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.]

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.]

Reviewing FIN 47

Let’s review what is required for environmental disclosure under FIN 47, recognizing that FAS 157 has “expanded disclosure” requirements for asset retirement obligations beginning in 2009. This step is part of determining what additional work is needed to implement FAS 157.

It’s both FIN 47 and FAS 143, which preceded the release of FIN 47, that already apply for fair value disclosure of material, estimable asset retirement obligations. Here’s what FAS 143 requires:

• Description of asset retirement obligations and the assets to which they apply.
• Fair value amount for assets subject to the asset retirement obligations.
• Reconciliation, whenever there is significant change, of beginning and ending amounts for asset retirement obligations (in aggregate) for the current year, showing separately changes that result from (1) liabilities incurred, (2) liabilities settled, (3) accretion expense, and (4) revisions in estimated cash.

Here’s what is additionally required under FIN 47 in the year a company adopts FIN 47, which for some companies would have been 2005.

• Accounting charge (or beneficial amount) for adopting FIN 47, which is the difference in net income before and after applying FIN 47.
• Fair value amount for asset retirement obligations, reported as both (1) the value at the beginning of the earliest year of asset retirement obligations and (2) the value at the end of the adoption year, adjusted for accretion.

In a subsequent posting, these disclosure requirements for FIN 47 and FAS 143 will be compared with those of FAS 157 so we can identify the additional work needed to meet the new requirements that apply to environmental disclosure.

Hard to say

FASB has required fair value measurement and disclosure of asset retirement obligations since 2005. Actually longer, since FAS 143, Accounting for Asset Retirement Obligations, released in June 2001, has been effective for financial statements for fiscal years beginning after June 15, 2002.

It was FASB’s interpretation of FAS 143 for application to conditional asset retirement obligations, in its release of FIN 47 in March 2005, effective for fiscal years ending after December 15, 2005, that seems to have set the most-referenced requirement date for disclosure of asset retirement obligations. Rather like there could be no more good excuses for non-disclosure after FIN 47.

It is hard to say how much disclosure of companies’ asset retirement obligations has taken place. In an often-cited study following up the first fiscal year of FIN 47 applicability, the Controllers’ Leadership Roundtable reported there was “great disparity,” including among similar companies, in how companies responded to FIN 47.

Somewhat obliquely, I would contend, the study cited accounting charges taken by companies for “truing-up” the cost of asset retirement obligations. [See the January 31, 2007 posting.] Those were one-time charges.

I would say they (the reviewers of the disclosure information) missed an opportunity to report asset retirement obligation costs themselves for that first year of FIN 47 applicability, i.e., to provide a benchmark. It is those costs that companies must continue to disclose after 2005.

No hands are tied, so to speak, including those of this writer, with regards to reviewing and reporting the asset retirement obligation costs disclosed for that first year, i.e., for composing a benchmark. The information is public.

Next year, i.e., for 2009, companies also will have the requirements of FAS 157 to instruct their development and disclosure of fair value measurements.

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.

Opportunity for confusion

Under FAS 143 – FIN 47, a company must accrue and report estimable, material asset retirement obligations at fair value, effective for fiscal years ending after December 15, 2005, e.g., for calendar year 2005 and thereafter. As noted in the previous post, some companies have proceeded with FIN 47 implementation and others have not.

With FASB’s release in September 2006 of FAS 157, however, which instructs on fair value measurements, comes an opportunity for confusion. FAS 157 was scheduled to be effective for fiscal years beginning after November 15, 2007, which for many companies means beginning in calendar year 2008. Responding to petitions to go slower and “to consider the effect of various implementation issues,” FASB announced in a news release on November 14, 2007 that it was granting a one-year deferral of the effective date for FAS 157 for certain applications. This deferral applies to “asset retirement obligations initially measured at fair value under FASB Statement No. 143,” as itemized in the proposed FASB staff position (FSP) paper FSP FAS 157-b.

A company reasonably may be confused about when it is late in disclosing asset retirement obligations. Prior to the release of FAS 157, it was clear that a company with estimable, material asset retirement obligations was late if it had not disclosed already. Now with the one-year deferral of FAS 157 for certain applications that include asset retirement obligations, is it possible that a company is not necessarily late yet? Does it have until the fiscal year beginning after November 15, 2008 for the disclosure, which for many companies means calendar year 2009?

It is more likely, instead, that companies have until the fiscal year beginning after November 15, 2008 to upgrade fair value measurement information on their asset retirement obligations under FIN 47 to the "expanded disclosure" required under FAS 157.