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ENVIRONMENTAL ACCOUNTING: EMERGING ISSUES OF THEORY

AND PRACTICE

Geoff Wells

In the practical world of business, environmental accounting has been, until

recently, a relatively minor matter of internal costs. It has related to a straightforward
management and management accounting issue: how to identify and capture
environmental costs, with a view to minimising them. In the course of the last
decade, however, the theory and practice of environmental accounting has taken it
well beyond the boundaries of this exercise. Environmental accounting is now seen
not only as a core business issue, but as raising fundamental questions of accounting
theory, and even of challenging the foundations of accounting and of the theory of
business itself. This paper attempts to trace the outlines of this trajectory, and
suggests some possible research strategies directed to exploring these issues further.
At a first level of analysis, it is clear that environmental impact and management is
increasingly seen as relevant to all the major divisions of modern corporate practice,
including marketing, operations, and finance. It now figures as a major component of
corporate strategy. The emphasis is moving away from the impact of environmental
factors on the cost burden, to the strategic opportunities becoming available as the
result of a sea-change in the marketplace. This change has been lead by a
transformation of consumer sentiment, particularly in Europe: environmental
legislation and regulation; media reporting of environmental damage; consumer
concerns over environmental safety and health; consumer preferences for
environmentally friendly products and services; an upsurge in community awareness
and understanding of environmental issues and implications, from a wide educational
base; all are well established trends, particularly in Northern Europe, but, to different
degrees, in most major developed and developing markets.1
It is a trend that is discernible even in countries that historically have largely
ignored the environmental dimension of government policy, such as China: faced with
catastrophic degradation of soil and water, on a vast scale, the Chines government is
beginning to incorporate environmental dimensions in major policy initiatives,
including those that regulate corporate practice, in the new environment of WTO
accession. Interestingly, this is a trend that is less well developed in North America,
where the underlying cultural belief in the intrinsic beneficence of science and
technology, and of the corporations who use them, is apparently highly resistant to
evidence to the contrary. Even in the US, however, the natural foods sector has been
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growing, admittedly on a small base, at more than 30% per year over the past decade;
and American corporations are coming to terms with the fact that they cannot, with
impunity, ignore consumer preferences for environmentally safe and friendly products
and services, even manufacturing processes. Monsanto presents perhaps the most
spectacular example of the consequences of American hubris, in its attempt to export
genetically-modified seed stocks to Europe, whose consumers, and therefore whose
national governments, have been fiercely resistant to such productsa miscalculation
(or culpable myopia) which even now, after a fruitless expenditure of millions of
public relations dollars, and its takeover and corporate relegation by Pharmacia,
Monsanto still seems unable to understand or accept.
To put it bluntly, a modern company ignores the environmental dimensions of its
business at its peril. Accounting theory and practice now has to reflect that new
reality.
Cost efficiencies are, nevertheless, still central to the way in which companies
think about the environment. There is nothing unreasonable in such a focus. Once
systematic analysis of business operations and processes is undertaken, it generally
becomes clear that environmental costs are a far greater percentage of total costs than
had been realised. Typically, this underestimation is a consequence of lazy accounting
practice. Overhead accounts become general dumping grounds for costs that are out
of the ordinary, or difficult to classify (in my experience, accountants are not, as a
rule, comfortable in having habitual practice challenged, and in having to think things
through from first principles). Environmental costs are scattered across overhead
accounts, and, because they are not consolidated and appropriately classified, are not
even identified for what they are. As a result, they cannot be effectively managed.
Thus the financial returns potentially available from waste reduction, energy
conservation, raw material initiatives, through identification of lower polluting
materials or reprocessing, or lifecycle cost reductions are typically not captured, or
captured only partially.
An example of a systematic attempt to capture internal costs and benefits arising
from its environmental programme comes from Baxter International, a US company
producing, developing and distributing medical products and technologies, with
annual revenues in excess of US$5 million. In 1995 Baxter developed an
Environmental Financial Statement, the purpose of which was to report on the total
of financial costs and benefits that could be attributed not only to the environmental
programme itself but to the environmentally beneficial activities across the
corporation. This financial statement identifies costs associated with the companys
environmental programmes, such as pollution controls, waste disposal, remediation
and clean-up; savings, through cost reductions from the prior year to the report year;
and a line item called cost avoidance relating to additional costs other than the report
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years savings that were not incurred, but would have been incurred in the report year
if the waste reduction activity had not taken place. The environmental bottom line is
then calculated as the sum of savings and cost avoidance less costsin Baxters case,
a healthy surplus. Note, however, that the focus of the analysis is entirely internal
the entity assumption is maintained, and no external environmental impacts of the
business is consideredbut it does demonstrate that by explicitly considering
environmental dimensions of a business, and by capturing its impact in the accounting
structure, actual cost savings can be made.2
It should be noted that intangible cost reductions are even less likely to be
identified and secured. Present outlays to avoid future expenses, such as landfill,
clean-up, customer boycotts, product recalls, and regulatory infractions, are not
common practice because conventional financial analysis doesnt support them.
Relatively few companies have begun to think about the potential upheaval in their
cost profiles and cost reduction strategies in the carbon emissions caps and trading
environment that is rapidly approaching. BP Amoco is a notable example to the
contrary: for the past several years it has been adopting in its global operations
strategies to maximise cost efficiencies and capture competitive advantage in this new
environment.
Risk management and liability reduction is an associated arena of environmentallydirected business strategy. Resource depletion, product liabilities, pollution, and
waste can generate significant contingent liabilities for rectification, legal defence
(against class actions, for example), fines, and penalties. There is no question that the
legislative and regulatory component of the societal framework within which
contemporary business functions is targeting fundamental aspects of business
operationsprocesses which may have funded a companys profitability for decades
and is being administered more strictly. Penalties for infractions are being raised
across the world, as societys expectations of company performance become greater
and less prepared to countenance environmental damage. The most notable example
of this liability, of course, is Exxon Corporations Alaskan oilspill, which cost more
than US$ 3.5 billion in clean-up, fines, environmental mitigation, and monitoring and
subsequently more than US$5 billion in punitive damages claims by commercial
fishers and native Alaskans. Closer to home, the BHP Ok Tedi copper mine has
turned a mountain into a basin, and flushed 70 million tonnes of waste a year down
the river system to sea. In the process, the riverbed has filled up with sediment,
flooding up to 2000 square kilometres (the size of greater Sydney), wiping out its
rainforest canopy, ruining the subsistence plots and destroying the wildlife of the
region. The land and watercourses of the lower Ok Tedi river have become a heavymetal toxic waste dump. It remains to be seen whether the $80 million settlement of
the class action launched on behalf of the Ok Tedi villagers will be the end of the
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matter, as the company jettisons its holding in the operation into a Singapore trust for
the benefit of the 30,000 villagers affected in both livelihood and health; one would
have to be sceptical.3
Clearly, when one attempts to manage and report on risks of this magnitude, the
tools of risk management and financial modelling are manifestly inadequate. That is
the result of an almost total lack of comprehension of the enormous costs of
miscalculating the environmental risks, with their associated physical and social
consequences.
As an example of what might be called the progressive corporate view of
environmental performance, we might look to this statement, taken from the oil and
gas industryan industry which, more than most, has been faced with the realities of
environmental challenges:
Oil and gas companies cannot continue to achieve financial success without also
achieving environmental excellence, and they cannot achieve environmental
excellence by evaluating and rewarding performance based strictly on short-term
financial indicators. Environmental performance, environmental multiplier, and
international environmental taxes will help oil and gas companies integrate
environmental performance into their management evaluation and rewarding
systems. For many oil and gas companies, current performance appraisal process
only incorporates a fraction of all environmental costs. The less tangible, hidden,
indirect costs such as potential legal liability, future regulatory compliance, and
the economic consequences of changes in corporate image linked to
environmental performance, are largely ignored. When evaluating management
performance, a company must consider total costs, including all internal and
external environmental costs. To do otherwise can lead to poor environmental
decisions which eventually will adversely affect the company's long-term
profitability.4
Again, however, note that the emphasis of such a comment is on the entity, rather
than on its social context. Total costs here means total costs to the entity, not total
costs produced to both entity and society. We may have an uneasy feeling that,
particularly when dealing with such vast environmental and social impacts as those of
Exxon Valdez and BHP Ok Tedi, the entity assumption that is fundamental to
accounting theory has become comprehensively breached; an observation to which we
will return.
In recent years, and increasingly in contemporary business, environmental
strategies offer not just cost reductions but competitive advantages in the market. As
noted, this is the result of a sustained and deeply-based upsurge of consumer
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sentiment in favour of environmentally friendly products, services, and processes.

That it is deeply-based is now well confirmed: recent market research undertaken in
Europe on consumer attitudes to genetically-modified food, for example, has
demonstrated that consumer resistance to these products has its roots in fundamental
beliefs and attitudesabout family health, about the nature of science, even about the
nature of life itselfwhich are simply not amenable to manipulation through standard
advertising and promotional techniques. In this consumer environment, demand has
emerged for the production and delivery of green products and services, and green
labelling and marketing are part of a companys differentiation strategies. One has
only to walk into a UK supermarket to verify this trend: products are labelled with an
array of environmental classifications, extending even to the processes by which they
are producedanimal welfare or sustainable agriculture production. In textiles, the
newly introduced European Ecolabel, driven by government regulation, places strict
requirements on the entire lifecycle of the product: in woollen fabric and garments,
for example, limitations on the residues of pesticides and chemicals in greasy wool
(unprocessed wool); required standards for dissolved solids in scouring effluent
(cleaning the wool); even standards of shrinkproofing in the yarn and fabric, to
conserve garment use and minimise disposal volumes. At present, such
environmental marketing strategies command a premium in the retail market.
Experience suggests, however, that these products will become commoditised, and
then the advantage for environmentally friendly products will be simply access to
market. Without it a company will not even be able to enter the competitive arena.
In this context, the costs associated with meeting environmental standards are seen
in an entirely different light. These are no longer unavoidable costs of doing business,
to be allocated as overheads, along with accountants and executives, to business
centres and products. They are product linkeddirect costsa central component of
the cost of goods sold, feeding directly into the calculation of gross profit. As such,
they are managed as a central business focus by margin analysis, across the range of
products and markets. Environmental considerations thus move from the margins of
the business into its core segments of operations, finance, and marketing; they become
not part of the business environment, but a central part of the business itself. The
focus of the analysis has still not moved outside the entitythe only environmental
costs considered are those incurred by the entitybut the entitys enterprise has been
penetrated by the environment, of which now, in the pursuit of competitive advantage,
it is necessary to take account.
Let us now come back to the question of external environmental impacts; or, for
that matter, external social impacts (Ok Tedi demonstrates how interdependent these
are). It is clear from the foregoing account that there may well be costs incurred by
the impacts of the operations of the business that are not met, either now or in the
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future, by the company itself. That is, they are costs picked up by the society at large.
In large part, this is due to limitations in conventional accounting and costing rules,
which in turn have their foundation in financial accounting theory, with its
underpinnings in political economy theory. Some of these limitations are as follows5:
(1) Financial accounting focuses on the information needs of those parties
involved in making resource allocation decisions about the entity
predominantly stakeholders with a financial interest in the entity. This limits
access to information by people who are impacted outside the financial
parameters of the entity; that is, the public at large.
(2) The basic principle of materiality has tended to preclude the reporting of
environmental information, given the relative difficulty of identifying and
quantifying some categories of environmental costs and benefits.
(3) Measurability is an associated limitation. The recognition criteria of financial
accounting require an item to have a cost or other value that can be measured
financially and reliably. Most attempts to assign value to external
environmental impacts move quickly into estimates, with their associated
controversies concerning methodology.
(4) In financial accounting expenses are defined to exclude the recognition of any
impacts on resources that are not controlled by the entity, unless fines or other
cash flows result. This is because the notion of expenses is linked to the notion
of reduction of assets; and assets are defined in terms of future economic
benefits controlled by the entity.
(5) Conventional accounting does not account for the full cost of production
because it assigns no monetary costs to the consumption of natural resources
such as air, water and land fertility. Social costs and related benefits are
ignored.
(6) Accounting rules may penalise environmentally responsible behaviour. Unless
this behaviour is reflected in a higher price for its products, it may result in a
lower net profit and lower earnings per share.
(7) Conventional accounting does not have a mechanism for recording green
assets, or their consumption; monitoring the use of green assets; distinguishing
between the costs of renewable and non-renewable resources; or providing
accounting incentives for protection of the environment.
The net result of these deficiencies of conventional accountingthe structure by
which, in the current environment, we evaluate the performance of companies and
their managementmean that if an entity were to progressively degrade the quality of
water in its vicinity, with the resulting decimation of associated flora and fauna, then
to the extent that no fines or other related cash flows were incurred, reported profits
would not be directly impacted. In fact, the performance of such an entity could well
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be portrayed as very successful. This is hardly hypothetical: business practice

worldwide abounds with such examples. As has been well, if emotionally, said:
. . .there is something profoundly wrong about this system of measurement, a
system that makes things visible and which guides corporate and national
decisions, that can signal success in the midst of desecration and destruction.6
There have been some attemptsone would have to say, in the current corporate
environment, courageous attemptsto develop new accounting approaches that might
begin to internalise the external environmental impacts of an entity. In one way or
another, all such approaches represent themselves as full-cost accounting. Here are
two examples.7 Ontario Hydro, a North American electricity distributor (now Hydro
One), pioneered a damage function approach. The damage function was calculated
by techniques using market prices to estimate monetary values from those impacts,
such as crop losses, that are traded in the market; and using willingness to pay for,
or willingness to accept, changes in environmental quality, for impacts that are not
explicitly traded in the market. These estimates were combined with environmental
modelling techniques to consider potential damage to the environment. Physical
impacts were then assigned monetary value through economic valuation techniques.
However, while impacts external to the entity were recognised and valued, they were
not fully internalised into the companys accounts, but presented in parallel.
A more radical approach has been offered by BSO/Origin, a Dutch computer
consultancy organisation. For some years the company provided environmental
accounts, which placed a monetary value on the external environmental costs of the
companys operations. Its methodology used two methods: actual damage costs; and,
where these are not available, or difficult to come by, prevention costs, as an
approximation to the real costs, using studies of sustainable shadow pricing. Not
content, however, with simply reporting these costs, in parallel with the companys
accounts, BSO/Origin deducted the total of these costs (which it called extracted
value) from operating income to give what was then defined as sustainable
operating income. Carried through to the bottom line, the new result becomes
sustainable net income.
It is interesting to note that the demand for full-cost accounting arose as a
consequence of, or in parallel with, the world-wide rise of the notion of sustainability.
The most-quoted definition of sustainability is that of The Brundtland Report, issued
by the World Commission of Environment and Development in 1987. There
sustainable development was that defined as . . .development that meets the needs of
the present world without compromising the ability of future generations to meet their
own needs. This lead to a concern with not only inter-generational equity, but intra 2004 Dr. Geoff Wells

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generational equity; in other words, a concern with globally conceived social justice
an important component of subsequent environmental accounting theory with
which, however, I will not attempt to deal here. The Brundtland initiative was
followed in 1992 by a European Earth Summit, which released a document called
Towards Sustainability. This document, called for, among other things, a
redefinition of accounting concepts, rules, conventions and methodology so as to
ensure that the consumption and use of environmental resources are accounted for as
part of the full costs of production and reflected in market pricesa tall order, one
may feel, in the contemporary business environment, however admirable in spirit.
However, this document made the crucial connection between sustainability and
environmental accounting which has governed radical critiques since that time.
Whether this has been a helpful link is open to question. Sustainability is one of
those concepts, like freedom, which commentators think they intuitively
understand, but which, on closer examination, has widely different interpretations. It
has been noted that the decade that followed the Brundtland Report has done little to
clarify the concept of sustainability: it has been estimated that there are more than
5000 definitions now circulating in the literature. One recent commentator noted,
Sustainable development is a term that everyone likes, but nobody is sure of what it
means (at least it sounds better than unsustainable development). In response, it
has been argued that although there is a conspicuous lack of consensus on the exact
definition of sustainability, it carries a core meaning which is substantive and
important, in the same way that principles like democracy are widely defined and
implemented, but used sensibly in discourse.8
While granting the validity of this argument for some purposes, it doesnt work for
accounting. Accounting concepts need to be sufficiently defined to allow, and
measure, uniform practice. The kind of difficulty one can encounter is illustrated by
the NZ-based Landcare Ltd. approach to full cost accounting, which is explicitly
linked to sustainability, through the following definition:
. . .sustainable cost can be defined as the amount an organisation must spend to put
the biosphere at the end of the accounting period back into the state (or its
equivalent) it was in at the beginning of the accounting period. Such a figure
would be a notional one, and disclosed as a charge to a companys profit and loss
account.9
The problem with this definition, to anyone educated in the elements of biology, is
that the biosphere (itself difficult to define) is a dynamic system, which follows a
development trajectory. One would have to reframe the definition to include:

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. . .the amount an organisation must spend to put the biosphere at the end of the
accounting period back into the state it would have been in without the operations
of the company during the accounting period.
This in turn would require sophisticated modelling and measurement at a level which
is only now taking its first, tentative steps (for example, the modelling of the complex
global land, water, and atmosphere systems associated with global warming). It
sounds a promising approach conceptually, but it is, to all intents and purposes,
useless in practice.
One other observation on the theoretical challenges to financial accounting theory
as it attempts to meet the demands of environmental externalities. It seems to me one
could argue as follows: if it is to be required that companys should internalise the
costs of their operations on society at large (as in environmental and social impacts);
and that financial statements reflecting these costs are a truer representation of the
companys value: why should one therefore not require similar treatment of benefits
to the society at large of the external impacts of the companys operations, and similar
financial treatment of these benefits in the companys accounts? For example, would
one want to measure the social benefit of employment, which would be far greater in
a large company than in a small one? Or the multiplier effect in the economy of a
companys transactions with suppliers? And so on. Without having analysed it very
fully, it does seem to me that this is a question that may have to be answered, if
approaches to full cost accounting of external environmental impacts are to be
logically consistent. And the answer may lead to a re-configuration of the very idea
of a business. I will return to this notion in a moment.
Let me turn now to a case study which nicely illustrates the main issues associated
with environmental accounting, as Ive laid them out here. A major Australian woolprocessing company (which shall remain nameless, for commercial-in-confidence
reasons) has been looking at the way it is handling in its accounts environmental
aspects of its operation. Wool processing is a dirty business. Essentially it involves
taking wool in its raw statetermed greasy wooland washing it with various
detergents and chemicals, then treating it in various ways for specific fibre
performance. There are two primary processes: combing and carbonising. Both are
directed to getting large contaminants, such as burrs, out of the wool: the first process
is, as the name implies, by physically combing the wool; the second, used on the
dirtier parts of the wool, such as skirtings, locks, bellies, and so on, employs acid,
which carbonises these solids to make them easier to eliminate. Effluent from
scouring (which is common to both processes) and from carbonising is treated, and
then, when it reaches the regulatory level of TDS, is allowed down the drain. At the
site of this particular processor, some of this effluent is first diverted to a large
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composting project, which is currently under development and testing. It is the

second of these processes, carbonising, that has been the focus of some initial work in
environmental accounting.
In looking closely at the carbonising process, the following environmentallyrelated accounting observations have been made:
Clearly anything one wants to do to advance environmental accounting requires
underpinning in the measurement of materials. However, only approximately 50% of
key materials flows in the carbonising process are currently measured. Moreover,
these measurements are captured in KPI reports, but are not currently costed.
Most of the environmental measurement currently occurring is at the plant level.
There has been no attempt to drive measurement through to the product level
(types). Different product types require different inputs of: water, detergent, sodium
carbonate, hydrogen peroxide. These are determined by looking at the previous ten or
so runs of that type, and the outcomes of these runs. Flow down the drain therefore
varies in composition from product to product. This is measured as Total Dissolved
Solids (TDS) before it is released to the drain. If the TDS measure is too high, the
flow from the plant is recycled back through the plant, with the expectation that
different wool types will dilute it. When the TDS measure is at the level allowed, it is
released to the drain.
The impact of running types that generate high TDS loads is thus increased water
flow and increased energy usage. However, data on the relationship between product
batches and water usage is collected but has not been analysed or costed. In addition,
electricity is only measured for the plant as a whole.
Secondly, if one wants to link waste and environmental impact, the definition of
waste becomes important. From one point of view, waste would be any output from
the plant that has no commercial value, and must therefore be disposed of with
maximum cost and environmental efficiency. Note, however, that under this view,
waste may change as commercial conditions change. Thus woolgrease was of no
commercial value a decade ago and had to be burnt; now it is a product in its own
right, earning significant revenue. The same may shortly apply to compost: if the
compost process reaches the required specifications, it has been calculated that this
plant (one of the largest wool processing plants in the world) would generate
sufficient material to compost the entire Barossa Valley vineyards every year.
At the same time, it is legitimate to question whether, just because a product has
commercial value, it is free of environmental impacts. One would want to be sure, for
example, that the kind of compost produced here did not itself generate environmental
negatives when applied to agricultural or horticultural enterprises.
Here therefore are some key questions that arise from this analysis:

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a) What elements of the manufacturing process contribute most to the cost

handling the TDS load? Have the costs of all elements been captured? What
does this imply for materials measurement, for costing, and for bringing these
costs to book? (This is an example of what we may call Level 1 analysis, in
which the focus of the environmental accounts is exclusively on capturing,
appropriately classifying, and therefore reducing manufacturing costs.)
b) What product types contribute most to the cost of handling the TDS load?
(This is an example of Level 2 analysis, where the environmental accounting
begins to impact marketing and selling decisions. Here a better understanding
of costs by product may lead to a revision of gross margins, and a change in the
marketing and selling strategies by product and market.)
c) If one looks at by-product sales, what is the best way of understanding the
costs of producing them (at present, for example, woolgrease is assumed to
have no cost of production)? Will this change as the commercial value of
outputs changes over time? (This too is an example of Level 2 analysis. But it
is intriguing, and raises some challenging questions. Could one, for instance,
conceive of a commercial environment where the main product resulting from
wool processing was not wool, but wool greasewith the clean wool fibre
becoming a waste product of no commercial value that must be disposed of?
What would be the trajectory of the accounts, including the environmental
accounts, in tracking this kind of fundamental change in the identification of
manufactured products?)
d) How can one best account for the potential impact of external costsfor
example, in the drain discharge, or in possible risks associated with the byproducts, wool grease and compost? (This is an example of Level 3 analysis,
where the question of externalities looms uncomfortably largeis becoming,
in fact, a stay-in-business issueyet is not in any way being captured in the
current accounting or projections.)
Finally, as noted above, the introduction of the Ecolabel may require a reexamination and reconfiguration of the manufacturing process. The Ecolabel criteria
set levels of certain components of the effluent from scouring, and these criteria
incorporate other standards relating to chemical residues in the greasy wool. In
addition, the Ecolabel criteria prohibit the use of some manufacturing processes, such
as the use of chlorine in shrinkproofing, while still setting standards for the
shrinkproof qualities of the processed fibre. Irrespective of the actual environmental
impacts of its manufacturing processes, the company will now have to meet these
environmental standards in order to maintain access to its European market.
All this is simply to demonstrate that the kinds of issues that are arising in
environmental accounting, and about which the academic accounting establishment is
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busying itselfvery real challenges to contemporary business practice. As noted

above, these are issues that have penetrated all the main segments of the business
here, specifically, operations, marketing, and financeand have become part of the
strategic landscape within which the company operates. Ultimately they may even
play the major part in determining whether the company stays in this business, or not.
Let us turn, finally, to two research directions which seem to me to arise from this
analysis. The first concerns what has been termed value based management. This
is the view that all companies, especially publicly owned companies, should be
managed to create as much wealth as possible.10 This equates to managing for
maximum shareholder value, which in turn is held to generate the maximum
economic benefit for the society of which the company is a part:
Managers create shareholder value by identifying and undertaking investments that
earn returns greater than the firms cost of raising money. When they do this, there
is an added benefit to society. Competition among firms for funds to finance their
investments attracts capital to the best projects, and the entire economy benefits.11
There is, as we will see, reason to challenge the view that shareholder value and
value to society are inherently linked. However, let us for the moment work within
the framework which accepts that economic results are the primary outcome by which
a company is to be evaluated; a view expressed with characteristic pungency by
Drucker, nearly four decades ago:
Economic performance. . .is the specific function and contribution of business
enterprise, and the reason for its existence. It is work to obtain economic
performance and results.12
The implementation of this dictum in modern best practice is widely agreed to be
value based management (VBM). This approach holds that the real economic value
of a firms business, whether it is completely reflected in the firms stock price or not,
is equal to the discounted value of expected future cash flows accruing to the
shareholders. Conventional GAAP principles, it is argued, are not designed to reflect
value creation, and cannot therefore be used effectively in managing for increased
value: accounting earnings do not equal cash flow nor do they reflect risk; they dont
reflect the opportunity cost of equity nor consider the time value of money. In
consequence, a business can appear to be (may well be, in my experience) profitable
in the conventional accounts, yet at the same time be destroying economic value.
Various discounted cash flow (DCF) methods have been developed for analysing the
expected future cash flows of a business: these include free cash flow (promoted by
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McKinsey), economic value added (developed by Stern Stewart), and cash flow return
on investment (developed by the Boston Consulting Group). These methods are far
from uncontroversial: there is continuing debate on the correlation of DCF valuations
with stock price, and on the significant management challenges associated with
driving VBM through an organisation. Nevertheless, they represent the ground on
which modern management is conducted. Moreover, discounted cash flows and the
use of net present value calculations are becoming commonplace in the external
reports of companies. Accounting standards in Australia enable the disclosure of
discounted cash flow information.
A first research question might therefore be: can discounted cash flow methods
capture the various dimensions of environmental business issues outlined above? In
June (2001) the European Commission produced guidelines on the recognition,
measurement, and public disclosure of environmental issues in the annual accounts
and reports of companies in the European Union. These guidelines focus on monetary
information and accept discounted cash flow and net present value as appropriate
measurement methodologies for environmental issues. There are at least two
important challenges to such an approach. The first is that the numbers to which the
DCF methods are applied are not historical: they are projected numbers, and they
arise from a comprehensive and detailed view of what the business will look like over
the next five or ten years. The valuation is only as good as the projections; and, as
any executive worth his or her salt will tell you, projections are hard to do well.
There is a systematic method for developing a view of the shape of the future
business: this is termed scenario analysis13. With respect to environmental issues, it
will include predictions of the likely trajectories of regulation and legislation,
environmental technology, the evolution of physical systems, consumer sentiment and
the form of demand, and so on. I repeat, this is very challenging, and most companies
wont take it on. But without it being done, and done well, DCF valuation techniques
dont have much validity. That will apply as much to environmental matters as it does
to any part of the business.
A further challenge arises from the discounting component of DCF methods. The
EC guidelines allow the present value measurement of environmental liabilities, even
if these liabilities will not be settled in the near future. However, it has been pointed
out that discounting the value of future liabilities in effect discriminates against future
generations. The structure of the numbers directs management attention, and
therefore resources, to environmental impacts that will occur in the immediate or
short-term future. It thus appears to contradict the basic notion of sustainability,
which, as we have seen, in its most widely accepted form looks for . . .development
that meets the needs of the present world without compromising the ability of future
generations to meet their own needs. The question that presents itself is therefore
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whether there is something in the particular character of environmental issues

associated with business which precludes the use of DCF methods in managing these
issues, or whether DCF tools can be developed to meet this challenge successfully.
Both challenges are important and require systematic resolution. Given the
promising record of DCF approaches in management, it is reasonable at least to begin
with the assumption that they can be met. Moreover, it should be noted that major
companies, particularly in the resources sector, are urgently seeking such methods in
order to manage their businesses, and their stakeholder relations, more effectively.
Working with members of this department, this is a research and consulting direction I
intend to pursue.
Behind this sitsor perhaps, lurksa second research question that has the
potential to overturn the fundamental assumptions about business within which one is
here functioning: I refer to the entity assumption. The nature of the business, or
accounting, entity, and its relationship to the society in which it functions is, as we
have observed, critical to the way in which the environmental impacts of business are
handled. The main accounting theory which attempts to deal with this relationship is
Legitimacy Theory. Under this theory, there is held to be a social contract between a
company and the society in which it operates. The social contract expresses the
expectations of the society, the criteria which a business has to meet in order to be
seen as legitimate:
Society. . .provides corporations with their legal standing and attributes and the
authority to own and use natural resources and to hire employees. Organisations
draw on community resources and output both goods and services, and waste
products, to the general environment. The organisation has no inherent rights to
these benefits, and in order to allow their existence, society would expect the
benefits to exceed the costs to society.14
This position is encapsulated in the phrase license to operate, which is now
found used with increasing frequencyand, one might observe, with widely differing
results in business practicein company reports.
The implications of this position, it seems to me, are very great, and its treatment
in the literature is less than convincing. It is, of course, a central entry point for
critical accounting theorists. I have some sympathy for these forays. I am not myself
a Marxist, having some thirty years ago concluded that Marxist theory has
fundamental, and irretrievable, flaws; but such critiques, it must be said, do tend to
raise disquieting questions that seem to demand resolution. Simply put,
environmental issues in accounting and finance practice and theory logically force an
analysis of the nature of business itself, and of the society in which it operates. I have
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been exploring the idea that an important component of what is needed to further the
analysis may be a theory of business. This is to be distinguished from the economic
theory of the firm, or the financial accounting theory of the business entity. Such a
theory would start from the axioms associated with a commercial transaction, and
attempt to construct logically the structure of contemporary business. It may be that
with such a conceptual structure in place these deeper questionswhich we recognise
but tend to push to one side, as too difficult, or perhaps too threateningcan be
moved towards some kind of resolution. However, the consequences of such a logical
resolution, for the current disciplines of accounting and of management, may well be,
I would warn, intellectually provocativethat, at least, is the hope.

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Parker (1977)
Deegan (2000), pp. 335-337.
3
Pheasant (2002), pp. 25-31.
4
Tinius and Wang (2001)
5
Deegan (2000), pp. 306-310; Parker (1977), p.48.
6
Gray and Bebbington (1992), p.6.
7
Deegan (2000), pp.338-343.
8
Rigby, Howlett and Woodhouse (2000), p.5.
9
Gray and Bebbington (1992), p.15, quoted in Deegan (2000), p.344.
10
McTaggart, Kontes, and Mankins (1994), p.7.
11
Martin and Petty (2000), p.3.
12
Drucker (1964), p.xi.
13
Schwartz (1996).
14
Mathews (1993), p.26.
2