Accretion expense is an ongoing expense related to a long-term liability. The liability is often an asset retirement obligation (ARO) under the contractual or compliance requirements of a company.
Accretion expense records the change in the ARO liability that changes with the passage of time. Usually, it represents the change in the present value of the discounted cash flows of the ARO liability over the useful life of the asset.
Let us discuss the asset retirement obligation liability and accretion expense with the help of an example.
What is an Accretion Expense?
The definition of accretion expense as per US GAAP guidelines can be:
“An amount recognized as an expense classified as an operating item in the statement of income resulting from the increase in the carrying amount of the liability associated with the asset retirement obligation”.
Accretion is an indirect operating expense that results due to a recognition of asset retirement obligation (ARO). ARO is the liability upon a company to safely remove the fixed assets it installed after their useful life.
Companies are contractually bound to arrange the asset removals in many cases. The prime examples are construction sites, mineral extraction machinery, oil and gas plants, and so on.
Accretion expense is recognized to record a change (often an increase) in the ARO liability over the years. Many factors including the PV of liability, inflation rate, and interest rate affect the value of the ARO liability.
Asset Retirement Obligations (ARO) and Accretion Expense
Let us discuss the asset retirement obligation first to fully understand accretion expense and its importance.
Asset Retirement Obligation (ARO)
Asset retirement obligation refers to the obligation of an entity to remove a physical and tangible asset. It is associated with the removal of property, plant, or capitalized goods when these assets are retired from service.
An entity records the obligation when it installs a tangible physical asset. Common examples of these assets include manufacturing plants, mineral extraction plants, oil and gas rigs, construction machinery, and so on.
In most cases, the liability is a legal obligation to remove hazardous material, debris, and scrap material. Most of these obligations fall under environment protection compliance as well.
Accounting for Asset Retirement Obligation
Accounting guidelines for the asset retirement obligation (ARO) are covered in detail by ASC 410.
Under ASC 410 guidelines if a company installs a physical asset, enter into a lease of a building or any other such installations that create an obligation for the company to remove these installations, it will record an ARO in its account books.
The company will calculate all types of obligations arising due to the usage of tangible assets. For accounting purposes, the company will generate an asset retirement obligation and a subsequent entry to increase the asset value of the leasehold.
Initial Recognition of Asset Retirement Obligation
The liability arising due to an asset installation recorded as an ARO will be accounted for using the fair value method. In simple words, it means to calculate the present value of the liability.
The company can take the following steps for initial recognition of the ARO:
- Calculate the fair value of the asset retirement costs using market rates.
- Calculate and include all obligations arising due to asset retirement such as environment obligations.
- Estimate the useful life of the asset as precisely as possible.
- Adjust the fair value of the ARO for inflation over the useful life of the asset.
- Adjust the ARO figure for present value using the risk-free interest rate as a minimum rate.
- Record and adjust the ARO liability to reflect the fair value of the leasehold improvements.
Journal Entry of Asset Retirement Obligation
The general journal entry to record the initial asset retirement obligation against the asset value of leasehold improvements will be recorded as:
| Account | Debit | Credit |
| Fair Value of Asset Leasehold Improvements | $ XXXX | |
| Asset Retirement Obligation- ARO | $ XXXX |
Subsequent Recognition with Accretion Expense
The liability amount arising due to asset retirement obligation changes with time. The entity does not need to update the changing values in its book on a monthly basis. However, it must update the values regularly to reflect the true obligation as soon as reliable data is available.
The journal entry to record the accretion expense will be:
| Account | Debit | Credit |
| Accretion Expense | $ XXXX | |
| Asset Retirement Obligation- ARO | $ XXXX |
Note that the accretion expense is an adjustment for the present value of the ARO. Thus, it will change every year until the ARO is fully amortized.
Accounting for Accretion Expense
The recognition of the asset retirement obligation is recorded under ASC 410. After the initial recognition of the liability, the entity may need to record a change in the remaining value of the liability for various reasons.
ASC 410-20 does not require to reflect these changes to be recorded frequently. However, it requires an entity to update the ARO values whenever substantial events affect the initial calculations.
The changes in the ARO liability are reflected through accretion expense. Accretion expense is basically recorded as an operating expense on the income statement of the entity. It represents the change in the value of ARO initial estimates.
A change in the value of ARO can arise due to several factors including:
- Change in probabilities or estimates in the value of ARO
- Change in the interest rate or inflation rate
- Any changes in contract clauses
- A regulatory change affecting the ARO measurement
Accretion expense is calculated using the risk-free interest rate that would be used to recognize the ARO liability initially. With the passage of time, the remaining period decreases, and the PV of the liability increases.
Accretion expense is the adjusted beginning value of the liability at each accounting period (usually at the beginning of the year). It is computed the same way as interest expense; however, it is recorded separately from the interest expense.
In some cases, remeasurement of the ARO liability can result in a gain. In that situation, the difference will be recorded for the same accounting period. However, all the accounting entries for the previous years will be adjusted on a pro-rata basis to reflect the change in the total ARO liability.
Accretion Expense – Working Example
Let us consider an example that will show us the initial recognition of the ARO and accretion expense arising due to a change in the liability.
Suppose ABC company leases land for 15 years. It installs construction machinery with a price of $ 1.5 million on the land with a useful life estimate of 10 years.
ABC company is contractually bound to remove the machinery once it is no longer used. It arises an asset retirement obligation for ABC company.
Suppose ABC company estimates the following expenses to calculate an estimated ARO in 10 years. It estimates an average inflation rate of 3.5% and a risk-free interest rate of 8% for PV calculations.
| Expense Item | Amount in $ |
| Labor Cost | 40,000 |
| Overhead and Equipment | 25,000 |
| Other expenses | 5,000 |
| Total Amount of the ARO | 70,000 |
| Inflation Adjustment at 3.5% | (70,000 × (1.035) ^10= 98,742 |
| PV of the ARO at 8% for 10 years | 45,736 |
Journal entries for initial recognition of machinery cost and ARO will be:
| Account | Debit | Credit |
| Machinery and Plant | $ 1.5 million | |
| Cash | $ 1.5 million | |
| Machinery and Plan | $ 45,736 | |
| Asset Retirement Obligation Liability | $ 45,736 |
Since we know the PV of machinery will change with the passage of time, ABC company will have to record an accretion expense as well.
The Table for the accretion expense for 10 years will be as below.
| Year | ARO Liability Beginning | Accretion Expense | ARO Liability Ending |
| Y1 | $ 45, 736 | $ 3,659 | $ 49,395 |
| Y2 | $ 49,395 | $ 3,952 | $ 53,347 |
| Y3 | $ 53,347 | $4,268 | $ 57,615 |
| Y4 | $ 57,615 | $ 4,609 | $ 62,224 |
| Y5 | $ 62,224 | $ 4,978 | $ 67,202 |
| Y6 | $ 67,202 | $ 5,556 | $ 72,758 |
| Y7 | $ 72,578 | $ 5,626 | $ 78,384 |
| Y8 | $ 78,384 | $ 6,271 | $ 84,655 |
| Y9 | $ 84,655 | $ 6,772 | $ 91,427 |
| Y10 | $ 91,427 | $ 7,315 | $ 98,742 |
The journal entry to record the accretion expense each year will be:
| Year | Account | Debit | Credit |
| Y1 | Accretion Expense | $ 3,659 | |
| ARO Liability | $ 3,659 | ||
| Y2 | Accretion Expense | $ 3,952 | |
| ARO Liability | $ 3,952 |
ABC company will continue to record the accretion expense in the same manner for 10 years. If there are any changes in the inflation rate, risk-free interest rate, or any other requirement, it will adjust for the gain or loss in the subsequent accounting period.
Accretion Expense Vs Amortization
The calculation methods for accretion expense and amortization look similar. In practice, amortization is a scheduled calculation to spread the intangible asset costs. In simple words, amortization is the depreciation charge for intangible assets.
Contrarily, an accretion expense is recorded with there is a change in the liability. The liability arises due to a commitment to retire physical and fixed assets. It is recorded as an expense on the income statement of the company.
