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April 2003 ABEL USER`S MANUAL Prepared for: Office of

1. UNNE 2 4 4 April 2003 B FINANCIAL PROFILE RATIO ANALYSIS In the second section of the financial profile which you reach by scrolling down below the financial statements as shown on the previous page ABEL generates five financial ratios for each year of tax return data Analysts commonly use such ratios to evaluate a firm s viability and its financial structure ABEL provides an explanation of each ratio and offers some guidelines for interpreting their values If all ofthe firm s ratios are strong relative to the target values and do not show significantly deteriorating trends the firm is most likely currently in good financial health If only some of the ratios show acceptable values however the firm s situation may be more uncertain Poor ratios do not necessarily indicate that a firm will be unable to pay proposed environmental expenditures Always use the ratio analysis in conjunction with theconclusions oftheability topay analysis As youreviewthe ratio results consider whether the firm sratios are improving or worsening over time Identify any ratios that appear to exhibit considerable variability year to year If you identify any trends or other interesting items contact the EPA Helpline at 888 ECONSPT to interpret the results Note that these ratios are only a rough measure of a firm s financial condition and can easily be manipulated Review this information with the appropriate caution and seek assistance from an
2. Note that the value ABEL uses for after tax cash flow does not strictly speaking include all items that affect cash flow Excluded are changes in non cash working capital capital expenditures paid for with cash dividends and cash flow resulting from debt and equity financing ABEL s version for cash flow was chosen for calculating Beaver s Ratio because it most closely replicates the definition used by William Beaver in his study 1 e cash flow equals after tax net income plus depreciation plus depletion Also Beaver s definition was used as the basis for determining healthy unhealthy Beaver s Ratio cutoff values 27 William H Beaver Financial Ratios as Predictors of Failure in Empirical Research in Accounting Selected Studies 1966 pages 71 111 28 The above equation for cash flow is quite sound without requiring an excessive number of inputs ABEL utilizes an identical definition of cash flowin its abilityto pay conclusion except that it also takes into account reinvestment in equipment e capital expenditures Thus the implicit cash flow assumptions are that net non cash working capital is at a steady state level no dividends are paid or if they are they can be discontinued in order to finance capital expenditures or to pay penalties and thatthe only sustainable cash flows are those from operations rather than from debt or equity financing A4 April 2003 5 Altman s Z Score The calculations for Altman s
3. The resulting total represents a rough estimate of the annual pre tax cash flow the firm is generating as opposed to its taxable income In most cases this calculation will only include an allowance for depreciation expenses In some cases a firm will also have amortization expenses which are non cash expenses similar to depreciation After subtracting out an appropriate cash allowance fortaxes and other tax related deductions and adjusting for inflation we can calculate a rough estimate of the after tax cash flow being generated by the firm Cash flow is the lifeblood of any business A firm with sufficient cash can easily fund its ongoing operations without acquiring additional debt furthermore it can easily make any interest or principal payments on debt it does maintain As you review the cash flow summary consider whether the firm s cash flow is positive or negative is trending upward or downward or is highly variable from yearto year Talk with the EPA Helpline at 888 ECONSPT to help you interpret the data B 9 April 2003 Remember that any positive cash flow amounts presented in this summary represent cash available after the firm meets all of its operating expenses Accordingly available cash flow is the primary consideration in ABEL s calculation of ability to pay The model uses this information to estimate the average annual cash flow a firm is likely to generate ABEL then projects this average cash flow amount out five years
4. s D E conclusions are based on the following decision rules e A D E less than 1 5 but greater than or equal to zero generally indicates that a firm has additional debt capacity e A D E greater than 1 5 generally indicates that a firm may have difficulty borrowing additional capital e A D E less than zero indicates that a firm has negative stockholders equity an extremely poor financial situation e A D E of na indicates that the firm s stockholders equity is zero an extremely serious financial condition 2 Current Ratio The current ratio CR is defined as the firm s current assets divided by its liabilities The ratio assesses whether the firm will be able to cover its short term debts using cash and other current assets which can easily be liquidated Five conclusions are possible e A CR greater than 2 0 generally indicates that a firm has good liquidity e A CR between 1 0 and 2 0 indicates that the firm may suffer from liquidity problems e A CR less than 1 0 indicates that the firm has serious liquidity problems e When a firm s current assets are greater than zero a CR of na generally indicates that the firm has good liquidity e When a firm s current assets are equal to zero a CR of na indicates that the firm may suffer from liquidity problems Note that acceptable debt ratios vary considerably with industry This conclusion represents a conservative rule of thumb but may not app
5. 0 2 is inconclusive e A BR less than 0 1 generally indicates poor financial health e A BR of na indicates that the firm had no liabilities in year Because this situation is extremely unusual you should check the accuracy of the firm s tax returns against all inputs before proceeding 5 Altman s Z Score Altman s Z Score AZS is calculated asa weighted average of several financial ratios AZS is a predictor of firm failure It is most accurate within two years prior to bankruptcy Four conclusions are possible 437 April 2003 An AZS greater than 2 90 indicates that it is unlikely that the firm will be forced into bankruptcy during the coming two years An AZS between 1 23 and 2 90 is inconclusive An AZS less than 1 23 indicates that the firm could be bankrupt within the next two years if its financial situation does not dramatically improve An AZS of na indicates that a numerical value could not be computed for year because either total assets or total liabilities were equal to zero Because this situation is extremely unusual you should check the accuracy of the firm s tax returns against all inputs before proceeding 4 8 April 2003 5 Corporafion Probability of Cash Flow ia Sam s Brewing Co Ability to Pay Analysis Ability to Pay Analysis Tax Form 11205 Run Name Civil Penalty Penalty Amount 1 000 000 2001 dollars Reinvestment Rate Annual Inflation Rate Discount Rate Weighted Average Smoo
6. 2003 i Sam s Brewing Co Financial Profile Income Statement Gross Sales 12 569 855 11 934 144 12 885 955 14 008 241 Cost of Goods Sold 6 236 052 5 943 901 6 535 666 7 954 927 Operating Profit 6 333 803 5 900 243 6 350 289 6 053 314 Other Expenses and Income Interest Expense 12 785 Depreciation 97 932 Depletion and Amortization 28 092 l Other Expenses Income 5353091 5 068 185 5 855 280 5 597 625 15 694 67 482 41 877 32 626 Total Expenses Income 5 463 808 5 163 759 5 903 157 5 645 945 Taxable Income Before NOL 869 995 26 484 447 132 407 369 Summary of Estimated Cash Flow Taxable Income Before NOL 369 995 326 484 447 132 Tax Credit for Regulated Investment Credit for Federal Fuels Depreciation Depletion and Amortization Income Not Included on Retum Available After Tax Cash Flow 97932 67 482 893 966 495 009 439 995 Available Pre Tax Cash Flow 967 927 893966 495 009 439 005 Adjusted for Inflation 1 007 031 948 634 535 814 485 790 May inchude loans to stockholders mortgage and real estate loans other investments buildings and other depreciable assets depletable assets land intangible assets and other long term assets see Schedule L of firm s federal income tax return Includes additional income categories listed on page 1 Income Section of firm s federal income tax return and additional expense categories
7. ABEL will calculate a company s total capability based on recent historical financial information It does not automatically account for a firm s total Superfund liabilities existing or contingent that may exist beyond the site under consideration If you are involved witha firm that may have additional Superfund liabilities you should investigate whether these potential obligations might affect the financial resources available to the firm 5 Fora detailed discussion on Superfund ability topay policy see U S EPA Office of Site Remediation Enforcement General Policy on Superfund Ability to Pay Determinations September 30 1997 ABEL s analysis of Superfund costs is designed to be consistent with this guidance 3 8 April 2003 b Tax Treatment ABEL allows you to specify whether the cleanup cost is tax deductible the default depreciable i e a portion may be deducted each year just like a capital investment or entirely non deductible Internal Revenue Service IRS rulings have not fully addressed the federal income tax treatment of Superfund and other environmental cleanup costs In some instances parties have been able to deduct remediation expenditures as ordinary and necessary business expenses while others have been required to capitalize and depreciate costs over time The only IRS revenue ruling dealing directly with this issue concerns a manufacturing plant owner who bought the property in a clean condition contaminated
8. Chapter 2 A Computer Program Structure 9 os td tere sn ro bt a e Lx 2 B A oec miter een et otii as eot Ls m a do 9 2 2 Es Data I cres dto rds 2 3 D Calculating and Printing Results o oo oo oooooooooooommom om 2 4 E Exiting dnd saving ces coru 2 duces ease E Seid deu n 2 4 DATA REQUIREMENTS Levant exekx c C CR RR EX UR Ca oW Ra Chapter 3 A Case Creta his wooo ae toh EUREN I DANS ERAS pH s AR ig 3 2 B Tax Return Data 3 4 CE Run Inputs AA A A a n e 3 7 l INonsupetrtunmd Cases stat errors a soe pda se bbe as 3 7 2 Supertund CAS v so eee Sade xo RES ia 3 8 a Cleanup Cost Estimates ibid EE Ip EEG ES 3 8 b Tax LEEMOS EN etta e d et e et 3 9 D Optional Rin Inputs iue dV E wae E RA Pg 3 12 l Reinvestment Rate 3 12 2 Annual Inflation Rated e b SUN 3 13 3 IDISCOUNE Rafe 0 aa aaa A Ed a EE 3 13 4 Weighted Average Smoothing Constant sessa 3 14 5 Marginal Income Tax Rate 215 cie cree p tex n ea oA 3 15 6 Number of Years of Considered Future Cash Flow 3 15 INTERPRETING OUTPUT ii e Mu depth ERA CHER CHE Ox Eh Chapter 4 A Financial Profile Financial Statements ooooooooooooommoooo o 4 1 1 Balance escisiones 4 3 2 Income Statement mii a A ta 4 3 3 Statement of Historic Cash Flows ooooooooooooooo o 4 3 B Financial Profile Ratio Analysis bea tada 4 5 l Debt to EQUIV Ratio 44 Gwe ad a EE afa 4 5 2 Current Ratios iras Labels oe aia Se
9. Z Score are more complicated than for the other financial ratios and occupy their own page z of the spreadsheet If the firm has no assets or liabilities then ABEL will display a value of na for that year D ABILITY TO PAY CALCULATIONS This section presents ABEL s ability to paycalculationsand decision rules ABEL discounts a firm s projected internally generated cash flows back to the date on which the firm will incur the environmental expenditure All after tax cash flows associated with the environmental expenditures penalty are subtracted out of these cash flows to estimate the funds that will remain after the expenditures are incurred For Superfund cases the user has the option of specifying alternative tax treatment ofthe expenditures so the after tax cash flows may or may not be equal to their pre tax values If the present value of these net cash flows is greater than or equal to zero the firm is deemed able to pay for all the environmental expenditures Ifthe present value isnegative however the firm is deemed unable to fund all or a portion of the sought expenditures The following are the nine main steps that ABEL performs in its ability to pay calculations Most of these calculations are performed on the calc page of the spreadsheet 1 Calculate Pre Tax Historic Available Cash Flow ABEL first calculates the historic pre tax available cash flow where the reinvestment rate has the value of 0 0 unless the us
10. available cash flows that a firm can be expected to generate in the future at different probability levels The firm s total population of all of its historic constant dollar available cash flows are assumed to be normally distributed ABEL employs the T distribution as the basis for estimating probabilities because of the small number of data points used in the calculations In general if a population is normally distributed then one can estimate the percentage of data points in the population that will exceed a particular value by using a standard normal table Even if we areonly dealing with a subset of the entire population we can still use the standard normal table to estimate percentages probabilities providing the sample is large enough typically in excess of fifteen to thirty data points When the population is normally distributed yet the sample size is very small the T distribution table is the analytically correct approach for estimating probabilities The T distribution also referred to as the sampling distribution has the same symmetrical bell shaped curve as the normal distribution It is somewhat flatter and lower at the mean however as well as somewhat more dense in the two tails than the normal distribution Note that the values for the number of standard deviations away from the mean is calculated on the nsd page of the spreadsheet 5 Compute Present Value of Future Available After Tax Cash Flows The present value
11. business operations that could be liquidated to fund a penalty or it may have loaned funds to its owners or officers which could be called in as a source of additional funds The firm may have additional debt capacity allowing it to acquire additional loans to fund a payment Finally the firm may have close relations with its parent entities subsidiaries and other affiliates all of which could potentially provide a source of funds for penalty payment ABEL s Financial Profile section provides a good place to start an investigation of these issues You can use the summary financial information to identify large or highly variable asset holdings and expenses or determine whether the company is carrying large amounts of debt Reference Appendix B of this manual for a detailed explanation of how to analyze this information Finally you can contact the EPA Helpline at 888 ECONSPT to help you assess these issues D ANALYZING PARTNERSHIPS In addition to analyzing corporations either C or S ABEL can assess the abilityto pay of partnerships which file form 1065 An owner s liability for corporate debts is limited to the owner s investment in the company by contrast owners of a partnership 1 e partners are liable for any and all the partnership s debts A general partner can be personally liable while limited partners exposure is limited to their investment Although ABEL accurately assesses the financial resources that a particular pa
12. expert These ratios should not be the basis of any decision to alter the penalty or contribution of a firm ABEL calculates five key financial health indicators 1 the debt to equity ratio 2 the current ratio 3 the times interest earned ratio 4 Beaver s ratio and 5 Altman s Z Score The interpretation of each of these ratios is shown below the method for calculating each ratio is presented in Appendix A 1 Debt to Equity Ratio The debt to equity ratio D E is defined as the firm s total liabilities divided by its stockholders equity This ratio measures the degree to which debt constitutes the company s financing Four conclusions are possible as shown below however a firm could fall into one category during a given year and the other category during the next year Similar variation may ABEL s target values come from a variety of sources and were chosen because they are generic non industry specific commonly applied standards One of the sources is Financial Tests as an Option for Demonstrating Financial Responsibility Volume II Text by International Research and Technology Corporation November 25 1980 More sophisticated users may want to compare the ratio resultsto those specifically calculated for the firm s industry orto evaluate ratio results over time This information may be found for example in Dun and Bradstreet s industry summary financial data 4 5 April 2003 occur with the other ratios as well ABEL
13. firm will make its first payment The inputs for the environmental expenditures are split into two sections NonSuperfund and Superfund ABEL s default is NonSuperfund but you can override this by clicking in the box the left of CERCLA Superfund Remediation Once you have finished with this screen you can either click OK to save your data or click Options to view edit the optional run inputs 1 NonSuperfund Cases For cases other than Superfund first enter the proposed lump sum settlement penalty ifany Then enter any of the following pollution control expenditures that may applyto the case or 0 for expenditure types that are not present For amounts other than 0 you must also enter an estimate year which will typically be either the year when the estimate was made or when the expenditures will be incurred Depreciable Capital Investment should include pollution control equipment that wears out over a number of years e g groundwater monitoring system air pollution control device The cost figure should include the purchase cost of the equipment as well as the installation costs but exclude any associated nondepreciable costs e g land 3 7 April 2003 Tax Deductible One Time Expenditure should include costs that are not depreciable yet still deductible from taxable income e g site cleanup record keeping system or one time employee training program Non Tax Deductible One Time Expenditure should include costs tha
14. its soil and groundwater with hazardous waste and then restored it to its original physical condition The ruling allows the owner to deduct soil remediation costs and ongoing groundwater treatment expenditures but requires him to depreciate over time the cost of constructing a groundwater treatment facility The revenue ruling assumes that the owner will either continue manufacturing operations at the site or will discontinue them and hold the land in an idle state An IRS private letter ruling which cannot be used or cited as precedent by other parties to a Superfund site owner allowed legal and consulting fees to be deducted as ordinary and necessary business expenses that were related to issuance of a consent order listing on the National Priority List NPL of a site that a predecessor company contaminated and development of a remedial investigation feasibility study RUFS The IRS found that these costs did not create or enhance an asset and that they did not produce a long term benefit for the property owner These rulings do not address all the possible scenarios for sites current owner operators particularly where a previous owner contaminated a site They also do not address how remediation may increase property value or when property will be put to a new use Furthermore IRS rulings do not address tax treatment for former owner operators generators and transporters For parties who are not current owner operators however cleanu
15. listed on page 1 Deductions Section of firm s tax return 967 927 x oo 45 09 e e e ee e A ga 6 o5 Print Printer Summar Detail tun C File B 7 April 2003 B INCOME STATEMENT The income statement as shown on the previous page provides the firm s profits or losses generated during the course of the operating period These earnings equal the difference between revenues and expenses The income statement matches the amounts received from selling goods and services against the costs incurred to produce those goods and services 1 Components of the Income Statement A firm s primary income source is gross sales To produce and sell a good or service a business incurs expenses through the purchase of the required materials and labor Expenses are generally broken into two categories including cost of goods sold and overhead or general and administrative costs For purposes of presentation ABEL also includes in this section a summary ofother income sources detailed in the Income section on page 1 of the tax return Such income might include rental payments received on real estate holdings or interest payments received from loans made by the firm Gross sales represent income received or likely to be received 1 e accounts receivable as a result of selling goods or services Sales are recognized when earned by the company e g when a product is shipped to a customer a
16. of expected future available after tax cash flows for a given probability level is then calculated The default value for the number of future years is five which the user can modify on the Optional Run Inputs screen Note that the firm s nominal after tax cash flows are discounted back at the firm s nominal after tax cost of capital whose default value that user can modify on the Optional Run Inputs screen Also the calculations treat the company s annual cash flows as occurring in the middle of each year This convention balances off cash flows which occur in the first half of the year with those that occur in the second half of the year A 6 April 2003 6 Compute Present Value of After Tax Cash Flows Associated with New Capital Investment Three primary components ofnew pollution control capital investments affect after tax cash flow 1 the original capital investment 2 the depreciation and deduction tax shields associated with the investment and 3 the annual operating expenses Note that for a Superfund case the user can specify the cleanup cost s tax treatment which can sometimes be classified as a depreciable capital investment according to IRS interpretations Two sources oftax shields correspond tothe initial pollution control capital investment both of which serve to reduce taxes and thereby increase cash flow 1 the depreciation tax shields associated with the capital investment and 2 the nondepreciable b
17. on Superfund Ability to Pay Determinations dated 30 September 1997 the Superfund interest rate should be used to calculate ability to pay settlements that include payments over time This rate is based on the investment rate of the Superfund trust fund All Superfund contributions are invested annually in one type oftreasury bill ABEL uses the mostrecentrate which is available at http www epa gov ocfo finstatement superfund int_rate htm A 8 April 2003 UNDERSTANDING THE FINANCIAL PROFILE APPENDIX B ABEL s financial profile presents possibly familiar yet potentially confusing information but with a little effort you can employ the information to better assess a firm s financial condition The financial profile is similar in substance and format to a business s own financial statements since the information is taken from income tax returns which are simply a standardized form of financial statements The information has three parts balance sheet income statement and summary of cash flows This primer on understanding financial information will not make you an expert in financial analysis but it will provide you with a better understanding of ABEL s results If you have questions or wish to conduct a complete review ofthis information contact the EPA Helpline at 888 ECONSPT The balance sheet is a snapshot of a firm s financial position at a moment in time showing assets liabilities and shareholders equity Liabilities and share
18. or some alternative number of years as designated by the user to predict the firm s future available cash flow From this projection the model then derives its conclusion presented in the Ability to Pay Analysis section of the model s results B 10 April 2003
19. presents the methodology that ABEL uses to calculate the five financial ratios These ratios are often used to evaluate a firm s overall viability and financial structure You can view all ofthese calculations in the Excel spreadsheet on the print page section A54 F61 The following sections provide additional details about the calculations that may not be readily apparent when reviewing the spreadsheet file 1 Debt to Equity Ratio This is simply the ratio of total liabilities to total equity but if total equity is equal to zero 1 e assets are equal to liabilities ABEL will display na indicating that the ratio cannot be computed A Debt to Equity ratio of na indicates that stockholders equity is zero a serious financial condition A3 April 2003 2 Current Ratio This is simply the ratio of various current assets to various current liabilities If the firm has no current liabilities then ABEL will display a value of na for that year 3 Times Interest Earned Ratio This is simply the ratio of earnings before interest and taxes i e interest expense plus taxable income before net operating loss deductions to interest expense If the firm has no interest expense then ABEL will display a value of na for that year 4 Beaver s Ratio This is simply the ratio of available after tax cash flow to total liabilities If the firm has no liabilities then ABEL will display a value of na for that year
20. read Appendix A to use ABEL Appendix B Understanding ABEL s Financial Profile Results helps the user to better assess the overall financial condition ofthe firm being analyzed Appendix B also alerts the user to items to look for on a firm s tax returns If you ever haveany questions concerning either Appendix A or B contact the Helpline at 888 ECONSPT ABEL references a Microsoft Excel spreadsheet to perform all of its ability to pay calculations although you do not need Excel to run ABEL The data you enter into the program is automatically transferred to the spreadsheet The spreadsheet performs the calculations and returns the result to the program for output The spreadsheet is in your ABEL folder on your C drive or wherever else you installed ABEL filename ABEL xls The asterisks represent the most recent year for which EPA has performed updates for the spreadsheet The easiest way to understand ABEL s calculations is to open the file in Excel This way you can look inside each cell and see exactly how the formula is written If you are ever having trouble determining the location of certain cell references in the formulas go under the Excel Tools menu and choose Auditing Here you can trace Precedents or Dependents which will draw arrows to all the cells that a formula uses However be sure not to alter the saved file as this has the potential to corrupt your copy of ABEL If you plan to spend considerabl
21. results and output Appendix A explains the model s calculations in more detail Appendix B contains a primer on reading and interpreting a firm s financial statements Help information is available in the program if you need a variable definition guidance on information sources or help with the format required for an input entry To access help click the Help button located at the base of each screen or press the F1 key If you need assistance in operating the program or understanding the results contact EPA s enforcement economics toll free helpline at 888 ECONSPT 326 6778 or benabel gindecon com For policy questions related to Superfund contact Bob Kenney Office of Site Remediation Enforcement Policy and Program Evaluation Division at 202 564 5127 or kenney robert epa gov For policy questions related to other statutes contact Jonathan Libber the BEN ABEL Coordinator at 202 564 6102 or libber jonathan epa gov 7 See footnote 4 supra 1 4 April 2003 USING THE COMPUTER PROGRAM CHAPTER 2 ABEL is an interactive computer program that runs in the Windows operating environment This chapter contains five sections Section A describes the computer program s structure Section B explains the procedures for installing the program on your computer Section C provides data format requirements and additional helpful hints for entering data at your computer Section D tells you how to calculate and print results Section E expl
22. return b Long Term Liabilities Long term liabilities represent debts owed by the firm due in more than one year They are important because the amount of debt held by a firm affects its debt capacity or ability to borrow additional money perhaps to fund a penalty payment or remediation expenditure e Loans from stockholders represents funds loaned to the firm by its owners e Mortgages bonds payable in more than one year are long term promissory notes or mortgages representing sums of money borrowed fora relatively long period of time under a formal written contract i e the portion of the firm s liabilities not likely to be repaid within the current year B 5 April 2003 3 Shareholders Equity Shareholders equity represents the total interest that all shareholders have in the corporation It is equal to the firm s net worth or assets less liabilities This item is typically split into two general components capital stock and retained earnings Capital stock represents shares in the firm or a proportion of ownership Retained earnings represents the sumof profits earned over the course ofthe firm s operating history net of any portion of these profits distributed to the owners in the form of dividends Retained earnings is the total amount of profits owners choose to leave in the firm to provide working capital fund reinvestment efforts or initiate other productive activities Note that shareholders have a residual interest
23. the firm has purchased in the past 2 Annual Inflation Rate ABEL uses the annual inflation rate to convert a firm s historic financial data into equivalent inflation adjusted future year dollars The standard value ABEL uses is based on the U S Gross Domestic Product GDP price deflator a broad based measure of economy wide inflation The standard value is derived by averaging the historical rate of increase over the past five years with a consensus projection for the next five years from the publication Blue Chip Economic Indicators You should not change this value without sufficient justification 3 Discount Rate ABEL uses the discount rate to express the firm s expected future cash flows in present value terms The concept of net present value is based on the principle that a dollar today is worth more than a dollar a year from now because today s dollar can be invested immediately to earn a return over the coming year Therefore the earlier a dollar occurs the greater its impact in present value terms ABEL accounts for this time value of money effect by reducing all estimated future cash flows to their present value equivalents This widely used technique is known as discounting This measure of inflation is more generalized than in the BEN model Specifically BEN s default is the Plant Cost Index from Chemical Engineering magazine to reflects cost increases in specific pieces of equipment Since ABEL s cash flows
24. 0 0008 B 8 2 Items to Look for in the Income Statement nn nnannnnaeana B 9 C Summary of Cash Flows Sud xor taa e PESE Dose m te Aa B 9 April 2003 INTRODUCTION CHAPTER 1 A OVERVIEW In environmental enforcement cases the defendant respondent may claim an inability to pay the penalty or environmental expenditure that the U S Environmental Protection Agency EPA seeks With the goal of providing fair and equitable treatment of the regulated community EPA policy states that the determination of penalty amounts should consider the violators ability to pay EPA policy identifies inability to pay as one circumstance of compelling public concern under which enforcement may settle a case for less than the economic benefit of noncompliance EPA policy further explains that such settlements are allowed if removal of the economic benefit would result in plant closings bankruptcy or other extreme financial burden and there is an important public interest in allowing the firm to continue in business Nevertheless if a violator either refuses to comply has a long history of previous similar violation or has committed egregious violations EPA reserves the right to seek penalties that might adversely impact a business The ABEL model is a screening tool that assists EPA in assessing a corporation s or partnership s ability to afford a civil penalty new investments in pollution control equipment non Superfund environmental clea
25. 43901 6 535 666 Operating Profit 6 333 803 5 990 243 6 350 289 SUNNE 2 4 2 1 540 996 132 753 17 149 61 145 641 065 2 393 108 621 436 309 722 3 580 1 434 738 2 393 108 14 008 241 6 053 314 April 2003 1 Balance Sheet ABEL uses information you have entered for accounts receivable cash inventories U S government obligations tax exempt securities and other current assets to compute a firm s total assets the first part of the balance sheet ABEL also uses information you have entered for accounts payable mortgages and bonds payable in less than one year other current liabilities loans from stockholders mortgages and bonds payable in more than one year and other liabilities to compute the firm s total liabilities Finally it provides the firm s stockholders equity an important indicator of a firm s overall viability Note that ABEL calculates all other assets to reconcile a firm s total assets with its total liabilities and stockholders equity 2 Income Statement The summary income statement provides information on the firm s income and expenses This information is critical to assessing the overall profitability of the firm and any trends in its performance over time ABEL uses the information you have entered for gross sales and costs of goods sold to calculate a firm s operating profit and then subtracts interest expense depreciation depletion amortization and other expenses from operating
26. ABEL USER S MANUAL Prepared for Office of Regulatory Enforcement Office of Enforcement and Compliance Assurance United States Environmental Protection Agency 1200 Pennsylvania Avenue N W Washington D C 20460 Prepared by Industrial Economics Incorporated 2067 Massachusetts Avenue Cambridge Massachusetts 02140 617 354 0074 www indecon com This manual is releasable in its entirety April 2003 ACKNOWLEDGMENTS This document was prepared under the direction of Jonathan Libber BEN ABEL Coordinator Office of Enforcement and Compliance Assurance U S Environmental Protection Agency Technical assistance was provided to EPA by Industrial Economics Incorporated IEc of Cambridge Massachusetts Additional input was provided by Bob Kenney U S EPA Office of Site Remediation Enforcement and Leo Mullin U S EPA Region III as well as other regional and state enforcement staff UPDATES and SUPPORT The most recent model installation files and related materials are available at http www epa gov Compliance civil programs econmodels index html Additional support is available for employees of federal state or local government environmental agencies via U S EPA s enforcement economics toll free helpline at 888 ECONSPT 326 6778 or benabel indecon com TABLE OF CONTENTS INTRODUCTION a AR IAS AA EA Chapter 1 A A a BIRTH oe bet etu H oia Ta 1 1 B How to Use this Manual A is AA 1 4 USING THE COMPUTER PROGRAM sse
27. EL also prepares a summary graphic illustrating the results presented in the summary table As indicated in this graphic the likelihood that the firm will generate a specific level of cash flow declines as the magnitude ofthe cash flows increases This summary graphic can be a useful tool to assess the reliabilityof ABEL s predicted future cash flow A sharp decline in the curve at the 50 60 or 70 percent probability level can often be attributed to significant variations in past cash flow If you notice this kind of variability in combination with a less than 70 percent probability that the firm can pay the proposed penalty or contribution you may wish to contact the EPA Helpline at 888 ECONSPT Alternatively a flat curve over the 50 60 or 70 percent probability level that declines only after the 90 or 95 percent probability level is often indicative of consistent cash flow 3 Conclusion Following the table and graphic ABEL prints a message summarizing the firm s ability to pay This message indicates the probability that the firm can meet the proposed penalty and or pollution control expenditures through its projected cash flow Note that these amounts are al ways in dollars regardless ofthe data entry format This estimation ofability to pay is based on funds the firm is expected to generate during the next five years ABEL also predicts the cash flow a firm is likely to generate with 70 percent probability a level selected bec
28. ETING OUTPUT CHAPTER 4 The ABEL analysis presents a comprehensive summary of a firm s financial status and quantifies its ability to pay a penalty or contribution This chapter describes the ABEL Model s output Section A discusses the part of the model s financial profile that generates financial statements Section B describes the five financial ratios that ABEL s financial profile generates for each year of tax return data Section C discusses how the ABEL Model uses the tax return information to determine a firm s ability to pay for an environmental expenditure You can view the financial profile 1 e Sections A and B below by clicking on the similarly named button on the left hand side of the case screen For the ability to pay analysis 1 e Section C you must first create a run as Chapter 3 explains in detail and then click Calculate A FINANCIAL PROFILE FINANCIAL STATEMENTS As shown on the following page the first section of the ABEL financial profile provides a summary balance sheet income statement and statement of historic cash flows for the firm ABEL develops these statements using the model inputs entered for each specific case These financial statements provide useful summary information on the firm s assets and liabilities income and expenses and historic cash flows The information can be used to determine possible trends in the firm s past performance and to identify balance sheet or income statement items that exh
29. ach item and describe its relevance to the ability to pay assessment B 1 April 2003 Sam s Brewing Co Financial Profile S Corporation Tax Form 11205 Financial Profile Financial Statements Jn Dollars 1999 1998 1997 Assets Balance Sheet Cash 1 081 945 906 995 1 106 663 1 540 996 Accounts Recervable 403 352 475 824 154 397 132 753 Inventories 25 821 31 042 29 032 17 149 US Government Obligations Tax Exempt Securities Other Current Assets All Other Assets Total Assets 55 791 77 990 61 145 835 752 614 461 641 065 2 305 404 1 983 443 2 393 108 161 458 793 732 2 466 308 Pl e g 6 6 Liabilities Accounts Payable Mortgages Bonds Payable in 1 Year Other Current Liabilities Loans from Stockholders 518 717 s Mortgages Bonds Payable in gt 1 Year 193 205 3 710 506 736 520 454 7 917 410 610 496 155 220 806 390 007 621 436 359 113 809 722 3 580 Other Liabilities Total Liabilities Stockholders Equity Total Liabilities and Stockholders Equity SUNNE 2 Rss 1 434 738 958 370 2 393 108 749 720 1 233 723 1 983 443 1 655 942 649 462 2 305 404 1 222 428 1 243 880 2 466 308 Pala e e e e e e Pala A e e e e e e e e 69 e 69 e B 2 April 2003 A BALANCE SHEET The balance sheet as shown on the preceding page has three components assets liabilities and shareholders equit
30. age and real estate loans are funds loaned to other parties for purchasing real estate property Depending on the nature of these loans they may be callable to fund an environmental expenditure e Other investments represent funds the firm has used to purchase a variety of assets that it does not intend to liquidate in the near future These assets and their value should be itemized in an attachment to the tax return e Buildings and other depreciable assets are manufactunng facilities warehouses and other pieces of productive equipment Since their productive capacities are likely to last for a period of years these assets are depreciated over time Depreciation represents the allocation of the purchase price of these assets over their useful life e Depletable assets generally include natural resource reserves like oil or coal e Land is simply property owned by the company e Intangible assets include patents non compete agreements and goodwill among others Patents and non compete agreements are rights granted or purchased to exclude others from manufacturing using or selling certain processes or devices Goodwill is an amount paid by the firm in acquiring another business enterprise that is greater than the sum of the then current values assignable to the business s identifiable assets Brand names for example represent potentially considerable yet intangible value B4 April 2003 e Other assets includes those assets no
31. ains how to exit the program and save files For an in depth description of each variable see Chapter 3 For information on interpreting ABEL s results see Chapter 4 A COMPUTER PROGRAM STRUCTURE ABEL consists of five different screens main screen case creation tax return data input financial profile output ability to pay run input and ability to pay run results output In general you start with the main screen enter data on separate screens return to the main screen then view and print your output from a final screen ABEL operates like EPA s BEN PROJECT INDIPAY and MUNIPAY models and any standard Windows application Use the mouse or the Tab and Return keys to move between cells and within a screen Hold down the Shift key while pressing Tab to return to previous entries You can access the help system from anywhere within the model by pressing the F1 key just as in any Windows application When you first open ABEL a blank case screen appears You can obtain a new screen at any time by selecting New from the File menu or usingthe Ctrl N shortcut To toggle between cases select the appropriate file name under the Window menu You can also save a case in any folder you specify with the abl extension The first inputs on the case screen are office agency and analyst name These values are for reference only and do not affect the results On the left side ofthe screen ABEL asks for the firm s name address
32. am s Brewing Co Tax Return Data Dollars Line 1c plus Schedule K Line 3a plus total gross rental income from Form 8825 Line 17 T 1999 1998 1997 1996 Gross Receipts or Sales Less Returns and Allowances 12 569 855 11 934 144 12 885 955 m Cost of Goods Sold 236 5 943 901 6 535 666 28 092 67 482 47 877 Taxable Income Before NOL and Special Deductions 069 995 825 484 447 132 NOL Deductions Special Deductions Total Tax Credit from Regulated Investment Companies Credit for Federal Tax on Fuels Cash 1 081 945 906 995 1 105 553 1 540 Trade Notes Accounts Receivable Less Allowance for Bad Debts 403 352 475 824 154 397 1327 Inventories 25 821 31 042 29 932 17 1 U S Government Obligations Tax Exempt Securities Other Current Assets 151 458 55 791 77 990 561 1 Accounts Payable 518 717 520 454 390 007 621 2 Mortgages Notes Bonds Payable in Less than One Year 3 770 7 917 Other Current Liabilities 506 736 410 610 359 713 809 7 Loans from Stockholders 496 155 l ages Notes Bonds Payable in One Year or More 193 205 220 806 35 or iahilitiae 3 5 April 2003 w Sam s Brewing Co Civil Penalty Dollars 1 000 000 100 000 SURE una 3 6 April 2003 C RUN INPUTS You must create a run before you can perform an ability to pay analysis To add a new run enter th
33. ause this is one common cut off EPA uses for determining ability to pay It is ultimately up to the litigation team however to determine an appropriate cutoff If during the input phase you requested to have the payment spread out over a period of years 2 to 5 the model will also provide the installment amount that will create a payment schedule that is equivalent to the lump sum payment 4 11 April 2003 4 Historic Comparison Ifthe firm s performance is worsening ABEL may overstate ability to pay ABEL performs two tests to determine if the firm s most recent year s actual cash flow derived from the firm s tax return was significantly worse than its historic average Based on these tests results ABEL may recommend that you change the weighted average smoothing constant 0 3 standard value which will place greater weight on the firm s most recent performance in the ability to pay calculation The most recent year s cash flow is significantly worse than its historic average which could mean that ABEL s future cash flow projections are overstated A 0 7 smoothing constant is recommended to weight this year more heavily Otherwise do not change the smoothing constant unless a financial analyst recommends this based upon a review of the data D USING THE RESULTS ABEL uses generally accepted accountingand financial methods to generate its conclusions Note however the model employs inputs taken directly from an entity s tax r
34. can expect that ABEL will conclude the firm can pay some amount If the values are negative the ABEL result will also be negative 4 3 April 2003 w Sam s B rewing Co Financial Profile Financial Profile Ratio Analysis 1997 Historical Financial Ratios 0 61 Defined as total liabilities divided by stockholders equity Measures the degree to which debt constitutes the company s financing Less than zero or na indicates no stockholder equity an extremely poor financial condition Greater than 1 5 indicates possible difficulty in borrowing additional capital Less than 1 5 but greater than or equal to zero generally indicates additional debt capacity Current Ratio CR 1 63 1 57 1 83 Defined as current assets divided by current liabilities Assesses whether cash and other easily liquidated current assets can cover short term debts Less than 1 0 indicates serious liquidity problems Between 1 0 amp 2 0 or na combined wi no current assets indicates possible liquidity problems Greater than 2 0 or na combined with current assets greater than zero indicates good liquidity Times Interest Earned TIE 69 05 30 42 na Defined as earnings before interest and taxes divided by interest expense payments Indicates how easily the firm can pay the interest expense on its debt Less than 2 0 indicates possible difficulty in meeting future interest payments the lower the value the higher this possibility
35. cial ratios that reflect firm liquidity and solvency ABEL assesses a firm s ability to pay by focusing on projected cash flows The model explicitly calculates the value of projected internally generated cash flows from historical tax information and compares these cash flows to the proposed environmental Internally generated cash flow reflects the income that a firm has generated from ongoing operations less all cash expenses including taxes For incorporated firms liability is limited to the value of shareholders equity 19 Tf the firm establishes that its status has changed then an analysis beyond the limited ABEL evaluation is needed This could happen if 1 the market outlook for the firm s products has changed considerably 2 the firm incurred a major loss since the time period covered by the most recent tax return or 3 the firm faces a major extraordinary expense in the near future e g a balloon payment on a loan Tf the ability to pay issue will be raised at a trial or hearing the Agency should be prepared to explain where the funds to pay for compliance cleanup or penalties are going to come from You may need to use an expert to accomplish this Agency personnel are strongly advised against using the ABEL model in a trial or hearing as it is biased in favor of the firm it only handles the cash flow part of the analysis and a trier of fact may not fully comprehend the complex analysis that ABEL performs A typica
36. city state and zip code The section for tax return information near the center of the screen asks for the number of years and most recent year of tax data available the tax form used and the data entry format that the user would like to use 1 e dollars thousands or millions 2 1 April 2003 Below these inputs are buttons for entering tax return data and generating the firm s financial profile The tax return data input screen allows the user to enter financial data for each year in a spreadsheet type format You must obtain the three to five most recent years of the firm s federal income tax returns which must be signed and dated To prevent the submission of fraudulent tax returns you can obtain a summary ofthe firm s tax returns from the IRS via Form 8821 The financial profile uses the tax retum data to generate a pro forma financial statement i e balance sheet income statement and cash flow statement as well as an analysis of five key financial ratios that provide a general indication of the firm s current financial condition The right side of the case screen is for ability to pay run management Here you can create a new run enter or edit run data copy a run remove a run and calculate a run You can create multiple runs for each case The run screen is where you enter the environmental expenditures for which the firm is liable You must enter all the expenditure data before you can run an affordability analysis From th
37. d to pay environmental expenditures should not be constrained from meeting those obligations by the need to replace machinery and equipment Because ABEL forecasts only five years into the future the firm is not permanently prevented from replacing such assets a five year period of reduced investment should not jeopardize the long run solvency of most firms In addition the firm could continue to reinvest by reducing other expense items like salaries or marketing expenses Under certain circumstances youmay wishto alter the reinvestment rate For example if you are examining a manufacturer in an industry with rapidly changing technology such asa microchip producer in the computer industry the manufacturer may need to reinvest aggressively in new plant and equipment to remain competitive You might consider changing the reinvestment rate to 1 0 to allow the manufacturer to invest at the same rate it has purchased plant and equipment in the past A 1 0 value will specify full replacement of the depreciated portion of the existing assets in the ABEL calculations taking inflation into account Any reinvestment rate between zero and 1 0 allows the manufacturer to use a portion of future estimated future available cash flow for reinvestment Implicitly you are allowing for partial replacement of the depreciated portion of the firm s existing assets Very rarely you might enter a value over 1 0 to allow for new capital expenditures above and beyond what
38. do not correspond not to a specific basket of goods a broader based measure of the economy wide inflation rate is necessary 3 13 April 2003 The default discount rate reflects a typical company s weighted average cost of capital WACC based on the following formula WACC CBA 1 0 TR W TN R W where CBA Corporate bond average interest rates TR Marginal corporate tax rate Wy Fraction of total financing made up of debt TN Average return on five year Treasury notes R Historical equity risk premia W Fraction of total financing made up of equity You should not change this value without sufficient justification For a detailed derivation of the standard value contact the EPA Helpline at 888 ECONSPT or review the BEN model s detailed printouts 4 Weighted Average Smoothing Constant ABEL uses the smoothing constant to calculate the weighted average of the firm s income The 0 3 default value weights the mostrecent year s income most heavily The table below provides the series of weights that a 0 3 value will generate for different years of data The default smoothing constant assumes that the most recent year of income is the most accurate predictor of the firm s future earnings potential Do not adjust the smoothing constant unless a the model issues a flag alerting the user to large variation in total income anda change is warranted or b you have other information such as a written explanatio
39. e form to the IRS within 60 days of the firm s signature 2 2 April 2003 After installing the model you may wish to create asubdirectory for storage ofall your case files Alternatively you may also choose to save your case files in any pre existing directories corresponding to different cases or projects C DATA ENTRY Like other Windows based programs ABEL uses the mouse or the Enter and Tab keys to move from entry to entry or from screen to screen Hold down the Shift key while pressing Tab to return to previous entries Each screen has several options and spaces for input ABEL will accept several entry formats Numerical values can include but do not require commas Monetary values should be entered as whole numbers they should not contain decimals They may be entered with or without dollar signs Negative dollar amounts should be entered with a minus sign before the amount rather than parentheses around the amount e g 45600 rather than 45600 Rates or percentages should be entered as a decimal number without a percent symbol e g enter 0 25 to represent 25 percent If you type 25 for a percentage rate ABEL will read it as a rate of 2500 percent ABEL converts all dates to a 1 Jan 2000 format but can understand almost any sensible format If you enter an atypical date format be sure to check that ABEL has interpreted it as you intended Be careful to use only number keys to enter numerical val
40. e run name under New Run and press Add ABEL will save the new run and list it under Existing Runs Run names can be any length and include any letter punctuation or number Each case may contain multiple runs To copy an existing run select the run you wish to copy from the list of existing runs and press Copy A window will appear asking you to enter a name for the new run No two runs can have the same name Enter the new name and press OK to save the new run or Cancel to delete it The copy will contain all of the information from the original Copies are particularly useful when making only minor changes in cost information from run to run because they can carry over consistent data To remove arun select it from the existing run window and press Remove A window will appear asking you if you aresure press Yes to confirm the deletion Remember that ABEL does not have a trash bin to hold deleted runs so you will have no wayto retrieve a run once you have removed it To access the run input screen as shown on the preceding page select a run and press Enter Edit or simply double click on the run name The first box reminds you of the data entry format you specified on the case screen i e dollars thousands of dollars or millions of dollars You must then specify the year when the environmental expenditures will be incurred If the firm will pay the penalty in multiple installments enter the year in which the
41. e run screen you can go to the options screen which allows you to modify ABEL s standard values for the run parameters You will never need to use this screen unless you want to customize the default settings The output screen displays the results of ABEL s calculation which estimates the probability that the firm can pay for these costs out of internally generated cash flows Here you have three options You can print out a summary of the calculation save the results as an html file or return to the run screen B INSTALLATION ABEL requires a personal computer running the Windows operating system Windows 95 or higher In addition for optimal formatting of various data entry screens set your displayin the control panel to the small fonts option Small fonts is the Windows default so unless your display settings have been altered your computer should be set appropriately To install the model go to http www epa gov Compliance civil programs econmodels index html Screens with instructions will guide you through each step of the process Note that you have the option to install all the models or only a subset Also once you have run the installation you can run it again at a future point to modify your setup Copies of Form 8821 are available at www irs gov first complete the form indicating which tax return years are needed next have the firm s representative sign the form and return it to you then mail th
42. e time reviewing the spreadsheet you might want to copy the spreadsheet file to another folder using a different name e g ABELtest xls Also do not try to run ABEL with the spreadsheet open in Excel as this will cause ABEL to crash Once you open the file you will see that it has many sheets but they mainly concern the process of exchanging data with the computer program The calculations that you will want to A April 2003 review are located on the print and calc pages with a few additional calculations on the nsd z and smooth pages B FINANCIAL STATEMENTS The Financial Profile section of the ABEL results allows the user to compare a firm s financial performance over time lt is an easy way to spot inconsistencies within specific cost categories as well as excessive variation in expenses income and deductions as claimed by a firm on its tax returns For a more general description of a firm s financial profile results as opposed to the calculations consult Appendix B 1 Balance Sheet The balance sheet provides important information about a firm s assets and liabilities The first section of the balance sheet illustrates a firm s assets In this section the entries for accounts receivable cash inventories U S government obligations tax exempt securities and other current assets are copied directly from data entered during the ABEL input session for each year Because the user does not
43. enter total assets during the input session ABEL computes the figureas equivalent to total liabilities and stockholders equity All other assets is equivalent to total assets less accounts receivable cash inventories U S government obligations tax exempt securities and other current assets On the second half ofthe balance sheet ABEL calculates a firm s total liabilities Entries for accounts payable mortgages bonds payable in less than one year other current liabilities loans from stockholders mortgages bonds payable in more than one year and other liabilities are taken directly from data entered by the user during the ABEL input session for each year ABEL then computes total liabilities by summing these entries Finally ABEL calculates stockholders equity by subtracting total liabilities from total liabilities and stockholders equity a figure entered during the ABEL input session You can view all of these calculations in the Excel spreadsheet on the print page section A4 F23 2 Income Statement The income statement illustrates the firm s financial performance It allows the user to identify whether the firm is generating profits from its daily business operations as well as whether its taxable income is positive In addition it highlights a few ofthe firm s expenses and deductions including depreciation depletion amortization and interest expense spent on servicing its current outstanding debt On the income sta
44. er modified it on the Optional Run Inputs screen Like the historical data provided these calculations yield available cash flow figures expressed in current nominal dollar terms A firm s pre tax historic available cash flows can be found on the Financial Statements section of the ABEL model output 2 Adjust Available Cash Flows for Inflation ABEL then converts the current dollar pre tax historic available cash flows into inflation adjusted constant real dollars as of the base year 1 e the year that the company will be incurring the environmental expenditures as entered on the Run Inputs screen The annual inflation rate is equal to the default value updated annually unless the user modified it on the Optional Run Inputs screen Edward I Altman Corporate Financial Distress A Complete Guide to Predicting Avoiding and Dealing with Bankruptcy 1983 and The Success of Business Failure Prediction Models Journal of Banking and Finance Vol 8 pages 171 198 June 1984 A 5 April 2003 3 Compute Mean and Standard Deviation of Historic Constant Dollar Pre Tax Available Cash Flows The weights for the historical mean are determined by the smoothing constant whose 0 3 default value the user can modify on the Optional Run Inputs screen ABEL will use the standard deviation as part of determining its probability levels see below 4 Estimate Future Available Pre Tax Cash Flows This equation calculates the constant dollar
45. eturns with no independent assessment concerning the quality of this information Since firms have incentives to minimize taxable income to lower their tax liabilities ABEL generally provides a conservative estimate of ability to pay If ABEL concludes that a firm has sufficient resources to pay the stipulated penalty the enforcement official can be reasonably assured that the penalty payment will not burden the firm with undue financial hardship If ABEL provides a negative or inconclusive result however you should not assume the firm cannot pay the penalty without first conducting additional analysis The analyst should take a second look after receiving a negative ABEL result for a number of reasons The first reason was mentioned above ABEL employs a number of conservative assumptions in its calculations In addition ABEL focuses on only one area of ability to pay cash flow Firms may have other potential sources of funds that are not captured in the ABEL analysis For example the firm s available cash flow may be understated if it has inflated or nonessential business expenses and distributions These might include among others e Extravagant or unnecessary compensation of officers e Extravagant or unnecessary travel and entertainment expenses e Contributions to charitable and other organizations and e Cash dividends paid out to shareholders 4 12 April 2003 Furthermore the firm might own assets that are not essential to its
46. he sum of all expenses equals taxable income Positive taxable income indicates the firm is generating sufficient incometo meet all of its business expenses and has additional income left over Like the balance sheet the summary income statement provides useful information to identify trends in performance Look to see whethersales are increasing or decreasing and whetherexpenses are changing in proportion Observe whether particular expense items are variable or appear high relative to the size ofthe company Determine whether profits appear to be increasing or decreasing over time Once you have identified any interesting items contact the EPA Helpline at 888 ECONSPT to help you understand and interpret the information Note that certain expenses may not represent an outflow of cash from the company The most important non cash expense is generally depreciation These expenses represent the annual usage of an asset The presence of non cash expenses has important consequences for the calculation of cash flow as discussed below C SUMMARY OF CASH FLOWS The flow of income and expenses in and out of a firm may differ from the flow of cash One source of this difference in the timing of income and expenses and cash is non cash expenses ABEL scash flow summary illustrates these timing differences To reconcile income with available cash we start with taxable income and add back any non cash expenses that are impounded in the taxable income amount
47. holders equity represent the firm s sources of funds Liabilities represent loans from banks owners or customers shareholders equity represents funds or capital provided by owners or the firm itself through retained profits Assets represent items that the firm has purchased with these funds Hence the balance sheet is a static presentation of what the firm has purchased and the amount of debt or equity used to finance those purchases Since the firm cannot purchase more items than it has resources to fund them assets must always equal the sum of liabilities and shareholders equity thus the term balance sheet While the balance sheet presents a snapshot of a firm s financial condition the income statement summarizes the operating activities of a firm over a period of time representing a link between a firm s balance sheet at the beginning and end of a period The income statement shows the income a firm earned in a particular period and the expenses it incurred to generate that income Somewhat similarly the summary of cash flows reconciles the flow of cash in and out of the firm with the flow of income and expenses in and out of the firm The flow of cash is not necessarily the same as the flow of income and expenses ABEL uses these past cash flows to predict future cash flows and derive its ability to pay conclusion Using the ABEL financial profile for the example that installs with the model the following sections discuss e
48. ibit considerable volatility Users who are unfamiliar with financial information might find it difficult to understand or interpret this profile and may wish to consult Appendix B Nevertheless you do not need to execute or understand a firm s Financial Profile to determine a firm s ability to pay for settlement purposes Instead you may proceed directly to the Ability to Pay Analysis 4 1 April 2003 i Sam s Brewing Co Financial Profile Financial Profile Financial Statements 1999 1998 1997 S Corporation Tax Form 11205 Balance Sheet 906 995 475 824 31 042 1 031 945 403 352 25 821 1 106 663 154 397 29 932 Accounts Recervable Irwentories U S Government Obligations Tax Exempt Securities Other Current Assets All Other Assets 71 990 614 461 1 983 443 55 791 835 152 2 305 404 161 458 793 732 2 466 308 Alo e Y eee Alo e c6 69 e e d alo e 45 e o Accounts Payable 518 717 Mortgages Bonds Payable in 1 Year 3 770 Other Current Liabilities 506 736 Loans from Stockholders 520 454 1917 410 610 496 155 390 007 359 713 Other Liabilities Total Liabilities 1 222 428 Stockholders Equity 1 243 880 Total Liabilities and Stockholders Equity 2 466 308 749 720 Mortgages Bonds Payable in 1 Year 193205 220 806 2 305 404 1 983 443 Income Statement Gross Sales 12 569 855 11934144 12 885 955 Cost of Goods Sold 6 236052 59
49. ic pre tax Constant cash flow and income figures Number of Years of Future Cash Flow Considered in Ability to Pa The optional run inputs screen also allows you on its right hand side to set up a payment schedule This will not affect the affordability results but will calculate for you the installment that is the equivalent of the lump sum amount given the number of payments with the first installment due at the beginning of the first period payment period i e yearly quarterly or monthly and interest rate that you specify For Superfund cases the default interest rate is set at the Superfund interest rate as reported at http www epa gov ocfo finstatement superfund int rate htm and for other cases is set at the discount rate 1 Reinvestment Rate The reinvestment rate determines the portion ofa firm s future cash flow that is allocated for reinvestment in depreciating assets Typically firms reinvest a portion of their earnings to replace machinery and equipment as it wears out However the more a firm reinvests the less cash it will have available for payment of environmental expenditures The reinvestment rate determines the fraction of the firm s depreciation expense that you assume the firm will reinvest ABEL uses a standard value of zero for the reinvestment rate meaning that no depreciation expenses are allocated to reinvestment This standard value is based 3 12 April 2003 on the assumption that a firm require
50. ile click on the Printer button in the lower left corner E EXITING AND SAVING You exit ABEL just like any other standard Windows application From the main screen select Exit under the File pull down menu at the top left corner of your screen or click on the x button at the top right corner of your screen or double click on the ABEL icon at the top left corner of your screen ABEL will ask you if you want to save your work before you exit Be sure to save your case s before you exit You save a case by selecting Save under the File menu or give the case a new name by selecting Save As or using the Ctrl S shortcut ABEL cases are automatically saved with the extension abl and can be accessed using the Open command under the File menu or the Ctrl O shortcut You can save cases in any folder and switch between different folders at any time Runs are automatically saved as part of a case 2 4 April 2003 DATA REQUIREMENTS CHAPTER 3 ABEL evaluates the capability of corporations to pay a specified penalty or environmental cleanup contribution Depending on the type corporations will file a Form 1120 1120 A or 1120 S federal income tax return Under some circumstances you may wish to use ABEL to evaluate the ability to pay of a partnership which files Form 1065 Formore details see Chapter 4 Section E ABEL accepts data directly from Forms 1120 1120 A 1120 S and 1065 The firm s most recent tax data
51. in the value of the firm i e other creditors claims must generally be satisfied before shareholders can claim their share of the value of the firm 4 Items to Look for in the Balance Sheet The summary balancesheet presented in the ABEL results is particularly useful in identifying trends in performance over time Look for items that exhibit considerable variability year to year or are trending upward or downward Also consider the relationship of current assets to current liabilities A healthy firm will generally have sufficient current assets assets that can readily be converted into cash to meet its near term debt payments A rough measure of this capability is having current assets that are at least twice as large as current liabilities Also look at long term assets to determine whether these items are increasing or decreasing in value perhaps suggesting that the firm is investing in new productive assets or sellingthese assets Determine whether the firmis increasing or decreasing the amount of debt it is carrying Increasing debt levels may indicate the firm is having difficulty generating sufficient funds internally to fund its ongoing operations requiring it to borrow money Determine whether the firm has loans from or to shareholders indicating a close relationship between the company and its owners After you have identified any interesting items or general trends in the data contact the EPA Helpline at 888 ECONSPT B 6 April
52. is necessary to produce a reliable analysis If the firm re filed any forms for the years that you are using you should obtain the most up to date version of these forms In addition all returns submitted for an ABEL analysis must be signed One of the key advantages of using tax returns is that the firm has stated under the penalty of perjury that the information provided on the tax form is true Without the signature you have no guarantee that this information is accurate If the firm no longer has signed copies the firm can obtain these from the IRS Alternatively you may obtain a summary of a firm s tax returns directly from the IRS if you obtain the firm s permission via Form 8821 EPA advises enforcement personnel to ask the firm to submit a Form 8821 even if you receive signed returns due to the marked increase in the submission of fraudulent tax returns The analyst can use the tax returns provided by the firm to assess its preliminary ability to pay a Superfund contribution or environmental penalty However the analyst should confirm the accuracy of the returns submitted by the firm against the returns that the IRS provides To evaluate a firm s financial condition using ABEL you must understand its relationship to other business entities For instance a firm may be the subsidiary of a large parent corporation or may be one of several closely related sister firms While the firm may be filing its own tax returns it is easy foranother e
53. l epe KE dd 4 6 3 Times Interest Earned Ratio llle 4 7 4 Beaver s Rag es A A A os efto 4 7 5 Altman s Z SGO e oe 200 25 A ARA be R 4 7 April 2003 TABLE OF CONTENTS continued C Ability to Pay Conclusion 2 a aia as 4 10 1 Summary Tableau o a cea tana T py 4 10 2 Summary Graphic rl o modas urs 4 11 3 Conclusion ias a ie o a a 4 11 4 Histone Comparison desidia randu A EPA CE CRUS 4 12 D Sitio the Results cse cum sque a Mei sak oat e ur erre 4 12 E Analyzing Partnerships aves adele eee add 4 13 DETAILED CALCULATIONS eeeeeee eren Appendix A A OVERVIEW S 9 ceat E AI but A BUD el opu Ed e E E A 1 B Financial Statements cade day pad we a id PON Pe A 2 C Financial Rao a e vM io EA A 3 D Ability to Pay Calculations ou avrete exa tienes xd daten S EA eR A 5 E Decision Rule for Changing Smoothing Constant saasa A 8 UNDERSTANDING THE FINANCIAL PROFILE ee Appendix B A Balance Sheet i ovo e VA UE a DRE Ee teu b BE a tois B 3 l AS TTT B 3 a CUENTAS ees a A RR I RA B 3 b Long Lived Assets ia Soc dre a dE B 4 2 abes FEET B 5 a Current Liabilities E REDE ds de B 5 b Long Term Liabilities a daret ies Gotta metu B 5 3 Shareholders Eguity x s a Ear L EET E excu Rr tee eeu B 6 4 Items to Look for in the Balance Sheet o oo ooooooo oo o B 6 B Income Statement s cuadra es de oa RA d eR a AA B 8 l Components of the Income Statement 0
54. le income is appropriate because it applies to incremental changes in the firm s tax deductible expenses and income ABEL uses this rate to derive the firm s after tax cash flow The marginal tax rate does not include sales tax inventory tax charter tax orproperty taxes Include one time tax payments e g sales taxes on equipment purchases as a capital investment on the run inputs screen Include regularly paid taxes e g property taxes on equipment of this nature as an annually recurring cost The standard value for this variable is based on the marginal federal tax rate at the highest income level and the average of all marginal corporate tax rates imposed by states ABEL applies corporate rates to C corporations and individual rates to S corporations and partnerships ABEL also varies the default rate by state For a firm in Puerto Rico or the Virgin Islands contact the EPA Helpline at 888 ECONSPT to determine the applicable rate Because states taxes are deductible from taxable income for computing federal income the combined tax rate calculation is Combined Federal State 1 Federal 6 Number of Years of Considered Future Cash Flow ABEL uses the number of years of cash flow to calculate the total amount ofthe firm s future income considered available to fund a penalty or contribution The default value is five years but you may select between one and four years or up to ten years for Superfund cases The model fi
55. ling address Except for the state which ABEL uses to determine the appropriate marginal tax rate these entries are for reference purposes only and do not effect the ability to pay calculations You must also enter certain information describing the tax return data number of years and most recent year for tax returns the firm submitted data entry the units in which you will enter data 1 e dollars thousands of dollars or millions and tax form 1 e 1120 1120A 1120S 1065 If you revisit a case after a year has passed and new tax returns have become available you can increase the value for number of years and update the value for most recent year 3 2 April 2003 ABEL File Window Help E Example abl Case Office Agency Analyst Region 1 X Ues Public r Firm Information Name Sam s Brewing Co Address 23 Main St City Salem State Zip Code DR m 97301 Tax Retum Information Number of Years Data Entry 4 Dollars y Most Recent Year Form fi 999 Tax Return Data Financial Profile EL Add Existing Runs Superfund BEE Stan Groupwise Mailbox XE Microsoft Excel Ka Corel WordPerfect 3 G Exploring ABEL SN ABEL Er 1 12 PM 3 3 April 2003 B TAX RETURN DATA Clicking the Tax Return Data button on the case screen takes you to the input screen shown on the following page The grid like format allows you to enter a
56. ll tax inputs for all years on a single screen Remember to enter data in the units you specified on the case screen the box at the top left of the screen reminds you whether to use dollars thousands of dollars or millions of dollars If the firm s tax return 1s blank for a particular item then leave that item blank in ABEL The input labels in the left most column stay the same regardless of the tax form and year However the line reference window at the top of the screen is customized for each item year and tax form For C corporations i e tax form 1120 and 1120 A the line references are very straightforward For S corporations 1 e tax form 1120 S and partnerships i e tax form 1065 the line references are more complicated and may involve combining together several figures from the tax return for such items ABEL allows you to enter a mathematical expression Certain items might not be applicable to S corporations and partnerships leave those items blank in ABEL If you would like to enter the data on paper prior to running ABEL you can print up the necessary forms complete with line references by selectingthis option under the File menu on the case screen Once you have finished entering the tax return data then you can generate the financial statements and a ratio analysis by clicking the Financial Profile button on the screen Chapter 4 and Appendix B describe the financial profile in more detail 3 4 April 2003 S
57. lly more effective strategy for trial or hearing is to identify specific sources of funds that are potentially available to pay for the environmental expenditures 1 3 April 2003 expenditure s ABEL assumes that the near future will resemble the immediate past Thatis the model projects future cash flows by assuming that the firm will continue to perform financially as it has over the recent past ABEL s measure of ability to pay is more stringent than measures ofcash or liquid assets on hand but less stringent than the legal liability of the firm s owners One crucial but often overlooked policy matter is that the Agency will not automatically reduce a penalty even when a violator proves conclusively that it cannot afford topay The Agency will not reduce the civil penalty for inability to pay in the following situations e the violator refuses to comply with pollution control requirements e the violator cannot afford to comply with pollution control requirements or e the violator s conduct was egregious e g willful violations or violations that might have or actually endangered lives B HOW TO USE THIS MANUAL This manual provides instructions for using the ABEL Model These instructions illustrate the model with a hypothetical example and demonstrate a typical model run Chapter 2 provides an overview of how to use the model along with installation instructions Chapter 3 covers data entry Chapter 4 describes the model s
58. ly in all cases 4 6 April 2003 3 Times Interest Earned Ratio The times interest earned ratio TIE is defined as the firm s earnings before interest and taxes divided by its interest expense payments This ratio indicates how easily the firm can pay the interest expense on its debt Three conclusions are possible e A TIE greater than 2 0 generally indicates that the firm is able to meet its interest payments e A TIE less than 2 0 indicates that the firm may have trouble meeting future interest payments As the TIE decreases the likelihood and potential severity of the firm experiencing problems in meeting those payments increase e A TIE of na indicates that the firm had no interest expense in that year This result may indicate a very poor financial condition because the firm has likely fallen behind its debt servicing requirements or it may indicate that the firm is carrying no debt a sign of strong financial health 4 Beaver s Ratio Beaver s Ratio BR is defined as the firm s after tax cash flow divided by its total liabilities The BR provides a useful measure for predicting a firm s long term solvency and likelihood of staying in business In particular the BR indicates whether the firm s internally generated cash flow is sufficient to meet it current and long term financial obligations Four conclusions are possible e A BR greater than 0 2 generally indicates that the firm is solvent and healthy e A BR between 0 1 and
59. n from the firm informing you that the most recent federal tax form is nota good proxy for the firm s future income In that case you must decide whether to adjust the smoothing constant based upon whether you think the year causing a large variation is a more accurate predictor than the other years 3 14 April 2003 Raising the smoothing constant weights the most recent year of income more heavily lowering it lowers the weight given to the most recent year s income simultaneously raising the weights given to the other years If for example the firm s most recent year of income is significantly higher than the average and you believe that year is a much better estimate of future cash flow than the other years you may wish to increase the smoothing constant Alternatively if you believe the most recent yearis significantly larger than the average because of an aberration in income that will not continue in the future you may wish to lower the smoothing constant thereby decreasing the weight of this year s income in the calculation of total average income and income from each source 5 Marginal Income Tax Rate The marginal income tax rate applies to the last dollar of income the firm earns This rate reflects the percentage of income paid for taxes 1f taxable income were to increase or decrease and includes both state and federal taxes The marginal tax rate as opposed to the average tax rate 1 e total tax divided by total taxab
60. nd if there is reasonable certainty that the firm will receive payment for that sale Cost of goods sold represents the input costs ofthe final product that is sold It includes costs that can be directly attributed to the production of the good or service Common items include cost of raw materials and labor rent paid on the manufacturing facility and expenses related to the operation and use of related equipment These costs are itemized in Schedule A ofa company s federal income tax return and related attachments Overhead or general and administrative expenses represent the cost of operations not directly related to the manufacture of the product or delivery of a service Examples include administrative and marketing costs The Deductions section on page one of the tax return details anumber of these expense items including officers compensation interest payments rent depreciation and a number of others including an itemization of these expenses in attachments to Line 19 of the return B 8 April 2003 2 Items to Look for in the Income Statement The income statement provides useful information on a firm s past and likely future profitability The difference between gross sales and cost of goods sold equals operating profit Operating profit is an important measure of firm health because it indicates whether a firm s core operating activities are generating positive returns The difference between the sum of all income and t
61. nterpolation For these calculations note that if the probability falls below 50 percent ABEL s output will simply display less than 50 and if the probability exceeds 99 percent ABEL will display greater than 99 9 Convert the Affordable Penalty into an Annual Equivalent Cash Flow Rather than paying a single lump sum penalty the government may wish to allow a firm to spread payment of that penalty over several years in equal installments The first installment would occur at the beginning of each period whether monthly quarterly or yearly as the user can specify on the Optional Run Inputs screen The default interest rate is either the company s cost of capital or for Superfund cases the Superfund interest rate E DECISION RULE FOR CHANGING SMOOTHING CONSTANT ABEL will occasionally suggest that the user adjust the smoothing constant ABEL compares the average income generated over all years except the most recent year with cash flows generated in the most recent year The following conditions will trigger such a prompt e The most recent year s cash flow is more than twice the historical average e The most recent year s cash flow is less than half the historical average or e The most recent year is negative yet the historical average is positive ABEL s calculations for these comparisons are on the smooth page in the spreadsheet Consistent with EPA policy outlined in amemorandum titled General Policy
62. ntityto make the firm look artificially poor by manipulating the firm s finances In these situations Agency personnel should insist on seeing tax returns and other relevant financial reports from all related firms Copies of Form 8821 are available at www irs gov first complete the form indicating which tax return years are needed next have the firm s representative sign the form and return it to you then mail the form to the IRS within 60 days of the firm s signature 3 1 April 2003 This chapter provides a screen by screen explanation of the model with screens from a hypothetical case accompanying the discussion Section A describes the main case screen Section B discusses the entry screen for the firm s tax return data and explains how to generate the financial profile Sections C and D describes the procedures for creating an ABEL ability to pay run The next chapter explains how to interpret ABEL s analysis A CASE SCREEN Upon opening the ABEL Model the main case screen will appear as shownon the following page On the left hand side of the screen you first enter the office agency and analyst name these are for reference purposes only and do not affect the calculations They can be any length with letters spaces punctuation and numbers although they may notbe left blank Office agency also provides a pull down menu for all ten EPA regions EPA headquarters and other The next entries are the firm s name and mai
63. nup costs and Superfund cleanup costs This manual collectively refers to all of these items as environmental expenditures ABEL evaluates a firm s claim U S EPA Policy on Civil Penalties February 16 1984 codified as PT 1 1 in the General Enforcement Policy Compendium previously codified as GM 21 2 U S EPA 4 Framework for Statue Specific Approaches to Penalty Assessments February 16 1984 Codified as PT 1 2 in the General Enforcement Policy Compendium previously codified as GM 22 pp 12 13 Ibid U S EPA Guidance on Determining a Violator s Ability to Pay a Civil Penalty December 16 1986 Codified as PT 2 1 in the General Enforcement Policy Compendium previously codified as GM 56 1 1 April 2003 regarding its ability to pay for such expenditures Given the firm s incentives to avoid large penalties and investments many firms will initially claim inability topay regardless oftheir financial health ABEL is a sophisticated screening tool and as such is designed principally for negotiations The ABEL model is generally not intended for use ata trial or in an administrative hearing If the Agency will present ability to pay testimony in these settings it should rely on an expert to provide an independent financial analysis This independent financial analysis while consistent with the principles of the ABEL model may not necessarily be identical to ABEL s methodology The ABEL model is part of an ong
64. ocess partially finished goods in the process of manufacture or finished goods ready for resale such as automobiles coming off an assembly line or canned goods on the shelves of a grocery store e U S government obligations are notes or bonds issued by the Federal government and purchased by the firm They represent very liquid assets that in general can be easily converted into cash e Tax exempt securities are notes or bonds issued by authorities with certain tax exempt status primarily municipalities In most cases these debt instruments are easily sold and converted into cash B3 April 2003 e Other current assets include a variety of items that are likely to be converted into cash over the next operating period These assets should be itemized in an attachment to the tax retums b Long Lived Assets The category All Other Assets appearing in the summary balance sheet includes a number of long lived assets detailed in the tax return These represent assets that are not intended for sale inthe near term and generallyare used continually over time throughout the production process The asset items typically include e Loans to stockholders represent money loaned to owners of the company EPA generally regards such loans as being available to fund a penalty payment or Superfund contribution Presumably the owners could borrow equivalent sums from a commercial lending institution and repay the loan to the firm e Mortg
65. oing EPA effort to evaluate the financial health of entities involved in enforcement proceedings In addition to ABEL the Individual Ability to Pay Model INDIPAY evaluates the financial condition of individuals held liable for environmental expenditures e g sole proprietorships partners The Municipal Ability to Pay Model MUNIPAY evaluates the financial condition of municipalities including cities towns villages counties regional authorities and other local governmental jurisdictions that are liable for environmental expenditures ABEL may also serve as an adjunct to other enforcement computer programs such as the BEN Model BEN calculates the economic benefit a violator derives from delaying and or avoiding compliance with environmental statutes As with any of these models however the results ABEL provides must be interpreted in a manner consistent with the assumptions within the model The purpose of this manual is not only to help you operate the program but also to help you understand the program s assumptions The type of analysis ABEL performs is often generically referred to as an ability to pay analysis because the program is analyzing a firm s ability to pay for environmental expenditures When interpreting the results of the ABEL analysis you must understand what ability to pay means as no strict definition exists in an economic or financial sense A firm s ability to finance environmental expenditures depends on
66. profit to reproduce the firm s taxable income ABEL also calculates other expenses income internallyto ensure that operating profit less total expenses is equivalent to taxable income before net operating loss NOL 3 Statement of Historic Cash Flows ABEL provides a table for the firm s cash flows which can assist a financial analyst in understanding the relationship between the firm s historical and projected cash flows The table is derived by subtracting taxes and adding back depreciation amortization depletion income not included in return credit for regulated investment companies and credit for federal tax on fuels to a firm s taxable income before net operating loss deductions ABEL adds back these expenses because they do not represent actual cash transfers ABEL then calculates a firm s historic pre tax annual cash flow by adding back taxes paid This pre tax cash flow showsthe firm s historic pre tax internally generated cash flows by year expressed in their respective years dollars Finally ABEL computes inflation adjusted pre tax cash flow using the inflation rate entered on the run input screen This row shows the same pre tax cash flow values expressed in current dollars so that they can be compared on an inflation adjusted basis These cash flow valuesrepresent cash generated bythe firm after meeting all of its business expenses and are considered available to fund a penalty payment Ifa firm has positive cash flow you
67. ps will typically be deductible in the year expended or incurred if the expenditures are related to carrying on a trade or business or can be characterized as an investment expense But a deduction may not be allowable if the party is an individual who cannot make either type of demonstration Because of the significant uncertainty and the importance of case specific facts the IRS has issued Revenue Procedure 98 17 which provides for a two yeartrial period special procedures for For depreciable cleanups ABEL uses a seven year depreciation schedule which typically applies to capital investments with useful lives between 10 and 25 years If the depreciation schedule for the cleanup costs you are assessing is significantly higher or lower thanthis figure and or you choose to consider more than five yearsof future cash flow contact the EPA Helpline as the ABEL result may be slightly inaccurate 7 Rev Rul 94 38 1994 1 C B 35 18 Priv Ltr Rul 96 27 002 3 9 April 2003 a party to obtain an IRS letter ruling on environmental cleanup tax treatment The procedures apply to any costs associated with the assessment mitigation or remediation of environmental hazards whether such hazards are on the property of the party requesting the ruling or on some other property Because most parties are unlikely to be current owner operators and because most of their cleanup costs are expected to be deductible as ordinary and necessary busines
68. rate a firm s financial profile click the button for this located on the lower middle part of the main screen To perform an affordability analysis select the desired run title from the list on the main screen and press Calculate If you have entered data for only one run you will have only one run to choose On the calculate screen you can view the summary or also choose to print the firm s financial profile as well The Summary print button will print only the information from the first screen The Detail option will print both screens For more information on interpreting results see Chapter 4 as well as the detailed calculations in Appendix A or call EPA s toll free enforcement economics support helpline at 888 ECONSPT 326 6778 Although printing is done from the output screen the printer setup is controlled by the pull down menu on the main screen The printer setup allows you to shift between landscape and portrait printing as well as choose more advanced options ABEL also allows you to save the calculation summary or details by using the print to file option To do so click on the File button in the lower left hand corner before clicking the appropriate print button ABEL will ask you to choose a name and folder for the resulting output file The data is saved in an html file and can be viewed using a web browser e g Netscape Navigator or Microsoft Explorer To switch back to printer mode after printing to a f
69. reening tool does not require a reading of Appendix A The main section of this manual contains all that you need to use the ABEL program successfully ABEL produces asummary table illustrative graphic and related explanatory text to convey the ability to pay result as shown on the previous page ABEL also evaluates the probability that the firm can afford the environmental expenditures that you have proposed 1 Summary Table ABEL first produces a table showing the present value ofthe firm s projected cash flows over five years or for fewer years as specified during the input phase both including and excluding the environmental expenditures that you specified This table will be the focus of almost all ABEL analyses Since ABEL bases the firm s projected cash flows on a statistical extrapolation of the firm s historical cash flows the table shows projected cash flows at seven different probability levels These probabilities reflect the likelihood that the firm will equal or exceed the specified level of cash flow The second column lists the firm s projected after tax cash flows which represent the likelihood that the firm will generate cash flows given an associated probability These values do This discussion assumes that you used the standard default value of five years of future cash flow considered available for penalty or contribution to EPA You may also selectone to four years of future cash flow considered in ability to pay anal
70. rst calculates the firm s annual weighted average cash flow based on past financial information Next ABEL projects this annual cash flow amount into the future for the number of years of cash flow considered available The model then calculates the present value ofthis stream of future cash flow 3 15 April 2003 using the discount rate which is also specified on the Model Parameters screen Appendix A provides a detailed description of this calculation In some cases you may wish to reducethe number of years of cash flow considered available for a penalty or contribution to less than five years You may choose to alter the default value 1f specific circumstances surrounding a case warrant a change or if the specific enforcement policy governing the case suggests using fewer years than the default value of five For example Superfund ability to pay guidance allows for reducing the number of years considered in certain instances including when revenues and expenses are very erratic the firm is going through a major restructuring or other significant changes are occurring Decreasing the number of years of cash flow considered available decreases the firm s ability to pay a penalty or contribution because the model calculates the lump sum of less than five years of future cash flows U S EPA Office of Site Remediation Enforcement General Policy on Superfund Ability to Pay Determinations September 30 1997 3 16 April 2003 INTERPR
71. rtnership controls the analyst should in addition consider assessing the personal financial capabilities of the partnership s individual owners to conduct a complete ability to pay analysis Enforcement staff often conduct a two stageability to pay analysis ofa partnership Thefirst stage evaluates the financial resources of the partnership entity alone using the ABEL model If and only if the resources of the partnership are inadequate for the sought penalty or contribution the second stage then evaluates the resources oftheindividual partners for their ability to pay the entire or remaining portion Partners can be either corporations or individuals If the partner is a corporation you should obtain the firm s completed income tax returns form 1120 or 1120 S and use ABEL to assess its ability to pay If the partner is an individual you should obtain the individual s completed individual income tax returns Form 1040 and have the individual Limited Liability Corporations LLC and Limited Liability Partnerships LLP are becoming increasingly more common For analysis purposes you should analyze the ability to pay of a LLC by selecting C corporation assuming the firm submits form 1120 on the Case Description Details screen You should analyze the ability to pay of a LLP by selecting Partnership on the Case Description Details screen If the ABEL results indicate that the LLP LL C can pay the proposed penal
72. s expenses for federal income tax purposes ABEL s default is that costs are fully deductible in the incurred year Butif the factors of a particular case and or the status of a party indicate that cleanup costs will be treated otherwise 1 e they will have to be capitalized and depreciated over time or they will not be deductibleat all you should adjust the tax treatment inputaccordingly For current owner operators of Superfund sites particular situations in which a different tax treatment may apply include 1 A previous owner caused the contamination 2 The expenditure is for a facility that will have value over time such as a groundwater treatment facility 3 The site will be put to a new use after the cleanup and or 4 The value of the site will increase after the cleanup compared to its value prior to contamination For other types of parties deductibility may be a problem if the party is an individual who does not have a business or investment relationship to the expenditure For example suppose aPRP owned and operated a dry cleaning business for 30 years but is now retired after closing the business This individual may not be able to deduct the Superfund contribution as an ordinary and necessary business expense since the business is no longer operating Similarly the expense is probably not investment related Instead the individual may have to pay the contribution using personal after tax cash flow In circumstances s
73. s to be conservative in predicting ability to pay 2 the ABEL analysis primarily focuses on a firm s cash flow and 3 ABEL does not consider the quality of the entered data Consequently if ABEL determines thata firm can afford to pay and nothing indicates that the firm s financial status has changed since the time period covered by the last tax return then Agency personnel do not need to look any further at the issue in settling the case If the case goes to trial or hearing the Agency will need to involve an expert financial analyst If the model yields an indeterminate answer or determines an inability to pay however the user should conduct additional financial analyses before reducing a civil penalty as even firms with poor cash flow often have sufficient resources to pay for environmental expenditures These analyses typically involve reviewing additional financial information on the firm including but not limited to the firm s financial statements including balance sheet income statement statement of cash flows and notes Dun amp Bradstreet Reports and other publically available information It may also involve analyzing sections of the firm s tax forms not utilized by ABEL and or a closer evaluation ofthe firm s assets and liabilities to ensure that the data recorded on the firm s tax returns adequately reflect the firm s current financial condition After providing summary financial statements and analyzing some basic finan
74. t are not depreciable and also not deductible from taxable income e g land purchase Annually Recurring Costs are typically for operating and maintaining the required pollution control equipment or for monitoring a site The figure should reflect the average annual incremental costs associated with monitoring and or maintaining the required environmental equipment including any cost changes in labor power water raw materials supplies annual employee training insurance premiums lease payments and annual property taxes Be sure to exclude any annualized capital reco very interest payments or depreciation The annually recurring costs can be partially or even wholly offset 1 e a negative entry by operation and maintenance savings that arise from heat or product byproduct recovery e g a reduction in sludge disposal costs 2 Superfund Cases For Superfund cases ABEL requires only a cost estimate and its tax treatment but the determination of these inputs can be more difficult than for the run inputs in other types of cases as the following sections explain a Cleanup Cost Estimate The cleanup cost estimate should include all Superfund site costs the firm will incur or has incurred after the end of the most recent year for which you have entered tax return data Do not for example enter cleanup costs incurred in 1999 if you have tax returns for 1999 as the 1999 data that you have already entered will reflect those costs
75. t identified above An itemization of these assets should be included in an attachment to the tax returns 2 Liabilities Liabilities are obligations ofthe firm to transfer assets or provide services at a specific time in the future as a result of past transactions Liabilities are generally measured at their current cash value if payment is to be made within one year or cost the amount originally borrowed Like assets liabilities are typically classified into two categories current and long term a Current Liabilities Current liabilities include all debts that fall due within the next operating period typically 12 months They have a close relationship with current assets since current assets represent the source of funds available to settle a firm s current liabilities The ability to fund current liabilities by converting current assets into cash is one of the most important indications of financial health e Accounts payable are amounts owed for goods or services acquired under an informal credit agreement These accounts are usually payable within one or two months The same items appear as accounts receivable on the creditors balance sheet e Mortgages bonds payable in less than one year equal the face amount of promissory notes given in connection with loans from a bank or other lender e Other current liabilities includes other liabilities not categorized above These items should be itemized in an attachment to the tax
76. tement gross sales and cost of goods sold are copied directly A2 April 2003 from inputs entered during the data entry session Operating profit is calculated as the difference between gross sales and cost of goods sold Taxable income before net operating loss deductions is also entered during the data input session This figure is then used to calculate total expenses such that operating profit minus taxable income yields total expenses Finally other expenses income is derived as the difference between total expenses less interest expense deprecation depletion and amortization You can view all of these calculations in the Excel spreadsheet on the print page section A26 F35 3 Estimated Cash Flows ABEL calculates a firm s historic cash flows using the methodology employed in the ability to pay section ABEL first calculates available after tax cash flow This figure is equivalent to taxable income before net operating losses less taxes paid plus credit for regulated investment companies credit for federal tax on fuels depreciation depletion amortization and income recorded on books not included in the return Finally ABEL calculates a firm s inflation adjusted available pre tax cash flows The calculation uses the inflation rate from the Optional Run Inputs screen You can view all of these calculations in the Excel spreadsheet on the print page section A37 F47 C FINANCIAL RATIOS This section of the appendix
77. the level of financial distress one is willing to impose on the firm For instance a very simple measure of a firm s ability to pay might be how much cash or liquid assets such as certificates of deposit the firm has immediately available Other more stringent measures might require the firm to rely on its future earnings to finance an environmental expenditure Examples of future earnings that could be used to fund these expenditures include The burden of proof in ability to pay matters can be a complex legal issue Government users can obtain advice on this issue by contacting Jonathan Libber the BEN ABEL coordinator at 202 564 6102 or libber jo nathan epa gov For the purposes of this manual any corporation or partnership that is a defendant in an EPA administrative or judicial enforcement action is referred to simply as a firm Forassistance with the selection ofan expert on ability topay and financial analysis EPA staff should contact Jonathan Libber the BEN ABEL coordinator at 202 564 6102 or libber jonathan epa gov 1 2 April 2003 internally generated cash flows loans on unlevered assets the sale of assets and the sale of stock Finally for cases involving unincorporated businesses the Agency or a court may look at the personal assets of the owners in determining their ability to meet a penalty assessment You should keep in mind three issues when using ABEL to assess a firm s ability to pay 1 ABEL tend
78. thing Constant Marginal Income Tax Rate No of Years of Considered Future Cash Flow Summary of Predicted Cash Flow a tabular figures expressed in Dollars Total Generated After Tax Initial Present Value of Cash Flow Net After Tax Pollution Control Annual Pollution of Environmental Cash Flow y j Control Costs 3 387 032 2 236 704 3 097 666 1 947 339 2 176 962 1 626 634 2 365 374 1 215 046 1 675 911 525 583 928 993 221 335 0 1 150 328 4 000 000 3 333 333 3 2 966 867 4 9 April 2003 ABILITY TO PAY CONCLUSION Calculating a run quantifies the firm s ability to pay for an environmental expenditure To make this determination ABEL uses the three to five years of tax return data you entered to project five years of internally generated after tax cash flows ABEL then compares the present value of these cash flows with the present value of the after tax cash flows following the environmental expenditures that you have specified If the present value of the firm s remaining projected cash flows is still positive after making the environmental expenditures ABEL will predict that the firm can afford the expenditure While the general methodology for determining a firm s ability to pay is straightforward the actual details of the calculations are quite complex Appendix A provides the detailed equations used in the ABEL analysis as an aid to financial analysts and other interested users Using ABEL as an ability to pay sc
79. ty or contribution at a probability level greater than or equal to 70 percent you should conclude the entity can pay the proposed penalty If the ABEL results are inconclusive you may wish to obtain the LLP s or LLC s articles of incorporation fora more detailed analysis You can also contact the EPA Helpline at 888 ECONSPT 4 13 April 2003 complete a Financial Data Request Form You should then analyze this information with the Individual Ability to Pay INDIPAY Model Remember that the shareholders who own a corporation contribute either money property or services to the firm in return for shares The main difference between a corporation either C or S and a partnership is that the shareholders ofa corporation are liable only to the extent that they have invested in the company For example if a corporation sustains significant losses to such an extent that it cannot repay its creditors the shareholders personal assets are legally protected In contrast the personal assets of a partnership s shareholders may be accessed to satisfy obligations 4 14 April 2003 DETAILED CALCULATIONS APPENDIX A A OVERVIEW This technical appendix explains how the ABEL computer program assesses a firm s ability to pay for civil penalties compliance costs and or Superfund contributions The explanations are intended for financial analysts who wish to obtain a more complete understanding of how the model performs its calculations You do not need to
80. uch as these you should use the Individual Ability to Pay INDIPAY model since the entity under examination is an individual not a corporation You might also investigate whether a party has received a private letter ruling or other communication from the IRS concerning the tax treatment of its Superfund related expenditures For additional assistance you can contact Bob Kenney of the EPA Office of Site Remediation Enforcement Policy and Program Evaluation Division at 202 564 5127 or kenney robert epa gov 1 Rev Proc 98 17 1998 5 I R B 21 3 10 April 2003 i Civil Penalty Optional Inputs 3 11 April 2003 D OPTIONAL RUN INPUTS Clicking Options on the optional run inputs screen takes you to the screen shown on the preceding page Some of model parameters on the left hand side of the screen are based on EPA policy whereas other model parameters reflect current economic conditions and are updated annual ly You should not adjust any of these values unless you have a strong reason for doing so and you have consulted with the EPA Helpline or another expert The following sections describe the various parameters in detail while the table below summarizes their impact upon the ability to pay results Impact on Ability to Pay Parameter of Parameter Increase Marginal Tax Rate Increase provided tax deductible expenditures are required Inflation Rate Discount Rate Weighted Average Smoothing Depends on specif
81. ues A frequent mistake is typing the lowercase letter L instead ofa number 1 Another error occurs when the letter O is typed instead of the number 0 zero ABEL will tell you ifthe format for an entry is incorrect If this happens correct the number and enter it again Some inputs are limited toa range of values If an entered value falls out of this range ABEL will display an error message with the allowable range of values Other error messages will appear if you did not enter data in a required field After typing your entry you might discover that you have typed an incorrect letter or number Typing errors are easy to correct simply return to the relevant value and type over the mistake Likeall computer programs ABEL follows the GIGO protocol Garbage In Garbage Out Verifying your data inputs is therefore extremely important You may do so by examining them on the screen as well as comparing the written input summary with the firm s tax forms Most people find that they can perform a better audit by checking the written summary than they can by checking the input window on the computer screen For that reason the model includes a data summary in its printout To generate this summary select the Print button located at the bottom of the Tax Return Data screen and then click the Summary button at the lower left hand corner of the resulting data summary screen 2 3 April 2003 D CALCULATING AND PRINTING RESULTS To gene
82. ut tax deductible items which are written off for tax purposes in the year in which they are incurred To be consistent with the Tax Reform Act of 1986 ABEL s depreciation follows the Modified Accelerated Cost Recovery System MACRS MACRS calls for the use of double declining balance DDB depreciation with half year convention a seven year life and a switch from DDB to the straight line method in the fifth year Theswitch is made in theyear depreciation equals or exceeds that determined under DDB in order to maximize the depreciation deduction Note that the tax shields are not inflated to current dollars before discounting them since the actual depreciation in any year is a fixed dollar amount thereby already in each year s current dollars 7 Compute Resulting Net Present Value of Five Years of After Tax Future Cash Flows for All Probability Levels Note that this step s results do not imply that the firm will have enough cash on hand as of the expenditures are incurred to make a lump sum penalty payment If the firm s current financial position is strong however as determined in the Financial Ratios section and the cash flow 1s sufficiently large with for example an 8096 confidence level then ABEL assumes that the firm would be able to obtain additional debt or equity financing sufficient to pay a lump sum penalty of that amount A 7 April 2003 8 Calculate the Probability Level Associated with the Penalty Amount Using Linear I
83. y Assets represent the investing activities of the firm liabilities and shareholders equity representthe financing activities ofthe firm Three factors are important when assessing items on the balance sheet including 1 when the balance sheet item is recognized 1 e determining when a financial transaction legitimately results in the generation of an asset liability or equity 2 how the balance sheet item is valued and 3 how it is classified 1 Assets Assets are resources that a have a potential for providing the firm with future economic benefits b can be measured in dollar terms and c are owned and controlled by the firm as a result of past transactions Assets are generally valued using their acquisition or historical cost They are typically classified according to their longevity yielding two broad categories of assets current assets and long lived assets a Current Assets In general current assets include cash and other assets that will likely be converted into cash in the near future generally within one year from the date of the balance sheet e Cash includes coins and currency held by the firm or in bank deposits o Accounts receivable represent amounts due from customers but not yet collected After goods are shipped or a service provided acustomer typically has a certain period of time e g 30 60 or 90 days in which to pay e Inventories represent raw materials held as inputs to a production pr
84. ysis however the methodology used in each calculation is exactly the same as the calculations employed for five years of cash flow The concept of net present value is based on the principle that a dollar today is worth more than a dollar a year fromnow because today sdollar can beinvested immediately to earn a return over the coming year Therefore the earlier a cost or benefit is incurred the greater its economic impact ABEL accounts for this time value of money effect by reducing all estimated future cash flows to their present value equivalents This widely used technique is known as discounting 4 10 April 2003 not take any environmental expenditures or penalties into consideration The third column presents the proposed civil penalty if any The fourth column reflects the initial pollution control expenditures required of the firm if applicable The fifth column lists the present value of the annual pollution control expenditures required to maintain any capital investments If instead the run is for a Superfund cleanup cost then third fourth and fifth columns will be condensed into a single column for the after tax present value ofthe Superfund cleanup cost The final column presents the cash flow ABEL predicts the firm will generate after pollution control expenditures and penalty payment ABEL provides you with a range of cash flows that might be generated based on its statistical analysis 2 Summary Graphic AB

April 2003 ABEL USER`S MANUAL Prepared for: Office of

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