New Accounting Standards May Encourage Companies To Sell Contaminated Real Estate
New accounting standards issued by the Financial Accounting Standards Board (“FASB”) may provide companies with a new incentive to sell environmentally contaminated properties they have been holding for years. During the past few decades, many companies have decided to close and “mothball” but not sell industrial facilities that have been contaminated by the release of hazardous substances. Sometimes that decision is made because of uncertainties related to the cost and timing of cleanup activities that might be required if the contamination is confirmed during an environmental due diligence investigation of the property.
Traditionally, companies were not required to report environmental liabilities, such as contaminated soil on a property or asbestos-containing materials in a building, unless there was some pending or threatened litigation regarding the property. That was supposed to change in 2002 when the Board issued FASB Statement No. 143. It provides that an entity is required to recognize the “fair value” of a liability for an “asset retirement obligation” in the period in which the obligation is first incurred if a reasonable estimate of fair value can be made.
FASB Statement No. 143 defines the term “retirement” to include sale, abandonment, recycling or disposal in some other manner. It also provides that: (i) if sufficient information is not available at the time the liability is first incurred, the liability must be recognized as soon as sufficient information becomes available to estimate its fair value; and (ii) if a liability’s fair value cannot be reasonably estimated, that fact and the reasons for it must be disclosed in the company’s financial statements.
In recognition that not all companies were interpreting Statement No. 143 in the same way, the Board issued FASB Interpretation No. 47 in March 2005. It explains that when an existing law, regulation, or contract requires an entity to perform an asset retirement activity, the unambiguous requirement to perform the retirement activity becomes an “asset retirement obligation” even if that activity can be deferred indefinitely. In such a case, the only remaining question is whether the obligation is reasonably capable of estimation.
To help answer that question, FASB Interpretation No. 47 provides that an “asset retirement obligation” is reasonably capable of estimation when: (a) it is evident that the fair value of the obligation is embodied in the acquisition price of the asset, (b) an active market exists for the transfer of the obligation, or (c) sufficient information exists to apply an “expected present value technique” for the obligation.
An entity has sufficient information to apply an “expected present value technique” if either of the following conditions exists: (a) the settlement date and method of settlement for the obligation have been specified by others - such as by a law, regulation or contract; or (b) information is available to reasonably estimate (1) the settlement date or range of potential settlement dates; (2) the method of settlement or potential methods of settlement; and (3) the probabilities associated with the potential settlement dates and methods of settlement.
The combined effect of FASB Statement No. 143 and Interpretation No. 47 will be that companies can no longer continue to own and show the depreciated value of environmentally contaminated properties as long-term assets on their balance sheets without either showing the corresponding liabilities for the expected cost of retiring those assets, or explaining why the fair value of those liabilities cannot be reasonably estimated.
Because many companies may not want to disclose significant environmental liabilities associated with sites that are no longer producing income, companies have an incentive to sell those sites to remove them and their associated retirement obligation liabilities from the company’s financial statements.