The American Institute of Certified Public Accountants ("AICPA") has issued Statement of Position 96-1, Environmental Remediation Liabilities ("SOP 96-1"). The AICPA perceives that there is a pervasive lack of understanding on the part of companies and their independent accountants concerning the magnitude of responsibility associated with environmental remediation. The AICPA justified the need for issuing SOP 96-1 on, among other things, a survey indicating that over half of the companies surveyed failed to properly give effect on their balance sheets to liabilities associated with environmental remediation responsibilities. SOP 96-1 provides 127 pages of background discussion and accounting advice designed to help companies give proper effect in their financial statements to their environmental remediation liabilities.

SOP 96-1 begins with 26 pages of non-authoritative background discussion of the underlying law that applies to environmental remediation. The discussion focuses primarily on federal law by summarizing the "Superfund" laws; the Comprehensive Environmental Response, Compensation and Liability Act; and the Resource Conservation and Recovery Act of 1976. While the discussion is brief, it provides a good overview for those who are unfamiliar with these laws. The portion of this background discussion that is likely to be deemed by most companies to be of greatest value is the description of the timing and procedures that underlie a typical mandated remediation effort.

Despite its length, the scope of accounting guidance offered by SOP 96-1 is relatively narrow. The guidance applies only to those costs incurred in connection with mandated remediations. Specifically excluded from coverage under SOP 96-1 are costs incurred in connection with any remediation effort that is undertaken on a purely voluntary basis. Also excluded from coverage is the proper accounting for costs incurred in connection with pollution prevention and control efforts. The accounting treatment required to be used by insurance companies in connection with their balance sheet presentations of obligations to pay costs incurred by their insureds is also excluded from coverage under SOP 96-1.

Also in striking contrast to its length, SOP 96-1 provides almost nothing in the form of newly mandated accounting treatment. Rather, it continues the AICPA’s tradition of providing guidance on how to apply the existing accounting literature. In this case, the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 5, Accounting for Contingencies, issued in 1975, ("SFAS 5") serves as the framework upon which the accounting treatment mandated by SOP 96-1 is built. SFAS 5 defines a "loss contingency" as an existing condition, situation or set of circumstances involving uncertainty as to possible loss or expense to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. SFAS 5 requires that an estimated loss or expense from a loss contingency shall be accrued by a charge to income if it is probable that an asset has been impaired, or a liability incurred, provided the amount of such asset impairment or liability incurrence can be reasonably estimated. If a loss is not probable or not estimable, then footnote disclosure of the contingency shall be made when there is at least a reasonable possibility that a loss may have been incurred, with an estimate of the possible loss or range of loss if it can be made.

SOP 96-1 provides guidance, in the form of a two prong test, to determine whether probable asset impairment or liability incurrence exists. The first prong of the test is met if litigation has commenced, a claim asserted or the commencement of either is probable. The second prong of the test is met if it is probable that the outcome of such litigation or claim would be unfavorable. This second prong of the test is presumptively met simply by showing that the company, whose financial statements are under consideration, is or was associated with the subject site. For these purposes, association consists of present or prior ownership or operation of a site, transportation of waste to the site or contribution of waste that is transported to the site by others.

The second prong of meeting the SFAS 5 criteria for mandatory accrual, an estimable amount of asset impairment or liability incurrence, is discussed at length. SOP 96-1 contains a reminder to companies that this prong is presumed to have been met even if only a range of loss can be reasonably estimated. SOP 96-1 provides a list of factors that can be applied in overcoming the difficulty of making these estimates. This appears to comprise the most substantive guidance offered in terms of inducing companies who have historically refrained from accruing a liability, based on the assertion that the amount of the accrual was not reasonably estimable, to accrue a liability in an amount that is at least equal to the lower end of a range of estimates.

The amount of liability accrued, and expense recognized, is required by SOP 96-1 to include the incremental direct remediation costs, including the compensation and benefits of employees involved in the remediation process as well as the legal costs incurred in connection with the environmental remediation efforts undertaken. The inclusion of legal costs is somewhat of a diversion from current practice since most companies account for these costs separately by expensing them as incurred under the theory that legal costs are, at most, only indirectly related to environmental remediation efforts. By requiring these costs to be included within the environmental accrual, SOP 96-1 serves to codify the belief by some that legal costs comprise an integral part of environmental remediation efforts.

Nonetheless, this codification might prove to have minimal impact on the amounts that companies actually accrue in connection with these legal costs. This is purely conjectural but can be supported by a brief analysis of the three general categories of legal costs typically incurred in connection with environmental remediation. The first category, determining the extent of remedial actions required and the type of remedial actions to be used, is likely to be the easiest category to estimate but also the category least susceptible to result in disproportionately high expenditures. The second and third categories, (i) allocation among potentially responsible parties and (ii) seeking recoveries from others, respectively, comprise the categories least susceptible to estimation in advance but are far more likely to be subject to disproportionately high amounts of expense incurrence. It can be assumed that the difficulty in estimating such amounts in advance will likely result in few companies being induced to accrue large liabilities in advance. This is because, to the extent companies are induced by SOP 96-1 to accrue any amounts for these costs in advance, they will, in all likelihood, accrue amounts representing the lower ends of the estimated ranges.

The balance sheet presentation generally required under SOP 96-1 is a "gross up" procedure meaning that amounts of liabilities typically cannot be netted against recoveries from third parties all within the same line item of the balance sheet. While such a netting approach is theoretically permissible, it will almost never be accomplished because of the fact that the preconditions for such treatment specified in SOP 96-1 will rarely, if ever, be met. Likewise, discounting of liabilities to reflect the lengthy period over which the accrued costs will actually be paid, while theoretically permissible, will rarely, if ever, be achievable because of the strict preconditions set forth in SOP 96-1 for such treatment.

The income statement presentation requirements set forth in SOP 96-1 will result in a continuation of the requirement to present these costs as a component of operating expenses, as opposed to extraordinary or non-operational. Most companies would have preferred a more lenient approach since there is universal preference to show costs of this type as far down on the income statement as is physically possible, under the theory that analysts typically assign less relevance or importance to costs such as extraordinary items and non-operational expenses because of how low they appear on the income statement. There is nothing about this aspect of SOP 96-1, however, that is particularly surprising, unique or unusual.

SOP 96-1 will be required to be given effect by companies in their audited balance sheets, income statements and footnote disclosures for fiscal years beginning after December 15, 1996. Prospective treatment is required. Retroactive restatement of prior periods is specifically prohibited. While neither the balance sheet nor income statement presentation requirements mandated by SOP 96-1 are particularly unique, SOP 96-1 does appear to represent a change in focus in how to properly assess the proper accounting for environmental remediation costs. Specifically, SOP 96-1 provides for greater emphasis on the legal aspects of remediation efforts by stressing the importance of carefully assessing the underlying law and the means of applying that law, including the administrative aspects of dealing with mandated remediation efforts, to each company’s unique facts and circumstances. It is probably safe to assume that this will result in lawyers becoming even more heavily involved in assisting companies in dealing with their environmental responsibilities.

While its mandated accounting treatment is not particularly revolutionary, SOP 96-1 is important and noteworthy for other reasons. It contains the most comprehensive guidance ever issued on the subject, following several earlier, more limited guidance offered by the Financial Accounting Standards Board’s Emerging Issues Task Force and the staff of the Securities and Exchange Commission. Having been subjected to the due process that accompanies the issuance of statements of this type, SOP 96-1 has earned a place for itself within the hierarchy of generally accepted accounting principles serving, in effect, to supersede the earlier guidance. By raising the profile of this issue, the AICPA might well succeed in reducing situations involving companies with financial statements showing liabilities that are understated and net incomes that are overstated all as a result of inattentiveness or unawareness of the law.