Environmental Protection

The New Deal

Tightening disclosure rules are making it difficult for companies to hide environmental liabilities

Accrual and disclosure practices of public companies related to their environmental liabilities have long been perceived to be inconsistent and generally inadequate. Recent developments, such as Financial Accounting Standards Board (FASB) Interpretation number 47, known as FIN47 in most circles, have tightened up the disclosure rules, especially in relation to environmental liabilities.

The recent changes (2002 onward), follow a long line of accounting prouncements including Staff Accounting Bulletin (SAB) 92, Statement of Position SOP 96-1, and Statement of Financial Accounting Standard (SFAS) 143 that were designed to standardize the reporting of environmental liabilities. They raise many questions and pose a raft of new challenges for senior management, which may be both onerous and far reaching.

Background
Environmental liabilities are among the significant issues that impinge on investment decisions. The U.S. Securities and Exchange Commission (SEC) therefore requires public companies to recognize and/or disclose both current and "contingent" environmental liabilities in their annual 10-K filings. However, only those liabilities that are considered "material" are required to be disclosed, and long-standing FASB rules such as FAS 5 dictate that a loss contingency should be accrued if it is "probable" that it will occur and the amount of the loss can be "reasonably estimated."

The inherent flexibility in these rules has allowed companies to interpret their disclosure obligations in different ways. This problem is epitomized by the way some companies account for potentially contaminated, non-performing real-estate assets. Reluctant to initiate investigations that might trigger enforcement actions and remediation expenditure, some companies have adopted a so-called "don't ask / don't tell" policy that involves moth-balling potentially contaminated facilities and not reporting future remediation obligations.

Recent Developments
The Sarbanes-Oxley Act of 2002 (SOX) does not specifically address environmental disclosure, but it has changed the legal and political context in which such disclosure requirements must be interpreted. SOX is specifically designed to ensure that companies look beyond just compliance with Generally Accepted Accounting Procedures (GAAP) requirements when preparing their financial statements, and it further requires that CEOs and CFOs personally certify the disclosures made by their organizations.

In addition, some specific developments during the past two years have "raised the bar" even further and may combine to change the way corporations report environmental liabilities.

The most significant of the recent changes are:

  • New 8-K disclosure requirements -- the SEC's new interpretation means that certain environmental liabilities, such as a new determination that one of the company's real-estate assets is contaminated, will now compel companies to file an 8-K.
  • FIN 47 New interpretation of FASB 143 -- "Accounting for Conditional Asset Retirement Obligations" -- will require companies to recognize and report an environmental liability even if the enforcement of the liability is conditional upon future events that are not within the control of the reporting company. This may well close the "don't ask / don't tell" loophole and prevent companies from deferring the reporting of liabilities by moth-balling sites.

FIN47
Issued in March 2005, FIN 47 addresses Conditional Asset Retirement Obligations (CAROs). CAROs are legal obligations to perform asset retirement activities in which the timing and/or method of settlement are conditional on future events that may or may not be within the control of the entity. Environmental cleanup and disposal obligations in connection with the retirement of contaminated property, plants, and equipment are CAROs. Retirement is defined broadly by FAS 143 and FIN 47 to include not only demolition on the economic obsolescence of an asset, but also the sale, abandonment, recycling, or disposal (but not temporary idling) of a long-lived asset.

The regulatory obligation to remove asbestos on the renovation or demolition of a building is a CARO. The environmental regulation is in force today, but the asbestos will not be removed until the owner decides in the future to "retire" the building. Since the definition of retirement includes "sale" and "recycling," the building (or parts of it) may be retired a number of times before it is finally demolished. Thus, the cost of the asbestos removal may be incurred long before the end of the building's useful life (as when the price is reduced on a sale, because of the asbestos contamination).

FIN 47 clarifies that companies must recognize liabilities for CAROs if their fair value can be reasonably estimated, and it provides guidance for the estimation of fair value.

FIN 47 also sets up an order of methods to determine whether the fair value of a CARO can be reasonably estimated. According to FIN 47, a CARO's fair value can be reasonably estimated if (1) the fair value of the obligation is embodied in the purchase price of the asset, such as if insurance or an escrow is provided for the obligation, (2) there is an active market for the transfer of the obligation (as is provided by insured environmental liability transfer transactions), or (3) there is enough information to apply an expected present value technique. If there is not enough information to estimate the fair value of the obligation, the company does not have to recognize a liability. However, the company must make certain special disclosures. In these circumstances, companies are required to describe the obligation, state that a liability has not been recognized because the fair value cannot be reasonably estimated, and disclose why the value cannot be reasonably estimated. And as far as FIN 47 goes, SOX's certification requirements seem to require more, because the certification that financial statements fairly present the financial condition of the company is not limited to GAAP.

Penalties and Fines
SEC rules under SOX require the CEO and CFO of public companies to sign and certify the issuers' SEC periodic reports and disclosure controls and procedures. False certifications are subject to civil penalties of up to $100,000 for individuals and $500,000 for the companies. In addition, false certifications under SEC 906 are subject to stiff financial penalties. A certifying officer who knowingly certifies a periodic report that does not fairly present in all material respects the financial condition and results of operations of the issuer can be fined not more than $1million or imprisoned for up to 10 years. An officer who willfully makes the certification knowing that the accompanying periodic report does not fairly present all material respects and financial condition of the issuer may be fined not more than $5million and may be imprisoned up to 20 years.

Incentives and Market Solutions
In the era of corporate transparency and heightened investor scrutiny, pro-activity is imperative. Environmental risk management should include re-evaluation of the adequacy of existing internal-control and disclosure-control policies, including establishment of appropriate systems for ensuring accurate data collection and consistent evaluation of environmental liabilities, and thorough assessment of available risk management tools. FIN 47 should add impetus to this process because it requires companies to "identify all their conditional asset retirement obligations."

Once an environmental liability has been identified and determined to be "material," there are several mechanisms available to mitigate the exposure and demonstrate that it is thoroughly and adequately managed. These options might include accelerated clean-up of a contaminated site, sale of relevant sites or operations, and/or use of risk-transfer arrangements such as environmental insurance or liability-transfer alternatives. Indeed, two of the three methods FIN 47 mentions for estimating the fair value of a CARO (when the fair value is embodied in the price of an asset through the use of insurance or when there is an active market for the obligation's transfer) seem to provide significant incentives for insured brownfield and environmental liability transfer transactions.

This article originally appeared in the 09/01/2006 issue of Environmental Protection.

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