 Hello and welcome to this session in which we would look at asset retirement obligation known as ARO. This topic is covered in intermediate accounting class as well as the CPA exam. This topic gives students many problems for few reasons. One, you are dealing with a plant asset. Two, you are dealing with time value of money. So when you combine those two, students will find difficulty because if you don't understand plant assets, you're not going to understand asset retirement obligation. If you don't understand the time value of money, you will find difficulty in this topic. Three, you're dealing with a long-term liability. Okay? Basically, when I say time value of money, you are dealing with long-term liabilities. And you're going to see how all those three topics interact with each other. As you understand your asset retirement obligation, don't worry, I will explain this to you in details. Whether you're an accounting student or a CPA candidate, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course. I am a useful addition to your CPA review course. I can help you understand the material better, as I will do it in this session, helping you understand the ARO. Keep your course. I will help you increase your understanding, increase your grade. Your risk is one month of subscription. Your potential gain is passing the exam. If not for anything, take a look at my website to find out how well or not well your university is doing on the CPA exam. Also, I do have other courses that I cover, intermediate accounting, of course, auditing, managerial accounting, taxation, governmental, so on and so forth. My CPA supplemental courses are aligned with your Beckel, Roger, Gleam, Wiley, so it's easy to go back and forth between my material and your CPA review course. Also, connect with me on LinkedIn. If you haven't done so, take a look at my LinkedIn recommendation. Like this recording. Share it with other. Connect with me on Instagram, Facebook, Twitter and Reddit. So what is the, what's the idea of asset retirement obligation? Well, it's an obligation. It's some sort of a liability incurred with the disposition when you need, when you need to get rid of some sort of a property, plant and equipment, or some disposition related to some natural resources that you are extracting. The best way to illustrate this is to give you a quick example and illustrating this concept. Let's assume, let's assume British petroleum leased this piece of land that you see it in front of you for oil exploration. And notice what they did. They erected a platform. They removed the, they removed the trees. And what happened at the end of its life, at the end of the life of the contract, after extraction is completed, that could take several years, British petroleum will be required by contract to restore the land to its original condition. What does that mean? It means they have to remove this platform, plant trees, make sure the area is safe, so on and so forth, safe for living. So those are, that's going to create an asset because that's going to increase the cost of the business, the cost of operating this business. But also it's going to create an obligation. So once you have this obligation to remove the platform, to restore the land, well, guess what? That's additional cost. The cost of doing so is an asset, but that asset creates an obligation. So simply put asset retirement obligation, we're going to see it's an asset and it's a liability. That's how it starts. So you have an asset, the asset is the cost and the liability is how much you're going to have to pay to satisfy your obligation. Okay, so then you, once you see an example, it will make more sense. So other examples of asset retirement obligation, it could be decommissioning of nuclear facilities when you do so you have an obligation at the end to clean up closure and post closure of landfills, cost of removing mining facilities. The best way to illustrate this concept is to actually work an example with my favorite journal entries. So let's assume British Petroleum, just working with that example, is required by contract to remove the oil platform in order to restore the land to its original condition after the oil extraction is completed. This is what we're talking about here. So they need to remove this, basically plant trees, take care of the land. So this is, they have an obligation. How much is the obligation? Because that obligation is not due until three years from now. This is what we're saying. We have three years to extract the oil, then put that land, make that land, go back to its original condition. Well, how much? Well, we're going to estimate the total cost and we're going to estimate to be 100,000. I just throw this number. In some textbook, what they do is they give you, you can estimate the cost through the probability. For example, they would say scenario, it's going to cost you 100,000. And there is a 60% chance. Scenario B, it's going to cost you 80,000. And this is, there is a 50% chance. Scenario C, a certain amount of the percentage. So you have to find the weighted probability or you could be giving the number itself. It doesn't really matter. The point is we're going to use the 100,000 as far as we're concerned. Therefore, not Adam, British Petroleum, rather than Adam, British Petroleum, is obligated to come up with $100,000, three years from now. So we estimated the liability to be 100,000. Simply put, this additional 100,000, this additional 100,000, three years from now is a cost to us. That cost is part of doing the business, part of the platform. So what we do is since we're not coming up with this money today, so remember, we don't have to come up with the money until three years from now. We have year one, year two, and year three. We have to come up with this money three years from now. So simply put, we have a liability. So how much is that obligation, is that liability? We cannot record the asset at 100,000. We cannot record the liability at 100,000. We have to discount this 100,000 to the present because we have to come up with that money. That money is a part of doing business cost of the oil platform, but we don't have to come up with it until three years from now. Well, we need to know that we discount. We're going to discount and we're going to just throw 10%. You can throw any number. You're going to discount the 100,000 and equal to three. Three periods are equal to 10%. And the factor, the present value factor is 0.75132. Simply put, we'll take 100,000 times 0.75132. Today, we have an obligation of 75,132 dollars and the cost to the drilling platform. So this simply put, this additional cost is added. So notice we have an asset and we have a liability. What we did is we establish an asset. The asset, why did we establish an asset? The cost of doing business is the asset. It's going to, we're going to benefit from this land for the next three years, but there's a cost to it, 75,132. We're not paying this amount now. We're going to pay it later. We have a liability. Now, so we're going to debit the drilling platform or some sort of a plant asset. Now, once we have a plant asset, remember plant asset get depreciated. We use a straight line depreciation. We're going to take the 75,132, depreciated over three years and every year we're going to depreciate 25,044 dollars. So the journal entry over the next three years will be depreciation expense, credit, accumulated depreciation. Well, simply put, let me just kind of finish this. So if we have the drilling platform as an asset, okay, the drilling platform, and we have in that drilling platform 75,132. Three years later, we're going to have an accumulated depreciation and we're going to have in that accumulated depreciation 25,044, 25,044, 25,044. Simply put, we're going to have exactly 75,132. Why am I doing this? I'm doing this to show you that this asset after three years will be gone, will have a zero book value. Basically, the asset, the drilling platform minus the accumulated depreciation will give you an asset of zero. So simply put, this asset will take care the accumulated depreciation, will take care of it for the next three years. So this is basically what's done with the asset. Well, guess what? We also have a long-term liability. A long-term liability of 75,132. And guess what? Every time you have a long-term liability, whether it's a bond, whether it's a note's payable, whether it's a pension liability, you have a note, you have a long-term liability. It means you have interests you have to account for. So now we have to account for the interest. So we have to record the interest component of the long-term liability. So the first year, we are computing the interest at 10%. Therefore, we're going to debit interest expense $7,513 and start to credit. Now let me start to keep track of the asset retirement obligation. We have a 75,132. This is what we started with, 75,132. Okay, 75,132. So a year later, we're going to record the expense. Well, the expense is 7,513, which is 75,132 times 10%, which is the liability balance times 10%. We're going to debit interest expense and some textbook, they debit accretion expense. That's fine, it's an expense. And we're going to credit the account, the asset retirement obligation, 7,513. Here comes, this is year one. This is for year one. Well, what's going to happen after year one? The balance becomes $82,645. So if we count the balance here, it becomes $82,645. Now again, for year two, we're going to have to accrue interest expense. How do we accrue interest expense? Since the balance is $82,645, we're going to multiply it by 10%. And that's going to give us interest expense $8,264. So we're going to debit interest expense $8,264 in credit, ARO $8,664. This is for year two, this is for year one. Then we're going to add $8,264 to the previous balance. Now our balance is, let me put the balance here, $90,909. Year three, we're going to take the $90,000 time, $90,905 times 10%. And it's going to give us interest component of $9,990. If we add this amount, $9,990, you guys got it. We're going to have an ARO of $100,000. So if I add $9,090,000, then I'm going to have, I'm going to write it up here, we're going to have an ARO of $100,000. We're going to have a balance of $100,000. Now rounding it's going to be a dollar or two difference. But the point is your ARO becomes $100,000. Remember the asset after three years, I showed you it's gone. Now we have an asset retirement obligation of $100,000. So notice over the three years, over the next three years, this is the year three interest, the ARO becomes $100,000. Now we cannot keep the obligation. Now we are ready to remove the obligation. So we contracted with someone, and Adam, which is British Petroleum, paid $97,000 to dismantle the platform. So we thought it's going to cost us $100,000. It costs us $97,000. Well, we're going to credit cash $97,000. We're going to debit the liability asset retirement obligation $100,000. And guess what? This asset retirement obligation is gone. So notice the drilling platform, I told you the accumulated depreciation will take care of it. We paid $97,000, but we get a route of $100,000. Now we need, we have $3,000 hanging. That's going to be again. So basically because we saved $3,000, it's considered again. Let's assume we paid more than $100,000. Let's assume we paid $105,000. Let's assume we paid $105,000. Then we will have a loss of $5,000, if that's the case, if we paid $105,000. And this is basically the asset retirement obligation. I show you how it's created. We started here with the drilling platform, an asset, and we got rid of that asset by depreciating the asset over three years. Then we had an asset retirement obligation and this asset retirement obligation, every year we kept adding the interest component until it became $100,000. Then we paid this $100,000 by only issuing a check for $97,000. We happened to be lucky to find someone to remove our liability by only paying $97,000. We have a gain of $3,000. And this is basically the asset retirement obligation we created it. Then we got rid of it. At the end of this recording, I'm going to remind you again, if you are an accounting student or a CPA candidate, take a look at my material, farmhatlectures.com. I can help you pass the CPA exam. I can add those 10 to 15 points that you need. Don't shortchange yourself. Your CPA exam is a lifetime investment. Good luck, study hard, and of course, stay safe. The CPA exam is worth it.