients in the manufacturing and distribution industry. At McKonly & Asbury, Brett… Read more
