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Accounting for the lender's environmental exposure.

Dangers associated with potential environmental liabilities have permanently changed the relationship between financial institutions and their commercial clients. The passage of the Comprehensive Environmental Response, Compensation and Liability Act (CER-CLA), as amended by the Superfund Amendments and Reauthorization Act of 1986, substantially increased the potential liability of lending institutions. As a result, existing, as well as new, commercial loans secured by land are not as secure as they were 10 years ago. In addition, recent court actions indicate that increased potential liabilities may extend to loans secured by plant, equipment and inventory.

Commercial loans may become a liability for a financial institution when the secured assets are environmentally contaminated. Since a federally sponsored cleanup of contaminated land can incur costs in the tens of millions of dollars, financial institutions must continue to take preventative action prior to extending loans. One common response for financial institutions is to routinely require environmental audits before closing any real estate loans and before foreclosing on property. Other viable options include efforts to improve the client's (the borrower's) environmental activities, such as careful handling, recording and disposing of hazardous materials. By monitoring a commercial client's environmental policy, a financial institution can help reduce environmental problems and the associated costs.

Risk Reduction

The most effective response for reducing a bank's risk is to conduct an environmental audit of loans secured by commercial real estate. However, a survey reported in the May 1990 issue of The Journal of Commercial Bank Lending found that only 61 percent of the responding financial institutions had a written policy regarding environmental audits for commercial real estate loans. It is important that a bank's internal controls include a written policy mandating the use of environmental audits before closing, before foreclosure and possibly periodically during the loan period. The policy should also identify acceptable consultants and provide a method for tracking the performance of the consultants.

While an environmental audit should be conducted prior to closing any real estate loan, it is still possible for the secured property to become environmentally contaminated after the loan is closed but before foreclosure becomes necessary. Periodic inspections will usually identify contamination before it becomes extreme. The bank's written policy should detail the language that will be used in the formal credit agreement to ensure the right to conduct periodic inspections. Also, consideration should be given to whether the bank wants the added security of obtaining an easement to ensure access to the real estate to conduct periodic environmental inspections. Without access to the borrower's facility, a proper environmental audit cannot be conducted.

Another important action a financial institution should take is to review its insurance coverage to determine if it covers the cost of an environmental cleanup. Because current laws and regulations prohibit previously commonplace disposal practices, all old insurance policies should be reviewed and updated (if appropriate). Considering that environmental contamination can occur over many years, it is possible that an insurance policy in effect during those same years may provide coverage for cleanups necessary today.

Going to the Source

While it is important to conduct an environmental audit prior to closing a loan secured by real estate, it is still possible for the commercial client (the borrower) to contaminate the real estate during the life of the loan and hence substantially reduce the value of the property. Periodic inspections can identify contamination, but it is better for the bank and the value of the real estate if the client practices proper handling, management and disposal of all hazardous materials. The client should also estimate and record the cost of cleanup associated with current revenues, closely control material balances and effectively use responsibility accounting. A client that follows an effective environmental policy ultimately reduces the risk of contaminating the real estate and thus the risk that the bank may foreclose on contaminated property.

If a client does not follow an effective environmental policy, and, for example, empties old paint cans on the property or does not identify and control where oil is lost during its manufacturing process, the client increases the risk of eventually paying for a costly environmental cleanup. Should the client then default on its loan, it could leave the lending institution in a position where it will not want to foreclose because of excessive cleanup costs.

Accounting for Contaminated Land

It would be reasonable to assume that if a firm is currently contaminating its land, then accounting regulations would require the firm to formally recognize in the current period on its financial statements an appropriate portion of the future cleanup costs. Thus, a banker reviewing a borrowing firm's financial statements could identify the potential decrease in the value of the secured real estate. However, while still in compliance with generally accepted accounting principles (GAAP), firms seldom recognize these costs in the current period because the accounting profession considers the future cost of cleanup to be a "contingent liability."

In 1975, the Financial Accounting Standards Board (FASB), which issues accounting regulations, detailed when a loss should be recognized in a company's financial accounting records. An estimated loss from a loss contingency should be recognized when both of the following conditions are met: information is available that indicates it is probable that an asset has been impaired or a liability has been incurred; and the amount of the loss can be reasonably estimated.

Since it is clear, given current laws and regulations, that future costs will be incurred as a result of the contamination, the first criterion is clearly met. But businesses generally can avoid disclosing the costs in their financial statements by judging that the amount of the loss cannot be reasonably estimated; therefore the second criterion for recognizing the loss is not met. Either way, depending on both the firm's ability to estimate the loss and the probability of the loss, the costs may be recognized as a loss and obligation, disclosed only in the footnotes, or not disclosed at all. In all of these cases, the firm is still in compliance with current accounting regulations and GAAP.

It is the responsibility of the firm's managers and accountants to determine whether or not the loss can be reasonably estimated. In order to estimate this loss, it is necessary to make a number of assumptions when forecasting future costs. When the costs will occur, what alternatives will be selected, how environmental laws will change and how the program will be funded are just some of the assumptions to be made.

A very conservative way to estimate the amount of the loss is to assume that the cleanup is occurring at the present time under current laws, current inflation levels and existing conditions. Doing this removes much of the uncertainty and enables the borrower to determine the amount of the loss to recognize in its financial records. Each subsequent year these estimates of future costs can be revised to reflect changes in contamination levels, the impact of inflation, and changes in laws and technology.

From the financial institution's perspective, the companies that choose to identify and recognize these future costs would have a more effective environmental policy than firms that do not recognize these costs. Also, financial institutions could make a more informed lending decision if their clients used a more conservative presentation of contingent liabilities.

However, recognizing the future costs of cleanup as an expense does nothing to ensure the availability of cash for the future cleanup. As with many other accounting entries, such as depreciation, the accrual accounting recording of the expense is not a cash flow. The lending financial institution could institute an additional safety measure by requiring the borrowing client to take steps to ensure that the cash would be available for cleanup. Actions by the client such as establishing a trust fund or purchasing a surety bond guaranteeing performance would reduce the probability of the financial institution paying the cleanup costs of contaminated land.

Material Balance Accounting

In addition to recognizing the portion of future costs associated with current revenues, a firm should closely monitor the physical control of hazardous material. A record system that is adequate for the majority of materials is not adequate for hazardous materials. Most materials can be tracked using the formula: "beginning balance" plus "transfers in" minus "ending balance" equals "transfers out." However, this approach assumes that if the company does not have the inventory, then the material has been transferred out, and hence ignores waste.

For hazardous materials, a better method of tracking is a system of "material balance accounting" developed in the nuclear industry to account for uranium. Material balance accounting enables the firm to identify and control known waste as well as identify any unknown waste, i.e., the inventory difference. Therefore, the firm will be less likely to contaminate its real estate if it knows precisely how much waste it needs to control. Of course, the accuracy of such a balance depends upon the accuracy of each component's measurements within the material balance formula: "beginning balance" plus "receipts" minus "shipments" minus "known waste streams" minus "ending balance" equals "inventory difference." Measurements can be difficult, especially identifying the quantity lost in the known waste streams. However, once the data is gathered and analyzed, it often becomes apparent where improvements to the measurement system can be made. While the use of material balance accounting is rare outside of the nuclear industry, it provides a superior method for controlling hazardous materials. Because of the added costs involved, material balance accounting would typically not be useful for material that was not hazardous.

Responsibility Accounting

For a client firm that employs organizational responsibility budgets to evaluate, promote or establish bonuses for the firm's managers, a critical area to consider is the proper handling of waste disposal. For example, workers may use protective clothing or cleaning materials that may become slightly contaminated with hazardous or toxic substances during part of the manufacturing process. In order to improve the unit's current period profit, however, an operating manager in a firm with a poorly designed responsibility accounting system may decide to store this waste on-site rather than incur the additional expense for proper disposal against his or her budget.

Since proper disposal of hazardous waste is many times more expensive than normal waste disposal, an even more dangerous action could develop should an operating manager try to reduce costs by including hazardous wastes in normal waste disposal. The result could be damage to the environment and disastrous exposure to the firm and, potentially, to its financial lenders. Therefore, strong internal controls must be established so that, whether by design or by mistake, improper disposal cannot occur.

An effective internal control accrues the costs of hazardous waste disposal as a current, common cost of the corporation and creates a reserve against which the actual disposal can be charged. The individual manager's evaluation, promotion or bonus should not be based on the expenses related to proper hazardous waste disposal. This encourages good housekeeping practices by the operating manager and safe disposal of hazardous wastes by eliminating the operating manager's incentive to improperly dispose of hazardous wastes. If the clients are properly disposing of wastes in the current period rather than improperly storing them on-site, the potential of the lender acquiring contaminated land is reduced.

Due Diligence

Current accounting practices allow a client to ignore the future costs of cleaning contaminated land by judging that the future costs cannot be reasonably estimated. However, a financial institution, as part of its loan documents or debt covenants, could reasonably require a client to estimate the future cleanup costs and to currently record the portion associated with current revenues.

Although recognizing the loss would impact a client's financial statements, it would not, however, ensure that the client would have cash available for cleaning the contaminated land. An additional safety measure would require the client to take steps (such as establishing a trust fund or purchasing a surety bond guaranteeing performance) to ensure the cash would be available for cleanup.

Companies should also ensure that they are properly controlling hazardous waste; the use of material balance accounting for hazardous materials requires identifying waste streams, recording material inputs and outputs, and examining the inventory difference for possible lost materials. By not "losing" hazardous materials on secured real estate, companies are reducing the potential for future cleanup costs.

For companies that use responsibility budgets to evaluate, promote or establish bonuses for their managers, proper treatment of waste disposal costs can have a significant impact on reducing land contamination. The responsibility budgets and internal controls must be structured to prohibit managers from increasing their evaluation, bonus or promotion possibilities by improperly storing or incorrectly disposing of hazardous wastes.
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Title Annotation:commercial real estate lending
Author:Duke, Joanne C.; Franz, David P.
Publication:Risk Management
Date:Sep 1, 1993
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