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?

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.]

Using expected cash flow under FAS 5

How can liability costs be estimated under FAS 5, Accounting for Contingencies, despite cost uncertainty?

The application of expected cash flow, an expected value approach, should be considered. It incorporates cost uncertainty (as probability) into cost estimation. An example can show how the expected cash flow approach is implemented.

This is from Appendix C of FAS 143, Asset Retirement Obligations. It demonstrates use of the expected cash flow approach in estimating labor costs to retire (i.e., dismantle and remove) an offshore oil platform.

Three possible labor cost cash flows are identified: $100,000, $125,000, and $175,000. (They could represent three ways of performing the work.) The probability for each being the outcome amount is assessed, respectively: 25%, 50%, and 25%.

The product of the probabilities and the cash flow amounts gives expected cash flows, respectively: $25,000, 62,500, and $43,750. Summing the probability-weighted, individual cash flows gives the project’s expected value for labor costs, $131,250.

So, the expected value (in this example, $131,250) incorporates consideration of cost uncertainty as probability, and is the probability-weighted average of expected cash flows.

For situations in which there is no market for obtaining a quoted price, e.g., the normal circumstance for environmental cleanup liabilities, ASTM E2137-06, Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters, ranks the expected value approach higher (in robustness and comprehensiveness) than other familiar measurement options (i.e., most likely value, cost range, and known minimum value).

This example pertains, as well, for estimating environmental liability costs under FAS 141R, Business Combinations (Revised), and FAS 157, Fair Value Measurements. That is, calculating expected cash flow is part of measuring cost (at fair value under those standards) for liabilities that have no active market for otherwise establishing value.

[See the March 4, 2009, post in Knowing Disclosure for using expected present value under FAS 141R.]

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.]

Reconsidering loss contingency postponement

Under FAS 5, Accounting for Contingencies, companies have been able to postpone recognition and disclosure of loss contingencies if they are uncertain about liability costs. Being uncertain keeps liabilities off company books and out of financial statements in the near term, which understandably has appeal.

Companies that postpone loss contingency liability recognition, however, likely also are postponing liability management, including cost management. Favorable cost situations that may develop for resolving unrecognized liabilities are being missed. Dates for resolving and removing those liabilities from company books and financial statements following their eventual recognition are being pushed further into the future.

More problematically, costs to resolve liabilities may increase with time, particularly costs for environmental cleanup liabilities. Cleanup requirements may become more stringent and thereby more costly to meet, for example. Additional cleanup may be necessary 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.

As a result, companies inclined to postpone recognition (and management) in the near term—from uncertainty about costs—may find themselves vulnerable to higher environmental liability costs over the long term.

FAS 141R, Business Combinations (Revised), a new standard effective in 2009, demonstrates a different approach to uncertainty about loss contingency liability costs. For liabilities like environmental cleanup, uncertainty (as probability) is made part of cost estimation.

FAS 141R has only limited direct applicability, i.e., for the loss contingencies of acquired properties in business combinations (e.g., mergers and acquisitions). Meanwhile, FAS 5 continues to be broadly applicable, as before.

It may be smart, however, for companies to consider FAS 141R’s role for uncertainty in cost estimation—and look again at their postponement of loss contingency liabilities under FAS 5. Is postponement contributing to good financial management? Is there opportunity to improve management of liability costs? What about vulnerability to cost increases?

Might a company “raise its game” by shifting emphasis in its FAS 5 implementation from minimization of liability recognition in the near term to minimizing 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.]

Proposed standard complaints

By its August 8, 2008 deadline, FASB had received more than 200 letters commenting on its new, proposed standard for loss contingency disclosure requirements. The proposed standard is FASB’s Disclosure of Certain Loss Contingencies, released on June 5, 2008 as an exposure draft, File Reference No. 1600-100. It amends the loss contingency disclosure requirements of FAS 5 and FAS 141R.

Tim Reason reported in CFO.com on August 18, 2008, that the majority of the comments were negative, with “many arguing that the proposal should be scrapped in its entirety.” The Wall Street Journal (WSJ) opined in an editorial on August 7, 2008, that the proposed standard was “a wealth transfer from corporations to trial lawyers, [with] FASB doing no favors to the investors it claims to represent.”

It is not clear, however, that the WSJ editorial staff carefully read either the proposed standard or the primary standard it amends, FAS 5, Accounting for Contingencies, before composing its criticism. The WSJ editorial expressed concern, for example, that companies must set about calculating the fair value of uncertain contingencies, when actually the proposed standard imposes no new measurement requirements (measurement of historic costs under FAS 5 still applies) and the words “fair value” are no where in its text.

Separate from the proposed standard, it is FAS 141R, Business Combinations (Revised), that does require measurement of loss contingencies at fair value. FAS 141R pertains to the surviving entity in mergers and acquisitions, applies only to their acquired properties, and, as planned for the proposed standard, is effective beginning in 2009. It is FAS 141R, not the proposed standard, that requires measurement of those loss contingencies at fair value. What the proposed standard requires is that companies expand the information they disclose about those loss contingencies.

The WSJ editorial also asserted that under the current system (of FAS 5 requirements), a company discloses the potential cost of a contingency, such as a lawsuit, “only when the [company] believes it is ‘probable’” to result in a liability. (WSJ, 2008) In fact, under FAS 5, a company must disclose an estimated loss if a liability is at least reasonably possible, not just probable, or state that such an estimate cannot be made.

There clearly is some distress and uncertainty about the proposed standard’s requirements for loss contingency disclosure. Uncertainty appears to extend, as well, to correct application of the existing standard FAS 5.

[For more information, see Raymond Rose's "Expanded Disclosure Distress and Two Classes of Loss Contingencies," Environmental Claims Journal, Corporate Environmental Disclosure Column, Vol. 20, Issue 4, Oct-Dec 2008.]

Expanded disclosure distress

There is the view that many, if not most, public companies disclose in their financial statements fewer loss contingencies than exist and lower loss contingency costs than are realistic, including for environmental loss contingencies. Investors holding this view contend this under-representation of loss contingencies leaves them unable to evaluate company liabilities sufficiently. FASB, acknowledging this view, has proposed a new standard on disclosure of loss contingencies for companies to implement beginning in 2009.

The new, proposed standard is FASB’s Disclosure of Certain Loss Contingencies, released on June 5, 2008, as an exposure draft, File Reference No. 1600-100. It amends the loss contingency disclosure requirements of FAS 5 and 141R. FASB has scheduled it to be effective for annual financial statements issued for fiscal years ending after December 15, 2008, and for interim and annual periods in subsequent years. This would be beginning in calendar year 2009 for most companies. Under the proposed standard, companies must expand disclosure about their loss contingencies beyond what has been sufficient under FAS 5.

Detractors contend that developing the expanded information will add to the compliance burden that companies already face. They also contend that companies will be vulnerable to subjective and risky judgments they must make about their loss contingencies in order to meet the proposed standard’s information requirements, vulnerable because such judgments can prove wrong.

In fact, for prior compliance with FAS 5, companies already have made their loss contingency determinations. Under the proposed standard, they simply must disclose the basis on which they reached those conclusions. The proposed standard essentially moves information investors need about loss contingencies from company files into investor’s hands.

So, it is not necessarily true that companies will have additional information to develop. Nor is it necessarily the case they will become more vulnerable to the consequences of their judgments as a result of having to provide more information about those judgments.

Distress among companies about compliance with FASB’s proposed standard, as currently written, may derive, at least in part, from prior misapplication of FAS 5 disclosure requirements, wherein companies may have avoided identification of loss contingencies that already should have been indicated in financial statements. This would be consistent with the view that loss contingencies historically have been under-represented in number and estimated cost.

It could well mean that the proposed standard, if it proceeds to finalization, has the messy job—beyond its specific scope—of bringing companies into correct application of FAS 5 recognition and measurement requirements in addition to new implementation of this standard's disclosure requirements.

[For more information, see Raymond Rose's "Expanded Disclosure Distress and Two Classes of Loss Contingencies," Environmental Claims Journal, Corporate Environmental Disclosure Column, Vol. 20, Issue 4, Oct-Dec 2008.]

Two classes of loss contingencies

In implementing FASB's new standard FAS 141R, beginning in 2009, companies will apply requirements that differ from those of the older standard FAS 5 in recognizing and measuring loss contingencies, including environmental loss contingencies. Under FAS 141R, loss contingencies will be measured at acquisition-date fair value, for example, instead of historic value.

This new standard pertains only to a subset of companies, however, to the surviving entity in acquisitions and mergers, and applies only to their acquired properties, not to all the entity’s properties.

While FASB indicates it is proceeding slowly on the matter, it may well broaden its fair value measurement applications. Fair value measurement currently is required for asset retirement obligations and, with FAS 141R, extends to the loss contingencies of acquired properties. There is reason to believe it may be indicating the future for recognition and measurement of all loss contingencies.

Until that future, however, (acquiring) companies complying with FAS 141R will be creating for themselves a second class of loss contingencies. This will complicate their liability management for at least the near term. The newer class of loss contingencies under FAS 141R will have relatively greater liability value, which results from application of the more inclusive recognition criteria and the more realistic (fair value) measurement methods of FAS 141R as compared with those of FAS 5, used for the company’s older class of loss contingencies.

This second class of loss contingencies also will complicate investors, who must discern and evaluate companies that have two classes of loss contingencies and will have to compare them with most companies having one.

[For more information, see Raymond Rose's "Expanded Disclosure Distress and Two Classes of Loss Contingencies," Environmental Claims Journal, Corporate Environmental Disclosure Column, Vol. 20, Issue 4, Oct-Dec 2008.]

Fair value issues

On February 14, 2008, the SEC Advisory Committee on Improvements to Financial Reporting sent a Progress Report to Christopher Cox, SEC Chairman. I found particularly interesting in the report some comments the Committee made concerning fair value measurements.

The Committee indicated it might suggest that FASB be "judicious" (my emphasis) about expanding the application of fair value measurements. Keep in mind that FASB’s new FAS 157, Fair Value Measurements, is effective this calendar year (technically, for fiscal years after November 15, 2007), except for application to asset retirement obligations, which begins in calendar year 2009. Remember also that FASB put on its agenda in September 2007 a project to reconsider the valuation of loss contingencies. Keep mind, as well, that FASB’s new FAS 141R, Business Combinations, effective in calendar year 2009, requires that loss contingencies for mergers and acquisitions be measured at fair value. This is not how loss contingencies outside of mergers and acquisitions are measured under FAS 5, Accounting for Contingencies.

The Committee acknowledged that if fair value was the only measurement method used in financial reporting, then comparing and evaluating the data would be less complicated. That is, the requirement to employ a particular measurement method would eliminate the complexity of interpreting data from various measurement methods.

The Committee expressed concern, however, that fair value had its own complexities from issues of relevance and reliability. For example, it worried that values determined verifiably from historic cost could become less reliable when calculated using fair value procedures. It worried further that reliability could suffer from the lack of “generally accepted valuation standards” and from the use of valuation inputs “that vary from one company to the next.”

Most interestingly, perhaps, the Committee recognized the view that the burden of measurement complexity (if fair value was required for all measurements) would shift from investors to preparers and auditors. That is, the greater effort would be among preparers and auditors applying the fair value methodology, as compared with investors having an opportunity to interpret data from a single valuation method.

Well, I have to say, I think the right place for resolving complexities is in the preparation effort, not in the interpretation effort, i.e., with those reporting, not those interpreting the reports. I do not think the credibility of this Committee would be well-served by complaining otherwise.

Under 141R

What’s required for environmental disclosure under FAS 141R? This is the revised FASB statement that applies to “business combinations,” e.g., mergers and acquisitions, which is effective beginning December 15, 2008. (FASB prohibits early implementation.)

Here’s what FAS 141R requires in the initial disclosure that follows acquisition:

• Fair value amounts for environmental loss contingencies.
• Nature of the contingencies (both recognized and unrecognized contingencies).
• Range of outcomes (undiscounted) for the contingencies (recognized and unrecognized).

The acquirer has a “measurement period” of up to a year from the acquisition date to firm up its disclosure information. That is, the acquirer initially may report provisional amounts when information is incomplete. When the acquirer receives the information needed or learns it is not available, the measurement period is ended.

Here’s what FAS 141R requires in subsequent disclosure after the initial disclosure:

• Changes in recognized fair value amounts for the environmental loss contingencies.
• Changes in range of outcomes (undiscounted) for the contingencies (recognized and unrecognized).

The acquirer may obtain new information that could affect the value of its loss contingencies. It could be about when or how resolution of contingencies is expected, or about likelihood of being incurred as a liability, for example. The acquirer evaluates that information and reports whichever amount is higher, the loss contingency measured at fair value or as determined from application of FAS 5.

Yes, I agree that returning to use of FAS 5 for determining loss contingency amounts in subsequent reporting would seem a step backward after initial (and perhaps some subsequent) reporting using the process and rigor of fair value measurement. FASB’s explanation for this apparent “reversion” was that (1) non-acquiring companies still applied FAS 5 for loss contingencies and (2) FASB is underway with a larger effort in which it is reconsidering the best way to account for contingencies, having taken that as a project in September 2007.

Some expect at the conclusion of this effort that FASB will extend fair value measurement broadly to all loss contingencies formerly measured under FAS 5.

What must be dislosed?

As noted in the previous post, FAS 157 “expands disclosures [emphasis added] about fair value measurements.” So, what exactly must be disclosed under FAS 157 for environmental liabilities?

Here is what FAS 157 requires in disclosure for environmental liabilities such as asset retirement obligations, loss contingencies, and asset impairments—liabilities that are “measured at fair value on a nonrecurring basis” after initial recognition:

• Amount of the fair value measurement, in separate amounts for each major category, e.g., asset retirement obligations, loss contingencies, asset impairments.
• Reason for the measurement, e.g., asset retirement obligations under FAS 143 – FIN 47, contingent liabilities (e.g., loss contingencies) under FAS 141R.
• Level number for the measurement within the fair value hierarchy, which is expected to be Level 3 for environmental liabilities.
• Description of inputs and information used to develop inputs for the fair value measurement, e.g., labor, overhead, and equipment costs from similar work.
• Identification of valuation techniques used in the measurement, e.g., expected cash flows method and credit-adjusted risk-free discount rate for expected present value technique.

What confidence do we have that these disclosure requirements apply for those environmental liabilities? In the FASB staff position paper FSP FAS 157-2, FASB identifies asset retirement obligations as a nonrecurring nonfinancial liability. In paragraph A25 of FAS 157, FASB cites asset retirement obligations as an example of Level 3 in the fair value hierarchy. In paragraph 33 of FAS 157, FASB indicates impaired assets as an example of liabilities measured at fair value on a nonrecurring basis. FASB has loss contingencies set for measurement at fair value for mergers and acquisitions when FAS 141R becomes effective in 2009. [See the February 11, 2008 posting on "Planning for FAS 141R."] These give us a pretty good sense of how those types of environmental liabilities are viewed by FASB for fair value measurement and disclosure.

The previous post dealt with when the FAS 157 expanded disclosure is required.

When is it required?

FASB states in FAS 157, Fair Value Measurements, released in September 2006, that it “establishes a framework for measuring fair value…and expands disclosures [emphasis added] about fair value measurements.” When is this expanded disclosure required for environmental liabilities under FAS 157?

To answer, first we assemble some parts. Fair value measurements already are required for asset retirement obligations under FAS 143 and FIN 47. In 2009, fair value measurements will be required, as well, under FAS 141R for contingent liabilities, including loss contingencies, in mergers and acquisitions. Asset retirement obligations and loss contingencies are two main types of environmental liabilities for many companies.

FASB made FAS 157 effective for companies beginning this current year. It granted a one-year delay, however, for the application of FAS 157 to asset retirement obligations. This was to enable FASB “to consider the effect of various implementation issues,” according to proposed FASB staff position paper FSP FAS 157-b.

So, for asset retirement obligations and for loss contingencies associated with mergers and acquisitions, the “expanded disclosure” requirements of FAS 157 for fair value measurements apply beginning in 2009.

Specifically, they apply for financial statements for fiscal years beginning after November 15, 2008 for disclosure of asset retirement obligations. For disclosure of loss contingencies in mergers and acquisitions (business combinations) under FAS 141R, they apply when the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. FASB prohibits early application of FAS 141R.

Planning for FAS 141R

FASB issued FAS 141R in December 2007, and it will change significantly and soon how companies recognize and report contingent environmental liabilities from business combinations, e.g., from mergers and acquisitions. This change will become effective for most companies in calendar year 2009; specifically, for acquisition dates and the beginning of first annual reporting periods that occur on or after December 15, 2008. Companies should plan for this change. They no longer will be able to use FAS 5 criteria to recognize and report liabilities from business combinations, but instead will have to apply the new criteria of FAS 141R. It likely will result in the necessity for companies to determine and disclose substantially more contingent environmental liabilities and their costs than before.

Under FAS 5, disclosure is required for material contingent liabilities, including loss contingencies, that are probable and reasonably estimable, and disclosed costs are calculated at current value, i.e., normally without techniques involving expected cash flows or discounting. With FAS 141R comes the requirement to accrue and disclose all contingencies that arise from contracts, which are referred to as contractual contingencies. A contractual environmental contingency might result from a remediation consent decree signed with a regulatory authority or from an environmental indemnification agreement signed with a property purchaser, for example. Contractual liability costs will be determined and reported at fair value, which for liabilities like environmental contingencies are expected to require the application of expected cash flow techniques and discounting.

Perhaps more significantly, for all other contingencies, referred to as noncontractual contingencies, the criterion of “more likely than not” will be applied. That is, if it is more likely than not that a noncontractual contingency will give rise to a liability (as defined in FASB Concepts Statement 6, or CON 6), then it must be included among the liabilities recognized and reported at fair value. With a less stringent criterion for inclusion (i.e., a liability being more likely than not to result) and since consideration of uncertainty is enabled in expected cash flow techniques (being probability-weighted averages of possible cash flows) used in determining fair value, companies likely will have more contingencies to disclose in 2009 under FAS 141R than previously under FAS 5. There will be fewer opportunities for companies to avoid disclosure of environmental contingencies by claiming liabilities are “not probable” or costs are “not estimable,” which was possible under FAS 5.

Again, companies should be planning now for how FAS 141R significantly will change environmental disclosure for mergers and acquisitions.