The New Deal
Tightening disclosure rules are making it difficult for companies to hide environmental liabilities
- By Darren Stone
- Sep 01, 2006
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.
About the Author
Darren Stone works for Willis's Environmental Regional Practice in Dallas. He has over 14 years of commercial experience in risk identification, management, and mitigation for environmental liability. He spent several years working with a specialist London Lloyds broker and AIG Europe within their risk finance team. In this capacity, he dealt with all insurance and risk finance matters relating to broking the issues associated with long-term environmental risks for leading U.K.- and U.S.-based companies. As a Project Manager for Ernst & Young Riyadh, Saudi Arabia), he also managed an international team of consultants undertaking a strategic economic and environmental evaluation for a national oil and gas company. He received a BSc in Land Economics from Anglia University/Writtle Agricultural College. Stone can be reached at (972) 715-6260.