Decision Analysis to Estimate Cleanup Value Under FASB 141-R

The following is excerpted from an article titled, "Accounting Changes For Contingent Losses: An Environmental Perspective" by J.D. Kern and Marc Faecher of TRC Companies, Inc. that appears in the October 2008 issue of The Metropolitan Corporate Counsel:

There is much recent controversy over the proposed changes to Financial Accounting Standards Board (FASB) 5 (Accounting for Contingent Losses) and FASB 141-R (Business Combinations [such as M&A transactions and asset sales]) that has resulted in a battle, pitting companies that must report financial results versus their shareholders, potential investors and stakeholders. The controversy surrounds a proposed increase in disclosure requirements in the context of litigation and how transparent financial reporting may adversely impact the outcome of that litigation. Nowhere is evidence of this struggle better highlighted than in the reporting of environmental liabilities that are often variable, difficult to quantify and subject to varying interpretation.

Of particular interest is FASB 141-R (Accounting Rules for Mergers and Acquisitions) that is already promulgated and becomes effective as part of GAAP for contingent (e.g., environmental) liabilities on November 15, 2008. This standard replaces the "probable and reasonably estimable" criteria under FAS 5 with more stringent standards that require fair value recognition of all contingencies that "more likely than not" give rise to a liability as of the date of the business combination transaction. In simplest terms, this change in GAAP is likely to result in more recognized liabilities and higher estimates/values than ever before. The following recognition and valuation criteria under FASB 141-R as contrasted to FASB 5/AICPA SOP 96-1 follow below:

Valuation Criteria
FASB 5/AICPA SOP 96-1 (Lower Cleanup Values Reported): Cleanup obligations were typically valued at "best estimate" - the one amount within a range that is better than any other (See "most likely value" in ASTM 2137). However, when no amount within range is better than any other, FIN 14 allows the use of a minimum amount, thus creating a "loophole" for companies to underaccrue. Cutting the other direction (towards larger accruals), time value of money discounting is not allowed unless timing and amount of payment are "fixed and determinable."

Compared To:

FASB 141-R (Higher Cleanup Values Reported): Cleanup obligations are to be reported at "market-based" fair value. FASB 157 provides details on the fair value methodology. In general, the most reliable estimate of fair value is measured by the value that a third party would place on the assumption of the cleanup obligation in an arms-length transaction. The lowest acceptable level of fair value measurement is that derived from an expected value analysis (probabilistic methodology using decision tree analysis and Monte Carlo Simulation) that considers better and worst cases in addition to the most likely case to establish a more realistic value for the cleanup obligation and in essence assigns a probability-weighted value based on a range of values. This valuation methodology considers all "life-cycle" costs to mitigate a cleanup obligation such as: overhead, vendor profit and market risk premium.

The recognition and valuation requirements of FASB 141-R are going to result in new and more extensive due diligence requirements, development of new valuation models and practices, training of due diligence teams and valuation experts.

Read the full article here.

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