For companies that have asset retirement obligations and such, what is the logic behind setting up a liability and charging interest expense against this liability rather than the value of the asset created to retire the obligation in the future? Can someone summarize the process? Thanks.
Disclosure in text on ARO’s is very spotty. Text itself even says that the practice is highly inconsistent and standards are still basically just forming on how to treat the obligations. Best to know simply what an ARO is and why it’s created.
from wiki Asset Retirement Obligations provide for future disposal of assets as required by SFAS 143 [1]. Firms must recognize the ARO liability in the period it was acquired, generally acquisition. The liability equals the market value, and if that is not available the present value of cash flows that will be required to extinguish the liability. An asset equal to the initial liability is added to the Balance Sheet, and depreciated over the life of the asset. The result is an increase in both assets and liabilities.
What does it mean to have the accrete the liability every year? Shouldn’t it just be about placing the PV of the required amount to dispose of the asset as a liability in the beginning and be done with it?
You set aside a reserve to meet the obligations in the future. Since those fund grow over time, we value the ARO obligations using the present value.