Due diligence: changes to us accounting standards

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Courtesy of WSP | Parsons Brinckerhoff

Recent changes in US accounting standards are profoundly affecting environmental due diligence requirements. The new standards require that broader assumptions be incorporated into the valuation of environmental liabilities and could change many corporations’ approach to environmental due diligence.

Existing standards
The prior standards only required environmental liabilities to be accounted for based on what could be reasonably estimated and were deemed probable to occur. Thus, in most instances, corporations were able to base financial statements on liability estimates that were on the low-end of a probable range of outcomes, assuming a liability could even be possible to estimate (referred to as “estimable”). These prior requirements applied to both existing liabilities and those that were assumed following a merger or acquisition.

New standards
The revised guidance requires a new approach to evaluating environmental liabilities following a corporatetransaction, but not liabilities associated with existing properties, claims, or contractual obligations.

This new statement requires that “fair value” principles be used to estimate environmental liabilities instead of
the prior probable and reasonably estimable approach.

Defining ‘fair value’
In corporate accounting terminology, the fair value is the value that the liability would be traded for in a market situation. For remediation liabilities, the fair market value of an environmental liability can be thought of in terms of what it would cost to transfer the liability to a third party in a liability buyout scenario. For other non-cleanup liabilities, such as third party property damages, including diminution in property value due to the presence of contamination, or bodily injury, the liability can be thought of in terms of a settlement, if one can be predicted, or the cost of an insurance policy.

The fair value definition presumes that every liability can be transferred at a price that is acceptable to the general markets. Most environmental professionals would quickly agree that establishing a market value for environmental liabilities, particularly those that are not well characterized, is a difficult undertaking. However, the application of the new accounting guidance requires that a best estimate be made and included as a liability in financial statements if the acquirer determines

whether the liability must be estimated based on whether it is “more likely than not” an expense will be incurred related to the liability. Thus, in situations, where a potential environmental condition may not be known, such as the case of historical facilities without any investigation data or other evidence of contamination, there may not be a need to speculate about the presence of contamination.

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