Introduction
In recent years climate change has become one of the most serious challenges faced by the world. Governments, businesses, and international organizations are working together to reduce the amount of greenhouse gases released into the atmosphere. One of the most important tools developed for this purpose is the concept of carbon credits. While it may seenn like an environmental or scientific issue, carbon credits are now a significant part of business operations and financial reporting. For this reason accountants, auditors, and finance professionals must learn how to handle them properly.
Accounting standards such as International Financial Reporting Standards (IFRS) are designed to ensure that financial statements provide a true and fair view of a company’s financial position. When companies are involved in emission trading schemes or hold carbon credits, these items can influence their assets, liabilities, and profit or loss. A company may need to purchase credits to continue its operations, record free allowances received from the government, or even create provisions when it has emitted more carbon than allowed. All these situations directly affect accounting records. The main aim of this article by CA X ACCA is to explain carbon credits and their accounting treatment in simple and practical terms so that both students and professionals can build a solid understanding.
What are Carbon Credits?
Carbon credits are certificates or permits that represent the legal right to emit a certain amount of greenhouse gases into the atmosphere. Normally, one carbon credit allows a company to release one metric ton of carbon dioxide or an equivalent amount of another greenhouse gas. The idea is simple but powerful: companies that reduce their emissions below a set limit can sell extra credits, while companies that exceed their limit must buy credits from others. In this way, carbon credits create a market-based system to control pollution.
Governments and international agencies often use carbon credits as part of emission trading schemes. These schemes work by setting a total cap on emissions in a country or industry. Within that cap, companies receive allowances in the form of carbon credits. The companies are then free to trade these credits in the market. If a company performs well and reduces its pollution, it can sell its unused credits and generate income. On the other hand, a company that pollutes more than allowed must purchase additional credits, which becomes an extra cost.
There are two main types of carbon credits:
- Compliance Credits – issued under legally binding programs like the European Union Emissions Trading Scheme (EU ETS). These are used by companies that are required by law to reduce emissions.
- Voluntary Credits – created outside legal systems and used by businesses or individuals who want to offset their emissions voluntarily. For example, an airline may buy voluntary credits to claim carbon-neutral flights.
For accounting purpose s both types of credits can appear in the financial statements. Whether a company receives credits free from the government or buys them from the market they have economic value and must be recognized properly. Since credits can be sold or used in future, they are generally seen as assets. At the same time, if a company has a shortage of credits compared to its emissions, it creates an obligation which becomes a liability.
This mix of environmental policy and financial reporting makes carbon credits an interesting but sometimes confusing subject. Students need to remember that the ultimate purpose of accounting is to present a true and fair view of a company’s financial position. Therefore carbon credits should be treated in a way that reflects their real impact on the business.
Why Carbon Credits Matter in Accounting
For many businesses especially those in industries such as energy, cement, aviation, and manufacturingg carbon credits are not just environmental tools but also financial instruments that can significantly affect their financial performance. From an accounting perspective, carbon credits influence both the balance sheet and the income statement, which makes it essential to understand their treatment under IFRS.
The first reason carbon credits matter is that they qualify as economic resources. A purchased credit or a free allowance received from the government has value and can be used to settle obligations. This makes them assets for the business, similar to other intangible items. If managed well, carbon credits can even generate income when sold in the open market.
Second.. carbon credits create liabilities when a company’s emissions exceed the credits it holds. This obligation can be settled only by purchasing additional credits or paying penalties, which makes it a present obligation under IFRS. Companies therefore need to estimate their emissions and ensure that provisions are recognized for any shortfalls. This directly affects reported expenses and profit.
Third… the treatment of carbon credits can impact financial ratios and investment decisions. For example, if a company records purchased credits at cost but their market value rises, the difference may not appear in the financial statements unless revaluation is applied. Investors and analysts who review such companies must consider the hidden value in credits, especially in industries with strict environmental regulations.
Fourth, carbon credits are closely connected with corporate social responsibility (CSR) and sustainability reporting. Regulators, shareholders, and even customers now expect companies to show how they are addressing environmental issues. Poor handling of credits in accounting records can raise doubts about transparency and reliability of financial statements.
IFRS Guidance on Carbon Credits
One of the main challenges in accounting for carbon credits is that there is no single IFRS standard dedicated only to them. Instead, accountants need to apply existing standards depending on the situation. This creates some complexity, but with the right understanding, it becomes easier to handle. The three most relevant standards are IAS 38 (Intangible Assets), IAS 20 (Government Grants), and IAS 37 (Provisions, Contingent Liabilities and Contingent Assets).
IAS 38 – Intangible Assets
Carbon credits are generally classified as intangible assets. The main reasons are:
- They have no physical substance.
- They are identifiable and can be sold or traded.
- They provide future economic benefits because they can be used to settle emission obligations.
Under IAS 38, intangible assets can be measured using:
- Cost Model – Credits are recorded at purchase cost and tested for impairment if their value falls.
- Revaluation Model – If an active market exists, credits can be measured at fair value with changes recorded in equity.
Example:
A company buys 1,000 carbon credits at $5 each, spending $5,000. If the market value rises to $7 per credit and the company uses the revaluation model, the asset will be shown at $7,000, with a $2,000 gain taken to the revaluation reserve.
IAS 20 – Government Grants
In many emission trading schemes, companies receive credits free from the government. This creates a different accounting issue. IAS 20 guides how government grants are recognized. The fair value of the credits received is treated as deferred income and then recognized in profit or loss as the related emissions occur.
Example:
A factory receives 500 credits free from the government. If each credit is worth $6, the fair value is $3,000. This $3,000 is recorded as deferred income. When the factory emits carbon and uses the credits, part of the deferred income is released to match the expense.
This method ensures that government support is not recognized as immediate profit but spread over the period when the credits are used.
IAS 37 – Provisions, Contingent Liabilities and Contingent Assets
When a company’s emissions are higher than the credits it owns, it must either purchase additional credits or pay fines. This creates an obligation that needs to be recognized as a provision.
IAS 37 requires a provision when:
- A present obligation exists due to past events.
- It is probable that resources will be needed to settle the obligation.
- The amount can be estimated reliably.
Example:
A company holds 1,000 credits but its actual emissions equal 1,200 tons. It needs 200 more credits. If each credit costs $8, then a provision of $1,600 is recognized. This shows the obligation clearly in the financial statements.
Why the Combination Matters
The use of multiple standards shows how complex carbon credit accounting can be. Depending on the situation, the same credit may be treated as:
- An intangible asset (IAS 38) when purchased.
- A government grant (IAS 20) when received free.
- A liability or provision (IAS 37) when emissions exceed allowances.
This mixed application is one reason why accounting bodies are considering whether a dedicated standard is needed in the future.
Emission Trading Schemes (ETS)
Emission Trading Schemes are one of the most common methods used by governments to control greenhouse gas emissions. Under these schemes, authorities set a cap on the total amount of emissions allowed in a region or industry. Within that cap, companies are allocated emission allowances, which are usually expressed as carbon credits.
The system works on a “cap and trade” principle. Companies that keep their emissions below the assigned limit can sell their extra credits, while those that exceed the limit must buy additional credits from the market or face penalties. This creates a financial incentive for businesses to reduce emissions and adopt cleaner practices.
From an accounting point of view, ETS transactions are important because they directly affect a company’s financial position and performance. Let us look at how they are treated under IFRS.
Initial Recognition
- Free Allowances: If credits are received free from the government, they are recognized as government grants under IAS 20. Their fair value is recorded as deferred income and released over time.
- Purchased Allowances: If credits are purchased, they are recognized as intangible assets under IAS 38 at cost.
Subsequent Measurement
Companies have two options:
- Cost Model: Credits remain at purchase cost, less impairment.
- Revaluation Model: If an active market exists, credits can be revalued at fair value. Any increase goes to revaluation reserve.
For instance, if a company buys credits for $10,000 and their market value increases to $15,000, the revaluation model allows it to show $15,000 as the asset value, giving a more realistic picture.
Settlement of Obligations
At the end of each reporting period, companies compare actual emissions with credits held:
- If emissions are equal or less, the company surrenders credits to authorities and settles its obligation. Surplus credits remain as assets for future use or sale.
- If emissions are greater, the company must purchase additional credits or record a provision for the shortfall under IAS 37.
Example:
A company holds 5,000 credits but its emissions total 5,200 tons. It must purchase 200 extra credits. If the market rate is $12 per credit, a liability of $2,400 is recognized.
Importance of ETS in Accounting
ETS is more than an environmental tool. For businesses, it represents:
- A source of cost if emissions are high.
- A potential revenue stream if credits are sold.
- A compliance requirement that directly affects financial reporting.
Understanding ETS helps accountants ensure that transactions are recorded correctly and financial statements reflect the true impact of emissions on business performance.
Practical Examples of Accounting for Carbon Credits
Understanding theory is useful, but the real clarity comes when we apply accounting rules to actual situations. Below are three simple examples showing how companies account for carbon credits under IFRS.
Example 1: Purchase of Carbon Credits
Company A buys 1,000 carbon credits from the market at $5 each.
- Journal Entry:
- Debit Intangible Asset (Carbon Credits) $5,000
- Credit Cash $5,000
At year-end, the market value of credits rises to $6 each. If the company uses the cost model, no change is recorded. If it uses the revaluation model, then:
- Journal Entry (Revaluation):
- Debit Intangible Asset $1,000
- Credit Revaluation Reserve $1,000
This shows how valuation choice under IAS 38 impacts the financial statements.
Example 2: Free Credits Received from Government
Company B receives 500 credits free from the government. Market value per credit is $8, so total fair value is $4,000.
- Journal Entry:
- Debit Intangible Asset (Carbon Credits) $4,000
- Credit Deferred Income (Government Grant) $4,000
As the company emits and uses credits, part of the deferred income is released. If 250 credits are used this year:
- Journal Entry:
- Debit Deferred Income $2,000
- Credit Other Income $2,000
This spreads the benefit of the grant over the period when credits are used, following IAS 20.
Example 3: Emissions Exceed Allowances
Company C holds 2,000 credits but its emissions for the year total 2,200 tons. It must purchase 200 credits at $10 each, costing $2,000.
At year-end, before purchase, the company must recognize a provision under IAS 37:
- Journal Entry:
- Debit Expense (Provision for Carbon Shortfall) $2,000
- Credit Provision for Liabilities $2,000
When the company buys the extra credits next year, the provision is settled.
Why Examples Matter
These practical cases highlight that:
- Purchased credits are assets.
- Free credits are treated as government grants.
- Excess emissions create liabilities.
By practicing examples, students preparing for ACCA, CA, ICAEW, or CPA exams can apply IFRS concepts with confidence. For professionals, these entries ensure that financial statements remain reliable and compliant with international standards.
Practical Challenges in Accounting for Carbon Credits
Although IFRS provides some guidance through existing standards, accounting for carbon credits remains complex in practice. Companies and accountants often face several challenges.
1. Price Volatility
The value of carbon credits can change quickly depending on supply and demand in the market. If a company uses the fair value model under IAS 38, frequent revaluations may be required. This increases workload and can make financial statements more volatile, reducing comparability over time.
2. No Dedicated IFRS Standard
There is still no single standard that directly addresses carbon credits. Instead, companies must use a mix of IAS 38, IAS 20, and IAS 37. This creates inconsistency because different companies may apply rules differently, making it difficult for investors to compare results across industries.
3. Estimating Emissions
For provisions, companies need to measure actual emissions and compare them with credits held. In some industries, measuring emissions accurately is challenging. If estimates are unreliable, it affects the reliability of reported liabilities and expenses.
4. Differences in Regulations
Every country or region may have its own emission trading scheme. Rules for allocation, surrender, and trading vary widely. This means multinational companies face additional complexity when consolidating financial statements.
5. Audit and Assurance Issues
Auditors must verify both the existence and valuation of credits. If credits are intangible and traded in markets with limited transparency, proving fair value becomes difficult. This raises audit risks, especially when financial statements rely heavily on these assets.
6. Link with Sustainability Reporting
Carbon credits are not only a financial reporting issue but also part of broader sustainability disclosures. With new standards from the International Sustainability Standards Board (ISSB), companies must integrate financial and non-financial reporting. This adds to the workload of finance teams and increases the demand for skilled professionals.
Carbon credits represent a growing area of importance in both business and accounting. They are not only about reducing pollution but also about financial transparency and responsibility. For students, learning this topic builds strong exam knowledge and prepares them for real-world challenges. For professionals, proper accounting of credits ensures compliance and gives investors confidence in financial statements.
FAQs
1. What is a carbon credit in simple terms?
A carbon credit is a permit that allows a company to emit one ton of carbon dioxide or an equivalent gas. Companies can buy, sell, or receive these credits to manage their emissions.
2. Are carbon credits assets or liabilities?
Carbon credits are assets when purchased or received, because they provide future benefits. They become liabilities when emissions are higher than the credits owned.
3. How are free carbon credits recorded in accounts?
Free credits from governments are treated as government grants under IAS 20. They are recorded as deferred income and recognized in profit or loss when used.
4. Why does IFRS not have a specific standard for carbon credits?
Because carbon markets are still developing, IFRS has not yet issued a dedicated standard. Instead, existing standards like IAS 38, IAS 20, and IAS 37 are applied.
5. How do emission trading schemes affect profit?
If a company sells surplus credits, it records income. If it needs to buy additional credits, it records expenses or provisions. Both situations affect profit directly.
you may also like the relevant articles by CA X ACCA:
Link Between IFRS Standards and Financial Markets Stability
Sustainability Accounting and ESG Reporting
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