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Pollution Solution.

Business-driven environmental activities require an accurate forecast of total liability and associated cash flows, which current accounting requirements do not address.

The first public standardization of accounting for contingent environmental liabilities in the United States was the Statement of Financial Accounting Standards No. 5, commonly referred to as FAS5.

FAS5 established a uniform process for valuation and disclosure of environmental liabilities to investors and the Securities and Exchange Commission for publicly traded companies in annual reports, 10-Ks and 10-Qs. The goal, in part, was to give investors the ability to assess the potential for material threat to future earnings from remediation of contaminated sites under new state and federal regulations. FAS5 was created in response to Love Canal, a Superfund site in New York polluted with dioxin and other contaminants, which was cleaned up during the 1980s.

FAS5 requires disclosure of costs only if there is reasonable probability that a liability has been incurred and a reasonable estimate of the liability can be made. Under FAS5, costs are usually modified and increased over the life cycle of a project in subsequent reporting periods. Accordingly, costs disclosed in financial statements at any point in time typically reflect only a portion of the total liability that ultimately will be incurred, particularly in the earlier stages of a remediation project's life cycle. Subsequent works, such as the American Institute of Certified Public Accountants Statement of Position 96-1, have provided more detailed guidance to accounting professionals within corporations and in external auditing functions in assessing FAS5 applicability, liability measurement and disclosure.

Although adequate for SEC and investor purposes, FAS5 and subsequent guidance are insufficient to meet the business-driven environmental activities of today, such as mergers and acquisitions, brown-fields redevelopment and the associated placement of environmental "cost-cap" insurance. Brownfields are abandoned or underused industrial facilities where expansion or redevelopment is complicated by environmental contamination.

These activities require a more accurate forecast of the total liability and associated cash flows to assess whether there is a positive investment decision from a net present value and/or internal rate of return capital-budgeting standpoint. In addition, these activities require an ability to assess deviations from projected liabilities in the same way sales and expense deviations are assessed via standard sensitivity analysis to gauge acceptable statistical risk and uncertainty. Finally there often is an absence of reliable contingent remediation-liability costs for privately owned properties, especially when reserve validation and adjustment are necessary for private mergers and acquisitions.

The following is a framework overview for assessing contingent environmental liabilities for mergers and acquisitions and brownfields-redevelopment projects. It has been developed by a team of environmental insurance professionals with advanced business degrees--integrating financial-analysis techniques into standard environmental-engineering approaches. This framework has been used in several major mergers and acquisitions and has driven tens of millions of dollars to the bottom line on individual transactions. In addition, it has been used as a screening process to assess the viability of brownfields-redevelopment projects.

Multicase Outcomes Needed

All too often, contingent environmental liabilities are addressed within the context of a projected single-case outcome. For example, in a merger or acquisition, engineering consultants often will exercise best professional judgment to assess a single best-case (for sellers) or worst-case (for buyers) outcome for individual sites. The engineering consultant will apply detailed engineering and standard cost analysis to identify the preferred remedy (depending upon your side of the transaction) and the associated single cost for the liability.

This myopia on a single case is rooted in the assumption that someone can accurately predict the future, including the ultimate outcome and associated costs for remediation projects. In this instance, engineering precision in detailing costs is mistakenly interpreted as accuracy in projecting a likely outcome. When pressed, few engineering consultants are willing to put their professional insurance, let alone their homes, on the line when their single prediction is challenged during negotiations. Ultimately, this approach is no better than a professional roll of the dice; they have faith in their engineered number "7" but not necessarily in the likelihood that it will turn up. This is little comfort for those seeking to make informed business decisions and having to live with the financial consequences.

In reality, when assessing contingent liabilities, it is necessary to address and measure the probability of multiple outcomes. For example, projects in the discovery phase may yield a large number of possible conditions regarding the nature and extent of contamination across multiple media, including soil, sediment, ground water and surface water. Even for sites that have been adequately investigated, what appears to be applicable remedies may not be achievable in field pilot studies and may require deviations to different remedies that could increase costs. As most corporate managers will attest, the costs are never certain until the project is finished and signed off by the agency. This doesn't mean that there are an unmanageable number of infinite possibilities. Rather, like any business investment, it is necessary to assess reasonable expected variability.

Most capital-budgeting projects or merger-and-acquisition analyses involve a minimum of three financial scenarios: best-case, most-likely or worst-case outcomes. Often, these outcomes are driven by major business variables, such as expected levels of sales growth. This same process can be applied for environmental liabilities.

Hypothetical Situation

The graphic, "Multicase Outcome Approach" (left), illustrates a hypothetical example of a site being assessed for possible acquisition. The site has three major environmental liabilities--two areas of contaminated soil and groundwater contaminated with volatile organic compounds.

Instead of assessing one possible outcome, three different outcomes--low cost, medium cost and high cost--could be assessed. Each outcome was based on reasonably varying a combination of the extent of contamination for each source, the remedy and its associated variables such as soil volumes, gallons-per-minute treated and length of operation. Variable outcomes are developed using professional judgment based on a number of project-specific factors including:

* consultant experience with similar contaminants and associated remedial technologies at similar sites;

* track record of similar sites within the corporate portfolio by either the buyer or seller;

* research on similar sites via public records; and

* application of standard feasibility study or corrective-measures study approaches to assessing alternatives.

In this case, the costs, with standard engineering contingency, are projected to be between $2,003,000 and $10,121,000.

In this hypothetical example, the site has been largely investigated. The uncertainty in cost, especially at the high range of the estimate, is driven by the possibility that soils will need to be disposed of as "hazardous" and that groundwater remediation will be necessary off site. This multiple-case outcome provides critical information, so business managers and environmental executives can make a more informed decision regarding:

* a go or no-go decision in the event all outcomes exceed risk or financial-materiality hurdles;

* a negotiating position to support either a purchase-price adjustment or indemnification; and

* a realistic capital budget from which to manage the liability after the acquisition.

The Power of Cash Flows

This hypothetical example is based on "undiscounted totals--that is, there is no "time value of money" element to the costs. Unlike many environmental capital-improvement projects, which occur within a single year, environmental-remediation projects typically take from five years to 30 or more years. Often, the highest-cost remediation expenditures occur over a long period of time, making their value particularly sensitive to time-value-of-money adjustments.

Projecting cash flows provides several opportunities:

* Undiscounted costs overestimate the amount of the liability. Cash-flow projections discounted at a company's weighted average cost of capital--that is, the company's average expected return on investments--result in the most accurate measure of the liability. This can free up funds unnecessarily tied up or stranded on the balance sheet within reserves for positive net present value business investments within the core business that will increase shareholder value.

* It can provide a source of competitive advantage in negotiations, or in multibidder situations. The company that discounts can cover the same liabilities at a lower cost than a company that does not discount and thus can offer a more favorable bid that includes lower purchase-price adjustment or indemnity terms.

* It provides a time-based forecast for benchmarking post-acquisition performance.

Referring back to the "Multicase Outcome Approach" graphic, the biggest difference between the undiscounted total and discounted total can be seen in the "high" projected cost column. The difference clearly shows the material advantage of discounted cash flow. For a long-term cleanup, discounted totals will result in significantly lower overall costs, due to the exponential time element in the basic discounting equation DC=FC/(l+WACC)". This equation means that discounted cost is equal to future cost divided by 1 plus the weighted average cost of capital, raised to the nth power, where n equals the elapsed year in which future cost is reflected.

Other opportunities are provided with cash-flow analysis by considering:

* variable inflation rates;

* accounting for other cost-accountable line items using activity-based cost-accounting principles; and

* completion of sensitivity analysis by varying major variables that can result in a variation in cost around an individual cash flow and its associated outcome.

Probabilistic Assessment

Although an improvement on the single-case outcome, the multicase discounted cash-flow analysis still provides only a finite number of points to measure financial risk. The presence of multiple cases, however, provides opportunity for a more sophisticated probabilistic assessment of risk and cost beyond hedging on any individual outcome.

The most elemental probabilistic approach is the derivation of an "expected value," which is essentially a weighted average. Probabilities can be applied to each outcome and a weighted average calculated. In the "Multicase Outcome Approach" graphic, probabilities of 70%, 25% and 5% were applied to the three cost projections. A weighted-average outcome was then derived and shown in the right-most column of the table. This expected value represents the most appropriate estimation of the (discounted) liability at $2.2 million for the site across all three scenarios given the individual probabilities of occurrence. The low and high costs serve as expected best-case and worst-case boundary conditions.

Monte Carlo Analysis

A more advanced approach beyond expected value is application of Monte Carlo Analysis.

Monte Carlo Analysis is an extension of game theory that involves applying a random number generator to complete a large number of trials across the probability distribution for a finite number of outcomes. Instead of three distinct cases or points, a Monte Carlo output is a continuous curve of probability vs. cost.

The graphic, "Monte Carlo Analysis" (see facing page), illustrates another discounted, three-case hypothetical scenario. In this example, the level of uncertainty vs. cost can be easily ascertained at any level. For instance, at the 75% probability level liability is estimated at $2,781,000, whereas the 50% probability level puts the liability estimate at $2,720,000. The Monte Carlo curve allows for proactive management of risk, uncertainty and cost and the ability to understand the trade-off of any decision in terms of potential upside or downside risk. For example, reducing the probability 25% from 75% to 50% results in a differential exposure of $60,000, whereas a 25% decrease from 100% to 75% results in a much greater differential exposure of $169,000.

For environmental managers, Monte Carlo analysis provides a platform to assess both individual sites during transactions and those undergoing brownfields redevelopment. For portfolio reserve managers, it provides a uniform risk-based benchmark for establishment of reserves across a portfolio.

Standards Out of Date

New business-driven demands have outpaced the standard accounting for contingent liabilities based on FAS5 and the standard single-outcome environmental engineering approach. Neither is suited for the advanced business needs of mergers and acquisitions, placement of environmental cost-cap insurance or brownfields-redevelopment assessment. Integration of financial-analysis processes with environmental-content knowledge offers a powerful framework for providing the financial information that environmental managers, business executives and consultants need to make informed business decisions.

James R. Vetter Jr. is a senior risk analyst with the Corporate Environmental Transactions Group at Kemper Environmental, a member of the Kemper Casualty Group of Kemper Insurance in Princeton, N.J.
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Title Annotation:standardization of accounting for contingent environmental liabilities
Comment:Pollution Solution.(standardization of accounting for contingent environmental liabilities )
Author:Vetter, James R.
Publication:Best's Review
Geographic Code:1USA
Date:Oct 1, 2000
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