Lawyers issuing legal confirmation letters to their client’s auditor will have one more item to consider. No later than December 31, 2005, companies with future environmental cleanup obligations may (depending upon the practices previously adopted) face a major change. Because the new rule requires complex judgments and estimates, lawyers and their clients should start to address these matters now.
Future environmental costs generally need to be recorded earlier, even when the timing of such costs remains uncertain. Currently, some entities recognize these future obligations only when the timing of an asset retirement is well-known, or when the asset is actually retired. The new pronouncement clarifies that these costs must be recognized as a liability as soon as a reasonable measurement can be made. This is true even if there are no plans to implement decisions (such as a retirement, sale, construction, or redevelopment of the asset) that would trigger such costs.
Before the change, companies were not required to recognize these future clean-up obligations as a liability on their balance sheet. Companies and their auditors took the position that the uncertain timing meant that a reasonable cost estimate was not possible. As a result, many of these obligations were not included on the balance sheet. The new pronouncement states that this rationale is inappropriate, even if management can delay those events, or does not know when the events will occur. Now, these obligations must be recorded, with probabilities being used to estimate the uncertainty.
For example, a telecommunications company might use wood poles treated with chemicals that have specified disposal requirements once the poles are removed from the ground. There is no obligation to remove the poles at any time. However, the company has experience (or can get information) about the replacement frequency for the poles. To use the words of the pronouncement:
“The entity has information to estimate a range of potential settlement dates, the potential methods of settlement, and the probabilities associated with the potential settlement dates and methods …[and] is able to estimate the fair value of the liability for the required disposal procedures using an expected value technique.”
Properly estimating the liability is best done with a multidisciplinary team of legal, environmental, and accounting expertise. Employing such a team is likely to provide much better measurement and disclosure, and helps avoid the “Don’t Ask/Don’t Tell” mentality that some companies employ in assessing environmental issues. The team should avoid temptations to:
- Delay quantification of liabilities based on the notion that insufficient information exists to make a reasonable measurement
- Use artificial time horizons or too large a discount rate to minimize the future cost
- Hide the issue in the footnotes, especially when the complete analysis is not put prominently in a single place
The underlying pronouncement is FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47). FIN 47 is an interpretation of Statement of Financial Accounting Standards No. 143, “Asset Retirement Obligations”. Both pronouncements are available at www.fasb.org.
A Lawyer’s Responsibility in These Matters
Lawyers become associated with these accounting decisions because of the standard language contained in legal confirmation letters with respect to “unasserted claims”. The American Bar Association approved policy, “Statement of Policy Regarding Lawyer’s Responses to Auditor’s Request for Information” describes a lawyer’s obligation to assist a client in assessing unasserted claims. The ABA statement includes:
(6) Lawyer’s Professional Responsibility. Independent of the scope of his response to the auditor’s request for information, the lawyer, depending upon the nature of the matters as to which he is engaged, may have as part of his professional responsibility to his client an obligation to advise the client concerning the need for or advisability of public disclosure of a wide range of events and circumstances. The lawyer has an obligation not knowingly to participate in any violation by the client of the disclosure requirements of the securities laws. In appropriate circumstances, the lawyer also may be required under the Code of Professional Responsibility to resign his engagement if his advice concerning disclosures is disregarded by the client. The auditor may properly assume that whenever, in the course of performing legal services for the client with respect to a matter recognized to involve an unasserted possible claim or assessment which may call for financial statement disclosure, the lawyer has formed a professional conclusion that the client must disclose or consider disclosure concerning such possible claim or assessment, the lawyer, as a matter of professional responsibility to the client, will so advise the client and will consult with the client concerning the question of such disclosure …”
Lawyers confirm this obligation to the auditors by including the following boilerplate language towards the end of the legal confirmation letter:
“Consistent with the last sentence of Paragraph 6 of the ABA Statement of Policy and pursuant to the Company’s request, this will confirm as correct the Company’s understanding as set forth in its audit inquiry letter to us that whenever, in the course of performing legal services for the Company with respect to a matter recognized to involve an unasserted possible claim or assessment that may call for financial statement disclosure, we have formed a professional conclusion that the Company must disclose or consider disclosure concerning such possible claim or assessment, we, as a matter of professional responsibility to the Company, will so advise the Company and will consult with the Company concerning the question of such disclosure and the applicable requirements of Statement of Financial Accounting Standards No. 5.”
As noted at the beginning of this article, this new rule requires complex judgments and estimates. Lawyers and their clients should start to address these matters now.