In FASB’s words, Statement no. 143’s stated objective is to “establish accounting standards for recognition and measurement of a liability for an asset retirement obligation and an associated asset retirement cost.”
The new rules regarding the retirement of tangible long-lived assets include these features:
A business must recognize an asset retirement obligation for a long-lived asset at the point an obligating event takes place—provided it can reasonably estimate its fair value (or at the earliest date it can make a reasonable estimate).
The entity must record the obligation at its fair value, either the amount at which the liability could be settled in a current transaction between willing parties in an active market, or—more likely—at a substitute for market value, such as the present value of the estimated future cash flows required to satisfy the obligation.
To offset the credit portion of the asset retirement liability entry, businesses must capitalize the asset retirement costs as an increase in the carrying amount of the related long-term asset.
Businesses must include certain costs in the income statement during the asset’s life—namely depreciation on the asset, including additional capitalized retirement costs, and interest for the accretion of the asset retirement liability due to the passage of time.
Statement no. 143 applies to tangible long-lived assets, including individual assets, functional groups of related assets and significant parts of assets. It covers a company’s legal obligations resulting from the acquisition, construction, development or normal operation of a capital asset. In many cases, the presence or absence of a qualifying legal obligation will be clear. Other situations will require CPAs to carefully analyze the circumstances and the statement’s detailed guidance.
The statement provides other guidance on the new standard’s scope:
A mere plan or intention to dispose of an asset does not require recognition.
Obligations—such as environmental remediation liabilities—related to the improper operation of an asset are not covered.
Businesses may incur retirement obligations at the inception of an asset’s life or during its operating life. For example, an offshore oil-and-gas-production facility typically incurs its removal obligation when it begins operating. A landfill or a mine, however, may incur a reclamation obligation gradually over the life of the asset as space is consumed with waste or the mine is dug. In other cases, the obligation may come because of the passage of laws or regulations during an asset’s life, such as environmental regulations.
Under Statement no. 143, an entity must recognize an asset retirement obligation at its fair value—the amount at which an informed willing party would agree to assume the obligation. However, acknowledging that a market for settling such obligations may not exist, FASB permits CPAs to estimate the obligation’s fair value and says that a present value technique is often the best approach.
An entity must estimate the cash flows required to settle a retirement liability and make those estimates consistent with information and assumptions “marketplace participants” would use. Companies should not allow proprietary information and internal cost structures to influence the cash flow estimates if they differ materially from market conditions.
Companies must also estimate the amount and timing of the related cash flows, incorporating explicit assumptions about inflation, technology advances, profit margins, offsetting cash flows and other factors. A single point estimate of value based on these assumptions apparently will not suffice. A company must determine the extent to which the amounts or the timing would vary under different future scenarios and the relative probabilities of each.
The scenarios CPAs consider in the present value calculation reflect uncertainties about settling a retirement obligation. These uncertainties do not, however, play a part in a company’s decision whether to recognize the liability—assuming the obligation’s existence is otherwise clear.
Companies must discount the estimated cash flows, with all their assumptions, probabilities and uncertainties, using what Statement no. 143 calls a credit-adjusted risk-free rate —a rate (such as that for zero-coupon U.S. Treasury instruments) adjusted upward for the effect of the entity’s credit standing. A liquid, solvent, relatively unleveraged company—one with a strong credit standing—would have a smaller adjustment than an entity that is less creditworthy.
All these features—assessing what the market “believes” about costs, anticipating inflation rates and technology advances, estimating probabilities for various scenarios and determining a credit-standing adjustment for the discount rate—combine to create a very subjective value. Yet, in the absence of an active market, such a present value technique should, if CPAs apply it properly, produce a reasonable and defensible substitute for fair value.
Exhibit 1 and exhibit 2 demonstrate Statement no. 143’s accounting treatment using a sample asset. The asset’s carrying cost includes the $1 million original cost plus the capitalized retirement cost—equal to the initial liability amount—of $162,892. The retirement entry of the long-lived asset would be as follows, assuming the actual cash flows to settle the retirement obligation match those estimated. (In this and following balance-sheet illustrations, debits are denoted by “Dr.” and credits by “Cr.”)
Any differences between the asset retirement liability balance and the actual retirement costs would flow through the income statement as a gain or loss on retirement.
Historically, many entities have accounted for retirement obligation costs as a part of depreciation. Depreciation-based accounting includes the estimated and undiscounted cash flows related to retirement in the depreciable base allocated over the asset’s useful life. Depreciation calculations also include estimated salvage proceeds. For most of the assets Statement no. 143 affects, retirement costs far exceed salvage, resulting in what some industries refer to as negative net salvage and also yielding a depreciable base—original cost plus estimated removal costs less estimated salvage—that exceeds the long-lived asset’s original cost. Exhibit 3 summarizes depreciation accounting for the sample asset (note Statement no. 143 has superseded the treatment of obligatory removal costs shown here).
At the end of the sample asset’s life, both depreciation accounting and the liability approach Statement no. 143 mandated yield the same net credit on the balance sheet. The accounting shows the credit as a liability ( exhibit 2 : net book value of zero less the $422,500 retirement liability), whereas depreciation accounting results in a negative—and counter-intuitive—net asset balance ( exhibit 3 : asset balance of $1 million less accumulated depreciation of $1,422,500, and no retirement liability).
Both approaches recognize the same total expenses—$1,422,500—over the asset’s useful life. Under Statement no. 143, the expenses are made up of $1,162,892 in depreciation plus $259,608 of interest accretion (see exhibit 2 ), while depreciation expense is the only income-statement item for the depreciation accounting approach (see exhibit 3 ).
The differences between liability accounting under Statement no. 143 and depreciation accounting arise within the asset’s life due to the timing and classification of the retirement cost liability and asset and their attendant expenses.
In most cases these timing differences cause the pattern of expense recognition to shift from a flat line under depreciation accounting (straight-line depreciation of a base that includes an estimate of the retirement costs) to an upward-trending expense line under liability accounting (straight-line depreciation plus ever-increasing interest accretion resulting from the passage of time).
In implementing Statement no. 143, CPAs may have to make some potentially complex calculations that are highly sensitive to several variables.
Cash flow estimates. The timing and amounts of the cash flows to cover the actual costs of retiring an asset and settling the retirement obligation can vary widely. Assets such as electric power plants, oil refineries and mines usually have long lives. Predictions out 30 to 40 years or more inevitably will be fuzzy. Yet entities required to implement Statement no. 143 must make educated guesses about inflation rates, labor costs, technological advances and profit margins in a way that reflects how the market would view such items.
Despite the inherent subjectivity, this often is the only practical approach for a company to take when implementing Statement no. 143. These estimates require CPAs to do careful analysis and documentation, including supportable underlying assumptions.
Credit-adjusted, risk-free rate. Companies must apply a “level effective interest rate.” They apply this rate to a liability balance that grows each year—as interest is added, the annual interest expense (accretion) also grows. The steepness of this expense line depends on the discount rate: the higher the rate (the credit-adjusted, risk-free rate), the deeper the discounting.
Deep discounting has three effects: (1) It creates a smaller amount of retirement costs for a company to capitalize as part of the asset’s carrying cost, rendering the more stable component of annual expense—depreciation—less significant; (2) it results in much smaller interest expense via accretion in the early years because the initial liability is smaller; and (3) it yields greater variation in accretion costs from early in the asset’s life to later. Exhibit 4 shows various annual expense lines for the sample asset.
Statement no. 143 requires companies to make a “cumulative-effect” entry when they implement its provisions. FASB decided that, at transition, an entity should measure the fair value of a liability for an asset retirement obligation and the corresponding capitalized cost at the date the liability was initially incurred using current information, assumptions and interest rates. Companies should use that initial fair value and initial capitalized cost as the basis for measuring depreciation and interest expense from the date the liability was incurred to the date of the statement’s adoption.
The result: “immediate recognition…of liability, asset, and accumulated depreciation amounts” with the net amount flowing through that period’s income statement as a cumulative-effect adjustment. For entities that had not previously provided for retirement costs, this cumulative effect could be sizable.
If a company owning the sample asset had not included any provision for retirement costs in its annual depreciation amounts, its accumulated depreciation balance at the end of year 4 would be $400,000 ($1 million original cost over 10 years X 4 years of depreciation). The company would record the following transition entry assuming implementation at the end of year 4 (see exhibit 2 for the balances required at that point):
If the same company had included the asset’s estimated retirement costs in its depreciable base (as shown in exhibit 3 ), the cumulative effect adjustment upon transition at year 4 would actually be a net credit flowing through the income statement, as follows (see also exhibit 5 ):
The cumulative effect amounts flowing through the income statement represent, in each case, the net offset to the combined adjustment of the relevant balance-sheet items as well as a catch-up for the cumulative differences in income statement amounts recorded under the differing accounting approaches.
Because the circumstances surrounding a business and its major assets will vary widely, the effect of adopting Statement no. 143 also will vary. The interplay of the factors involved—particularly the credit-adjusted, risk-free discount rate, the age of the asset relative to its overall useful life, cash flow estimates and the adequacy of prior provisions for retirement costs—means each situation requires CPAs to do careful analysis.
Companies will find Statement no. 143’s new approach to accounting for asset retirement obligations has these important implications:
A shift in the components and stability of period expenses.
A change in balance-sheet components—adding a new liability and capitalized retirement costs as part of the carrying cost of the long-lived asset, and removing accumulated depreciation of retirement-related costs embedded there. (Note: This is the case only for costs related to retirement obligations covered by Statement no. 143; retirement costs not related to obligations presumably may remain a component of depreciation accounting.)
Revised depreciation expense (to remove the component intended to provide for obligatory asset retirement costs).
To prepare to implement Statement no. 143—required for fiscal years beginning after June 15, 2002—entities with long-lived assets need to perform the steps listed below. (In many cases, CPAs will need to apply these steps for a company’s significant individual assets on a stand-alone basis.)
1. Using the specific guidance in the statement, determine whether the entity has a legal obligation related to retirement of the long-lived asset. This essential scope issue will require CPAs to do research in many instances.
2. Use market information, if possible, to value an obligation. Otherwise, follow these three steps:
Estimate how “market participants” likely would view the costs and circumstances related to the retirement obligation (for example, labor rates, cost structures and technological advances). Since the statement does not provide any explicit guidance on how CPAs would do this, practice will vary depending on the circumstances.
Prepare a range of estimated cash flows related to settlement of the obligation and weight them for their probabilities of occurrence.
Discount the probability-weighted cash flow data to the date the liability was incurred using a risk-free interest rate adjusted for the entity’s credit standing.
3. Roll forward the balance-sheet items—liability, capitalized costs, accumulated depreciation—from the liability date to the implementation date to compute the balances required at implementation.
4. Prepare a cumulative-effect adjustment entry reflecting the requisite balance-sheet amounts, with the net difference flowing through the income statement.
5. Prepare the required financial statement disclosures (a general description of the asset retirement obligation and of the associated asset; the value of any assets legally restricted for purposes of settling the obligation; and a reconciliation of the asset retirement liability balance for the period).
6. Adjust depreciation rates for long-lived assets for which the estimated retirement obligation was part of the depreciable base.
Ongoing accounting oversight for these long-lived assets and their retirement obligations requires CPAs to be alert to changes in the cash flow estimates—their amounts, timing, probabilities and market expectations. Such changes, if material, are treated as a change in estimate: CPAs evaluate the new data to determine adjustments to make to the liability and capitalized cost balances (with prospective effects on income-statement items).
Statement no. 143 imposes sweeping changes in how companies—and their CPAs—will have to account for asset retirement obligations. For capital-intensive entities in particular, these changes require significant analysis, the likelihood of procedural changes and, depending on past accounting practices, the possibility of material transition charges. However, and this represents the benefit that FASB believes justifies and outweighs those costs, the new statement provides a mechanism for ensuring that companies’ balance sheets reflect more clearly the economic realities of retirement obligations associated with long-lived assets.