THE INTERNATIONAL CONFERENCE ON “Insurance Pollution Risks: Cover For
Personnel, Properties, Liabilities and Loss Prevention Techniques”
Emirates Insurance Association
In Conjunction With The United Nations System
Background
In the last thirty years, many governments and government jurisdictions started enacting legislation to protect the environment and to impose substantial penalties on violators. This legislation has affected many industries and changed the manner in which many organizations conduct their business.
Accounting and reporting for the environment has become increasingly relevant to business enterprises and not-for-profit entities. Investors, creditors, governments, and the public at large have become increasingly concerned about the impact of environmental risks on the financial health of business enterprises and not-for-profit entities. Many users of financial statements want to know the extent of a company’s environmental exposure and how the company is managing
its environmental costs and liabilities. For example, in the banking industry, concern for potential penalties to be paid by borrowers and the resulting impact on the borrowers’ ability to repay their loans led to the inclusion in numerous loan agreements of extensive environmental representations, warranties and indemnities. Real estate developers are also concerned with whether the projects they are considering are in areas where past activities have adversely affected the soil or groundwater. The possibility of becoming liable for environmental remediation costs associated with past waste disposal practices and past soil contamination has also become a very significant factor in the evaluation of candidate companies for mergers and acquisitions.
Environmental laws are generally of two types:
1. Those that impose requirements for remediation of environmental pollution arising from a past activity, and
2. Those that are in the nature of pollution prevention laws.
The accounting profession was slow to act on environmental issues at the beginning, but lately there has been increased awareness of the problems involved and the need to address them. The purpose of my paper is to discuss the accounting issues related to environmental risks and to review some of the most recent standard-setting efforts in this regard.
At the outset a definition of Environmental Accounting or Accounting for the Environment is in order. One of many definitions that may be used is that:
Environmental accounting is the understanding, recognition and incorporation of the impact of environmental issues upon a firm’s traditional accounting system.
There are also the issues of litigation and lawsuits brought against companies accused of polluting the environment. These issues may materially impact the financial statements and require recognition. The 1997 annual report of TEXACO included the following disclosures:
On December 28, 1992, an administrative complaint was served on TCC (Texaco Chemical Corporation) by the EPA (Environmental Protection Agency) alleging
hazardous waste, PCB, release notification and reporting violations at TCC’s Port Neches chemical plant. The EPA is seeking civil penalties of $3.8 million and corrective action.
The US Department of Justice has filed suit against Texaco Trading and Transportation, Inc. in connection with spills along pipelines in Kansas in 1991. The suit seeks civil penalties of approximately of $4.2 million and injunctive
relief.
The materiality of the above items suggests the need for specific accounting standards to deal with the disclosure and the accounting treatment of expenditures and potential liabilities emanating from environmental matters. The official standards that presently exist and that are relied on deal with the accounting for contingencies and the measurement of liabilities and were not promulgated with substantial environmental remediation and protection costs in mind.
Companies are reluctant to report costs and liabilities under existing standards because of alleged difficulties in determining what is an environmental cost and uncertainty about the size and timing of liabilities.
The Need for Better Internal Reports
The lack of proper internal reporting for environmental costs has also been pointed out. A study by the Tellus Institute and the US Institute of Management Accountants blames conventional accounting practices for not informing managers of the actual environmental cost implications of their decisions. They attribute this to the fact that many of the environmental costs are buried in the manufacturing overhead and are allocated to production without separate disclosure. More guidance is needed if disclosure is to improve.
One may argue that since many costs such as pension costs and employee benefits are included among the overhead, why should there be a special treatment for environmental costs. The answer to this is that:
( 1 ) Environmental costs are usually very large and are growing as in the examples that were cited.
(2) The inclusion of environmental costs as part of the general manufacturing overhead results in allocating to some products costs caused by other products, thus distorting product costing and the profitability of products.
(3) Environmental costs relate to numerous activities within an organization and may relate to production, waste disposal, maintenance, penalties and fines. These costs should not be hidden among the functional areas involved but need to be disclosed separately.
Some Organizations Involved with Environmental Accounting
One should not have the impression that no work is being done in the area of environmental accounting. As a matter of fact a lot of research has been done, a number of meetings were held, and a number of recommendations were presented. Many official parties were involved. To name just a few:
• In the UK, the Association of Chartered Certified Accountants (ACCA), the Chartered Institute of Management Accountants (CIMA), the Institute of Chartered Accountants of Scotland (ICAS), and the Institute of Chartered Accountants of England and Wales (ICAEW).
• In Canada, the Society of Management Accountants of Canada (SMAC), and the Canadian Institute of Chartered Accountants (CICA).
• In the USA, the Institute of Management Accountants (IMA), the American Institute of Certified Public Accountants (AICPA), and the Environmental Protection Agency (EPA).
• In France and other European countries, the Federation des Experts Comptables Europeans (FEE).
• In Australia, the Australian Society of CPAs and the Institute of Chartered Accountants in Australia.
• Globally, the International Federation of Accountants (IFAC).
• Last but not least, the United Nations through a number of committees and groups especially, the United Nations Conference on Trade and Development (UNCTAD) through its Intergovernmental Group of Experts on International Standards of Accounting and Reporting (ISAR).
I am pleased to report to you that the Arab Society of Certified Accountants (ASCA) is an active participant in the United Nations Intergovernmental Group of Experts on International Standards of Accounting and Reporting. Through a cooperation agreement among the International Trade Center UNCTAD/WTO (ITC) in Geneva, the Commonwealth Secretariat in London , Talal Abu-Ghazaleh International (TAGI) and the Arab Management Society (AMS) , an authorized Arabic edition of the Business Guide to the Uruguay Round was published. The guide is intended to serve as a basic reference for the business community on how to maximize benefits resulting from the Uruguay Round as well as meet the requirements of the new international trading systems. Moreover , it discusses the new international rules on trade in goods, trade in services , government procurement and state trading and trade-related aspects to intellectual property rights.
Allow me to cite a selection of activities that were accomplished in the area of accounting for environmental risks.
The World Commission on the Environment and its Impact
In 1987, the World Commission on Environment and Development that was appointed by the United Nations developed its Action Plan for sustainable development which was adopted at the United Nations Conference on Environment and Development that was held in Rio de Janeiro in 1992. Accounting for Sustainable Development is meant to link environmental, economic, and social aspects of corporate performance. The Action Plan challenged business organizations to recognize environmental management as among the highest of priorities and as a key determinant to sustainable development.
Following the Rio Summit, a number of studies and empirical analysis indicated that the challenge was being met by an increasing number of companies.
In a book under the title Accounting for the Environment by Gray, Bebbington and Walters published in 1993, the authors classified the incentives for businesses to adopt environmental policies into three groups:
(1) Direct Business Reasons. These include the long term survival of the companies, marketing and public relations opportunities, economic savings, and competitive advantage.
(2) Indirect Business Reasons. These include a fear of prosecution, a fear of exposure to public criticism, a fear of accidents, and the impact on staff motivation and morale.
(3) Personal and Social Reasons. These include community involvement, personal concern of the management and employees, the action of environmental groups, and the culture.
The above reasons are voluntary actions and exclude legal requirements.
Role of the American Institute of CPAs
In the United States, the closest to an official pronouncement on environmental accounting was the issuance in 1996 by the American Institute of CPAs of aStatement of Position on Environmental Remediation Liabilities. Although statements of position are not binding like the pronouncements of the Financial Accounting Standards Board (FASB), they represent considered opinions and guidelines to be used by the members of the AICPA.
The Statement of Position (SOP) builds on existing standards for the recognition of contingent liabilities on the balance sheet. The present standards require that a contingent loss be recognized as a liability when two conditions are present: (1)the loss is probable in occurrence, and (2) the amount of the loss is subject to measurement.
On the criterion of probability of occurrence, the SOP states that a remediation loss is probable if both of the following elements are met on or before the date of the balance sheet:
(1) If litigation, a claim, or an assessment has been asserted, or, based on available information, assertion of litigation, a claim, or an assessment is probable. In other words, if it has been asserted (or it is probable that it will be asserted) that an entity is responsible for participating in a remediation process because of a past event.
(2) If based on available information, it is probable that the outcome of such litigation, claim, or assessment will be unfavorable. In other words, an entity will be held responsible for participating in a remediation process because of a past event.
On the more difficult criterion of measuring or estimating a remediation loss, the SOP states that the recognition of a liability should not be precluded because of the fact that the components of the overall liability may not be reasonably estimated. The SOP identifies the following factors that are integral to developing cost estimates:
(1) The extent and types of hazardous substances at a site.
(2) The range of technologies that can be used for remediation.
(3) Evolving standards of what constitutes acceptable remediation.
(4) The number and financial condition of other potentially responsible parties (PRPs) and the extent of their responsibility for the remediation.
The SOP recommends that a liability for the best estimate or, if no best estimate is available, a liability in the minimum amount of the range of the expected loss should be recognized. Such an amount should be revised periodically and any change thereto should be accounted for as a change in an accounting estimate which requires absorption in the income statement.
In addition to dealing with the recognition of a contingent remediation loss, the SOPhas also dealt with the components of the loss. It classifies the loss components into incremental costs and costs to be allocated internally.
The incremental remediation costs include:
• Pre-cleanup activities, such as the performance of a remedial investigation, risk assessment, or feasibility study and the preparation of a remedial action plan.
• Operation and maintenance of the remedy, including post-remediation monitoring.
• Fees to outside law firms for work related to the remediation effort.
• Fees to outside engineering and consulting firms for site investigations and development of remedial action plans and remedial designs.
• Cost of contractors performing remedial actions.
• The cost of machinery and equipment that is dedicated to the remedial actions and that does not have an alternative use. The costs to be allocated internally include costs of compensation and benefits for employees to the extent employees are expected to devote time directly to the remediation effort. Internal costs also include the compensation and benefits of the legal staff devoted to this matter.
The inclusion of legal costs as part of the remediation efforts is at variance from the current generally accepted accounting treatment of legal costs. At this time, the costs of defending against lawsuits are not accrued for other kinds of liabilities such as product liabilities.
When several potentially responsible parties (PRPs) are involved in remedial efforts, the cost to be recognized by each entity should be based on its estimate of its allocable share of the joint and several remediation liability. This requires identifying the PRPs involved, assessing the likelihood that all PRPs will pay their share, and determining the percentage of the liability to be allocated to the entity.
For purposes of estimating an entity’s share of the cost, the SOP classifies PRPs into the following five categories:
(1) Participating PRPs. These are the ones who acknowledge their involvement.
(2) Recalcitrant PRPs. These adopt a defiant attitude towards the remediation effort despite evidence that points to theft involvement.
(3) Unproven PRPs. These are identified PRPs who do not acknowledge their involvement due to the lack of substantive evidence.
(4) Parties that have not yet been identified as PRPs. Once these are identified, they are classified as one of the three previous groups.
(5) Parties that are PRPs but cannot be located or have no assets. No contribution is expected from this group.
In estimating the share of an entity in the joint and several remediation liability, there should be the presumption that costs will be allocated among participating PRPs. Participating PRPs may reach an agreement among themselves or they may retain the services of an allocation consultant. Allocations may change over time in light of new evidence as it is discovered.
The SOP states that the measurement of the liability may be discounted to reflect the time value of money if the aggregate amount of the obligation and the amount and timing of cash payments are fixed or reasonably determinable. The SOP however did not recommend the discount rate to be used.
The SOP concludes by addressing issues related to the presentation of the financial statements and the proper footnote disclosures. The SOP made it clear that remediation losses should be charged to operations and that they do not qualify as extraordinary items in the income statement.
Role of the United Nations
The United Nations since the late 1980s and through various committees has done a lot of work related to environmental accounting issues. The Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting (ISAR) took up the topic of environmental accounting in 1989. In its first survey on the subject, ISAR discovered that there were no accounting standards specific to environmental issues. Some corporations believed that environmental information was not necessary for the fair presentation of financial statements whereas other corporations that were faced with sizeable environmental costs demanded guidelines to distinguish those costs and were measuring them at least for internal management purposes.
In 1991 ISAR formulated its first guidance on environmental disclosures in financial statements. This was followed by two comprehensive surveys in 1992 and in 1994 that revealed that disclosure of environmental information remained qualitative, descriptive, biased and difficult to compare.
The most comprehensive work came in a position paper adopted by ISAR in February 1998. The main chapter in the position paper entitled “Recommendations Adopted by the Intergovernmental Working Group of Experts on International Standards of Accounting and Reporting,” although not authoritative, provides guidelines for the best practice in accounting for environmental transactions and events. These recommendations are based on two reports submitted to the United Nations Conference on Trade and Development (UNCTAD). The first report entitled “Accounting and Reporting for Environmental Liabilities and Costs within the Existing Financial Reporting Framework” was prepared by Mr. David Moore, Director of Research Studies at the Canadian Institute of Chartered Accountants. The second report entitled “Linking Environmental and Financial Performance: A Survey of Best Practice Techniques” was prepared by Mr. Roger Adams, Head of Technical Services and Research at the Association of Chartered Certified Accountants in England.
The following are some of the basic recommendations of ISAR’s position paper:
1. Environmental costs should be charged to income in the period in which they are identified, unless they meet the criteria for recognition as an asset.
2. Environmental costs that relate to a prior period should not be treated as prior period adjustment unless there is a change in the accounting method used or there was an error in the application of sound principles.
3. Environmental costs should be capitalized if they meet the following conditions:
(a) They increase the capacity, or improve the safety or efficiency of other assets.
(b) They reduce or prevent environmental contamination.
(c) They conserve the environment.
4. Environmental liabilities should be recognized when there is an obligation on the part of the enterprise to incur an environmental cost. An obligation does not have to be legally enforceable for an environmental liability to be recognized. It could be a constructive obligation or even an equitable obligation. A constructive obligation is thus, ISAR has considerably widened the conflict of environmental liability.
5. When there is difficulty in estimating an environmental liability, the best possible estimate should be provided. In such an instance, the best estimate within the range should be provided. If it is not possible to arrive at a best estimate, the minimum estimate should be recognized. In the rare situation where an environmental liability can not be estimated, disclosure should be made of the existence of such a liability.
6. Expected recoveries from third parties should not be netted against environmental obligations. These items should be reported separately.
7. Disclosure should be made of the types of items that are identified as environmental costs.
With respect to the measurement of environmental liabilities that will be paid over a long period of time and that relate to future site restoration, closure, and removal of long-lived assets, ISAR proposed a number of approaches. These include:
(a) The “present value” approach which ISAR considers to be the preferred approach. Under this approach the liability is measured at the present value of the estimated future expenditures that will be needed. The discount rate to be used should be a risk-free rate such as the rate on government securities.
(b) The “current cost” approach which ISAR considers to be the acceptable alternative. Under this approach the liability should be measured at the estimated cost of performing the required activities in the current period. This approach is more reliable than the present value approach because of the absence of uncertainties about future costs.
(c) The “anticipated expenditures” approach which ISAR does not support. Under this approach, the anticipated expenditures over the life of the related operations is based on an estimate of the undiscounted cash outflows that will be required in the future rather than on the expenditures that would be currently required.
ISAR is hopeful that its recommendations will capture the attention of policy makers worldwide. It also hopes that its initiative will prompt the International Accounting Standards Committee (ISAC) to put with environmental issues on its agenda.
Due to the increasing need of environmental accounting as a cost accounting and liabilities system , the Arab Society of Certified Accountants (ASCA) in cooperation with UNEP and the Arab Academy for Science and Technology attached to the Arab League are preparing a workshop on environmental accounting to be held in December in Alexandria. ASCA is also working on issuing the UN paper on environmental accounting in Arabic which gives instructions on the best accounting practices.
The Role of the International Federation of Accountants
The International Federation of Accountants (IFAC) issued a number of publications on environmental matters. These include a discussion paper released in 1995 entitled “The Audit Profession and the Environment,” and more recently in March 1998 a discussion paper entitled “Environmental Management in Organizations.” Outside these publications, IFAC and its various committees have not issued standards that are specific to environmental matters.
Also in March 1998, IFAC’s International Auditing Practices Committee (LAPC) (ASCA is a member in its board of directors) has released an international Audit Practice Statement entitled “The Consideration of Environmental Matters in the Audit of Financial Statements.” This Statement does not establish any new basic auditing principles or essential procedures but its purpose is to assist auditors by providing guidance on the application of international accounting standards in cases where environmental matters are significant to the financial statements of an entity.
The Statement acknowledges the fact that an auditor is not necessarily an expert in environmental matters and recommends that when planning and performing audit procedures and in evaluating and reporting the results thereof, the auditor should recognize that noncompliance by the entity with environmental laws and regulations may materially affect the financial statements. In some cases, no specific audit procedures may be necessary. In other cases, the auditor is to use professional judgment to determine the nature, timing and extent of the specific procedures considered necessary in order to obtain sufficient appropriate audit evidence that the financial statements are not materially misstated. If the auditor does not have the professional competence to perform these procedures, the Statement recommends that technical advice be sought from specialists, such as lawyers, engineers, or other environmental experts.
The Statement reminds auditors of the responsibility of management to ensure that the entity’s operations are conducted in accordance with laws and regulations. As such, the auditor should obtain from management written representations on matters material to the financial statements when other sufficient appropriate audit evidence cannot reasonably be expected to exist. “The auditor may therefore wish to obtain specific representation that management:
(a) is not aware of any material liabilities or contingencies arising from environmental matters, including those resulting from illegal or possibly illegal acts;
(b) is not aware of any other environmental matters that may have a material impact on the financial statements; or
(c) if aware of such matters, has disclosed them properly in the financial statements.”
LAPC’s Statement provided a definition for the term “environmental matters.” Environmental matters are defined as:
(a) initiatives to prevent, abate, or remedy damage to the environment, or to deal with conservation of renewable and non-renewable resources (such initiatives may be required by environmental laws and regulations or by contract, or they may be undertaken voluntarily);
(b) consequences of violating environmental laws and regulations;
(c) consequences of environmental damage done to others or to natural resources;
and
d) consequences of vicarious liability imposed by law (for example, liability for damages caused by previous owners).”
Examples of environmental matters provided by the Statement include:
• The writing down of assets due to new environmental laws and regulations.
• Accrual of remediation, compensation or legal costs for failure to comply with legal requirements related to environmental matters.
• Costs incurred on environmental matters by companies in the extraction industries, chemical manufacturing, or waste management as a part of their regular business.
• Costs incurred on a voluntary basis to remedy contamination of land to protect the entity’s reputation and its relationship with the community.
The Role of Institute of Chartered Accountants in Australia
Recognizing the importance of environmental issues, the Institute of Chartered Accountants in Australia formed the Environmental Accounting Task Force (EATF) to consider the impact of environmental issues on businesses. In 1996 the EATF released a research paper entitled” Corporate Reporting- Green Gap” which showed that there is a demand for businesses to provide information on the environmental implications of their operations.
In January 1998, EATF released a discussion paper to explore the issues surrounding environmental performance evaluation, reporting and auditing, with a view of identifying the role the accountancy profession can play, and what guidance may usefully be provided to assist accountants in this important area.
Although Australia, like many other countries, has a large number of environmental protection laws and regulations, there are no general or specific accounting or auditing requirements that deal with environmental issues. Accounting and auditing practice in Australia relies on existing accounting standards for the recognition and reporting of liabilities.
Concluding Remarks
Many efforts have been exerted by several individuals and organizations on the subject of accounting for environmental risks. These efforts have taken us beyond the traditional methods of accounting for expenses and liabilities; some of these efforts have directly tackled issues relating to the components of environmental costs and expenses, their classification and treatment on the financial statements and also dealt with guidelines to be observed in recognizing and measuring the liabilities involved. The time has come now for the authoritative bodies like the International Accounting Standard Committee, the Financial Accounting Standards Board in the USA, the Institute of Chartered Accountants in Canada, and other officialaccounting bodies to issue authoritative pronouncements on the subject. The seriousness of environmental risks and the material impact of environmental costs and obligations on financial statements make it imperative for the accounting profession to act now. THE WORLD
CANNOT AFFORD TO WAIT.