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Carbon accounting
Accounting for emissions
Time for the IASB to speed up new accounting
standards for emissions rights
By K. Y. Cheung
C
oncern about the environment
is a hot accounting topic,
especially in how to account
for carbon dioxide emissions.
The issue will be high on the agenda
of the United Nations Climate Change
Conference, to be held in Copenhagen
from 7 to 18 December. The meeting
should provide the climax to years of
international negotiations over a new
global treaty aimed at addressing the
causes and consequences of greenhousegas emissions.
World leaders attending the meeting
in the Danish capital are expected to
hammer out a policy to succeed the
1997 Kyoto Protocol, which became
fully effective in February 2005 and
expires in 2012.
The “cap and trade” scheme,
introduced through the Kyoto treaty,
forces companies to pay penalties or
purchase additional carbon allowances
if their carbon dioxide emissions
surpass an agreed level. Firms can
choose to emit carbon dioxide within
the agreed level, without suffering
penalties, or sell the unused portion
of the quota to other firms, creating
significant financial returns.
Five exchange markets exist for
trading carbon dioxide emission
allowances: Chicago Climate Exchange,
the European Climate Exchange, Nord
Pool, Powernext and the European
Energy Exchange. The open markets
allow the cost of the emissions rights to
be measured fairly and reliably.
However, before they can be traded,
emissions rights are required to satisfy
four criteria in accordance with IAS 38.
Under IAS 38, intangible assets can only
be recognized if they are identifiable,
controlled by the entity, expected to
generate future economic benefits for
the entity and have a cost that can be
measured reliably.
Cost and revaluation models are
both used to measure trading prices
for carbon dioxide emissions. The
cost model measures emissions sales at
cost and tests for impairment under
IAS 36 Impairment of Assets. Under the
revaluation model, emissions sales are
measured at “fair value” and tested for
impairment regularly and changes in
this value are recorded.
Different methods of hedge
accounting are applied to the costing,
depending on which hedging relationship – fair value hedge or cash flow
hedge – is established. Hedges can be
highly effective and their effectiveness
can be assessed regularly and reliably.
If the futures contracts of the emissions
rights are classified as derivatives and
held for trading purposes, the changes
in fair value should be recognized in
the income statement. Companies aim
to avoid fluctuations in the value of the
emission rights so that futures contracts
will be a fair value hedge.
Gains and losses in carbon dioxide
emissions trading and the hedged
portion of the hedged item, or the
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Carbon accounting
emission allowances, need to be
measured at fair value and the resulting
gains and losses are reported in the
income statement.
If a company’s carbon dioxide
emissions exceed its prescribed
limit and it needs to buy additional
allowances, the firm may enter into a
futures contract to mitigate the risk of
excessive cash outflow. This hedging
instrument is called a cash flow hedge
and must also be measured at fair value;
the gains or losses of the effective part
of the hedge are recorded in equity.
Liability recognition and
deferred income
According to IAS, a liability is a
present obligation arising from past
events and its settlement is expected to
cause an outflow of economic benefits.
Obligations can be constructive or legal.
As a result of its carbon dioxide
emissions (a past event), a firm has a
present legal obligation to deliver the
economic benefits – that is, the market
value of the allowance. If the firm
does not settle this obligation, it will
be vulnerable to severe penalties by its
respective government. Furthermore,
the liability of a company’s carbon
dioxide emissions should be recognized,
as the reliability of the measurement of
its obligation can be ascertained in the
open exchange markets.
According to IAS 20, a deferred
income or government grant is recorded
in the balance sheet at deemed cost
(the market price of emission rights
on the date of receipt of the grant).
This deferred income is not subject
to subsequent revaluation no matter
how much fluctuation there is in the
current market price, because under
the International Financial Reporting
Standards framework a deferred credit
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is not a liability for a firm that does
not have a legal or constructive present
obligation for emission.
When the firm is using the
government-granted emissions quota,
it does not need to pay for these
emissions. Therefore, the firm is
enjoying the economic benefit in a
given financial period and the income
should be recognized and the deferred
income should be decreased by the
same amount.
Two areas of asymmetry in
emissions rights recognition have been
identified. In asset recognition, the
emissions allowances (intangible assets)
are revalued through equity under the
revaluation method, while the change
in value of emissions obligations is
recognized in the income statement.
The deferred income is recognized
in the income statement on cost
basis, while the emissions expense is
recognized in the income statement
based on the current market value
of carbon dioxide allowances. Such
asymmetries in accounting methods
inevitably lead to volatility in the
income statement.
Regional disparity
China is not required to meet specific
emissions targets under the Kyoto
Protocol. At the state level, legal
provisions for trading of emissions
rights are yet to be developed, but the
allocation system for emissions rights
was provided for in the Prevention and
Mitigation of Air Pollution Ordinance.
The ordinance stipulates that the
responsibility for setting the standards
and regulations to control air pollutant
levels rests with the State Council.
Regional or provincial governments
should adhere to the conditions and
procedures spelt out by the State
Council in verifying the amount of air
pollutants emitted by enterprises and
issue “emission permits” in an open and
fair manner.
Although there is no specific set of
accounting standards regarding emissions
rights in China, the authorities have taken
steps to develop emissions trading; there
are laws and regulations with provisions
on trading emissions rights at the
regional and provincial level.
In February 2006, the Ministry
of Finance formally announced
the issuance of 38 specific new
Accounting Standards for Business
Enterprises together with a new ASBE
Basic Standard. The ASBE includes
provisions on all the topics covered by
IFRS. The application of the ASBE
was mandatory for listed Chinese
enterprises with effect from 1 January
2007 and recommended for other
Chinese enterprises.
ASBE 6 Intangible Assets has
provisions similar to IAS 38, namely that
intangible assets that are identifiable,
controllable, likely to generate future
economic benefits and are reliably
measurable should be recognized.
Since carbon dioxide emissions
rights meet these criteria, Chinese
enterprises should recognize such
rights under ASBE 6; however, these
enterprises are only permitted to employ
the cost model for reporting intangible
assets in accordance with ASBE 6.
The ASBE Basic Standard defines
liability in a similar manner to the IAS.
Therefore, the accounting treatment for
liability recognition of carbon dioxide
emissions rights required by ASBE
for Chinese enterprises is the same as
discussed above under the IAS context.
ASBE 16 Government Grants requires
the presentation of asset-related grants
as deferred income.
Undoubtedly, demand for a unified
accounting standard to make accounting
for emissions more comparable between
companies is growing – this is something
investors and other stakeholders want.
Under the Kyoto Protocol, Hong
Kong is not required to meet specific
emissions targets. Since there are only
minor textual differences with no
practical effects between Hong Kong
Financial Reporting Standards and
IFRS, the accounting requirements
relating to emissions rights trading in
Hong Kong should be the same as the
international requirements.
The U.S. has already implemented
emissions rights mechanisms for
other kinds of pollutants. The U.S.
Environmental Protection Agency
started its acid rain emissions allowance
trading programme in 1995, but
no single accounting rule has been
developed and the emissions allowances
have been considered as assets.
There are some controversies in
the recognition of such “assets.” Some
believe that emissions rights should be
recorded as intangible assets according
to Statement of Financial Accounting
Standards No. 142 Goodwill and other
Intangible Assets and no financial asset
should be recognized under SFAS 140
Accounting for Transfers and Servicing
of Financial Assets and Extinguishments
of Liabilities because the emissions
allowances are not yet readily
convertible into cash. Some think
the emissions rights can be treated
as financial assets because they can
be actively traded. Others argue that
emissions transactions should be
included in inventory because emissions
purchases are a necessary cost of a
company’s operation.
Classification greatly depends on the
intended use of emissions rights. If the
rights are used for trading purposes, they
can be recognized as financial assets.
If the rights are used for operational
purposes, they should be classified as
intangible assets or inventory.
From the point of view of the
U.S. standard-setter, the Financial
Accounting Standards Board, emissions
rights are intangible in nature and
should be treated as such. They should
therefore be tested regularly under the
cost model for impairment according to
SFAS 144 Accounting for the Impairment
or Disposal of Long-Lived Assets.
Recommendations
For measuring the value of emissions
rights, the fair value model is the most
appropriate. Even though the cost
model is more reliable, it does not
reflect true value since the onset of
the financial crisis, during which the
demand for emissions allowances has
shrunk. The fair value model provides
more information about the value of the
emissions rights, thus enabling better
economic decisions.
The allocation mechanism and
conditions placed on the recipients
may vary among similar firms in
different countries, giving rise to
incomparability issues in their
financial statements, even if the
same measurement and recognition
accounting policies are adopted.
Another issue is the measurement
of the actual emissions levels. There
are many types of economic activities
for which the emissions level can only
be estimated based on theoretical
calculations. Adopting different
methodologies affects the measurement
of emissions levels, so more disclosure
guidelines should be set out to eliminate
issues arising from different approaches.
There is no unified accounting
standard on these issues. The U.S. and
China are more conservative in their
accounting standards compared to the
stipulations set out by IFRS. In addition
to concerns regarding the adoption of
different accounting methods, further
disclosure by the companies about the
justification of their chosen methods is
also required.
Undoubtedly, demand for a unified
accounting standard to make accounting
for emissions more comparable between
companies is growing – this is something
investors and other stakeholders want.
It is time for the IASB to expedite
the process of formulating the new
accounting standard on emissions rights.
K.Y. Cheung is a teaching
assistant in the School of Business
and Administration at The Open
University of Hong Kong.
December 2009
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