Question

According to the AASB the present definition of liabilities is:

“a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”.

Some commentators have suggested that a company’s profits may be overstated due to this definition because the full cost of operations are not taken into account. Further it may be argued that potential future impacts on the environment on both production of produces and the eventual disposal of manufactured items are ignored.

Considering the current approach to accounting for liabilities explain the following.

1. What are the shortfalls of the current definition for liabilities when applied to potentially negative environmental situations? (Explain in 10 Sentence)
2. How might this lead to profits being overstated? (Explain in 5 Sentence)
3. Does it matter that accounting often fails to capture this information? Explain why. (Explain in 10 Sentence)
4. What would be the broader ramifications for accounting and businesses if we were able to more accurately capture these liabilities? (Explain in 10 Sentence)

Answer 1

a. Liability is a Present obligation arising from past events that is expected to result in cashoutflows embodying economic benefits. This definition of liability completely ignore any environment costs which is cost of damage caused by the entity due to its operations in the current year. The environmental damage may be created by dumping of wastes into water resources, air pollution from industries, etc. There is no present liability on the part of company to pay for the damage caused and hence no liability is recognised in books. But if any legal complaint has filed and sued on the company, only then the contingent liabilitiely or actual liability is recognised based on the expected outcome of the case. That compensation then paid will belong to all these years when no such environmental costs are recorded.

b. As there are no costs recorded in the profit and loss account as environmental costs. This will lead to overstatement of profit in such years. But for the years in which any compensation is paid for causing such environmental damage, in those years the profit will be reduced as the compensation was then recorded in the books as expense. So the definition of liability is leading to overstatement of profits.

c. Accounting in the books is done based on the set principles of accounting, accounting standards, Generally Accepted Accounting Principles (GAAP), policies of the company, any guidance notes etc. These principles provide the basis of accounting. As there is shortfall in the definition of Liability in these documents, it will ultimately lead to failure in accounting as accounting is based on these concepts.

The basic purpose of accounting is to give a clear picture of the company's financial performance and position during the period. Without recording the environmental costs caused by damaging the environment, these financial statements would fail to show the correct picture of the year for the investors and other stake holders. This may be termed as misleading the stakeholders by improper accounting.

d. If we were able to capture these liabilities more accurately, this would have broader ramifications in the field of accounting. The accounting of the environment costs would be the financial statements complex and difficult to understand as it requires better knowledge to prepare and understand the financial statements. The profits from the business will undergo change due to accounting of environmental costs. Also, there will be effects on the business of the entity. They will start being more environmentally responsible and their policies change to become more environmental friendly. These companies as are viewed positively by the general public and stake holders.

For Example : Puma started the environmental accounting in the year 2010 as a new form of accounting. For that year their normal profit is €202 million but they also have calculated on reasonable basis that they have caused an environmental damage of €145 million (which is almost 2/3 rd of the conventional accounting profit). This would impact the profits of the company and stakeholders opinion on the company.