SOX and Environmental Reporting

The EPA reports that companies, governments and other entities, are required to spend a record $10 billion to come into compliance with environmental laws as a result of enforcement actions in 2005. A record 627 entities voluntarily disclosed violations and more than 600,000 businesses and individuals received EPA assistance in understanding and complying with environmental laws. Despite this, environmental liabilities, even SuperFund liabilities, may be significantly under-reported, representing a significant risk for CEOs, CFOs and other members of management who are required by the Sarbanes Oxley Act (SOX) to certify the accuracy and completeness of financial statements.

SOX does not directly address environmental reporting. Neither does the Financial Accounting Standards Board (FASB) Statement No. 5, Accounting For Contingencies, which went into effect for fiscal years beginning after July 1, 1975, and presents the greatest potential risk to companies and management under-reporting environmental liabilities because it requires the accrual of liabilities if the liability was incurred prior to the date of the financial statements or the amount of the liability can be reasonably estimated. Statement of Position (SOP) 96-1, Environmental Remediation Liabilities, is among the only accounting guidance available on environmental accounting standards and reporting, however, it focuses on SuperFund sites and federal liability, while most environmental cleanup enforcement occurs on the state level.

According to an article published by Joseph Berlin and Stephen Goldberg in the July/August 2005 issue of the Journal of Corporate Accounting and Finance., the potential risk of under-reporting at the federal level, and misinterpreting of SOP 96-1 as applying only to actions directed by an agency, is significant because some type of reasonable environmental cost estimates (ECE) can be made for almost any site. The steps given by Berlin and Goldberg for preparing an ECE are:

  1. Evaluate any existing ECE, including any notes, reports or correspondence.
  2. Gather data regarding environmental status including compliance reports, hydrological studies, corrective action plans, closure reports, contractual obligations for sold or purchased property, unreported environmental obligations, agency correspondence and changes in environmental regulations affecting operations.
  3. Develop or update the ECE.
  4. Assess the ECE relative to materiality, the materiality threshold identified by the Security and Exchange Commission (SEC) is 10 percent, however, according to guidance from the American Society for Testing and Materials (ASTM) “a material item is one in which its omission or misstatement is of such magnitude that in the judgment of a reasonable person, it would mean significantly altering the information.
  5. Provide the assessment to CFO/auditors.

Berlin and Goldberg also identify the common reasons ECEs are underestimated as:

  • Using minimum cost and present ECE as expected value.
  • Artificially limiting the planning horizon
  • Excluding the impact of new legislation
  • Not notifying agencies
  • Keeping corrective action in interim mode
  • Artificially minimizing information to keep from reasonably estimating
  • As previously noted, ECEs can be made for most sites. For optimum accuracy, Berlin and Goldberg recommend that an independent engineer, outside the company’s usual chain of command, prepare the ECE and materiality be determined using the expected value method. Auditors and management should carefully scrutinize financials and require documentation of the organization’s environmental status in order to reduce the risk of being caught by SOX or the EPA.

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