Living in a Post-Enron World

A primer to the Sarbanes-Oxley Act and the new disclosure requirements related to environmental liabilities

It is no secret that the financial scandals of recent years have had a dramatic impact not just on the business world itself, but also on individual investors and government regulators. Enron, WorldComm, Tyco, MCI and others have entered the popular lexicon as words that will forever be associated with rampant greed and seemingly non-existent oversight. Whether we've seen the last of the fall of the giants, involving nearly incomprehensible loss of capital, is anyone's guess.

In an effort to restore shattered investor confidence in the equity markets, the U.S. Congress passed the Sarbanes-Oxley Act (SOX) of 2002. SOX -- complex legislation designed to address the even more complex issue of corporate governance -- provides stricter controls on everything from the makeup of corporate boards to the manner in which companies report their earnings. Companies and their myriad advisors have scrambled to achieve compliance with SOX, in many ways being forced to address issues deeply seeded in their corporate cultures.

In speaking with colleagues, digesting the prevailing wisdom, and serving as the only technical advisor on the American Institute of Certified Public Accountants' taskforce dedicated to the related issue of green-house gas trading, it is becoming increasingly obvious to me that the impact of SOX on a company's environmental matters is all but ignored. And I assure you that companies ignore this at their own peril.

Section 404 of SOX holds corporate officers responsible for the evaluation of internal controls and processes for disclosure of financial liabilities, including those of an environmental nature. Historically, reportage on environmental liabilities has been lax because, frankly, it was in the company's best interest to downplay the exposure, and because the oversight was all but non-existent. But this is a different regulatory world.

Setting Aside Reserves to Cover Environmental Liabilities
Establishing reserve amounts to cover environmental liabilities has always proceeded with a nod and a wink, to say the least, with environmental managers being pressured to downplay liability so reserves could be set lower. The result, according to the 2002 Rose Report, was that the reserves were too little to cover liability at 70 percent to 80 percent of companies, meaning stockholders weren't given an accurate picture of a company's financial soundness. And few people thought to look at anything as mundane as environmental liability reserves.

Until Sarbanes-Oxley came along, that is. Now, the federal government will now require more detailed information and scrutiny is much higher. Companies are scrambling to not only to set more accurate reserve levels but also to get a better handle on environmental liabilities overall. Several things are likely to happen. Companies will find that their reserve analyses have been woefully inadequate; the resulting increase in the reserves may trigger fear among investors. Companies may also find that the technical expertise now needed can't be provided by in-house staff or existing outside counsel. And, finally, companies will recognize that simply acknowledging environmental exposure is no longer enough; they will now need to develop plans to address it.

New Environmental Disclosure Requirements
Most executives are familiar with the processes and controls for routine business transactions. The procedures and controls for estimations of environmental liabilities, however, often fall to environmental, health and safety (EHS) managers who may be unfamiliar with the available standards and practices.

Although companies have estimated the financial liabilities associated with environmental compliance and remediation as part of their usual financial reports, SOX will place a higher level of scrutiny on the estimates for several reasons. Under Section 404 of the Act, officers of the company must certify that they have reviewed the internal processes and controls. Also, external auditors will be providing attestations that rely on the disclosures. Furthermore, non-routine transactions and estimated liabilities will meet increased scrutiny. With this increased scrutiny and emphasis of audits on non-routine matters, environmental managers need to have prepared documented, defendable estimates of liabilities, and have sufficient procedures and controls in place for disclosures.

Despite past efforts to obtain accurate information, companies have submitted environmental disclosures and cost estimates based on inaccurate and inconsistent information because of misunderstandings by environmental managers about what to disclose, when to disclose, the amount to disclose, and how to address uncertainty and contingencies. Their past procedures were often intuitive and informal. Various guidance documents assist in the development of internal controls to improve accuracy and completeness. The applicable reference documents are as follows:

  • American Institute of Certified Public Accountants (AICPA) Statement of Position (SAP) 96-1, Environmental Remediation Liabilities;
  • Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards Number 5, Accounting for Contingencies;
  • FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss;
  • American Society for Testing and Materials (ASTM) document E 2137-01, Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters.

These documents guide an environmental manager through the questions that one must ask as the foundation for environmental disclosures.

Because an environmental manager must know what to report to his or her superiors, he or she should be guided by a strong corporate message of responsibility and accountability. A company should recognize an environmental loss when there is or there is likely to be an unfavorable result related to a claim, litigation, or assessment. Legal counsel can assist an environmental manager in evaluating whether a matter meets these criteria and, thus, would need to be reported.

The environmental manager also must know when and what amount to disclose. Given the nature of most environmental projects, the amount of the cost estimate is dynamic and should be adjusted as additional information develops. For example, upon discovering there may be soil or ground water contamination, the environmental manager must recognize the liability for appropriate levels of investigation. If the investigation shows that remedial action is required, the environmental manager should recognize the liability for remediation as that milestone is passed in the process. As different project milestones are reached, the environmental manager should reassess the reasonably estimable range of costs for remediation and post-remediation monitoring.

Under the ASTM standard, document E 2137-01, an environmental manager may estimate uncertainty using one of four methods: expected cost, most likely value, range of values, and known minimum value. Which method a manager uses depends on the amount of information available and the degree of uncertainty. As the uncertainty is reduced, the estimated liability evolves from a known minimum to an expected cost.

In developing potential remediation liability estimates, an environmental manager must know how to deal with uncertainty. Sources of uncertainty include issues related to legal matters, effectiveness of remedial actions, and undetermined physical conditions. Some of these sources can be resolved with additional testing, but others are resolved only as the project develops. Software packages and computer models can help calculate expected values for complicated matters.

There is some confusion about whether an environmental management system constitutes the proper procedures and controls for compliance with Sarbanes-Oxley. Environmental management systems are meant to limit a company's environmental liabilities through proper risk management procedures. Examples of procedures and controls under environmental management systems are waste minimization programs such as inventory controls to limit the purchasing of regulated materials and the accumulation of out-of-specification products, a vendor return policy to limit raw materials disposal and disposal facility audits to limit potential PRP claims. SOX is more focused on the procedures and controls for identifying and quantifying financial liabilities.

The COSO Framework
Most public accounting firms recommend the COSO Internal Controls - Integrated Framework (1992) as the most appropriate framework for procedures and controls under Section 404 of the Sarbanes-Oxley Act. The COSO framework grew out of a need for management tools to improve operations, corporate compliance and accurate financial disclosures, but it is applicable for environmental matters and the related estimation and disclosure of liabilities. The COSO framework has three objectives:

  • Create efficient operations
  • Prepare reliable financial reports
  • Comply with applicable regulations

The benefits of improved operations, reporting and compliance in environmental matters are obvious.

The COSO framework addresses five components of each of these objectives for an entity or activities. The five components are:

  • Control environment. The company's management establishes and communicates expectations and goals.
  • Risk assessment. An evaluation is made of operational areas that are affected by the management's expectations and goals.
  • Control activities. Procedures and systems are established in risk areas to manage relevant operations so that the management's goals, and expectations are met.
  • Information and communication. There is complete vertical and horizontal communication of the management's expectations, goals, control activities, accountability, and responsibilities.
  • Monitoring. The implementation of the control activities and communication are evaluated to verify their effectiveness in meeting the management's expectations and goals.

An example of how the COSO framework may apply to environmental management may be the estimation of environmental remediation costs as follows:

  • Control environment. The company's management establishes and communicates to the staff that all operations must be in compliance with applicable environmental laws and regulations. Furthermore, the management expects full disclosure of all environmental liabilities to senior level managers without consideration of materiality.
  • Risk assessment. An evaluation is made of functional areas and operations that have potential environmental exposures.
  • Control Activities. Procedures and systems are established to evaluate the environmental liabilities quarterly. For example, all estimates of potential remediation costs are updated quarterly using the ASTM guidance document Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters. As quarterly remediation goals are met, the estimates are refined to reflect the progress.
  • Information and communication. Quarterly environmental reports that summarize environmental incidents, including updated estimates of remediation liabilities, are prepared and distributed to the company management.
  • Monitoring. The corporate EHS department audits selected facilities or operations to verify the implementation of the procedures and controls and assess their effectiveness.

Other operations that are not under the control of the environmental manager also are aspects of the COSO framework. For example, if a key environmental manager leaves, is the selection of his or her replacement based on the appropriate qualifications? Are the management's expectations and goals clearly communicated to him or her? Does the environmental manager know the responsibilities associated with the job and how he or she will be held accountable? Is there an incentive program in place that contradicts the management goals and expectations for full disclosure? Thus, the COSO framework instills appropriate procedures and controls to form a basis for efficient operations, compliance, and accurate financial reports.

The Sarbanes-Oxley Act of 2002 will be an unwelcome intrusion to some environmental managers. Others, however, will view it as an opportunity to improve operations and compliance. In time, the implementation of the COSO framework will reduce "fire fighting" and overall environmental risk. And under the heading of unintended consequences, SOX should be the catalyst for companies to take a fresh look at how they deal with environmental matters, not simply how to comply with a new law. There may be short-term, unavoidable pain, but it just might usher in a new, profitable beginning.

Regardless of how a company views SOX, there is no getting around the fact that they have to come to grips with it. Companies with market caps of $75 million or more have to file "SOX Section 404-compliant" reports along with their annual reports for the fiscal year that ends on or after November 15, 2004. Those with market caps of less than $75 million have a bit longer to comply -- April 15, 2005.


This article originally appeared in the 09/01/2004 issue of Environmental Protection.

About the Author

John L. Payne, PE, is president of The Payne Firm Inc. in Cincinnati. He is a graduate of both the University of Cincinnati (bachelor's degree, civil engineering) and the Georgia Institute of Technology (master's degree, civil engineering). He is a certified professional in the Ohio-Brownfields Voluntary Action Program and a registered professional engineer in seven states. Payne has been a faculty member of the American Law Institute-American Bar Association since 1988, where he presents environmental courses to national legal audiences. He is a frequent speaker to and has conducted numerous seminars for corporations, law firms, banks, and insurance companies across the country. He can be reached at (513) 489-2255.

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