How to be lean, mean and green.

Before you can rein in your environmental costs, you need to know what you're spending. New accounting standards and a cross-disciplinary team can help you keep score.

A 1993 United Nations report revealed many companies spent 1.1 percent to 2 percent of sales revenue, and often more than 25 percent of net income, on environmental measures. The inefficiencies of regulatory requirements dilute the effectiveness of every dollar earmarked for the environment. But a determined corporation can contain environmental costs if it can pinpoint what, where and why it spends. Although controllers and CFOs know how to mind the corporate piggy bank, when it comes to the environment, traditional cost-benefit analyses can be problematic, and the financial checks and balances most other activities are subjected to aren't well-defined.

Don't think so? Ask an accountant to assess the effectiveness of your firm's environmental programs. You'll probably get a run-down of capital costs, reserves, projected expenses and a suggestion to speak to the environmental staff for more details.

Because environmental spending isn't scrutinized as much as other activities, it's been hard to implement cost-containment efforts. Without precise information on the roots of environmental costs, companies can't accurately assess their true costs and liabilities. This, in turn, may limit their ability to make informed decisions, secure financing and obtain property, casualty and product-liability insurance.

Many cleanup and other environmental costs are presently off-balance-sheet items, and companies often don't disclose future costs. But accounting and reporting standards are now more clearly defined, as are the mechanisms for identifying, measuring and accounting for environmental costs. Recently, the Internal Revenue Service decided to allow the immediate deductibility (vs. capitalization) of certain associated cleanup costs. This ruling may lead to more complete environmental reporting, because the after-tax cost of remediation and compliance could be lower for some companies. But that's not true for every company, especially if it has significant direct remediation expenditures and monitoring costs that it must capitalize.

THE TAIL WAGS THE DOG

If you want to reduce environmental costs, consider developing a detailed environmental accounting policy with the collaboration of management and your environmental, accounting, legal, production and internal-audit departments. Although laws, such as the Comprehensive Environmental Response, Compensation and Liability Act, as well as the Resource Conservation and Recovery Act, ultimately drive environmental expenditures, customer requirements, products and services drive a corporation. Effective environmental cost containment integrates these competing interests, but at first, the environmental tail may wag the corporate dog.

It's doubtful the corporate legal and environmental staffs that initiate and oversee compliance programs understand the balance-sheet implications of the Financial Accounting Standards Board's Financial Accounting Standard 5. For publicly traded companies, both the architects and accountants of environmental policy also should understand Securities and Exchange Commission Staff Accounting Bulletin No. 92, "Accounting and Disclosures Relating to Loss Contingencies," which clarifies the SEC's position on environmental liabilities. Other accounting standards, particularly the 1993 Emerging Issues Task Force pronouncement 93-5, "Accounting for Environmental Liabilities," and the American Institute of Certified Public Accountants Statement of Position 94-6, "Disclosure of Certain Significant Risks and Uncertainties," are equally important in classifying and reporting environmental expenditures and liabilities.

Currently, some companies report only estimates of waste-disposal costs, pollution-control equipment, permit costs, environmental studies and salaries. Although quantifiable, these fall short in revealing the total environmental costs companies actually incur. If a corporate accounting function asks its business functions to provide cost data based on these factors, reporting variances may occur without clear guidance, since definitions of an environmental cost may differ. Even harder to define are future costs and adequate reserves associated with groundwater remediation projects, especially given complex and often changing regulatory requirements.

SAB 92, which incorporates FAS 5 as well as the related Financial Interpretation 14, requires contingent environmental liabilities to be recorded at the lower limit of the range of estimated probable loss if no amount can be determined to be a better estimate. The regulation also says the liability should take into account inflation and other societal and economic forces. Plus, management can't delay recognizing a contingent liability until it gets to the point at which it can reasonably estimate a single amount.

SOP 94-6, which was issued in the fall of 1994 and applies to public and privately held firms, adds to the reporting and disclosure requirements in FAS 5. SOP 94-6 will require companies to address more clearly in their footnoted disclosures risks and uncertainties for fiscal years after December 15, 1995. It specifically addresses environmental remediation obligations and contingent liabilities for obligations of other entities under the area of "certain significant estimates."

Not surprisingly, many companies are scurrying, because to comply with the SEC and generally accepted accounting principles, they must separately show, for example, the amount of ground-water contamination and remediation liability and any outstanding insurance-recovery claims. Some companies' balance sheets may weaken, and their income statements may show losses or substantially reduced profits. Shares may be revalued and bond-rating agencies could downgrade ratings as companies disclose their current and potential environmental liabilities. For companies with environmental exposures that are considering public offerings, SAB 92 may pose a particularly tough dilemma. Fully disclose and risk what may become a baseless securities lawsuit from certain types of shareholders - professional plaintiffs - or don't fully disclose and risk an SEC enforcement action.

Current accounting practice shows future cost estimates usually accrue as a liability when a company completes a remedial investigation/feasibility study, the process that determines the cleanup method to be used. Deciphering how these costs have been reported in annual reports could baffle a SWAT team of lawyers, accountants and environmentalists. As for liabilities, multimillion-dollar ground-water and product-liability issues often get little more than a cryptic line in the footnote section of many annual reports. If regulatory history holds true, the SEC will follow the time-honored tradition of giving companies ample time to improve, while targeting enforcement actions against those suspected of questionable reporting. The commission has warned it won't tolerate failure to report actual and contingent liabilities.

THE GREEN POLICE

As you might imagine, the ever-present environmental movement is holding the SEC's feet to the fire. Adding more clout are banks, stockholders and an increasing number of socially responsible investment funds. Of course, no corporation wants to find itself on Fortune's next top-10 list for green irresponsibility. Getting an answer to Right-to-Know and Freedom of Information Act inquiries on a company's actions once took a concerted effort. Now they're much easier to obtain, courtesy of the information superhighway. The Investor Responsibility Research Center in Washington, D.C., now offers environmental profiles of the Standard and Poor's Corporate 500 and says institutional investors are very interested in a company's environmental liabilities.

A number of corporations keep one step ahead by proactively issuing "environmental reports" to stockholders and interested parties. Although some environmental groups deride these reports as "green-wash," others like the reports for their plain-English explanation of the company's environmental efforts, which isn't readily available elsewhere.

Determining the most effective environmental program and ensuring it remains cost-effective requires a multidisciplinary effort. This may include environmental, design, production, legal and, most important, accounting and auditing personnel. Everyone should recognize accounting is the common language of business. Early environmental efforts often centered on implementing environmental controls to insure regulatory compliance. That approach often separated the words effective and cost, with disastrous results for the balance sheet. Accountants were left to total up the costs, when and if they could find them.

To refine or develop an environmental program and select the best costing methods for an environmental accounting system, develop a process map of the interactions in your company. If you don't address environmental issues at the front end, you permit downstream progression and increasing pollution abatement, disposal or shipping costs. You must include the environmental tab to accurately calculate the total cost of a product or service, and it's often rolled into overhead.

To ferret out these hidden environmental costs, consider using activity-based costing, which traces overhead and period expenses to products, customer groups and, in some instances, to individual customers. You can't arbitrarily allocate indirect environmental costs within the ABC framework. In fact, the framework can help identify and trace the source of wasted time and materials. And you can use variance analyses to target and better manage products and processes that create environmental costs.

HELP IS ON THE WAY

Although the Environmental Protection Agency doesn't have the lead watchdog role in financial matters, it's initiating efforts with accounting associations to help promote fundamental environmental accounting concepts. The Global Environmental Management Initiative is developing a primer on the subject. The Tellus Institute, in conjunction with research from the Institute of Management Accountants, is preparing an EPA-sponsored survey of current and best accounting practices, and a subcommittee of the American Society for Testing and Materials is incorporating total cost-assessment principles in a standard guide for pollution prevention.

You should also be aware that EITF 90-8 lists a number of direct and indirect environmental costs that require expensing or capitalization. Such lists are helpful when laying the groundwork for an ABC system, but don't rely solely on them. You need a multi-disciplinary team to help you map business processes, one that knows the difference between cost and benefit. To prevent micro-solutions, review the team's findings against the company's strategic, operational and financial objectives. And give the team direction to insure that meeting regulatory requirements is part of your cost-containment and reduction plans.

Make sure you know the amounts of chemicals your company uses and where it uses them. Become familiar with your emissions, waste streams and materials recycled on and off site, as well as any products with environmental implications, including packaging and emerging "take-back" concerns (the issue of whether manufacturers should be required to take back products with an environmental exposure once the consumer is done with them). Once you have a good handle on these areas, you can answer virtually any question a regulator, activist or the media poses.

According to a General Accounting Office report, the EPA spends almost one-third of its total budget on information management. Not surprisingly, many corporate environmental staffs are also struggling to access, analyze and monitor the myriad of data necessary for life-cycle analysis, environmental design and total-quality environmental management. These are now the baseline strategies for implementing the programs necessary to address the "total environmental solution" the EPA and its sister agencies champion. The life-cycle analysis process is data- and resource-intensive, as well as methodologically and analytically complex.

Also, you must bridge an information and knowledge gap to implement life-cycle analysis and environmental design. Using existing and emerging communications and computing technologies can help improve analytical and decision-making processes. Although environmental information-management solutions exist, there's no generic off-the-shelf software program that will handle all of a company's environmental information. So when you add up customization and all the other hidden costs found in any information system, the real price tag may run into millions.

You may want to begin your environmental analysis by identifying which of your company's sites use chemicals, generate wastes or produce products with liabilities. Then rank company sites by existing or potential risk, based on chemical and waste volumes, toxicities, regulatory climate or other relevant factors. Other crucial baseline information includes tracking suppliers and subcontractors to insure their products and services add value, not liabilities.

Customers are also part of the puzzle. You may be able to reduce risks by modifying a process or product specification, but of course you need to know whether it really saves money and whether the customer will still buy your wares.

The more you look, the clearer it is that environmental issues transcend boundaries. For example, an internal design or customer request may generate the need for and initial cost of the chemical. But storage and production - not to mention environmental, health and safety, legal and shipping considerations all may add costs to the process. These include chemical use fees, process and waste permits, treatment systems, environmental and disposal taxes, specialized handling and employee training requirements, insurance costs and an unquantifiable paperwork burden.

In the past, pollution decreases have often translated into reduced needs for emission controls, waste disposal and related expenses, such as public relations. But while you may save money, don't count on a windfall, because the costs of future compliance requirements and remediation remain uncertain. If you're encouraged by initial and impressive savings from fundamental pollution prevention measures, remember what a log curve looks like. Additional improvements may require an exponentially increasing capital outlay.

THE COST OF YOUR REALITY CHECK

Ultimately, the cost of getting to a zero-defect level will provide the reality check, but if you can view pollution as a quality "defect," you'll have plenty of options for solving problems. Benchmarking, both in and out of your industry, may provide good ideas. Widely accepted solutions include just-in-time inventory techniques to reduce the quantity of chemicals on site at any given time and nondisruptive environmental reviews of products and processes, which can flag potential issues.

And you can require suppliers to comply with environmental specifications that insure their products and services complement, not compromise, your company's environmental programs. Reducing packaging materials, saving electricity and recycling everything possible from paper, soda bottles and cans to excess and waste materials and even grass clippings have yielded companies varying degrees of savings. These efforts provide excellent visibility and goodwill, but for the best financial results, incorporate them into your business' strategic and operational plans.

Another good investment is drawing up waste-disposal contracts that Houdini would be hard-pressed to break out of. The Fortune 500 is well-represented on the EPA's lists of potentially responsible parties for failing to look beyond a waste vendor's paperwork, which certifies it's authorized to accept, treat or dispose of wastes. Companies that have been burned or seen their neighbors hemorrhage cash now invest in site visits to insure their wastes are properly handled.

Training employees on basic environmental issues and their financial consequences is vital to the success of your cost-containment and reduction efforts. You can educate them through employee newsletters, meetings and, importantly, corporate policy. For example, an accounting review can prevent gung-ho employees from spending thousands of dollars in staff time and other costs on ideas that will net only a few dollars of environmental savings.

Of course, senior management backing is crucial, too. Production, operations, facilities and other chemical-user and waste-generating functions are more likely to respond to directives from above. Expecting an environmental staff to successfully manage and drive the necessary resource allocations, commitments and consensus required from a plethora of departments, customers and suppliers, all without management support, is wishful thinking at best.

In all of this, you must get past the paradox that even if environmental regulations don't make sense, you must make sense out of them to stay competitive. As with golf, by properly reading the green, you can use fewer strokes to do the job. To effectively balance economic and environmental considerations, accept nothing less than an accurate assessment of the environmental activities that affect your operations. If you don't use an integrated, multidisciplinary approach when assembling this picture, you risk not fully identifying environmental costs and liabilities. And worse, you'll do a lot of unnecessary spending.

RELATED ARTICLE: DON'T BET THE FARM

It could be any company's nightmare: Company X discovers an abandoned leaking storage tank on property it purchased years ago. The company and the original owner, Company Z, are both named as potentially responsible parties for the site-remediation effort and agree to share equally in the cleanup.

Company X completes a remedial investigation/feasibility study for $500,000, which results in remediation and monitoring costs of $10 to $15 million. It then installs a $3-million water-filtration system near the leaking tank to improve its existing plant facility. If you were Company X, how would you account for these costs? Here are some examples of what you should - and shouldn't - do.

Good accounting treatment. Company X considers the estimate of the cleanup costs probable, and no amount within the range was a better estimate than the other. By applying FAS 5, the company's reporting recognizes the lower end of the range ($10 million) as a liability. The company divides this number by two, since each company is equally responsible, and recognizes the liability, charging $5 million to current-year income and expensing the $500,000 cost of the remedial investigation/feasibility study in the current period.

The $3-million water-filtration system is a betterment to its physical plant, with a useful life of 20 years, so the company capitalizes and depreciates its cost over that period. In the annual report, Company X recognizes a contingent liability of $5 million and explains the matter in a related footnote disclosure.

For tax-accounting purposes, the company also capitalizes the cost of the water-filtration system, the remedial investigation/feasibility study and cleanup costs. IRS rules state that since remediation is necessary and estimable, the assessment costs and cleanup expenditures, including monitoring, must be capitalized and then depreciated.

Bad accounting treatment. Company X recognizes the $500,000 cost of the remedial investigation/feasibility study in the current period and capitalizes the costs of the water-filtration system. It gambles that cleanup technology and the applicable regulatory requirements will change in its favor and lowers the $10- to $15-million remediation estimate. The company also believes its insurance carrier will pay at least half of the claim and that too many variables exist to reasonably estimate a liability. To play it safe, the company places $1 million of retained earnings in reserve.

Company X doesn't accrue a probable contingent liability and says in a footnote disclosure that while it can't accurately determine cleanup costs, it doesn't expect any adverse effects on the company's financial condition. For tax purposes, the company properly capitalizes the cost of the water-filtration system, but deducts as a current expense the full cost of the remedial investigation/feasibility study because it considers it relatively immaterial and incidental. - BB and EN

Mr. Buxton, a certified public accountant, is a supervisory auditor for the Department of Defense. Mr. Nielsen is a registered environmental manager.