A lessee can make several temporary installments or improvements in an underlying asset. However, at the time of lease contract expiry, these installments must be removed.
Asset retirement is an obligation under certain terms and conditions in leasing. US GAAP rules ASC 410 and ASC 842 apply to asset retirement obligation accounting in various cases.
Let us discuss the concept and accounting treatment of asset retirement obligation (ARO).
What is Asset Retirement Obligation?
Asset retirement refers to the removal of assets, property, or plants installed for specific projects. Once removed, these installations will have no use for the same project again.
In other words, after project completion or suspension, these assets must be removed. In lease contracts, asset retirement often relates to temporary installations, property improvements, and other relevant installations.
Asset Retirement Obligation (ARO) is an obligation of the lessee to remove any fixed assets such as installations, property improvements, and equipment at lease expiry.
Common examples of asset retirement obligations include building improvements, temporary partitioning, shop space alterations, installation of machinery and equipment, construction machinery on a project, and so on.
There is a fine distinction between an asset retirement obligation and lease payments for asset removals. Both parties can make a professional judgment to apply ASC 410 or ASC 842 in certain situations.
Purpose of Asset Retirement Obligation
The main purpose of asset retirement obligation is to plan for certain events in the future. For instance, a company leasing land to build stores or install construction machinery for the long term.
ARO obliges the lessee to return the asset in its original condition to the lessor. Hence, both parties can plan for future events.
The costs of ARO arising at a future date can be assessed and calculated in the present value terms. That also makes it easier for both parties to account for the expenses and agree on the right lease payment structure.
Accounting Recognition for Asset Retirement Obligation – ASC 410 and ASC 842
US GAAP rule ASC 410 provides guidance on the recognition and measurement of asset retirement obligation.
Generally, a lessee will incur an ARO if the conditions to return the asset in the original condition (apart from natural wear and tear) are included in the lease term. In other words, if the lessee is legally obliged and the legal obligation is unavoidable.
The scope of ASC 410 provides the following conditions where the ARO applies:
- Legal obligations for the retirement of long-lived fixed and tangible assets. These assets may come from the construction, installation, development, or acquisition methods by the lessee.
- An environmental obligation that arises due to the long-lived asset operations and the lessee is obliged legally for the remediation. The environmental obligation may include partial or full remediation obligation. ASC 410-20 or ASC 410-30 apply in certain conditions.
- A conditional asset retirement obligation activity for the lessee.
- Any legal obligations for the lessor under certain conditions will also apply ASC 410-20 rules.
Some common cases where the ARO rules apply include:
- Dismantling, removing, or relocating the oil and gas facilities including pipelines.
- Closure and remediation activities for mining projects.
- Removal of transmission lines.
- Landfill cleanup activities including wastewater treatment.
- Leasehold improvements by lessee for property, plant, or equipment.
Here are a few important points regarding the scope inclusion of the ARO:
- The obligation must be legally unavoidable
- It must be associated with the long-lived asset retirement
- It must result as a direct acquisition, construction, or development of an asset
- An ARO arises due to the normal usage of assets. It does not obligate the lessee in case of accidents or improper use of assets.
- The sub-topic ASC 410-20 defines the permanent retirement of assets. It excludes the temporary retirement, removal, or transfer of assets by the lessee from the scope of ARO under ASC 410.
ASC 842 or ASC 410
Some leasehold improvements and expenses will fall under variable lease payments that should be recognized under ASC 842 and not ASC 410 ARO.
In such cases, the ARO is due on the lessor side usually. The lessee would not recognize the ARO in these situations.
Any expenses or costs that are incurred by the lessee and fulfill the definition of either lease payment or variable lease payments should not be recorded separately under ASC 410. These obligations should be recorded along with the lease liability and the ROU asset entries under ASC 842 scope.
Asset Retirement Obligation – Scope Exclusions
In many cases, the lessee will incur asset improvement and retirement expenses that may apparently fall under the scope of ASC 410 as well as ASC 842.
The sub-topic ASC 842-10-55-37 offers guidance on the issue:
Obligations imposed by a lease agreement to the lessee to return the asset in its original condition (if there are any modifications carried out by the lessee) do not fall under the ASC 842 lease payment or variable payment definition.
Similarly, any obligations incurred by the lessee to remove fixed assets due to the lease contract terms and conditions would fall under the ASC 842 scope or lease payments or variable lease payments.
Working Example
Suppose a company ABC is in the real estate leasing business. The tenant company XYZ enters into a 5-year leasing contract with ABC.
Following details are available for the lease contract terms and conditions:
- Yearly lease payments: $ 30,000
- XYZ additional construction and modification: $ 200,000 (ARO)
- Costs for obligation of ARO: $50,000
- Discount rate: 5%
The tenant company XYZ will record the lease payment under ASC 842 annually. However, it needs to record the future cost of ARO in PV terms. The cost is accreted on a straight-line basis for 5 years.
| Year | Yearly Accreted Expense | ARO Balance |
|---|---|---|
| PV of $ 30,000 in 5 years | $ 23,520 | |
| Year 1 | $ 1,170 | $ 24,690 |
| Year 2 | $ 1,230 | $ 25,920 |
| Year 3 | $ 1,290 | $ 27,210 |
| Year 4 | $ 1,350 | $ 28,560 |
| Year 5 | $ 1,440 | $ 30,000 |
The accreted expense table shows a yearly expense that the tenant XYZ will record as a fair value of the future expense.
The Journal Entry for the Total Asset Installations will be:
| Account | Debit | Credit |
|---|---|---|
| Leasehold Improvements | $ 200,000 | |
| Cash | $ 200,000 |
The Journal Entry for recording the PV of the future liability (At fair value) will be:
| Account | Debit | Credit |
|---|---|---|
| Leasehold Improvements | $ 23,520 | |
| Accrued Removal Costs | $ 23,520 |
The Journal entry for accreted expense for Year 1:
| Account | Debit | Credit |
|---|---|---|
| Accretion Expense | $ 1,170 | |
| Accrued Removal Costs | $ 1,170 |
At the lease expiry, the tenant company XYZ will record the journal entry for the retirement of the asset as:
| Account | Debit | Credit |
|---|---|---|
| Accrued Removal Costs | $ 30,000 | |
| Cash | $ 30,000 |
