In February 2016, Ceramic Crucibles of America was notified by the state of Colorado that the state was investigating the company's Durango facility to determine if there were any violations of federal or state environmental laws. In formulating your opinion on Ceramic Crucibles' 2015 financial statements, you determine that, based primarily on management's representations, the investigation did not pose a serious threat to the company's financial well-being.
The company subsequently retained a local law firm to represent it in dealing with the state commission. At the end of 2015, you concluded that the action did not represent a severe threat. However, it is now 2016 and you have just received the attorney's letter, which you find a little unsettling. It states:
On January 31, 2016, the U.S. Environmental Protection Agency (EPA) listed the Durango site in Durango, Colorado, on the National Priorities List under the Comprehensive Environmental Response, Compensation, and Liability Act (Superfund). The site includes property adjoining the western boundary of Ceramic Crucibles' plant in Durango and includes parts of Ceramic Crucibles' property. The EPA has listed Ceramic Crucibles as one of the three "potentially responsible parties" ("PRPs") that may be liable for the costs of investigating and cleaning up the site. The EPA has authorized $400,000 for a "Remedial Investigation and Feasibility Study" of the site, but that study will not begin until sometime later in 2016. Thus, we do not deem it possible or appropriate at this time to evaluate this matter with regard to potential liability or cost to the company.
You immediately set up a meeting with Dave Buff, Ceramic Crucibles' vice president;
Ron Bonner, the company's attorney; and Margaret Osmond, an attorney who specializes in EPA-related issues. At the meeting you ascertain that
∙ Ceramic Crucibles bought the Durango facility from TW Industries in 2005.
∙ TW Industries had operated the facility as a manufacturer of ceramic tiles, and it had used lead extensively in incorporating color into the tile.
∙ The site has been placed on the National Priorities List ("the List") apparently because each state must have at least one site on the List. All sites on the List are rated on a composite score that reflects the relative extent of pollution. The Durango site has a rating of 8.3 compared to a rating of no less than 25 for the other sites on the List.
∙ The most severe lead pollution (based on toxicity) is in an area located on the other side of a levee behind Ceramic Crucibles' facilities. Although the area close to the building contains traces of lead pollution, the toxicity in this area is about
50 parts per million (ppm), compared to 19,000 ppm beyond the levee.
∙ Although Ceramic Crucibles used lead in coloring its crucibles until about 2007, the lead was locked into a ceramic glaze that met FDA requirements for appliances used in the preparation of food. Apparently, the acids used in determining the leaching properties of lead for EPA tests are stronger than that used by the FDA. Since 2007, Ceramic Crucibles has used lead-free mud in its crucibles.
∙ Affidavits taken from present and former employees of Ceramic Crucibles indicate that no wastewater has been discharged though the levee since Ceramic Crucibles acquired the property in 2005.
∙ The other PRPs and TW Industries are viable companies that should be in a position to meet their responsibilities resulting from any possible EPA action.
Materiality for purposes of evaluating a potential loss is $10 million to $13 million.
This is based on the assumption that the loss would be deductible for income tax purposes. In that case, the loss would represent a reduction in stockholders' equity of 4.5 percent to 7.0 percent. Your best guess is that the company's exposure does not exceed that amount. Further, based on the financial strength of the company and its available lines of credit, you believe such an assessment would not result in financial distress to the company.
The creation of the Environmental Protection Agency (EPA) and that of the Comprehensive
Environmental Response, Compensation, and Liability Act is a result of the increasing concern of Americans about pollution. An amendment to the act permits the EPA to perform the cleanup. The EPA has a national priorities list of several thousand sites thought to be severely damaged. The average cost of conducting remedial investigation and feasibility studies ranges from $750,000 to over $1 million, and such studies may take as long as three years. Cleanup costs can often exceed $10 million to $12 million. It is said that the current estimates of $100 billion to clean up nonfederal hazardous waste sites may be conservative. The law requires the EPA to identify toxic waste sites and request records from PRPs. The PRPs are responsible for the cost of cleanup, but if they lack the funds, the EPA uses its funds for the cleanup. The EPA has spent $3.3 billion from its trust fund and collected only $65 million from polluters since the passage of the legislation.
Required:
a. How would this type of contingency be classified in the accounting literature, and how should it be accounted for?
b. Would the amount be material to the financial statements?
c. What additional evidence would you gather, and what kinds of representations should you require from the entity?
d. Should the investigation affect your opinion on those financial statements?