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.]