The auditor, SAS 54 and environmental violations.

How can auditors learn to recognize environmental red flags?

Financial statement auditors are becoming increasingly familiar with accounting for environmental costs and environmental liability disclosure. However, many are not aware of the steps parties to real estate and corporate transactions take to limit those liabilities or to apportion them among themselves. Some auditors are not fully aware of their responsibilities under Statement on Auditing Standards no. 54, Illegal Acts by Clients, regarding environmental matters even though they encounter numerous environmental "red flags" in the course of an audit. This article is intended to help auditors recognize the red flags that raise questions about possible illegal acts relating to environmental laws.

ENVIRONMENTAL LIABILITY UNDER CERCLA 

The Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), as amended by the Superfund Amendments and Reauthorization Act (SARA), is the environmental law that most often imposes potential liability on parties engaged in real estate and corporate transactions. Although there are other significant federal and state laws, CERCLA (and laws modeled after it) is perhaps the most formidable because of the wide range of potentially responsible parties (PRPs) and CERCLA's provisions for joint and several liability among those parties.

Four broad categories of PRPs may be liable for hazardous waste site cleanup costs:

* The owner or operator of a facility (the current landowner).

* The owner or operator at a time when hazardous substances were disposed of at the site-(a former landowner).

* The parties that arranged for the disposal, treatment or transport of wastes to the facility (including hazardous waste generators).

* Parties that transported hazardous wastes to the facility.

In a routine corporate or real estate transaction, the following may become PRPs:

* The purchaser of real property, even though contamination occurred before its acquisition of the site.

* The seller of real property (owner at the time of the contamination), even though no longer the owner.

* A lessor (owner) that might be held liable for cleanup due to a tenant's actions, although unaware of the hazardous waste.

* A lessee deemed to have an ownership interest under a long-term lease under generally accepted accounting principles or that is regarded as the business or property "operator."

* A successor corporation through merger or consolidation.

* A lender that becomes an owner of contaminated property through foreclosure of a delinquent debt.

Thus, during the year an audit client may be engaged in one or more transactions with environmental liability implications. Under CERCLA, any party to these transactions may be held liable for the entire environmental remediation cost, as often happens when other PRPs cannot be located or have become insolvent. Liability may be imposed regardless of a party's culpability or knowledge of the hazardous disposal activity.

DEFENSES UNDER CIRCLA

CERCLA, as amended by SARA, provides a liability exemption for the "innocent landowner" that acquires property after hazardous substances are disposed of on the site and did not know or have reason to know of the disposal. A party seeking exemption under this defense must establish it made "all appropriate inquiry into the previous ownership and uses of the property consistent with good commercial or customary practice."

The Environmental Protection Agency (EPA) provides for a case-by-case determination of the adequacy of the party's inquiry. The following factors outlined in SARA are considered:

* Specialized knowledge or experience on the part of the real estate purchaser (familiarity with real estate transactions).

* Ability to detect contamination through inspection.

* The site's obvious condition or physical appearance at the time of acquisition (for example, odors, seepage, soil discoloration and absence of vegetation).

* Any commonly known or reasonably ascertainable information about the property (for example, reputation as a dump site; common knowledge of a site as a gas station, photo lab, dry cleaner, etc.).

* Relationship of the property's purchase price to the market price of comparable (uncontaminated) property (the purchaser paid a "bargain" price).

One readily available means of inquiry environmental experts, particularly attorneys, advise before acquiring real property is the environmental audit. Although currently there are no clear standards on what it should include, the environmental audit, as performed in the United States, is usually site-specific. It generally is performed by an independent environmental investigator under an environmental attorney's supervision and involves investigating a particular parcel of real property to determine the likely presence of hazardous substances that have been released or may be released.

A phase-one environmental audit usually includes a review of

* The recorded chain of title documents (deeds, easements, restrictions and covenants and leases for a 50-year period).

* The recorded federal, state or local environmental cleanup liens.

* Reasonably obtainable government documents or aerial photos that may reflect the property's prior use or that may identify hazardous sites or activities likely to cause the release or threatened release of contaminants.

* The site itself (a visual inspection of the site, including all improvements and adjacent properties).

A phase-two audit, used when the phase-one audit indicates possible contamination, typically includes physical soil and water testing. This phase usually includes a risk assessment or quantification of estimated remediation costs.

The information provided by the phase-two audit is particularly significant to the financial statement auditor because of risk assessment or quantification of costs. However, the auditor should be aware that environmental audits probably will not come to light through client accounting records and personnel but, rather, through corporate minutes and legal documents.

OTHER ATTEMPTS TO LIMIT OR APPORTION LIABILITY

In addition to, or in conjunction. with, the environmental audit, parties to real estate and corporate transactions are using numerous "transactional structures" and legal provisions to limit or apportion potential environmental liabilities. For example, a potential buyer, lender or lessee often structures a transaction so it is contingent on the results of an environmental audit.

A buyer today often makes a partial acquisition of desired assets rather than a stock purchase or buys property at a discounted price--not avoiding CERCLA liability but obtaining a "bargain" price in exchange for the implicit assumption of environmental liability. In other instances, a buyer often is successful in requiring the seller to set aside funds for potential cleanup costs. These set-asides may be letters of credit, holdbacks, guarantees, surety bonds or escrowed funds.

Buyers and sellers also include in real estate purchase agreements the parties' representations and warranties about the property's condition, compliance with laws and regulations and their knowledge of matters having an environmental impact. They often seek a contractual allocation of potential environmental liabilities or use indemnification provisions, which do not affect CERCLA liability but provide for reimbursement of the indemnified party's cleanup costs.

Lenders, too, are alert to the potential for environmental liability, although CERCLA includes a liability exemption for a secured creditor who "without participating in the management of a... facility, holds indicia of ownership primarily to protect [its] security interest .... "Lenders in particular have begun to require environmental impairment liability insurance to provide third-party liability coverage.

Although such insurance is expensive and does not provide coverage for the insured's property, it might protect the lender to the extent it protects the borrower's assets from third-party claims. Lenders also have begun to conduct environmental audits before foreclosure, allowing them to abandon foreclosure efforts on contaminated properties and write off loans instead of incurring cleanup judgments in excess of the properties' collateral value.

Lessors have begun to structure agreements to limit the liabilities resulting from tenants' environmental violations. These lease agreements often require higher security deposits, escrow accounts and periodic inspections or environmental audits. Restrictions may be placed on a tenant's use of the leased property. Lessees, in turn, have tried to limit exposure resulting from lessors' actions by requiring an environmental audit before entering into a lease and again at the end of the lease term.

In the current recessionary climate, lessees also have negotiated indemnification provisions, representations and warranties about prior property use or default provisions allowing the tenant to terminate the lease if a cleanup action interferes with the tenant's use of the property.

Because these efforts may shift environmental liabilities among the parties to a real estate or corporate transaction, it is important an auditor exercise due care in reviewing the client's corporate minutes and legal documents. The auditor also must be aware of the extent of his or her responsibility under SAS no. 54 for detection of illegal acts of clients who violate environmental laws.

SAS 54 AND ENVIRONMENTAL LIABILITIES

SAS no 54 is intended to provide auditors with guidance on

* The nature and extent of an auditor's consideration of the possibility of illegal acts by a client.

* Audit planning and performance.

* The auditor's responsibilities when a possible illegal act is detected in the course of an audit performed in accordance with generally accepted auditing standards.

SAS no. 54 expressly says determining whether an act is, in fact, illegal normally is beyond the auditor's professional competence. The pronouncement specifies such determination generally would be based on a legal expert's advice or on the final determination by a court of law. Despite this, auditors must consider laws and regulations generally recognized to have a "direct and material effect on the determination of financial statement amounts" from the perspective of their known relation to audit objectives (rather than from the perspective of legality, per se). Examples of such laws and regulations are tax laws and regulations governing revenue recognition by government contractors.

SAS no. 54 says environmental laws relate more to an entity's operations than to its financial and accounting aspects and their financial statement effect is indirect. Although the auditor's responsibility to detect and report misstatements resulting from illegal acts with a direct and material effect on the financial statements is the same as that for errors and irregularities (under SAS no. 53, The Auditor's Responsibility to Detect and Report Errors and Irregularities), the auditor does not bear the same level of responsibility for environmental laws.

The auditor must, nonetheless, be aware of the possibility a violation may have occurred. SAS no. 54 specifies inquiries should be made of management about the auditee's compliance with applicable laws and regulations. When appropriate, the auditor also should inquire about policies to prevent illegal acts and management's representations about compliance. The auditor also may encounter specific information raising questions about possible illegal acts. Due to the strict liability (not requiring culpability) nature of environmental laws, the auditor also must be aware of the possibility of a contingent environmental liability, even though the client has not itself engaged in hazardous waste disposal.'

SAS no. 54 provides a laundry list of information that may raise questions about possible illegal acts; a more specific list of potential environmental liability red flags is provided in the exhibit on page 71, The table includes red flags the auditor might otherwise overlook.

For example, little inquiry ordinarily would be made about a real estate deal that fell through, but what if the deal involved the audit client as the seller of real property and was contingent on environmental audit results, and the results were unfavorable? The fact no transaction was consummated may indicate the client has an unrecorded contingent liability. Under SAS no. 54, the auditor should not ignore the fact but should ask the client about it.

If, instead, the client made a partial sale of assets, retaining a parcel of real property, the auditor ordinarily would focus on any additions and deletions of fixed assets and not inquire into the reasons for the partial sale. The circumstances of the sale, however, may indicate a contingent liability if the potential buyer declined to buy the parcel due to environmental concerns.

In a third instance, the auditor may find its lender client has not foreclosed on property securing a past-due note receivable or its borrower client still has possession of real property securing a defaulted note payable. The lender's reluctance to foreclose may be due to an environmental problem. The defaulting borrower not only may be liable for a past-due note but also contingently liable for an environmental cleanup; the lender is essentially left with an unsecured loan in default.

In these three instances the auditor is not required to design the audit to provide reasonable assurance of detecting material misstatements resulting from these client acts. However, when specific information raises questions about a possible illegal act, the auditor is required to obtain an understanding of the nature of an act, the circumstances involved and other information necessary to evaluate its financial statement effect.

SAS no. 54 specifies further inquiry of management and, if the auditor is unable to conclude there has been no illegal act, he or she must consult legal counsel and apply the additional audit procedures necessary to obtain a better understanding.

If the auditor concludes an illegal act has occurred, its impact on the financial statements must be assessed; the auditor's finding must be communicated to the board of directors audit committee or its equivalent. Under certain circumstances, the auditor also may be required to issue a qualified or adverse opinion or withdraw from the audit engagement.

FASB 5 AND MANAGEMENT DISCLOSURE

Even though a client may be responsive to inquiries, the auditor also must consider the adequacy of the client's disclosures of any contingent liabilities relating to environmental matters. An auditor's assessment of the adequacy of client disclosures relating to contingency losses is guided by Financial Accounting Standards Board Statement no. 5, Accounting for Contingencies, which governs the accounting treatment of liabilities that must be estimated due to "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."

Statement no. 5 says a loss contingency must be accrued and a liability recognized (and reported in the body of the financial statements) if both of the following conditions are met:

* It is probable an asset has been impaired or a liability incurred at the date of the financial statements (it is probable a future event or events will occur confirming the loss).

* The amount of the loss can be reasonably estimated.

If the loss can be reasonably estimated, but it is only reasonably possible (not probable) a future event or events will confirm it, the contingency must be reported as a note to the financial statements with no accrual of loss and liability. Statement no. 5 does not require either an accrual or a note when there is a remote possibility of the future event, although a note is permitted in those instances.

In circumstances involving an "unassetred claim or assessment when there has been no manifestation by a potential claimant of an awareness of a possible claim or assessment," Statement no. 5 does not require disclosure "unless it is considered probable that a claim will be asserted and there is a reasonable possibility that the outcome will be unfavorable." Securities and Exchange Commission rules, however, differ from those of Statement no. 5.

The SEC has addressed environmental disclosure primarily in the context of its requirements for management's discussion and analysis (MD&A) of financial condition and operations results. The SEC issued Financial Reporting Release (FRR) no. 89-6835, which includes disclosure examples and gives the SEC s views on several disclosure matters, including a registrant's designation by the EPA as a potentially responsible party under CERCLA. Under FRR no. 89-6835, a disclosure duty exists when "a[n]... uncertainty is both presently known to management and reasonably likely to have material effects on the registrant's financial condition or results of operations" (emphasis added).

The SEC, in effect, requires management to determine the uncertainty is not reasonably likely to occur, in which event no disclosure is required. If management cannot make that determination, it must "evaluate objectively... the consequences of the ... uncertainty, on the assumption that it will come to fruition." Disclosure is required unless management decides "a material effect on the registrant's financial condition or results of operations is not reasonably likely to occur."

REPRESENTATIONS AND AUDITOR DOCUMENTATION

To evaluate properly the effect of environmental matters on a client's financial statements, and in connection with the auditor's assessment of the adequacy of the client's disclosures, it would be advisable (although not required by generally accepted auditing standards) for the auditor to request that the client's legal counsel address these matters in its attorney letter. The client's refusal to include these matters in its inquiry of a client's lawyer concerning litigation, claims and assessments could constitute a scope limitation, possibly resulting in a qualified opinion or a disclaimer of opinion.

Most important, the prudent auditor should document his or her compliance with SAS no. 54 and his or her assessment of the adequacy of the client's treatment and disclosure of contingencies according to FASB Statement no. 5. Even the most competent auditor faces a losing battle in court if nothing in the workpapers supports an exercise of judgment in these matters. Although GAAS does not require documentation of compliance with SAS no. 54, juries are not necessarily convinced, nor monetary judgments necessarily limited, by the argument the auditor complied with GAAS.

LINDA B. SPECHT, CPA, JD, is assistant professor of accounting, Trinity University, San Antonio, Texas. She is a member of the American Accounting Association and the American Bar Association.

* PARTIES TO REAL ESTATE or corporate transactions may be liable for environmental cleanup costs, regardless of fault or knowledge on their part. As a result, many parties are attempting to limit or apportion the environmental liabilities among themselves.

* BEFORE ENTERING into a real estate transaction, companies are routinely performing environmental audits. These site-specific investigations, typically under the supervision of an environmental attorney, are designed to detect the likely presence of hazardous substances.

* WHILE AUDITORS ARE NOT required to design an audit to provide reasonable assurance of detection of material misstatements resulting from environmental violations, they must not ignore red flags that might signal the presence of environmental liabilities.

* NUMEROUS "TRANSACTIONAL structures" and legal provisions, including piecemeal sale of assets, indemnifications or purchase of property at a discount may signal environmental concerns and lead the auditor to make appropriate inquiry of the client.

* THE AUDITOR SHOULD document compliance with Statement on Auditing Standards no. 54, Illegal Acts by Clients, and assess the adequacy of the client's treatment and disclosure of environmental contingencies.