When it comes to accounting, accretion is the steady time-bound growth reflected on a business’s earnings and assets due to its overall success, market growth, or if the business undergoes a merger or acquisition.
Understanding accretion is important. However, there is a slight difference between accretion and accretion expense. The accretion expense, similar to accretion itself, is acknowledged when balance sheet liabilities are updated with an overall increase in the value of the liability over time. It is characterized as an operating expense.
It measures the changes over a sufficient period of time into the carrying amount of the liability. The expense also shows the changes in liability of an asset retirement obligation over time because of the interest applied in the method of allocation to the liability amount during the beginning of the period.
The interest rate used to denote this change in the liability is credit-adjusted and risk-free such that when the liability was initially measured. The excess amount is not to be recognized as an interest cost but as the increased value in the liability and is classified as an expense.
In business settings, accretion expense is most commonly recognized as an integral part of asset retirement obligations (AROs).
Asset Retirement Obligations:
Asset Retirement Obligations knew as AROs, characterizes the end of the life of a long-lived asset. It’s a legal obligation to reflect the asset’s retirement and for the company to abolish using the equipment or cleaning up hazardous materials at a stipulated date in the future. When these obligations are added to a company’s financial statements, they tend to help generate a more transparent image.
AROs are meant to be used to act as a just and fair evaluation of the asset that the company has leased out to another to serve as a legal obligation to allow both parties to execute their part of the agreement. The value of the ARO must be acknowledged immediately to generate a holistic view of the company’s financial position executed reliably. These are most usually used by companies that require infrastructure for their operations. This is why a good example of this can be Oil and Gas Companies.
When measuring AROs, a company should regularly check on them to account for either upward or downward liability revisions. Apart from this, a few points should be kept in mind.
- Fairly evaluate the future costs of the liability
- ARO liability has to be allocated over the duration of the asset
- Changes in the liability should be recorded with time by using the discount rates. This will be reflected back as differing balance in the balance sheet.
- With the passage of time, the ARO amount will become more accurate and should be adjusted either by upward or downward liability.
Adjusting upwards means that the current credit is adjusted with the risk free-rate discounting it. Whereas when adjusting it downwards, the risk-free rate should be applied to the original credit.
Let’s assume a company has contracted a 50-year lease on a piece of land and builds a warehouse. Before the lease runs out, the company has to demolish the warehouse, remove all equipment and waste, and hazardous material as per the obligation.
Restoring the land to its original condition. This concludes the asset’s retirement as having been completed once the process is finalized.
Accretion vs. Amortization:
Accretion is often confused with amortization since their functions can seem similar at the outset. However, this is not true as accretion and amortization are separate concepts targeting different asset classes.
Amortization is used in accounting when intangible assets need to be depreciated over a specific period of time. It gradually decreases the asset’s overall value to show its depreciation in a continuous form until the asset’s retirement. It is usually applied to intangible assets such as trademarks, loans, patents, right-of-use assets, etc.
On the contrary, accretion is applied when liability is discounted to its present value and consequently increased over a fixed period of time. This involves AROs practiced in business activities representing a lessee’s commitment to restoring the asset to its original condition before the lease agreement runs out.
The Journal entries for accretion expense and amortization are similar in their credit and debit terms. An amortization expense of $30,000 would be debit, and the asset being amortized would be credited in the same amount.
|Patent, Trademarks, etc.||30,000|
Amortization expense differs from Accretion expense based on its effects on the financial statement. It shows a decrease in equity due to the debit of the expense account whereas, a credit shows the decrease to the asset account.
Similarly, accretion expense is journalized in the same way. Let’s assume there is an accretion expense of 40,000. This would be debt, offset by the same amount of the asset being credited.
|Asset Retirement Liability||40,000|
Accretion expense is calculated as ARO. The formula for which is as follows:
Asset Retirement Obligation = Present ARO cost x (1 + Inflation) ^Compounding Periods
Let us assume the following figures to utilize the formula.
A company has a Present ARO cost of $20,000 with inflation of 3% per year. If the lease’s duration runs for a total of 30 years, its ARO would be calculated as:
ARO= $20,000 x (1 + 0.02) ^40
ARO=44,160.79 in ARO cost 30 years from now.
Rules for ARO:
ARO calculations follow the Financial Accounting Standards Board’s Rule 143. This rule specifies that a company has to follow the legal obligation to remove equipment, hazardous materials, and assets after the duration of the lease. Additionally, some rules ensure that the correct calculation is utilized for the ARO.
CPA encourages accountants to use the present value technique for which you need to get a credit-adjusted and risk-free rate to discount cash flows to their current present value.
Once that’s complete, the calculation requires you to:
- Find out the time duration for the lease
- Determine the discount rate depending on the business’s credit rating and the risk-free rate.
- See if there are any increases in the ARO carrying amount.
- Recognize Upward liability Revisions – discount any additional costs that weren’t warranted.
- Recognize Downward liability Revisions – the discounted effect of any overestimated costs should be removed.
By following these simple rules, an accountant ensures that their calculation is not disrupted by any additional costs and is thoroughly accurate.
AROs are a part of the accretion expense and a legal obligation that ensures that equipment and assets are removed at the end of the lessee’s tenure. In contrast, accretion and amortization function as opposites of each other even though the way they are journalized can seem similar to a novice. Where one increases the value of the assets, the other decreases it over a specific period of time.
Overall, accretion expense can be tricky to calculate, and accounting for it properly requires a thorough understanding of the variables involved. However, with the right mindset and following the rules outlined above, any accountant can calculate it from making improvements on the leased assets to correctly estimating the cost to retire said assets at the end of their period.