August 22, 2017
Valuing environmental liabilities (ELs) and asset retirement obligations (AROs) is a highly judgmental and nuanced process. It can be quite complex, partly due to the inherent complexity of environmental reporting and partly due to accounting standards that are open to interpretation. In addition, the SEC is paying close attention to companies’ disclosures and filings which adds considerable pressure to getting it right.
There are two lenses through which to view these valuations: one is through the lens of normal financial reporting and one is through the lens of an acquisition. For the latter, it is extremely important to do your due diligence to thoroughly understand existing liabilities and account for any unknown/unrecognized ELs/AROs you’ll be acquiring as part of a deal.
Because properly estimating these liabilities can raise complex financial reporting and engineering issues, we want to highlight five key considerations to keep in mind when valuing an ARO/EL:
- Estimates are inherently judgmental – There is a lot of uncertainty when valuing a liability because it’s difficult to determine what remedial work and costs are truly probable, and what is a reasonable estimate of costs to be incurred in the future – sometimes far into the future! Management must determine what factors and assumptions to use based on available information for a specific site, future retirement obligation, experience with remediation of similar contaminants or retirement of similar assets, regulatory agency preferences and other uncertainties.
- Everybody’s got an opinion – Accountants, engineers, and attorneys may have different perspectives on these liabilities (e.g. strict legal liability, technical and operational, and financial reporting perspectives). Management must consider these different viewpoints accordingly and determine the appropriate valuation of the liability.
- The accounting framework matters – There are differences in accounting standards depending on whether you report under IFRS or US GAAP. The four main differences to consider are:
– IFRS does not distinguish between AROs/ELs, but US GAAP does
– Different recognition thresholds (“probable” vs “more likely than not”)
– Both require the best estimate but if a range exists – IFRS requires mid-point and US GAAP allows the low-end
– Different discounting criteria
- This could take a while, and it can change over time – When evaluating one of these liabilities, you’ll need to estimate when and how long it will take to extinguish the liability. The estimated duration may impact both the amounts used in financial reporting, as well as the all-in or “bookend” costs. Management must ensure it is factoring in all aspects of the liability and then determine the final costs, and also know that these costs may change over time as more information becomes available.
- Fair valuing is complex – When performing valuations for a transaction, the accounting guidance requires you to consider whether you can determine a fair value estimate for these obligations. For AROs that means assessing the inputs and assumptions to the cost estimate and ensuring they reflect the most current facts and circumstances. For ELs, companies should carefully consider their choice to fair value the contingency, especially in light of the complexities that will result in subsequent accounting.
Professionals can help guide you through the diligence and valuation process – ones who can bring clarity to complex regulations, understand and filter the legal, accounting and technical perspectives, help you reduce your financial reporting risks, and ultimately improve deal value. Check out our recent report for a deeper dive on evaluating environmental liabilities and their impacts on future earnings.