Accounting for Toxic Cleanup.

STANFORD, Calif.--(BUSINESS WIRE)--Feb. 12, 1996--Corporations often have substantial financial liabilities related to Superfund site cleanups, but they don't always show up on their balance sheets.

In part, this is because it is so difficult for companies to estimate them. For example, how can a company that shares the liability for a site with a handful of other companies determine its share of an estimated bill? What if the government were to set harsher cleanup guidelines in the future that changed all the costs to clean up a site? What if it relaxed the guidelines already in place? Lacking any means of arriving at a solid cost estimate, how can a company responsibly assign a specific dollar amount on its balance sheet?

For Stanford Business School's associate professor of accounting Maureen McNichols, the upshot of all this uncertainty is that balance sheets often fail to reflect the extent of a company's liabilities. This could have a profoundly adverse effect on unwary investors. "The prime concern is that you could be paying too much for a firm's shares if the liabilities are understated and you don't know that," says McNichols.

McNichols and Mary Barth, also an associate professor of accounting, using data from an environmental consulting firm and the EPA, put together their own cleanup cost estimates for a sampling of 1,100 firms over a 10-year period. While the estimates were rough, the two researchers believed they were more accurate and inclusive than what companies were owning up to - if they were recognizing any liability at all. "It would be fair to say that there was limited disclosure by these firms," says McNichols. "We're not suggesting that firms have misled anybody or aren't following the rules. Their liabilities are simply bigger than what is booked."

Barth and McNichols decided to see if investors were picking up on the unrecognized liabilities, and if so, to what extent. They put together a model that would measure the stock market value of different firms against their stated assets and liabilities - and against Barth and McNichols' estimates of the firms' environmental liabilities. Says Barth: "When accountants are trying to figure out whether to recognize something or not, one piece of evidence that indicates maybe they should be doing it is that investors are already doing it."

Investors were doing it. In McNichols and Barth's analysis, the greater the environmental liability - even if it was not recognized - the lower the share price of the firm. "Even if accountants aren't putting numbers on a balance sheet, the market is figuring something out," says Barth. "That's a clue that balance sheets don't match up with what investors think should be on them." Barth and McNichols found that investors valued the liabilities of their sampling of firms at an average of 28 percent of equity.

One reason investors might want to see more environmental liabilities on the balance sheet is that companies have access to the best information. Investors come up with their estimates based on clues gathered from financial statements, environmental consulting firms, and EPA data. These estimates may be way off, warns McNichols. "We can't really say that investors have the correct price," she says. "They could be overpricing these liabilities, or they could be underpricing them."

As a follow-up, McNichols and Barth have looked at different factors that seem to motivate firms to disclose information about environmental liabilities. For instance, from 1991 to 1993, the SEC substantially increased environmental disclosure enforcement and the researchers found drastic increases in what firms reported over that period. They also discovered that when firms seek access to capital markets, they frequently begin disclosing more of their environmental liabilities. McNichols and Barth think this is because investors perceive companies that are forthcoming about their problems to be less risky.

On the other hand, there are some compelling disincentives to disclosing liability. A company that shares responsibility for a Superfund cleanup with other companies may be reluctant to mention an exact figure until it has struck a bargain with its partners. To indicate on its balance sheet that it is liable for a set amount could weaken its position in allocation negotiations later. And firms are probably justified in doing what they can to minimize what they pay: Environmental remediation will be a crushing expense for a lot of companies. According to Barth, total environmental cleanup costs in the United States may add up to as much as $750 billion, with Superfund sites comprising $150 billion of that.

CONTACT: Stanford Business School

Janet Zich, 415/723-9193