Matrix accounting - accounting for ARO's under leases

Should asset retirement obligations or costs incurred by an entity at the time of retirementof a fixed asset in a lease be included in calculating the minimum lease payments...

 Asset retirement obligations or ARO's are defined as legal obligations imposed on an entity to reimburse costs to a third party upon retirement of tangible long lived assets. The term retirement is defined as the other-than-temporary removal of long lived assets from service and includes sale, disposal of assets etc. 

To illustrate this in simple terms

 Assume a Chemical Company takes on lease a factory for a period of 10 years from the Govt, the Company has been obligated by the Govt to decommissions all hazardous machinery at factory at the end of the lease term. The costs which will be incurred to dispose of the hazardous machinery are commonly referred to as ARO's. 

Accounting for the ARO's are primarily been zeroed in USGAAP'sFAS 143, wherein Companies are required to estimate the fair value of the ARO at the time of retirement and account them at their present values. 

This issue of Substance over form looks at whether costs in an AROfor a leased property should be included while calculating the minimum lease payments for a lease classification there impacting lease accounting under FAS 13 under US GAAP or AS 19 underIGAAP. 

Let us take two cases where there is a ARO involved 

Case 1 - Company leases a fully furnished office (with carpets, cubicles, Air conditioning etc) and has been contractually obligated to remove the furnishings at the expiry of the lease 

Case 2 - Company leases a raw office and furnishes the office, the Company is obligated to remove all furnishings at the expiry of the lease and hand over the office in the same raw condition back to the lessor 

In both the circumstances there is a cost which the Company will incur at the expiry of the lease, the question is whether these costs should be categorized as minimum lease payments of the leased office for determining the classification and accounting of the lease of the office. 

GAAP by definition, defines lease as the right to use the asset, therefore only monies which are directly identifiable to that assetshould be included in the minimum lease payments.   

Case 1 - As the Company leased a furnished office, and has to incur costs at the end of the lease term to dismantle the asset, the cost of the dismantling or ARO will be construed as a minimum lease payment as the rent for the leased property included the cost of the furnishings and that the assets belonged to the lessor. 

On case 2, as the assets were constructed post the leasing of the office, the dismantling costs or the ARO should not be included as the costs are not linked to the lease payments of the office. Rather these should be accounted under FAS 143 under USGAAP, at present there is no such  requirement under Indian GAAP. 

Let us take an another example to illustrate this further

Company A (lessor) owns a petrol station that it leases to Company B (lessee). The property includes pre-existing underground fuel storage tanks that are required by the local government to be removed in ten years. Even though Company A leases the petrol station to another party, it remains legally obligated for removal of the underground storage tanks and must recognize an ARO pursuant to FAS143.

If the lease agreement requires Company B to remove the underground storage tanks at the end of the lease term, the cost of removal would be included in the minimum lease payments and accounted for under GAAP for leases 

 As the concept of ARO is still not very understood in the IndianGAAP context, one must always look for such costs embedded in agreements lease as these could be covered under AS 19. 

Its an another example of an embedded lease - GAAP is in more ways than truly substance over form.

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