CPA Exam - FAR (Financial Accounting and Reporting)Select TransactionsMedium
A company incurs a liability for environmental remediation. The remediation is required by law when a manufacturing plant is decommissioned, which is expected in 10 years. The company can reasonably estimate the fair value of the obligation. The company should recognize this liability as:
- AA contingent liability, disclosed in the notes to the financial statements.
- BAn expense in the period the plant is decommissioned.
- CA gain contingency, disclosed in the notes to the financial statements.
- DAn asset retirement obligation (ARO), recognized at fair value with a corresponding asset increase.
Show answer & explanationAnswer & explanation
Correct answer: D. An asset retirement obligation (ARO), recognized at fair value with a corresponding asset increase.
Environmental remediation costs that are legally required upon decommissioning of an asset, and whose fair value can be reasonably estimated, meet the criteria for an asset retirement obligation (ARO) under ASC 410. An ARO is recognized as a liability at its fair value, and a corresponding increase in the carrying amount of the related asset is recorded.
Why the other options are wrong
- A. While it's a future obligation, it's not a contingent liability because it's a present obligation whose fair value can be reasonably estimated.
- B. The liability is recognized when incurred, not when the decommissioning actually occurs, and then systematically expensed through depreciation.
- C. This is a liability, not a gain contingency.
Asset Retirement Obligation (ARO)
A legal obligation associated with the retirement of a tangible long-lived asset, recognized as a liability at fair value in the period in which it is incurred.
- Recognized when incurred, not when settled.
- Initial measurement at fair value (present value of estimated future costs).
- Corresponding increase in the carrying amount of the related asset.
- The liability is subsequently increased for accretion expense, and the asset is depreciated.
Memory trick: Decommissioning duties, discounted present value, asset's future beauty.