Financial Reporting for Pollution Reduction Programs

We develop a conceptually grounded approach, based on the International Accounting Standards Board’s conceptual framework, to the accounting for the rights and obligations embodied in a cap-and-trade program. Under this approach, firms recognize allowances as intangible assets, initially measured at fair value with a credit to cash for purchased allowances and to a current period gain for allocated allowances; firms recognize current period expense and accrue liabilities, at fair value, as they emit; both asset and liability are remeasured at fair value at every reporting date. We apply our treatment and three alternative treatments, based on current practice and proposals considered by standard setters, to transaction-level data from the U.S. sulfur dioxide cap-and-trade program to calculate as-if financial statement outcomes using actual data. The alternative treatments result in noncomparable accounting for otherwise similar arrangements. To provide ex ante evidence on the effects of noncomparable accounting, we analyze reporting outcomes and show that alternative accounting treatments of the same arrangement result in meaningful differences in reported assets and liabilities, income volatility, and commonly used performance and leverage metrics. Because the financial reporting effects of noncomparable accounting are exacerbated by business combinations and plant-level purchases of allocated allowances that may have been initially recorded at zero, our analysis explicitly accounts for the effects of these transactions. Finally, we find that among the four accounting treatments we consider, reporting outcomes under our proposed approach are most aligned with investor perceptions, as indicated by the associations between the market value of equity and assets, liabilities, and income. This paper was accepted by Shiva Rajgopal, accounting.