An asset retirement obligation (ARO) is the cost to dismantle and remove an underlying asset at the end of the lease term that is imposed by the lease agreement. For a detailed explanation, please check the ASC 842 guide.

Here is an example:

Company X rents an office space and agrees to return the office space in bare-shell condition. The ARO amount is $10,000 to pay at the end of the lease. The discount rate is 7%.

The ARO amount and leasehold improvement share the same opening balance. The leasehold improvement balance needs to be first calculated to net present value.

Then compute the depreciate expense of the leasehold improvement on a straight-line basis [NPV of leasehold improvement/ # of days]

Deduct the depreciation expense from the opening balance to get the closing balance

Replicate the Leasehold Improvement Opening Balance to ARO Opening Balance

Calculating the daily discount rate. The formula is (1+ Discount Rate)^(1/365)-1

Based on the daily discount rate and the leasehold improvement closing balance, calculate the daily interest expense

Calculate the ARO daily closing balance by adding the ARO opening balance with the daily interest expense

By the end of the lease, the ARO amount will add up to the amount initially recognized, which is $10,000

Prepare the following journal entries by month end during the course of the lease term to recognize the depreciation exp

By the end of the lease term, prepare the following journal entries to recognize the ARO payment as well as the remaining interest expense and depreciate expense