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Environmental cost liability.

The environmental crisis may be described as a crisis of major proportion. Toxic waste and dangerous pollutants poses severe hardship to the physical and economic well-being of society. Few, if any, would argue that the environmental problems of society have reached a critical stage.

There is an urgent need for heightened awareness by auditors of the existence of regulations that may result in civil, judicial and administrative fines that can be imposed for environmental infractions. It is estimated that over $100 billion dollars a year will be spent in the near future in response to Congressionally-mandated clean air acts (Brooks, 1990). The purpose of this article is to provide guidelines to be followed by the auditor when auditing entities with material real estate transactions. Specifically, we will address these concerns in relation to SAS No. 54, Illegal Acts; SAS No. 59, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern; and FASB No. 5, Accounting for Contingencies.

"Field work standard No. 3, as identified in SAS No. 1, states that sufficient competent evidential matter is to be obtained through inspection, observation, inquiries and confirmation to afford a reasonable basis for an opinion regarding the financial statements under audit" (AICPA, 1973).

How does the auditor comply with this standard as it relates to environmental cost? The auditor should have the ability to grasp the basic tenets of such laws as the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 and the Resource Conservation and Recovery Acts. A contingent liability, according to FASB No. 5, is 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. The loss may be probable, reasonably possible or remote. Therefore, what is the appropriate audit response as relates to possible environmental contingencies?

SAS No. 59, Going Concern, states that the auditor has a responsibility to evaluate whether there is substantial doubt about the entity's ability to continue as a going concern. How can the auditor obtain sufficient evidential matter to determine the impact of environmental cost on going concern? SAS No. 54, Illegal Acts, refers to violations of laws or government regulations. How will the auditor know if there is an illegal environmental act? What should the auditor do in response to the above questions?

The auditor needs to realize that real estate transactions have become more risky as a result of society's concern for the environment. The auditor should make certain that a thorough investigation of potential environmental liabilities was performed prior to the property acquisition. A company that buys contaminated property may be ordered by the state to clean it up, at a cost that could exceed the value of the property. This situation gives rise to the possibility of a contingent liability as well as concerns about future existence depending on the materiality of the transaction. Recently, an elementary school in Houston, Texas, was forced to close because of its proximity to a Super Fund site.

The Federal laws governing hazardous substances and petroleum--Super Fund and the Resource Conservation and Recovery Act (RCRA)--have many state counterparts, often different in detail and more stringent in concept. Fortunately, it is not necessary to understand the fine points of these complex, ambiguous and overlapping laws to comprehend their effect on auditing strategies. It is enough to grasp their basic tenets, which are illustrated by the following (Brown, 1989):

"Assume for purposes of discussion that on a parcel of land is buried one fuel tank, one gasoline tank and one waste-oil tank and that they fit the definition of underground storage tanks. The tanks were installed in the 1940s and began leaking 15 years later. All contain thick sludges and debris, and the waste oil tank contains PCBs. The soil around the tanks smells like petroleum and is visibly contaminated. In the 1940s, the site was owned by Big Petroleum Co. and contained a small office building (heated by fuel oil) and a parking lot with a small service station on one corner (where there were also gasoline and waste-oil tanks). In the 1950s, SmallTime Paper Co. bought the site and leveled the service station (burying demolition debris in the sub-basement) without pulling the tanks. In the 1960s, Speculator M bought the site and built a low-rise parking garage on the parking lot. He switched from fuel oil to natural gas for heating the office building but did not pull the tanks. In 1985, XYZ Partnership, which bought the site under an agreement requiring Speculator M to indemnify for all pre-existing environmental conditions, demolished the existing structures.

What should the auditor know?

* Everyone who owned or operated the tanks is likely to be liable for some response cost. Whether former owners and operators of the property are liable under Super Fund depends on various facts, including whether the substances stored or released were hazardous (petroleum being excluded under Super Fund). Whether former owners and operators are liable under RCRA for leaking petroleum is much more problematic, depending mainly on whether they were the owner at the time the tanks were abandoned.

* Liability extends to all response costs: tank removal, sampling and testing of tank contents and soil, removal and off-site disposal of waste, and remediation of ground water if necessary. Statutory limits on liability are so high that costs are likely to be capped only if the event approaches the magnitude of the Exxon Valdez oil spill.

* Responsible parties are strictly liable, even if they did nothing wrong and broke no laws and probably even if they did not know the tanks were there.

* Responsible parties are jointly and severally liable with each other for Super Fund response cost. If XYZ is the only solvent party left, it pays all response costs by itself. If two or three are viable and none has an effective defense, costs may be allocated on some basis, either through negotiation or court order.

* Liability is retroactive and prospective without limit. XYZ Partnership is liable for soil contamination, even though the tanks began leaking before RCRA and Super Fund were adopted. As the generator of wastes sent to an off-site disposal facility, XYZ Partnership will forever be liable for Super Fund response costs should that disposal facility later require remediation.

* Responsible parties are liable to the government for response costs despite private agreements to the contrary. Should XYZ Partnership refuse to clean up the site and the government itself undertake remediation, the government can collect its costs from XYZ, which may then seek to enforce its indemnification from Speculator M.

How, then, does the auditor use these tenets to account for actual and contingent liabilities when auditing real estate transactions? A very careful approach is necessary. Courts will bend traditional principles of law to find private parties, rather than the government, liable for response costs. And response costs are startlingly high.

When auditing entities with material real estate transactions, the auditor should consider the use of the above tenets as a guide to determine the possibility of the existence of contingent liabilities and going concern problems. The appropriate audit procedures for testing contingencies are less well-defined than those for other audit areas because the primary objective at the initial stage of the test is to determine the existence of contingencies. Application of the above tenets to the audit process should be of material benefit to the auditor in discovering the existence of contingent environmental liabilities related to real estate transactions.

In response to the question of illegal acts, it may be necessary for the profession to rethink its official position. The AICPA Audit and Accounting Manual, section 3150.07, states that "an auditor ordinarily does not have sufficient basis for recognizing possible violations of environmental laws and regulations. Their indirect effect is normally the result of the need to disclose a contingent liability because of the allegation or determination of illegality." In reality, the auditor should know that virtually any firm that had any connection with the hazardous waste deposited at a site may be required to share in the cost of Federally-mandated cleanup. A company may be held responsible for substance disposed of many years ago even if it paid another party to haul its waste away or even if it merely owns a site contaminated by a previous owner.

The breadth and seriousness of this problem is documented by a U. S. Environmental Protection Agency report, which states that 137,581 tanks holding billions of gallons of gasoline, oil and diesel fuel have been registered with the Texas Water Commission and as many as a quarter of them may be leaking. According to water commission officials, there is an unknown number of unregistered tanks and an unknown or unreported number of related leaks because many of the tanks were abandoned in the '50s and '60s and nobody remembers where they are. Nationwide it is estimated that there are about 1.8 million underground fuel tanks and 110,000 leaks (Morris, 1991). This widespread leakage of fuel containing the carcinogen benzene and other toxic and explosive compounds rank as one of the biggest environmental menaces, in the worst cases threatening drinking water supplies and utility lines and even taking lives.

In conclusion, the auditor should carefully evaluate his or her client's compliance with environmental regulations and the client's use of hazardous substance and disposal practices. Securities and Exchange Commission regulations require companies to disclose any material effect of compliance with environmental laws on capital expenditures, earnings and competitive position. When auditing entities with material real estate acquisitions, the auditor would do well to examine SEC registration statements for compliance.

Given the broad reach of recent legislation, auditors need to pay close attention to the environmental consequences of all business decisions. Current audit procedures may be inadequate to deal with the magnitude of this problem. However, careful attention to the tenets presented in this article should be followed by the auditor until such time as the profession rethinks the significance of this problem.

As society continues to grow and become more and more complex, it is inevitable that the role of the auditor will become increasingly important to achieving society's goals and objectives. Adequately dealing with the problems imposed by environmental pollution is one part of this process. The audit process is designed to reduce risk. The process outlined in this article is one step toward risk reduction. What level of risk is the auditor willing to accept?


1 Brookes, Warren T, "The wasteful pursuit of zero waste," Forbes, April 30, 1990. p. 160.

2 Brown, Johnine J, CFO, September 1989, p. 58.

3 Mautz, RK, and Hussein A. Sharof, The Philosophy of Auditing, American Accounting Association, 1961.

4 Morris, Jim, Houston Chronicle, July 21, 1991, p. 1D.

5 SAS No. 1, Statement On Auditing Standards (AU 150), AICPA, 1973.

6 SAS No. 54, Statement On Auditing Standards, AICPA, 1988.

7 SAS No. 59, Statement On Auditing Standards, AICPA, 1988.

Richard Pitre, PhD, CPA, is an associate professor of accounting at Texas Southern University. Pitre earned his doctorate at the University of Houston. The author of many articles, Pitre currently is involved in accounting and auditing for small businesses.
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Title Annotation:new regulations affecting accounting practices
Author:Pitre, Richard
Publication:The National Public Accountant
Date:Apr 1, 1993
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