Accounting and Disclosure of Environmental Contingencies

By Paul Munter, René Sacasas, and Elaine Garcia

The problems of environmental cleanup costs are not restricted to large chemical and petroleum companies. Many small businesses now have to face these predicaments. The authors explain the background and provide guidance on accounting and disclosure requirements for entities faced with this dilemma. A sidebar presents an outline of AcSEC's proposed guidance on accounting when the threat of litigation, claim, or assessment results in the decision to take remedial action.

Have you heard the story about the local florist who bought a piece of property for $80,000 because it would be the perfect place for his new store? Turns out, the property was once used as a service station, and a local ordinance requires that property converted into alternate use must first be remediated. The cost to remove the underground gasoline tanks, which were abandoned after the service station closed, and to remediate the soil came to $600,000‹all of which was to be paid by the florist.

How about the local automobile dealer who had been paying a registered company to remove and dispose of the used motor oil? Turns out, the hauler did not properly dispose of the motor oil and all the haulers' customers were required to help pay for the cleanup efforts.

We often hear accountants say, "Oh, that talk about environmental liabilities is just a subject for the big companies who operate in polluting industries." In today's environmentally sensitive era, that is not true. Companies big and small, in all industries‹from the two cases just cited, to the small municipality that operates a landfill, to the local dry cleaner, to the bank who financed property that subsequently had to be cleaned up‹are faced with paying for and, consequently, accounting for the cost of environmental cleanup. Further, because the problem is so pervasive, it can be an issue in the financial statements regardless of whether the financial statements are prepared on a GAAP basis or an OCBOA basis.

History of Environmental Regulation

Environmental regulation in the U.S. began in earnest in the late 1950s as legislation was passed at the Federal, state, and local levels to decrease the nation's water and air pollution. During the following decade, significant environmental legislation was enacted in response to public demands. This was followed with the creation of the Environmental Protection Agency (EPA) which was created in 1970 to enforce the Federal government's legislation regulating air and water pollution, solid waste disposal, water supply, pesticide and radiation control, and ocean dumping. Subsequent legislation has expanded the EPA's mandate to include other pollution problems such as toxic waste disposal and acid rain.

Environmental regulation continued to evolve significantly in the 1980s through the present as politicians and judges reacted to society's efforts to refine the rules to balance the preservation of the environment with the growth demands of our society. These laws typically address three categories of pollution: air, water, and solid waste disposal. However, some pollution problems are so comprehensive that they may affect all elements of the environment.

Air Pollution

The Clean Air Act, originally passed in 1963, was amended in 1990 to focus on issues such as acid rain, urban smog, airborne toxins, ozone-depleting chemicals, and other problems. These recent amendments had a substantial impact on businesses not normally considered polluters. Now, paint shops and bakeries can be labeled as polluters because the definition of a major polluter was changed. Utilities and other factories also have been affected by a new cap on sulfur dioxide emissions‹a contributor to acid rain. Interestingly, however, the amendment allowed companies whose emissions were cleaner than required by law to sell their rights to emit more sulfur dioxide to other companies. This has lead to a new commodity for sale‹so-called pollution credits.

An example of the financial implications of these laws can be seen with asbestos. As a toxic air pollutant, asbestos is regulated by the EPA. As a known carcinogen, liability can result from the emission of its fibers. Its presence can impose a serious financial obligation on property owners and, thus, should be disclosed to potential buyers. Although the use of asbestos in new construction has been banned since the 1970s, many older structures still have asbestos-containing materials, such as ceiling tiles and insulation on boiler systems, elevator shafts, fan units, and hot water tanks. Federal requirements only stipulate the removal of asbestos in schools or where existing asbestos results in airborne levels exceeding Federal standards. It must be removed, however, before the demolition of a building or if the demolition debris could be classified as hazardous waste. If it is not removed, all the demolition debris can be classified as hazardous waste, which will significantly increase the cost of disposal. Further, it often is necessary to remove the asbestos when major reconstruction of the facilities takes place. This could significantly increase the anticipated cost of a construction project if this cost is not considered in planning the project.

Water Pollution

With the enactment of the Clean Water Act in 1972, control of water pollution was established at the Federal level. This law also required industries discharging wastes into waterways to install the best available water pollution control technology. These dischargers were also required to obtain permits specifying the pollutants and amounts allowed to be discharged.

The wetlands provision of this act has enormous significance for property owners. Wetlands‹which provide essential habitats to a variety of animal life and 35% of endangered species, moderate effects of flood waters, and control water pollution‹have only gained recognition and protection recently. A permit is required to construct in a designated wetland area and is usually not granted unless the applicant can prove the wetlands will not be harmed. Some permits are granted on the condition the wetlands will be restored or recreated in another location, but equal to or greater than the proposed loss of wetlands. This can be an expensive undertaking. Therefore, a prospective buyer should thoroughly investigate the possibility that the property or adjacent area is considered a wetland.

The water pollution and wetlands provision can have far-reaching implications. Companies, both small and large, in industries as diverse as construction, agriculture, dry cleaning, mining, and theme/ amusement parks have been affected.

Solid Waste Disposal

The safe disposal of garbage and other waste has always been an ecological concern. Proper disposal is becoming more difficult as the population and our production of wastes increase.

Hazardous waste disposal is a comprehensive pollution problem whose effects on land, drinking water, and human health will span generations. After encountering the problems created by open chemical dumping at places such as Love Canal, the EPA was authorized to prevent, restrict, or stop the manufacture and use of chemicals that present an unreasonable risk of injury to humans or the environment. Manufacturers also must obtain a permit for the storage or transfer of hazardous wastes.

Underground storage tanks represent yet another potential problem. Currently tanks are constructed of steel with corrosion protection, but this was not always the case. Many older tanks on properties formerly used as service stations and fuel oil distributors are developing leaks after 10 to 20 years of use. The material, once leaked out, can go undetected until soil and groundwater are contaminated. The EPA enacted regulations in 1988 that require leak testing, installation of corrosion protection and leak detection systems, and insurance against leakage. While the cost of these preventive measures can be significant, it pales in comparison to the cost of a cleanup if the old tanks have leaked.

Congress created the Comprehensive Environmental Response Compensation and Liability Act (CERCLA) or Superfund in 1980 to manage the growing problem of uncontrolled or abandoned hazardous waste-disposal sites. Under Superfund, the EPA identifies and assesses sites where hazardous substances have been spilled, stored, or abandoned. Sites are subsequently ranked after consideration of a number of factors, including the potential number of people exposed, types of exposure, and risk of contamination of drinking water. Sites with the highest rankings receive priority attention from the Federal and/or state government to facilitate cleanup. The cleanup process may include excavating and disposing of some surface soil at a cost of a few thousand dollars. It may involve the more expensive procedure of pumping groundwater through filter systems and returning it to the aquifer, as well as removing and disposing of extensive quantities of soil. In the latter case, the cost of cleanup can quickly run into millions of dollars for even a small site.

When a site requires cleanup, the EPA demands that the owner and all other parties responsible for contaminating the site, including the owner or operator of the contaminated site, transporter of the wastes deposited at the site, or owner of the wastes, undertake the cleanup effort (including responsibility for the costs of the cleanup). If the parties refuse, the EPA has the authority to clean up the site and demand payment plus treble damages from the responsible parties. Accordingly, noncompliance with such an EPA demand presents very substantial economic risks to companies. This liability has been expanded to include subsequent purchasers of the property who did not perform sufficient "due diligence" checks on its history, financial institutions lending money to the responsible persons, and creditors foreclosing on the property.

Legal Liability

All prospective purchasers and successors in interest, such as foreclosing creditors, must evaluate carefully the potential environmental liabilities of each parcel of property they plan to acquire since they may be held financially and legally responsible for future problems. If the land is targeted for cleanup by the EPA, it can request the current owner to commence a cleanup operation, even if it was not responsible for the damage. Imagine the chagrin of a creditor who forecloses on a piece of property that, unfortunately, was a hazardous waste site. The EPA can order the lender to clean up the site. If the creditor refuses, the EPA will remove the contamination and sue the creditor for the cost of the cleanup. In some cases the corporate officers may be held personally responsible.

The issue of this expanded liability remains cloudy, particularly with regard to lender liability. The EPA has proposed to eliminate cleanup liability for lenders who cease activities on the property or sell the site within six months after takeover. Foreclosures and purchases of properties with known or possible hazardous waste problems nevertheless should be undertaken cautiously and with the supervision of an attorney and other professionals to limit potential liability.

Other defenses to liability for the cleanup of contaminated property include proving the contamination was caused solely through an act of God, an act of war, or an act or omission of a third party. The third party, however, may not be an employee or agent of the defendant or one whose act or omission occurs in connection with a contractual arrangement (including land contracts) with the defendant.

There is also an "innocent landowner" exception to the legislation's requirement that no privity of contract exist between the defendant and the party responsible for the contamination for the defendant to invoke third party defense. This exception may be established by proving the defendant acquired the property subsequent to the occurrence of the contamination at the site, the contamination was unknown when the site was acquired, due care was exercised with the hazardous materials involved, and the defendant took precautions against foreseeable acts or omissions by third parties. To establish the requisite legal foundation that the defendant had no prior knowledge of the contamination, the defendant must have appropriately inquired into the previous ownership and uses of the property.

Properly assessing the property for potential environmental concerns and risks through environmental due diligence is crucial to the "innocent landowner" defense. An initial evaluation will involve a site inspection to uncover potential environmental hazards, including underground storage tanks, asbestos materials, and wetlands, a comprehensive background investigation of the property's history, and a review of records for noncompliance of regulations. If no evidence of potential problems is discovered, more thorough and expensive research may not be necessary.

If, however, the above inquiries and investigations find evidence of problems, these must be identified and resolved. Chemical testing of samples from the soil, water, air, or suspected materials should be conducted. An electrical conductivity/resistivity survey may be performed to detect underground storage tanks or drums. Hydrostatic leak tests will reveal any leaking. These tests may be expensive, but not when compared with the costs if contamination is discovered in the future.

Disclosure Laws

After a number of industrial accidents were published in the press, in 1986 Congress amended the Superfund with Community Right to Know requirements. These included emergency planning, notification of spills and accidents involving hazardous materials, and disclosure by industry to the community about the presence and amounts of listed chemicals released into the surrounding area. These regulations have motivated corporations to reduce their emissions to avoid public scrutiny. Further, a duty to disclose the presence of these listed chemicals to potential buyers, tenants, or employees may also exist.

Accounting and Reporting Issues

The current accounting and reporting guidance for the accrual and disclosure of environmental liabilities exists in several sources within the GAAP hierarchy. The applicable documents include the following:

* SFAS No. 5, Accounting for Contingencies

* FASB Interpretation No. 14, Reasonable Estimation of the Amount of a Loss

* FASB Interpretation No. 39, Offsetting of Amounts Relating to Certain Contracts

* EITF Issue No. 89-13, Accounting for the Cost of Asbestos Removal

* EITF Issue No. 90-8, Capitalization of Costs to Treat Environmental Contamination

* EITF Issue No. 93-5, Accounting for Environmental Liabilities

* SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties

In June 1995, AICPA's AcSEC issued a proposed SOP, Environmental Remediation Liabilities, whose purpose is to "narrow the manner in which existent authoritative accounting literature is supplied by entities to the specific circumstances of recognizing, measuring, and disclosing environmental remediation liabilities." The exposure draft also contains a discussion of major Federal legislation dealing with pollution control laws and environmental cleanup laws and the need to also consider state and non-Federal laws and regulations. The proposal closes with a section on how to audit environmental remediation liabilities. An accompanying sidebar briefly explains the contents of the proposal, whose deadline for comment was October 31, 1995.

In addition to these standards, SEC registrants must be cognizant of the provisions of SAB No. 92, Accounting and Disclosures Relating to Loss Contingencies. Conceptually, the accounting and reporting requirements of environmental liabilities or contingencies are no different than those for other liabilities. Because of the significant exposure that exists, however, and the difficulty in estimating the potential costs, it is often difficult to evaluate adequately the accounting and disclosure requirements applicable to environmental issues. Let us consider the accounting requirements and then examine the disclosure provisions of these documents.

Accrual of Environmental Costs

As is the case in evaluating other contingencies, the primary guidance can be found in SFAS No. 5. Paragraph 8 of SFAS No. 5 specifies that a loss contingency should be accrued when the loss is deemed to be both probable (defined as the future events are likely to occur) and reasonably estimable. While the provisions of SFAS No. 5 appear to provide adequate guidance in evaluating many contingent liabilities, when applied to environmental liabilities companies are faced with more difficult problems because of changing laws and regulations, changing technologies, and the legal environment (joint and several liability).

Thus, given today's accounting and reporting environment, it would seem all companies (regardless of whether publicly or privately held and regardless of whether they use GAAP or OCBOA reporting principles) need to carefully evaluate their operations to determine whether any environmental exposure exists. If the company has identified an existing environmental problem for which it may be required to participate in the cleanup, the company should determine if an accrual is appropriate unless it can clearly show that the cost will not be material to the entity. On this point, SAB No. 92 argues that accruing a rough estimate now (which may need to be significantly revised later) is a better accounting approach than waiting until more precise information is available later.

The fundamental point raised by the SEC is that the entity has a liability and, while it may not know the precise amount, it is probable the ultimate amount will exceed $0 (or the entity's materiality threshold). When an entity argues it does not yet have a reasonable estimate, it will accrue no provision, thus reporting a liability of $0. Even the imprecise information shows the company's liability is larger than $0; thus, the SEC's point is that the accrual of some amount is a better representation of the company's financial position than is no accrual.

While it can be argued that SAB No. 92 is applicable only to SEC registrants, the fact remains the SEC's logic is perfectly consistent with the provisions of SFAS No. 5.

It is perhaps when the estimates of liability are the least precise that SOP 94-6 will come into play. That statement, which is effective for years ending after December 15, 1995, requires disclosure when it is reasonably possible that estimates included in financial statements will change in the near term and the change could be material to the financial statements.

The EITF's conclusions in Issue 93-5 address another very important component of the estimation issue. While some of the costs might be covered by other parties (such as other participants or insurance carriers), the entity must separately evaluate the liability and any recoveries. Thus, if it is probable the entity will incur costs, the liability is probable and, thus, accruable. If recovery is also probable, then the expense can be reduced by the probable recovery.

While the expense can be reduced for probable recoveries in accordance with EITF Issue 93-5 (i.e., the income statement treatment), the provisions of Interpretation No. 39 would lead to the conclusion that the asset and liability need to be separately reported in the balance sheet. Thus, even if no material cost (net of recoveries) is expected to be incurred by the entity, the provision may still need to be accrued since the company may have both a material liability and a material asset to report in the balance sheet.

Disclosure of Environmental Matters

The foregoing conclusions argue for earlier accrual of potential environmental matters and for "grossing up" in the balance sheet. What of the issue of disclosure? Of particular concern to many entities is whether disclosure needs to be provided on a site-specific basis. The argument that many companies will make is that providing such specific disclosures may trigger legal and other costs that would not have been otherwise incurred.

Again, the practice applicable to SEC registrants may be instructive. Environmental cleanup can be segregated, broadly, into two groups: 1) Superfund sites (or other sites where the cleanup is conducted under the direction or authority of a Federal or state agency) and 2) other cleanup sites. Entities involved in Superfund cleanups are listed by the governmental agency. Thus, it can be argued the company's involvement in that cleanup effort is already a matter of public record. Following this argument, many in the profession would suggest that site-specific disclosure would be called for when an entity is involved in Superfund cleanup site(s).

Conversely, however, if the company has discovered an environmental problem following its own due diligence procedures and has cleaned up the site on its own authority, the information is not a matter of public record. For these types of cleanup efforts, a strong argument can be made that an aggregate disclosure is appropriate in discussing such sites.

The Need for Due Diligence

If a company fails to properly report environmental liabilities, the responsible parties expose themselves to future claims that the financial statements did not have adequate disclosure of all material information.

Conversely, though, if the financial statements do contain specific presentation of the exposure for environmental cleanup, it is possible that outsider parties who might not have been aware of these problems may be able to more readily press claims for the cost of cleanup plus additional damages.

Given this dilemma, it appears that due diligence is the operative word. Management must apply appropriate due diligence when it acquires property, when it monitors its operations and disposal methods, and when it discovers an environmental problem.

While companies may seek to avoid the accrual or disclosure requirements, it is unquestionably true that these issues can only become more significant in the future. Thus, it behooves companies to adequately address the accounting and disclosure implications of potential monetary consequences from today's environmentally-sensitive society. *

Paul Munter, PhD, CPA, is the KPMG Peat Marwick Professor of Accounting and René Sacasas, JD, an associate professor of business law, both at the University of Miami. Elaine Garcia, MPA, CPA, is with Coopers & Lybrand L.L.P. Ms. Garcia was a graduate student at the University of Miami when this article was written.

PROPOSED STATEMENT OF POSITION ON
ENVIRONMENTAL REMEDIATION LIABILITIES

On June 30, 1995, AcSEC issued for public comment a proposed Statement of Position entitled Environmental Remediation Liabilities. If approved by AcSEC and cleared for issuance by the FASB, the SOP would constitute the most authoritative guidance available on the accounting for environmental liabilities. The guidance generally would apply where remediation is required because of the threat of litigation, a claim, or an assessment. The exposure draft includes two primary parts. Part I provides an overview of environmental laws and regulations. Part II addresses the accounting issues. Additionally, included in the appendices are the current authoritative guidance (appendix A), a remediation liability case study (appendix B), and audit considerations (appendix C).

The primary accounting provisions proposed can be summarized as follows:

Overall Approach

* Based on probable and reasonably estimable criteria of SFAS No. 5, Accounting for Contingencies.

Benchmarks for Accrual/Evaluation of Estimated Liability

* Identification and verification of an entity as a potentially responsible party (PRP)

* Receipt of unilateral administrative order

* Participation, as a PRP, in the remedial investigation/feasibility study (RI/FS)

* Completion of feasibility study

* Issuance of Record of Decision (ROD)

* Remedial design through operation and maintenance, including postremediation monitoring

Amount of Liability--Overall Approach

* Entity's allocable share of liability for a specific site

* Entity's share of amounts related to the site that will not be paid by other PRPs or the government

Costs Included in Liability

* Incremental direct costs of the remediation effort

* Costs of compensation and benefits for employees to the extent an employee is expected to devote time directly to the remediation effort

Examples of Incremental Direct Costs

* Fees to outside law firms for work related to the remediation effort

* Costs related to completing the RI/FS

* Fees to outside engineering and consulting firms for site investigations and development of remedial action plans and remedial designs

* Costs of contractors performing remedial actions

* Government oversight costs and past costs

* Cost of machinery and equipment dedicated to the remedial actions that do not have an alternative use

* Assessments by a PRP group covering costs incurred by the group in dealing with a site

* Costs of operation and maintenance of the remedial action, including costs of postremediation monitoring required by the remedial action plan

Effective Date and Transition

* Years beginning after December 15, 1995

* Treated as change in accounting estimate--current and prospective treatment; retroactive adjustment prohibited *

JANUARY 1996 / THE CPA JOURNAL