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A refresher on asset retirement obligations

Oil and gas assets have legal obligations that must be met when the asset is retired.

FASB Statement No. 143 addresses financial accounting and reporting for obligations associated with the retirement or decommission of tangible long-lived assets and the associated asset retirement costs. The statement is a required accounting concept for all industries, but has particular implications for oil and gas companies due to the many legal obligations involved with retiring long-term assets in this sector.

For example, oil and gas companies would need to make a provision for the future cost of dismantling, removal and abandonment of long-term assets such as wells, pipelines or offshore operations at the time these assets are acquired or constructed. Under FASB No. 143, entities are required to record the costs of the asset retirement obligation (ARO) at fair value, defined as the amount an informed and willing third party would agree to assume in order to complete decommissioning activities. Many times, calculations of fair value of a potential liability thirty to fifty years down the road can be very complex and include a high degree of uncertainty.  A good CPA can help with the some of the more complicated assumptions used in these calculations.

The calculated fair value amount becomes included in the carrying amount of the related asset. The capitalized cost of the retirement obligation is then depreciated using an accepted methodology or useful life. In most cases, entities cannot write off 100 percent of the asset retirement cost in the year of acquisition. Statement No. 143 does not provide specifics on how asset retirement costs can be depreciated other than to specify the depreciation be systematic and rational.

When does Statement No. 143 apply?
It's important to realize Statement No. 143 is not limited to the actual retirement activities of long-lived assets. It is also applied to legal obligations for disposal of assets even if retirement is not legally required. For example, if any components within the asset need to be replaced before the asset is retired, entities must meet all legal obligations for proper disposal of these components.

"Statement No. 143 is not limited to the actual retirement activities of long-lived assets."

Additionally, while ARO is generally settled when the asset is retired, in some instances the ARO may be partially settled while the asset is still in operation. For example, if a portion of a production site is retired, any costs incurred in this retirement would fall under the scope of Statement No. 143.

Estimating the fair value of retirement obligations
In determining the fair value of an ARO, entities must estimate the cash flow that would be required to retire the asset while meeting all legal obligations. This includes existing or enacted laws, statutes, ordinances or written or oral contracts. Statement No. 143 may apply to any costs related to acquisition, construction, development or normal operation of a long-lived asset.

For the oil and gas industry, the fair value of an ARO typically relates to the estimated cost of plugging and abandonment of wells many years in the future. These costs typically consist of the actual raw materials used in plugging the hole as well as labor and other direct costs. Companies can always start with current plugging and abandonment costs; however, these amounts need to be adjusted to reach a future value at the end of the wells' estimated useful lives. Typical assumptions used to achieve a future value may be inflation rates, plugging and abandonment costs per foot, credit adjusted risk free rates or discount rates and the estimated lives of the wells.

"The fair value assessment should be periodically adjusted to account for the passage of time."

The fair value assessment should also be periodically adjusted to account for the passage of time. However, as the actual cost of meeting the ARO may be off from the estimates used in the initial fair value assessment, many entities will show a loss or gain once the asset is actually retired.

Why ARO estimates are important
Having accurate assessments of future retirement liability can be essential during the acquisition of an oil and gas property. The carrying cost of this liability will affect the overall profitability of the asset. Having realistic assessments of the scope and future and current costs of AROs can help in more informed financial planning and better financial reporting.

Oil and gas entities that have questions about Statement No. 143 or are in need of assistance in calculating the fair value of retiring their assets should contact the accounting professionals in LaPorte's Energy Industry Group for more information and assistance in these evaluations.