Accounting for Carbon credits

Dolphy D’Souza

A number of Indian companies generate carbon credit under the Clean Development Mechanism (CDM). The amount involved is material enough to the overall viability of a project.

Under the International Financial Reporting Standards (IFRS), the International Accounting Standards Board (IASB) had issued an interpretation IFRIC 3 (Emission Rights), which was withdrawn in June 2005. Thus, the IASB is still debating on an appropri ate treatment for Carbon Emission Reductions (CERs).

Under IFRS, most entities generating CERs treat the same as government grant covered under IAS 20 (Accounting for Government Grants and Disclosure of Government Assistance). This is because an international agency grants the same. Accordingly, based on IAS 20 requirements, a generating entity recognises CERs as asset once there is a reasonable assurance that it will comply with conditions attached and CERs will be received.

IAS 20 gives an option to measure such grants either at fair value or nominal value. Most entities will measure the CERs at fair value to ensure appropriate matching with the costs incurred. They will recognise this in the income statement in the same period as the related cost which the grant is intended to compensate. The corresponding debit will be to intangible assets in accordance with IAS 38 (Intangible Assets).

No guidance is currently available under Indian GAAP (generally accepted accounting principles). Consequently, various practices exist (a) income from sale of CERs is recognised upon execution of a firm sale contract for the eligible credits, as prior to that there is no certainty of the amount to be realised; (b) income from CERs is recognised at estimated realisable value on their confirmation by the authorities concerned; and (c) income from CER is recognised on an entitlement basis based on reasonable certainty after making adjustments for expected deductions.

The Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI) has issued an Exposure Draft (ED) of the Guidance Note on Accounting for Self-generated Certified Emission Reductions. The ED proposes to lay down the manner of applying accounting principles to CERs generated by an entity.

According to the ED, the generating entity should recognise CERs as asset only after receipt of communication for credit from United Nations Framework for Climate Change (UNFCCC) and provided it is probable that future benefits associated with CERs will flow to the entity and costs to generate CERs can be measured reliably.

Further, such assets meet the definition of the term ‘inventory’ given under AS 2 (Valuation of Inventories) and, hence, are valued at lower cost and net realisable value.

Only the costs incurred for the certification of CERs bring the CERs into existence and, therefore, only those costs should be included in the cost of inventory. According to the prescribed criteria, all other costs are either not directly relevant in bringing the inventory to its present location and condition or they are incurred before CERs come into existence . Thus, those costs cannot be inventorised.

The ED will result in significant cost and revenue mismatch in the financial statements. This is because entities would need to expense most of their costs as soon as incurred (with an insignificant amount being capitalised as inventory), but will recognise revenue arising from CERs only when these are actually sold.

Clearly, the accounting recommended by the ICAI is very different from existing practices under Indian GAAP and, hence, every company that has significant revenue from carbon credits will have to consider the impact of the ED carefully.

Inconsistent treatment

The treatment prescribed in the ED appears to be inconsistent with the existing Indian GAAP literature in more than one regard. The ED requirement to recognise CERs as asset only when these are credited by UNFCCC in a manner to be unconditionally available is contrary to the principles currently being followed for recognition of an asset.

In most cases, recognition of assets is based on criteria of probability/reasonable assurance as against absolute certainty prescribed in the ED. For example, both under AS 9 (Revenue Recognition) and AS 12 (Accounting for Government Grants), recognition of income is based on the criteria of reasonable assurance.

The ED is also inconsistent with an Expert Advisory Committee’s (EAC’s) opinion on export incentives. According to the EAC, DEPB credit should be recognised in the year in which the export was made, without waiting for its actual credit in the subsequent year, provided there are no insignificant uncertainties of ultimate collection. The EAC opinion is based on the application of existing accounting principles, including definition of the term ‘asset’ given in the Framework, which is based on the probability theory.

The ED clearly is in conflict with the existing requirement and practices under both Indian GAAP and IFRS and is contrary to the definition of an asset in the Framework.

As India is adopting IFRS and the guidance in these areas are being developed under IFRS, issuing India-specific guidance is duplicating the effort and creating more differences in how the two GAAPs are applied, which will have to be then taken care of in 2011, which is the transition date for adopting IFRS.

(The author is Partner, Ernst & Young.)