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The Corporate Finance Institute Accounting
Asset Retirement Obligations
ARO costs incurred by companies to restore a site to its original state
and clean up for any damage may be quite significant and, thus, are
capitalized to the cost of the asset. In order to determine the amount to
be capitalized, companies must calculate the present value of the costs
they expect to incur when the asset needs to be removed in the future.
For example, if a company were to build a 10-year oil drilling platform
that costs $10,000,000 with an estimated future dismantling cost of
$450,000, the company needs to record a journal entry for the present
value of the future dismantling costs. So, the company first records an
ARO liability, which is capitalized to the asset and the liability is then
amortized every year that the oil platform is used. Assuming a market
interest rate of 5%, the present value of the dismantling costs would be:
450,000
PV = = 276,261
(1.05) 10
Purchase of Oil Platform Journal Entry:
DR Oil Platform: 10,000,000
CR Cash: 10,000,000
ARO Journal Entry:
DR Oil Platform: 276,261
CR ARO Liability: 276,261
Finally, just like how the ARO liability is amortized every year,
depreciation expense must also be recorded every year for the oil
platform, depending on the method the company chooses to use. Learn
more about the different methods of deprecation on the link below.
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