Financial Reporting for Pollution Reduction Programs

We apply the IASB’s conceptual framework to develop an accounting treatment for a cap-and-trade program. Under our treatment, firms recognize allowances as intangible assets, 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 both our treatment and alternative treatments to transaction-level data from the U.S. SO 2 cap-and-trade program to provide ex ante evidence that financial reporting outcomes under alternative treatments, including our own, result in significant differences relative to current practice, including increased assets and liabilities, reduced net income, and increased income volatility. Our proposed treatment is most aligned with investor perceptions as indicated by the association between market value of equity and assets, liabilities and income.