Recent changes to accounting rules governing asset retirement obligations, particularly with respect to environmental legal obligations, have put the spotlight on environmental disclosure. The new rules are quite complex and ambiguous. Many of the finer points in their application have yet to be worked through by the accounting industry, in-house counsel and environmental specialists. Until a principled, consistent method for applying these new accounting rules emerges, companies and their advisers will be navigating in uncharted waters, and therefore would be well-advised to exercise caution. The practical application of the new rules will also be influenced to a significant extent by continued pressure from the investment and environmental communities for full and robust disclosure of environmental risks to investors.
FIN 47 Requires Disclosure of Conditional Asset Retirement Obligations
In March 2005, the Financial Accounting Standards Board (FASB) issued Interpretation No. 47, Accounting for Conditional Asset Retirement Obligations (FIN 47), which construes Statement of Financial Accounting Standards No. 143 (FAS 143), previously issued in 2001. FIN 47 became effective in December 2005. If applied according to its letter and spirit, FIN 47 could significantly expand accounting for and disclosure of environmental exit costs associated with industrial property, plants and equipment.
Until FIN 47 came into force, most environmental investigation and remediation costs were accounted for under Statement of Financial Accounting Standards No. 5, Accounting for Contingent Liabilities (FAS 5). Under FAS 5, an environmental cost arising from a contingent liability must be accrued only if it is “probable” that a liability would be incurred and only if the scope of that liability is “reasonably estimable.” Advocates have long complained that, as a result of these limitations, significant future environmental remediation costs associated with closing a facility have not been reflected on company financial statements, even when a facility is likely to require significant remediation when it is shut down.
FIN 47 Focuses on Whether There Is a Legal Obligation to Incur Environmental Costs
FIN 47 explicitly provides that future environmental costs for properties, plant and equipment should be accounted for even when a future environmental claim would not be considered “probable” under FAS 5. FIN 47 focuses on whether there is a “legal obligation” to incur environmental costs at the end of a facility’s economic life. That legal obligation could arise under a statute or regulation – such as a state law requiring investigation and, if necessary, remediation of industrial property upon cessation of operations (as is the case in New Jersey under its Industrial Site Recovery Act).
Significantly, FIN 47 also states that a legal obligation can arise from a contractual commitment. Any number of contractual commitments could create obligations to investigate and remediate contaminated property, including lease exit provisions, environmental remediation covenants and even certain environmental covenants in loan documents. As a result, a much broader range of environmental “triggers” will have to be examined under FIN 47 than was previously the case under FAS 5. The question is no longer restricted to whether there is a “probable” environmental claim. Under FIN 47, it will be now be necessary to determine whether there are any federal, state or local law triggers for investigation and/or remediation at the end of the facility’s commercial life. Similar end-of-life contractual triggers will also have to be examined. FIN 47 specifies that “[a]n entity shall identify all of its asset retirement obligations.” This seems to impose an affirmative duty under GAAP (generally accepted accounting principles) to analyze each of the statutory, regulatory and contractual triggers that apply to a company on a facility-by-facility basis.
Uncertainty and Fair Value Under FIN 47
Unlike under FAS 5, where uncertainty about a particular outcome goes directly to the threshold question of whether a contingency is “probable,” under FIN 47 “uncertainty about whether performance will be required does not defer the recognition of an asset retirement obligation.” This is a dramatic break with past practice. FIN 47 requires a company to calculate a conditional asset retirement value even when it believes a regulator (or contract counterparty) is unlikely to require cleanup at some point in the future.
If a legal obligation exists but is unlikely to be triggered, FIN 47 requires such uncertainty to be factored into a “fair value” analysis of the retirement obligation. If there is a low risk of a high environmental cost, the resulting analysis could, at least in the aggregate, yield numbers that are potentially material to a company’s financials. Some would argue that this “fair value” approach to environmental cost estimation is consistent with the “expected value” analysis many companies already undertake when they conduct environmental due diligence of industrial facilities. Under current commercial practice, companies typically analyze a likely range of exit costs associated with the environmental condition of the assets they are purchasing, and discount those costs according to their probability of occurrence. FIN 47 indicates, in fact, that companies should consider the entity’s past practice, industry practice, the asset’s estimated economic life and management’s intent in assessing such probabilities. When a “legal obligation” is present, however, FIN 47 requires a probability-adjusted financial calculation, if material, to be reflected in a company’s financial statement. This probability-based “fair value” analysis also departs from current practice under FAS 5, whereby companies may elect in certain circumstances to accrue contingent liabilities at a “known minimum” value.
FIN 47 does recognize, however, that in certain instances “sufficient information may not be available to reasonably estimate the fair value of an asset retirement obligation.” An example cited in the FIN 47 document illustrates how this principle might be applied. If an entity purchases a factory that has material containing asbestos that would have to be handled and disposed of in compliance with environmental laws if the building underwent renovation or demolition in the future, recognition of that asset retirement obligation would depend on whether or not the entity had any plan or expectation that it would be renovating or demolishing the facility. If management had no such plans, the company could reasonably conclude at point of purchase that there was insufficient information to estimate a fair value for the future asset retirement obligation. Future technology changes or planned operational changes might later make it more likely that renovation could be expected, causing the company to revisit that initial determination. Similarly, if market conditions changed to the point where management was considering closing the plant, the asset retirement obligation for that plant would then be capable of a fair value estimate.
Unfortunately, as was pointed out in comments submitted to FASB, the examples FASB cited in FIN 47 and FAS 143 do not provide sufficient guidance to cover many of the typical scenarios faced by companies within different industry groups. Thus uncertainty as to the application of this exception will continue until there is greater experience with its implementation.
Contaminated Property: FAS 5 or FIN 47?
FIN 47 states that it does not apply to remediation obligations that arise from “improper” operation of an asset, and that in such circumstances FAS 5 applies. Thus, for example, a current spill that violates applicable law or permit requirements would not be captured by FIN 47. It is not entirely clear, however, whether historic spills that fully complied with applicable law at the time they happened can be categorized as “improper” operations that fall outside FIN 47’s scope. This is a significant issue, because if the historic contamination is addressed under FAS 5, accrual of costs is required only when remediation is probable and reasonably estimable. By contrast, under FIN 47, historic contamination would have to be accounted for as an exit cost when the property is no longer in service. It seems likely that FIN 47 will apply to historic contamination only when the property is subject to a regulatory exit trigger or a contractual exit trigger is otherwise imposed. In instances where there is no property exit trigger, it is likely that FAS 5 will continue to apply. There will be many gray areas, however, between these two options, as often properties are subject to remediation both because there has been an exit trigger and because there are non-exit remediation obligations. This is just one of many areas of ambiguity that will have to be resolved over time as FIN 47’s application evolves and consensus is achieved.
FIN 47 in Company Financial Statements
Despite these ambiguities, which are substantial, there is already evidence that FIN 47 is being applied by companies and their accountants to end-of-life costs associated with their facilities. Recent filings by several public companies have reported cumulative costs arising from adopting FIN 47 that, in some cases, involve hundreds of millions of dollars.
Keeping an Eye on Disclosure
Environmental advocates and other advocates of greater corporate environmental disclosure can be expected to watch SEC filings to determine whether FIN 47 is being applied appropriately and consistently across peer companies within industry groups.
Because of FIN 47’s focus on the existence of legal obligations that would trigger asset retirement obligations, lawyers can be expected to play an increasingly important role in these disclosure determinations. Environmental lawyers and environmental consultants will have the opportunity to add value as these disclosure and accounting determinations are made by CEOs, CFOs, general counsel and accounting firms in the coming months and years.
Jeff Gracer ([email protected]) is a partner in the Environmental, Health and Safety Group at Torys LLP.