Asset retirement obligation, or decommissioning cost, is the liability incurred by organizations in reversing the adjustments made to the landscape when fixes assets run out of their useful life. Asset retirement obligation accounting broadly refers to the calculation of the amount a company expects to spend in disposing of a fixed asset and reversing the changes made to the installation site.
Installing a fixed asset requires a significant adjustment to the landscape in which it is erected. Such an adjustment affects the communities in which it is installed. Consequently, it is the responsibility of the organization to reverse that adjustment and protect the communities from the negative effects of the asset when it runs out of its useful life.
An example of a fixed asset that carries significant ARO costs is an oil well. Drilling an oil well would require drilling holes in a landscape in pursuit of oil. Regardless of whether a company finds oil or not, the well must be plugged when the oil is not being extracted from it to prevent the leakage of hazardous fluids or gases.
Accounting standards require companies to include the face value of future ARO costs in the total purchase cost of the asset. The decommissioning cost increases over time to account for the unwinding of discount. Essentially, it is a sort of liability that incurs interest with time. Companies record it as a debit in their ledger as the time the asset is acquired to represent an estimate of how much it will cost to decommission the asset when the time comes.
For example, if company ABC purchases a manufacturing plant it plans to retire in 10 years, it will have to record an ARO equal to the cost of decommissioning the plant 10 years later. Thus, if it would cost $10,000 to retire the plant at the time the company acquires it, and there will be a 5% annual inflation in the cost of retiring the plant, the decommissioning cost would be $16,288.95 total. Therefore, the amount entered on the company’s ledger each year would be $1,628.89, which is the total amount divided by ten.
However, asset retirement obligation accounting is more complicated in real life, but the basic idea is the same. AROs only apply specifically to the cost of decommissioning a fixed asset, which means that they do not cover repairs or other costs incurred by accident. Likewise, they do not cover the cost of converting existing assets or purchasing replacement assets.
