Asset retirement obligation can be defined as a liability that has to be fulfilled by a firm on the retirement of certain fixed asset. The most common example of asset retirement obligation is to return site to its previous condition and state. Whenever a business incurs the liability it must recognize the fair value of the ARO or an estimation of ARO must be done before incurring the liability. Estimation and recognition of the ARO at the point of incurring the liability gives a clear picture to the management regarding their obligations that they need to fulfill in the near future.
In most of the cases the present value technique is used to calculate ARO. The net present value technique comes with a large number of probabilities having different possible outcomes. While calculating the net present value of some future cash flows a number of calculations must be done that can be explained as under:-
The Discount Rate
A credit adjusted risk free discount rate must be used to calculate the net present value of the future cash flows.
Distribution of Probability
Whenever the net present value of future cash flows of ARO is calculated there come two possible outcomes. You should give fifty percent probability to those outcomes each until the initial real information comes and may alter the calculation of the initial probability.
Most of the firms settle ARO when finally the fixed assets are retired however in certain cases the settlement can be done prior to the retirement of fixed assets.
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