Can someone please explain how this is done. I just looked at the notes and got quite confused!
A company is building for example a coal mining plant for 1M$. and the project is expected to last say 10 years. They know at the end of the life they have some cleanup activity to do. So what they do is increase the price of the plant now (so increase it to say 1.25 M instead of 1 Million). This becomes your asset. And then depreciate that new amount over the life of the asset. As a result of taking your ARO --> Asset goes up. You would also have the 250K as a new Liability. this is what I remember from my L1 studying days. CP
increase the carrying value of fixed asses by PV of futur cost u can depreciate full cost increase in liabliity due to recognition of ARO Hiher interest and depreciation expense --> lower net income lower Asset turnover higher D/E lower ROA lower EBIT/I
An ARO asset retirement obligation occurs when there is environmental damage resulting from a fixed asset use. When incurred, the PV of the clean-up cost must be recognized, a liabiltity on BS and accretion of expenses recorded each period on IS. Assets go up by the same amount as the liability, and is depreciated over the life of the asset. Result: higher assets on BS higher liablities on BS lower NI due to higher depreciation and accretion expenses
map, you da man!!! wow, if you are typing these on your own, then i think you can write a book now for all of us.
Thanks a lot but one q. Why does interest expense increase?
Remember you have a liability on your BS? well, you pay interest and principal on it with each payment that you make to extinguish your liability to clean-up and repair the damage. Just as if you would capitalize an asset, or say for example a lease.
Wait… So with an ARO you take the PV of the cost of cleaning up and increase fixed assets by that ammount, then depreciate this. And with capitalising an asset doesn’t it just add to the assets on the balance sheet and get amortised? How does this affect liabilities? I’m getting quite confused, I know that leases add to assets and liabilities but doesn’t capitalising an asset just increase assets??? I really thought i knew all this stuff. Better to clear it up now then on the day!
My bad, I’m always thinking of leases when it is about capitalizing… In ARO, long term assets go up and liability go up by the same amount like in a capital lease.
Oh right. that clears it up! I was going through all the books trying to find references to what you were saying! lol… having used the CFAI texts in a while!