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Cleaning up environmental accounting.

(The following article presents a general background and summation of the emergence of environmental liabilities and the role accountants play in recognizing such liabilities. In subsequent issues we will present practical, everyday examples of small businesses facing environmental liability. If your client base includes such businesses as a gas station, dry cleaner or lawn service, you may find this information helpful in your practice.)

The problem of environmental pollution is a pervasive one for modern society. It is also a potentially expensive problem for modern businesses, which, under federal law, can be held financially liable for the effects of pollution they caused or to which they contributed.

For several years, the accounting profession has faced the dilemma of when and how potential environmental liabilities should be recognized, measured and disclosed on financial statements. There was little definitive guidance for accountants working in the industry, nor for practitioners who had businesses as clients.

In 1996, the American Institute of Certified Public Accountants (AICPA) issued a statement of position that addresses accounting matters associated with environmental liabilities. This SOP provides some of the most extensive guidance ever available to accountants on environmental accounting issues.

Regulation Begins

Environmental regulation began in the late 1950s when federal lawmakers considered the first laws aimed at decreasing the nation's water and air pollution. One of the first major environmental bills was the Clean Air Act of 1970, which established emissions standards for several primary pollutants. That same year, Congress set up the Environmental Protection Agency to enforce federal legislation regulating air and water pollution, solid waste and disposal, pesticide control, and radiation. Ten years later, lawmakers passed the Comprehensive Environmental Response Compensation and Liability Act (CERCLA), which established the Superfund, a pool of federal money used to pay for cleanup, or remediation, of some contaminated lands. All parties identified by the EPA as responsible for the contamination at a site must share costs for cleanup and ongoing remediation efforts. If any party refuses to do so, EPA has the authority, under CERCLA, to clean up the site using Superfund money, then demand payment plus treble damages from that party.

The move toward stronger environmental laws has continued in the 1990s. The Clean Air Act Amendment of 1990s, for example, set stringent new air quality standards. In a State of the Union Address, President Clinton urged toughening environmental regulations by asking Congress ". . . to pass my proposal to make big polluters live by a simple rule: If you pollute our environment, you should pay to clean it up."

What does this mean for business? It could mean significant additional expenses - expenses that must be accounted for properly. According to an article in the January 1993 issue of The CPA Journal, the nation's overall environmental liability as of early 1993 was estimated to be 2-5% of the gross domestic product. This figure includes costs for cleaning up air emissions, meeting water quality standards and removing asbestos. By the end of 1990s, the EPA had spent more than $4.8 billion to clean up some of the 1,200 sites it had designated as needing long-term remediation. (The EPA estimates that by the year 2000, it will add another 1,100 sites to its list of sites needing extensive remediation.) In The CPA Journal article, the current cost of cleaning up air emissions was put at around $25 billion a year. Meeting the standards of the Clean Water Act costs about $30 billion per year. An estimated $200 billion will be required to clean up asbestos in buildings across the nation.

Besides cleanup costs, companies face the possibility of paying huge awards in lawsuits filed over environmental pollution. In the 1990s, a Missouri jury awarded $16.2 million in damages to a family that sued Georgia Pacific, a building materials producer and distributor, for adverse health effects the family claimed were caused by particle board in their new home. But perhaps the best-known environment-related judgment levied against a company is the $5 billion in punitive damages that Exxon Corp. was ordered to pay after its tanker, the Exxon Valdez, ran aground and spilled almost 11 million gallons of crude oil into Prince William Sound.

Because of the possible financial consequences of being associated with pollution problems, companies should record their potential environmental liabilities, including cleanup and litigation costs. CPAs now have guidance to help their employers and clients properly account for environmental issues. In 1993, more than 30 people took part in a roundtable discussion on environmental issues sponsored by AICPA. Participants included public practitioners and staff members from AICPA, the Securities and Exchange Commission and the Financial Accounting Standards Board. During the meeting, they:

* examined practice problems in applying generally accepted accounting principles to environment-related financial statement issues;

* identified environmental issues for which the need for authoritative accounting guidance should be evaluated; and

* provided a starting point for developing guidance on applying existing accounting standards to environmental issues.

The group came to two conclusions:

* Accounting guidance is needed on the recognition and measurement of environmental liabilities.

* Financial statement preparers and users need to become more knowledgeable about federal laws on environmental remediation and the concepts of joint and several liability.

Later, AICPA issued its statement of operating position on environmental accounting issues, SOP 96-1, "Environmental Remediation Liabilities." The SOP, which is effective for fiscal years that began after Dec. 15, 1996, covers the entire range of issues involved in environmental accounting: the remediation process, recognition, measurement, display and disclosure.

Taking Responsibility

A company may first become aware of its possible responsibility for a contaminated site when the site appears in a government database or on a government list, such as the National Priorities List. (Note: The EPA compiles this list by analyzing reports that companies are required to file regarding hazardous sites. The EPA visits these sites and ranks them numerically. Those sites that score above a certain number are placed on the NPL.) The company's official involvement with the site usually begins, however, when it receives a letter from the EPA requesting the company pay for a remedial investigation and feasibility study. The letter will often contain the names and addresses of other parties associated with the site who are known as potentially responsible parties (PRPs). The PRPs can negotiate among themselves to determine each company's share of the cleanup responsibilities and costs. If negotiations fail, however, the EPA can issue a unilateral administrative order for the PRPs to clean up the contaminated site, or the EPA can remediate the site and try to recover costs from the PRPS. Before companies can be held liable for remediation costs, they and the EPA must go through a series of phases. (See "The Superfund Remediation Process.")

Recognition deals with the issue of when a liability should be reported in financial statements. Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies," requires accrual of a liability when it is probable that the liability has been incurred and it can be reasonably estimated. The difficulty with environmental-remediation liabilities is that they do not become determinable at a specific point in time. Rather, they become determinable over a continuum of events. This is because:

* The company may be associated with a site, but not considered a PRP.

* Even if it is a PRP, it is difficult to determine in the early stages the cost of the total remediation effort. This figure often does not crystallize until the feasibility study has been completed.

According to the AICPA SOP, the probability criterion of SFAS No. 5 is met if the EPA has decided (or probably will) that the company must participate in remediation.

Once a liability is identified, its magnitude must be estimated. Several factors should be considered when developing the estimate:

* The extent and type of hazardous substances at the site.

* The range of technologies that can be used in remediation.

* The number and financial condition of other PRPS.

Early estimates can be revised later if new information comes to light about any of these factors. According to AICPA's SOP, the revisions should be accounted for as a change in accounting estimate in accordance with Accounting Principles Board Opinion No. 20. The opinion says that changes in accounting estimates require current-period treatment, and that retroactive restatement of previous statements and prior-period adjustments are prohibited. Uncertainty about the magnitude of the liability should not keep a company from recognizing its best estimate of the liability, if the liability is probable and can be estimated within a range.


The AICPA SOP identified several stages of remediation that should be used as benchmarks when evaluating the probability that a liability has been incurred and the extent to which it can be estimated. At minimum, the estimate should be evaluated as each benchmark occurs.

* Identification of the company as a PRP. If, after reviewing its records, the company determines that it is associated with the contaminated site, officials can assume that the company will probably be held liable for cleanup. When at least a portion of the liability can be reasonably estimated, it should be recognized. In some cases, the business may not have enough information to reasonably estimate even the minimum amount of the liability; in these cases, recognition should be postponed until other benchmarks occur.

* Receipt of a unilateral administrative order requiring a removal action. The cost of a removal action - a short-term emergency response - can usually be estimated within a range, so its recognition should not be delayed.

* Participation in a remedial investigation (RI) or feasibility study (FS) as a PRP. At this stage, the company has been identified by the EPA as a PRP, and has agreed to pay for the RI/FS. Although the cost of the RI/FS can be reasonably estimated within a range, the cost of the total remediation effort may not be. At minimum, the company should presently recognize its share of the RI/FS. When more information becomes available, the business can use it as a basis for estimating its total remedial liability.

* Completion of the feasibility study. Recognition of the remedial liability should not be delayed beyond this point, since the liability is probable and can be estimated.

* Issuance of a record of decision. At this stage, the EPA specifies how it prefers the contaminated site be cleaned. Previous estimates of remediation costs can be raised based on this new information.

* Operation and Maintenance. During this phase, engineers get a better sense of the work to be done and can provide more precise estimates of the total cost.

In a 1992 Price Waterhouse survey, 20% of the companies polled recognized a liability upon completion of the RI/FS, while 12% recognized it when they were notified by the EPA that they were potentially responsible parties. Another 15% recognized a liability on the date a settlement offer was made by the company to the EPA, while 18% waited until actual cash was expended for the settlement. Only 5% recognized liability on the date they consented to an RI/FS. The remaining 30% recognized their liabilities at a variety of different points. Comparability of financial reporting may be undermined when companies subjectively recognize environmental liabilities at different amounts and at different times.


Once a company has determined that a liability has been incurred, it must be measured, based on available information. The measurement should include the company's share of the costs (as allocated by the EPA, an independent consultant or the PRPS), plus its share of any expenses that will not be paid by other PRPS. AICPA's SOP specifies that the measurement should also include incremental direct costs of the remediation efforts and employee compensation for the time workers are expected to spend on the cleanup. Examples of these costs are:

* legal fees for work related to the remediation;

* expenses for the RI/FS; fees for engineers and consulting firms to develop remediation plans and designs;

* charges from contractors who perform the cleanup;

* purchase and rental of machinery and other equipment that will be used only for the remediation; and costs of implementing and maintaining the remedial plan.

Legal work related to the cleanup can include determining the extent of remedial action necessary, the type of remedial action and the allocation of costs among PRPS. No distinction is made between fees paid to outside firms for legal work and in-house legal costs.

It may take several years to remediate a site, and the laws governing the remediation process may change during this time. The AICPA SOP states that measurements of environmental liabilities should be based on the laws that are in effect when the measurement is made; no changes in the laws should be anticipated. Similarly, the equipment and other technology needed for remediation may also change before cleanup is complete. Some changes in technology can be anticipated in the measurement until the EPA issues a record of decision which specifies how the agency wants the contaminated site cleaned. Companies can plan for changes in technology by consulting with environmental engineers and scientists.

According to the SOP, an environmental liability can be discounted to reflect the time value of money if the aggregate amount of the liability and the amount and timing of cash payments can be readily determined. The discount rate specified in SEC Staff Accounting Bulletin No. 92 will produce an amount for which the liability could be settled in an arm's length transaction with a third party. The rate should not exceed the interest rate on monetary assets that are essentially risk-free and have comparable maturities to that of the environmental liability, like U.S. government paper. For example, if it is estimated that the cleanup will take one year, the interest rate on U.S. government paper with a one-year maturity should be used as the discount rate.

The measurement should identify other PRPs involved with the contaminated site and assess the likelihood that they will pay their allocated share of the remediation costs. (Note: This is a subjective process that takes into account the financial condition of other PRPs and their attitude toward the situation.) The PRPs can agree among themselves what percentage of the cleanup costs each will bear, or they can hire an allocation consultant to make this determination. They can also request a non-binding allocation from the EPA. At every benchmark, each company should calculate its share of remediation costs, including any amounts that are not expected to be paid by other PRPS, based on which allocation method it believes will ultimately be used.

Possible recoveries from insurance companies for remediation expenses should be determined independently from the liability, according to the SOP. An asset related to the recovery should be recognized if recovery is probable. If a claim for remediation costs is in litigation, the company should presume that recovery is not probable. If the liability is discounted to reflect the time value of money, the recovery must also be discounted. If the liability is not discounted and the timing of the recovery depends upon the liability, the recovery should not be discounted.

Display And Disclosure

A company's balance sheet may show an asset relating to potential, probable recoveries from insurance claims or PRPS. Under FASB Interpretation No. 39, "Offsetting of Amounts Related to Certain Contracts," this asset can be offset against the liability only when all of the following conditions have been met:

* Each of the parties owes the other deter-minable amounts.

* The reporting party has the legal right to set off these amounts.

* The reporting party intends to set off.

According to the SOP, rarely, if ever, will all of these conditions be met, since the legal right of set off is usually not present.

The SOP also says that environmental liabilities should not be considered extraordinary items, since they are not unusual in nature and have become a regular cost of doing business. They should be reported as a component of income from continuing operations. If the liabilities can be attributed to discontinued operations, they should be classified as such.

Financial statements should disclose whether the liability is measured on a discounted basis. If it is, the discount rate should be disclosed. If only a portion of the liability is discounted, the undiscounted portion should also be disclosed.

The SOP encourages companies to disclose the benchmarks that triggered recognition of an environmental liability. It also urges businesses to disclose estimated time frames of payment for liabilities and estimated time frames for probable recoveries. Neither of these disclosures is expressly required by the SOP. When a potential loss is merely reasonably possible and not probable, no accrual is necessary, but the nature of the possible loss should be disclosed.

Cleaning Up

In light of President Clinton's strong position on the responsibility of corporate America to pay for its pollution, it is almost certain that environmental issues will continue to affect companies. The AICPA's SOP will trigger earlier recognition of environmental liabilities, thus making it easier for business to properly address and record related costs.

Courtesy of Today's CPA, April 1997


Before a company actually becomes liable for remediation costs, it must go through a series of steps initiated by the EPA. Those steps are:

Site Identification and Screening. Since 1981, the EPA has identified more than 30,000 sites for scrutiny and placed their names into a database. Each site undergoes a preliminary assessment to determine what, if any, future action is needed. This is accomplished by EPA representation visiting the sites, then ranking them according to the Hazard Ranking System, a mathematical rating scheme that takes into account several "danger" variables. Sites scoring 28.5 and above are placed on the National Priorities List for future long-term remedial action.

Removal Action. Some sites may be required to take removal action - a short-term emergency response that is needed to remedy an imminent and substantial danger to the public. Sites do not have to be on the NPL for the EPA to order such an action.

Remedial Investigation. This is a comprehensive study performed by environmental engineers that identifies the nature and extent of hazardous substances at the site, and assesses the site's potential risks. It involves extensive sampling of soil and groundwater in and around the site.

Risk Assessment. This is a baseline evaluation that identifies hazards, assesses exposure to hazardous substances and toxicity, and quantifies the potential risks posed by the site.

Feasibility Study. This uses the information generated in steps 3 and 4 to evaluate remedial actions. A list of remedial alternatives is created, along with estimates of their costs and analyses of their ability to fulfill EPA criteria.

Remedial Action Plan. The EPA decides what cleanup standards should be applied to the site and which remediation methods can achieve these standards. The most cost-effective method that achieves these standards is chosen.

Public Comment and Record of Decision. The remedial actio plan is made available for public comment. After reviewing the comments, the EPA may modify the plan. It then issues a record of decision, which specifies the remedy and the time frame for implementation.

Remedial Design. This phase includes the development of a complete site remediation plan, including engineering drawings and specifications.

Remedial Action. This phase includes actual construction and implementation of the remedial design.

Operation and Maintenance. After the remedial action is completed, the site must be monitored to ensure that the remedy is effective. Such maintenance activities can continue for as long as 30 years.

Joel A. Hochman, CPA, JD, MBA, is an assistant professor of accounting and business law at Yeshiva University in New York City.
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Title Annotation:includes related article on the Superfund remediation process
Author:Hochman, Joel A.
Publication:The National Public Accountant
Date:Jun 1, 1998
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