Measurement of financial leverage in the presence of environmental liabilities relating to Superfund sites

Abstract

This study examines the effect of environmental liabilities on risk assessment by investigating whether the markets consider these liabilities a form of corporate debt in the assessment of the firm's risk. A model developed by Rubinstein (1973) and further expanded and operationalised by Dhaliwal (1986) is used to examine whether the inclusion of environmental liabilities relating to Superfund sites has any incremental explanatory power. A positive association between the environmental liabilities and measures of firms' risk is expected. Such results should help policy-makers decide whether or not to require companies to disclose environmental liabilities in their financial reports. The empirical results weakly support the hypothesis that environmental liabilities relating to Superfund sites are considered corporate liabilities in assessing firm's risk. One possible explanation is that the problems in recognising and determining the exact amount of liabilities for the Potentially Responsible Party (PRP) firms make it difficult for the investors to use this information for risk assessment. This paper addresses some important issues such as reporting environmental liabilities in the financial statements, their recognition and their roles in firm risk assessment.