FAS 141R's different approach to uncertainty

FAS 141R, Business Combinations (Revised), takes a different approach to uncertainty in cost estimation than FAS 5, Accounting for Contingencies. Both standards apply to the recognition (and disclosure) of loss contingencies as liabilities, which include environmental cleanup liabilities.

Under FAS 5, as described in the previous post, a company may postpone recognition of a loss contingency liability if it cannot reasonably estimate liability cost, i.e., if it is too uncertain about cost.

FAS 141R currently provides no equivalent opportunity to postpone recognition. For the type liabilities that include environmental cleanup—in which active markets are not available to establish liability values—liability measurement under FAS 141R is performed (must proceed) by incorporating uncertainty (as probability) in cost estimation.

That is, (very briefly sketched) probability values are assigned to potential cost outcomes. Probability-weighted cost outcomes are summed for an expected cash flow amount. A (credit-adjusted, risk-free) discount rate is applied (for consideration of the time value of money) in producing an expected present value, i.e., estimated cost.

The application of this expected value approach to cost estimation under FAS 141R assumes there is sufficient information about potential cost outcomes, probabilities, and resolution date. This is mostly an appropriate assumption for environmental cleanup contingencies.

FAS 141R, effective beginning in 2009, directly applies only to a subset of companies, to the surviving entity in business combinations (e.g., mergers and acquisitions). As well, it pertains only to acquired properties, not to all the entity’s properties.

Yes, FAS 141R has limited direct applicability. Its approach to cost estimation for environmental cleanup-type liabilities, i.e., using expected value, deserves broader attention, however. It is indication to companies implementing FAS 5 that cost estimation for such liabilities can proceed, despite uncertainty.

Can proceeding with recognition work to a company's advantage? Yes, if management and minimization of liability costs follow. The result can be lower liability costs over the long term.

[See the March 3, 2009, post in Knowing Disclosure for FASB's change of heart about cost uncertainty under FAS 141R.]