ARO Example

Consider a gas station with a 40 year lease. Five years after the lease begins, a new underground storage tank is installed. The tank has an estimated useful life of 40 years. The current cost to remove a tank is $15,000. You estimate inflation (for removal work) over the next 40 years at 2.5% per year. Your credit-adjusted risk-free borrowing rate is 8%.

The life of the tank cannot extend past the life of your lease, so you must assume retirement of the tank after 35 years. The assumed future cost (after inflation) of removing the tank in 35 years is 15,000 * (1 + .025) ^ 35 = 35,598.08. The present value of that is 35,598.08 / (1 + .08) ^ 35 = 2,407.66. This is your initial ARO.


Sample ARO journal entries, first year
Account Debit Credit
 Asset retirement cost (ARC) 2,407.66  
     Asset retirement obligation   2,407.66
 (Initial booking)    
 Accretion expense (2,407.66 * 8%)
192.61
 
      Asset retirement obligation
 
192.61
 (Annual ARO accretion)    
 Depreciation expense (2,407.66 / 35)
68.79
 
      ARC accumulated depreciation
 
68.79
 (Annual depreciation)    
Sample ARO journal entries, second year
Account Debit Credit
Accretion expense ( (2,407.66 + 192.61) * 8%)
208.02
 
      Asset retirement obligation
 
208.02
 (Annual ARO accretion)    
 Depreciation expense
68.79
 
      ARC accumulated depreciation
 
68.79
 (Annual depreciation)    

The obligation continues to accrete at compounded amounts until at the end of the useful life of the tank, the total ARO on your balance sheet is 35,598.08, while the ARC asset has fully depreciated to zero. You then hire a contractor to dig up the tank, calculating the expenses involved. If the final cost is 34,000:

Sample ARO journal entries, end of asset life
Account Debit Credit
 Asset retirement obligation 35,598.08  
 ARC accumulated depreciation
2,407.66
 
     Cash (for services rendered)   34,000.00
     Asset retirement cost (ARC)
 
2,407.66
     Gain on termination
 
1,598.08
 (Retirement of asset: tank removal)    

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