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Environmental Accounting and Reporting 101
by Charles J. Coate
University of Kansas
Karen J. Frey
Gettysburg College
and
Nikkie S. Sakuvich
Spring, Corporate Audit Services
Introduction
Accountant's eye shades may soon be turning from money green to environmental green. Why? Because environmental accounting and reporting are of increasing importance for businesses. Environmental accounting deals with recognizing and disclosing a company's environmental costs and liabilities in financial reports. Because the concepts are relatively new, environmental accounting may not be covered in the text or even listed in the index of your favorite accounting book. However, some more recent textbooks (Wallace, p. 954; Horngren, et. al, p. 435) contain a paragraph or two on the issue, and professional and academic journals are more commonly addressing the subject. As environmental issues and their related costs grow in dollar size and in public awareness, accounting professionals must be prepared to incorporate their impact into financial decisions and reports.
Environmental expenses have been estimated to be between two and five percent of the gross national product (GNP). Legal and regulatory requirements imposed on environmental wrongdoers formally drive these expenditures. However, consumers are more frequently considering a company's environmental responsibility in deciding whether to purchase its products or services. Hence, good business practice can require that firms abide by "socially imposed regulations" as well. Environmental responsibility, then, may not only protect the firm from a variety of charges from government agencies, but also enhance its reputation in the community.
Yet, even as businesses become more aware of environmental liabilities, they are often uncertain how to account for them. Surveys by Price Waterhouse revealed that, at one time, most respondents with known exposure to environmental liabilities were reluctant or slow to record them in the financial statements. As late as 1990, only a small minority of firms had policies to address environmental issues. More recently, the trend has been to increasing disclosures and/or recording of environmental liabilities. By 1995, most companies had developed formal statements of environmental policies.
Federal Environmental Acts and Environmental Audits
Environmental costs and liabilities are primarily driven by increasing federal regulation and enforcement. Federal environmental acts establish requirements for remediation, abatement, and prevention of hazardous waste sites. The three major acts are:
- The Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA). Better known as Superfund, this act requires potentially responsible parties (PRPs) to incur costs for remediation. The EPA identifies PRPs as firms with operations involving hazardous waste and site contamination.
- The Resource Conservation and Recovery Act of 1976 (RCRA) is concerned with preventing events that could lead to contamination and result in the need for future site cleanups. It establishes responsibility for the monitoring, transportation, treatment, storage, and disposal of hazardous wastes.
- The Clean Air Act Amendments of 1990 (CAAA) attempt to reduce pollution by requiring public utilities to restrict the amount of sulfur dioxide and nitrogen oxides that their generating units may emit.
Violation of these statutes can result insignificant fines, remediation costs, or even imprisonment. The EPA, through the Department of Justice, charges 5 to 10 engineers and business people per week with criminal violations of environmental regulations. Liability for environmental wrongdoing is strict, joint and several, and retroactive. Furthermore, lack of knowledge is not a defense and negligence may result in imprisonment. thus, companies need to be particularly careful when dealing with environmental laws.
As with legal liabilities, accountants must rely on the work and opinions of experts in other fields to determine the impact of environmental issues. Firms may undergo an environmental audit to determine the legislation applicable to the firm, to assess the compliance of the firm with the legislation, and to assist in estimating environmental liabilities.
A team of internal and external experts, including environmental engineers and legal counsel, performs the audit. The team reports findings to company management by issuing a formal environmental audit report. Where appropriate, this report includes recommendations for attaining regulatory compliance and improving environmental cost efficiency.
Recording Environmental Liabilities
Although accounting for environmental exposure is one of the six issues considered tremendously important to the SEC, no environmental-specific GAAP has yet been issued. Accountants rely on existing GAAP (FASB #5, FIN #14) to account for environmental issues. Consequently, there is an increasing need for accountants to be familiar with the substance of and potential financial treatment of environmental liabilities and costs.
Currently, the major financial accounting issue in environmental accounting is estimating and recording environmental liabilities in the financial statements. Treating environmental costs as loss contingencies is most common in practice. FASB #5 provides guidance in defining and determining how to report loss contingencies, and FIN #14 provides guidance in estimating them. FASB #5 defines a loss contingency as:
An existing condition, situation or set of circumstances involving uncertainty as to possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur.
Environmental liabilities often fit this description. The possibility of a company's noncompliance with environmental regulations is the "uncertain condition." The "future event" that resolves his uncertain condition is the declaration by regulatory agencies that the company is or is not liable to pay damages for harming the environment.
To test your readiness for the world of environmental accounting, try the short quiz below. These questions represent the types of challenges accountants routinely face as new GAAP emerge.
Quiz.
In questions 1-3, suggest the appropriate accounting treatment for each of the situations. In questions 4 and 5, provide a short answer. You have one professional career to complete this quiz.
Question 1: Suppose a pharmaceutical company is concerned that its disposal of hazardous waste may not be in compliance with recent environmental regulations, and hires a consulting team to perform an environmental audit. The team assesses the likelihood that the firm will be liable for cleanup costs as probable. The team's report further reveals that:
-The average cost for similar cleanups is unknown.
-The lowest cost estimate for this cleanup is $1 million.
-The most this cleanup will cost is $10 million.
-Evolving technology may reduce the cost of this cleanup to $500,000.
Question 2: Suppose, in contrast to question 1, the firm must decontaminate land rather than waste materials. Ten years prior to the environmental regulation requiring the cleanup, the land was purchased for $4,000,000. Current market value in the absence of any environmental liabilities is $7,000,000.
Question 3: Now suppose a firm purchases two similar tracts of land. Tract A is pollution-free and the firm pays $7,000,000. Tract B is purchased with pre-existing pollution (i.e., the firm did not contribute to its hazardous nature) with an estimated $1,000,000 cleanup cost. The firm paid $6,000,000 got Trace B. The cleanup of Tract B has begun ($500,000 expenditure), but is not complete.
Question 4: Are timing issues important considerations in environmental accounting? Why?
Question 5: How do the established concepts of 1) subsequent events, 2) changes in accounting estimates, and 3) accounting errors relate to environmental accounting ?
Quiz Answers.
Question 1. FASB #5 requires the accrual of a loss contingency, because the likelihood of loss is probable and the amount of the loss is estimable. FIN #14 requires that the minimum be accrued, when the reasonable estimate of a loss is a range, and no amount within the range is a better estimate than another. Thus, the firm should record a $1 million environmental liability and expense on the balance sheet and income statement, respectively: Notes to the financial statements must disclose the nature and amount of the potential liability.
Question 2. Questions like these must be carefully considered in the absence of environmental-specific GAAP. (Translation, there may be no right answer). Nonetheless, here are some questions to consider in formulating an "answer." Should the association of the environmental expenditure with site contamination rather than waste disposal change the accounting treatment? Specifically, since the contamination can now be associated with a particular asset, should the book value of the land be reduced? If setting up a contra asset account is an appropriate treatment, should cleanup expenditures be taken against this contra account? If the liability is greater than the book value of the land, should the land be presented as a liability?
Question 3. The value of Tract B is greatly increased by the cleanup. Should both tracts be recorded at cost? And if so, should the cleanup expenditures increase the land's book value (similar to capitalizing capital improvements)? If the firm, unaware of the pollution, purchased Tract B for $7,000,000, how should the environmental cleanup be recorded when discovered?
Question 4. Yes. Because . . . well . . .er . . I think you get the idea. But, think about the following. Consider that environmental cleanup may involve contaminated materials accumulated over the past three years, while the relevant environmental regulation became effective in the current year. The question arises whether the environmental expenses should be recognized in the period the regulation becomes effective, or during the period of physical contamination; that is, whether the expense should be recorded in the current period or in past periods. Or, if a new environmental regulation is to become effective next year, are there circumstances when environmental expenses should be recorded in the current year?
Environmental cleanup technology provides another twist to the timing issue. Suppose the firm has a $l,000,000 environmental liability accrued from the prior year. In the current year, prior to cleanup, new technology becomes available and the actual cleanup cost is $500,000. In what period should the reduction be recorded?
Question 5. You're on your own here. It's time to go out into the "real world."
Managerial Accounting and Auditing Concerns.
The impact of environmental issues on accounting professionals is not limited to financial reporting. It affects managerial accounting, environmental costs must be recognized, measured, and included in product costs and firm decisions. Practitioner journals are already responding to this need (Kreuze & Newell, 1994; Brooks, et. al, 1993). In auditing, environmental issues present substantial challenges. Not only muse auditors attest to the fairness and appropriateness of recorded environmental issues, but they must be aware of possible unrecorded environmental liabilities.
Conclusion
Environmental issues have increased in importance in past decades. That this trend promises to continue is reflected in the increasing financial attention firms are giving to these issues. Thus, accountants need to be aware of environmental issues and to consider their influence upon both internal and external reporting.
The evolution of the appropriate financial treatment (GAAP) for these issues will provide challenges to accounting professionals. This evolution is interesting both for its own sake and also for the perspective it provides on other emerging GAAP issues.
Bibliography
Anonymous. 1995. Price Waterhouse Study Focuses on Environmental Practices. Environmental Manager 10 (May): 11-12.
Brooks, P.L., L.J. Davidson and J. H. Palamides. 1993. Environmental Compliance: You Better Know Your ABCs. Occupational Hazards (February): 41-46.
FASB Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies," 1975, par. 1.
Horngren, C.T., G. Foster and S. M. Datar. 1994. Cost Accounting : A Managerial Emphasis. Prentice-Hall.
Kreuze, J. and G. Newell. 1994. ABC and Life Cycle Costing for Environmental Expenditures. Management Accounting (February): 38-42.
Wallace, W. A. 1995. Auditing (Third Edition). SouthWestern College Publishing.
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