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By Gregory Bibler and Nathan Brodeur, Goodwin Procter LLP
In March 2005, the Financial Accounting Standards Board ("FASB") issued a new interpretation, FASB Interpretation No. 47 ("FIN 47"), clarifying when and how companies must estimate and recognize costs that they will incur in the future
when they retire fixed assets. Public companies were required to implement FIN 47 no later than the end of the fiscal year ending after December 15, 2005. From their financial reports, it is apparent that companies are applying FIN 47
differently.
To evaluate whether and how FIN 47 may apply to their operations, companies should start by asking four key questions:
Is there a current "legal obligation" that is "associated with retirement of a long-lived asset"?
Under FIN 47, a "legal obligation" is an obligation that an entity is required to settle as a result of a statute, contract, or other enforceable duty under the law. The legal obligation need not be one that must be carried out immediately
for FIN 47 to apply, but it must be binding on the entity. According to FIN 47, neither the ability to defer indefinitely the settlement of an asset retirement obligation, nor the ability to avoid it through sale of the asset, truly
relieves a company of the underlying retirement obligation. Therefore, it must be recognized.
FIN 47 applies to obligations assumed by contract, including, for example, the obligation to remove improvements and restore leased premises to their original condition. It also applies to statutory obligations, such as may arise in
jurisdictions with transfer acts, such as New Jersey and Connecticut, or in those with local laws imposing decommissioning requirements. In such jurisdictions, a company may have a present legal obligation to investigate, and potentially
to remediate, its facilities upon their closure or sale.
Did the obligation result from the "normal" operation of the asset?
FIN 47 applies to environmental remediation liabilities that result from the normal operation of a long-lived asset and are associated with the retirement of that asset. Liabilities caused by "improper" activities or "catastrophic" events
are not within its scope.
At what point contamination moves from "inherent in normal operation" to "caused by improper operation" is open to debate. FASB acknowledges, for example, that a certain amount of spillage may be inherent in the normal operations of a fuel
storage facility. Contamination that occurs gradually over time, is not identified with any specific incident or equipment failure, and is commonly encountered as a result of the same or similar operations, generally may be considered
"normal." By contrast, contamination that results from improper or prohibited conduct, can be traced to a specific historical event, or would require immediate response action when it occurs, may not be considered "normal."
Can the fair value of the obligation be estimated?
FIN 47 states that an asset retirement obligation is reasonably estimable if:
- the fair value of the obligation is embodied in the acquisition price of the asset;
- an active market exists for the transfer of the obligation; or
- sufficient information exists to apply an expected present value technique.
The first two approaches – deriving value directly from a negotiated acquisition price or indirectly by comparison to rates charged by insurers or others to transfer the risk – are based on market transactions and, as such, are preferred
but often unavailable. The third approach, using an expected present value technique, is more likely to apply. It is worth emphasizing that, as compared to the "probable" and "estimable" standard applicable to the recognition of contingent
liabilities under Financial Accounting Standards No. 5, the "expected present value" technique required by FIN 47 encourages quantification of uncertainties and alternative outcomes. By its nature, therefore, it is more likely to result in
accelerating recognition of liabilities for which some degree of forecasting is required.
If a company does determine that a fair value determination cannot be made, then the asset retirement obligation cannot be recognized. In that instance, however, FIN 47 requires disclosure in the company's financial statement that the
liability has not been recognized because fair value is not reasonably estimable, with an explanation supporting that conclusion.
Is the obligation material?
FIN 47 states, without further explanation, that it "need not be applied to immaterial items." Therefore, once an estimate of the fair value of an asset retirement obligation has been formulated, a company must determine whether the
obligation is "material." Perhaps the key point with respect to the materiality determination is that it should be the final, not the initial, step in a company's evaluation of its asset retirement obligations. Even if a company ultimately
concludes that its obligations are not material, it should be able to document the internal process for identifying and estimating asset retirement obligations that was followed and led to such conclusion.
Gregory Bibler
(email) is Chair of the Environmental Practice at
Goodwin Procter LLP, and Nathan Brodeur
(email) is a senior associate in that practice.
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