Financial Accounting and Reporting-CPA Practice Exam

What is the primary effect of accretion expense on an ARO?

1. Decrease in net income

2. Increase in cash flow

3. Increase in ARO liability

4. Reduction in asset cost

The correct answer is: Increase in ARO liability

Accretion expense is an accounting term that relates specifically to Asset Retirement Obligations (AROs). An ARO represents a company's legal obligation to retire an asset or restore a site to its original condition at the end of its useful life. This obligation is initially recognized as a liability and is recorded at its present value, reflecting the future cash outflows expected to be incurred for the retirement or restoration. As time passes, the present value of this obligation increases due to the passage of time and the effect of interest accrual. This increase is recognized as an acceation expense, which essentially represents the growth of the liability until the actual retirement occurs. Therefore, the primary effect of accretion expense is that it leads to an increase in the ARO liability, reflecting the increased obligation owing to the time value of money. The other options relate to different aspects of financial accounting. For example, while accretion expense will affect net income by increasing expenses, this is not its primary effect. Similarly, it does not directly increase cash flow since it's an accounting expense and does not imply a cash outflow immediately. Lastly, reduction in asset cost does not occur as a result of accretion; instead, the original cost of the asset remains unchanged