In the past, companies have been slow to deal with environmental contingencies in their financial statements. The size of real and potential environmental liabilities is difficult to estimate, the possibility of recovery from insurance or third parties is often unknown, and the future effect of governmental regulation is sometimes uncertain. One certainty is that environmental accounting can no longer be ignored. Here are some practical guidelines for companies and their outside auditors.

Environmental issues today are becoming increasingly complex and difficult. The public is more aware of industries' environmental performance and more critical of lax standards. Litigation is on the increase, with more stringent penalties including criminal liability and more toxic tort lawsuits. The U.S. government is becoming increasingly active in attempting to prevent events that harm the environment and to rectifying and indemnifying for events that have already happened.

Accounting for the costs of past, present and future environmental activities is becoming increasingly important, although there are few definitive standards. Often it is difficult or impossible to predict the actual extent of a newly discovered contamination problem, much less the cost of cleanup. Such "fuzzy" situations do not lend themselves to easy measurement and disclosure in financial statements.

Magnitude of the Cleanup Problem

EPA has designated some 1200 locations as highest priority sites needing long-term cleanup. Through the end of fiscal year 1990 these sites on the National Priorities List (NPL) have consumed $4.8 billion of the EPA's Superfund program. The EPA estimates that another 1000 to 1200 sites will be added to the NPL by the year 2000. Estimates for total cleanup under the Superfund are now placed at $500 billion, with cleanup taking 40 to 50 years to complete. This does not include Department of Defense or Department of Energy sites.

In addition, companies are spending $23 billion per year for ongoing disposal activities and cleanup of retired Resource Conservation and Recovery Act (RCRA) sites. By the year 2000 this number will probably increase to $34 billion per year.

The cost to clean up air emissions currently runs $25 billion per year. The 1990 Clean Air Act amendments will increase that number by an estimated $12 billion per year by 1995 and an additional $435 billion per year by the year 2005.

Meeting water quality standards set by the Clean Water Act costs about $30 billion per year.

There are two other noteworthy costs: An estimated $200 billion will be required to clean up asbestos across the country, and additional $28 billion will be required to clean up underground storage tank contamination.

The overall known environmental liability is currently estimated to be between two and five percent of the gross national product (GNP). A problem of this magnitude cannot simply remain swept under the "future expense" rug. Some means of accounting for these liabilities must be dealt with.

Environmental Liabilities

There are four basic types of environmental liability: soil contamination, groundwater contamination, surface water contamination, and air emissions.

Soil Contamination. Soil contamination can take a variety of forms. Ponds used to impound industrial waste can contaminate the ground underneath. Underground storage tanks pose a serious leakage problem. The New York Times estimates that there are 1.4 million underground storage tanks, and that the average cleanup now ranges between $100,000 and $350,000 per leaking tank. The EPA estimates that 25% of all underground tanks have leaked or are leaking. Catastrophic spills add to soil contamination, as do landfills and pipelines.

Groundwater. Groundwater can be contaminated by inflow of contaminated surface water, or by some driving force that pushes soil contaminants into the groundwater system. In one case, pumping water out of a construction site caused the migration of contaminated water from under an adjacent industrial disposal pond. Wells can also cause problems as oil and gas wells may allow hydrocarbons to migrate into groundwater, and industrial waste disposal wells can introduce any number of noxious substances.

Surface Waters. Surface waters--lakes and rivers--can be contaminated either by point sources (regulated discharges from industrial operations and sewage treatment plants) or non-point sources (storm water and agricultural run-off). Unlikely as it may seem, point sources account for only 10% of total surface water pollution.

Air Emissions. Air emissions arise from point sources like process facility stack discharges, from fugitive emissions that arise from industrial valve and compressor leaks, and from the tailpipes of automobiles and other forms of transportation.

Identifying the type of contamination is the easiest part of the task. Quantifying the problem leads into the realm of the inexact.

Quantifying Environmental Contamination

The methods used to quantify and solve a contamination problem vary, depending upon the type of contamination.

Soil Contamination. Quantifying soil contamination is a three-step process: First, all information about the site is reviewed to determine the appropriate field activities. Second, it must be determined how much soil is contaminated and to what extent. This phase involves field sampling and analysis and can take from six months to two years. The final step is a feasibility study (which may include pilot testing) to determine the most cost-effective approach for remediation. Under the Superfund program, the EPA requires a 15% to 50% remediation estimate at the conclusion of this three step process. Although this is a wide variation, it does provide a low-end number that can be used in accruing the costs of environmental liabilities.

Groundwater Contamination. Measuring groundwater contamination requires a specialization in geology and hydro-geology. The investigation includes studies to determine the depth of the groundwater system and its relationship to the source of contamination. The direction and flow of the groundwater indicate the potential spread of contamination. Such studies can take from three months to a year. Another three months to a year will be required for cleanup feasibility studies. Contaminants may be treated in situ; or groundwater may be removed, treated and discharged to surface water; or reinjected to the groundwater.

Surface Water Contamination and Air Emissions. Quantification and remediation of surface water contamination and air emissions are relatively straightforward. Direct sampling of ponds and liquid or gaseous process streams using a number of available techniques can result in an accurate analysis. The cost of remediation using available technology can be estimated within plus or minus 10%, similar to most major engineering projects.

Having arrived at some estimate of cleanup costs, the next step is to reflect those costs in the company's financial statements.

Accrual of Cleanup Liabilities

Four factors drive the industry's trend toward accrual of cleanup liabilities: regulatory requirements, legal requirements, acquisition and divestiture proceedings, and good business practice.

Regulatory Requirements. Regulatory requirements for cleanup result from several legislative acts: Comprehensive Environmental Response, Compensation and Liability Act (CERCLA) better known as "Superfund," Clean Air Act (CAA) and the 1990 Clean Air Act Amendments (CAA), Resource Conservation and Recovery Act (RCRA), Clean Water Act (CWA), the Underground Storage Tank Program, and Hazardous and Solid Waste Amendments (HSWA), which requires cleanup of PCBs and asbestos.

Legal Requirements. Legal requirements include consent decrees, administrative orders from regulatory agencies, and the results of toxic tort lawsuits.

Acquisition and Divestiture Proceedings. Acquisition and divestiture of real property where contamination may have occurred can require accounting accounting for cleanup liabilities. In some instances, remediation of contamination costs more than the property itself. Most major lending institutions now conduct environmental health and safety due-diligence at the time of loan origination. Several states require that property be cleaned up before it can be sold.

Good Business Practice. Environmental cleanup is no longer an optional process. As companies face the magnitude of cleanup costs, more and more are dealing with cleanup liabilities and risks as part of their long- term strategic business plan. Given the increasing implementation of governmental regulations, a pro-active stance in this area is becoming good business practice.

Accounting Standards

Several pronouncements apply to accounting for environmental issues. FASB Statement 5, Accounting for Contingencies, requires the assessment of the "likelihood that the future event or events will confirm the loss or impairment of an asset or the incurring of a liability." If the assessment concludes that loss or impairment is probable and if the loss is subject to reasonable estimation, a charge to income and the recognition of a corresponding liability should be made.

FASB Interpretation 14, Reasonable Estimation of the Amount of a Loss, requires recording a liability even if it is only possible to estimate a range of probable costs. Although these pronouncements have been in effect for some time, the impact of recent developments merits further review of their applicability to environmental issues.

The EITF issued EITF Bulletin No. 90-8, which requires that environmental contamination costs be expensed as incurred unless the following conditions exist:

* The expenditures extend the useful life or improve the efficiency or safety of the property;

* The expenditures mitigate future environmental contamination; or

* The expenditures relate to preparation of property designated for sale.

The intent is to require current recognition of the costs in the income statement unless the expenditures enhance the remaining asset or extend its useful life. Capitalization of the expenditure as an intangible asset with subsequent amortization is not acceptable in most circumstances.

Effects of Recovery Provided by Insurance

Sometimes companies that encounter loss contingencies assume recovery under existing insurance policies, either under general liability clauses or under expressly contracted coverage. Court decisions have been mixed about holding insurance companies liable for loss contingencies in general liability suits. In the case of express coverage, some companies offset the liability in their financial statements with an asset predicated upon insurance recovery.

The SEC has raised questions regarding such accounting. Two schools of thought currently exist about accounting for contingent liabilities where insurance coverage has been contracted:

* Some advocate that the probability of an environmental obligation and the related insurance recovery should be assessed and reported independently of one another. Such an assessment could result in the recognition of the loss and no recognition for the possible recovery from insurance proceeds.

* Others view the same scenario as one integral event composed of components that offset each other. They reason that recovery is directly caused by the liability and that the proceeds from the probable recovery can offset the expenditures caused by the liability.

Offsetting is the more common practice, and while it may seem more logical, it can pose difficulty if the recovery is challenged by the insurer. Litigation can be very lengthy; yet the liability must be satisfied on a current basis. FASB Technical Bulletin 88-2 permits offsetting of liabilities and assets in limited situations, but it does not apply directly to environmental cases. The SEC staff is currently considering this issue. Clarification of the applicability of FASB Statement 5 Accounting for Contingencies is needed to determine a more definitive statement of reporting. Before concluding in the appropriate presentation, management should make a careful assessment of the likelihood of the insurer honoring the claim.

SEC Staff Accounting Bulletin (SAB) 92, which addresses the disclosure aspects of environmental issues. The following disclosures are required:

* Disclosure of the company's policies for assessing the impact of environmental issues. In this disclosure the following topics should be reviewed: the conditions that lead to management's decision to evaluate the site; the means by which other exiting contingencies that were not reported were factored into the assessment; whether discounting of future costs or outlays was used; whether recoveries from insurance companies were considered; whether outside consultants were used in the assessment; and whether the impact of inflation upon cost was considered.

* The disclosures mandated by FASB Statement 5 and FASB Statement 14, plus these additional disclosures: The number of claims for which the company is potentially liable; the period of time over which the company expects to pay these costs; the breakdown of the accrual by component, such as legal fees, insurance deductibles, and actual clean up costs; the existence of other parties who may be jointly and severally liable; and any factors that prevent estimating the liability.

Discussion of these topics and presentation of the disclosures cannot be relegated to the footnotes without a thorough review in the Management's Discussion and Analysis (MD&A) section of the SEC filing. Item 303 of Regulation S-K makes this clear by requiring disclosure of known uncertainties unless there is little likelihood that they will have a material impact. Assessment of materiality should include an analysis of the impact of the contingency based on factors that could influence the investor. A statement that the contingency would not have a material impact upon the consolidated balance sheet of the entity is not adequate. Again, the SAB encourages consideration of a broad array of conditions.

Possible recovery from insurance companies or third parties requires additional disclosures, and the assessment of liability must be separate from the discussion of recovery. The ability of the insurance company or third party to pay for the recovery should be discussed as well as the existence of coverage from other insurance policies.

The duration over which the liability must be liquidated raises the issue of discounting cash outflows to determine present value of the liability. The SEC takes the position that discounting should not be used unless the final cost and payout dates are known. Under such circumstances, the gross amount of the liability, the discounted amount and the average discount rate used at each balance sheet date should be disclosed.

Finally, SAB 92 reviews presentation of the contingency on the financial statements. The charge on the income statement should be categorized as an operating expense and should be included as a component of operating income or loss. Presenting the contingency as a restructuring charge would not be acceptable to the SEC.

The SEC continues to review the reporting requirements regarding environmental conditions. Measurement requirements are currently being discussed and may be the subject of a forthcoming SAB.

Perspective of the Outside Auditor

Just as companies must focus on the financial reporting aspects of environmental contingencies, so must the company's auditor. It is crucial that the auditor not only understand the environmental risks inherent in the client's operations, but also that he or she understand the basic framework of environmental regulations and proceedings to assess the appropriateness of the client's current accounting and disclosure standards.

The Auditing Challenge

An outside auditor dealing with environmental exposures faces difficulty in three areas:

* Extensive laws, regulations, and litigation;

* Management hesitancy; and

* Dependence on environmental specialists for measurement decision data.

Each of these relates to the complexity and difficulty of measuring environmental obligations. The auditor must evaluate the measurement and the disclosure representations of the client.

Laws, Regulations, and Litigation. The auditor must have some knowledge of pertinent regulations. Such knowledge is essential for broad assessment of the client's environmental obligations and to communicate with environmental specialists and legal counsel.

Management Hesitancy. Management hesitancy with respect to environmental exposures comes in many forms. Management may not want to acknowledge potentially responsible party (PRP) status. It may be hesitant to engage a consultant to measure an obligation under the assumption that better measurement technology will be available in the future. It may not be willing to accept a minimum level of probable responsibility due to uncertainty regarding the number of PRPs at a site, potential insurance recovery, or continuing discussions with regulatory authorities.

Environmental Specialists. The use of engineering consultants to assist in measurement of environmental obligations presents yet another challenge for the auditor. SAS 11, Using the Work of a Specialist, describes the necessary audit procedures when a specialist is used to determine amounts that will appear in the financial statements.

With respect to environmental exposures, the auditor should be comfortable with the engineering consultant's qualifications and inquire as to whether the appropriate available technologies have been considered. Even when a client has in-house environmental engineering expertise, the auditor must satisfy SAS 11 requirements. Of course, the auditor may have a greater challenge if the client is not using specialists to help measure environmental liabilities.

Environmental Risks and Audit Planning

Environmental risks should be considered in planning the audit. Based on his or her understanding of the client's business and industry, the auditor should consider potential significant exposure areas and sources of environmental risk. The auditor should ask management and legal counsel for the history of the company's compliance with existing Federal, state, and local environmental regulations and related legal actions. The auditor should consider the relevant facts obtained from applying these procedures, evaluate the potential magnitude of the contingencies, and consider the reasonableness of estimates to remedy or abate the conditions.

Assessment of Results

Special consideration should be given to the results provided by the company's expert consultants regarding the feasibility of cleanup. The auditor should consider requesting the client to engage independent environmental consultants to review technical data and related disclosures in the company's financial statements. Engaging an independent consultant provides added assurance of the accuracy of engineering studies and the company's reports to its shareholders and the SEC.

The auditor must then assess the adequacy of the amounts recorded in the financial statements. Measurement of the liabilities and the related disclosure of material environmental contingencies can be an issue of significant audit focus. The auditor may also advise management concerning discussion of environmental accruals and related disclosures in the MD&A section of the filing.

Material Uncertainties

The auditor's report may need to reference material uncertainties relating to the ultimate disposition of environmental obligations. SAS 58, Reports on Audited Financial Statements, provides guidance on reporting material uncertainties.

After establishing the existence of an uncertainty, the auditor may want to include an explanatory paragraph in the report, based on careful evaluation of the facts, the representations of management, and the advice of legal counsel and independent consultants.

The auditor should evaluate the likelihood of a material loss. For those uncertainties that are unusual or infrequent in occurrence, it is reasonable to measure materiality against certain balance sheet categories such as equity or total assets. In cases where a contingency relates to a company's normal recurring operations, it should be considered in relation to operating results.

A Demanding Matter

The accounting for and disclosure of environmental issues will continue to demand the attention of financial managers, regulators, auditors, and those with the technical acumen to assess the events. Given the increasing emphasis by government and the growing awareness of the public, appropriate financial reporting concerning environmental matters is essential.

Bill Chadick is a leading consultant with the Pilko firm in Texas.

John Surma is a partner of Price Waterhouse in Pittsburgh.

Robert Rouse teaches accounting at the College of Charleston, South Carolina.