In 2006, the Financial Accounting Standards Board released Statement 157 on Fair Value Measurement. This standard applies not just to assets, but to environmental liabilities as well. One new obligation is that environmental remediation liabilities (covered under FASB 5) and asset retirement obligations (FASB 143) now need to contain a company’s self-assessment of their own creditworthiness.

In other words, a company needs to state its environmental liabilities and then discount that liability if there is doubt that it will actually pay them.

Dun & Bradstreet notes that the general default rate for US companies is about 1.4% a year. This isn’t a “bankruptcy rate”, but will be a proxy for our example. During good times, with a growing client base and ample credit, a company may determine its own chances of filing bankruptcy at <1%. During a recession, after losing key clients and credit facilities, it may determine that there is a 10% or 15% chance of filing bankruptcy.

Under FASB 157, an environmental liability of $10 million would still be about $10 million in good times, but when a company decides it is less creditworthy, it should revalue the liabilities to $9 million or less. By changing the self-assessment of bankruptcy from 1% to 10%, the income statement shows a liability write-down of $1 million; in other words, a paper profit. If you see this in an income statement, stay on your toes. It’s a deadbeat dividend.

Think about that moment, when a company decides it is time to confront its credit condition, it cuts environmental liabilities because the “ability to pay” is diminishing, and the reward is… a book profit.

Fast forward two years, the same company survives, and the ability to pay improves. The reward is… a book loss for marking the liability up to the full, original value.

Environmental liabilities are never going to be simple again.