This article is also co-authored by Robert Lipscomb, the Brownfield Program Manager for the engineering firm of Barge Waggoner Sumner & Cannon in Nashville, Tennessee.
Recent events over a twenty-four hour period indicate that the reporting of environmental liabilities is a continuing problem. On July 15, Senator Jon Corzine hosted a symposium on corporate disclosure of environmental information in financial statements in the Dirksen Senate Office Building. On July 16, the Governmental Accountability Office (GAO) issued a study titled “Environmental Disclosure, SEC Should Explore Ways to Improve Tracking and Transparency of Information.” And finally, Martha Stewart was sentenced to prison for crimes related to financial reporting.
The problem of accurate reporting of environmental liabilities is epitomized by old industrial and commercial properties known as brownfields. Brownfields are properties that are underused and unused because of the perception that these properties might have environmental contamination that has yet to be discovered. Environmental investigations to assess contamination are often expensive and sometimes inconclusive.
If contamination is found, it can trigger additional investigations. The investigations themselves are expensive, but the remedial actions they recommend can be even more costly. Companies are understandably reluctant to initiate investigations that may trigger enforcement actions and will certainly increase costs. Instead, many companies have opted to mothball these properties in a kind of an environmental “Don’t Ask / Don’t Tell” policy.
But “Don’t Ask / Don’t Tell” flies in the face of “The Public Company Accounting Reform and Investor Protection Act of 2002,” better known as Sarbanes-Oxley. Under Sarbanes-Oxley, corporate officers who willfully make false financial statements may receive a fine of up to $5 million, or a prison sentence of up to 20 years, or both. The stakes for preservation of the “Don’t Ask / Don’t Tell” policy have been dramatically increased.
As noted in the GAO report, generally accepted accounting principles (GAAP) require companies to report environmental liabilities if occurrence is “probable” and their amounts are “reasonably estimable.” A liability is reasonably estimable if company management can develop a point estimate or determine that the amount falls within a particular dollar range. Even if the liability fails to meet one or both of these criteria, it must be disclosed in the footnotes of the financial statement if it is “reasonably possible.” “Reasonably possible” is defined as a range of possible outcomes that have a greater then remote chance of occurring.
In the absence of environmental investigations, companies have insufficient information to conclude that the environmental liability exists, much less whether it is “probable.” Even when there is sufficient information to make the liability “reasonably estimable,” the valuations are often in the form of a wide range of estimates. If no single estimate is better than the others, GAAP specifies that the company use the lowest estimate and disclose the potential for additional liability in the footnotes.
SEC regulations also generally require disclosure of information only if it is “material.” Material means that there is a substantial likelihood that a reasonable person would consider it important. In light of surrounding circumstances, its omission or misstatement would likely change or influence such person’s judgment. Because individual environmental liabilities typically do not meet the definition of “material,” none are reported. So-called “socially responsible investors” (individuals who screen their investments based on companies’ environmental, labor or community practices and who represent 11 percent of the assets under professional management) have formally requested that environmental liabilities be aggregated in determining whether they are “material,” with the assumption that total environmental liabilities are “material.”
On June 17, 2004, the Financial Accounting Standards Board issued “Exposure Draft, Proposed Interpretation, Accounting for Conditional Asset Retirement Obligations, an Interpretation of FASB Statement 143,” File Reference No. 1099-00. The exposure draft requires an entity to recognize environmental liabilities even when the environmental liability is based on a future event. In layman’s terms, environmental liabilities are to be valued and reported.
Section 302 of Sarbanes Oxley requires that CEO’s and CFO’s certify all quarterly and annual financial reports, stating (among other things) that the report fairly represents the financial condition and results of operation of the company for the reporting period. This is akin to the “general duty clause” of the Occupational Safety and Hazards Act (“OSHA”). The OSHA general duty clause permits citation for any hazard causing or likely to cause death or serious physical harm, regardless of whether a specific standard has been promulgated under the Act. Similarly, conformance with GAAP does not ensure conformance with Sarbanes-Oxley. Or more to the point, GAAP is no longer the ceiling. It is the floor.
Because the low level of disclosure might mean an absence of environmental liabilities, the presence of non-material liabilities or inadequate compliance with disclosure requirements; the answer to the problem is not yet clear. What is clear is that good business practices by managers, owners, lenders and investors require accurate and meaningful financial reports that fairly represent the condition of the business, including environmental liabilities that are part of the business. The SEC might adopt some of the less desirable suggestions contained in the GAO Report if the regulated community fails to address these concerns. A rebuttable presumption of materiality for all environmental liabilities or the initiation of a few high-profile enforcement cases emphasizing the seriousness of non-disclosure and establishing legal precedent for reporting standards might serve to exacerbate rather than remedy the continuing problem of inadequate disclosure.
Until we have regulations establishing specific reporting standards, CEOs and CFOs are well advised to assemble teams of accounting, legal and technical experts for the management of business risks associated with valuation and reporting on real estate assets.