Environmental contamination: disclosing liabilities & asset impairments.

Water, soil and air contamination have been a major concern in the United States, especially over the last several years. Industrial pollution, in particular, has had a negative influence on the environment and in many cases on the quality of life. Heightened environmental awareness, public pressure, government reaction and corporate good neighbor policies have increased public concern over environmental damage.

This increased concern combined with the high cost of environmental cleanups have changed corporate policies and practices to reduce or eliminate environmental contamination resulting from current operations. In addition, the cleanup of prior environmental damage has been completed (or is underway) at many contaminated sites. Negotiations are ongoing in thousands of jurisdictions concerning the extent of past contamination, the dangers that exist from such contamination, as well as who should pay and how much for its cleanup/containment.

The Upjohn Company, for example, has taken responsibility for the cleanup of a Superfund site in Kalamazoo County, Michigan that will cost in excess of $40 million. Upjohn, in turn, is seeking partial reimbursement from numerous other potentially responsible parties (PRPs).

Growing environmental awareness and concern has contributed to an increasing number of federal governmental regulations concerned with protecting the environment. These federal regulations include the Clean Air Act (CAA), the Clean Water Act (CWA), the Resource Conservation and Recovery Act (RCRA), the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), the Superfund Amendments and Reauthorization Act (SARA), the Leaking Underground Storage Act (LUST) and the Safe Drinking Water Act. In addition, other, sometimes stricter, regulations are imposed by state or local governments.

The pressure from environmental groups has been coupled with the recognition by most businesses that being environmentally responsible is good business practice. The environmental impact of a decision is now a major consideration in their decision making process. This article will first review the general relevance of environmental matters to accountants; then discusses the effect of environmental contamination on two important aspects of financial accounting - the recognition and reporting of any potential liability resulting from environmental risk, and the recognition and disclosure of any decrease in an asset's value due to environmental contamination.

Relevance To Accountants

The increasing concern over the environment has had a significant impact on accountants responsibilities. These increased responsibilities affect the management accountant, the cost accountant, the financial accountant, the internal auditor and the external auditor. The management accountant must consider the expected environmental costs in providing data for decision making. The cost accountant must insure that environmental costs incurred in the production process are appropriately allocated to the proper products. The financial accountant must make certain that all potential liabilities and asset impairments due to environmental contamination are properly recognized in the statements. Finally, the internal auditor and the external auditor must make sure that the financial statements and internal reports properly reflect information and disclosures relevant to environmental issues.

The Securities and Exchange Commission has addressed the issue of environmental disclosures. In 1986 the SEC issued the current version of Regulation S-K which requires the registrant to disclose the material effects of complying with regulations concerning environmental costs. There can be little doubt "...the SEC views disclosures of environmental liabilities as effectuating important public purposes..." (Rabinowitz 1991). However, the SEC does not inspect sites for the related environmental liabilities or asset impairments. They rely instead on the companies' independent auditors for such disclosures.

One specific example of environmental relevance concern is the decision to acquire property. This decision is made more complicated due to the risks associated with acquiring contaminated property. The superfund law provides for joint/several liability which means that in some cases a financially healthy party could be liable for all environmental cleanup and damages even though they were not responsible for the contamination. Accordingly, the prepurchase investigation should include a thorough environmental investigation or audit. Although the Innocent Land-owner Provision of the Superfund Act may offer some protection (if due diligence is proved), this is not a well defined provision.

The accountant must recognize the effect of any past environmental damage on the well-being of the company and, if necessary, report any present obligations due to environmental contamination. Also, the effect of any contamination on the value of the firm's assets must be considered.

Liability Recognition

The full disclosure principle in accounting requires, subject to the cost/benefit and materiality constraints, all relevant financial information be presented to informed readers. Recognizing realized and potential liabilities are important in adhering to the full disclosure principle.

Environmental Cleanup Requirements

Federal regulations require contaminated sites be cleaned up or the contamination be contained. They also provide any liability associated with such cleanup is joint and several. Consequently, a potentially responsible party (PRP) could be assessed for the entire cost of the cleanup even though they were only involved in a limited way.

The Environmental Protection Agency (EPA) has identified over 27,000 contaminated sites in the United States. Of these, over 1,200 are on the Superfund Site list. The EPA estimates the cleanup costs of these sites will average $25 million (Newell, Kreuze, Newell 1990). Obviously, many contaminated sites are not Superfund sites, but nonetheless may have significant amounts of cleanup costs associated with them. These costs could involve any site the firm used for dumping or storage purposes, the property on which the production facility is located and/or the buildings used for production or storage. Generators of hazardous waste have a legal responsibility for any amount of hazardous waste created from "cradle to grave." Federal and state court decisions have held the original generator remains legally liable even after the disposal of the waste. Under Superfund law, persons and businesses generating wastes are legally responsible for damages resulting from the wastes. This liability includes costs imposed by the government regulatory agencies, as well as costs from litigation by individual parties. This potential liability has become a much bigger issue in recent years and requires an expansion of the accountant's typical investigation and reporting responsibilities.

Determining the potential liability may be seen as a two step process. The first step involves determining if there is any potential liability due to past or current environmental contamination. One possible approach used to ascertain potential environmental problems is through an environmental audit. The environmental audit is a systematic review of physical facilities, production processes, documentation and other aspects of the business. This inquiry helps to determine the compliance, risk status and management practice of the firm or facility being audited as it relates to the environment. It would be helpful in determining if the facility is presently in compliance with federal, state and local environmental regulations, as well as identifying any possible contamination from past operations.

Though some firms may have an environmental expert on staff capable of conducting an environmental audit, in many cases an outside environmental consulting firm is needed. To assist auditors, detailed information on environmental audits is available through an assortment of governmental and public sources.

The second step involves estimating possible liabilities associated with an identified environmental problem. It is essential management develop a realistic range of environmentally related costs as they relate to a specific concern. An independent appraisal of the cost of an environmental cleanup may be reached by obtaining an estimate from an environmental consulting or engineering firm. It may be more difficult to estimate the cost to the firm if the firm is one of several responsible parties.

Some relevant questions to ask in estimating the cost include: a. What is the most likely scenario

of future events related to this

problem? b. What is the worst thing that

could happen? c. What remedial action will be

taken? d. Will significant costs be recovered

from others and if so, how

much? e. What is the likelihood the

remediation efforts will be successful?

If it is not successful,

what further action is necessary?

Though answers to these questions may be helpful in developing rough cost estimates concerning an environmental cleanup, more precise evaluations may be more difficult to attain without a more extensive information search.

SFAS No. 5

Once a potential problem has been identified and an estimate made of the cost of correcting it, a decision must be made concerning the reporting and disclosing of the problem. Financial Accounting Statement No. 5 provides guidance in this regard.

Financial Accounting Statement No. 5 (SFAS 5), "Accounting for Contingencies" is applicable to potential environmental liabilities (FASB 1975). SFAS 5 defines a contingency as an uncertainty that will be resolved when one or more future events occur. The likelihood of the uncertainty happening must be categorized as being "probable," "reasonably probable" or "remote."

An estimated loss from a loss contingency must be accrued by a charge against income if it is both: 1. Probable a liability has been incurred;

and 2. The amount of the loss can be

reasonably estimated.

If these two conditions are not met, a disclosure of the loss contingency must be made if there is at least a reasonable possibility a loss may have occurred. The disclosure shall indicate the nature of the contingency and shall give an estimate of the possible loss or range of loss or indicate such an estimate cannot be made. If there is only a remote chance of a loss, disclosure is not generally required.

Valuing Contaminated

Property

Contaminated property may lose much or all of its value because of: 1.) the liability for the contamination cleanup, or 2.) the limited use of the property until, and even after, the cleanup.

The cost of the cleanup may be much higher than the value of the uncontaminated property. Even in those situations where cleanup is not yet legally required, the threat of possible environmental contamination limits the property's market-ability. Seriously contaminated property is often unsaleable particularly if the EPA has designated it for Superfund cleanup.

For example, the 80 acre landfill in Kalamazoo County, without contamination, perhaps would have a market value of $160,000. The projected costs of cleanup excees $40 million. And even after cleanup, the land's value will be impaired due to the uncertainty of cleanup results.

It is, however, important to note that though the property is unmarketable, it does not necessarily indicate it is useless. If the present owner can continue to utilize the property for its' current application or for some other useful purpose it has "value" to the owner. Valuation of the property may pose a problem, however.

Asset Impairment

In accounting, "impairment" is defined as the inability to fully recover the carrying value of assets over their useful lives. Historically, this has often resulted from inadequate depreciation, changes in customer demand, competition, as well as many other reasons. More recently contamination of land, buildings and other properties by hazardous waste has often caused impairment. The accounting issue has been: 1. If and when to recognize asset

impairment; 2. How to recognize such impairment; and 3. What required disclosures are

needed concerning such impairment.

Recognizing Asset Impairment

There is a lack of consistency in accounting for impaired assets. Impairment recognition varies depending on the type of asset impaired. The Lower of Cost or Market valuation procedure for inventory accounting reports the amount of the writedown on the income statement. Inventory is not written up if in subsequent years the inventory recovers its value. In the case of temporary investments however, investments are written down but are written up to original cost if they recover in value. The writedowns and recovery (up to original cost) are reported on the income statement.

Long-term investments are written down if the decline is thought to be temporary. The effect, however, is reported as a contra account in the owners' equity section of the balance sheet and there is no effect on income. If the investment recovers in value, it is written back up to original cost by reversing the entry made at the time of writedown. Again there is no effect on income. If the long-term investment is thought to have experienced a permanent decline in value, the investment is written down and the effect is reported on the income statement as a realized loss. Any recovery in value is not recognized in the accounts.

Impairment writedowns of long-term assets are not treated consistently between firms. The profession has no specific standard requiring a consistent application except that only permanent writedowns should be recognized for long-term assets. However, in a survey conducted by the Financial Executives Institute (FEI) in 1985, sixty percent of the surveyed firms used the probability criteria given in SFAS No. 5 and only 36% used the permanence criteria (Schuetze 1987).

Deciding what constitutes a permanent loss involves not only judgment by the accountant, it may also involve a philosophy that is not consistent among firms. However, in the case of property, plant or equipment contamination by hazardous waste, the impairment is probably permanent even if cleanup is successful. accomplished.

Asset Impairments/Environmental

Costs - Emerging Issues Task

Force

Although accounting pronouncements provide only limited guidance in accounting for environmental impact, the Emerging Issues Task Force (EITF) has specifically addressed the accounting for asbestos removals. The EITF addressed the following two asbestos related issues: 1. Should asbestos treatment costs

incurred be capitalized or expensed

if the costs are incurred to

treat an asbestos problem known

to exist in property acquired? 2. Should asbestos treatment costs

incurred be capitalized or expensed

if the costs are incurred to

treat a problem in an existing

property?

In discussing these issues the EITF concluded that costs incurred to treat asbestos within a reasonable time period after a property with a known asbestos problem is acquired, should be capitalized as part of the cost of the acquired property and such capitalization should be subject to an impairment test for the property. The EITF also concluded that costs incurred to treat asbestos in an existing property should be capitalized as a betterment.

However, this capitalization should also be subject to an impairment test. To illustrate, assume contamination was discovered on a parcel of land which was acquired two years ago for $1,000,000. The company spent $500,000 to have the contamination removed and detoxified. Assuming similar, noncontaminated land could be acquired for $1,100,000, the asset impairment test would indicate $1,100,000 ($1,000,000 + $100,000) of the cleanup costs could be capitalized, with the remaining $400,000 being a current expense.

Other Considerations

Accounting for asset impairments has been an important issue for some time. The Emerging Issues Task Force (EITF) in 1984, 1985 and 1986 noted an increase in asset writedowns and a lack of consistency in reporting such writedowns. In 1986 and 1987 the EITF labeled asset impairments as the number one issue facing the profession. The Financial Accounting Standards Advisory Council (FASAC) in 1980 suggested asset impairment not be addressed by the FASB until the concept statement was finished. In 1987 they listed it as the number one issue for the FASB agenda.

In 1986, at the request of the FASB, the Financial Executives Institute (FEI) completed a survey concerning this issue. The results indicated a wide diversity in accounting for asset impairments. Approximately one-half of those participating in the survey wanted advice as to how to handle the issue (Financial Executives Institute 1986).

In 1987 the National Association of Accountants (NAA), encouraged by the FASB, completed a similar survey (Fried 1989). The results of this survey also noted both an increase in asset impairment writedowns and wide diversity in the way they were accounted for. They suggested additional guidelines be given concerning how asset impairments should be accounted for. In 1991 the FASB released a Discussion Memorandum, "Accounting for the Impairment of Long-lived Assets and Identifiable Intangibles," (FASB 1990). The FASB is presently deliberating the issues included in the Discussion Memorandum. Possible criteria for recognition as well as other disclosure possibilities presented in that Discussion Memorandum are discussed below.

Criteria to be Used for Determining

Impairment

Three criteria were advanced as possibilities for determining if an asset has been impaired and should be recognized in the accounts. There are as follows:

Economic. If the carry value of the asset in question is greater than the measured attribute of the asset, then impairment has occurred and the asset should be written down.

Permanence, If the carrying value of the asset in question is greater than the measured attribute of the asset and the impairment is thought to be permanent, then impairment has occurred and should be recognized in the accounts.

Probability. If the carrying value of the asset is probably higher than its attribute value, the impairment should be recognized in the accounts. Although the definition of "probable" is not specific, it is often interpreted as more likely than not.

Along with the criteria for recognizing impairment in the accounts is the need to agree on what should. happen if the asset value recovers once it has been written down. That is, should the writedown be reversed and the asset be written up to original cost?

Accounting for Asset Impairment

in Other Countries

Although most other countries require the asset impairment be permanent before writedowns are allowed, this practice is not universal. Also, there is no agreement concerning how to handle the recovery in market value if an asset is written down. Australia, Canada, France, Germany, Japan and the United Kingdom all recognize impairment under the "permanence" criteria. Of these all recognize the recovery in asset value by writing the asset up and taking the effect to income (except for Canada which does not allow reversal). Other countries, such as New Zealand and Mexico, use the "economic" criteria for recognizing writedowns. Mexico allows for reversal if market value recovers while New Zealand does not allow for reversal.

Implications For Auditors/

Accountants

The implications for auditors and accountants are that environmental contamination may have a severe effect on the value of a firm's assets. This effect has to be evaluated by the accountant and auditor; and if it meets the subjective definition of an impairment, it should be written down. Failure to inspect for asset impairment or cleanup obligations is a failure of the accountant to do his/her job in a professional and responsible manner.

The writedown can be applied to either a major group of assets (i.e., a division), a subgroup (i.e., a plant) or to individual assets. These alternatives are similar to those available when applying the lower-of-cost-or-market valuation procedure to inventory.

Conclusion

The intent of this article is to encourage accountants to be aware of their responsibilities concerning liability recognition, asset valuations and disclosures as they relate to environmental contamination. Environmental contamination for which the firm is involved in any way has the potential to affect a firm's obligations and the value of its assets. If, in fact, the firm has environmental risks then the risk should be recognized either through the financial data or through other appropriate disclosures. This discussion should be seen as a starting point in recognizing environmental liabilities and asset impairments due to environmental contamination. Accounting and auditing procedures will most likely evolve to more fully recognize the potential impact of environmental matters.

References

Financial Accounting Standards Board, Discussion Memo, Accounting for the impairment of Long-lived Assets and Identifiable Intangibles, (December 1990). Financial Accounting Standards Board, Statement No. 5, Accounting for Contingencies, (March 1975). Financial Executives Institute, "Survey on Unusual Charges: Summary of Responses," (1986). Fried, Dov, Michael Schiff, and Ashwinpaul C. Sondhi, Impairment and Writeoffs of Long-lived assets, National Association of Accountants (1989). Rabinowitz, Daniel L. and Margaret Murphy, "Environmental Disclosure: What the SEC Requires," Environmental Finance, (Spring 1991). Schuetze, Walter, "Disclosure and the impairment Question," Journal of Accountancy, (December 1987).

Gale E. Newell, PhD,is a professor of accountancy at Western MIchigan University. He received his BBA degree from Wester Michigan University and his PhD from Michigan State University. He has published in many professional business journals.

Jerry G. Kreuze, PhD, is a professor of accountancy t Western Michigan University. He received his BBA degree from Ferris State University and his PhD from The University of Missouri. He has published in numerous professional business journals.

Stephen J. Newell, MBA,is a doctoral student at Florida State University. He received his BBA degree from Michigan State University and his MBA from Indiana University. He has published articles in several professional journals and has worked as a consultant in the area of environmental contamination.