Impact of Emission Trading Schemes on British Airways Financial Performance - Research Paper Example

Impact of Emission Trading Schemes or Carbon Tax on British Airways Financial Performance and Position Student’s Name Instructor’s Name Course Code and Name University Date of Submission Impact of Emission Trading Schemes or Carbon Tax on British Airways Financial Performance and Position Introduction Climate change dominated global news in recent times since it effects start to become evident as weather patterns have continued to change. A major milestone was achieved for climate change campaigners is when countries signed the Kyoto Protocol, where they committed to cutting emission of greenhouse gases by setting emission targets for their nations (Maydybura, Alina & Brian 2011, p. 123). A tool that has been used by nations to help them cut emission has been the Emissions Trading Scheme where countries allow their industries to emit a certain amount of emissions with the aim of reducing the amount over time. The system has also been referred to as Cap-and-trade scheme. The EU Emission Trading System (EU ETS) is the largest trader of greenhouse gas emission allowances for power stations, industrial plants and airlines in about 24 member countries of the EU. The carbon tax system is also another way countries encourage households to reduce emission of greenhouse gases by investing and adopting greener practices. Carbon taxes are mainly imposed on greenhouse gases emitted from burning of fossil fuels. The advantage of the carbon tax system is that it does not favour a particular method of reducing emission, but encourages companies to invest in clean technologies. In recent times, this phenomenon has been reflected in the financial statements of companies operating in countries that have enacted greenhouse gases legislations. The taxes have also affected the operations, as well as disclosures made by entities. In order to examine the impact emission trading schemes and carbon taxes have had on entities, the research will analyze the financial statements of British Airways. In particular, the analysis will cover the reporting and disclosure of these systems in the financial statements. Literature Review The EU has been on the forefront in implementing the emission trading scheme through the EU ETS, and this has seen the airline industry affected as all airlines flying in or out of Europe have to get an allowance for emission of greenhouse gases. The aim of this chapter is to examine the literature that has analyzed accounting for emission trading systems and carbon tax, with the aim of broadening an understanding of the way companies report and disclose the greenhouse gas emission allowance. In an article by Fornaro et al., the author examined the evolution of accounting for emission by examining the recognition and measurement of allowances granted to companies under the U.S. GAAP and IFRS, where his results revealed diversity under the two standards (Heather 2010, p. 50). The author identified that the U.S. GAAP required emissions allowances to be reported and measured based on the Federal Energy Regulatory Commission (FERC) “Uniform Systems of Accounts” where allowances were classified as inventory and reported at historical cost. However, the accounting guidance provided by the FERC distorted liabilities, assets and operating income for U.S. companies as emissions allowances were presently being received for free and had a zero cost basis (Farnaro, Winkelman & Glodstein 2009). The IFRS in response to the authoritative accounting guidance of the FERC established the IFRIC 3 Emission Rights in 2004, which required emission allowance to be classified as intangible assets and accounted based on IAS 38, which allowed for reporting based on evaluation method or historical cost model (Farnaro, Winkelman & Glodstein 2009). Purchased allowances were also required to be recorded at cost on the guidance of IAS 20 on Accounting for Government Grants and Disclosure of Government Assistance. The author notes that the standards as proposed by the IFRS were objected by the European Financial Reporting Advisory Group (EFRAG) based on the IFRIC 3 recognition of allowances received as revenue on the basis of the market price on the date of receipt (Farnaro, Winkelman & Glodstein 2009). In conclusion, the author identified that there lacked comparability among companies in terms of their financial results. Other scholars Andor and Fazekas also examined the accounting aspect of emission allowances in their article where they based their analysis on IFRS standard in relation to recognition, derecognition, classification and capitalization of emission allowances. The article borrows heavily from the study mentioned above, but its results reveal that the numerous accounting treatments have an impact on a company’s equity, profit or loss. The author recommends for the development of a comprehensive accounting guidance for emission allowances so as to help users of financial statements make informed decisions (Fazekas & Andor 2012, p. 120). In response to the continuing debate on the current IFRS standards on emission allowance, Madlen Haupt and Roland Ismer also analyzed the IFRS accounting policies for carbon hedging instruments, emission allowance and liabilities that are used by members of the EU ETS. The author proposes assessment criteria for evaluating the diverse accounting approaches to address the improprieties of the current IFRS rules (Haupt & Ismer 2013, p. 71). In addition, she recommends that the tentative decisions reached by the FASB and IASB should guide future accounting standards for emission trading schemes. The research gives a different approach to subsequent measurement of emission allowances that are held for compliance and credit side entry for those that are zero-rated (Haupt & Ismer 2013, p. 84). From her analysis, she is of the thought that such an approach would be able to capture the nature and purpose of emission trading schemes, thus resulting in financial information useful to its users. A piece by Andrew Yeoman analyses the accounting rules for emissions allowances based on both U.S. GAAP and IFRIC 3, and is in support of the argument made by the previous authors. However, the article introduces the issue of taxation of emission allowances by describing three ways of tax treatment as proposed by Ernst and Young. The author questions whether credits should be taxed when they are received as income, or the period when they are available for the first time and be considered as excludable income (Yeoman, 2013). This is based on the fact that the IRS treated government provided credit as nontaxable income in relation to Acid Rain emission, but is quiet of carbon emissions (Ernst and Young 2013). The literature review shows how the IFRS has not played its authoritative role in establishing standards to guide the accounting practices regarding emission allowances by companies. Although, it has been instrumental in implementing the IFRIC 3, it has come under huge criticism from the institutions in jurisdictions where cap and trade emission trading systems have been imposed. This explains the diversity in reporting and treatment of emission allowances by companies as it has affected the profits and equity of such companies, thus affected the financial information available to users of financial statements (Pat 2007, p. 74). Theoretical Framework There has been widespread debate with regards to accounting for emission allowances as companies continue to report emission allowances in their financial statements. The cap and trade system is a market oriented approach where allowances are used to give incentives to entities so as to reduce emissions through the assignment of an economic value to pollution. A carbon allowance amounts to one metric ton of carbon dioxide that a holder is allowed to emit. The Cap is the maximum level beyond which a company is required to buy additional allowances to cover for such pollution. On the other hand, where a company does not exceed the allowance granted by the regulator, they are allowed to offset subsequent year’s compliance targets. However, it is the classification, reporting and measurement of emission allowance that has an impact on the financial performance and position of companies. The problem arises from the different accounting treatments under both U.S. GAAP and IFRS. In order to analyze whether there is material impact on financial statements from the use of the two approaches, it is prudent to examine if there is an implication of classifying emission allowances as either inventories or intangible assets. The emission allowances are the dependent variables in this case based on the two approaches. With regards to the measurement of allowances, we need to establish whether its being based on either historical cost, or revaluation cost model has an impact of the financial statement. Therefore, the analysis would be based on two scenarios namely the U.S. GAAP under the FERC regulations and the IFRIC 3. Analysis The EU ETS policy on carbon emission came into effect on 1st January 2012, and affected the airline industry as aircrafts taking off or landing from EU airports were subject to emission trading schemes as a way of reducing greenhouse gases (Steenkamp, Rahman & Kashyap 2012, p.114). The charge was based on the estimated amount of carbon dioxide generated by an aircraft during a flight and was based on the amount of fuel consumed. British Airways started to report emission allowances in 2011 as the amount is recorded as an intangible asset in the 2011 annual report. It is important to mention that the consolidate financial statements for the company for both 2011 and 2012 were prepared based on IFRSs as adopted by the EU, which differs on some aspects with the IFRSs issued by IASB. With regards to the recognition of emission costs, BA recorded the receipt of $12 allowances in 2011 as intangible assets (British Airways 2011, p. 19). However, the deferred revenue that is equivalent to the fair value of the emission allowance received was not recognized. This in contrast to IFRIC 3, where the emission costs would recognize as deferred revenue and intangible assets recognized on a systematic basis. This has an impact of increasing the net income reported by BA as it increases the revenue. In terms of the U.S. GAAP rules, the purchase of emission allowances would be recorded as inventories and at cost. In 2012, the revenues were purchase of $27 emission allowances was recognized as intangible assets, as well as an emission expense in the consolidated income statement (British Airways 2012, p. 22). It is also important to mention that the purchased emission allowances are recognized based on cost, and usually are tested for impairment whenever there are indications that the carrying amount may not be recoverable. However, the emission expense is not recorded as a liability in the consolidated balance sheet in 2012 as per IFRS as adopted by the EU. Where the IFRIC 3 was used, it could have recognized the emission expense at the fair value on the reporting date. The lack of recognition of the purchased emission costs in 2012 may have an impact, as well, on the leverage ratios for the company as the current liabilities would be less the expense. The results match to the theoretical framework as they reveal areas of mismatch in the recording and measurement of emission allowances for BA based on the three scenarios. Conclusion From the analysis, it is evident that there are different accounting treatments for emission allowances as the IFRS as adopted by the EU that was used by BA recorded purchased emission allowances as intangible assets. This is borrowed from the IFRS standards as proposed by ISAB, but differ from the U.S. GAAP that records them as inventories. Where BA fails to recognize the purchased emission allowances for the year 2012 as liabilities, but recognizes as expenses indicates the mismatch in the reporting based on the three approaches. This has an impact on the financial results of the company as they are likely to increase or decrease the net income, as well as the return from assets. Therefore, there is a need to have a uniform standard for accounting treatment for emission allowances to address material misstatements. Limitation of Study The study only considered a single airline company, British Airways, but made use of financial statement for two years. In addition, the analysis was based on the airline industry. Further, the impact of emission trading schemes was analyzed based on three scenarios namely U.S. GAAP, IFRIS 3 and IFRS as adopted by the EU. Suggested Future Research From the study, the research proposes further research on the IFRIS 3 standards as a foundation for universal standards for accounting for emission allowances. In addition, there is a need to research on whether reporting and measurement of emission allowances can be based on materiality rather than standards. List of References British Airways 2011, British Airways Plc: Annual Report and Accounts, Year ended 31 December 2011. British Airways 2012, British Airways Plc: Annual Report and Accounts, Year ended 31 December 2012. Ernst and Young 2013, Tax implications of GHG emission allowances, Accessed from http://www.ey.com/US/en/Industries/Oil—Gas/Carbon-market-readiness—8—Tax-implications-of-GHG-emission-allowances Ernst and Young 2013, Accounting Guidance for Emissions Programs, Accessed from http://www.ey.com/US/en/Industries/Oil—Gas/Carbon-market-readiness—4—Accounting-guidance-for-emissions-programs Farnaro, JM, Winkelman, KA & Glodstein, D 2009, “Accounting for Emission: Emerging issues and the need for global accounting standards”. Journal of Accountancy, Vol. 208, No. 1. Fazekas, D & Andor, A 2012. Accounting Aspects of Emission Trading. Accessed from http://www.academia.edu/444656/Accounting_Aspects_of_Emission_Trading Haupt, M & Ismer, R 2013, “The EU Emissions Trading System under IFRS – Towards a “True and Fair View” Accounting in Europe, Vol. 10, No. 1, p. 71-97. Heather, L 2010, Accounting for Carbon, Association of Chartered Certified Accountants, Accessed from http://www.accaglobal.com/content/dam/acca/global/PDF-technical/climate-change/rr-122-001.pdf Maydybura, A & Brian, A 2011, “A study of the Determinants of Emissions Unit Allowance Price in the European Union Emissions Trading Scheme,” Australasian Accounting Business and Finance Journal, Vol. 5/94, p. 123-142. Pat, C 2007, Accounting for Emission Rights. Deloitte Publications, Accessed from http://www.deloitte.com/assets/Dcom-Australia/Local%20Assets/Documents/Deloitte_Accounting_Emissionright_Feb07.pdf Raiborn, C & Massoud, M 2010, “Emissions Allowances: Accounting and Public Policy Issues”, Accounting and the Public Interest, Vol.10, No. 1, p.105-121. Souchik, LE 2012, Accounting for Emissions Trading: How Allowances Appear on Financial Statements Could Influence the Effectiveness of Programs to Curb Pollution, 39 B.C. Envtl. Aff. L. Rev. 475, http://lawdigitalcommons.bc.edu/ealr/vol39/iss2/7/ Steenkamp, N, Rahman, A & Kashyap, V 2012, Recognition, Measurement and Disclosure of Carbon Emission Allowance under the EU ETS – An Exploratory Study, Accessed from http://www.utas.edu.au/__data/assets/pdf_file/0007/188539/Steenkamo_Rahman_Kashyap_15.pdf Veith, S, Werner, JR & Zimmerman, J 2009, Competing Accounting Treatments for Emission Rights: A Capital Market Perspective. Accessed from http://www.frankfurt-school.de/clicnetclm/fileDownload.do?goid=000000276189AB4 Yeoman, A 2013, “Accounting for Cap and Trade”, BAP Journal, March 07, 2013. Accessed from http://www.betaalphapsi.pdx.edu/?p=2287 Zhang-Debreceny, E, Kaidonis, MA & Moerman, L 2009, “Accounting for Emission Rights: An Environmental Ethics Approach”, Journal of the Asia-Pacific Centre for Environmental Accountability, Vol. 15, No. 3, p. 19-27. Read More