What is an asset retirement obligation?
Have you ever entered into an operating lease for a building, constructed leasehold improvements, and determined based on the provisions of the lease that you are legally obligated to remove the leasehold improvements at the end of the lease?
Under GAAP, if a company enters into an operating lease for a building, constructs leasehold improvements, and determines based on the provisions of the lease that it is legally obligated to remove the leasehold improvements at the end of the lease, then the company has an asset retirement obligation, or an ARO.
In this blog post we will explain how to account for a lease when the tenant/lessee has an obligation to return the asset back to its condition at the inception of the lease. We will begin by explaining the accounting treatment under GAAP, followed by a comprehensive example using actual numbers.
ARO accounting under GAAP
To account for this scenario under GAAP, the company would record a liability for the cost to remove the leasehold improvements, and increase the asset value of the leasehold improvement by the same amount. The liability would be recorded at fair value, which is another way of saying it should be recorded at the present value.
Click here to learn how to use Excel to calculate the present value of payments or download our free present value calculator:
Sound complicated? It’s really not. Let’s simplify it.
Asset retirement obligation example
Assume a tenant enters into a 10-year operating lease for a building starting 1/1/2016 with monthly payments of 10,000 and annual escalations of 3%. The tenant constructs leasehold improvements totaling $500,000. The useful life of the improvements is 20 years. Under the terms of the lease agreement, the tenant must remove all leasehold improvements constructed at the end of the lease term. The company estimates that it would cost $50,000 to remove the improvements at the end of the lease.
Assume the following:
- The tenant has no renewal options under the lease.
- The improvements are not going to be used elsewhere (the tenant retires the improvements after the lease term).
- The tenant’s borrowing rate is 4%.
Because this is an operating lease and the cost to remove the leasehold improvement is considered an asset retirement obligation, or ARO, the leasehold improvement would have no effect on the straight-line rent amortization of the lease. It would be straight-lined per GAAP according to the following amortization schedule:
As stated above, the tenant will need to record a liability representing the cost to remove the improvements, however that liability has to be recorded at fair value. All this means, ladies and gentlemen, is that we need to calculate the present value of the cost to remove the improvement.
Let’s think about this for a second: it will cost $50,000 to remove the improvements 10 years from today, so if we are to record the liability in today’s dollars (at fair value), then the liability we will record should be less than $50,000. All we need to do is calculate the present value of a one-time payment of 50,000 in 10 years, discounted using the tenant’s borrowing rate. Using the method explained here using Excel, we get the following amortization schedule:
Note that at the end of the 10th year, the liability would have accreted to $50,000, which is the amount required to remove the improvement at that time. We now have everything we need to record our entries. Upon constructing the leasehold improvements, the tenant will make the following journal entry:
To record leasehold improvements constructed.
At the same time, the tenant will record the liability and corresponding asset reflecting the cost of removal of the leasehold improvement:
|Accrued Removal Costs||33,778|
To record leasehold removal costs at fair value.
Note that the total value of the leasehold improvements is now $533,778, which is depreciated on a straight-line basis over 10 years (the lease term). The liability, on the other hand, is accreted using schedule 2 (called the level-yield method). The journal entry at the end of year one is as follows (once again from schedule 2):
|Accrued Removal Costs||1,351|
To mark leasehold improvement removal cost to fair value.
Note that while accretion expense of the removal liability is calculated the exact same way as interest expense using the borrowing rate, it should NOT be reported as interest expense on the statement of operations, and it is included as a component of operating income. So while depreciation expense from the leasehold improvement asset affects EBITDA, the accretion from the corresponding removal liability does not. At the end of the 10th year, the liability would have accreted to $50,000, and the entry to record the actual removal would be as follows:
|DR||Accrued Removal Costs||50,000|
It’s simpler than you think
So there you have it folks: accounting for leases when the tenant must return the asset to its initial condition. This seems a little complex, but it is actually very simple. Remember that we are simply calculating the present value of the removal cost of the improvement, and recording a corresponding asset for the same amount.
Based on that previous remark, you should be having an “Aha! Moment” right about now. The “aha” moment you should be having is this: asset retirement obligations (AROs) are treated just like capital leases! That’s it folks, plain and simple. The obligation for removal costs of a leasehold improvement is calculated, recorded and subsequently amortized exactly like a capital lease. The only difference is that the liability is not recognized as debt.
As always, you can always contact us or comment below with your lease accounting questions.
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