It is a well-known “dirty secret” that environmental liability estimates developed in conformance with U.S. accounting standards are unreliable and all too often materially understated. The vagaries of contingency accounting and environmental law and science, however, have made it practically impossible to empirically demonstrate this conclusion. As a result, the inherent incentives for manipulation have been unconstrained. Those days are over.
Financial analytical techniques are now being used to gauge the reliability and relevance of corporate disclosures of liabilities arising under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or Superfund), the Resource Conservation and Recovery Act (RCRA), and similar state laws. These techniques promise to improve market efficiency by introducing more timely and accurate information. They also hold the potential to empower boards to exercise stronger oversight and make more informed decisions on important environmental, social, and governance (ESG) issues.
The Problem with Accounting Estimates
Accounting estimates can significantly understate the amount that will ultimately be expended to resolve environmental liabilities. Generally accepted accounting principles (GAAP) seek to match expense with incurrence of liability. Estimates of contingent liabilities, including contingent environmental liabilities, are intended to reflect the “best estimate” of eventual expenditures that are considered probable and reasonably estimable. In practice, accounting estimates often reflect only those costs that are nearly certain—in other words, expenditures that have been budgeted. When initial estimates prove to be inadequate, additional accruals are needed to replenish the reserve. In effect, this is an implicit accounting policy to match expense with expenditures rather than to match expense with incurrence of liability.
Accounting estimates often are unreliable. Based on the author’s research, audited financial data often shows the following pattern over a multi-year period: (1) consistent or increasing expenditures; (2) accruals that closely correlate with expenditures; and (3) steady or rising loss reserves. When this pattern exists, it is intuitively obvious—even to non-experts—that accounting estimates do not represent a reliable estimate of future cash flows.
Conformance with GAAP can be misleading. As a general rule, regulators consider financial information that fails to conform with GAAP to be per se misleading. But critics complain that loopholes allow companies to manipulate the numbers without running afoul of accounting standards. One highly visible critic, Ed Trott, a former member of the Financial Accounting Standards Board, considers GAAP, as it applies to environmental liabilities, to be an “embarrassment.”
The author’s study of 24 petroleum and chemical companies shows that estimated off-balance sheet environmental liabilities were relevant to financial decision-making—in that they exceeded five percent of stockholders’ equity — for 16 (two-thirds) of the companies. The research also shows that 9 of the 24 companies had a financial incentive to improve the reliability of their accounting estimates by increasing reserves and decreasing ongoing charges to net income.
The Importance of Fair Value Estimates
Fair value estimates are market-based and far more encompassing than accounting estimates. The fair value of a contingent environmental liability is the market exchange price that would be paid to transfer the liability to an independent party in an orderly transaction. This is sometimes called the “exit price.”
There are three important points to know about environmental liability estimates. First, there is a negotiated market for the transfer of environmental liabilities. Although observable market data is limited, the notion of a market exchange price for environmental liabilities is real and not merely an academic construct. Second, because the (real or hypothetical) party assuming the liability must account for all reasonable contingencies, not just those considered highly likely, fair value estimates of environmental liabilities often will be much higher than accounting estimates. Third, accounting estimates are irrelevant in determining solvency under bankruptcy and corporate law. When legal solvency is at issue, fair value is what counts.
Information about the fair value of environmental liabilities may be relevant to various board-level judgments about business performance and legal compliance, including those discussed below. Unwary directors may be surprised to realize that environmental liability estimates can be relevant to judgments about non-environmental matters.
Do the company’s accounting estimates conform with GAAP? If the difference between accounting estimates and fair value estimates of environmental liabilities is large, this may call into question whether the company has reported its “best estimate” of the liability.
Do the company’s SEC filings contain any untrue statement of a material fact or omit to state a material fact? If the difference between accounting estimates and fair value estimates is large, this may be considered a material misleading fact for purposes of the certification required under Section 302 of Sarbanes-Oxley.
Do the company’s SEC filings “fairly present in all material respects” the financial condition and results of operations? If the difference between accounting estimates and fair value estimates is material to the overall financial condition of the company this fact will bear on the certification required under Section 302 of Sarbanes-Oxley.
Is the company solvent? If the fair value of a company’s liabilities—including contingent and off-balance sheet liabilities—is at risk of exceeding the fair value of its assets, this condition will trigger a change in the fiduciary duties of the board. A later judicial finding of insolvency can serve as the basis for legal and contractual claims, including fraudulent and preferential transfers (intentional or constructive) under the Bankruptcy Code and state laws, the commencement of an involuntary bankruptcy, pursuit of illegal dividends or wrongful distributions, and enforcement of loan covenant violations.
Is the company managing its business in a prudent and effective manner? If the business has significant environmental liabilities, the board must assure itself that information and reporting systems are sufficient to support informed judgments concerning the company’s environmental operations and compliance with law. Knowing the fair value of environmental liabilities is essential in gauging the effectiveness of corporate resources expended to address such liabilities. “What gets measured gets done,” said management guru Peter F. Drucker. The corollary is that you cannot manage what you cannot (or will not) measure.
Estimating Environmental Liabilities
The ultimate cost to resolve an environmental liability is contingent on the outcome of future events. Some future outcomes are subject to management’s control. Others are not. Uncertainty about future outcomes makes reasonable estimation of the ultimate loss difficult, but not impossible.
The fair value of environmental liabilities is typically estimated using expected present value techniques. In layman terms, expected value is the probability-weighted average of all possible outcomes. If there is a 50 percent chance that the ultimate loss will be $2 million and a 50 percent chance that the ultimate loss will be $20 million, the expected value is $11 million. Expected present value adjusts this probability-weighted average to reflect the time value of money.
Obtaining the information needed for fair value estimates involves investigation of existing circumstances and informed assumptions about future outcomes. Investigation is often necessary to identify and assess pre-existing pollution conditions arising from past releases of hazardous substances into the environment. Investigation is particularly relevant to estimating losses for environmental liabilities because the underlying physical conditions often are latent and because it often is within management’s control to conduct or allow investigation, especially with regard to properties owned or controlled by the company. Management often has discretion to identify and fully assess all pre-existing pollution conditions or only those matters subject to pending enforcement or litigation. Following an evaluation of existing circumstances, educated assumptions about future outcomes are necessary to determine the potential methods of resolving the liability, the timing of expected cash flows, and the associated probabilities.
Investigation of existing circumstances and assumptions about future outcomes, although necessary for determining fair value, have three readily apparent drawbacks. First, these activities can entail significant cost and effort. Environmental investigation and valuation requires the use of costly experts in environmental science, engineering, law, and finance. Second, these activities can generate prejudicial information — information whose collection or dissemination could adversely affect the outcome of the contingency itself. Third, by generating fair value estimates that differ from accounting estimates — in essence creating a second set of books that is not disclosed in the financial statements — the entity increases its exposure to accusations of accounting and securities fraud. Faced with this Catch-22, willful blindness has often seemed the prudent choice. But this choice invariably leads to unreliable disclosures.
Overcoming Unreliable Disclosures
In the absence of reliable “bottom up” financial data, the market must turn to “top down” analytical techniques to test the reliability and relevance of accounting estimates and to develop alternative estimates that more closely reflect observed historical data. By analyzing expenditures over time—for example, by measuring the degree to which accruals are correlated with expenditures and by measuring the effectiveness of expenditures in reducing reserves—one can gauge the reliability of accounting estimates. Where cash flows belie reported estimates—for example where a company’s expenditures over five years equal 250 percent of its average reserve during the same five-year period—one can develop an alternative estimate by projecting the loss development history into the future.
“Development Estimates”—estimates of future cash flows based on projections of historical cash flows—are inherently imprecise. Because past performance may not be indicative of future results, such estimates may significantly overstate or understate eventual costs. But from the market’s perspective, it is better to be vaguely right than precisely wrong.
The market will create its own assumptions to compensate for unreliable environmental disclosures. “Unlike nearly every other income-statement line item, there is very little if any visibility into the annual charge for ‘probable and reasonably estimable environmental liabilities,’” complained JPMorgan analyst Stephen Tusa, who downgraded Honeywell for this reason in 2006. When the market’s assumptions are wrong, companies may need to correct them.
The information needed to identify unreliable accounting estimates is readily available. The Securities & Exchange Commission instructs public companies to separately disclose annual expenditures for environmental cleanup. This data can be used to gauge the reliability and relevance of accounting estimates and to produce Development Estimates that are often significantly higher. Since these techniques use publicly available audited financial data, they can be performed without undue cost and effort by financial analysts, auditors, government regulators, NGOs, insurers, prospective purchasers, lenders, parties to litigation, and even corporate boards. Willful blindness may now seem less prudent.
Informed ESG Oversight and Decision-Making
The ability to gauge the reliability and relevance of accounting estimates empowers boards to exercise stronger ESG oversight and make more informed decisions. Boards now have a low-cost tool to assess the reliability and relevance of accounting estimates without risking prejudicial effect and without inundating themselves with burdensome information. If analysis shows that current estimates are either reliable or irrelevant to the company’s financial condition, the exercise is complete. Conversely, if analysis shows that current estimates are both relevant and unreliable, the board will have an informed basis for taking action.
C. Gregory Rogers, JD, CPA, is president and founder of Advanced Environmental Dimensions, LLC and author of Financial Reporting of Environmental Liabilities & Risks after Sarbanes-Oxley (Wiley 2005). He is listed in Best Lawyers in America in the field of environmental law.