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Oil Exploration destroys land and must set up an asset retirement obligation. Annual obligation upon retirement...

Oil Exploration destroys land and must set up an asset retirement obligation.

Annual obligation upon retirement 1,000,000
Interest rate 5%
Number of payments 5
Years until retirement 30

10) What is the reduction in pretax income as a result of recording the ARO?

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Answer #1

The given question is trying to test the understanding of present value of the obligation that would be incurred after 30 days, and the deductible expense shall be the interest charged on the unwinding of the obligation.

PV of the ARO (for 5 years) after 30 years =  

=1000000/(1.05)^1 =1000000/(1.05)^2 =1000000/(1.05)^3 =1000000/(1.05)^4 =1000000/(1.05)^5

=

952,381 907,029.5 863,837.6 822,702.5 783,526.2

=

4,329,477

PV of ARO (current period) = 4,329,477/(1.05)^30
= $1,001,743
This shall be recognised as liability in the books of the company undertaking the project and the interest on the same @5%, amounting to $50,087 is tax deductible and hence the reduction in income is the interest amount.

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