Substantive Tests on Environmental Liability

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What is an Environmental Liability?

• Obligation based on the principle that a polluting party should pay for any and all damage caused to the environment by its activities. In some countries, this is a strict liability if the damage can be attributed to a specific party.

Read more: http://www.businessdictionary.com/definition/environmental-liability.html#ixzz3n1Vb3nvW

What is a liability?

• A liability exists if there is a probable and measurable future outflow or other sacrifice of resources as a result of a past transaction or event

For example

When chemical contamination at a site (a potential financial liability) is identified (an event) future cost data is estimated (a transaction) and posted into the accounting system.

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EARNINGS MANIPULATIONEnvironmental Liabilities

Columbia Transmission in recent years recorded projected compliance costs related to low levels of contamination by PCB-based lubricating oils. . . resulted in additional pre-tax charges of $65 million

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MANAGEMENT, AUDITOR INCENTIVES

• Management– Incentive to understate cleanup costs– Examples• Arco, Exxon, Phillips’ stock prices declined due to environmental disasters

• Auditor– Incentive for reasonable assurance that 

material environmental liabilities are disclosed• Shareholders may sue if unreported

WHAT IS THE AUDITOR TRYING TO DETERMINE?

The environmental liability source documentation be retained for the life of the liability.

When an audit is conducted, the auditor examines source documentation to support the transaction. 

Source documentation might include the assumptions used in the cost model, and test data results

Acceptable supporting documentation must be:

• Sufficient – Enough documentation must be available for an auditor to form an opinion.

• Competent – Documentation must be valid and reliable.

• Relevant – Documentation must be related to what is being supported.

Assertions

Existence or Occurrence • Management is attesting that the account 

balances are not overstated• Example:

cost estimates are not included in the account balances when they are not a responsibility of the entity

Assertions

Completeness – Management is attesting that the account balances are not understated.

Example:environmental site cost estimates that are the 

responsibility of the entity have not been excluded from the account balances

Assertions

Valuation or Allocation – Management is attesting that the account balances are accurate

Example:Based on known information the cost estimate 

is accurate

Assertions

Rights and Obligations – Management is attesting that the account balances are owned by (Assets) or are the responsibility of (Liabilities) the entity.

Presentation and Disclosure – Management is attesting that the account balances are properly classified and appropriate disclosures have been made.

Substantive test Procedures

Analytical:For example, the auditor may compare the 

environmental liabilities reported in Fiscal Year (FY) 2004 for a specific program to the environmental liability reported in FY 2005 for that same program.

Substantive test ProceduresTracingWith a source document and follow it through the 

process to the financial statements. This verifies the “completeness assertion”.

Vouching  The auditor may start with an amount in the 

financial statements and work back through the process to the source document. This procedure verifies the “existence or occurrence assertion,”

Substantive test Procedures

Computation The auditor may check the mathematical 

accuracy performed by the auditees.

Inquiry – The auditor may question or interview individuals to obtain testimonial evidence.

Substantive test ProceduresExternal Confirmation The auditor may request information from third parties 

to corroborate evidence obtained from the auditee.

Inspection The auditor may obtain documentation from examining 

material such as records or documents. For example, the auditor may examine the property record for an environmental liability site to verify the assumptions used when developing the estimate.

Substantive test Procedures

Observation – The auditor may directly view actions performed by the auditee.

Sampling – The auditor may apply auditing procedures to a portion of the universe being audited in order to draw conclusions about the whole universe.