Liability and the financial statement.

Some guidance on when liabilities associated with environmental expenditures should be recognized, and when and what should be disclosed.

There has been a significant increase in the volume of environmental disclosure provided by corporations after the Environmental Protection Agency agreed to share corporate environmental data with the Securities and Exchange Commission (SEC). With the increasing evidence that these disclosures are moving from minimal to more complete, the following questions arise: What is causing the heightened awareness and increased disclosures? Is this a signal that there is a deficiency in the accounting requirements?

A number of factors may be contributing to corporate awareness of the impact of environmental issues on the financial statements:

Legislation. Some of the major legislation enacted during the last two decades, and strengthened by amendment in the last few years, include the Resource Conservation and Recovery Act (RCRA), Toxic Substances Control Act (TSCA), Comprehensive Environmental Response, Compensation and Liability Act (CERCLA or the Superfund Act), and the Clean Air Act. These regulations address the containment of pollution and preservation of resources.

They also impose responsibility for the cleanup for past contamination. The resulting environmental liabilities fall into four primary categories: * Liabilities for environmental cleanup or remediation costs; * Liabilities for ongoing compliance with legislation directed at curtailing future contamination and minimizing the impact of operations on the environment; * Liabilities for violations imposed as penalties; and * Liabilities for damages imposed or awarded due to environmental contamination.

Information. There has been an observable increase in disclosures of environmental liabilities and contingencies in financial statements since the EPA began sharing information with the SEC. So far, that information has included: * Lists of companies named as potentially responsible parties under CERCLA and the associated hazardous waste sites that have been designated for remediation priority; * Lists of all cases on which EPA action is pending under RCRA or CERCLA; * All facilities barred from government work under the Clean Water Act; and * All hazardous waste disposal facilities subject to cleanup under RCRA.

The SEC is reviewing disclosures to determine whether the registration statements and other reports of public companies provide sufficient information about the extent of environmental liabilities.

Magnitude. Estimates of the environmental liabilities under CERCLA alone -- the cost to remediate contaminated sites -- have ranged from $500 billion to $750 billion. Annual environmental expenditures for legislative compliance reached $115 billion in 1990. It may be useful to compare these costs to a recent estimate of the corporate obligation to provide retiree health care benefits, which has received so much recent attention from the media. To put environmental expenditures into perspective, contrast those sums to a 1991 estimate by the General Accounting Office that put the private-sector liability for retiree health care benefits at $335 billion.

Disasters. Environmental disasters, such as the Valdez oil spill, have resulted in corporate introspection regarding environmental efforts and exposures. They have also sparked shareholder interest in the impact of corporate operations on the environment and the initiatives undertaken by management to minimize that impact.

While it is evident that environmental issues will be a major consideration for the business community in the 1990s, it is not clear what actions accounting standard-setting bodies need to take to improve financial reporting in this area. This article discusses in general terms the perceived problems, the existing accounting guidance, and the role that the Financial Accounting Standards Board (FASB) may fill.

Need for Additional Guidance?

Some believe there is a need for additional accounting guidance to address deficiencies they perceive in the financial reporting of environmental liabilities. Certainly one can read into the increase in disclosures after the SEC/EPA agreement that previous disclosures were not in compliance with existing requirements.

Also, some have observed a lack of comparability in the disclosures of corporations operating in the same industry -- where exposure to similar liabilities would be expected. That suggests that certain liabilities may not have been accrued as required by existing guidance. It also suggests that relevant information may not have been disclosed to users of financial statements to enable them to make informed decisions.

If those deficiencies indeed exist, they do not automatically signify that the FASB needs to take action; however, it may be appropriate for another organization to act. The following reviews the primary guidance that addresses when certain liabilities associated with environmental expenditures should be recognized in the financial statements, how they should be classified, and when and what should be disclosed.

Recognition. FASB Statement No. 5, "Accounting for Contingencies," requires recognition of a liability (or impairment of an asset) and accrual of an expense when two criteria have been met: (a) It is probable that a liability has been incurred or an asset impaired, and (b) the amount of the liability or the impairment can be reasonably estimated. FASB Interpretation No. 14, "Reasonable Estimation of the Amount of a Loss," interprets that guidance and states that when the reasonable estimate of the loss is a range and no amount within the range is a better estimate than another, the minimum amount should be accrued.

Classification. The FASB Emerging Issues Task Force (EITF) addressed whether to capitalize remediation costs or other costs incurred to reduce or abate future environmental contamination as an asset or to recognize those expenditures as an expense of the current reporting period. EITF Issue No. 90-8, "Capitalization of Costs to Treat Environmental Contamination," says, in general, that those costs may be capitalized if recoverable and the condition of the property is enhanced relative to its condition when built or acquired.

Disclosure. Statement 5 also requires disclosure of environmentally related contingencies if it is reasonably possible that a loss has been incurred or that the loss will exceed an amount that has been accrued. In addition, if a liability is probable but cannot be reasonably estimated, disclosure is required.

The SEC requires public companies to make the following additional disclosures in certain reports and registration statements filed with them: * The material affects that compliance with environmental laws may have on the capital expenditures, earnings, and competitive position of the registrant. This would include disclosure of estimated material capital expenditures for the current and future periods to bring the enterprise into compliance with environmental regulation. * Pending or contemplated administrative or judicial proceedings that arise under environmental laws if their impact is material, the claim exceeds 10% of the registrant's current assets, or a governmental authority is a party to the claim and fines or penalties will exceed $100,000. * Estimates of future costs of environmental compliance, if those costs are expected to be materially higher than current costs. * All material effects on results of operations, liquidity, and capital resources, unless management can determine that a material effect is not reasonably likely to occur. Companies that have been designated as potentially responsible parties by the EPA generally must disclose the effects of that status, quantified to the extent reasonably practicable.

Deficiencies in Reporting?

If, as seems to be the case, some liabilities are not being recognized or disclosed as currently required, to what do we attribute that lack of compliance? In part, it may result from a corporation's decentralization of the management of regulatory compliance. For example, responsibility for reporting under RCRA's "cradle to grave" requirements may rest at the operating or business unit level. Internal systems may not exist to aggregate and translate the information maintained by individual operating or business units into a form required for accounting and disclosure purposes.

Measurements difficulties, perhaps, are another reason, at least for delaying the recognition of a liability in the financial statements. As the number of potentially responsible parties at a site increases, a corporation may find it difficult to determine the portion of the costs to remediate that site for which it will ultimately be responsible.

In addition, the types of contamination present at a site as well as the technology available may affect the cost from site to site. Remediation requirements can vary from the relatively simple to the extremely complex depending on the factors or conditions present at a site. Even so, the SEC has expressed concern that recognition of the liability is unduly delayed in many circumstances and that disclosure in compliance with the requirements of Statement 5 and the SEC is deficient.

Other measurement issues arise concerning the recoverability of costs from third parties, such as insurers or other potentially responsible parties. In addition, difficulties may arise in measuring the liability for post-cleanup monitoring periods which, under RCRA and CERCLA, can extend to 30 years. During that time, periodic testing and ongoing remedial actions may be required to ensure the adequate containment of waste.

The FASB's Plans

In January 1992, the Financial Accounting Standards Advisory Council (FASAC), which consults with the FASB on matters likely to require the FASB's attention, was asked to advise the FASB on the need to address reporting deficiencies and implementation issues. FASAC responded overwhelmingly that while improvement in reporting of environmental liabilities by corporations is necessary, the guidance in Statement 5 is, or should be, sufficient: Rather than approaching the issue as one in need of additional recognition requirements, perhaps the need is for compliance with existing requirements. FASAC members identified this as an area the accounting profession as a whole needs to address.

The FASB has not formally discussed FASAC's views, nor has it undertaken to add a project on environmental issues to its technical agenda. While there seems to be a need for improvement, the FASB is not convinced that an accounting standard is the appropriate mechanism to effect that improvement. If additional guidance is needed, the American Institute of Certified Public Accountants (AICPA), the EITF, or the SEC may be the more appropriate organization to provide that guidance. The SEC has already sent signals about heightened compliance and enforcement activities. Possibly a need exists for expanded auditing guidance.

While the FASB is not convinced that the development of an accounting standard is the solution, it is actively monitoring issues related to environmental liabilities. We would like to hear from users of financial statements about their particular needs. We encourage expanded research efforts in this area by interested parties. To the extent that a lack of information about existing guidance, or the pervasiveness of environmental issues to the operations of a business, is a cause of some deficiencies, we are interested in facilitating an informational network or exchange. In summary, we are interested in ensuring that an informed dialogue on these issues develops and continues.

Jane B. Adams joined the Financial Accounting Standards Board in May 1987. She is the project manager on the Board's project on accounting for investments with prepayment risk.