1. Asset Retirement Obligations
FASB 143

2. FASB 143 Scope
Applies to legal obligations associated with the retirement of a tangible long-lived asset resulting from
Acquisition Construction, or development Normal operation  

3. Legal obligation based on
Existing or enacted law, statute or ordinance
Written or oral contract
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

4. Examples Landfill that must be capped and closed
Off-shore oil rig that must be dismantled and removed
Decontamination activities for nuclear power plant

5. 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

6. Measurement at Fair Value
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.]

7. Present Value Computations
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  

8. May affect many periods
Events that give rise to ARO may occur over multiple reporting periods
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

9. 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.

10. 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  

11. Asset Retirement Obligation
Debit P P & E
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
Asset Retirement Obligation
$100,000
PP&E
$100,000

12. Subsequent Recognition and Measurement
Period-to-period changes in ARO are recognized differently:
related to the passage of time
Accretion expense (discount rate times balance forward in ARO)
related to revisions in assumption about timing or amount of cash flows
Changes impact PP&E and ARO rather than an expense account.
Revised PP&E amount will affect future depreciation expense

13. First step – time passing effect
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.

14. Second step – revisions effect
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
Or a weighted-average historical discount rate

15. Accounting for revised estimate of clean-up cost
Estimated costs increase (use new rate)
Estimated costs decrease (use orig. rate)
Long-lived asset account
Debit
Credit
Asset retirement obligation

16. Revised estimates:
In other words, recognize change in the carrying value of the related long-lived assets and a corresponding change in the asset retirement obligation

17. There is no immediate impact
The revision in ARO 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

18. 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

19. ARO Example 1
This is an example based on FASB 143 that shows how complicated it will be to project the asset retirement obligation.
It involves both analysis of probabilities and the use of present value techniques

20. ARO Example 1 Labor Cost – estimated cash flows Probability assessment
Expected Cash Flows
$300,000
25%
$375,000
50%
$450,000

21. ARO Example 1 Labor Cost – estimated cash flows Probability assessment
Expected Cash Flows
$300,000
25%
75,000
$375,000
50%
187,500
$450,000
112,500
375,000

22. ARO Example 1 $375,000 labor + $85,000 materials
This amount is in today’s dollars. We need to allow for inflation. We can use a PV calculator to do it.

23. ARO Example 1 PV = 912,000 n=12 years i= 3% (expected inflation rate)
FV = ?
$1,300,294

24. ARO Example 1
FASB’s examples also include putting in an additional amount for the risk premium a contractor would demand because the contract is far in the future
This amount is now in future dollars, an estimate of what we will actually have to pay to restore the landfill.

25. ARO Example 1
To get our liability, we have to discount the future estimated cash flow back to the present using the “credit-adjusted risk free rate.”
Initial ARO Liability at 1/1/03
FV = $1,391,315
n=12 years
i = 12% (credit-adjusted risk free rate)
PV = $357,116

26. ARO Example 1
Now, we can compute the “historical cost” of the landfill – including all costs necessary to get the landfill ready to use PLUS costs to restore the property at the end of its useful life.
Cost = $600,000 land + $800,000 prep + 357,117 retirement cost = $1,757,116

27. ARO Example 1 Depreciation Base = cost less residual value:
$1,757,116 – 200,000 = $1,557,116
Using an activity method, we would divide by 120,000 tons of garbage to get
$12.98 per ton
To keep things simple, we’ll assume even production over the years or $129,760 per year. [Equivalent to SL: $ ÷ 12 years]

28. Why do we need to increase the liability account?
ARO Example 1
Expenses for 2003:
Depreciation 129,760 Acc’d Depreciation ,760
Accretion expense 42,854 Asset Retirement Obligation ,854 [357,116 * 12%]
Why do we need to increase the liability account?

29. 357,116 + 42,854 OR find PV for FV=1,391,315 n=11, i=12%, pmt=0
ARO Example 1
399,970 * 12%
Year
ARO – beginning
Accretion Expense
Depreciation Expense
2003
357,116
42,854
129,760
2004
2005
2006
399,970
47,996
357, ,854 OR find PV for FV=1,391,315 n=11, i=12%, pmt=0

30. ARO Example 1 So accretion expense is really INTEREST EXPENSE!
It is what it takes to make the liability correct because we are one year closer to the end of the asset’s useful life
Note that FASB says we should not treat accretion expense like interest when it comes to interest capitalization

31. ARO Example 1
Note that when we get to 1/1/2015, the liability account will equal the expected future cash flows we predicted when we acquired the land fill

32. ARO Example 1
The example continued on the next page. It illustrates what happens if we need to revise our estimates.
Solution is in the back – I’ll leave it for homework.

33. ARO Example 2
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.

34. ARO Example 2 Relevant cost information follows:
Land $9,000,000
Asset retirement obligation ,500,000
a. What should be the depletion charge per ton of extracted material?
9,000, ,500,000 ARO – 1,000,000 RV ,500,000 tons
= 3.80 per ton

35. ARO Example 2
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
Accretion expense would INCREASE the liability account

36. ARO Example 2 A schedule would look like this: Date
Date
Accretion Expense (8%)
ARO Liability
Balance fwd
1,500,000
12/31/2001
120,000
1,620,000
12/31/2002
129,600
1,749,600

37. ARO Example 3 Here is one more practice problem.
Please do the solution for homework

38. Impairment of Long-lived Assets
FASB 121
Now FASB 144

39. Impairment or Disposal of Long-lived Assets - FASB 144
A departure from transaction-based Historical Cost Model
For assets to be held and used:
Carrying value is written down to fair value when projected future cash flows (undiscounted) are less than carrying value

40. Application (Scope) Land Building Equipment Natural resources
Intangible assets
FASB 147 says FAS144 covers long-term customer-relation intangible assets in the banking industry

41. Goodwill Impairment
Remember, we are to test goodwill for impairment at least annually
FASB 144 evaluations may include goodwill but this analysis happens only when there is a “triggering event” and not on an annual basis

42. Assets held for use See flow chart
Note that FASB 144 has different rules for assets to be sold or abandoned that are NOT on this flow chart

43. Assets held for use When should impairment be recognized?
Testing each asset each period would be too costly
We wait for a “triggering event”

44. Impairment test when
Events or changes in circumstances indicate that the carrying amount may not be recoverable
Decline in market value
Change in way asset is used or physical change in asset
Adverse changes in legal factors or business climate
Probable sale of asset before end of useful life
Current period losses with history of operating or cash flow losses associated with asset

45. To apply impairment tests
A long-lived asset shall be grouped with other assets and liabilities at the lowest level for which identifiable cash flows are largely independent of the cash flows of other assets and liabilities.
This is referred to as a “primary asset” approach – because we need to have a group of assets that generates cash flows

46. An impairment loss is recognized if
Carrying amount of asset (book value) is greater than undiscounted future cash flows related to use and disposal of asset
The asset is written down to fair value
The fair value becomes the new carrying value (book value) and depreciation is recorded over remaining useful life
Restoration of a previously recognized impairment loss is prohibited.  

47. Triggering Event

48. Determining fair value
FASB 144 describes a probability-weighted cash flow estimation approach to deal with situations in which
alternative courses of action to recover the carrying amount of a long-lived asset are under consideration, or
a range is estimated for the amount of possible future cash flows

49. Long-lived assets to be disposed of and NOT held for use
These rules are substantially different from FASB 121 and NOT covered on the flow chart

50. Long-lived assets to be disposed of by sale
Classified as “held for sale” in period in which all of the following criteria are met:
Management commits to a plan to sell the asset
Asset is available for immediate sale in its present condition
Active program to locate a buyer has been initiated

51. Long-lived assets to be disposed of by sale
Classified as “held for sale” in period in which all of the following criteria are met:
Sale is probable within one year
Asset is being actively marketed for a reasonable price
It is unlikely that the plan to sell will be changed  

52. Measurement Write asset down to the LOWER of
Carrying amount
Fair value less cost to sell
Stop depreciating the asset  

53. Hidden slide but in notes
Costs to sell
Includes incremental direct costs to transact the sale
Broker commissions
Legal and title transfer fees
Closing costs
Generally does not include costs to protect or maintain asset
Insurance Security services Utility expenses
Hidden slide but in notes

54. Assets to be disposed of other means
Situations include:
Abandonment
Exchange for similar productive asset
Distribution to owners in a spinoff
The asset shall continue to be classified as “held and used” until it is disposed of

55. Assets to be disposed of other means
Asset stays in PP&E
Depreciation estimates should be revised to reflect shortened life
Depreciation ends and a gain or loss is recorded when the property is “disposed of”

56. The “disposed of” date:
Abandoned
The date it ceases to be used
Exchanged or distributed to owners through a spinoff
The date when it is exchanged or distributed

57. Impairment Example 1
Johnson Company purchased equipment 8 years ago for $1,000,000. The equipment has been depreciated using the straight-line method with a 20-year useful life and 10% residual value.
Johnson's operations have experienced significant losses for the past 2 years and, as a result, the company has decided that the equipment should be evaluated for possible impairment.

58. Impairment Example 1
The management of Johnson Company estimates that the equipment has a remaining useful life of 7 years. Net cash inflow from the equipment will be $80,000 per year. The fair value of the equipment is $240,000. No goodwill was associated with the purchase of the equipment.

59. Example 1 - a Determine if an impairment loss should be recognized.
Annual depreciation for the equipment has been $45,000 ($1,000,000 - $100,000)/20 years. Current book value of the equipment is:
Original cost $1,000,000
Accumulated depreciation , ($45,000 * 8 years)
Book value $ 640,000

60. Example 1 - a Determine if an impairment loss should be recognized.
Anticipated future cash flows $ 560,000 
(7 years * $80,000 per year)
Look at the flow chart – should we recognize an impairment?
The fair value is lower, so an impairment loss should be recognized.  

61. Example 1 - b
Determine the amount of the loss and prepare the journal entry to record the loss.
The impairment loss is equal to the $400,000 ($640,000 - $240,000) difference between the book value of the equipment and its fair value. The impairment loss would be recorded as follows:
Acc’d Depreciation ,000
 Loss on Impairment ,000
   Equipment ,000 

62. Example 1 - c
What journal entry should Johnson Company make if future cash flows related to the equipment were $980,000 in total?
Since the future cash flows (undiscounted) equal $980,000 and this amount is greater than the book value of $640,000, Johnson Company will not do anything.
No impairment is recognized and no upward revaluation is recorded.
No journal entry needed.

63. Example 2 Here is a problem to do for homework
Also, there are more examples on old exam files on my Acct 315 web page