Someone please explain how Accretion works. How does it affect Asset, Liability or Owner’s Equity? Thanks. Take a look at the question below: A company acquires a manufacturing facility in which it will produce toxic chemicals. The cost of the facility (exclusive of the underlying land) is $25 million and it is expected to provide a 10-year useful life, after which time of the company will demolish the building and restore the underlying land. The cost of this restoration and cleanup is estimated to be $3 million at that time. The facility will be amortized on a straight-line basis. The company’s discount rate associated with this obligation is 6.25 percent. The total expense that will be reported in the first year associated with the asset retirement obligation on this property is closest to: A) $163,618 B) $224,945 C) $265,879 Please show your calculation. I’m trying to under the concept of AROs. Thanks!
A? during the first year. 3m/1.0625^10 At the end of first year, the obligation should be about 1.7m…
^ wrong.
Future Obligation of $3M in 10 years, discount rate is 6.25%. So, PV is $1,636,183 First years accretion expense will be 1,636,183 * 6.25% = 102,261 Plus, depreciation expense of 1,636,183/10 = 163,618 Answer is C $265,879
C Sorry (stand corrected). The expense re: the obligation will be Depr the asset of 1.63m so 163k. Now, the liability build up portion is another 102k So, you have 163k+102k =265k
^ C is the correct answer. I understand that you discount the future expense back to PV and put it on the balance sheet. 1) Do you add it to both Assets and Liabilities? 2) If you depreciate $163,618 (reducing assets) coupled with the accretion expense of $102,261 (another reduction of assets), how do you balance both these asset reductions on the liability side of the equation? 3) Since accretion is increasing liability (at least, I think), how do you reduce assets and increase liability? Won’t that cause a mismatch of the Balance Sheet? Or is there something you have to do with Owner’s Equity?
- Yes 2) Accretion expense is on the liability 3) Not sure I assume it just comes out of working capital.
If accretion expense is on the liability side, how does the PV of the ARO then increase to 3M, if you keep reducing liability with the accretion expense? Accretion expense (an expense) makes the liability (PV of ARO) go up to 3M? I don’t get it.
decrease in assets by $163K increase in liabilities by $102k decrease in OE by $265k (Depreciation $163 + $102k) Balances.
1: Yes. Add to both. 2 and 3:Depreciation reduces Asset. But accretion INCREASES liability. To Balance this Equity decreases by sum of (Depreciation Expense and Accretion Expense). Actually the expenses are recorded in the Income Statement, so Equity should decline.
Yes, you depreciate the asset (to reduce its vlue) … your goal is to zero the asset value of ARO and incr the liability value to its actual value as we approach the end of the life of the asset. I dont care what method you use and take advantage of the tax situation.
The accretion of the liability is a noncash component usually tacked on to the income statement, they say it’s as a component of int expense, but in practice it’s usually distributed all over the place across SG&A, Int Exp, Depr and Amort, etc. This combined with the depr on the asset created by the ARO both decrease revenue, therefore net income, and therefore owners equity. The liability increases by the accretion amount which is perfectly offset by the accretion charges to the income statement (owners equity). As for the depreciation related to the asset, it balances by also reducing OE through decreasing Net Income. Hope this helped.
Dumb question, but why don’t we depreciate the $25m?
Conquistador, I believe you do, dep expense for the actual asset would be 2.5 = 25/10. But the question is only asking for total expense associated with the ARO.
thanks