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.]

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.]

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.

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.

How is it disclosed?

As noted in the two previous posts, FAS 157 “expands disclosures [emphasis added] about fair value measurements.” In this post we describe how fair value information for environmental liabilities is disclosed under FAS 157?

Under FAS 157, a company makes such disclosure in financial statements for each annual and interim period after initial recognition. So, a company discloses fair value information about its environmental liabilities annually in its 10-K, quarterly in its 10-Q, and as needed in 8-K filings with the SEC.

The information required is the same in annual and interim reporting, with one exception. The previous day’s post on “What must be disclosed?” describes what's required. The exception is the identification of valuation techniques for the fair value measurements, which is necessary only in the annual report.

FAS 157 requires that all fair value quantitative information be presented in table format. As shown by example in paragraph A34 of FAS 157, FASB suggests that major categories (of assets or liabilities) be listed down in rows, with total amounts and amounts for each fair value hierarchy level shown in column entries. A company might display a single table with fair value information for its environmental liabilities.

In FAS 157, FASB encourages, but does not require, a company to present its fair value information combined, i.e., in one area of its financial statement. This would be all the fair value information, not just that for environmental liabilities. It would include fair value information from other pronouncements, in addition to FAS 157.

In the two previous posts, we described what must be disclosed and when disclosure is required under FAS 157.

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.