EXTERNALITIES

ACCOUNTING
 Learning objectives

Define positive and negative externalities and

explain their importance in modern management
accounting
Define environmental costs and describe five tiers
of environmental costs used by EPA in the USA.
Analyse environmental costs as prevention,
appraisal, and internal and external failure
Integrate environmental costs in information for
decision making
Assess the effects of environmental and social
factors when managing suppliers and customers
 Positive and negative externalities
3

Positive externalities are unpaid for

benefits to society as a result of
production and exchange.
Negative externalities are
uncompensated costs borne by
members of society as a result of
production and exchange.
Environmental costs
Environmental costs are the costs that
an organization incurs to prevent,
monitor and report environmental
impacts. They can also include the costs
an organization incurs when it does not
comply with environmental regulations,
some of which may extend well into the
future.
Environmental components and
management accounting choices
Physical Components/ management accounting
environment choices
Air & atmosphere Air quality / emissions accounting
Water resources and Water quality and quantity/ water withdrawal
water bodies accounting, waste water discharge accounting,
water footprint of suppliers
Soil and geology Erosion, contamination/land
contamination/recovery accounting
Climate Temperature, rainfall, and wind etc./ annual
yield accounting
Energy Light, noise, vibration etc./health effects
The management accounting choices involves assigning direct and indirect
accounting
environmental costs to products, using physical and financial data.

The management accountants may also include costs of waste

management, permits, fees, and recycling under the financially oriented
management accounting.

Note: there are no universally agreed accounting principles to do physical

oriented environmental accounting and therefore it is sometimes difficult to
measure these in financial terms.
 Identifying and classifying environmental
costs
6

Tier 1 conventional costs

Tier 2 hidden costs
Tier 3 contingent costs
Tier 4 relationship and image costs
Tier 5 societal costs
 Tier 1 conventional costs
7

Direct costs associated with capital expenditures

Raw materials, and other operating and maintenance costs.

These can be obtained from the accounting systems of most

organisations.

May not be reported in a form that can be readily used by managers

to assess environmental expenditures.
 Tier 2 Hidden costs
8

Monitoring and reporting costs.

Cost of searching for environmentally responsible suppliers.

Ongoing cost of cleaning contaminated land

These costs are often hidden in various overheads accounts

and in the cost of wages and salaries.
 Tier 3 - Contingent costs
9

Contingent liabilities
Failure to clean up contaminated sites,
Fines and penalties for non-compliance with regulations.
These costs might be indicated in internal company
reports, only if there is a high probability that the
company will be obliged to pay these costs in the future
and if they are material in value.
 Tier 4 Relationship and image costs
10

Intangible costs and benefits that relate to

Negative consumer perceptions.

Poor employee and community relations.

These costs are rarely measured in standard information

systems and are difficult to measure objectively.
11
Tier 5 Societal costs

Costs for which organizations may not be held legally

responsible and which cannot be compensated for in the
legal systems.

These are very difficult to recognize and measure

because of the cost of estimating the impacts, and lack of
the specialized environmental knowledge that might be
needed to do so.
 Analyzing environmental
12
costs

Prevention activities
Appraisal activities
Internal failure activities
External failure activities
 Prevention activities
13

Prevention activities are designed to solve environmental

problems before they occur, or even turn problems into
opportunities.

The costs of prevention activities includes:

Cost of employee training,
Cost of installing environmentally responsible equipment, processes and
activities.
 Appraisal activities
14

Appraisal activities monitor the level of environmental

impacts and include measuring damage, inspecting
processes and products, and auditing supplier
performance.

Appraisal costs include depreciation of testing equipment, costs of

supplies used in testing and monitoring, and costs of obtaining
external certification and tests.
 Internal failure activities
15

Internal failure activities correct environmental

breakdowns that have been discovered in appraisal
activities.

These costs may include the costs of cleaning up the plant following a
chemical explosion or leakage, and costs of occupational health and
safety claims.
 External failure activities
16

External failure occurs when the resolution or remediation

efforts fall outside of the companys management.

These costs may include the cost of cleaning up polluted sites, fines
for environmental damage, and losses associated with a loss of
reputation (and future sales) due to public awareness of the
organizations failure to engage in environmentally responsible
actions.
Environmental costs information in
decision making

In the short-run increasing the costs of

prevention and appraisal may reduce the
risk of failure costs.
In the long-run cost advantage over
competitors , as well as possible
marketing and reputation advantages.
Environmental costing benefits to
Suppliers and customers

Suppliers
Externalities accounting provide useful information
for gauging a supplier environmental footprint
An organization may be willing to pay more for
supplies that are know to have reduced adverse
impacts on society and the environment.
Long-term contracts stipulating the quality of
supplies, production methods, employment
practices, storage, and delivery practices can
provide vital information to evaluate supplier
performance.
Environmental costing benefits to
Suppliers and customers

Environmental costing aims to raise customer awareness about

negative externalities.
The additional costs may detract or promote brand switching but it
may also provide opportunity to identify and target niche profitable
market segments.
Customer relationship management approaches such as strategic
customer-based value metrics can further help the companies to fine
tune or radically change their [product/services]
Manufacturers and service organizations can work with customers to
reduce adverse social and environmental impacts.
New legislations and pressures from non-governmental organizations to
educate customers on their responsibility to understand recycling.
Many organizations are encouraging their customers to recycle using
methods that include take back and disposal programme.