Assessing environmental risk; financial statement users are carefully scrutinizing the adequacy of environmental cleanup disclosures.

Faced with myriad potential sources of financial exposure from ever-increasing environmental regulation, companies are grappling with the substance and timing of shareholder disclosures about the effect of environmental laws and regulations. Equally challenged, financial statement auditors must assess whether environmental issues have beet) considered properly before reporting a company's statements are presented in accordance with generally accepted accounting principles. This article will help accountants and auditors assess the sources of a public or private company's financial risk and the adequacy of presentation or disclosure of environmental matters in financial statements.

STATUTORY SOURCES OF ENVIROMMENTAL LIABILITY

Companies are subject to a wide range of federal, state and local environmental laws and regulations. Major federal statutes include the Clean Water Act, the Clean Air Act, the Resource Conservation and Recovery Act of 1976 (RCRA), the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) as well as the Toxic Substances Control Act.

The scope of current environmental laws is very broad. Under RCRA, for example, companies must track hazardous waste from cradle to grave. " Environmental Protection Agency (EPA) regulations developed pursuant to RCRA impose strict standards for hazardous waste treatment, storage and disposal. RCRA also empowers the EPA to investigate potential violations and, if necessary, initiate legal proceedings against violators.

Just four years after RCRA, Congress enacted CERCLA, the so-called superfund statute, which was extended and refined by the Superfund Amendments and Reauthorization Act of 1986 (SARA). Touted by environmental groups for its comprehensive scope, CERCLA imposes hazardous waste-site cleanup liability on a broadly defined group of potentially responsible parties (PRPS):

* The current owner or operator of a facility identified as a hazardous site.

* Anyone who at the time of disposal of hazardous substances owned or operated any facility at which such substances were disposed of

* Generators of hazardous substances disposed of at the facility.

* Anyone who transported hazardous substances to the facility.

CERCLA liability defenses are limited and difficult to assert successfully. Due both to CERCLA'S extensive reach and the financial magnitude of cleanup costs, the statute has spawned considerable environmental litigation in recent years.

Many states have adopted their own CERCLA-TYPE cleanup statutes. New York, for example, has an active state superfund program. New Jersey's Environmental Cleanup Liability Act (ECLA) requires industrial-establishment owners or operators planning to sell or transfer operations to notify state environmental authorities and provide either a negative declaration there are no hazardous substances or wastes on site or a cleanup plan to address any site contamination. Failure to comply is grounds for the buyer or the state to void the sale.

POTENTIAL SOURCES OF FINANCIAL EXPOSURE

Federal and state laws and regulations may result in a number of financial risks that CPAS must consider. One such risk is the possibility a company will be required to commit substantial funds to comply with environmental laws and regulations. For example, a manufacturing facility is required to install or upgrade devices to remove particulate matter from smokestack emissions or to remove chemicals or heavy metals from liquid or solid waste before disposal. The resulting capital expenditures will increase production costs-which cannot be fully passed on to customers and will lead to a decline in future earnings.

CPAS must consider a company's exposure to toxic tort liability for personal injury or property damage due to chemical exposure. In toxic tort lawsuits, massive damages often are sought by victims of a company-caused environmental problem. These lawsuits, which normally seek damages for personal injuries allegedly caused by violations of environmental statutes, rely on a variety of theories ranging from negligence to strict liability, trespass and nuisance, as well as product liability.

Companies and their officers and directors face substantial fines and penalties for the companies' failure to comply with environmental laws and regulations. Where a knowing violation is shown, the possibility of significant punitive damages exists. In one case involving knowing contamination of subsurface waters used by local residents for drinking, the court levied punitive damages of $10 million. Companies failing to take appropriate preventive action, such as implementing effective control procedures to identify and prevent environmental contamination, may be liable for significant penalties. Under new Justice Department guidelines, companies failing to undertake voluntary compliance or disclosure efforts risk substantial fines.

Remediation (cleanup) obligations can put huge financial demands on a company. Businesses from small, family-owned gas stations to large manufacturing enterprises may have knowingly or unknowingly contaminated the soil or water on or under their property. For example, soil polluted by leaking underground fuel or chemical storage tanks may need to be remediated before pollutants reach underground drinking water. Contaminants generated over years of operations and flushed into on-site ponds may need to be cleaned up in connection with a plant closing. A company also can face remediation obligations for polluted sites identified by government agencies or third parties. Those sites frequently include waste-disposal landfills containing hazardous wastes from numerous sources. Under CERCLA, all generators of such wastes are considered to be PRPS, which face joint and several liability for site remediation. Any PRP may be found liable for the entire cleanup cost of a site, regardless of how small its contribution. Unsuspecting companies can suddenly find themselves mired in a superfund cleanup project totaling hundreds of millions of dollars. By some estimates, industry will have to spend $150 billion to clean up hazardous wastes in 1,200 disposal sites already identified by the EPA.

THE ACCOUNTANTS ASSESSMENT

Environmental issues can significantly affect a company's financial position and its long-term financial health. Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, provides CPAS with the framework for assessing the financial statement impact of an entity's environmental exposure.

Statement no. 5 says a loss contingency is "an existing condition, situation, or set of circumstances involving uncertainty as to possible ... loss ... to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur." When an uncertainty is resolved (for example, a verdict is reached in a citizen suit or private enforcement action), the result might be a loss or impairment of an asset or incurrence of a liability. Under GAAP, a CPA determines the appropriate financial statement treatment of a loss contingency after considering both the probability future events will confirm a loss and the extent the loss amount can currently be estimated.

Under Statement no. 5's broad guidelines, environmental exposure is generally reflected in financial statements as follows:

* If before issuance of the financial statements it appears probable an environmental exposure has resulted in a liability or an impaired asset as of the balance sheet date and the amount of loss can be reasonably estimated, the loss is accrued by a charge to income and appropriate disclosure is provided. If the loss amount can be measured only as a range, the best loss estimate is recorded or, if there is no best estimate, the minimum loss is recorded.

* If a loss is not accrued because either it is not assessed as probable or there is no reasonable estimate, an environmental exposure still must be disclosed in the footnotes to the financial statements if there is at least a reasonable possibility a financial loss has been incurred. That disclosure should describe the environmental exposure, including an estimate, or range of estimate, of the loss (or if there is no reasonable estimate, it should so state). With the proliferation of environmental liability laws, it is common for companies to find themselves saddled with substantial liability from lawsuits in which the company was confident the risk of significant liability was remote. Large, unexpected verdicts assessing punitive damages emphasize the importance of paying attention to possible environmental losses.

In one case, a shareholder brought suit against a company in Denver, alleging stockholders should have been told a building the company's subsidiary sold for million contained asbestos. The building's purchaser sued, winning a $9,125,000 judgment, including punitive damages. The plaintiff claimed, by not disclosing the asbestos problem, the company managed to look profitable enough to issue new stock and debentures and inflate its stock price.

Environmental issues affect financial statement presentation in more ways than just assessment of a loss contingency. If a production process generates hazardous wastes that must eventually be remediated, a reserve should be accrued as units are produced to reflect, in current earnings, expected cleanup costs. In addition, while consumption of a productive asset is certain to occur eventually, that asset's useful life may be shortened by environmental regulations requiring replacement by more environmentally friendly equipment by a specified future date. Also, the carrying value of property held for sale might need to be reduced to reflect environmental cleanup costs required before transfer but not recoverable from the buyer.

The FASB emerging issues task force recently provided guidance on when certain environment-related expenditures can be capitalized and amortized over succeeding periods rather than expensed immediately. The EITF Issue no. 90-8, Capitalization of Costs to Treat Environmental Contamination, consensus is that when a company incurs costs "to remove, contain, neutralize, or prevent existing or future environmental contamination," the costs should be expensed immediately. They are to be capitalized only if recoverable because they

* Extend the life, capacity, safety or efficiency of company-owned property.

* Mitigate or prevent environmental contamination likely to result from future operations.

* Prepare for sale property currently held for sale.

Even when recording a liability or providing for a reduced asset carrying value is not required under GAAP, disclosure of an environmental exposure and its potential effect on future earnings or equity still may be necessary to ensure the financial statements are not misleading. For example, it may be necessary to provide disclosure in the notes to the financial statements if a company is required to commit funds for significant capital expenditures in response to an environmental law change. Further, a company may need to disclose an anticipated negative trend in margins or net earnings from more costly manufacturing processes required by environmental regulations or a potential decline in sales as a result of widely publicized, company-caused environmental contamination.

SEC DISCLOSURE REQUIREMENTS

Publicly held companies have special disclosure requirements when filing registration statements or annual reports with the Securities and Exchange Commission. The regulations'underlying purpose is to ensure securities purchasers and sellers have access to vital information about a company's environmental liabilities. Since the first SEC environmental rules were adopted in 1971, environmental disclosure requirements have been augmented and refined by SEC rulings, regulatory amendments and litigation.

SEC regulation S-K, item 1, requires companies to disclose the material effects compliance with federal, state and local environmental laws may have on capital expenditures, earnings, and competitive position." Item 1 also requires companies to reveal the material estimated capital expenditures for environmental control facilities for the current fiscal year, the succeeding fiscal year and "such further periods as the registrant may deem material. " Item 103 directs companies to disclose pending administrative or judicial proceedings arising under any federal, state or local environmental statutes, including "such proceedings known to be contemplated by governmental authorities."

In preparing the management's discussion and analysis (MD&A) under item 303 of regulation S-K, CPAS need to consider environmental risks'impact on a company's financial position, earnings trend, liquidity and capital expenditure commitments. The sidebar above illustrates the factors to be considered in complying with item 303, shows the CERCLA disclosure requirements and indicates the SEC will scrutinize a company's disclosure reports, with particular attention to key factors such as anticipated environmental liability expenses, availability of insurance coverage and the prospect of third-party indemnification or contributions for damages.

SEC regulations require companies not only to reveal their status as defendants in pending administrative or judicial proceedings but also to gauge whether a known but unrevealed-environmental condition is reasonably likely to have a material effect on future capital expenditures.

The SEC has taken action to enforce compliance with its environmental liability disclosure rules. In 1977, for example, an enforcement action was brought against Allied Chemical for failure to inform shareholders about possible material expenses resulting from releasing toxic chemicals into the James River.

In 1979, the SEC determined U.S. Steel had neglected to disclose the company's failure to comply with the Clean Air and Clean Water acts could lead to material liability expenses. The SEC concluded U.S. Steel's policy of "actively resisting environmental requirements" was "reasonably likely to result in substantial fines, penalties, or other significant effects on the corporation." In 1980, the SEC commenced an action against Occidental Petroleum for failure to disclose pending environmental proceedings concerning the Love Canal site against Occidental's Hooker Chemical subsidiary.

The SEC environmental disclosure requirements extend also to shareholder proxy materials. In January 1991, a federal judge in New York rejected Exxon's request to dismiss a shareholder suit for failure to disclose in a proxy statement pending litigation arising from the Exxon Valdez oil spill in Alaska.

CPAS should consider if an environmental exposure's potential effects may be mitigated by third-party indemnification, insurance claims or recovery from PRPS. A recent case involving an NL Industries Ohio subsidiary considered these potential third-party funding sources. The court found NL Industries was not required to disclose environmental violations because the Department of Energy had previously pledged to indemnify NL and its Ohio subsidiary in the event of liability or loss arising from environmental law violations. The court reasoned "there was no plausible way NL's shareholders could suffer financially from the consequences of the alleged environmental violations."

A company that does not enjoy federal indemnification, however, must consider its indemnifier's financial soundness in determining if such protection relieves it of the need for disclosure. Further, protection against environmental liability likely will be less common as awareness of the enormity of potential liability increases.

The availability of insurance or contribution from other parties for damages also may affect a company's environmental disclosure requirements. Insurance or third party contribution may shield a company from exposure to monetary sanctions that would trigger its duty to disclose. As such, CPAS must assess the soundness of a company's insurance coverage and the financial resources of potential contributing parties. According to the SEC staff, a probable liability should not be offset by a merely possible insurance recovery. Even when insurance coverage is applicable, the liability and coverage gross amounts should be disclosed if not shown on the balance sheet.

THE LONG ARM OF ENVIROMENTAL RISK

Before the sweeping effect of CERCLA'S joint and several liability became known, many companies and their CPAS became complacent in the belief environmental issues relate only to large smokestack or chemical companies. The danger of that belief is best illustrated by recent concern over the definition of an owner under CERCLA and related environmental liabilities. In numerous instances, regulators and third parties have asserted that banks and other lenders are owners and thus liable when hazardous substances are found on property subject to a bank's mortgage.

Recently, the EPA proposed a rule to clarify CERCLA'S security interest exemption for lending institutions, allowing them to undertake a broad range of activities to protect their interests in contaminated properties without being considered participants in the properties' management.

Any company purchasing property may find itself financially exposed because it has unwittingly become the owner of a contaminated property. A CPA should consider if company management has taken appropriate steps before an acquisition to assert an "innocent purchaser" defense under CERCLA. To invoke this defense, "appropriate inquiry" must be made into the prior ownership history and use of a property "consistent with good commercial or customary practice in an effort to minimize liability."

AN INCREASED CHALLENGE

Identifying and interpreting environmental risks will continue to challenge CPAS. As people increasingly focus on protecting the world around them, accountants will have to increase their efforts to assess the proper financial statement presentation and disclosure of environmental contingencies.

WHEN TO DISCLOSE

While only companies filing financial statements under the securities acts are subject to SEC disclosure requirements, the following hypothetical example from the SEC'S 1989 MD&A release illustrates some of the factors important to a proper assessment of environmental risk by CPAS preparing or auditing any financial statement in accordance with GAAP.

"An SEC registrant has been correctly designated a PRP [potentially responsible party) by the EPA with respect to cleanup of hazardous waste at three sites. No statutory defenses are available. The registrant is in the process of preliminary investigations of the sites to determine the nature of its potential liability and the amount of remedial costs necessary to clean up the sites.

"Other PRPS have been designated, but the possibility of obtaining a contribution from them is unclear, as is the extent of insurance coverage, if any. Management is unable to determine that a material effect on future financial condition or results of operations is not reasonably likely to occur.

"Based on the facts of this hypothetical case, MD&A disclosure of the effects of PRP status, quantified to the extent reasonably practicable, would be required.'

The above example shows that companies will be required to disclose potential environmental liability at a very early stage of discovery-even before concluding insurance or third-party indemnification is not available.