The Greening of GAAP

Are corporations being forthright about their environmental liabilities?

On July 21, when New York State Attorney General Eliot Spitzer announced that eight states were filing a law suit against five utilities, Joe Buonaiuto, the senior vice president and controller of American Electric Power Co., was working on his company’s 10-Q.

AEP was one of the five power companies named in the suit, which seeks to force the utilities to cut back on emissions of carbon dioxide, which many scientists believe contributes to global warming.

Two weeks later, when Buonaiuto and chief financial officer Susan Tomasky filed the company’s quarterly report with the Securities and Exchange Commission, the lawsuit was disclosed in the document’s “significant factors” section, and it will probably be included in the “management’s discussion and analysis” section of the company’s 10-K.

In general, says Buonaiuto, environmental factors are a key reporting focus for AEP, and the company strives for full and fair disclosure in that area. Indeed, AEP’s 10-K lists pages of environmental regulations, policies, and other factors that could affect the utility’s financial performance. The document also details past and current pollution-abatement costs, and it estimates future environmental liabilities — such as $1.2 billion in capital costs to comply with sulfur dioxide emissions regulations over the next two years, and $500 million to reduce nitrogen oxide emissions.

But not all companies are interpreting disclosure rules so conservatively. At least that’s the contention of many socially responsible investors (SRIs), the institutional investors and mutual fund groups that screen their portfolio companies for several social and environmental criteria. Some SRIs claim that while many companies comply with the letter of SEC and accounting rules, they fail to embrace the spirit of the law in not providing a full picture of their future environmental liabilities.

The attempt by SRIs to focus more attention on such breaches of the legal spirit was bolstered in July, when the Government Accountability Office (formerly the Government Accounting Office) published a 75-page report on the state of corporate environmental disclosures. The study, which sparked partisan reactions from SRIs and corporate executives, didn’t take sides. Rather, the GAO study crystallized the underlying debate, underscoring SEC deficiencies in collecting and monitoring corporate environmental disclosure data.

As a result, SRIs and other like-minded stakeholders are renewing their two-year-old call for changes in generally accepted accounting principles (GAAP). The changes would require companies to disclose detailed estimates of their contingent environmental liabilities, among other things.

Overwhelmed with Details

Indeed, the advocacy for that point of view has grown formidable. SRIs now represent $2.2 trillion worth of assets and account for one in every nine dollars under professional management in the United States, according to the Social Investment Forum, a Washington, D.C.-based nonprofit group that promotes socially responsible investing.

The targets of this investor ire are two venerable rules of the Financial Accounting Standards Board, FAS 5 (Accounting for Contingencies) and FIN 14 (Reasonable Estimation of Loss). SRIs see loopholes in the FASB standards that “allow companies to hide the financial significance of environmental problems,” says Tim Little, executive director of the Rose Foundation for Communities and the Environment.

The disclosure issue is a “classic” rules-based versus principles-based accounting argument, according to Jay Hanson, national director of accounting for accountancy McGladrey & Pullen. Hanson posits that on one side, investors want more-precise guidelines to tighten the perceived loopholes in GAAP. On the other side, corporate finance managers seek flexibility in reporting material information, arguing that to provide much more would overwhelm shareholders with useless data.

To be sure, FAS 5 currently provides for a relatively flexible approach. The rule requires companies to disclose environmental contingencies if the liabilities are material to the financial condition of the company; companies must then accrue the estimated cost of the liabilities with a charge to income. But there are caveats. For instance, FASB requires corporations to accrue for the future liabilities only if the cost can be reasonably estimated and the liability is probable. In cases in which the liability is probable but cannot be estimated, the company needs to disclose only the nature of the liability.

FIN 14, however, pushed for more disclosure. It states that even if a company has only enough information to work up a range of estimates, it’s required to disclose that range. Under FIN 14, corporate accountants must accrue either the best estimate in the range, or if that can’t be determined, the minimum amount.

With that much flexibility, say experts, some companies chose to accrue as little as possible on the grounds that the minimum amount under FIN 14 was zero. In 1992, 15 years after FAS 5 was released, the SEC decided more guidance was needed and issued Staff Accounting Bulletin 92. The rule warned companies that the cost of environmental remediation was “unlikely” to be zero and that a “known minimum” estimate was required, but SAB 92 didn’t make it illegal to report zero or a relatively low estimate.

Accordingly, says Little, companies continued to report lowball estimates. Among other studies, he points to a warning that the SEC’s Division of Corporate Finance aimed at Fortune 500 companies. In December 2001, in the wake of the Enron scandal, the commission cautioned a number of oil, gas, mining, and manufacturing companies to properly disclosing environmental and product liabilities. The SEC didn’t name the companies or provide a count, only stating that “many companies did not provide adequate disclosure” and that “companies could improve their disclosures required by SAB 92.”

Possible Patches

In August 2002, the Rose Foundation — backed by SRI funds representing more than $1 trillion in assets — petitioned the SEC to adopt rules based on two voluntary best-practice standards proposed by the American Society of Testing and Materials (ASTM). The foundation hoped to tighten — if not altogether close — what it considered to be loopholes in FAS 5, FIN 14, and SAB 92 and to stop companies from wriggling out of detailed disclosure.

One of the two guidelines, ASTM standard E 2137-0 (Standard Guide for Estimating Monetary Costs and Liabilities for Environmental Matters) is a blueprint for using an expected-value methodology to calculate cost estimates of environmental liabilities. Essentially, it’s a weighted-average calculation that takes into consideration both the likelihood of a remediation scenario and its cost.

The second, ASTM standard E 2173-0 (Standard Guide for Disclosure of Environmental Liabilities) assumes that users of financial statements would benefit if potential liabilities were expressed in the aggregate because the total would likely be considered material and therefore subject to disclosure rules. None of the GAAP or SEC regulations require that companies aggregate environmental liabilities. But under the ASTM standard, asserts Little, companies would no longer be able to segregate the cost of single-site cleanups into nonmaterial chunks that could be hidden from investors.

The idea that the SEC might adopt anything like these standards has been unpopular with corporate finance departments. A day before the GAO released its study, a 30-company coalition called the Corporate Environmental Enforcement Council issued a comment letter to the SEC outlining its opposition to the Rose Foundation’s petition. The council contended, for example, that the petition’s call for aggregate disclosures does not ensure that the information would adequately reflect the company’s financial condition to investors.

Estimating the potential cleanup costs of 50 or 100 corporate sites (a typical number for a large company) would compound inaccurate guesses and render the information “useless to investors,” asserts Ken Meade, an attorney who represents the CEEC.

CEEC companies — which include Alcoa Inc., Coors Brewing Co., General Electric Co., Halliburton Co., and Proctor & Gamble — promote the idea of full disclosure. Company executives, however, believe that the SEC already has adequate tools to enforce environmental liability disclosures. Meade says that the CEEC takes a “don’t fix what’s not broken” attitude, and he maintains that the petition’s rule changes would impose a one-size-fits-all prescriptive framework on SEC rules.

Other experts argue that aggregating individual-site estimates would inaccurately balloon potential liability costs. That’s particularly true in the case of estimating pending lawsuit damages, says senior bond analyst Phil Adams of Gimme Credit Research, since the legal outcomes of future damage claims can be highly uncertain. A company should mention the court case in filings but not gauge the cost of the settlement, he argues.

Further, it’s unreasonable to expect executives to act against their companies’ interests by disclosing a potential outcome of litigation, especially when the policy and politics affecting the outcome are moving targets, he adds. Adams reckons that there’s no way to assigning worth to lawsuit damages before a case is settled, and in the long run “it’s probably only worth a basis point or two on the spread, so there’s nothing actionable for investors to do.”

The CEEC comment letter also highlights a more fundamental argument. The group claims that the Rose Foundation petition “has more to do with driving environmental performance of public companies” than ensuring that investors have accurate and complete information.

Steve Lippman, a senior research analyst with Trillium Asset Management Corp. (whose Website describes the company as a “leader in socially responsible investing”), disputes the CEEC’s claim. Lippman says the idea that “investors who care about environmental issues can’t care about the investment is a specious argument,” particularly when it refers to a very small part of a broader push by investors to unearth more material information.

Lippman doesn’t see a difference between general liability disclosures that require a “fair representation” of a risk and environmental disclosures. “The fact that a risk affects the environment does not mean that the impact is less real,” he says.

The Rising

AEP’s Buonaiuto also favors a straightforward approach to disclosures. The finance executive says that claiming that information is too abundant or complicated to present to investors is no reason to omit information from filings. “It’s incumbent upon the corporation to find a way to disclose complex information in a meaningful way,” contends Buonaiuto.

At the same time, Buonaiuto doesn’t think the FASB or SEC rules need clarification. Rather, he thinks companies can bridge the disclosure gap by thoroughly grasping their own environmental liabilities, then judiciously applying the appropriate accounting rules.

McGladrey & Pullen’s Hanson says the challenge is to strike a balance in the 10-K between too much and too little information about a company’s pollution exposures. He explains that if financial statements are weighted down with frivolous information, the document becomes incomprehensible and irrelevant. Yet if you ask a user of financial statements what they would want to give up, “they invariably say, nothing.”

Hanson, however, shuns the notion of bright-line environmental accounting rules. He likes to cite advice given to him by SEC staffers: a two-page, forthright, numerically uncluttered explanation of a complex issue is worth more than 25 pages of meaningless facts and figures.

In light of the Sarbanes-Oxley Act’s apparent mandates of transparency and fair representation in financial reporting, it would seem that the Rose Foundation petition might have garnered a mainstream following. That hasn’t happened yet. The issue “has yet to generate a groundswell of support,” notes Doug Cogan, deputy director of social issues at the Investor Responsibility Research Council, one of the 30 experts the GAO polled for its study.

However, Cogan sees some headway being made. For instance, sell-side analysts who traditionally have paid little attention to potential environmental liabilities — with the exception of the long-term effects of asbestos litigation — are putting pollution disclosures on their priority list. Recently, officials from 11 international brokerage houses, including Goldman Sachs, ABN AMRO Equities, Deutsche Bank, HSBC, Nikko-Citigroup Japan, and WestLB, noted that their sell-side analysts consider “social, environmental, and corporate governance issues … relevant to long-term shareholder value.”

What’s more, on Capitol Hill, senators Jon Corzine (D-N.J.), John McCain (R-Ariz.) Joe Lieberman (D-Conn.), and other lawmakers held a reception for the GAO report at a symposium called “Coming Clean: Corporate Disclosure of Environmental Issues in Financial Statements,” which gave a platform to the SEC, the Environmental Protection Agency, the Rose Foundation, and SRIs.

Gimme Credit’s Adams says disclosures related to environmental liabilities have always been important to credit analysts, but he stresses that such information is meaningful to him only insofar as it records the liabilities’ effects on future free cash flow. As a result, “speculative numbers [such as overblown aggregate estimates] do nothing but make 10-Ks weigh more.” Adams, who covers the utility sector, also maintains that he’s always found that 10-Ks provide enough information for his analysis.

No Way of Knowing

During their research for the GAO’s July report on the state of corporate environmental disclosure, agency staffers examined 27 studies released since 1998 and seriously considered the findings of 15. Perhaps most startling was a 1998 EPA report, which revealed that 75 percent of publicly traded companies that had incurred environmental fines of $100,000 or more failed to properly disclose them. Omitting such fines from SEC filings is a violation of one of the few bright-line materiality guidelines provided by the commission.

In this year’s report, the GAO concluded that the low level of many corporate disclosures was inadequate to determine if the disclosures were, in fact, adequate. A low level of disclosure, noted the agency, could mean one of three things: that a company has no environmental liabilities, that the costs are immaterial, or that the company is hiding information from investors.

The GAO proposed that the SEC create a searchable database of comment letters and company responses (a Website was launched in August); that SEC and EPA staffers work more closely, for example, by matching up EPA data on site-specific violations with the SEC database of parent companies; and that the SEC replace its current paper-based system of company-review memos with an electronic system.

Not groundbreaking proposals — and moving no faster, it seems, than a glacial pace. Indeed, notes the Rose Foundation’s Little, the SEC staff has its hands full with Sarbanes-Oxley enforcement, so the commission has yet to establish a timetable for assessing the foundation’s own proposal that it adopt the ASTM standards — although “they are receptive to hearing comments.” Another drag on the process, says McGladrey & Pullen’s Hanson, is that new Sarbanes burdens have sent corporations “hunting for experienced accounting talent,” so even though the SEC has the budget to hire more accountants, the market is dry.

Nonetheless, says Cogan at the Investor Responsibility Research Council, the stage seems set for SRIs and general investors to turn up the pressure on corporations to disclose their pollution liabilities in greater detail. For both types of investors, he asserts, a robust disclosure policy related to environmental liabilities “is a proxy for good management.”

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