The Greening of GAAP

On July 21, when New York State Attorney General Eliot Spitzer announced that eight states were filing a law suit against five utilities, Joe Buonaiuto, the senior vice president and controller of American Electric Power Co., was working on his company's 10-Q.

AEP was one of the five power companies named in the suit, which seeks to force the utilities to cut back on emissions of carbon dioxide, which many scientists believe contributes to global warming.

Two weeks later, when Buonaiuto and chief financial officer Susan Tomasky filed the company's quarterly report with the Securities and Exchange Commission, the lawsuit was disclosed in the document's "significant factors" section, and it will probably be included in the "management's discussion and analysis" section of the company's 10-K.

In general, says Buonaiuto, environmental factors are a key reporting focus for AEP, and the company strives for full and fair disclosure in that area. Indeed, AEP's 10-K lists pages of environmental regulations, policies, and other factors that could affect the utility's financial performance. The document also details past and current pollution-abatement costs, and it estimates future environmental liabilities — such as $1.2 billion in capital costs to comply with sulfur dioxide emissions regulations over the next two years, and $500 million to reduce nitrogen oxide emissions.

But not all companies are interpreting disclosure rules so conservatively. At least that's the contention of many socially responsible investors (SRIs), the institutional investors and mutual fund groups that screen their portfolio companies for several social and environmental criteria. Some SRIs claim that while many companies comply with the letter of SEC and accounting rules, they fail to embrace the spirit of the law in not providing a full picture of their future environmental liabilities.

The attempt by SRIs to focus more attention on such breaches of the legal spirit was bolstered in July, when the Government Accountability Office (formerly the Government Accounting Office) published a 75-page report on the state of corporate environmental disclosures. The study, which sparked partisan reactions from SRIs and corporate executives, didn't take sides. Rather, the GAO study crystallized the underlying debate, underscoring SEC deficiencies in collecting and monitoring corporate environmental disclosure data.

As a result, SRIs and other like-minded stakeholders are renewing their two-year-old call for changes in generally accepted accounting principles (GAAP). The changes would require companies to disclose detailed estimates of their contingent environmental liabilities, among other things.

Overwhelmed with Details
Indeed, the advocacy for that point of view has grown formidable. SRIs now represent $2.2 trillion worth of assets and account for one in every nine dollars under professional management in the United States, according to the Social Investment Forum, a Washington, D.C.-based nonprofit group that promotes socially responsible investing.

The targets of this investor ire are two venerable rules of the Financial Accounting Standards Board, FAS 5 (Accounting for Contingencies) and FIN 14 (Reasonable Estimation of Loss). SRIs see loopholes in the FASB standards that "allow companies to hide the financial significance of environmental problems," says Tim Little, executive director of the Rose Foundation for Communities and the Environment.

The disclosure issue is a "classic" rules-based versus principles-based accounting argument, according to Jay Hanson, national director of accounting for accountancy McGladrey & Pullen. Hanson posits that on one side, investors want more-precise guidelines to tighten the perceived loopholes in GAAP. On the other side, corporate finance managers seek flexibility in reporting material information, arguing that to provide much more would overwhelm shareholders with useless data.

To be sure, FAS 5 currently provides for a relatively flexible approach. The rule requires companies to disclose environmental contingencies if the liabilities are material to the financial condition of the company; companies must then accrue the estimated cost of the liabilities with a charge to income. But there are caveats. For instance, FASB requires corporations to accrue for the future liabilities only if the cost can be reasonably estimated and the liability is probable. In cases in which the liability is probable but cannot be estimated, the company needs to disclose only the nature of the liability.

FIN 14, however, pushed for more disclosure. It states that even if a company has only enough information to work up a range of estimates, it's required to disclose that range. Under FIN 14, corporate accountants must accrue either the best estimate in the range, or if that can't be determined, the minimum amount.

With that much flexibility, say experts, some companies chose to accrue as little as possible on the grounds that the minimum amount under FIN 14 was zero. In 1992, 15 years after FAS 5 was released, the SEC decided more guidance was needed and issued Staff Accounting Bulletin 92. The rule warned companies that the cost of environmental remediation was "unlikely" to be zero and that a "known minimum" estimate was required, but SAB 92 didn't make it illegal to report zero or a relatively low estimate.

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