Review of Accounting Studies, 2 38-64 (1997) (© 1997 Kluwer Academie Publishers, Hoston, Manufctaed in The Netherlands Factors Influencing Firms’ Disclosures about Environmental Liabilities Graduate School of Business, Stanford University, Stnfond. CA 94305 MAUREEN F MCNICHOLS Graduate School of Busnes, Sanford Universit, Stanford. CA 94305 Carol School of Management, Boston Coleg, Chesnut Hil, MA 02167 Abstract. This paperesamines factors related to eavironmental ibility disclosure decisions fr firms in industries ‘with substantial Superfund site involvement. We hypothesize that the extent of disclosure about environmental libilites is associated with ive factors: (1) regulation, including enforcement activity, (2) managements Infor mation, including ste uncertainty and allocation uncer, (3) ligation and novation concer, (2) capital market coaces, nd (5 oter regulatory influence. Our empirical tests examine the assotation between measures ‘of environmental libility disclosure, based on disclosures i rm annvalropors and Fors 10-K, and proxies forthe ive Factors, based on information fom other public soutes, including the EPA, We find that ll of oat hypothestved factors excep site unceriny significantly influence ‘This paper aims to identify factors that influence firms’ decisions to disclose information about environmental liabilities. These disclosure decisions are important to many firms in several industries. Estimates of the costs to clean up sites named by the Environmental Protection Agency (EPA) under the Comprehensive Environmental Response, Compensa- tion, and Liability Act of 1980 range from $500 to $750 billion, of which $150 billion relates to Superfund sites (Lavelle, 1992), the focus of our study. Barth and MeNichols (1994) report that 1,496 publicly traded firms in $7 two-digit SIC codes have been named as potentially responsible parties (PRPs) to clean up Superfund sites. Based on EPA data and various assumptions about the ways PRPs will ultimately share these liabilities, they estimate liabilities that average from 1 to 22 percent of the market value of equity. They also report that information about these potentially large liabilities often is not included in fim’s financial statements. We provide evidence on several factors hypothesized to be associated with firms’ decisions to disclose such information, ‘There is considerable room for judgment under Generally Accepted Accounting Principles (GAAP) regarding whether a firm discloses information about or accrues these liabilities. GAAP permits voluntary disclosure and specifies rather vague requirements for disclosure and accrual. Statement of Financial Accounting Standards (SEAS) No. 5 requires firms to ‘accrue material loss contingencies if they are probable and reasonably estimable, Although Barth and McNichols' (1994) estimates suggest that environmental liabilities often are36 MARY E. BARTH, MAUREEN F MCNICHOLS, AND G. PETER WILSON material, such liabilities generally are difficult to estimate, leaving managers considerable discretion in determining whether toaccrue them. Moreover, under Securities and Exchange Commission (SEC) disclosure requirements, accrued liabilities such as these need not be disclosed separately unless they exceed five percent of total liabilities. If the potential liabilities are not estimable or only reasonably possible, SEAS 5 requires disclosure rather than accrual. However, the level and content of such disclosures are not well-specified, again permitting managers considerable discretion in determining what information to disclose. In fact, the SEC has become increasingly concerned about the paucity of environmental liability disclosures, and increased its oversight ofthese disclosures over the 1991 to 1993 time period (Roberts, 1992), Disclosures about environmental liabilities provide a novel context for understanding the relative importance of several factors identified by prior research as influencing voluntary disclosure. We expect that managers weigh costs and benefits in exercising financial re- porting discretion, after taking regulatory requirements and the quality of their information into account. Prior research has identified several benefits and costs of disclosure that we investigate in the context of environmental liabilities. First, information about involvement in Superfund sites may jeopardize the firm’s litigation and negotiation positions with other PRPS and the EPA over its share of site investigation and remediation costs, Prior research hhas showa that disclosure of such proprietary information can be costly, leading to reduced disclosure, Second, firms may be concerned about capital market effects oftheir disclosures if they face potentially higher costs of capital for failing to disclose value-relevant informa tion. Third, firms in regulated industries such as utilities may have incentives to disclose more information about their expected remediation costs than other firms, to influence the rate-setting process. ‘We assess the extent to which these factors are related to firms’ decisions to disclose information about their potential environmental liabilities by estimating the association between environmental lability disclosure measures and proxies for regulatory influence, managements" information about Superfund site remediation costs and about the allocation of these costs across PRPS, litigation and negotiation concerns, capital market concerns, and other regulatory effects. Using data about firms’ Superfund liabilities obtained from the EPA. and firms’ disclosures in their annual reports and Forms 10-K, we develop proxies for these factors that incorporate the institutional features unique to environmental liabilities. These proxies should allow powerful tests of hypotheses about environmental disclosures. We find that all of our hypothesized factors except site uncertainty are significantly associated with firms’ environmental disclosure decisions. “The paper is organized as follows. Section 1 briefly describes the institutional features of environmental liabilities that likely affect firms’ disclosure decisions and Section 2 re- views related research on discretionary disclosure and environmental liabilities. Section 3 describes our research design, dependent and independent variables, and hypotheses. Sec tion 4 describes our data and section 5 presents our findings. Section 6 summarizes and concludes.FACTORS INFLUENCING FIRMS" DISCLOSURES ABOUT ENVIRONMENTAL LIABILITIES 37 Institutional Background Obligations for remediating environmentally impaired sites result from firms’ past actions and from regulators’ objective of reducing externalities associated with perceived environ- ‘mental abuse. The Environmental Protection Agency (RPA) meets this objective largely by assigning the responsibility to remediate (clean up) damaged sites and by prevention programs. Both remediation and prevention are associated with significant and controversial account ing issues involving recognition and disclosure. For remediation, the question is whether contingent liability should be accrued, and for prevention, whether related expenditures should be capitalized or expensed. We focus on the liability issue only and, in particular, (on a specific type of remediation, cleaning up Superfund hazardous waste sites. Superfund sites represent some of the largest remediation obligations of publicly traded corporations and are therefore of interest in their own right, Moreover, the related accrual and disclosure decisions are generally more complex than for other environmental obligations because of uncertainty about the costs to remediate a site, and uncertainty about each firm’s share of those costs. Our research design exploits two features of Superfund liabilities that are not applicable to other environmental liabilities: the availability of remediation cost estimates for Superfund sites from Records of Decision and allocation uncertainty arising from the joint and several liability feature of Superfund law." LL. Regulatory Environment ‘The EPA's authority to identify and remediate hazardous waste sites stems from the Com- prehensive Environmental Response and Liability Act of 1980 (CERCLA) and a major amendment to it in 1986, the Superfund Amendments and Reauthorization Act (SARA), CERCLA gives the EPA authority to identify hazardous waste sites and to designate as Superfund sites those with the most damage, to identify Potentially Responsible Parties (PRPs) at all hazardous waste sites, including Superfund sites, to negotiate settlements, to ‘order PRPs to remediate sites, and to sue PRPS to recover costs incurred by the Superfund ‘Trust? The EPA has the authority to cast abroad net in naming firms as PRPS, including the current owner, those who owned or operated the site when the damage occurred, those who ‘transported hazardous material to the site, and those who arranged for this transportation Several features of CERCLA and SARA make it difficult for firms to estimate the extent of their environmental liabilities. First, the total cost to remediate a hazardous waste site can be large, highly uncertain, and not fully known for 30 years or longer. This uncertainty, which we refer to as site uncertainty, and the events that resolve it over time significantly influence whether a firm’s liability is estimable and consequently can significantly influence disclosure and accrual decisions. Second, once named as a PRP, a firm faces uncertainty regarding its share of a site's remediation costs, which we refer o as allocation uncertainty, CERCLA liability is strict, retroactive, and joint and several. This means that the EPA need not prove negligence, that the liability can be imposed for actions that were legal when taken, and that a PRP can be held responsible for the full cost of cleanup if the harm is indivisible,