Financial Reporting

1

• Financial Reporting
• of Emissions Reduction Programs

• Yonca Ertimur, Jennifer Francis, Amanda Quiring
  and Katherine Schipper
• Duke University
• October 16, 2009
• We appreciate financial support from the Doris
  Duke Foundation.

2
Overview of current guidance

• US GAAP contains no explicit guidance
• Federal Energy Regulatory Commission guidance
  would imply measuring allowances at cost (zero if
  granted, amount paid if purchased)
• IFRIC 3 (issued 2004 and withdrawn 2005)
• Both the IASB and the FASB have active projects
  on the accounting for emissions reduction
  programs
• Our approach analyze emissions allowances and
  obligations in the context of the FASBs
  conceptual framework
• Qualitative characteristics, including relevance,
  reliability and comparability
• Elements definitions (definitions of assets and
  liabilities)
• The projects also include baseline arrangements
  and (possibly) emissions reductions projects, not
  considered in this presentation.

3
The accounting issues

• Are emissions allowances assets?
• If so, should they be recognized in the statement
  of financial position?
• How should they be measured?
• When should an entity recognize a liability
  arising from an emissions reduction program?
• Should the answers to the above questions depend
  on whether the entity acquired the allowances as
  a government grant?
• Should the accounting for an emissions allowance
  depend on how the entity acquired it?
• Does acquiring an emissions allowance as a
  government grant create a liability?
• If a grant of an allowance does not create a
  liability, what is the offsetting credit?
• Immediate gain
• Deferred gain (amortized into income)
• Observation and question What are the
  implications of the idea that the issue does not
  seem to arise if the allowance is acquired by
  paying cash?

4
Emissions allowances are accounting assets

• Definition An asset is a probable future
  economic benefit obtained or controlled by an
  entity because of a past event or transaction
• Regardless of how obtained, an emissions
  allowance meets this definition
• Recognition criterion and measurement attribute
  The asset must have a relevant measurement
  attribute that possesses sufficient reliability
• Cost
• Is simple to implement
• Accounting treatment varies depending on how the
  allowance is acquired (granted versus purchased
  allowances)
• Does not capture economic conditions, including
  changes in those conditions as they occur
• Fair value, including possible remeasurement at
  every reporting date
• In this context, fair value is the price that
  would be received from a market participant to
  sell the asset in an orderly transaction at the
  measurement date
• Comparable measurement for allowances that are
  granted versus purchased
• Captures economic conditions, and changes in
  those conditions as they occur

5
An accounting liability arises as an entity emits

• Definition A liability is a probable future
  economic sacrifice that arises from a present
  obligation of an entity to transfer assets or
  provide services to other entities as a result of
  a past event or transaction
• An emitting entity would record (accrue) an
  obligation as it emits, with an offsetting debit
  to expense
• Obligation is measured at the amount that would
  be required to settle the obligation (generally,
  the fair value of the required allowances)
• Income is reduced and the obligation increases as
  emissions occur
• The obligation is settled by transferring
  emissions allowances to the government
• Regardless of how obtained, receiving an
  emissions allowance does not create a present
  obligation
• Plans, intentions or commercial necessity to emit
  do not create an obligation emissions do
• An entity that does not emit has no obligation

6
Summary of accounting treatment

• Recognize an allowance when it is acquired,
  measured at fair value
• Acquiring an allowance in exchange for cash
  payment
• The offsetting credit is to cash
• There is no immediate income statement effect
• Receiving an allowance as a government grant
  (nonreciprocal transaction)
• Alternative 1 The offsetting credit is to
  deferred gain (later amortized into income)
• Alternative 2 The offsetting credit is to gain
  (an immediate income increase)
• Subsequent accounting for allowances
• The allowance might be remeasured to fair value
  or subject to impairment testing. It would not
  be amortized.
• Recognize a liability (obligation to transfer
  allowances) as emissions occur, measured at the
  amount that would be required to settle the
  obligation (fair value)
• Income is reduced and liability increases as
  emissions occur
• Observation This treatment (with Alternative 1)
  is similar to IFRIC 3, but not similar to
  FASB/IASB proposals.

7
Potential objections to this accounting treatment

• Objection 1 Undesirable income statement
  effects
• Objection 1A Recognizing a gain upon receipt of
  allowances that are granted does not capture the
  economic substance of the arrangement and does
  not provide decision useful information because
  the purpose of an emissions trading arrangement
  is to impose costs
• Objection 1B The accounting creates income
  volatility and does not match revenue and
  expense (or gain and loss)
• The asset (emissions allowances) is recognized
  when it is acquired and the liability (obligation
  to transfer allowances) is recognized over time
  as emissions occur
• Governments award (or sell) the allowances months
  and even years before they must be used, to
  facilitate the development of a market
• Objection 2 Ignores management intent and the
  entitys business model
• There is a difference between allowances held for
  use in production and allowances held for
  trading, and the accounting should reflect that
  difference

8
Comments on these concerns/objections

• Does a gain arise if an entity receives a
  valuable right without making a payment?
• There is no necessary connection between the
  imposition of a cost (of emitting) and
  governmental decisions to provide subsidies to
  offset those costs
• Suppose there were no allowances and at the end
  of every year a covered entity had to make a cash
  payment based on the amount of emissions
• The liability would accrue over the year, as
  emissions occurred, and then be settled by paying
  cash
• A governmental grant of allowances means the
  government is issuing certificates that can be
  used in lieu of cash payments to settle the
  obligations that arise as emissions occur
• An entity that holds the allowances can
• Use them to settle an obligation
• Sell them
• If there is a gain, the timing of that gain is
  linked to the receipt of the assets, not to the
  passage of time or the entitys emissions behavior

9
Comments on these concerns/objections

• In terms of their characteristics and value as
  assets, emissions allowances do not differ based
  on
• How they were acquired (purchase versus grant)
• Fair value is the same, regardless of how
  acquired
• The entitys intent and/or business model (e.g.,
  trading versus production)
• Basing the accounting for an item on management
  intent introduces explicit noncomparability
  (similar items receive different accounting
  treatment)
• As a practical matter, FASB discussions in public
  meetings have noted the difficulties in devising
  guidance that would meaningfully distinguish
  trading from production

10
Conclusion

• No explicit guidance in US GAAP or IFRSs
• Analysis based on FASBs conceptual framework
• Recognize an allowance when it is acquired,
  measured at fair value
• Recognize a liability as emissions occur,
  measured at the amount that would be required to
  settle the obligation (fair value)