Accretion expense arises from an increase in the present value of a future liability over a specified period. It usually arises from asset retirements or restoration activities due to compliance or contractual requirements.
What is an Accretion Expense?
The accretion expense is a scheduled and incremental recognition of the change in the present value of a long-term liability over its life.
It is an operating expense and it is recorded in the income statement. However, like depreciation and amortization, it is a non-cash item and it must be adjusted for the effect in the statement of cash flow.
Accretion expense gradually increases the long-term liability associated with the long-term use of assets of an entity.
It is commonly relevant in situations where an entity has an asset retirement obligation (ARO). Such situations come from contractual or regulatory obligations for the reporting entity when it must restore an asset or take actions to restore the environmental hazards from the entity’s operations.
Accretion Expense and Asset Retirement Obligation (ARO)
The accounting standard ASC 410-20 requires a reporting entity to record an asset retirement obligation (ARO) that arises from the development, construction, and/or normal operation of an asset.
It also requires a reporting entity to record this ARO at fair value. Then, there arises a difference in the present value and future value of this liability.
This difference is gradually recognized through an accretion expense that increases the liability over the defined period.
The reporting entity can make adjustments to the increase or decrease in the present value of this future liability. The same adjustments can be made at the end of the recognition period by reporting a net gain or loss in the income statement.
The disclosure requirements for an asset retirement obligation mean the reporting entity must recognize the ARO liability at fair value and also record the accretion expense in the income statement.
For recognition and measurement purposes, an entity should gather sufficient information to assess the fair market value of the asset retirement obligation.
In most cases, a reporting entity would use the expected present value method to calculate the ARO liability and the accretion expense amount subsequently.
The Purpose of Asset Retirement Obligation and Accretion Expenses
An asset retirement obligation arises from a contractual or regulatory compliance requirement in the first place.
For example, a construction company takes a construction site for the installation of its heavy machinery, equipment, and production activities. The local laws require such companies to undertake corrective measures at the end of the project to minimize environmental hazards.
The company undertaking this project will then estimate the costs of remedial work and record this liability at its fair market value in its financial statements as and when it arises.
The recognition of the ARO is to record the fair value of this liability. The difference is recorded as an accretion expense which gradually increases the liability to its present value at the end of the estimated period.
Thus, the main purpose of recording an accretion expense is to cover the gap between the ARO liability’s current and future values in the discounted present value terms.
How to Measure and Record an Accretion Expense?
The first step in the recognition of an accretion expense is to determine the legal obligation for an asset retirement obligation (ARO) liability.
Once the entity determines there is a legal obligation to record an ARO liability, it must analyze the fair market value of this liability.
Then, it will record the difference in the current and present value of the future obligation as an accretion expense in its income statement.
This accretion expense is then gradually increased at the discount rate (used by the entity) to match the present value of the future ARO liability.
The accounting treatment of this accretion expense is to credit the asset retirement obligation (ARO) and debit the subsequent expense account.
Project Restoration Expense Dr
Asset Retirement Obligation Cr
Then, the entity will periodically record the accretion expense (debit) and the ARO liability for the same amount (credit).
Accretion Expense Dr
Asset Retirement Obligation Cr
At the end of the estimated period, the entity would have recovered the full accretion expense and the ARO liability.
It will then record a journal entry to remove the liability and issue cash:
Asset Retirement Obligation Dr
Cash Cr
If the actual transaction or costs are equal to the estimated value, then there will be no adjusting entry. However, any difference in the actual versus estimated value of the liability will be recorded as a gain or loss in the income statement.
Example
Suppose ABC Co. is a construction company and it leases land from local authorities for 5 years. The company aims to construct a heavy vehicle parking lot on this land.
The local laws require the company to restore the land to its original condition by removing all the constructed infrastructure.
The company estimates a fair market value of this future obligation to be $300,000 at the end of 5th year.
The ABC Co.’s uses a 5% interest rate for its present value calculations.
So, the PV of its future obligation in 5 years will be $235,057.
It means ABC Co. will record an asset retirement obligation (ARO) of $64,942.
Account | Debit | Credit |
Leased Land Restoration | $64,942 | |
Asset Retirement Obligation | $64,942 |
ABC Co. will then record an annual entry for accretion expense for 5 years that will accrete the ARO to its full value of $300,000.
The accretion schedule for 5 years will be:
Year | Accretion Expense | Liability Increase | ARO Balance |
Beginning | $235,057 | ||
Year 1 | $11,725 | $11,725 | $246,782 |
Year 2 | $12,325 | $12,325 | $259,107 |
Year 3 | $12,956 | $12,956 | $272,063 |
Year 4 | $13,618 | $13,618 | $285,681 |
Year 5 | $14,319 | $14,319 | $300,000 |
ABC Co. will record the journal entry for accretion expense at year 1 as:
Account | Debit | Credit |
Accretion Expense | $11,725 | |
Asset Retirement Obligation | $11,725 |
Similarly, it will record yearly entries from year 2 to year 5.
At the end of year 5, when ABC Co. fully recovers its accretion expense, it will record a reversal entry:
Account | Debit | Credit |
Asset Retirement Obligation | $300,000 | |
Cash | $300,000 |
Any differences at the end of year 5 from the estimated fair value of the ARO would be recognized as a gain or loss to the income statement of ABC Co.
Accretion Expense Vs Amortization
Amortization and accretion are contrasting concepts in accounting. However, both represent non-cashflow items on the financial statements of a reporting entity.
Amortization is the process of gradually decreasing the book value of an intangible asset. It is also used to periodically adjust the loan amount over a specified period.
Contrarily, accretion is the process of a gradual increase in the value of a future liability. It is commonly associated with obligations arising from asset retirements.