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An Asset Retirement Obligation (ARO) is an accounting liability reported on a company’s general ledger that is meant to represent how much it will cost to retire an asset. Companies record these obligations when making major asset acquisitions, particularly for assets that will necessarily go out of service at a certain time, or that the company will have to clean up after, like an underground gas tank that will eventually have to be removed. When purchasing an asset, companies will record this information as a debit in the company ledger. An asset is retired when it is completely taken out of service from the company’s normal business operations.
AROs are recorded at the time an asset is purchased to represent an estimate of how much it will take to retire that asset when the time comes. In a very simplified example, if a company acquires a manufacturing plant that it will have to decommission in 10 years, it will need to record an asset retirement obligation equal to how much it will take to decommission that plant 10 years later. So, if it would cost $10,000 US Dollars (USD) to decommission the plant at the time the company buys it, and there will be an inflation in the cost of decommissioning plants of five percent per year until the company decommissions it, then the ARO would be $16,288.95 USD total. The actual ARO written on the company ledger for the year would be calculated by dividing this number by 10, since the asset will be active for 10 years, leaving an ARO of $1,628.89 for each year. In real life, calculating actual AROs is more complicated, but the basic idea is the same.
This liability only applies specifically to costs of retiring an asset. This means that it does not cover any costs that happen by accident, or repairs that need to be made. Likewise, ARO does not cover costs of building or purchasing replacement assets or converting existing assets into a new asset. For example, in the case of the manufacturing plant that's set to be decommissioned in 10 years, the ARO would not cover costs of cleaning up after an accidental fire that destroyed the plant, or costs of converting the manufacturing plant into a museum when it's no longer in use.
Companies can use the asset retirement obligation accounting rule for any long-term assets, not just manufacturing plants. Long-term assets, or "non-current assets" are typically grouped into property, plant, and equipment.
Property often refers to the physical land owned by a company. Companies usually own property to take advantage of the natural resources available on these parcels. The property will go out of service under the asset retirement obligation rule once the natural resources are depleted.
Plant assets include physical buildings or other facilities companies use to produce goods or services. These items usually last a specific number of years depending on the type of building or how often the company uses the facility. Plant retirements can also occur when a company outgrows its current facilities or need new buildings for increasing production output, and thus retires the old buildings.
Equipment assets are one of the most common type of assets that require asset retirement obligation liabilities. Companies use equipment to produce specific consumer goods or services. These assets often have a specific useful life for the asset retirement obligation calculation. Companies retire equipment assets after they can no longer produce satisfactory products.