THE RELATION BETWEEN ACCOUNTING AND TAXATION: THE EXAMPLE OF EMISSION RIGHTS - ACCOUNTING ASPECTS

Transcription

1 EUROPEAN ASSOCIATION OF TAX LAW PROFESSORS CONGRESS Helsinki June 8, 2007 THE RELATION BETWEEN ACCOUNTING AND TAXATION: THE EXAMPLE OF EMISSION RIGHTS - ACCOUNTING ASPECTS Päivi Räty, M.Sc. (Econ.), Confederation of Finnish Industries EK

2 2 THE RELATION BETWEEN ACCOUNTING AND TAXATION: THE EXAMPLE OF EMISSION RIGHTS - ACCOUNTING ASPECTS Contents 1. INTRODUCTION 3 2. SCOPE AND CONTENTS OF THE IFRIC 3 GUIDELINES Cap and trade schemes Relevant IFRSs Gross vs. net method of reporting NON-ACCEPTANCE OF IFRIC 3 IN THE EU ENDORSEMENT PROCESS EFRAG s views on the mismatches ARC advice FINNISH ACCOUNTING AND TAXATION GUIDELINES Guidelines by the Finnish Accounting Board Guidelines by the Finnish Tax Board REPORTING PRACTICES OF EMISSION RIGHTS BY FINNISH LISTED COMPANIES Survey on IFRS reports for Examples of disclosures about the emission rights Prospects of the international guidelines for emission rights reporting Summary 26

3 3 1. INTRODUCTION Several governments have schemes to encourage reduced levels of emissions. In particular, schemes are being developed to encourage reductions of greenhouse gas emissions in the light of the Kyoto agreement, which comes into effect in Many companies are, or will be, subject to such schemes. The European Union scheme for greenhouse gas emissions trading started in The International Financial Reporting Standards Board (IASB) 1 launched already in 2002 a project in order to give guidance about the accounting for schemes that are based on a cap and trade model. In the absence of any guidance on the accounting for such schemes, the International Financial Reporting Interpretations Committee (IFRIC) 2 started to prepare an interpretation about the accounting of emission rights, on the basis on existing International Financial Reporting Standards. The IFRIC was informed that no consensus had emerged among market participants on what the accounting treatment should be. Because there was a risk of divergent practices developing, the IFRIC concluded that it should develop an Interpretation. As part of the process, the IFRIC published Draft Interpretation D1 Emission Rights for public comment in May Most respondents to the draft interpretation supported the IFRIC s proposal to develop an Interpretation. However, although agreeing that the IFRIC should add the topic to its agenda, some respondents suggested that the IFRIC should not yet 1 The IASB, based in London, began operations in It is funded by contributions collected by its Trustees, the IASC Foundation, from the major accounting firms, private financial institutions and industrial companies throughout the world, central and development banks, and other international and professional organisations. The 14 IASB members (12 of whom are full-time) reside in nine countries and have a variety of professional backgrounds. The IASB is committed to developing, in the public interest, a single set of high quality, global accounting standards that require transparent and comparable information in general purpose financial statements. In pursuit of this objective, the IASB cooperates with national accounting standardsetters to achieve convergence in accounting standards around the world. 2 The IFRIC first met in It comprises 12 voting members (all part-time) drawn from a variety of countries and professional backgrounds and meets about every two months. The IFRIC s principal role is to consider, on a timely basis within the context of existing International Financial Reporting Standards and the IASB Framework, accounting issues that are likely to receive divergent or unacceptable treatment in the absence of authoritative guidance, with a view to reaching consensus as to the appropriate accounting treatment. In developing interpretations, the IFRIC works closely with similar national interpretation committees.

4 4 finalise its proposals. Two main reasons were given: (a) emission rights schemes are in their infancy. Therefore, the IFRIC should wait until the design of the various schemes becomes clearer so that, if necessary, the interpretation could deal with a broader range of accounting issues (b) the International Accounting Standards Board had on its active agenda a project to amend IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. Given that IAS 20 was an important reference for the Interpretation, the IFRIC should wait until it is able to interpret the revised IAS 20. In considering these comments, the IFRIC initially decided to defer finalising its interpretation pending the Board s project to revise IAS 20 and also a possible amendment of IAS 38 Intangible Assets to require allowances to be measured at fair value with changes recognised in profit or loss. However, it became clear that these changes could not be made before a number of schemes started. The IFRIC concluded that the need for timely guidance to prevent divergent practices developing outweighed the disadvantage that the Interpretation might be amended in the medium term. It therefore decided to finalise its Interpretation. It acknowledged that the Interpretation might need to be amended if the Board amends IAS 20 or IAS 38, but noted that any such amendments would be made as consequential amendments by those revised Standards. The final IFRIC 3 Emission Rights was published in December 2004, just before the EU emission trading was about to start. The Interpretation was to be applied for annual periods beginning on or after 1 March Earlier adoption was encouraged. In the endorsement process of the European Union, in May 2005 the European Financial Reporting Advisory Group (EFRAG) 3 refused to recommend the endorsement of IFRC 3 to the European Commission. EFRAG believed that application of IFRlC 3 would not always result in relevant financial information 3 European Financial Reporting Advisory Group was set up in 2001 to assist the European Commission in the endorsement of International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB) by providing advice on the technical quality of IFRS. EFRAG is a private sector body set up by the European organisations prominent in European capital markets.

5 5 because in certain cases it would not faithfully represent the economic reality. EFRAG also believed that the disadvantages that would arise from endorsing the interpretation outweighed the advantages of guidance on the accounting on the emission right schemes. EFRAG had therefore concluded that IFRlC 3 did not meet all of the requirements of the Regulation (EC) No I606/2002 of the European Parliament and of the Council on the application of international accounting standards. In June 2005 the IASB decided to withdraw IFRIC 3 Emission Rights with immediate effect. Commentators had indicated that the markets for emission rights necessary for the proper functioning of the EU Scheme, although developing rapidly, were still thin. In addition, some European governments had yet to issue emission rights to companies. The IASB had therefore concluded that it was questionable whether there was as urgent a need for an Interpretation as originally concluded by the IFRIC in The IASB affirmed that IFRIC 3 was an appropriate interpretation of existing IFRSs for accounting for the EU Scheme. Nonetheless, both the IFRIC and the IASB acknowledged that as a consequence of following existing IFRSs, IFRIC 3 created unsatisfactory measurement and reporting mismatches. The IFRIC had in fact developed for the IASB s consideration possible solutions to eliminate these mismatches. However, because the IASB had an active project to amend IAS 20 Accounting for Government Grants and Disclosure of Government Assistance, the IASB decided not to pursue these solutions before it had considered the effects of the revised IAS 20 on the accounting for allowances received from government. The IASB was concerned that short-term amendments to Standards might result in a series of changes in accounting for emission rights, which would be unhelpful to both preparers and users of financial statements. In the light of the reduced urgency for an Interpretation, the IASB had decided to withdraw IFRIC 3, with immediate effect. The IASB argued that this would enable the IASB to address the underlying accounting in a more comprehensive way than originally envisaged by the IFRIC.

6 6 2. SCOPE AND CONTENTS OF THE IFRIC 3 GUIDELINES 2.1 Cap and trade schemes The IFRIC 3 Interpretation deals with how to account for a cap and trade emission rights scheme. Such a scheme typically has the following features: (a) An entity participating in the scheme (participant) is set a target to reduce its emissions to a specified level (the cap). The participant is issued allowances equal in number to its cap by a government or government agency. Allowances may be issued free of charge, or participants may pay the government for them. (b) The scheme operates for defined compliance periods. Usually, allowances for a compliance period are issued to each participant at the beginning of a period. Actual emissions are normally verified after the end of the period in question. (c) Participants are free to buy and sell allowances. Thus a participant has three options: it can limit its emissions to its cap, it can reduce its emissions to below its cap and sell (or carry forward) the allowances that it does not require it can produce emissions in excess of its cap, in which case it must buy additional allowances for the excess emissions and/or incur a penalty A participant can also sell some or even all of its allowances in the expectation of later buying allowances equal to its actual emissions. (d) At the end of a compliance period (and any additional reconciliation period, during which actual emissions are verified and participants may undertake any further trading necessary to ensure they hold enough allowances to meet actual emissions), a participant is required to deliver allowances equal to its actual emissions. If a participant does not deliver sufficient allowances, it will incur a penalty (and will typically be required to deliver the shortfall of allowances in the future). The penalty may take a variety of forms, including a cash payment, reductions in the allowances

7 7 issued to the participant in subsequent periods, and restrictions on the participant s operations. (e) In some schemes, unused allowances may be carried forward to be used against future emissions either within the current scheme or, in some cases, in subsequent schemes. (f) The scheme provides for brokers or other position-taking institutions, ie entities that buy allowances from and sell allowances to participants in the scheme. The presence of such brokers may encourage an active market in allowances as defined in IAS Relevant IFRSs The IFRIC 3 Emission Rights was based on the following cornerstones, as they were in force as the Interpretation was written: emission rights (allowances) are intangible assets that should be recognised in the financial statements in accordance with IAS 38 Intangible Assets. when allowances are issued to a participant by government (or government agency) for less than their fair value, the difference between the amount paid (if any) and their fair value is a government grant that is accounted for in accordance IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. as a participant produces emissions, it recognises a provision for its obligation to deliver allowances in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. This provision is normally measured at the market value of the allowances needed to settle it.

8 8 IAS 38 Intangible Assets The objective of IAS 38 is to prescribe the accounting treatment for intangible assets that are not dealt with specifically in another IAS or IFRS. The Standard requires an enterprise to recognise an intangible asset if, and only if, certain criteria are met. The Standard also specifies how to measure the carrying amount of intangible assets and requires certain disclosures regarding intangible assets. An entity must choose either the cost model or the revaluation model for each class of intangible asset. [IAS 38.72] Cost model. After initial recognition the benchmark treatment is that intangible assets should be carried at cost less any amortisation and impairment losses. [IAS 38.74] Revaluation model. Intangible assets may be carried at a revalued amount (based on fair value) less any subsequent amortisation and impairment losses only if fair value can be determined by reference to an active market. [IAS 38.75] Such active markets are expected to be uncommon for intangible assets. [IAS 38.78] Under the revaluation model, revaluation increases are credited directly to "revaluation surplus" within equity except to the extent that it reverses a revaluation decrease previously recognised in profit and loss. If the revalued intangible has a finite life and is, therefore, being amortised, the revalued amount is amortised. [IAS 38.85] IAS 20 Accounting for Government Grants and Disclosure of Government Assistance The objective of IAS 20 is to prescribe the accounting for, and disclosure of, government grants and other forms of government assistance. IAS 20 applies to all government grants and other forms of government assistance. [IAS 20.1] However, it does not cover government assistance that is provided in the form of benefits in determining taxable income. [IAS 20.2]

9 9 A government grant is recognised only when there is reasonable assurance that (a) the enterprise will comply with any conditions attached to the grant and (b) the grant will be received. [IAS 20.7] The grant is recognised as income over the period necessary to match them with the related costs, for which they are intended to compensate, on a systematic basis, and should not to be credited directly to equity. [IAS 20.12] Non-monetary grants, such as land or other resources, are usually accounted for at fair value, although recording both the asset and the grant at a nominal amount is also permitted. [IAS 20.23] Even if there are no conditions attached to the assistance specifically relating to the operating activities of the enterprise (other than the requirement to operate in certain regions or industry sectors), such grants should not be credited to equity. A grant receivable as compensation for costs already incurred or for immediate financial support, with no future related costs, should be recognised as income in the period in which it is receivable. [IAS 20.20] A grant relating to assets may be presented in one of two ways: [IAS 20.24] 1. as deferred income, or 2. by deducting the grant from the asset's carrying amount. A grant relating to income may be reported separately as 'other income' or deducted from the related expense. [IAS 20.29] If a grant becomes repayable, it should be treated as a change in estimate in compliance with IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. Where the original grant related to income, the repayment should be applied first against any related unamortised deferred credit, and any excess should be dealt with as an expense. Where the original grant related to an asset, the repayment should be treated as increasing the carrying amount of the asset or reducing the deferred income balance. The cumulative depreciation which would have been charged had the grant not been received should be charged as an expense. [IAS 20.32]

10 10 IAS 37 Provisions, Contingent Liabilities and Contingent Assets The objective of IAS 37 is to ensure that appropriate recognition criteria and measurement bases are applied to provisions, contingent liabilities and contingent assets and that sufficient information is disclosed in the notes to the financial statements to enable users to understand their nature, timing and amount. The key principle established by the Standard is that a provision should be recognised only when there is a liability i.e. a present obligation resulting from past events. The Standard thus aims to ensure that only genuine obligations are dealt with in the financial statements. The amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the balance sheet date, that is, the amount that an enterprise would rationally pay to settle the obligation at the balance sheet date or to transfer it to a third party. [IAS 37.36] In reaching its best estimate, the enterprise should take into account the risks and uncertainties that surround the underlying events. Expected cash outflows should be discounted to their present values, where the effect of the time value of money is material. [IAS 37.42] If some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the reimbursement should be recognised as a reduction of the required provision when, and only when, it is virtually certain that reimbursement will be received if the enterprise settles the obligation. The amount recognised should not exceed the amount of the provision. [IAS 37.53] 2.3 Gross vs. net method of reporting According to the IFRIC 3, the accounting treatment of emission rights is based on gross method. A cap and trade scheme gives rise separately to an asset (for allowances held) and a liability, deferred income and/or income.

11 11 Already in the comment round, some commentators argued that a cap and trade scheme rather gives rise to a net position. According to the net method, a participant that produces emissions to the extent of its allowances, should not recognise either an asset for allowances issued free of charge, or a liability for its emissions. Instead, they proposed that the participant should recognise a liability only when it has produced emissions and holds insufficient allowances to cover them (or, recognise an asset when it holds allowances in excess of its requirements). Those respondents argued that accounting for an emission rights scheme in this way would reflect that a participant that produces emissions to the extent of its allowances is acting in accordance with the rights granted to it, whereas a participant that produces emissions in excess of its allowances is obliged to acquire additional allowances. The IFRIC rejected these arguments for the use of net method and decided that its original arguments for concluding that an emission rights scheme gives rise to an asset (for allowances held) and a liability, deferred income and/or income were valid. In support of its conclusion, the IFRIC stated the following arguments: An allowance meets the definition of an asset in the Framework, namely it is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. This is evidenced by the nature of an allowance as a transferable certificate, which the participant can either sell or use to settle an obligation. Once emissions have occurred, the participant has a liability within the definition in the Framework, namely it has a present obligation arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits. The obligation is to deliver allowances. The allowance and the obligation exist independently. Although a participant may intend to use the allowances it holds to settle its obligation, it cannot be compelled to do so. Instead it may choose to sell allowances and either reduce emissions or buy allowances at a future date. Thus, there is no contractual link between the asset and the liability, even though many participants will hold the allowances

12 12 solely for the purpose of settling their obligations. Under some schemes, participants need to hold an emissions permit in order to produce emissions. This confirms that an allowance itself does not confer a right to emit. Rather it is the instrument that must be delivered in order to settle the obligation that arises from emissions. In some cases, a participant may be able to choose which of a number of different allowances (issued under different schemes) it uses to settle its obligation. This feature is likely to become more common as schemes are developed in various countries, with the ability to use allowances issued under one scheme to settle obligations arising in another. A cap and trade scheme does not merely represent a tax on emissions in excess of the cap. An important feature of a cap and trade scheme is the ability it gives participants to trade allowances. Accordingly, some participants will purchase allowances from other participants for cash and recognise these purchased allowances as assets. However, purchased allowances are indistinguishable from those issued by government, which confirms that allowances issued by government are assets in their own right. There is no right of offset between the allowances and the obligation to deliver allowances, nor is there a debtor/creditor relationship. It is therefore inappropriate to offset the asset and liability.

13 13 3. NON-ACCEPTANCE OF IFRIC 3 IN THE EU ENDORSEMENT PROCESS 3.1. EFRAG s views on the mismatches In its opinion on the adoption of IFRIC 3 Emission Rights released in May 2005, EFRAG agreed with the IFRlC that a cap and trade scheme gives rise to an asset (for allowances held), a government grant (if the allowances are issued for less than their fair value) and a liability (when emissions are made). However, EFRAG had concerns about the overall effect of the accounting requirements in IFRlC 3, particularly in circumstances where entities have not acquired or sold allowances. EFRAG believed that applying IFRlC 3 would not always result in economic reality being reflected and relevant information being provided properly. That is because the accounting required by IFRlC in IFRlC 3 was constrained by the IFRIC's interpretation of the interplay of the existing standards IAS 38 Intangible Assets, IAS 20 Accounting for Government Grants and Disclosure of Government Assistance and IAS 37 Provisions, Contingent Liabilities and Contingent Assets. This created a measurement mismatch (whereby some items are measured at cost (IAS 38 and IAS 20) and others at fair value (IAS 37)) and a reporting mismatch (whereby some gains and losses are reported in profit or loss (IAS 37 and IAS 20) and others in equity (IAS 38)). According to EFRAG, these accounting mismatches are all the more critical because of the fact that there is an economic interdependency between the assets and liability involved in the cap and trade scheme. Emission rights are granted to allow entities to settle their liability for emissions made up to a specified level. Further, emission rights are the only assets eligible for settlement of the liability for emissions made. Because of these mismatches EFRAG was of the opinion that the resulting financial information would not always faithfully reflect economic reality. EFRAG's main concerns can be summarised as follows: (a) Under the cost model described in IFRlC 3, the allowances at hand are measured at cost and the corresponding liability at fair value. When changes in the

14 14 market price for the allowances appear, the income statement may be affected by a mismatch that is created by the mixed measurement model. EFRAG believed that this accounting mismatch was artificial and may not faithfully represent economic reality particularly in cases where the entity does not trade emission rights. (b) Under the revaluation model described in IFRlC 3, there is no mismatch as regards the value of the allowances and the liability in the balance sheet at year-end; however, there is a mismatch in relation to the income statement both during the interim periods and at year-end, because revaluation gains are recognised directly in equity while expenses relating to the liability are recognised in profit or loss. EFRAG was concerned that this would result in information that is not relevant for the users. (c) Further EFRAG was concerned about the accounting when the compliance period is finished because under IFRlC 3 the measurement of the asset (the allowances) and the liabilities (the provision) must be continued and the mismatch will continue to exist even though the compliance period is over until the liability is extinguished via settlement. EFRAG challenged whether it was in accordance with the standards that entities are not allowed to calculate the result of the scheme at the end of the compliance period and take the net effect to the income statement. EFRAG concluded that IFRlC 3 did not meet all of the requirements of the Regulation EC/I606/2002 of the European Parliament and of the Council on the application of international accounting standards because: it was contrary to the 'true and fair principle' set out in Article 16(3) of Council Directive 83/349/EEC and Article 2(3) of Council Directive 78/660/EEC; and it did not meet the criteria of understandability, relevance, reliability and comparability required of the financial information needed for making economic decisions and assessing the stewardship of management. For the reasons given, EFRAG stated that it was not in the European interest to adopt IFRlC 3 in its present form. EFRAG therefore recommended that the EU

15 15 Commission should not endorse IFRlC 3 Emission Rights. 3.2 ARC advice The ARC 4 discussed at its meeting in July 2005 the question of what accounting principles should be applied by listed companies in the European Union after IFRIC 3 had been withdrawn. According to the ARC statement, after the withdrawal of IFRIC 3 by the Board, there was no interpretation that specifically applied to accounting for Emission Rights. In these circumstances, the current hierarchy in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, as endorsed by Commission Regulation (EC) No 2238/2004 of 29 December 2004, states as follows: 10. In the absence of an [endorsed] Standard or an [endorsed] Interpretation that specifically applies to a transaction, other event or condition, management shall use its judgement in developing and applying an accounting policy that results in information that is (a) relevant to the economic decision-making needs of users; and (b) reliable, in that the financial statements: (i) represent faithfully the financial position, financial performance and cash flows of the entity; (ii) reflect the economic substance of transactions, other events and conditions, and not merely the legal form; (iii) are neutral, ie free from bias; (iv) are prudent; and (v) are complete in all material respects. 4 The Accounting Regulatory Committee (ARC) is composed of representatives from Member States and chaired by the Commission. The Committee was set up by the Commission in accordance with the requirements contained in Article 6 of the IAS Regulation (EC/1606/2002). The function of the Committee is a regulatory one and consists in providing an opinion on Commission proposals to adopt (endorse) an international accounting standard or interpretation as envisaged under Article 3 of the IAS Regulation.

16 In making the judgement described in paragraph 10, management shall refer to, and consider the applicability of the following sources in descending order: (a) the requirements and guidance in [endorsed] Standards and [endorsed] Interpretations dealing with similar and related issues; and (b) the definitions, recognition criteria and measurement concepts for assets, liabilities, income and expenses in the Framework. 12. In making the judgement described in paragraph 10, management may also consider the most recent pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards, other accounting literature and accepted industry practices, to the extent that these do not conflict with the sources in paragraph 11. According to the ARC, it is up to the management to decide upon the accounting treatment for Emission Rights, either granted by the government or acquired from other companies. IFRIC 3, which was not inconsistent with endorsed standards, was based on the following set of endorsed standards: IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors IAS 20 Accounting for Government Grants and Disclosure of Government Assistance IAS 36 Impairment of Assets IAS 37 Provisions, Contingent Liabilities and Contingent Assets IAS 38 Intangible Assets According to the European Financial Reporting Advisory Group (EFRAG) the application of IFRIC 3 will not always result in relevant financial information because in certain cases it does not faithfully represent the economic reality. Therefore management should carefully assess the overall effect of their accounting treatment for emission rights.

17 17 According to the ARC, it should be noted that IFRIC 3 is not the only possible interpretation of endorsed standards. Some of the above standards contain alternative accounting treatments, which were explicitly ruled out by IFRIC 3. For example, the treatment of the government grant, if any, was limited to one out of the two alternatives given in paragraph 23 of IAS 20. According to the ARC statement, management will need to consult the current hierarchy in IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors, as endorsed by Commission Regulation EC/2238/2004 of 29 December 2004, and determine an appropriate accounting regime for Emission Rights.

18 18 4. FINNISH ACCOUNTING AND TAXATION GUIDELINES 4.1 Guidelines by the Finnish Accounting Board The Finnish Accounting Board published a statement of the accounting treatment of emission rights in November 2005 (KILA 1767/ ). This statement is relevant for the operators which draw up their financial statements according to the Finnish GAAP. The Finnish Accounting Board has also given illustrative examples of the accounting treatment of emission rights in a separate statement about the recognition, measurement and presentation of environmental issues, given in October, According to the Finnish Accounting Board, the net method is the appropriate treatment of emission rights in the framework of Finnish accounting legislation and good accounting practice. In case the emissions exceed the emission rights received, an expense is deducted corresponding to the excess amount emitted. The valuation is based on the market value at the end of the accounting period, and a provision is recognised in the balance sheet. However, if the acquisition of the emission rights needed is bound by a contract to a certain price level, the valuation is to be based on the contract price. In case the emissions are lower than the emission rights received, the operator is regarded to have assets off balance sheet, and this information is to be disclosed in the notes to the financial statements. The purchases and sales of emission rights are to be registered as transactions on accrual basis. In order to give a true and fair view of the impact of the emission rights, the operator has to disclose in the notes to the financial statements information on its situation regarding the emission rights, the emissions made and its emission rights trading including information on the prices of emission rights. The same information is to be given also in interim reports.

19 Guidelines by the Finnish Tax Board The Finnish Tax Board published instructions on the taxation of Emission Rights Trading in December 2005 (Dnro 1742/345/2005, ). The instructions cover both the direct and indirect taxation issues. According to the instructions of the Finnish Tax Board, the emission rights are granted to be used in the business activity of a company. Therefore, they are to be treated in taxation as part of the business income. The emission rights belong to the fixed assets. The nature of the emission rights is intangible, and according to the classification used in Finnish company tax system, they are intangible rights with a definite useful time. As to their nature, the Finnish Tax Board considers the emission rights to be comparable with copyrights and patent rights. The emission rights are allocated for the first period ( ) free of charge. In income taxation, the acquisition cost of the emission rights allocated is EUR 0. When the emission right is acquired from the market, the consideration paid in such a transaction indicates the cost. The acquisition cost of an intangible asset has to be amortised in the case the company has not returned the emission rights to cover the emissions caused during the year in question. According to the Business Taxation Act, section 37, the acquisition cost of an intangible asset is to be amortised over a period of ten years, or a shorter period based on the estimated economic life of the intangible asset, at the latest when the emission right has to be returned to the national Emissions Trading Registry. The emission rights may be transferred, and the transfer price is taxable income. According to the general principles of the Business Tax Act, the unamortised part of the acquisition cost is deducted in the tax year when the emission right is transferred. An excess emissions penalty will be charged if the operator does not return the emission rights equal to the emissions made during the previous calendar year by April 30. According to the Finnish Tax Board, the excess emissions penalty is a sanction payment which is not a tax-deductible item (Business Taxation Act, section 16.5).

20 20 5. REPORTING PRACTICES OF EMISSION RIGHTS BY FINNISH LISTED COMPANIES 5.1 Survey on IFRS reports for 2005 The Financial Supervision Authority (FIN-FSA) published in September 2006 a survey on Finnish listed companies 2005 IFRS financial statements. FIN-FSA reviewed the 2005 financial statements of 125 listed companies as part of its enforcement of financial reporting. The survey provided an overall picture of the quality of financial statements and pointed out areas in need of improvement as well as more detailed information on how the companies had applied the IFRSs in some selected areas. One of these areas was the accounting and reporting practices of emission rights. According to the FIN-FSA survey, the situation concerning treatment of emission rights (allowances) in financial statements was unregulated, since IASB cancelled the IFRIC interpretation on accounting treatment of emission rights (IFRIC 3) in summer As there are no accounting guidelines concerning emission rights, listed companies shall take other steps to ensure that their financial statements disclose the effects of emission rights adequately. Guidelines for the choice of an accounting policy shall be sought from IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. According to the standard, management shall use its judgement in selection of an accounting policy that best applies to the relevant transaction. Companies shall describe in the summary of accounting policy and notes to the financial statements their status related to emission rights and emissions as well as the applied accounting practice. In their financial statements of 2005, 14 Finnish listed companies reported on emission rights. There was a great variation in the extent of information provided. Information disclosed on emission rights was limited with most companies. On the other hand, in addition to the disclosed accounting policies and the numerical information contained by the income statement and balance sheet items, some companies provided general information on emission rights, such as volumes of

21 21 granted emission rights, their adequacy, and factors affecting the company s emission rights status. In addition to notes, disclosures were made in annual reports as well. Almost all of the companies disclosed a separate accounting policy on the recognition of emission rights in the financial statements, or presented the main accounting principles in the disclosed accounting policy concerning the recognition of intangible assets and/or government grants. In some financial statements the disclosed accounting policy concerning emission rights was totally absent or was so limited that the effect of emission rights on the company s income statement and balance sheet remained unclear. The description of the accounting policies revealed that most companies did not recognise emission rights received without consideration in the balance sheet at their gross value, but disclosed in the balance sheet a net surplus or deficit. The accounting policy concerning surplus of emission rights available for sale remained with most companies unclear: whether the emission rights available for sale were recognised in the balance sheet and how they were measured. At the end of the accounting period, on 31 December 2005, the market value of unused emission rights by Finnish companies from the 2005 emission rights quota exceeded EUR 90 million. The gain on the sale of emission rights defined as surplus by the companies was disclosed by six companies. For the year 2005, this gain exceeded EUR 40 million. On the whole, FIN-FSA considered the disclosure of emission rights in the IFRS financial statements for 2005 to be limited. In the absence of clear accounting guidelines, it is very important to disclose in the financial statements sufficient information on applied accounting policies, including relevant recognition and measurement principles. Information on the company s emission rights policies and the emission rights status, verified emissions and the result and prices of emissions trading at the end of the accounting period, as well as of the interim periods, is vital information for investors.

22 22 FIN-FSA also noted that the development process of an international standard concerning emission rights and government grants has according to the IASB work plan been postponed, and IASB has not yet announced any preliminary publication date for a draft standard. The subsequent schedule depends on finalisation of other standard projects related to this subject. 5.2 Examples of disclosures about the emission rights The following extracts from the annual reports for 2006 of two Finnish companies, Fortum and Stora Enso, illustrate the information given about the emission rights. There are no uniform practices to be found, and the extent of the detailed information given about the emission rights and their accounting treatment varies. Some companies give information about the value of their emission rights even in the balance sheet, but normally only a short explanation on the accounting principles are given in the notes.

23 23 Example 1: Fortum 2006 Annual Report Accounting Policies Emission allowances Group accounts for emission allowances based on currently valid IFRS standards where purchased emission allowances are accounted for as intangible assets at cost, whereas emission allowances received free of charge are accounted for at nominal value. A provision is recognised to cover the obligation to return emission allowances. To the extent that Group already holds allowances to meet the obligation the provision is measured at the carrying amount of those allowances. Any shortfall of allowances held over the obligation is valued at the current market value of allowances. The cost of the provision is recognised in the income statement within materials and services. Gains from sales of emission rights are reported in other income. Operating and Financial Review 2006 At year end, Fortum s total power generating capacity was 10,913 (11,281) MW, of which 10,768 (11,136) MW was in the Nordic countries. Changes are mainly due to the divestment of thermal power plants in Finland and Sweden. The Fortum Espoo integration increased Fortum s combined heat and power production capacity. The share of CO2-free power generation was 84% (93%) of Fortum s power generation in A preliminary estimate for CO2 emissions from Fortum s own power plants in 2006 totals 11.0 million tonnes, 4.5 million tonnes higher than in the previous year. The emissions subject to EU s emissions trading scheme rose to about 10.4 million tonnes. The average volume of emission allowances allocated to Fortum s installations in various countries totals approximately 9 million tonnes per year during The annual average CO2 emissions subject to emissions trading have been approximately 8.1 million tonnes during The average volume of emission allowances allocated to Fortum s installations totals approximately 9 million tonnes per year during

24 24 Example 2: Stora Enso 2006 Annual Report Accounting Policies Emission Rights & Trading The Group s participation in the European Emissions Trading Scheme, in which it has been allocated allowances to emit a fixed tonnage of carbon dioxide in a fixed period of time, gives rise to an intangible asset for the allowances, a government grant and a liability for the obligation to deliver allowances equal to the emissions that have been made during the compliance period. Emissions Allowances recorded as intangible assets are recognised when the Group is able to exercise control and are measured at fair value at the date of initial recognition. If the market value of emission allowances falls significantly below the carrying amount, and the decrease is considered permanent, then an impairment charge is booked for allowances which the Group will not use internally. The liability to deliver allowances is recognised based on actual emissions; this liability will be settled using allowances on hand, measured at the carrying amount of those allowances, with any excess emissions being measured at the market value of the allowances at the period end. In the Income Statement, the Group will expense, under Materials & Services, emissions made at the fair value of the rights at their grant date, together with purchased emission rights at their purchase price. Such costs will be offset under Other Operating Income by the income from the original grant of the rights used at their fair value at the grant date, together with income from the release or sale of surplus rights. The Income Statement will thus be neutral in respect of all rights consumed that were within the original grant, any net effect representing either the costs of purchasing additional rights to cover excess emissions, the sale of unused rights or the impairment of allowances not required for internal use.

25 25 6. PROSPECTS OF THE INTERNATIONAL GUIDELINES FOR EMISSION RIGHTS REPORTING After the withdrawal of the IFRIC 3, the IASB decided at its September 2005 meeting to add the topic of emissions trading to its agenda. The project does not have a working group due to its limited scope. Further, this project is being conducted by the IASB only. The project interacts with the project to revise IAS 20 Accounting for Government Grants and Disclosure of Government Assistance. The Board has therefore decided first to consider the treatment of permits and licences (including emission rights) issued to entities by government for less than fair value as part of its IAS 20 project. Once this has been completed, the Board will consider other issues relating to emission trading schemes, for example the subsequent accounting for emission allowances and credits. The Board discussed its IAS 20 project in February At that meeting, the Board decided to defer the IAS 20 project until further work is completed on other projects (in particular, the project to amend IAS 37 Provisions, Contingent Liabilities and Contingent Assets). Because the IAS 20 project is precedential to the Emissions Trading project, work on the latter is also deferred. The estimated project completion date is yet to be decided. There are important interactions between the project on emission rights and other projects, particularly the IASB s consideration of amendments to IAS 37, revenue recognition, and government grants. One of the mismatches found in the IFRIC 3 was due to the two valuation models given in IAS 38 Intangible Assets. This duality is at present under further consideration and it has been suggested that only valuation based on fair value model should be used when there is an active market for the intangible assets in question. In the IASB Work Plan, latest version dated 31 March 2007, both a project on

26 26 Emission Rights and Government grants (IAS 20) is mentioned. Still, no timetable for these projects is given. According to the IASB, work on government grants and emission rights has been deferred pending the conclusion of work on other relevant projects. 7. SUMMARY The European Union scheme for greenhouse gas emissions trading started in The emission rights are a new phenomenon in the financial accounting regime, and there was no consensus between the market participants on the accounting and reporting treatment of emissions trading as the system started in In order to ensure comparable financial information on emissions trading, the International Financial Reporting Interpretations Committee published an interpretation, IFRIC 3 Emission Rights, in December IFRIC 3 was based on existing IFRSs, above all on the standards referring to government grants, intangible assets and provisions. During the endorsement process of the European Union it was stated that IFRIC 3 entailed a mixed measurement model which would not ensure representing economic reality faithfully, especially in cases where the entity does not trade emission rights. The interplay between existing IFRSs created a measurement mismatch as some items are measured at cost (intangible assets and government grants) and others at fair value (provisions). There was also a reporting mismatch as some gains and losses are reported in profit or loss (provisions and government grants) and others in equity (intangible assets). As a consequence of the non-endorsement of IFRIC 3 in the European Union, the IASB withdrew IFRIC 3 in June 2005 with immediate effect. Thus, the accounting and reporting treatment of emissions trading remained unregulated. Currently, the IASB has a project on emission rights on its Work Plan but the IASB has not given any timetable for this project. Several amendments to existing standards need to be done before it is possible to consider a new interpretation to be given.

27 27 Also nationally the treatment of emissions trading issues remains unregulated in many jurisdictions. In Finland, for instance, a general statement has been published by the Accounting Board. Nonetheless, the reporting practices are at present divergent and the elaborateness of the information given varies considerably. The comparability of the financial data is thus endangered. There is an apparent need for detailed guidance for the accounting and reporting of emissions trading issues, both on international level for listed companies and on national level for the companies which draw up their financial statement according to national GAAP. The first step in this process is the modernisation of the relevant IFRSs, concerning the treatment of government grants, intangible assets and provisions. In this work, the interplay of these international standards have to be taken into account, in order to build up, as a next step, workable guidelines for the accounting of emission rights.