| Front page | | Contents | | Previous | | Next |

Perspectives in the Development and Application of Environmental Management Accounting

5 The relationship between EMA and the annual report

• 5.1 Introduction to the annual report
• 5.2 The purpose of the annual report
• 5.3 The parts of the annual report
• 5.4 Requirements for environmental information in the annual report
  • 5.4.1 Reporting in accordance with section 99(2)
  • 5.4.2 Reporting in accordance with section 99(1), no. 4
  • 5.4.3 Other aspects regarding users of accounts
• 5.5 Relationship between EMA and the annual report
• 5.6 EMA and the annual report's control function
• 5.7 EMA and the annual report's forecast function
  • 5.7.1 Investments and EMA
  • 5.7.2 EMA and risks of impacting the financial position
  • 5.7.3 Summary

This part of the report analyses how EMA can be used in meeting the requirements of the Danish Financial Statements Act on illustrating the interplay between environmental conditions and the results of the enterprise, its development and financial position.

The chapter starts with a brief introduction to the legislation on an annual report. After this it describes the actual purpose of an annual report. The parts of the annual report are listed and after this there is a description of how the specific requirements for environmental information could be incorporated in the annual report. Next there is an analysis of the relationship between EMA and the annual report.

5.1 Introduction to the annual report

The annual report includes the financial statements published each year by the enterprises and organisations subject to the Financial Statements Act. This Act identifies who is subject to the duty to file accounts and the regulations to be met in the preparation and publication of the annual report.

The Danish Financial Statements Act is Denmark's implementation of the accounting directives issued by the EU, including the 4th and 7th Accounting Directives.

The Danish Financial Statements Act was extensively revised with the Danish Act on Commercial Enterprises' Presentation of Financial Statements, etc. (the Financial Statements Act) of 7 June 2001. Subsequently there have been minor adjustments which have entered into force for accounting years commencing 1 January 2005 or later (Act no. 99 of 18 February 2004).

The 2001 Act brings environmental conditions explicitly into legislation, and the adjustments from 2005 incorporate the environment to an even greater extent.

5.2 The purpose of the annual report

The purpose of the annual report is to support users of accounts in their financial decisions.

There is no all-embracing definition of users of accounts, but the Act defines them as: `private individuals, enterprises, organisations and public authorities, etc., whose financial decisions must normally be expected to be affected by an annual report, including present and possible members of the undertaking, creditors, employees, customers, alliance partners, the local community, authorities providing government grants, and fiscal authorities'.

The decisions of the users of accounts can be based on three general conditions:

• Investment of the user's own resources
  
  The annual report has a forecast function for users seeking support for decisions regarding investment of their own resources. This may be directly as investors or lenders, or indirectly as suppliers, employees etc.
  
  
• The management's administration of the resources of the enterprise
  
  Here, the annual report has a control function. Users can monitor the financial development of the enterprise through the accounts and thus observe and decide whether management is administering the assets of the enterprise appropriately etc.
  
  
• Distribution of the resources of the enterprise
  
  The third function of the annual report is the distribution function. This is how the enterprises profits are to be appropriated.

The forecast function aims at the future and is based on the fact that users of accounts allocate their resources on the basis of expectations of the enterprise's future revenues, liquidity, survivability, employment etc.

In this connection users are looking for information in the annual report which can improve their ability to judge the future prospects of the enterprise in these areas.

The forecast function for the environment is related to the enterprise's general measures to prevent environmental damage.

The control function is retrospective. Users of accounts look for information in the annual report to assess how responsibly management have administered the resources tied up in the enterprise and flowing into the enterprise.

The Act mentions decisions regarding management's administration of the resources of the enterprise. This may be profitable administration of funds by management, administration of resources in an environmentally appropriate manner, size of management remuneration etc.

The distribution function includes decisions made within the enterprise by management, including appropriation of profits as commissions, bonuses etc.

The Act uses the expression distribution of the enterprises' resources to express the relative distribution between the owners of the enterprise and the enterprise.

Environmental issues are not relevant with regard to the distribution function.

5.3 The parts of the annual report

The parts of the annual report are:

• Management endorsement
• Audit report
• Management review, including review of key figures
• Annual financial statements (and consolidated accounts for groups)
  • Accounting policies
  • Income statement
  • Balance sheet
  • Statement of changes in equity
  • Cash-flow analysis ^[2]
  • Notes
• Supplementary reports (voluntary).

The management endorsement contains a statement by the management of their responsibilities for the annual report.

The audit report is the auditor's report on the annual report.

The management review is a narrative description of a number of aspects of the enterprise. Through this, users of the annual report can get an impression of the enterprise, its business, and the conditions to which it is subject. Environmental information is now an explicit new requirement in the management review.

The annual report also contains a separate section called accounting policies. This section describes the methods of recognition and measurement applied by the enterprise for its revenues, costs, assets and liabilities; for example when costs are recognised in the income statement, how the value of liabilities is measured etc. The descriptions in the accounting policies are a set of user guidelines for the annual report.

The income statement starts at the top with the net turnover of the enterprise, followed by operating costs. This gives the operating profit, i.e. the net turnover less operating costs. Next come interest and financial items as well as the results of subsidiaries etc. The next sub-total, after deducting or adding these items is the profit on ordinary activities before taxation. Tax on the profit for the year is deducted and the resulting bottom line is the profit for the year.

The balance sheet is divided into assets and liabilities. Assets are divided so that the least liquid assets, such as patents and goodwill, are shown first. The most liquid assets, such as cash at bank, are shown last. Liabilities are divided into external liabilities and the enterprise's equity capital. External liabilities include ordinary debt such as trade creditors etc. as well as provisions. Provisions are made when the enterprise probably, but not definitely, will have to pay money. Remediating damage to the environment is often included in the annual report as a provision because of the uncertainty as to when the remediation will be necessary, or the uncertainty as to the amount that will have to be paid. Equity capital is an expression of the net wealth of the enterprise and corresponds to the enterprise's assets less its external liabilities.

The statement of changes in equity explains the changes in the equity capital. However, there are some items which do not go through the income statement and which are posted directly to equity capital. This is the reason for a statement of changes in equity, which describes the changes in the net wealth of the enterprise from the start to the end of the year.

The cash-flow statement shows the amounts of the enterprise's cash inflows and outflows during the year. The cash-flow statement is divided into cash flows from the operating activities of the enterprise, investment activities, and financing activities. The income statement shows when income is 'earned' and the associated costs incurred, without distinguishing whether or not they have been paid. The object of the cash-flow statement is to show when cash flows occur physically.

The notes are a supplementary tool for the users of accounts with further break-downs of the individual items in the income statement and in the balance sheet.

In addition to the statutory part of the annual report, the enterprise can voluntarily add a supplementary report. A supplementary report is a report from the enterprise on non-financial aspects which are significant for the operation and profits of the enterprise. These may include environmental matters, knowledge and social aspects, or ethical issues etc. The enterprise itself chooses the target group for this supplementary report.

This report on EMA does not deal with the supplementary report in the annual report, but only the statutory requirements of the Financial Statements Act.

5.4 Requirements for environmental information in the annual report

Section 99 of the Financial Statements Act includes requirements for information on environmental aspects in the management review:

Section 99(1), no. 4 states:

• `describe the enterprise's impact on the external environment and measures to prevent, reduce or remedy any damage to the environment.'

Section 99(2) states:

• `to the extent necessary to understand the development of the enterprise, its result and financial position, large enterprises shall also supplement the report pursuant to section 77, no. 4, with information on non-financial aspects which are relevant for the specific activities, including information regarding environment and personnel issues'.

Section 99 is linked to section 77, which deals with more general requirements for information in a management review.

The Financial Statements Act divides enterprises into different reporting classes, each subject to different accounting requirements. The enterprises for which the environmental requirements are relevant are listed in the table below.

Table 3: Enterprises subject to the duty to include the environment in the management review in their annual report.

* The criteria used in the Financial Statements Act relate to the number of employees, the balance sheet and net turnover. An enterprise is covered if the size limits in the table are exceeded in two consecutive accounting years at the balance sheet date and for two of the size limits. The figures in the table apply for accounting years commencing 1 April 2004 or later.

From the accounting year 2005, the management review for large enterprises and listed/governmental limited companies also supplements the traditional and well-known report on the developments in the activities and financial situation of the enterprise with information on all non-financial aspects relevant to the specific activities of the enterprise.

From 1 January 2005, the Financial Statements Act therefore contains two different reporting requirements on environmental aspects. Table 4 shows how the two requirements differ from each other:

Table 4: Comparison between section 99(1), no. 4 and subsection (2) requirements

Section 77 of the Financial Statements Act has the fundamental requirements for the content of the management review. The requirements are listed under five numbers; 1. describe the principal activities of the enterprise, 2. describe any uncertainty connected with recognition or measurement, stating amounts where possible, 3. describe any unusual matters affecting the recognition or measurement, stating amounts where possible, 4. account for the development in the activities and financial affairs of the enterprise and 5. mention any significant events occurring after the end of the financial year.

5.4.1 Reporting in accordance with section 99(2)

In order to meet the reporting requirement in section 99(2), the enterprise must describe the environmental aspects which are relevant for understanding the earned or expected results from each of the enterprise's activities.

The description must contain information on the connection between the enterprise's results and current and expected actions.

The description may be narrative or in figures. The enterprise itself can decide which is the most meaningful. If quantitative data is most beneficial for the user's understanding of the accounts, then this is recommended.

That environmental information must be relevant for understanding means that the information must be necessary for the user to understand the development, results and financial position of the enterprise. If environmental information has no significance for these aspects, it should not be included in the annual report.

The aspects to be described will depend on the enterprise, as the information is linked to the enterprise's specific activities so that it supplements the current causality explanations regarding the activities of the enterprise.

The Financial Statements Act does not contain a clear definition of activities. It is up to the individual enterprise to decide how its activities should be reported. The objective of the Financial Statements Act in including activities is to give the user insight into what the enterprise is doing and thus a basis on which to assess the operational risks.

For some enterprises, the most natural division will be at product level; what types of products are produced and sold? For other enterprises, division by functions such as research, sales and production will be more relevant. Some will consider geographic division as the best. The division of activities should be seen in the context of the overall account of the enterprise in the management review. The table below gives some examples of how environmental aspects can be relevant in describing different divisions of activities.

Table 5: Environmental information in relation to activities

The relationship between the financial development of the enterprise and the environment must be described according to section 99(2) to the extent that it helps the user's understanding of the accounts. Therefore, it is not an objective in itself to describe generally known relationships. The basis for disclosure could be formed by addressing the following questions:

• What external conditions have influenced the current or expected environmental impacts of the enterprise? (New regional limit values for emissions, new national take-back requirements after products have been used, energy-savings regulations etc.)
  • Can the enterprise influence these external conditions? (Through negotiation, through closing or moving certain activities, through changing products or production processes etc.)
  • What are the results of this influence and can they affect the enterprise's assumptions behind its expected development? (Changes in costs structure for logistics, production or need for innovative development etc.)
  • Are there uncertainties which should be included in the management review, so that the reader of the accounts can understand the underlying assumptions and their variability for the expected developments? (Technical or temporal realisation of product development, useful lives of fixed assets and their useful values, access to new CO2 allowances, users and user-behaviour following new laws, new knowledge etc.)
• What internal conditions influence the current or expected environmental impacts of the enterprise? (Technology applied, age of plant, use of materials and substances, processes and management systems etc.)
  • Can the enterprise influence these internal conditions? (Changes in plant, processes or staff know-how etc.)
    
  • What are the results and is the enterprise willing and able to influence these internal conditions? (Replacements, reduction in activity, adjustments in previous financial expectations, changes in product range, mergers horizontally and vertically in the supply chain etc.)
    
• What changes are necessary, including investment or change projects, and what is the time horizon?
  
• What assumptions and uncertainties must be included in the description of the changes in the management review?
  
• In order to aid understanding is it advisable to indicate the financial size of the specific changes mentioned?
  
• If so, could it be appropriate to incorporate EMA as a method of indicating the cost-benefit amounts involved in the change?

5.4.2 Reporting in accordance with section 99(1), no. 4

In order to meet the reporting requirement in section 99(1), no. 4, the enterprise must describe the enterprise's impact on the external environment and measures to prevent, reduce or remedy any damage to the environment.

In this context, external environment means natural, physical surroundings such as air, water, flora, fauna and non-renewable resources such as fossil fuels and minerals. This requirement is narrower than the subsection (2) requirement as it does not deal with health and safety, for example.

The description does not have to be divided into activities, as in the subsection (2) requirement.

However, the description must cover two parts. In the first part the enterprise must describe its environmental impacts, and in the second part the enterprise must describe what it is doing to reduce, prevent or remedy these impacts. The environmental aspects relevant to include in the description are solely those aspects which are significant for the operation and financial development of the enterprise.

There is no positive duty to disclose. This means that the enterprise has no duty to state that it does not consider it has any environmental impacts of significance for its operation and financial development.

The subsection (1) requirement is more narrative in nature that the subsection (2) requirement. There is no direct requirement in subsection (1) to describe the relationship between the environment and the enterprise's financial performance as there is in subsection (2). However, in some cases it may be necessary in order to aid a true and fair view of the enterprise's assets, liabilities and equity, financial position and results for the year.

There is no requirement for quantitative data, only a narrative description.

The information required should enhance the transparency of how environmental aspects are managed by the enterprise and how the enterprise's management administers its environmental responsibilities.

Traditionally there is a certain transitional period when new qualitative conditions are included in legislation on the presentation of annual financial statements. The Financial Statements Act is a framework law and therefore the enterprise has a large degree of independence in deciding whether conditions are significant enough to be included in the management review. This also applies to the subsection (1) requirement where best practice (2005) is being prepared.

Table 6 below suggests how the process of collating environmental information for the management review could be organised.

Table 6: Aid for the process of the subsection (1), no. 4 requirement

5.4.3 Other aspects regarding users of accounts

Many users of accounts have no prior knowledge of the link between the environmental impacts mentioned by the enterprise and the actual or potential influence of these impacts on the commercial development of the enterprise.

For example, if an enterprise describes its environmental impacts such as emissions into the air, the user of the accounts will have no immediate understanding of the consequences of these for the development of the enterprise. These should be explained.

Users of accounts can be divided into three categories; those interested in the environment, those interested in the enterprise, and those interested in both the enterprise and the environment. In preparing the annual report it is advisable for the enterprise to consider which type of user is most important for the enterprise. Below is a brief description of the characteristics of these users in relation to environment information.

• Those interested in the environment focus on the enterprise taking most possible account of environmental aspects and this group has little or no interest in the financial development of the enterprise. As users of accounts, when examining the annual report, this group is looking for information about how the enterprise manages the control function. This group is often disappointed because the annual report is not prepared primarily with this type of user in mind.
  
  
• Those interested in the enterprise do not focus on the environment, but solely on the financial development of the enterprise. This group is looking in particular for accounting information about the future of the enterprise and how it manages the forecast function. They are only interested in environmental aspects and the requirements in subsection (1) and (2) if these will have a direct effect on the development of the enterprise, its risks and opportunities.
  
  
• The final group is the mixed group, interested both in how the enterprise tackles its environmental responsibilities and its financial development. The most important thing for this group is probably more a description of the environment which includes both the forecast function and the control function. This means that the description under subsection (1) is based on the environmental effects caused by the enterprise's environmental impacts, together with associated explanations about the possibilities of remedy, reduction or prevention. Next, this group wants to see a description providing insight and understanding of the initiatives decided by the enterprise, including possibly a description of the monetary amounts spent in the accounting year and expected to be required in the future.

5.5 Relationship between EMA and the annual report

The two most prominent similarities between EMA and the annual report are:

1. Both EMA and the annual report focus on information which can support decisions.
2. Both EMA and the annual report (management review) highlight the relationship between financial matters and the environment.

However, despite these similarities there are also important differences.

One difference is that EMA takes its point of departure in internal users in the enterprise, while the annual report addresses external users. Before EMA information can be included in the annual report, therefore, it is important to consider whether it is significant for external users.

Another difference could be the interpretation of when information is considered significant. For example it may well be relevant for an individual division to work with EMA and achieve a saving of EUR 70,000, but in a very large enterprise the financial criterion for when an item is considered significant enough to be included in the annual report may well be EUR 1 million.

The following section reviews a number of examples of how EMA can be used to inform about the requirements in section 99(1) and (2), as well as the interface between the control and forecast functions of the annual report, and EMA.

5.6 EMA and the annual report's control function

The control function for environmental information will primarily include that the management of the enterprise report on how it has managed the environmental impacts which are significant for the enterprise's financial position and result.

In this connection, EMA information can be used to provide a quantitative statement of how the enterprise's resources have been managed in an environmentally appropriate manner and how this has affected the income statement and the result for the year. This information could be used to describe an initiative to reduce the enterprise's environmental impacts in accordance with section 99(1), and it could demonstrate the financial relationship required under section 99(2).

The table below provides an example of how an EMA project can be relevant in reporting in the management review.

Table 7: Example of a statement on environmental management accounting for waste in the management review

So, EMA can be used to quantify the influence of environmental work on the financial results.

Of course, the costs highlighted by EMA have already been reported as part of the operating costs in the income statement part of the annual report. The income statement discloses the operating costs, either divided into production costs, distribution costs etc., or divided by the nature of the costs to raw materials, salaries, etc. Therefore, the income statement does not show specific information on environmental costs allocated to activities. Therefore, it is not apparent from the income statement whether costs of waste, for example, have been calculated in accordance with EMA principles, where the value of all the activities and processes which become waste are included in the price of waste, or whether the waste has been measured merely using a traditional method. Therefore, it is not enough merely to repeat information from the income statement when incorporating EMA data in the management review.

5.7 EMA and the annual report's forecast function

The forecast function in relation to the environment is associated with the enterprise's measures to prevent environmental damage in general and thus manage risk. Prevention of environmental damage is typically linked to financial development through investments in cleaner technology etc. Similarly, management of environmental risks can demand the development of new production methods, if future legislation means that the enterprise can no longer use certain chemical substances.

The following two sections describe the relationship between investments in EMA as well as between EMA and the risks of impacts on the financial position.

5.7.1 Investments and EMA

Prevention of environmental damage is often through investments in cleaner technology etc. In accounting terms, when these investments are made they are called tangible fixed assets. This also applies in cases where an earlier investment is improved.

The basis for measuring an enterprise's tangible fixed assets (property, plant and equipment) is the cost price of such assets, most often the costs of acquisition. In some cases, EMA can play an important role in relation to subsequent improvements to fixed assets such as factory plant, machinery etc.

Subsequent expenditure relating to a tangible fixed asset that has already been recognised should be added to the carrying amount of the asset when it is probable that future economic benefits, in excess of the originally assessed standard of performance of the existing asset, will flow to the enterprise. This means expenditure on an asset which improves the condition of the asset beyond its originally assessed standard of performance. Examples of improvements which result in increased future economic benefits include:

• Modification of an item of plant to extend its useful life, including an increase in its capacity.
• Upgrading machine parts to achieve a substantial improvement in the quality of output.
• Adoption of new production processes enabling a substantial reduction in previously assessed operating costs.

Future economic benefits are savings, increased revenues, better performance etc. realised in the year of improvement.

When using EMA for investment decisions, cost-benefit scenarios are set up incorporating the financial effects derived from variable environmental measures. That is, financial savings or changes which can be attributed to the future use of the asset are made visible.

EMA can be used to highlight more values than are traditionally considered in connection with measurement of the improvement value of tangible fixed assets.

An example:

A production line is acquired at a historical cost price of EUR 10 mill. The expected useful life is 10 years, corresponding to annual depreciation of EUR 1 mill.

After five years an improvement is made which means that the production line can be used without the use of a specific additive which is considered harmful to human health. The improvement costs are EUR 2 mill. After the improvement, it is estimated that the production line can be used for four more years than was originally estimated.

Without EMA the effect on the enterprise's annual report would look like this:

* Residual value EUR 5 mill. and improvements EUR 2 mill. depreciated over 9 years = EUR 0.8 mill.

Table 8: Illustration without EMA

Using EMA makes it likely in the following that the value of the improvement is EUR 8.3 mill. Future operation of the line can now save an annual EUR 0.2 mill. on cleaning wastewater, and the change in production can save operating costs of EUR 50,000 per shift because the additive is no longer necessary. With a normal ten shifts per year, the total reduction in the estimated annual operating costs is therefore EUR 0.7 mill. (0.2 + (10 x EUR 0.05 mill.)). The useful life of the improved production line is 9 years over which the improvement value, including the future likely benefits is EUR 8.3 mill. (2 + (9 x EUR 0.7 mill.)).

Including EMA gives an effect on the financial development of the enterprise of:

* Residual value EUR 5 mill. as well as improvement of EUR 8.3 mill. depreciated over 9 years = EUR 1.5 mill.

Table 9: Illustration with EMA

It is clear that the actual useful value for the enterprise of the improvement is greater than the external costs incurred. This is made visible by EMA. Under normal accounting rules only the EUR 2 mill. invested will appear in the accounts, but as can be seen above, the investment has an actual added value of EUR 6.3 mill. (EUR 8.3 mill. – 2 mill.). According to the Financial Statements Act this effect cannot be recognised in the enterprise's balance sheet. The visible value of EUR 6.3 mill. can therefore not be seen directly from the published balance sheet.

However, the enterprise can decide to include the information in the management review so that with quantitative data it can show the influence of the improvement on its financial development. This statement could be in the form of table 10 below. This shows added value of EUR 6.3 mill. depreciated over 9 years.

** (6.3 mill. – 0.7 mill.) = 5.6

Table 10: Illustration of the visible added value with EMA

The enterprise could also decide to include the supplementary calculations and statement shown in the table in a supplementary report.

The special role which can be played by EMA in the annual report is therefore supplementary. This means that EMA provides the enterprise with an opportunity to calculate and report the added value accruing to the enterprise from the improvement.

5.7.2 EMA and risks of impacting the financial position

The annual report also has a forecast function to help users of accounts to understand the financial position of the enterprise.

The financial position of the enterprise means the quality of the enterprise's ability to pay. Understanding the relationship between an enterprise's financial position and its environmental situation is especially important regarding such environmental factors as can enhance the enterprise's financial position.

Two examples are described below:

• An external factor could be a requirement to remediate damage to the environment, typically soil contamination. Such costs will typically be included in the annual report as a note on contingent liabilities in the years when the enterprise's responsibility is undergoing legal consideration. If the likelihood that the enterprise will have to pay for the remediation increases, then the contingent liability will be included in the balance sheet as a provision with a corresponding reduction in equity capital. EMA could be included at this point as a supplementary element. In connection with estimated measurement of any pollution liabilities, the EMA method could be a constructive way of including several derived future financial amounts for the consequences of different clean-up strategies.
• Another external factor could be new statutory requirements. For example a ban on using certain pollutants, including the use of lead in the enterprise's products and production. Another example is the producer's obligation to take back products after use. Both changes mean the enterprise must take a position regarding their financial effects at the time the new rules become likely and thus can be expected by the enterprise. EMA could be used as a methodology to disclose the overall financial significance of the change.

5.7.3 Summary

As demonstrated in this chapter, EMA can be used to illustrate the value of environmental work and environmental investments in the annual report. However, the Financial Statements Act does not require quantitative environment-financial figures, so including EMA is voluntary.

If an enterprise wants to use EMA data in its annual report, it is important to consider whether such data is financially material for the annual report, and how the information is relevant for users of the annual report. EMA information is often calculated for internal use and therefore it is rarely designed for external use as well.

Foot notes

[2] Not a requirement for reporting classes B and A (see table 3 for an explanation of reporting classes)

| Front page | | Contents | | Previous | | Next | | Top |

Version 1.0 Februar 2006, © Danish Environmental Protection Agency