 Hello and welcome to this session in which we would we would look at an exercise or a CPA simulation that deals with asset Retirement obligation in the prior session. I explain what asset retirement obligation is in this session I would look at a complete exercise from A to Z illustrating the asset retirement obligation on January 1st 20x1 Adam oil reserves paid a million dollar for an oil tanker depot Adam is expected to operate this depot for 10 years. That's the life After that time Adam is legally required to dismantle the depot and remove the underground storage tank So now Adam will have an obligation in the future the estimated cost for this cleanup obligation is 100,000 so this is the asset retirement obligation, but the thing is this we don't have to pay this money until 10 years from now, so today we have to record an obligation that's gonna Reflect our obligation in 10 years from now what we have to do is we have to find the present value of this obligation Also, what we know is the depot is expected to have a salvage value of zero Adam uses the straight line for depreciation the effective interest rate for similar obligation is 3% So the first thing I'm gonna do let's start with the easy part first Compute the asset how much assets we need do we need to put on the books? We paid a million dollar for the oil tanker Well, we're gonna debit the plant asset for the oil tanker for a million dollar Credit cash for a million dollars start with the easy stuff now. This is an asset This is a long-term asset long-term asset. That's gonna last as specifically 10 years with no salvage value. What do we need to what do we need to do with long-term assets? We need to depreciate them. There's no salvage value using the straight line for 10 years easy peasy debit depreciation expense 100,000 credit accumulated depreciation plant asset 100,000 before we proceed any further I have a public announcement about my company farhat lectures calm Farhat accounting lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today No obligation no credit card required 10 years later, we're gonna have the plant asset for a million Accumulated depreciation for a million. This is year 10. Therefore the Book value of the plant asset is zero. Therefore this plant asset is gone. That's fine What else do we have to do? Well, we have this obligation now. We need to record the asset retirement obligation Remember, we don't have to do this Until 10 years from now in 10 years. We have to come up with a hundred thousand Now what we know is this the effective interest rate for similar obligation because the difference between the 100,000 and the present value will be the interest So our effective interest rate for a similar obligation is three percent. It means when we go to the time value of money You're gonna use three percent and the period is ten So three percent the period is ten the factor is point zero seven four four Now if you don't know what I'm doing right now You need to go to Farhat lectures and look at the time value of money What I'm doing is discounting the obligation to the present value This is a present value of a single sum present value of a dollar Now I'm gonna take the one hundred thousand dollar the obligation multiplied by the present value factor of point seven four four and my Obligation will be seventy four thousand four hundred dollars. Simply put today. I'm gonna have to record seven hundred seventy four thousand four hundred in ten years from now. I have to I will have an obligation of a hundred thousand I will debit plants. I can debit any asset I'm gonna call it plants or whatever you want to call it or cleanup or anything you want But it's an asset long-term asset seventy four thousand four hundred and I have an obligation of seventy four thousand four hundred today So this is my obligation today now. What comes with each obligation? What comes with each obligation? This is a liability comes interest So we need to know this and what comes with each long-term asset comes depreciation Let's start with the easy part depreciation. I'm gonna depreciate this asset over ten years as well Therefore, I will debit depreciation expense every year seven thousand seven thousand four hundred forty credit accumulated depreciation plants Seven thousand four hundred and forties. This is to depreciate this asset. Well, that's fine But I also have an obligation to be aware of the obligation would require interest Therefore every year I have to record some sort some sort of an interest expense on this obligation because this is a liar Ability specifically long-term liability. Therefore, I'm gonna take for year one seventy four thousand four hundred Which is the book value of the liability? Times three percent and that's gonna give me interest of twenty two thirty two the interest expense for year one Well, I debit interest expense twenty two thirty two. Am I paying anything? No, all what I'm doing now is increasing my obligation by Twenty two thirty two. Therefore, I credit my asset retirement obligation. That's for year one. Well year two What do I need to do year two? I will need to compute my interest expense, which is I'm gonna take my Loan value in year one book value plus what I added in year one Multiplied by three percent and my interest expense for year two is twenty two ninety nine The first thing I want you to notice It's a greater than year one which it should be because my loan obligation went up my asset retirement obligation Went from seventy four forty four. I added to it twenty two thirty two. Therefore my interest expense for year two Is twenty two ninety nine my asset retirement obligation is increased again by twenty two ninety nine now for year three I will do the same thing. I will take my original obligation plus year one Obligation added plus year two obligation added times three percent and my interest expense should be higher than year two I will debit interest expense credit asset retirement obligation Also, I am going to book this depreciation in three ten times So by the time I'm done this plant or plants asset is gone as well Now I'm not done yet I'm not done yet because I got root of the original plant asset of a million I showed you how to how we get rid of this now we get rid of this plant asset at the end of ten Year, it's worth a million what we're gonna have after ten years to as we add the interest expense and Asset the asset retirement obligation. We're gonna have an asset retirement obligation of a hundred thousand Now we are ready to remove the asset on December 31st 2030 Adam paid a firm one hundred and five thousand hold on a second. We thought that's gonna cost us one hundred thousand Well, it cost us a little bit more. That's fine. So what do I need to do? I need to remove the asset I debit asset retirement obligation one hundred thousand so I can get rid of this asset this I'm sorry get rid of this liability I'm gonna have to debit a loss on the retirement of asset retirement obligation of five thousand because I paid 105 So I paid cash 105. I debit the loss now if I happen to pay less I will have a gain Let's assume I paid 95,000 for the sake of illustration if I paid 95,000 just basically got a discount It's five thousand discount or five thousand less than what I expected. I will have a gain So I'll either have a gain or a loss or I could just you know Maybe I can sign someone with a contract with someone in year one promising to only pay 100,000 most not likely because it's a 10-year period but everything is possible but the point is You may not exactly pay 100,000 you may pay a little bit more little bit less the difference will be a gain or a loss So also the retirement obligation is gone and remember the million dollar is gone at this point the company Can keep this on the books or they can do a reversal and just remove all the plant asset or the accumulated Depreciation if they want to or they can keep it because the book value of the assets that we created is zero Anyway, what should you do now go to far hat lectures and look at additional multiple choice true false Exercises that's going to help you with asset retirement obligation and other liabilities Whether you are a CPA candidate or a student this topic is important. Don't shortchange yourself Good luck study hard. I'm always here for you. The CPA exam is worth it