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  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 developmentNormal 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 PP&E $100,000 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 $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

  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

  21. ARO Example 1 375,000

  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: $1557116 ÷ 12 years]

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

  29. ARO Example 1 399,970 * 12% 399,970 47,996 357,116 + 42,854OR find PV forFV=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 1,500,000 • a. What should be the depletion charge per ton of extracted material? • 9,000,000 + 1,500,000 ARO – 1,000,000 RV 2,500,000 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:

  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