Asset-Based Finance: How This Lending Model Works

Julia Kagan is a financial/consumer journalist and former senior editor, personal finance, of Investopedia.

Janet Berry-Johnson is a CPA with 10 years of experience in public accounting and writes about income taxes and small business accounting.

In accounting, an asset retirement obligation (ARO) describes a legal obligation associated with the retirement of a tangible, long-lived asset, where a company will be responsible for removing equipment or cleaning up hazardous materials at some future date. AROs should be included in a company's financial statement to present a more accurate and holistic snapshot of the enterprise's overall value.

Key Takeaways

• Asset retirement obligations (ARO) are legal obligations associated with the retirement of tangible, long-lived assets, where a company must ultimately remove equipment or clean up hazardous materials from a leased site.
• Companies are required to detail their AROs on their financial statements to accurately portray their overall values.
• ARO rules are governed by the Financial Accounting Standards Board (FASB), outlined in Rule No. 143: Accounting for Asset Retirement.

Understanding Asset Retirement Obligations

Asset retirement obligation accounting often applies to companies that create physical infrastructure which must be dismantled before a land lease expires, such as underground fuel storage tanks at gas stations. AROs also apply to the removal of hazardous elements and/or waste materials from the land, such as nuclear power plant decontamination. The asset is considered to be retired once the clean up/removal activity is complete, and the property is restored back to its original condition.

An Example of an Asset Retirement Obligation

Consider an oil-drilling company that acquires a 40-year lease on a parcel of land. Five years into the lease, the company finishes constructing a drilling rig. This item must be removed, and the land must be cleaned up once the lease expires in 35 years. Although the current cost for doing so is $15,000, an estimate for inflation for the removal and remediation work over the next 35 years is 2.5% per year. Consequently, for this ARO, the assumed future cost after inflation would be calculated as follows: 15,000 * (1 + 0.025) ^ 35 = 35,598.08.

Asset Retirement Obligations Oversight

Because calculating asset retirement obligations can be complex, businesses should seek guidance from Certified Public Accountants to ensure compliance with the Financial Accounting Standards Board's Rule No. 143: Accounting for Asset Retirement Obligations. Under this mandate, public companies must recognize the fair value of their AROs on their balance sheets in an effort to render them more accurate. This represents somewhat of a departure from the income-statement approach many businesses previously used.

Asset Retirement Obligation: Calculating Expected Present Value

To calculate the expected present value of an ARO, companies should observe the following iterative steps:

1. Estimate the timing and cash flows of retirement activities.
2. Calculate the credit-adjusted risk-free rate.
3. Note any increase in the carrying amount of the ARO liability as an accretion expense by multiplying the beginning liability by the credit-adjusted risk-free rate for when the liability was first measured.
4. Note whether liability revisions are trending upward, then discount them at the current credit-adjusted risk-free rate.
5. Note whether liability revisions are trending downward, then discount the reduction at the rate used for the initial recognition of the related liability year.

Asset Retirement Obligations do not apply to unplanned cleanup costs resulting from unplanned events, such as chemical spills and other accidents.