When faced with an obligation to restore a long-lived asset or the environment surrounding it to its original condition, the proper accounting treatment is dependent upon whether the obligation is an asset retirement obligation (ARO) or an environmental obligation tied to a catastrophic event such as an oil spill. The criteria for each of these classifications is presented in ASC 410 Asset Retirement and Environmental Obligations (ASC 410). This article will discuss both facets of ASC 410 and provide a means of differentiating between asset retirement obligations and environmental remediation liabilities governed by federal regulations.
Revisiting AROs
Our previous blog defined an ARO as a liability for the costs to remove property, equipment, or leasehold improvements at the end of the lease term, stemming from contract stipulations for a leased asset to be returned to its original condition at the end of the lease term. Now, we are going to expand on that definition to not only consider leased assets, but to also include any legal obligations associated with the retirement of tangible long-lived assets.
ASC 410-20 covers retirement obligations that stem from the acquisition, construction, development, or normal operation of these assets. A key consideration when assessing if remediation efforts fall under the guidelines of ASC 410-20 is whether or not the environmental impacts are expected as a result of normal operation of the asset. The emphasis here is on “normal” operation. If the remediation liability is reasonably unavoidable and a byproduct of using the asset as intended, you may conclude you are dealing with an ARO. For example, a small level of pollution from a manufacturing facility resulting from normal operations would fall under ASC 410-20. Typical examples of AROs related to environmental remediation may include but are not limited to cleaning up and restoring the environment surrounding nuclear plants, mines, oil wells, and landfills after their closure.
One point of confusion with AROs stems from the guidance found in ASC 410-20-15-2. This specific section of the FASB‘s guidance defines the scope of ASC 410-20 and references environmental remediation liabilities, usually not thought of as AROs. The difference is that environmental remediation liabilities that are within the scope of ASC 410-20 are a result of normal operations. However, if the obligation is related to environmental remediation and results from improper use of the asset, you are most likely dealing with an environmental obligation under ASC 410-30.
Below we’ll discuss environmental remediation liabilities resulting from the improper use of an asset that is outside the scope of AROs. But first, let’s look at an example of a liability that would qualify as an ARO.
Let’s assume a company commences the operation of an offshore oil rig and constructs a platform that will no longer be in service in 15 years. When the rig is shut down, it must be dismantled and removed. Over the service period, the company’s operation of the rig also leads to a small amount of spillage. However, due to the nature of offshore drilling, some spillage is generally unavoidable and to be expected. Additionally, the company is not required to immediately rectify any environmental impacts.
The following facts presented in the scenario are considered when classifying the costs to remove and dismantle the rig, as well as remediate any environmental impacts of the oil rig:
- The asset is being used as intended and in accordance with environmental regulations.
- The small amount of spillage is generally unavoidable and predictable.
- Immediate remediation is not required.
Due to these points, the estimated costs to seal the oil well, dismantle and remove the platform and clean up any environmental impacts stemming from its use are categorized as an ARO. The estimated obligation should be recorded on the balance sheet when the oil rig is installed, assuming the costs are estimable.
Please note, this classification is a judgment call, and other factors, such as changes in environmental regulations or a company’s past practices can complicate this assessment.
Accounting for AROs
Initial recognition of an ARO relates to timing. Essentially, the obligation will be recorded in the period that it is incurred, provided that the reporting entity can arrive at an estimate of the obligation’s fair value.
The initial entry to record an ARO is a credit to a liability equal to the discounted fair value of the obligation (i.e. its present value) with an offsetting debit to increase the carrying value of the long-lived asset undergoing retirement by an equal amount. There is no impact to the income statement or statement of cash flows during the initial recognition of an asset retirement obligation.
Subsequently, an entity will recognize accretion expense through the income statement for the passage of time. Accretion expense is a noncash expense that increases the carrying value of the ARO on the balance sheet. In addition, the capitalized retirement cost will be amortized on a systematic and rational basis over the remaining useful life of the asset. Both the activity stemming from the accretion of the ARO liability and depreciation of the capitalized asset will be recognized as noncash adjustments to the entity’s operating cash flows. Any changes to the estimated timing or amount of the initial ARO are recognized as an increase or decrease to the carrying value of the ARO and the related long-lived asset. When the asset is retired, the obligation is relieved as expenses are incurred.
Overview of ASC 410-30 & Environmental Liabilities
Broadly speaking, the term environmental liability may be applied to scenarios that fall under the jurisdiction of ASC 410-20 or ASC 410-30. However, as we’ve established above, ASC 410-20 is generally applied to environmental obligations that occur as a result of the normal operation of a long-lived asset. Environmental obligations under ASC 410-20 have different requirements for recognition, measurement, and disclosure when compared to environmental obligations under ASC 410-30. This section will focus on environmental remediation liabilities under the scope of ASC 410-30.
Environmental remediation liabilities under the scope of ASC 410-30 result from the improper use of an asset and lead to devastating environmental contamination or pollution. These types of liabilities are governed by federal laws surrounding environmental remediation and are typically overseen by the Environmental Protection Agency (EPA). The guidance in ASC 410-30 was specifically written to take these regulations into consideration. These types of environmental obligations are linked to entities who have or have had some past association with a site requiring remediation efforts. Terms like primary responsible party and superfund site are commonly associated with these kinds of obligations.
Some factors to consider when assessing whether you are subject to remedial environmental obligations under ASC 410-30 include:
- Whether the entity contributed to the contamination due to the improper use of an asset or an avoidable catastrophic event
- Whether the contamination was the result of a catastrophic or unexpected event
- Whether the entity is obligated to undertake remedial efforts immediately
To better demonstrate an environmental obligation that would fall under ASC 410-30, let’s look at another example:
Let’s assume a company commences the operation of an offshore oil rig and constructs a platform that will no longer be in service in 15 years. In year 3, under pressure to increase outputs due to demand, the company takes some excessive risks, which lead to a catastrophic oil spill. Operations are immediately halted and the company undergoes emergency cleanup efforts overseen by the EPA.
In this situation, the costs incurred to clean up the oil spill would be accounted for as an environmental remediation liability under ASC 410-30. We can confidently come to this assessment because:
- The company has the responsibility to operate the oil rig in a safe manner.
- The contamination is a direct result of the company’s actions.
- Remedial efforts were immediately required and under the observation of the EPA.
Accounting for Environmental Liabilities under ASC 410-230
As with most liabilities, to recognize an environmental remediation liability under ASC 410-30, the following two criteria must be met:
- It is probable a liability has been incurred (i.e. the entity has an obligation to remediate or clean up a site from the improper use of an asset)
- The liability is reasonably estimable
Now that we have differentiated between an environmental remediation liability that would be accounted for as an ARO and an environmental obligation under ASC 410-30 from a qualitative standpoint, let’s review the accounting treatment. It is important to note that there are acute differences between both types of obligations during the initial and subsequent recognition.
A key distinction in the accounting for environmental remediation liabilities under ASC 410-30 is that the estimated costs to remediate the contamination stemming from the improper use of the asset are generally not discounted. The entity records a credit to the liability when it is incurred, and an offsetting debit to the income statement. The liability is relieved as costs are incurred and any adjustments for updated estimates are also recorded to the income statement as incurred. Additionally, unlike AROs, recognition of environmental remediation liabilities does not generally result in a capitalized asset.
For a more detailed breakdown of those rare situations that may result in a discounted or capitalized remediation cost, please reference ASC 410-30.
Summary
Obligations to restore a long-lived asset or its surrounding environment to the original condition can either result in recognizing an ARO or an environmental remediation liability. An entity must carefully consider the circumstances leading to the obligation to determine the classification of the commitment. Paramount to this decision is whether the obligation is a result of proper or improper use of the long-lived asset. If the obligation is related to environmental remediation and results from improper use of the asset, you are dealing with an environmental obligation under ASC 410-30. If, however, the liability occurred while the asset was being used as intended, you most likely have an ARO. The detailed accounting guidance for AROs is found in ASC 410-20.
