Financial Accounting And Reporting - Sustainability Accounting - Assessment Answer

Liability is an amount or value that is owed by the business to the outsiders. It is something that is measured and defined in figures. It is an amount which is currently owned by the entity to the creditor but has not been paid in the current financial year. Therefore, this amount is carried over to the next financial year. However, its impact on the current financial statements is accounted for even if it is carried over to the next financial year. The rationale behind the same is to account for correct and reasonable profits and ensure that the profit has not been overstated in any manner.

Solution to Part A

The liabilities are of two types: current liability and non-current liabilities. Current liabilities refer to the liabilities that are within 1 year from the date from which they have been incurred. They are separately classified in the Balance Sheet in order to separation the current portion of liabilities from the non-current portion.

If we observe it can be assessed that the liabilities consist of only those items that are incurred in the day to day working of the business. The environmental impact that is caused by the operations of the business activities is not considered while computing the liabilities of an entity. The main reason for exclusion of the same is that the liabilities owed by the entity on account of environmental impact are generally not measured by the entity.

In the past years the concept of environmental impact caused by the entity was not common. Only few companies understood the concept of sustainable growth and the incorporation of the environmental obligations in the books of accounts. However, as the time has passed by the environmental impact that is prevalent due to the working of these entities has increased over time which has highlighted the need for environmental accounting. Since this accounting was not practiced in the past years the accounting system did not take into account the liabilities that would arise due to environmental obligations. Therefore, this has become as a main challenge because the traditional accounting did not have provisions to consider this factor and therefore, the entities are not acquainted to deal with these issues in their financial statements currently.

Therefore, the current definition of liabilities is not acquainted to incorporate the environmental obligations and liabilities that are inherent by the companies due to their nature of operations and therefore, this item is generally excluded from liabilities at the time of presentation of the financial statements.

Solution to Part B

Since these liabilities are not taken into account, they are not reflected in the financial statements of the company. According to the principle of prudence, the entities should provide for all possible losses but should not provide for possible profits. The principle of prudence states for providing for all possible losses therefore, the companies incorporated all the possible losses in the course of working. However, the factors that were considered for possible losses were only the factors that were involved in the normal course of operations. As a result, the potential environment impact is not considered at the time of preparation of the financial statements. Therefore, the potential expense of environmental impact gets neglected and it results in the over-stating of the profit.

Normally, these costs are generally not considered by the entities because their presence is currently very dormant. Suppose an industry had been operating from the past 25 years which deals in harmful chemical substances which adversely impact the environment. The company prepares its financial statements but does not account for any expense relating to the environment damage it is causing. It is suddenly penalized by $10 million dollars for causing harm to the environment by the regulatory authorities. This incident would lead to drastic fall in its net profit of the current year because of the huge amount of sum that is involved in the payment of the penalty. This cost cannot be deferred over to subsequent years because the penalty is due to harm caused to the environment due to its activities in the past. The amount would prove to majorly impact its profits and might even turn its profits into losses. Therefore, here we can assess the failure of the organization to recognize its liability of the potential environment harm it had been causing with its activities. The penalty that has been levied on the organization is as a result of its operations over the past 25 years therefore, ideally this sum should have been distributed over the past 25 years. But since the company did not account for the same in the past it has entirely been absorbed in the 25th year which has impacted the profit of the company. It is not possible to accurately predict the cost of environmental damage that is being incurred by the entity. However, still an assumption of the same is possible therefore, it is important to assume and recognize the expense as provision in the financial statements of the entity in order to ensure that the burden of such fines is not absorbed in a single financial year. These instances can also result in the shortage of working capital funds for the company. This is a potential expense for the companies therefore, it is important to create a provision for the same in order to assure stability in the profits of the company and prevent the profits from being over-stated in the financial statements.

Solution to Part C

Accounting often fails to capture the cost of potential environment impact caused by the entities. The main reason behind the same is that the traditional concepts of accounting did not incorporate such information in the formation of accounting principles as this factor was not important at that time. Therefore, the inclusion of the same in the books of accounts has always remained dicey because due to absence from inclusions in the accounting principles it has always remained at the discretion of the entities to incorporate the same in their books.

The environmental regulatory bodies have increased the awareness with the passage of time and have taken the required actions in the form of penalties on environment damage and subsidies in case of usage of environment friendly products which has highlighted the importance of using the equipments or methods that are in confirmation to the rules and regulations prescribed by the regulatory bodies. Generally these are employed by the entities to ensure that they are in conformity with the rules set up by these bodies. All these factors have clearly highlighted the importance of incorporation of the potential environment impact in the financial statements of the entities in order to ensure correct statement of the operating expense and correct assessment of the profits for the financial years.

Solution to Part D

The liabilities currently refer to all the obligations that are recognized by the entities in their financial statements and at the time of computation of the profits. These obligations generally comprise of all the operating expenses that the entities incur in the course of operations. In addition to it, it also includes some non-cash expenses like depreciation and provisions that are generally present in the regular course of working.

The definition of the liabilities can be modified by incorporating the term like present and potential liabilities. Potential liabilities would be the liabilities that have not yet been incurred by the entities in any of the financial years but may be incurred by it due to its nature of working or the environment in which it operates. Therefore, the entities can then provide for the potential environmental damage expense that they incur each year in the financial statements of the company. If we observe then it can be stated that it would be initially difficult for the companies to provide for the cost of potential environmental damage in their books as they are unaware of the amount of provision that is required to be made. This would be major factor which would prevent them from incorporating the same in their books of accounts. Therefore, in order to ascertain the amount of provision that is required to be incorporated in the books certain factors would have to be considered by the companies like the nature of industry in which the company is operating and the potential damage that is caused to the environment by its operations. This would help in providing for the provisions because the companies would only be required to compensate for the amount of damage they have caused to the environment. The companies can also study the assumptions and the estimates that have been made by their books in order to ascertain this cost or they can also study if any of the peer industry has been penalized by the regulatory bodies, the type of offence and the amount of fine they have paid. Therefore, these factors would help in ascertaining a justified amount of environmental damage cost and incorporating the same in the financial statements.

Solution to Part E

If these liabilities are more accurately captured, it would help in better presentation of the financial statements, the profits of the company would not be overstated and the operating activities expense would also be taken into account fully. If the ascertainment of proper amount is there the entities would incorporate the same in their financial statements as the profits of the company would not be overstated and it would also reduce the tax liabilities of the entities because this expense would be admissible as a business expense. In addition to it, they will also have a separate reserve created for the cost of potential environment damage so, if they are penalized in any of the financial years they would be able to meet the obligations more effectively.

In spite of its advantages, it might not be very welcoming for the companies that are in the initial stages of operations as it would further reduce their profit. The companies aim at maximizing the profitability in the initial years in order to gain investor confidence but this would decrease their income, the funds for declaration of dividend would also reduce.

Conclusion

Keeping in mind, the pros and cons it important to incorporate the cost of potential environmental damage in the financial statements. It would give a clearer and more justified profit for the organization and in addition to it, it would also create a reserve for the payment of any future environment related costs that have to be incurred by the entity.