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Failure to fully report environmental liabilities a growing business risk

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MADISON, Wis.—The days of corporate reticence toward environmental liabilities are numbered, according to an environmental legal and accounting expert.

While flexible interpretation of a three-decades-old Financial Accounting Standards Board rule, FAS 5, has resulted in widespread underreporting of environmental liabilities on most corporate financial statements today, more companies will be forced to recognize and assess such liabilities in the future as more stringent accounting standards are implemented, said C. Gregory Rogers, president of Advanced Environmental Dimensions L.L.C., a Dallas-based management consulting company that specializes in environmental financial reporting strategies.

And while companies may be reluctant to disclose their environmental liabilities and potentially open themselves up to third-party litigation, they will have little defense should a shareholder lawsuit arise for not doing so, Mr. Rogers said, noting that executives are required to sign off on their financial statements as a result of the 2002 Sarbanes-Oxley Act.

Furthermore, should such shareholder lawsuits arise in the future, companies likely will not have coverage due to the pollution exclusions contained in most directors and officers liability policies, he added.

"People need to think about a new type of risk in the environmental area and that's financial reporting risk, not the underlying environmental risk itself, but the fact that you haven't properly identified, assessed, measured and reported that liability or risk in your financial report," Mr. Rogers said.

"Willful ignorance" of an environmental liability will become less defensible and "a lot more liabilities" are going to be recognized as a result of new accounting standards and trends in environmental liability reporting, he added.

At a recent "Advanced Environmental Risk Management Strategies" seminar presented by the Environmental Risk Resources Assn. and the University of Wisconsin School of Business in Madison, Mr. Rogers outlined the past and future trends of environmental financial reporting.

He explained that the historical framework for financial accounting of environmental liabilities resides in Financial Accounting Standard 5, which in 1975 set forth the ground rules of when an environmental risk becomes a liability and must be recognized in financial statements.

Under FAS 5--and further interpretations of the standard--an environmental liability is triggered either by a governmental enforcement action or a lawsuit, he said. It has to be "probable" that a loss has occurred and in an environmental situation, the contemplation or contingency is a claim, he said.

In order for unasserted environmental claims to be recognized, certain criteria must be met, and in most cases corporate attorneys will advise companies that the threshold has not been reached, he said.

"You don't want to disclose an unasserted claim. That's just reality," Mr. Rogers said.

So "if you have a property, and you know you have some problems with it, and nobody knows about it and you think you might want to go clean it up some day," it does not have to be recognized. "This is why all the brownfield sites are not on the balance sheet," Mr. Rogers said. "The rules say it doesn't belong there."

Under FAS 5, companies do not have to account for such environmental costs as voluntary cleanups and asset retirement obligations. AROs are legal obligations associated with the removal, sale and redevelopment of a tangible long-lived asset, such as a shut-down building or facility.

For those environmental liabilities that are recognized, FAS 5 says companies can report the losses at a "known minimum value" in absence of a "most likely value," Mr. Rogers said. As a result, reported environmental liabilities rarely reflect the true liability, if they are reported at all, he said.

FAS 5's days are numbered, though, Mr. Rogers said. "It's not going to live for another 10 years in this country."

The movement toward fair value measurement of liabilities, new accounting rules and the convergence of global accounting standards is going to change the way companies must identify, assess, measure and report their environmental liabilities, Mr. Rogers said.

The concept of "fair value measurement" basically wipes out the longstanding notion of contingent liability, which is currently governed by FAS 105, Mr. Rogers said. It also is "fundamentally different" from the FAS 5 measurement techniques of "known minimum value" and "most likely value," he said.

Under fair value measurement, the uncertainty is not whether there is a liability, but rather "how much you're going to have to pay and when," he said.

"So say you've got asbestos in the building or contamination in the ground, and even though you might not have to deal with it today, there is a clear legal obligation to deal with it in the future," he said. Under fair value measurement, companies will have to take all the uncertainty around that and factor it into a probabilistic analysis called fair value measurement, he said.

"It's exactly what people do in arm's-length transactions every day," Mr. Rogers said. "If I want to transfer an obligation to somebody else and there's lots of uncertainty around it, you get sophisticated and look at all the different scenarios and run probabilistic analysis" and come up with a fair price.

"It's the same underlying principles of insurance underwriting," he noted.

Are companies going to do that with their environmental liability? "They're going to fight like hell not to," Mr. Rogers said. "But if they end up in court or in bankruptcy, they may not be able to defend themselves for having not done that."

And if companies do end up in court, they most likely will not have insurance coverage due to pollution exclusions. "Financial reporting claims will hit your D&O policy and we've got case law that these pollution exclusions are valid," he said.

"The trend is not going away. The whole accounting profession is moving toward fair value measurement," Mr. Rogers said.

Currently, under the 4-year-old accounting standard FAS 143 and the subsequent FASB Interpretation No. 47, companies must use fair value measurement when recognizing their asset retirement obligations, which include old facilities or equipment that have environmental issues that are not currently being addressed, but will be some day when the asset is sold, redeveloped or otherwise "retired," Mr. Rogers said.

Furthermore, the International Accounting Standards Board in Europe is moving toward fair value measurement and is working with the Financial Accounting Standards Board in the United States toward common accounting standards, Mr. Rogers said.

One of their joint projects is FAS 141-R, which affects mergers and acquisitions, Mr. Rogers said. Effective in 2008, companies will have to account for all assets and liabilities of an acquired company using fair value measurement and those liabilities include environmental liabilities, he said.

"Even if you don't have to do fair value measurement now on your whole portfolio of environmental liabilities, you should start because to do it right, it takes time," Mr. Rogers said. "And you don't want to be in a compliance period where FASB says you have six months to do it."