Accounting for carbons

Australia needs a consistent basis for the financial reporting of emission rights.

Story Georgina Dellaportas CA

Australia has now ratified the Kyoto Protocol and has, as a result, bound corporate Australia to reducing
greenhouse gas emissions. The Federal Government has passed the National Greenhouse and Energy
Reporting Act 2007 which introduces a single, national reporting regime for greenhouse emissions,
energy consumption and energy production effective 1 July 2008.

Underpinning the legislation is an Australian Emissions Trading Scheme (AETS) which the Federal
Government has committed to commence no later than 1 July 2010. This scheme is likely to be based on
a cap-andtrade model whereby participants will be allocated emission rights or allowances equal to a cap
(ie target level of emissions) and will be permitted to trade those allowances. The information gathered
under the National Greenhouse and Energy Reporting Act 2007 will be used to set the caps under the
AETS.

So what does this mean for corporate Australia from an accounting perspective? Prior to the operation of
the AETS, it is necessary for all interested parties (standard setters, pollution emitters, academics and
so on) to take part in a rigorous debate on the appropriate accounting for cap-andtrade emission rights
in order to ensure a consistent basis for financial reporting. With the present lack of accounting guidance
for such schemes, it is foreseeable that divergent practices would otherwise occur in Australia.

Development Of IFRIC 3
Cap-and-trade schemes have been in operation in Europe for a number of years. In December 2004, the
International Accounting Standards Board (IASB) issued IFRIC 3 Emission Rights to address accounting
for emission rights arising from such schemes. In Australia, the Australian Accounting Standards Board
(AASB) issued an equivalent Urgent Issues Group Interpretation, UIG 3.

However, the Interpretation met with significant resistance on the basis that it resulted in accounting
mismatches between the valuation of assets and liabilities leading to potential volatility in the profit and
loss. Consequently, the IASB decided to withdraw the Interpretation in June 2005 despite the fact that it
continued to consider it to be an appropriate interpretation of existing IFRS.

Possible Approaches
Until definitive guidance on accounting for cap-and-trade emission rights schemes is issued, an entity
has the option of either:

applying the principles of IFRIC 3/UIG 3 ; or

developing its own accounting policy for cap-and-trade schemes based on the hierarchy of
authoritative guidance in AASB 108 Accounting Policies, Changes In Accounting Estimates And
Errors.

IFRIC 3 Approach
IFRIC 3 takes the view that a cap-and-trade scheme gives rise to various items that are to be accounted
for separately:

an asset for allowances held: allowances, whether allocated by government or purchased, are to
be accounted for as intangible assets under AASB 138 Intangible Assets. Allowances issued for
less than fair value are to be measured initially at their fair value. On a go-forward basis,
entities have the choice to carry the intangibles at cost or at fair value (to the extent that there
exists an active market for the allowances)
a government grant: this arises when allowances are granted for less than fair value and
represents the differential between the fair value and the nominal amount paid. The grant is
accounted for under AASB 120 Accounting For Government Grants and is recognised as deferred
income in the balance sheet and subsequently recognised as income on a systematic basis over
 the compliance period for which the allowances are issued regardless of whether the allowances
are held or sold
a liability for the obligation to deliver allowances equal to emissions that have been made: as
emissions are made, a liability is recognised as a provision under AASB 137 Provisions,
Contingent Liabilities and Contingent Assets. The liability is the best estimate of the expenditure
required to settle the obligation at the balance sheet date. This would usually be the present
market price of the number of allowances required to cover the emissions made up to the
balance sheet date.

As noted above, the application of IFRIC 3 met with significant resistance on the basis that it results in
the following accounting mismatches:

a measurement mismatch between the assets and liabilities recognised

a mismatch in the location in which the gains and losses on those assets are reported. For
example, to the extent that the intangibles are carried at fair value any upward revaluation
would be recognised in equity while changes in the liability would be charged to the income
statement
a possible timing mismatch as allowances would be recognised when they are obtained, typically
at the start of the year, whereas the mission liability would be recognised during he year as it is
incurred.

Given these mismatches, very few overseas companies where such schemes exist have applied IFRIC 3
on a voluntary basis. Instead we have seen a range of approaches develop in practice, including the net
liability approach and the government grants approach.

Net Liability Approach

Under the net liability approach, emission rights granted are recorded at the nominal amount (ie nil if
granted for nil consideration) and the entity only records a liability once actual emissions exceed the
rights granted
and still held. The above approach is plausible given the lack of specific guidance on the accounting for
emission rights and the requirements of AASB 120 which allow non-monetary government grants and
the related asset received (emission rights) to be measured at nominal amount (ie nil) or at fair value.

Under AASB 137, a provision can only be recognised if the recognition criteria in the standard are met.
As far as emissions are concerned, the obligating event is the emission itself therefore a provision is
recognised as emissions are made, but only when the reporting entity has made emissions in excess of
rights held. This means that an entity should not recognise a full provision for an expected shortfall
immediately when the expectation arises; nor should it accrete a provision over the period of the
expected shortfall. Under AASB 137, the entire obligation to deliver allowances should be measured at
the best estimate of the expenditure required to settle the present obligation at the balance sheet date.
In this situation, an outflow of cash or other resources only occurs if and when the entitys emissions
exceed the emission rights that it holds. The allocated emission rights are not recognised as assets and
therefore are not considered to be part of the expenditure.

Government Grants Approach

Another approach which has gained acceptance in practice is to recognise the emission rights granted by
the government initially at their fair value and a corresponding government grant in the balance sheet.
The government grant element is subsequently recognised in income in accordance with the
requirements of IAS 20. To that extent, the approach follows that required by IFRIC 3. However, rather
than measuring the liability for the obligation to deliver allowances at the present market price of those
allowances, the liability is measured instead by reference to the amounts recorded for the emission
rights held as assets that are used to settle the liability.

Other Considerations
Amortisation and impairment testing of emission rights In principle it is possible to amortise emission
rights that are accounted for as intangible assets, but their expected residual value, at least at inception,
will be equal to their fair value. Subsequently, the residual value of emission rights is equal to their
market value. In the case of cap-and-trade schemes, however, there is no consumption of economic
benefitwhile the emission right is held. Instead, the economic benefits are realised by surrendering the
rights to settle obligations under the scheme for emissions made, or by selling rights to another party.
Therefore, the amount to be amortised will in many circumstances be nil. However, it is necessary to
perform an IAS 36 impairment test whenever there is an indication of impairment. Nevertheless, when
the market value of an emission right drops below its carrying amount, this will not automatically result
in an impairment charge because emission rights are often tested for impairment as part of a larger cash
generating unit.

Other accounting issues There are a number of other issues which would need to be considered when
developing an appropriate accounting policy for emission rights including, inter alia:

accounting for the tax treatment of the rights

determining whether an active market for the rights exists
valuation of permits where such a market does not exist
sales and purchases of rights, including purchases of offsets from overseas markets
valuation of rights as part of a business combination
identification of which entity is responsible for/has ownership of the emission rights and
therefore should recognise the liability
recognition of a liability for direct and indirect emissions.

Conclusions
While there has been a strong trend towards the adoption of the net liability method in Europe, the
application of different approaches by European entities to date has resulted in divergence in practice.
The Federal Government has committed that the Australian Emissions Trading Scheme will commence
no later than 1 July 2010. It is therefore imperative that the accounting for such schemes is clarified by
that time to ensure consistency in practice.

While the IASB has included a project on its agenda on accounting for emissions trading schemes, due
to the time involved in developing a pronouncement it is quite likely that the IASB project may not
progress in time for the introduction of the Australian scheme. The AASB has decided that it is
preferable to wait for the outcome of that project rather than to develop an Australian pronouncement.
This is on the basis that any pronouncement issued by the AASB could be inconsistent with that
subsequently issued by the IASB.

Until any pronouncement is issued by the IASB or the AASB for that matter Australian entities can
choose to adopt any method of accounting for emission rights as long as it is compliant with AIFRS. The
result may be divergence in accounting practice which will undermine the comparability of financial
statements between entities and hence potentially affect the decision making ability of stakeholders. The
development of a pronouncement on accounting for emission rights as soon as possible is therefore
imperative.