Overview

The accounting and auditing professions are presently tackling the major issue of how to classify environmental expenses and when to accrue any related liabilities. The Financial Accounting Standards Board's (FASB) Statement of Financial Accounting Standards (SFAS) No. 5, Accounting for Contingencies, provides the primary guidelines for both internal and external auditors to follow when determining the existence of contingent liabilities.

There are four potential areas for environmental liabilities to occur:

• Noncompliance with environmental codes,
• Cleanup costs,
• Physical damage or injury, and
• Third-party damages (e.g., when a contractor transports hazardous material from the organization's site and spills it on someone's property or collides into another vehicle).

The internal auditor must take an active role in this area to verify that the organization maintains the appropriate system of internal controls to capture sufficient, adequate, competent, relevant, reliable, and timely information to identify potential economic events which require an accrual and/or disclosure in the financial statements and related notes. Hence it is imperative for the auditor to verify that the EMS program specifically addresses the collection, identification, and classification of events which may have economic implications and should be reviewed accordingly by the appropriate financial and legal functions.

The organization's legal counsel will play a major role in the environmental liability accrual audit process. In addition, the organization's external auditor should also play a role, particularly if the company is regulated by the Securities & Exchange Commission (SEC). This type of audit requires an extensive knowledge of the extant environmental laws and regulations along with the relevant accounting and legal standards governing the organization. Thus, it is essential that the internal auditors determine their role within the EMS program and identify the appropriate skill set required to effectively execute their environmental auditing mission.

Objectives

The following two objectives should be achieved when conducting an environmental liability accrual audit:

• Verify that all contingent liabilities related to environmental noncompliance, remedial cleanup, or personal injury or damage have been identified and appropriately recorded and disclosed in financial statements.
• Verify the existence of management systems that identify, evaluate, report, and control events that result in potential contingent liabilities.