Environmental liabilities under FAS 157-f

Does FASB’s new FAS 157-f bring changes that affect measurement of environmental liabilities?

FASB released on May 1, 2009, the proposed staff position paper (FSP) FAS 157-f, “Measuring Liabilities under FASB Statement No. 157” [Text] (and will accept comments on the document until June 1, 2009).

FASB cited in FAS 157-f as background the concern expressed by companies about the successful determination of liability fair value when observable market information is lacking. For this and other issues it noted, FASB concluded “that the consistency in application of FAS 157 could be improved” with additional guidance, a role that FAS 157-f was drafted to serve.

The normal situation for environmental liabilities (e.g., litigation and cleanup) is no market, active or inactive, to obtain quoted prices for “identical” or “similar” liabilities—for establishing fair value. For such circumstances, FAS 157-f calls for use of:

...Another valuation technique that is consistent with the principles of Statement 157. [An example] would be an income approach, such as a present value technique. [Para. 9.d]

Application of an "income approach" already is indicated in FAS 157 guidance, which describes this approach as using:

...Valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present amount (discounted). [Para. 18.b]

So, FAS 157-f brings no change for companies intending fair value measurement of environmental liabilities under FAS 157. That is, for cleanup-related liabilities, expected present value methodology remains suitable (and normally effective) for their fair value measurement. Meanwhile, any successful approach—income or otherwise—to measuring litigation-related liabilities must overcome the difficulty of anticipating litigation outcomes.

Concerning environmental liabilities, FASB's release of FAS 157-f, if nothing else, serves to remind companies that there is an approach for handling the uncertainties inherent in cost estimation for cleanup liabilities—and that is the application of expected present value methodology.

[See the April 10, 2009, post in Knowing Disclosure on determining fair value for environmental contingencies.]

Fair value for environmental contingencies?

Can companies determine fair value for environmental loss contingencies?

As noted in the post on April 2, 2009, FASB stepped back from its earlier requirement that loss contingency liabilities for acquired properties (e.g., from mergers and acquisitions) be measured at fair value. With its release of FAS 141R-1 [Text] on April 1, 2009, FASB requires measurement at fair value only “if [it] can be determined [emphasis added].”

Fair value measurement formerly was required (period, no excuses for uncertainty about costs) under FAS 141R, which preceded FAS 141R-1's release. Companies complained to FASB, however, that fair value measurement of litigation-related loss contingencies was too difficult. That is, litigation outcomes were too uncertain to predict, meaning litigation costs were too uncertain to measure.

So, for that and other concerns expressed about litigation-related contingencies, FASB retreated. It made recognition of (acquired) loss contingencies at fair value no longer a broad requirement, but dependent on whether the acquiring company believed that fair value could be determined on a case-by-case basis. FASB attempted no distinction between litigation-related contingencies and those that are not.

Companies routinely have environmental contingencies that are not litigation-related, or at least not primarily driven by litigation outcomes. Cleanup-related contingencies make up the largest group of those. Companies normally can determine fair value for cleanup contingencies—through application of expected present value methodology in which uncertainty about cost is incorporated (as probability) into cost estimation.

Can companies determine fair value for environmental loss contingencies? Likely yes for cleanup-related contingencies, despite cost uncertainty; expected present value methodology is an applicable tool. No may be a credible answer for litigation-related contingencies, because litigation outcomes, including costs, can be so difficult to predict.

Response to FASB's retreat from fair value

How might companies respond to FASB’s recent retreat from fair value?

As noted in the previous post, FASB stepped back from its earlier requirement that loss contingency liabilities for acquired properties be measured at fair value. With its release of FAS 141R-1 [Text] on April 1, 2009, FASB requires measurement at fair value only “if [it] can be determined.”

Formerly, under FAS 141R, released in December 2007, companies were to measure and recognize loss contingency liabilities at fair value—period, no exceptions for uncertainty about costs.

There were complaints from companies, however, that it was too difficult to determine costs for litigation-related loss contingencies. This, in part, was why FASB retreated.

So, how might companies respond to FAS 141R-1 with respect to environmental loss contingencies for acquired properties?

Setting aside consideration of litigation-driven loss contingencies, companies may well have other environmental contingencies (e.g., cleanup-related) that are amenable to fair value determination—through expected present value methodology in which cost uncertainty is made part (as probability) of cost estimation.

Should companies be motivated to apply fair value measurement to environmental loss contingencies that have not been recognized that way before?

FASB's further retreat from fair value

Fair value measurement of environmental loss contingency liabilities for acquired properties will not be required, after all.

With its release of FAS 141R-1 [Text], Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies, FASB has marked a further retreat from liability (and asset) measurement at (acquisition-date) fair value. Under FAS 141R-1, dated April 1, 2009, measurement of contingencies at fair value is required only “if [it] ...can be determined." FASB gives no guidance in FAS 141R-1 about how to make that determination.

Under FAS 141R-1, if a company determines it cannot calculate fair value—e.g., because of uncertainty about factors affecting costs—then it is to apply FAS 5 and FIN 14 guidance. FAS 5 instructions allow a company to postpone recognition of a probable loss until it concludes it can reasonably estimate the amount of loss. FIN 14 allows the low value from a cost range to be the amount recognized—or no value at all—as a result of cost uncertainty.

Formerly under FAS 141R, Business Combinations, the draft revision of FAS 141 that preceded FASB's release of FAS 141R-1, companies were to measure and recognize loss contingency liabilities at fair value—period, no exceptions for uncertainty about costs. This applied for all contractual loss contingency liabilities and for noncontractual loss contingencies that were more likely than not to be liabilities. It was to be effective beginning in 2009.

Companies expressed issues with FAS 141R, however—many of them litigation-related, e.g., the difficulty of determining fair value for litigation-related contingencies, the concern for protection of supporting information that may be subject to attorney-client privilege, and the exposure of potentially prejudicial information in financial statements.

Acknowledging these issues, FASB showed in its February 25, 2009, board meeting (minutes) that it was backing away from a strict requirement for recognition at fair value. It indicated it would be making such recognition conditional on whether fair value was “reasonably estimable.” [See the March 3, 2009, post in Knowing Disclosure about FASB’s change of heart.]

Now FASB has retreated further. Under its just-released FAS 141R-1, FASB makes recognition at fair value contingent on whether fair value can be “determined,” leaving it up to companies how they go about that determination.

Environmental cleanup postponement premium

Are companies paying a premium for postponing recognition?

As noted in the March 5, 2009, post, companies applying FAS 5, Accounting for Contingencies, and FAS 141/141R, Business Combinations (Revised), have options for measuring loss contingency liability costs. One option is for companies to postpone recognition when they believe they cannot reasonably estimate liability costs. Might companies postponing recognition be paying a premium for that option?

It likely is less expensive to resolve environmental cleanup loss contingencies in the near term, rather than later. Paying a premium refers to absorbing the difference in costs for resolving later.

Why should companies expect that costs to resolve later will be higher?

First, environmental problems tend to worsen with time. For example, cleanup needs can increase where contamination sources have been insufficiently secured, e.g., against human and animal intrusion, wind transport, surface water erosion and infiltration. There may be more exposure of personnel to contaminated materials or more subsurface migration of contaminants as time passes.

Second, costs to resolve environmental cleanup tend to rise, e.g., in response to environmental problems worsening. Increases also result from cleanup requirements of regulatory authorities that become more stringent and thereby more costly to meet. They result when structural deterioration due to weathering complicates cleanup.

Third, companies that are postponing recognition of environmental loss contingencies likely also are postponing management of them, including cost management. Those companies, consequently, will be missing the development of favorable cost situations for resolving the liabilities, should they arise. By the time they do recognize and begin management, environmental problems may well have worsened and costs increased.

There appears potentially to be a considerable premium for companies to pay for postponing recognition.

[For more information, see Raymond Rose's "Reconsidering Loss Contingency Postponement—Raising the Game," Environmental Claims Journal, Corporate Environmental Disclosure Column, Scheduled for Vol. 21, Issue 2, Apr-Jun 2009.]

Situations affecting views on measurement options

How can situation affect view on measurement options?

As noted in the March 5, 2009, post, companies applying FAS 5, Accounting for Contingencies, and FAS 141/141R, Business Combinations (Revised), have options for measuring loss contingency liability costs. Might companies in different situations take differing views about those measurement options?

Here is a hypothetical example to consider, with companies in three simplified situations—not looking to acquire or be acquired, being a prospective buyer, and being a prospective seller.

First is Company X, which is not looking to acquire other companies or be acquired. It wants liabilities minimized, quarter to quarter, including environmental liabilities.

So, it postpones recognition of environmental liabilities to the extent possible, i.e., those for which it cannot reasonably estimate costs. For those in which it can estimate costs, it recognizes only minimum liability values, i.e., the low value of a range (the known minimum value). Its view is to use measurement options (under FAS 5) to minimize near-term liability recognition.

Next is Company Y, a prospective buyer. It needs liability information about companies it is considering buying in order to develop offers and, potentially, negotiate price. It wants the environmental liabilities of those companies truely identified and realistically valued. Its view as a prospective buyer is that measurement options should enable that outcome.

Company Y, the prospective buyer, may take a different view after acquisition. It can postpone recognition of (contractual) liabilities (for the acquired properties) if it cannot reasonably estimate their fair value. This comes from FASB’s recent decision about FAS 141/141R. In which case, FAS 5 applies (for loss contingencies at acquired properties), if fair value cannot be reasonably estimated.

So, after acquisition, Company Y's view may come to resemble Company X's—which is to use measurement options (under FAS 141/141R and FAS 5) to minimize near-term liability recognition.

There is also Company Z, a prospective seller. It wants to be considered for purchase, so it is motivated to meet a prospective buyer’s information needs. Its view is to use measurement options for true identification and real valuation of environmental liabilities.

[See the March 6, 2009, post in Knowing Disclosure on how individual roles can affect views on measurement options.]

Roles affecting views on measurement options

How can role affect view on measurement options?

As noted in the March 5, 2009, post, companies applying FAS 5, Accounting for Contingencies, and FAS 141/141R, Business Combinations (Revised), have options for measuring loss contingency liability costs. Might individuals in key roles within a company take different views about those measurement options?

Here is a hypothetical example to consider with simplified viewpoints of individuals in four key roles—CEO, Plant Manager, CFO, and Environmental Manager.

A company has acknowledged a liability for an environmental cleanup loss contingency at a plant site. Now it must consider what liability cost to recognize. Individuals in key roles at the company independently come to these amounts for liability cost:

• Amount A: No value, i.e., there is too much uncertainty for cost to be reasonably estimated yet, so no liability should be recognized at this time.


• Amount B: $850,000, the most likely value for resolving this liability.


• Amount C: $400,000, the low value of a cost range.


• Amount D: $632,250, the expected present value (in year one) for resolution of this liability in year five, i.e., fair value.

Amount A—no value—is the view of a CEO concerned that recognition and disclosure of this environmental liability adversely may affect near-term stock price and thereby prefers to postpone recognition.

Amount B—the most likely value—is the take on the situation by a Plant Manager. He has overseen similar environmental cleanup. He believes he knows, from his experience, the most likely amount for this work.

Amount C—the low value of a range—is how a CFO sees it, who believes a liability should be on the books but wants only a minimum amount entered.

Amount D—expected present value (fair value)—is the view of an Environmental Manager. He would like the same measurement method used for all environmental liabilities, to the extent possible, so he can compare the resulting liability values. He would like this method to produce liability values that are realistic, as well. He has the job, after all, of recommending priorities and budgets for environmental liability management.

What is the measurement outcome that best meets the company’s needs for compliance and financial management?

Mash of measurement options for loss contingencies

Companies now face a mash of options on the matter of measuring liability costs for loss contingencies, including environmental loss contingencies.

Under FAS 5, Accounting for Contingencies, effective since 1975, and FIN 14, Reasonable Estimation of the Amount of a Loss, effective since 1976, a company can apply any of these measurement options in decisions about recognizing loss contingency liabilities:

• No value, i.e., no liability cost is recognized because the company finds it cannot be reasonably estimated yet.


• Most likely value, although the company has no instructions from FAS 5 or FIN 14 about how to determine it.


• Low value of a range (known minimum value), a company’s option if it can discern a cost range but cannot determine a most likely value within that range.

So, in applying FAS 5 (and FIN 14), if a company is uncertain about a liability cost, it can postpone recognition of the loss contingency (the no value option) or recognize the low value from a cost range.

FAS 141R, Business Combinations (Revised), scheduled to be effective beginning in 2009, took a different approach. It required loss contingency liability costs to be measured at fair value (period, no exceptions for uncertainty about cost). It referred companies to FAS 157, Fair Value Measurement, for measurement instructions.

As of February 25, 2009, however, the Financial Accounting Standards Board (FASB) has decided that companies need more measurement outcomes available under FAS 141/141R. So—now—a company should recognize a loss contingency liability cost at fair value—"if fair value can be reasonably estimated.” Otherwise, FAS 5 instructions apply.

Which means companies implementing FAS 141/141R or both FAS 5 and 141/141R have four options potentially applicable for liability costs, with considerably different measurement outcomes: no value, most likely value, low value, and fair value.

This is not necessarily a good development for companies managing environmental liabilities, i.e., for making decisions about resource allocation. It is not good news for investors and shareholder trying to evaluate environmental liabilities.

That is, how can differences in liability values among loss contingencies be adequately interpreted when they can result from differences in both the nature of the loss contingencies and the measurement options used to assign value?

Using expected present value under FAS 5

How can the expected present value approach be useful for estimating liability costs under FAS 5, Accounting for Contingencies, including environmental cleanup liability costs?

What the expected present value approach brings to liability cost estimation is consideration of the time value of money. This is useful when resolution of a liability is anticipated at a future date—the further into the future, the more valuable its consideration.

Through discounting, the expected present value approach enables initial recognition of an estimated cost at a reduced amount (discounted relative to its matured value). The value recognized is accreted (increased) periodically (e.g., annually) until it reaches a mature liability value when the liability is scheduled for resolution.

Distinctive in this expected value approach is the opportunity for a company to postpone recognition (and disclosure) of the full liability cost until resolution of the liability is expected. Systematically-determined lesser amounts, progressively increasing, are recognized until that time.

To demonstrate, here’s example information from Appendix C of FAS 143, Asset Retirement Obligations. A liability having a matured value of $440,619 is recognized in year one at an estimated cost of $194,879, in year two at $211,444, and so on, increasing to $440,619 in year ten, based on a (credit-adjusted, risk-free) discount rate of 8.5%.

That is, the full liability cost, $440,619, is not recognized until year ten, when the liability is scheduled to be resolved.

This shows the potential usefulness to a company of including consideration of the time value of money, i.e., discounting, in cost estimation under FAS 5 for recognition of liabilities—including environmental cleanup liabilities—having resolution dates that are not imminent.

[See the March 2, 2009, post in Knowing Disclosure for using expected cash flow under FAS 141R.]

Change of heart about uncertainty under FAS 141R

Must companies proceed with estimation of liability costs under FAS 141R, Business Combinations (Revised), despite cost uncertainty?

The new answer appears to be no. Formerly, it was yes.

The Financial Accounting Standards Board (FASB) has decided to require that liabilities (and assets) arising from loss contingencies in business combinations (e.g., mergers and acquisitions) be measured at fair value—if fair value can be reasonably estimated.

Formerly, under FAS 141R, being reasonably estimable was not a consideration. That is, FAS 141R simply instructed measurement at fair value.

Under FASB's new decision, if fair value cannot be reasonably estimated, then liabilities will be recognized (and disclosed) in accordance with FAS 5, Accounting for Contingencies, and FIN 14, Reasonable Estimation of the Amount of a Loss.

“Reasonably estimated” will replace the word “determined” in FAS 141, which FAS 141R was being drafted to revise. (“Reasonably determined” was considered in FSP FAS 141Ra.)

FAS 5 already applies "reasonably estimable" to loss contingency decisions, i.e., enabling companies to postpone recognition if liability cost cannot be reasonably estimated.

This development appears to mark a retreat by FASB. Formerly, in FAS 141R guidance, FASB had indicated how overcoming cost uncertainty might proceed. By reference to FAS 157, Fair Value Measurements, it showed that cost uncertainty could be incorporated into cost estimation for liabilities in which active markets were not available to establish values. This would have pertained to environmental cleanup liabilities.

Concerns raised about determining fair value of liabilities arising from litigation-related contingencies, including environmental litigation, were part of what affected this reconsideration by FASB.

This despite other contingencies having less inherent cost uncertainty, e.g., environmental cleanup. Proceeding with measurement and recognition of environmental cleanup liabilities could lead to cost control and liability resolution, which are potentially favorable financial management outcomes.

It appears, however—with FASB's change of heart—that companies can continue to postpone liability cost recognition, citing cost uncertainty—with wording in FAS 141R no longer set to nudge them into overcoming that uncertainty, where possible.

[See the February 26, 2009, post in Knowing Disclosure for FAS 141R's formerly different approach to cost uncertainty.]