An emission allowance is a tradable instrument representing the right to the owner to emit an amount of a class of gasses, typically represented as a ton of carbon dioxide equivalents. Some emission allowance programs are required, while others are optional. The goal of setting up emission allowance programs is to reduce the emission of gasses that are considered detrimental to human health and the environment.
Understanding the accounting for emission allowances can be complicated given the sparse guidance that currently exists. The FASB added this topic to its research agenda in 2009, but the topic was ultimately removed from the agenda in 2014. While diversity in practice exists, this article seeks to provide an overview of the existing accounting guidance on the full emission allowance lifecycle, including:
- Inventory or intangible asset designation
- Acquisition of the emission allowance
- Change in value
- Using the allowance
- Selling/trading the allowance
Inventory or Intangible
The unique nature of emission allowances means that they can be accounted for as either inventory or as intangible assets. Companies may have both classifications of emission allowances on their balance sheet. Companies can use discretion in deciding how they want to categorize their emission allowances, provided they are consistent in their categorization. Although both methods are allowed, Deloitte points out in a Q&A that the intangible asset method is preferable.
Labels such as “held for use” and “held for sale” are appropriate for emission allowances. Emission allowances treated as intangible assets should be categorized as “held for use,” while allowances categorized as inventory can be reported as “held for use” or “held for sale.”
Because the treatment of the asset is different based on the initial classification, many sections in this article include a portion about treatment for inventory-classified emission allowances and a section for emission allowances classified as intangible assets.
Emission Allowance Acquisition
Granted by a Regulatory Body
Most cap-and-trade programs in the United States allocate emission allowances to companies free of charge. Because of this fact and current Federal Energy Regulatory Commission (FERC) guidance, emission allowances received from the government are recorded at zero cost. Of course, this zero-recorded value does not reflect the amount for which a company could sell the emission allowance.
Because of the lack of US GAAP on the subject of emission allowances, some companies turn to the international standards for guidance. IAS 20.23 states:
“A government grant may take the form of a transfer of a non-monetary asset, such as land or other resources, for the use of the entity. In these circumstances it is usual to assess the fair value of the non-monetary asset and to account for both grant and asset at that fair value. An alternative course that is sometimes followed is to record both asset and grant at a nominal amount.”
Following this guidance and treating the receipt of the emission allowance as a government grant, the emission allowance would be put on the books at its fair value, along with a liability—called “deferred income”—for the same amount. Note that the asset should still be put on the books as either an inventory asset or an intangible asset, as determined by how the company plans to treat the asset. The remaining “diversity in practice” sections of this article will deal with this accounting.
Companies can also acquire emission allowances through purchase (e.g., through government auctions, or from another company that has excess emission allowances). In this case, the buyer records the asset on its books at the amount paid. The seller records a gain on sale to the extent the purchase price exceeds the book value of the emission allowance. Similarly, the seller would record a loss if the opposite were true.
Change in Value of the Emission Allowance
Inventory is kept on the books at the lower of cost, market, or net realizable value according to the Financial Accounting Standards Board (FASB) in Accounting Standards Codification (ASC) 330-10-35. This means that emission allowances initially recorded at zero will not have their book values increased no matter what happens with the market price of a tradable allowance. However, if allowances were purchased and/or initially recorded at a value above zero on the balance sheet, a company should keep track of market price to ensure that it is kept at the lowest of the allowable prices, and, when necessary, record an impairment loss.
Emission allowances classified as intangible assets should be evaluated for impairment based on the guidance found in ASC 360. Impairment analysis is required when circumstances or events signal the book value of the emission allowance may not be recoverable. The following are indicators that impairment has occurred according to PwC:
- “A significant decline in the price of emission allowances
- An adverse change in the manner in which the reporting entity’s generating assets are used, impacting the possible usage of the allowances (e.g., resulting from a change in the fuel mix)
- A significant adverse change in the business or regulatory environment, such as a regulatory action requiring that a plant be shut down”1
If the asset is impaired, the company would decrease the recorded amount of the asset with a corresponding impairment expense. If the asset is already recorded at zero cost, impairment is not necessary.
Using the Emission Allowance
Emission allowances are usually only valid during a specific time frame. Allowances that pertain to different time periods are referred to as vintages. For example, emission allowances that expire in 20X9 are “vintage year 20X9.” As these emission allowance vintages expire, the cost of the assets is expensed as a reduction to net income. This expense is included in operating income, often as part of the reported “cost of sales.” Treating the asset like this is similar to how inventory on the balance sheet turns into the cost of goods sold on the income statement once the inventory has been sold.
Similar to emission allowances treated as inventory, emission allowances treated as intangible assets are amortized as they are used up. This amortization expense is equal to the book value of the emission allowance vintages that expired in a given period.
After using up an emission allowance that was initially recorded at fair value as a grant, the asset and liability need to be taken off the books. This is done by creating a journal entry that takes the asset (whether an inventory asset or an intangible asset) and liability (deferred income) off the books at an appropriate amount at the end of an appropriate period. Note that the offsetting removal of these two balance sheet items does not impact the income statement.
Selling/Trading the Allowance
When selling an emission allowance treated as inventory, the full gain should be recognized as the difference between the book value and the consideration received. This means that if the government granted allowances that were initially recorded at zero are sold, there would be a potentially significant amount of gain to recognize. Given that the emission allowance is treated as inventory, the cash related to these transactions would be recorded as part of operating activities in the statement of cash flows. Keep in mind that inventory sold is subject to valuation methods such as FIFO, LIFO, Average Cost, or Specific Identification.
In the case where there is a vintage year swap of emission allowances (where vintages related to one year are traded for vintages related to a different year) treated as inventory, a carryover basis should be kept. This means that a government-issued allowance initially recorded at zero could be traded for an allowance corresponding to a different year, and the new allowance would still have a book value of zero.
The general practice is that emission allowances are treated as intangible assets when they are not expected to be actively traded. However, such intangible asset emission allowances can still be sold. There are rules governing gains and setting the basis for sales and swaps. When selling an emission allowance treated as an intangible asset, the full gain should be recognized as the difference between the book value and the consideration received. Because selling these allowances is not a typical part of normal operations, the cash inflows and outflows should be found in the investing activities section of the statement of cash flows.
In the case of a vintage year swap of emission allowances treated as intangible assets, the fair value of the new allowance should become the book value. However, this can only take place if the transaction has commercial substance, and swaps between vintage years would meet this qualification, while swaps of the same vintage would likely not meet this qualification (because the asset given up is the same as the asset received). This means that an allowance with a book value and recorded cost of zero, when swapped with a different year vintage allowance, would have a new fair value basis rather than zero.
When selling an emission allowance originally valued at fair value as a grant, consideration needs to be given to the fact that the emission allowance is on the books as both an asset and liability for the same amount. This means that any consideration received for the asset will run through the income statement as a gain. In such a situation, cash will be received, the deferred income liability will be taken off the books, the emission allowance asset will be taken off the books, and a gain will be recorded in the amount of the cash received.
Accounting for emission allowances under US GAAP can be complicated given the lack of concrete guidance from the FASB. However, the inventory and intangible asset models provide a framework for these assets that make them familiar to most accountants. Remember these key details when dealing with emission allowances:
- Emission allowances expected to be traded in the ordinary course of business should be accounted for as inventory. Otherwise, the preferred accounting treatment is as an intangible asset.
- Emission allowances go on the books at their cost, meaning that allowances granted by the government should have a zero-cost basis. Purchased allowances go on the books at their cost as well.
- Emission allowances are generally kept at a lower of cost or market value for inventory allowances, or an impaired value for the intangible asset allowances.
- As the allowances expire, their book value is taken off the books as a cost of sales for inventory, and as an amortization expense for intangible assets.
- Gains and losses should be recognized as a difference between the book value of the allowance when sold and the consideration received.
- Accounting For Carbon (Research Report 122) by Dr Heather Lovell, Dr Thereza Sales de Aguiar, Professor Jan Bebbington, and Dr Carlos Larrinaga-Gonzalez
- FASB Board Meeting Handout on February 21, 2007