Virtually all fixed assets are retired at some point. They either get scrapped for no value or sold off to another party. In this typical process the retirement activity isn’t given much thought until it occurs. Simple, right?
But in some situations, companies that manage long life fixed assets are obligated to account for the retirement costs well in advance of the retirement itself. In fact, they have to account for the retirement costs at the time that the asset is initially capitalized and recognize it as a pending liability. The liability must then be continuously funded throughout the asset’s life and must also account for transactions made to the asset such as partial retirements, transfers, or other value adjustments. This poses a bit of a quandary because it means that a liability must be setup to offset the initial fixed asset purchase. So, yes, an asset can sometimes require its own specific liability.
Asset Retirement Obligations
What I’m referring to are asset retirement obligations (ARO). AROs have been around for quite awhile and are well documented. The initial standard was defined by FASB (more information on wikipedia) in statement 143 in June 2001. The regulation has the following passage that best summarizes its scope:
This Statement addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. It applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and (or) the normal operation of a long-lived asset, except for certain obligations of lessees.
What this means is that some assets have embedded costs associated with their retirement. These assets tend to be very large and tangible. The retirement costs are typically the costs to physically remove the asset but also include those costs associated with the restoration of the land. Note that the regulation applies to all entities, both for-profit and non-profit.
After SFAS 143 was issued there was considerable variation in how it was interpreted. Specifically, different companies valued the AROs differently and recognized the liability at different times. As a result, FIN 47 was issued to provide some additional clarification of SFAS 143. In particular, FIN 47 clarifies that if the valuation of the ARO can be reasonably estimated, then the ARO must be recognized.
I’ve referenced the US GAAP regulations issued by FASB but AROs are also required and defined in other regions as well. Internationally, specifications for ARO are covered by the IASB in IAS37 which can be found here (registration required). AROs are not explicity covered by the German Accounting Principle HGB but the concept of provisions/obligations are documented in §249 and §253 HGB (in deutsch). Their requirements and treatment for AROs are similar to what I’ve detailed above.
Let me walk you through an example of an ARO. If an Oil&Gas company builds a pipeline or refinery, they are obligated to restore the land to its original condition once the facility (asset) is no longer operational and is retired. In addition, they have to set aside the funds and account for the pending liability once they can assess the value of the retirement costs. Sometimes these costs can be estimated in the form of a bid from a contractor. For instance, an oil services firm may provide a bid/appraisal that they can tear down a particular refinery for $50MM. The capital that is initially set aside can also be capitalized and depreciated. All of this takes place even though no cash is actually being spent on the ARO. The net result is an increase in both the company’s assets and liabilities.
What’s the Solution?
It’s been possible to handle AROs in ERP but the solution wasn’t comprehensive… basically, a series of work-arounds with some negatives that some customers might not have wanted to pursue. For comparative purposes I’ll first cover a typical ARO solution and then introduce SAP’s new solution. A typical approach might combine the following point solutions and external processes:
- A finance group manages the various appraisals and bid estimates for each ARO. They use a variety of spreadsheets to calculate the ARO terminal value as well as the monthly accrual amounts. A final spreadsheet is prepared that lists each ARO, its value and its corresponding fixed asset that it is related to.
- The SAP group creates new fixed assets in the Asset Accounting (FI-AA) subledger for the AROs (and the final assets if they are not already created). A good solution would include new user fields to designate the asset as an ARO since SAP does not ship an identifying field. Also, the ARO would ideally be linked to its associated fixed asset via another user field so that any processing changes (i.e., partial transfers, revaluations, and retirements) to the asset could be tracked and replicated on the ARO if necessary.
- The ARO is posted to based on the ARO valuation provided by the finance group. From this point the ARO depreciates normally each month.
- The finance group prepares journal entries each month to record the accruals so that the AROs are properly funded. Unlike some other accruals, ARO calculations fluctuate on a monthly basis so the effort to post/upload the entries is more tedious.
- Since the ARO data is not directly managed in SAP, the finance group has to continuously monitor SAP to look for specific transactions that affect their external ARO spreadsheet database. If the fixed asset is later transferred to another entity, the ARO asset should also be transferred. If the assets are revalued then the external information must also be updated appropriately. Most importantly, the finance group has to monitor FI-AA for any retirement postings and reference them against their list of ARO assets. If one of the affected assets have been retired, then the ARO calculation must be stopped and the next month’s accrual posting updated.
The problem with this solution is that it’s not integrated. A lack of integration increases redundancy, duplicates information which has to be continuously reconciled, and is error prone. This can lead to inaccurate calculations and adjustments which is a significant issue when working with fixed assets of these types. One of the unique characteristics about fixed assets is their investment values tend to be high, particularly amongst those customers that operate in capital intensive industries such as Oil&Gas, Heavy Manufacturing, Chemicals, and Utilities. Since the values of the assets are so large, even slight inaccuracies in how the costs are captured, reported for tax, depreciated, or in this case, calculated for an ARO, can yield material financial differences.
Introducing SAP Asset Retirement Obligation Management (AROM)
SAP released a new solution on June 29th, 2011 to support the proper calculation and posting for AROs. The solution, SAP Asset Retirement Obligation Management (AROM), satisfies this long standing requirement in the financial community and has several key benefits.
- Integration – AROM is an end-to-end solution whereas previous solutions (noted above) tended to be a combination of point solutions within SAP ERP and external spreadsheets. AROM is integrated with the necessary components of ERP Financials such as the General Ledger, FI-AA, and Lease Accounting (FI-LA). Fixed asset records are created and automatically updated based on adjustments to the AROs.
- Automation – The AROM solution can automatically calculate the retirement costs, the terminal value and the initial settlement value of the ARO. It also automatically handles the monthly accrual postings, and the capitalization and ongoing depreciation of the ARO.
- Multiple Accounting Principles – As SAP customers continue to adopt international accounting standards (IAS) in addition to their local GAAP regulations, most and more SAP solutions are providing the ability to manage an item’s value to support different principles. AROM allows SAP customers to manage up to 8 separate accounting valuations for a single ARO.
- Rate and Event Changes – The ARO solution can account for changes in interest and inflation rates, as well as different events that might trigger adjustments to the ARO.
- Compliance & Control – By being integrated throughout the relevant modules of ERP, AROM provides a far more centralized, controlled, and audit-able solution than previous off-line methods. AROM also provides tracking of changes to AROs as well details into the calculations and further analysis with the Asset Explorer and LAE Explorer.
- Reporting – A key advantage to AROM is that the reports provide a centralized and integrated list of a company’s AROs. AROM provides several ALV list based reports that provides detail into the AROs, their expected maturity date, their value, and their association to any underlying objects (assets, real estate, etc.). In addition, there is a sorted list report that is similar to the Asset History Sheet in FI-AA. Like the Asset History Sheet, it provides a way to flexibly define a column/row structure to best present the ARO data.
- Standard Solution – Accounting for AROs within ERP no longer requires a host of enhancements or any self developed screens/tables.
AROM is supported only on SAP ERP 6.0 EhP4. In addition, the EA-FIN add-on is required because the new depreciation calculation program that it contains serves an important function in the determination of some of the values. You can read more about the NewDCP in the links below.
AROM heavily integrates with the Lease Accounting Engine (LAE) that is part of the existing FI-LA module. LAE plays a critical role for AROM because while the calculation of the ARO values is done within AROM, it is LAE that manages the posting of those values to the GL and FI-AA modules. LAE also provides functionality to the AROM solution to perform one time postings and provide detailed analysis via the LAE Explorer. Here is a diagram that gives an overview of how ARO and LAE relate to one another.
In the next blog I’ll provide specifics about how AROs are managed and calculated in AROM.
Note: This blog was originally published on SCN on July 14th, 2011.
Links to NewDCP Information: