Should social cost or externalities be included in financial reporting?

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In today’s era, accountants play a vital role in business. Traditionally, their role was to perform financial functions related to the collection, recording, accuracy, analysis, and communicate information to all interested parties on how companies perform. However, in recent times, the environment has been growing in the minds of the community as well as in the minds of business. With this rise in awareness, accountants now realize that they need to understand and respond to environmental imperatives too. So far, this response has focused on the scope of social and environmental accounting and externalities.

Externalities in here mean that the effects of products, services or production that imposes on an unrelated third parties. Externalities can be negative or positive. Negative externalities include illegal logging, hill cutting, river pollution, marine pollution, air pollution, improper treatment and disposal of toxic waste, deterioration of water quality, declining coral reefs, coastal erosion, over-fishing and biodiversity loss. For example, the largest freshwater lake, Loagan Bunut in East Malaysia, is drying up fast due to sedimentation from logging and land clearing activities (Balasegaram, 2005). Whilst for positive externalities, an example will be the effect of a well-educated labor force on increasing the productivity of the company thus creating job opportunities.

Therefore, a question was raised about whether should the social cost or externalities cost be included in the financial reporting of the community. However, in order to develop a wider understanding of environmental accounting and the central role that accountants plays in society, we need to consider it from a few social views.

Some conventions of financial accounting that constrain broader accountability

The International Accounting Standard Board (IASB) is an independent accounting standard setter that being founded on February 6, 2001. The IASB adopted all current IASs and also responsible for maintaining the International Financial Reporting Standard (IFRS). The IFRS framework addressed:

  • Concept of debit and credit

Debit and credit are entries made in double entry accounting system. It was first described by an Italian mathematician called Luca Pacioli. The basic theory of double entry system is that every transaction put into bookkeeping goes into at least two different places. These entries into books will be either a debit or a credit to keep accounts in balance. However, as externalities is a ‘one-side transaction’ (Thornton 1993, 2013), then there will not be a balancing credit entry to be made.

  • Concept of separate entity

In the beginning, a business is created for the purpose of making money for the owner. In accounting, a business is created with the distinct an independent existence that is known as the separate entity. So the business exists as an entity that is separate from the owner. At the point of its creation, the business owns nothing and it owes nothing.

  • The objective of financial reporting

In the IASB Conceptual Framework for Financial Reporting 2010, state that ‘the objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity. Those decisions involve buying, selling or holding equity and debt instruments and providing or settling loans and other forms of credit’.

  • Definition of the elements of financial reporting

Asset, liabilities, equity, income and expenses are the five elements of financial reporting where all of them have different meaning. Asset, liability and equity are the elements relating to financial position whereas income and expenses are relating to performance. For example, asset is placed with the meaning of a resource that can be controlled by an entity. If a resource is not controlled by an entity, then it cannot be counted as an asset for that entity. Besides that, expenses are also linked in this situation. Expenses are defined as outflows or other using up of assets or incurring liabilities from delivering or producing goods, providing services or carrying out other activities. However, as social and environmental cannot be controlled; therefore it is not recognizing by the entity.

  • Recognition criteria of financial reporting

Before even considering recognition criteria, it must first have an item meet the definition of one of the elements. Once have the definition being complied with in, there will be 2 recognition criteria in terms of the framework. Firstly, the probability of future economic benefits related with the item that will be a future inflow or outflow. Probability here must at least greater than 50%, that’s the cash in the future are either flow into the business or flow out of the business. If flowing in the business then it’s talking about asset, if flowing out of the business then its liability. Secondly, the item must have a cost or value that can be measure with reliability.

  • The practice of discounting future cash flows

Information is available from the cash flow statement which shows cash flows from operating, investment and financing activities providing a perspective that is largely free from allocation and valuation issues. This information is useful in assessing and reviewing previous assessments of cash flows.

  • Verifiability

There are few qualitative characteristics that determine the usefulness of information such as relevance and reliability. Verifiability is also one of it. Verifiability enhanced the usefulness of financial information by truly represent the information to help users in deciding the reporting entity in its financial report.

Should we include the externalities cost

Externalities cost are the cost include things like pollution that are suffered by third parties where no appropriate compensation is paid. To determine the financial value of externalities cost are difficult; nevertheless, some businesses are still trying to address these costs as part of their environmental accounting system (Cornelia Dascalu, 2008).

However, there will be some issues that are unavoidable if the externalities cost is included in the financial reporting. A major problem is that the difficulties in valuing environmental goods. Some natural resources like air or water do not have observable prices. Assigning monetary values to environmental resources is hard. One would need to use implicit or shadow prices in some way. Even these prices may not be helpful since they may be affected by market imperfections and taxes. For instance, some organizations in the mining industry are recognizing the need to account for future costs of cleaning up previous damage on industrial sites and properties which might have substantial contingent liabilities. This issue raises some interesting questions. There was a case some time ago of a refinery site which was valued on the books at $2 million, but with a $4 million site clean-up cost. This illustrates the dilemma for both management and accountants in terms of deciding what to do with the site. Indeed, it shows that, without accurate information or a process to define these issues; wrong decisions could easily be made (Patrick Madley, 1997). From this situation, it shows that there is no fixed dollar amount for the damage. It would be in their interest to overstate the damage in order to ensure the largest possible payment. Externalities costs are hardly to reliably estimate.