Tightening Standards For Reporting Environmental Liabilities: Conditional Asset Retirement Obligations

Transcription

1 Tightening Standards For Reporting Environmental Liabilities: Conditional Asset Retirement Obligations by Reed W. Neuman Reed W. Neuman is a partner at the Washington, D.C., law firm of O Connor & Hannan LLP. Mr. Neuman s practice focuses on litigation and related risk management and transfer issues associated with hazardous materials and contaminated properties. Mr. Neuman can be reached at rneuman@oconnorhannan.com. This article is based on a paper the author prepared for a seminar sponsored by the ABA s Section of Taxation. The views expressed herein are offered solely for information purposes and do not constitute legal advice. The reader should consult an attorney about the issues described herein. The information provided herein does not create, and receipt of it does not constitute, an attorneyclient relationship. FIN 47 significantly expands the reach of FAS 143 to many environmental legal obligations, thus requiring proper recognition in financial statements. As a result, many companies may face increased reporting obligations. In an era of ever-increasing scrutiny of the accounting practices of public companies, fueled in large part by the Sarbanes-Oxley Act, lawyers recently have faced the implications of stringent new requirements in how certain environmental liabilities must be recognized and disclosed. The issuance in March 2005 by the Financial Accounting Standards Board ( FASB ) of FASB Interpretation No. 47 ( FIN 47 ), Accounting for Conditional Asset Retirement Obligations ( CAROs ) (available at www. fasb.org/pdf/fin%2047.pdf), has forced a fundamental reconsideration The Practical Real Estate Lawyer

2 The Practical Real Estate Lawyer January 2008 of how and when material environmental liabilities associated with the retirement of corporate assets (i.e., the future sale, disposal, recycling, or abandonment of industrial facilities) are addressed on financial statements. With FIN 47, FASB the board responsible for setting standards for companies adhering to Generally Accepted Accounting Practices ( GAAP ) has reset the bar for interpretation of its standard on Accounting for Asset Retirement Obligations, known as Financial Accounting Standard ( FAS ) 143. (Available at pdf/fas143.pdf.) FIN 47 became effective in December Essentially, FIN 47 expands the reach of standards applicable to asset retirement obligations ( AROs ) to obligations for which the timing or method of settlement is conditioned on future events. Most typically, CAROs arise with respect to legal obligations to conduct environmental remediation or closure actions associated with the retirement of contaminated property, plants, and equipment. Even if the date of settlement cannot be predicted including due to reasons or events not in the company s control FIN 47 generally requires recognition when the liability can be reasonably estimated. Asset Retirement Obligations Under FAS 143 Generally, FAS 143 requires companies facing existing legal obligations associated with the future retirement of long-lived assets to recognize the liability in its financial statements for the period incurred typically, at the time the asset is acquired or built or at such later date when a duty is created by law if the present fair value of the liability can be reasonably estimated. FASB developed the standard in 1994 to clarify requirements applicable to the costs of retiring assets in certain highly Essentially, FIN 47 expands the reach of standards applicable to asset retirement obligations ( AROs ) to obligations for which the timing or method of settlement is conditioned on future events. regulated industries (particularly, the decommissioning of nuclear power plants). FASB expanded FAS 143 in 2001 to apply to retirement obligations generally. Although FASB s own guidance for implementation of FAS 143, which became applicable as of June 15, 2002, cited environmental obligations to illustrate how the standard would apply, neither 143 nor the guidance delineated the types of environmental obligations that were to be addressed under FAS 143. In particular, FASB provided no guidance as to how to address obligations associated with certain pre-existing contamination or conditions. As a result, many companies and accounting advisors adopted the view that, because of uncertainties about the timing or method of settling a legal obligation to address a historic condition (for example, a known obligation to remove asbestos material from a building whose date of renovation, demolition, or sale could not be predicted), a fair value of the CARO could not be reasonably estimated on current financial statements. Others took the stance that a liability deferred for future determination did not represent a current legal obligation within the meaning of FAS 143. Understandably concerned that recognition and reporting of significant, known liabilities was being delayed or ignored entirely FASB issued FIN 47 in FASB s ATTEMPT TO TIGHTEN RECOG- NITION OF CAROs FIN 47 In FIN 47, FASB confirms how CAROs are to be treated under FAS 143. Reporting companies must make provision for a CARO liability as soon as a fair value can be reasonably estimated. As a result, accounting professionals and lawyers will find themselves much more closely evaluating long-term and clearly uncertain environmental liabilities, even if

3 Environmental Liabilities the company has no current plans or schedule to retire the impacted asset. FASB hopes these changes will produce earlier, more consistent and more detailed recognition and disclosure of CAROs. In particular, FIN 47 helps clarify several key issues, including when a CARO liability should be recognized, how and when a fair value may be reasonably estimated, and what information should be deemed sufficient for a reporting company to make a fair value estimation. Accounting For Uncertainty In large measure, the approach spelled out in FAS 143, as expanded by FIN 47, represents FASB s attempt to alter traditional accounting practices. FAS 5, Accounting for Contingencies (available at www. fasb.org/pdf/fas5.pdf), is the general accounting standard governing recognition and disclosure of contingent liabilities. Under FAS 5, companies must accrue for potential environmental liabilities if probable of assertion. However, as to AROs, FAS 143 and FIN 47 together remove probability from that exercise. Uncertainty as to whether or when a liability will arise is immaterial to whether or when the liability must be recognized; that uncertainty instead is a factor of how to determine a fair value for the liability. Thus, the FAS 143 inquiry runs to how much of an environmental liability must be estimated, not whether or when. In FIN 47, FASB provides examples to drive home the point that uncertainty is not germane to the recognition or disclosure of a CARO, only to its valuation. In a common scenario, existing laws typically require removal of asbestos materials before a building is demolished. However, the timing of when the asbestos actually will be removed may depend on when the building is renovated, demolished or sold (all events constituting retirement of the building asset). Notwithstanding the uncertainty of when this known obligation will be addressed, or by whom, FIN 47 requires prompt recognition of the liability, if a fair value can be reasonably estimated. Fair Value Estimation FASB takes the position that the liability for an ARO can be reasonably estimated if sufficient information exists to determine its present fair value. Under FIN 47, whether a reporting company has sufficient information may turn on a matter of judgment. If it is not possible to make a determination of fair value, the company is not required to accrue a liability. It is required, though, to describe the obligation, state that a liability cannot be recognized because its fair value cannot be reasonably estimated, and explain why the obligation is not estimable. Under FIN 47, fair value can be regarded as the amount at which willing parties could agree to settle the legal obligation in question in a transaction. In the absence of objective, market-based valuation for a contingent or conditional legal obligation, FIN 47 indicates that fair value can be determined if: The acquisition price of the asset reflects its fair value; An active market exists for the transfer of that obligation; or Sufficient information exists to calculate its expected present value. FIN 47 itself does not prescribe how to determine if the value of an ARO is reflected in the asset s acquisition price. Some objective indicators may exist if the transaction reflects an identified price discount for the asset or the use of environmental risk transfer devices such as insurance or indemnities. Independently, comparisons can be made of the purchase price of the contaminated asset to similar uncontaminated assets. Alternatively, FIN 47 envisions reference to a market price that a willing buyer would pay for transfer of the obligation. Increasingly, a variety of environmental cleanup liabilities are being monetized in arm s-length transactions. The fair value

4 10 The Practical Real Estate Lawyer January 2008 of a CARO liability can be reasonably estimated if an active market exists for its transfer. If the objective information above is not available or sufficient, an expected present value can be calculated by use of discounting techniques to develop possible future scenarios with respect to settlement date or method, and then calculating a probabilistic weighted average among those outcomes. This contrasts with the traditional approach to accounting for contingent environmental liabilities. Acceptable practice under FAS 5 typically involves the use of ranges of estimated future cost that reflected current uncertainties; in the common case in which no one estimated outcome was more likely than any other, booking the low end of the cost range is acceptable. Under FIN 47, however, reporting companies may well have to evaluate the probabilities posed by a range of possible outcomes and selecting a single most likely cost. Sufficiency Of Information FIN 47 provides that sufficient information exists to prepare a present-value estimation for an ARO if the settlement date and method has been specified by others, whether by law or under contract. Even if the settlement date and method is not set by a third party, FIN 47 provides that a reporting company will have sufficient information to reasonably estimate the fair value of the obligation if the company has information to estimate the date or a range of potential settlement dates, potential methods of settlement, and to assign probabilities to the potential settlement dates and methods. Information likely to form a basis for estimating the probabilities associated with potential settlement scenarios include the company s past practice, industry practice, and the estimated economic life of the asset. Another, more subjective, factor is management s intent with respect to settlement date or methods. However, FASB was concerned that determining fair value or more likely, that fair value cannot be reasonably estimated solely on management s subjective intent to defer settlement of an ARO until it decides to retire the asset would untenably delay recognition and disclosure. FIN 47 thus prohibits the use of management s intent as the sole basis for determining whether the probabilities associated with potential settlement dates and methods of settlement scenarios can be reasonably estimated. Practical Implications Of FIN 47 Much is still to be determined regarding how profoundly FAS 143, as expanded by FIN 47, will affect accounting for environmental obligations. FIN 47 does not address the dichotomy set forth in FAS 143 between accounting treatment for the costs to address contamination resulting from the normal operation of a facility (FAS 143 uses the example of the ordinary spillage associated with a fuel storage operation, the costs of which are to be treated as a retirement obligation) and the costs to address contamination resulting from a catastrophic accident or improper operation (which, because it does not result from ordinary operations, would not qualify as a retirement obligation, and instead would be treated as an environmental remediation liability under SOP 96-1, Environmental Remediation Liabilities (AICPA 1996)). However, FIN 47 does provide some clarity regarding how the current lack of certainty whether a legal obligation exists should be treated. FAS 143 makes clear that a known liability (for example, to remove asbestos upon demolition) must be recognized as an ARO. FIN 47 indicates that when the liability to address the environmental condition may instead be subject to the enforcement discretion of a regulatory agency, that uncertainty does not preclude recognition of a legal obligation. Rather, even if the regulator never compels an action, the uncertainty is to be factored into the valuation of the ARO. More challenging, perhaps, will be whether FASB (or the SEC) regards these changes as imposing an affir-

5 Environmental Liabilities 11 mative duty on companies to investigate environmental conditions that may require recognition. CAROs INVOLVING ENVIRONMENTAL LIABILITIES Although not addressing a host of questions, FASB does attempt to illustrate the application of FIN 47 to environmental legal obligations that may constitute CAROs, through several detailed examples. Example 1 The first example involves a telecommunications company that owns chemically treated wooden poles. The company is under no legal obligation to replace the poles, but it does so periodically for operational purposes. Once removed, existing laws require that the poles be disposed of properly. The example assumes that the company currently has sufficient information to estimate the potential dates, methods, and costs of disposal, and the probabilities associated with the settlement scenarios based on industry experience. Thus, the company is in a position to reasonably estimate the amount of the liability. Although the removal and disposal of the poles will occur in the future, the legal requirement for proper disposal exists at the time of purchase. Thus, the fact that the company will defer the settlement (i.e., the outlay for the cost to dispose) into the future, FIN 47 requires recognition currently of this obligation. As a result, the company in this example would be required to make provision for the expected present value of the liability, dating to its purchase of the poles. Example 2 The second example involves components of an asset. A manufacturer owns kiln ovens that contain bricks that must be replaced periodically. Because the bricks become contaminated with hazardous substances, they must be properly disposed of as hazardous waste. However, the legal obligation arises only when the bricks become contaminated, not at the time of purchase of clean bricks. (Presumably, contamination occurs essentially when they are first put in service.) The timing of removing the bricks is uncertain, yet the duty to dispose of them properly once removed is unconditional. The example assumes the entity is able to estimate how often it replaces the bricks, and the costs and methods of doing so. Therefore, the company in the example must make provision for the expected present value of the liability currently. Example 3 The third example involves a company that purchases a factory laden with asbestos-containing materials, before the enactment of laws for governing the handling and disposal of the asbestos upon renovation or demolition. However, the timing of the ARO is conditioned on the plant undergoing renovation. Nonetheless, under FIN 47 the obligation to recognize attaches when the asbestos rules were adopted. However, the company has no current plans to renovate the plant. As a result, the time period when the liability may actually be settled is unknown or cannot be estimated, so FIN 47 indicates that the company is not in a position to reasonably estimate the present value of the liability. Therefore, the company does not have to make provision for the liability at present, but it must disclose and describe the obligation and explain that the liability cannot be reasonably estimated currently and the reasons why it cannot be estimated. The last example involves another company that acquires a factory with asbestos-containing materials, but here the asbestos rules already are in effect at the time of purchase. Thus, the purchase of the plant triggers the ARO obligation. However, the company cannot determine when the factory might be renovated or demolished, and thus the settlement period is uncertain. Moreover, no active market exists for the transfer of the obligation, so the purchase price does not reflect its value. At this point, then, the company is not able to reasonably

6 12 The Practical Real Estate Lawyer January 2008 estimate the fair value of the liability, although the company will have to provide the requisite explanatory disclosure. Ten years later, however, the plant requires modifications to accommodate new product lines. In the example, the company now has sufficient information to estimate a range of settlement dates (to remove and dispose of the asbestos). At this later point, the company is able to estimate the fair value of the ARO using an expected present value. Practical Implications The impact of FIN 47 likely will be greatest on those reporting entities that historically have more narrowly interpreted FAS 143 and thus deferred recognition of conditional asset retirement obligations. Those entities may soon need to take steps to identify, recognize, or restate many of their environmental liabilities. Moreover, companies likely will need to be more proactive in assessing current liabilities, whether arising from changing laws affecting handling of demolition materials, acquisition of contaminated assets, or conditions at owned or acquired properties that appear to involve a current but uncertain legal obligation. In addition, care must be taken to stay aware of changes to environmental requirements that would become existing legal obligations requiring prompt recognition. The implications of FIN 47 are not limited to the balance sheet. Sections 302 and 906 of Sarbanes-Oxley (15 U.S.C and 18 U.S.C. 1350, respectively) require that CEOs and CFOs certify that a public company s financial statements fairly present the financial condition of the company. Although no clear delineations yet have emerged regarding how FIN 47 affects these Sarbanes-Oxley requirements, the prospect of exposure to the considerable penalties authorized by that law are cause for substantial concern. To avoid understating their environmental liabilities, companies are implementing far more extensive evaluations of environmental legal obligations. These concerns for accuracy extend to lawyers as well. Section 307 of Sarbanes-Oxley, 15 U.S.C. 7245, as interpreted by the SEC in 2003, requires lawyers to report evidence of a material violation of securities laws or a breach of a fiduciary duty to the general counsel or CEO, and perhaps further up the corporate chain if the matter is not handled appropriately. Counsel thus will find themselves personally invested in helping determine if the financial statement fairly presents the client s financial condition. CONCLUSION FIN 47 significantly expands the reach of FAS 143 to a host of environmental legal obligations requiring proper recognition in financial statements. Many companies may face increased reporting obligations regarding heretofore too uncertain AROs, both those of which it currently is aware and which may arise in the future. These developments will require heightened attention and analysis from accounting and legal advisors to identify legal obligations associated with the retirement of contaminated assets and to assist in developing appropriate estimates for recognition. To purchase the online version of this article, go to and click on Periodicals.