Asset Retirement Obligation Journal Entry

Assets retirement obligation is the process of reversal of fixed assets modification which impacts the surrounding community. It is the company’s obligation that needs to remove any impact from the community caused by the investment.

Some fixed assets require the company to make installations on the landscape and the area. These modifications will impact the public around them, so the government requires the company to reverse it back at the end of fixed assets useful life. For example, a company drills the oil from the ground, and some of the oil will leak from the well and impact the surrounding area. At the end of drill operation, the company must spend cash to remove all the impact which cause by the oil drilling.

Assets retirement obligation is also known as the decommissioning cost which presents as the company’s liability to be settled in the future. This cost happens when company makes a huge investment that impacts the whole community, so the government requires to reverse the impact otherwise the license will not be issued.

Assets retirement obligation also happens when the company leases the fixed assets from the property owner. The company modified the assets and promise to reverse back at the end of the operating lease. It is the obligation that the lessee needs to remove any modification during the lease term.

Assets retirement obligation journal entry

Assets retirement obligation is the company liability that needs to record on balance sheet. It is the cost to remove or reverse the modification to comply with government requirements or lease contracts. It is the estimated cost that company makes based on past experience and technical analysis.

The liability needs to record at fair value, most companies use the present value. It is the present value of the estimated future cost. It will record as part of the associated fixed assets.

The journal entry is debiting fixed assets and credit assets retirement obligation.

This cost will be part of fixed assets on balance sheet. The obligation will present as a liability at the present value. The amount of This fixed asset will be included with associate assets to make the depreciation depend on the estimated useful life.

At the end of the accounting period, the company needs to record additional assets retirement obligations which need to increase to the future value on the retirement date. It will update the present value of ARO. The debit side will impact the accretion expense. We need to use the same discounted rate which applies during initial recognition. The journal entry is debiting accretion expense and assets retirement obligation.

The ARO will keep increasing every year base on the interest rate. At the end of assets useful life, it will equal the company estimation (future value). It also increases the value of ARO to the present value.

At the end of fixed useful life, the company has to complete its obligation. It is also the time to settle the liability in the balance sheet. The journal entry is debiting ARO and credit cash paid to complete the assets’ decommission.

The criteria to record the assets retirement obligation

Company requires to record lability when there are enough criteria as follow:

• The company is able to measure the ARO’s fair value.
• The entity has no option to avoid the future transfer or use of assets.
• Obligation event has already incurred.

Assets retirement obligation journal entry Example

ABC is an oil drilling company, they expect to drill the well which costs $ 50 million. The well will be able to generate income for 10 years. However, the government requires the company to remove any negative footprint which incurs due to the leak of oil and so on. Management has estimated the cost to remove the impact would cost 10 million. The interest risk-free rate is 6%.

Please prepare a journal entry related to assets retirement obligation.

ABC has the obligation to remove any negative impact which incurs due to their business operation. The accountant needs to record the assets retirement obligation which is the liability into the balance sheet. Management has estimated the AOR is $ 10 million which will happen in 10 years, so we need to discount today’s value with interest-free rate of 6%.

Present value of ARO = [10,000,000 /(1+6%)^10] =  $ 5,583,948

The journal entry is debiting Fixed Assets (Oil Drill) $ 5,583,948 and credit ARO.

This transaction will include the fixed assets (Oil Drill) on the balance sheet, it will be depreciated over the useful life. The total cost of oil drilling would be $ 55,583,948 ($ 50,000,000 + $ 5,583,948), it will be classified as fixed assets on balance sheet.

The company needs to depreciate the oil drilling over the useful life of 10 years.

Depreciation Expense = $ 55,583,948 / 10 years = $ 5,558,394 per year

The journal entry would be debiting depreciation expense $ 5,558,394 and credit accumulated depreciation.

As normal, the transaction will reduce the fixed assets balance (oil drilling) and increase the expense. ABC needs to post this transaction for 10 years and the oil drilling balance will decrease to zero at the end of the 10^th year.

Moreover, at the end of the 1^st year, we need to record accretion expense and ARO as the ARO needs to increase to $ 10 million at the end of the 10^th year.

Accretion expense = Initial ARO * interest free rate

Accretion expense = $ 5,583,948 * 6% = $ 335,037

At the end of 1^st year, the journal entry is debiting accretion expense of $ 335,037 and credit ARO $ 335,037.

Accretion expense will present on income statement and it also increase the balance of ARO on balance sheet. ABC needs to repeat this transaction every year for 10 years. The transaction amount will different from one year to another, please refer to below table:

ABC needs to record accretion expense and ARO base on the table above. By end of the 10^th year, the ARO will increase to $ 10 million.

At the end of the 10^th year, ABC needs to pay for the decommissioning of the oil drill. They will record the debit of ARO and credit Cash.

This transaction will remove the ARO from balance sheet and decrease the cash as well.

By the end of the 10^th year, the fixed assets (Oil Drilling) will be zero as well as the Assets retirement obligation.