The following post is provided by our guest author, Graham Crockford from TRC Environmental Corporation. Graham can be reached at firstname.lastname@example.org.
Our firm is often retained to assist companies evaluate environmental risk/liabilities during acquisitions and divestitures. Whether a company is preparing to divest non-core assets, or preparing for a stock sale, contingent environmental liabilities are an element of prospective purchaser due diligence that will be scrutinized. Many corporate entities report these contingent liabilities as loss reserves on the balance sheet, and do so based upon a wide range of accounting methodologies and guidance. The reported reserves often meet the needs of stakeholders and auditors from a routine financial reporting perspective, but often provide limited comfort as they are shared with and evaluated by a prospective purchaser looking at contingencies from a buyer’s perspective. As published accounting standards and guidance change and adapt to market trends, look for contingent liability reporting obligations to continue to migrate towards a more transparent, life-cycle approach that mirrors fair-value principles.
Historical corporate disclosures for contingent environmental liabilities are deeply rooted in American Institute of Certified Public Accountants (AICPA) Statement of Position 96-1 (SOP 96-1). Referenced within that document, the older Financial Accounting Standards Board Financial Accounting Statement 5(FAS 5) requires that a loss contingency be accrued and that the nature of the contingency be described if (1) it is probable that a loss has been incurred, and (2) the amount of the loss can be reasonably estimated. FAS 5’s “probable and reasonably estimable” guidance has been the benchmark for reporting obligations for years, undoubtedly with a wide variety of interpretations on that standard. One commonality, however, that this standard produced was the practice of reporting at the best case estimate, or minimum value of the range. Replacing FAS 5, FASB Accounting Standards Codification Topic 450 (ASC 45) has built on the “probable and reasonably estimable” threshold, albeit at expanding the evaluation of “probable” into terms consistent with statistical likelihoods.
We have observed that regardless of the specific accounting methodology a company uses for environmental losses, chances are it is in stark contrast to how a buyer, specifically a private equity (PE) firm, will evaluate and recognize the potential for financial exposures from environmental risks. During a bid due diligence process, a PE buyer will want to know the full spectrum of risks, potential outcomes, and associated cost over the life-cycle of their investment. As such, potential buyers and their advisors will seek out information and ask questions to “snuff out” the details hidden behind a “best case” or minimum value estimate. PE investors evaluating a corporate target will look broadly within the portfolio to find other contingent liabilities that have not met the “probable and reasonably estimable” threshold, hence not accounted for by the company. Left unchecked, these issues can quickly be transformed into negotiated deal points. If the buyer relies on the seller’s information, the seller has set the stage for value discussions.
The Sarbanes Oxley Act may have added pressure to corporate reporting of liabilities, but it has not substantially created confidence in the reliability of disclosures. According to “Environmental Liabilities: Are Estimates Disclosed to the SEC Reliable?” (Advanced Environmental Dimensions, 2009), a study group of 24 industrial companies reported an average cash efficiency rate (dollar for dollar reduction on reserves based on cash payments) of -9%, and an average accrual rate of 25%, indicating a high rate of new accruals relative to existing reserves. These trends, although indicative of a small subset of U.S. industry, point to a systemic deficiency in liability disclosures relative to market value.
In 2008, Financial Accounting Standards Board Statement 141(R) “Business Combinations” [FAS 141(R)] became effective and was projected to make meaningful changes in how prospective purchasers account for environmental loss contingencies and liabilities of businesses targeted for purchase. FAS 141(R) paved the way for fair value accounting by stating a contingent liability must be recognized if it is more likely than not, as of the acquisition date, that the contingency gives rise to a legal obligation. Further, if an acquired contingent liability meets the recognition criteria, the amount recognized should be the Fair Value of the liability, with Fair Value defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (FAS 157).
While since retracted, FAS 141(R) reduced the measurement criterion from “probable” to “more likely than not” while adding valuation burden from “reasonably estimable” to a fair value measurement. The concept has since been codified in FASB Accounting Standards Codification (ASC) Topic 820 (Fair Value Measurement). Full life-cycle valuation of contingent liabilities is an emerging trend, one that PE firms leverage to their advantage in an acquisition process. If environmental liabilities become a focal point of the deal, the PE firm’s liability estimates can be a value-added proposition for the acquired entity post-acquisition, serving as a baseline to “re-set” the reserves going forward, given that they have already met the fair value criterion during the transaction.
In preparation for sale, many corporations conduct sell-side due diligence leading up to an auction or bid window. Discussions regarding reserves and exit planning should take place internally with in-house accounting and audit teams before approaching external advisors. However, if your team decides an independent, third party fair value analysis of contingent liabilities prepared in context with existing reserves is warranted, the resulting work may augment your disclosures and provide additional information as to how the loss reserve fits within the corporate strategic growth platform. When shared with prospective buyers, the analysis can temper objective questioning, and possibly quell negotiating leverage. Knowing the valuation perspective of your potential purchasing entities is a big part of the exit plan.