A company has to pay an accretion expense for the fixed assets acquired under Asset Retirement Obligation (ARO) when the asset’s useful life is ended. From a business perspective, accretion expense is recorded as a periodic operating expense in the company’s income statement for a long-term liability. The term accretion expense appears in the topic 410-20 of the United States Generally Accepted Accounting Principles (GAAP) which describes Asset Retirement Obligation ARO. ARO imposes the following obligations of the company for certain assets:
- Safe removal of assets from the site
- Clearing the site of any hazardous materiel
- Restoring any damage caused to the site and returning it into its original form
Accretion expense is calculated using a discounted cash flow analysis (DCF). It is basically an expense which is to be paid by the company in the future. The company has to consider both the present value (PV) and future value (FV) of liability to be able to write it off when the time comes. The following example illustrates this concept.
Let’s suppose an oil extraction company has leased land for 50 years. This land is to be used for drilling and mining purposes. The company has to remove the equipment, clean any kind of waste, and restore damages to the land, after 50 years, under ARO. The PV of this land is $70,000, and its FV is $90,000. In order to raise $20,000 in 50 years, the company’s accountant would show an increase in the present value of this liability, in the balance sheet, by recording an accretion expense in the income statement. The increase in PV is according to the discount rate on the leased land, which is 10% in this example. With annual compounding, the accretion expense for the first year would be $7000, so the PV of the land at the end of year one would be $77,000. Other liabilities under ARO construction areas include nuclear energy, plants, etc.
Accretion Expense on Income Statement
Accretion expense is recorded as an indirect operating expense on the income statement. It is deducted from the revenues like all other expenses to generate the net income. At the end of the period, asset retirement liability is calculated and charged in the income statement. The present value of long-term fixed assets increases over time according to the risk-free discount rate, and so does their liability. This change in liability amount is recorded as an accretion expense.
The formula for accretion expense is as follows:
Accretion expense = Present ARO cost * (1+inflation) ^ Compounding Periods
Accretion Expense in the Oil and Gas Industry
Oil and gas are found on rare grounds, so companies borrow these lands on lease to extract these precious resources. Such land is leased on an ARO policy for a specified time, like 60 years. As the oil and gas industry has grown, the cost of dismantling the lent assets has become significantly high. This cost or accretion expense is to be paid upon the retirement of an asset as the asset retires when its useful life is completed either because the asset might be sold, recycled, worn out, or abandoned. The oil and gas mining equipment must be removed from the construction site once the allowed duration is completed and the asset (land) has retired. In addition, the surface must be returned to its original condition. A lot of hazardous wastes are produced in the mining process, so all kinds of waste must be eliminated under the ARO policies. To cover all these expenses, accretion expense is deducted periodically.
Accretion expense tax treatment
A company’s finance department is responsible for the cleanup activities after the end of long-term assets (land, building, etc.), which is required by the law. According to GAAP (General Applied Accounting Principles), there are requirements to be followed for “asset retirement obligations,” for which the company schedules their accretion expense.
The obligations are as follows:
- The accretion expense is only incurred when the asset’s original fair value can be reasonably estimated.
- An interest rate must be applied annually in accordance with possible inflation rates and appreciation of the asset over the future years.
- The amount must be reasonable and relevant to the asset’s market value. Overstating or understating the accretion expense in attempts to avoid tax or reduce tax applied per year is punishable by law under the FASB statement 143.
Accretion expense vs. amortization
Accretion and amortization, both, are scheduled recognitions of liabilities, but they differ greatly in regards to use. Amortization is an accounting technique commonly used to spread an asset’s cost over its useful life, such as the depreciation of intangible assets. It is utilized for the periodic reduction in the value of these assets over a period known as the useful life of the assets. Examples of such assets are patents, trademarks, loans, and other non-physical assets.
Accretion treatments mostly apply on AROs for the purpose of environmental remediation due to business operations. On the other hand, accretion is an accounting treatment used when a certain liability has been discounted to its present value at initial recognition of that liability and increased over a period of time. For example, the land is an asset purchased by a mining company that wishes to utilize the land for mining purposes. The landowner agrees to lease the land on the condition that the asset (land) must be returned in its original state after the company has performed its mining business. Upon mutual agreement, the land is rented to the lease (company) and is expected a future payment which is equivalent to the cost of returning the used land back to its original or non-specialized condition.
The journal entries of amortization would recognize amortization expense as a debit with the asset being credited by the same amount. This shows that amortization results in a decrease in asset value as well the company’s equity.
For the journal entries of accretion expense, the company has to first provide an estimated amount of restoring the asset to its original state. Then an annual interest rate is applied per year. The journal entry records a debit for an asset retirement obligation and a credit of the same amount for the expense which accumulates periodically over the years.
Accretion expense and cash flow statement
Accretion expense is a discounted cash flow technique. It is necessary to add this expense in the company’s cash flow statements as this liability typically has a long, pre-determined presence on the balance sheets as well. Accretion expenses are reported under the “Cash flows from Operating Activities” as the asset is being used in business operations. Under one heading, it is commonly grouped with other scheduled accounting treatments, depreciation, and amortization.
Accretion expense is related to the long-term liability of the business. Mining and oil extraction companies mostly use it. This is because these companies have to restore production with massive expenses. Hence, the companies keep charging expenses throughout the life of the liability. So, it does not seem logical to charge massive expenses in the last year. Hence, the expense is charged in the income statement throughout the life of liability, such expense is called accretion expense.
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