The AAI Rule and SOX Intersect
New accounting obligations present opportunities for EPs
November 1, 2006, was an historic day for the environmental due diligence industry. That’s the date the U.S. Environmental Protection Agency’s All Appropriate Inquiry (AAI) rule took effect, changing the environmental due diligence requirements for those seeking to qualify for cleanup liability protection under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA).
Four years earlier, the corporate world was in the midst of its own sea change. A rash of accounting scandals that cost investors billions of dollars -- the ENRON disaster is the most notable -- led Congress to pass sweeping securities reform legislation to restore investor confidence. President George W. Bush signed into law the Sarbanes-Oxley Act, commonly known as SOX, on July 30, 2002.
By now, most environmental due diligence professionals (EPs) can cite the requirements of EPA’s AAI rule in their sleep. But those same EPs are likely unfamiliar with the ins and outs of SOX, and fewer still are aware of the link between the two. Once this link is understood, however, EPs can take advantage of new opportunities arising from corporate America’s need to assess and quantify liability, including environmental exposure.
SOX: An Overview
Also known as the Public Company Accounting Reform and Investor Protection Act of 2002, SOX establishes new or enhanced standards for U.S. public companies. Among other things, this complex legislation requires full and accurate disclosure of financial liabilities -- including those stemming from environmental issues -- in a publicly traded company’s balance sheet.
Corporate disclosure is nothing new, but the fact that corporate executives now face civil and criminal penalties for incomplete or inaccurate representations is. And gone are the days when executives could defer making material issues known until the next quarter: Companies must now disclose these changes immediately -- all part of Congress’ plan to avert future accounting disasters.
A Side Note: FIN 47
SOX isn’t the only notable accounting change. In March 2005, the Financial Accounting Standards Board, which establishes generally accepted accounting principles, adopted FIN 47, which requires companies to adopt new standards for accounting for their conditional asset retirement obligations. FIN 47 defines a CARO as “a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within control of the entity.” Prior to the adoption of FIN 47, companies didn’t always recognize future clean-up obligations as liabilities on their balance sheets, taking the position that if the timing was uncertain, they were unable to “reasonably estimate” costs. Under FIN 47, companies must disclose liabilities today, even if they can delay those events or do not know when they’ll occur. A tall order indeed!
What’s Environmental Due Diligence Got to Do with It?
Plenty, as it turns out. The new accounting requirements necessitate a full and accurate disclosure of a company’s liabilities. While environmental liabilities are just one piece of the pie, they’re a significant piece that can lead to serious financial liability. Just take a look at DuPont, a company in the midst of a class-action lawsuit. Accused of deliberately dumping dangerous heavy metals at an industrial site and exposing nearby residents to contamination, DuPont has been ordered to finance the cost of providing medical monitoring to 8,000 people over a 40-year period -- a significant line item on the company’s balance sheet. DuPont has already set aside $15 million for legal costs -- a substantial sum that is still less than a quarter of the estimated $63 million the company must pay to remediate the area. Environmental liabilities can add up quickly.
For most companies, the new reporting requirements represent a major change in current accounting practices. Prior to the implementation of SOX, failure to adequately report environmental liabilities in financial statements was common. Even if a company was reporting environmental liabilities to the public pre-SOX/FIN 47, chances are those costs were presented in piecemeal fashion, rather than in an aggregate form that would give investors a better idea of overall risk exposure.
To paint an accurate picture for stakeholders, companies must develop systems to identify and disclose potential and real environmental liabilities. But complying with the new regulations is anything but simple for management, who, with respect to environmental liabilities, must:
*Quantify those liabilities
*Make materiality determinations
*Determine the diminished market value of environmentally impaired properties
*Assess potential liability exposure associated with contamination
Many companies are just now beginning to address these issues, and the learning curve is steep. That’s where EPs come in.
The AAI/SOX Link: Opportunities
Traditionally, a company’s internal staff, such as environmental health and safety officers, attorneys, and real estate managers, have been responsible for compiling environmental information for internal due diligence and compliance auditing purposes. Under the new accounting requirements, corporations need to collect information on material environmental liabilities for both an internal and external audience that will be scrutinized by independent, third-party auditors and monitored by the Securities and Exchange Commission. As companies struggle to assess environmental liabilities and determine accurate reserve levels for handling them, they’ll likely require outside help. Identifying whether an environmental liability warrants disclosure, for example, can in and of itself be problematic. Too, many issues, such as a threat of litigation from potential clean-up costs, are difficult to quantify; judgment calls create opportunities for EPs, whose professional opinions are invaluable. Indeed, some corporations are already calling on EPs to help evaluate disclosure procedures and analyze and document material environmental liabilities.
The new accounting requirements present a number of opportunities for EPs who conduct environmental site assessments. Because an AAI-compliant Phase I Environmental Site Assessment includes a review of current and historical operations to identify recognized environmental conditions and business environmental risk, the process yields valuable information that companies can use to comply with disclosure requirements, particularly while going through an acquisition, divestiture, or refinancing.
The site visit can be used to identify both environmental remediation liabilities within the scope of the AAI rule, as well as asset retirement obligations that corporations need to report under SOX. For example, if a public company is considering buying a property that contains several underground storage tanks in compliance with federal, state, and local regulations and in proper working order, they won’t be recognized as environmental conditions in the Phase I; however, their presence is important because under the new accounting rules, their future closure costs must be reported on the company’s balance sheet.
An AAI-compliant Phase I also can uncover information critical to estimating known valuation reductions for environmental impacts relating to purchased assets. Such reductions are indicative of the fair market value of environmental liabilities and may be used to evaluate whether a company’s reported liability estimates are reasonable. Environmental issues identified during the Phase I ESA can be cross-checked against internal documents for misrepresentations or exclusions. Furthermore, as EPs have always known, an AAI-compliant Phase I ESA can protect the site’s owners and operators from legal responsibility under CERCLA that otherwise would be a reportable environmental liability.
Too, the growing pressure on corporations to open their books to public scrutiny could provide them with a strong impetus to reduce liabilities by selling off contaminated properties. The CERCLA liability protections in the 2002 federal Brownfields Amendments may make it easier for corporations to find willing buyers for their contaminated real estate, driving more deals forward.
The key for EPs to cash in on these opportunities is to learn to use an enhanced approach when collecting and interpreting information acquired for a Phase I ESA. For corporate accounting purposes, environmental risk data gathered during the due diligence process requires a determination of financial impacts associated with those liabilities. To effectively aid corporations, EPs must develop a basic literacy in environmental financial reporting and keep up with new developments.
In our post-ENRON world, transparency is the name of the game. By offering to go beyond traditional environmental due diligence, EPs can help companies meet their accounting obligations and create long-lasting, more profitable business relationships in the process. While significant changes in corporate environmental disclosures will take time and probably more than a few lawsuits to materialize, consultants can use that time to become familiar with the new requirements and educate clients about the importance of proactively moving toward full environmental disclosure.