PLACE ll RETURN BOX to roman this choekout from your neord. To AVOID FINES mum on or baton dd. duo. DATE DUE DATE DUE; ‘DATE DUE ABSTRACT ACCOUNTING INFORMATION FOR ENVIRONMENTAL DECISIONS By Myles Stern In order to delineate the ways in which the accounting function relates to decisions regarding environmental disrup- tion and its control, this dissertation addresses the following four questions, in the order stated: 1. What is the nature of the environmental decisions made by government agencies, business managers, and private individuals who use published financial reports? 2. What information is relevant to these decisions? 3. What portions of this information might reasonably be supplied through the accounting function? 4. By what means and to what extent could accountants gather, report, and audit such information? The methodology employed to attack these questions begins ‘ with the presentation of conceptual descriptions, drawn largely from the literature in accounting and economics, of the decisions mentioned in question one above. The second step, for decisions made by government agencies and business managers, comprises an empirical study of the activities of a regional air pollution control agency and a large utility firm respectively. Finally, based upon both the conceptual structures and the Myles Stern empirical findings, conclusions are formed in response to all four questions. After surveying the current regulatory status of environmental disruption, including existing reporting requirements, the focus shifts to governmental decisionmaking at the national and regional levels. While this subject is important in itself, it is especially crucial because government decisions control the framework within which firms and individuals must make thgir decisions. Specific economic models are presented to furnish (1) a foundation for discussing economic aspects of disruption and its control; (2) an a priori basis for assessing the effectiveness and efficiency of alternate regulation strategies; and (3) a concrete approach for evaluating individual factors under benefit-cost analysis-— the essential method by which government agencies can select among alternative environmental proposals. The information that government agencies require to implement these concepts is described. Following this treatment of governmental decision— making, the dissertation turns to the decisions made by and the corresponding information needs of firms and individuals. Conclusions are drawn about the relationship of the accounting function to environmental decisions made at each of the three levels: government, firms, and individuals. For government agencies, much of the information relevant to economic analysis pertains to financial characteristics and activities that are recorded in accounting systems of indi- vidual firms. Typically, in using such accounting data, Myles Stern economists encounter problems concerning asset valuation, depreciation, the cost of capital to the firm, and the inter- relationships among individual cost factors. Accountants could help ameliorate these difficulties by applying current costing to assets and depreciation charges; by disclosing more fully the nature of and the returns to individual classes of a firm's security-holders; and by describing, for each material cost item, its behavior, the segment of the firm with which it may be directly identified, and the underlying purpose and necessity for its incurrence. The empirical findings about a particular agency are used to help Specify the Scope of the accounting function within such government units. By designing report forms to be submitted by subsidiary agencies and individual firms, and by participating in benefit-cost studies based partly upon accounting data for individual firms, accountants can contribute to the development of environmental regulations. The case study further demonstrates that accounting for the administrative aspects of these agencies is both essential and fully consistent with the "conventional" accounting function. A specific proposal for a computerized information system for the agency studied outlines the manner in which accountants can become involved meaningfully in such systems design efforts. Within a particular firm, accountants must determine, as part of their usual function, the extent to which environ- mental disruption and its abatement bear upon the entity's financial statements furnished stockholders and government Myles Stern agencies. Moreover, the study of an actual set of decisions made by a utility firm clearly delineates the kinds of reports the accounting function must provide to managers for coordina- ting environmental policies with the firm's overall goals. for making specific environmental decisions within a capital budgeting context, and for controlling environmental projects. Examples are taken from the case study to support the conten- tion that, within businesses as within government agencies, accountants must play a major role in designing comprehensive, environmental information systems: the same principles that underlie the structuring of effective accounting systems apply to these systems as well. In order for users of reports published by individual firms to be able to rely on the information contained therein, generally—accepted standards must govern their preparation and some type of independent examination must be conducted. A suggested format for such reports includes a background des- cription of the firm's disruption concerns and its abatement goals and progress as well as a financial summary linking environmental items to the conventional statements of income, financial position and changes in financial position. It appears likely that public accounting firms or groups of social auditors, rather than government auditors, will increasingly be called upon to study such reports. Independent accountants could "attest" to the environmental financial summaries and could provide a somewhat lesser "degree of assurance" about the background descriptions. ACCOUNTING INFORMATION FOR ENVIRONMENTAL DECISIONS By Myles Stern A DISSERTATION Submitted to Michigan State University in partial fulfillment of the requirements for the degree of DOCTOR OF PHILOSOPHY Department of Accounting and Financial Administration 1974 Copyright by MYLES STEVEN STERN 1974 For Laura and Rebecca ii ACKNOWLEDGMENTS My gratitude is expressed to Messrs. Howard Murray and Pat Garvey of the Wayne County (Michigan) Air Pollution Control Division and to several individuals from "Midwest Utility" who, alas, must remain anonymous here. Special thanks are offered to the members of my dissertation committee: Professors George C. Mead, Gardner M. Jones, and Byron W. Brown. I also cheerfully acknowledge a substantial debt to my wife, Laura Stern, for her dedicated typing and editorial assistance. iii I. II. III. IV. TABLE OF CONTENTS INTRODUCTION AND METHODOLOGY Purpose and Scope of this Dissertation . The Nature of Accounting Accounting and Environmental Quality The Methodological Approach Research in Socio-Economic Accounting Types of Disruption and Abatement Classifying Fbrms of Disruption Possible Remedies THE CURRENT STATUS OF DISRUPTION ABATEMENT The Historical Context . . Distinguishing Between the Current, Transitional Period and the Future, THE ECONOMIC FRAMEWORK . Economic Theories of Environmental Disruption The Static Microeconomic Approach Aggregative Approaches . . Constraints Involved in Implementing the Models Economic Constraints . . . Social Constraints . . . . Political Constraints . . Using Economic Models: Appendix: GOVERNMENTAL DECISIONMAKING: CONSTRUCT . . . . . . . . A THEORETICAL The Selection of Public Programs . A Pragmatic Approach to the Selection of Public Programs . . . Dynamic Aspects of Environmental Disruption Control Mature State A Reassessment . A Sample Input-Output System Information Required for Economic Analysis . iv 14 18 23 23 37 44 45 47 51 56 57 64 67 7o 72 76 76 84 88 92 V. GOVERNMENTAL DECISIONMAKING: AN EMPIRICAL STUDY . The Development of the Division and Its Duties . . The Activities of the Division Today . . . . . . . Statutory Authority: An Overview . . . . . . . . Controlling New Sources . . . . . . . . . . . . . Controlling Existing Sources . . . . . . . . Regulating Sulfur Oxides Emissions: A Case Histor VI. DECISIONMAKING BY FIRMS: A CONCEPTUAL FRAMEWORK An Overview of Environmental Decisions of Firms Determining an Overall Strategy toward Compliance Selecting Specific Approaches to Compliance Managerial Planning and Control Information Needs and Problems . . . . . . . . . . Who Makes Environmental Decisions . . . . . . . . Sumary I I I O O O O I O I O O I O O O O O I I O VII. AN EMPIRICAL STUDY OF CORPORATE DECISIONMAKING . Overall Attitude toward Abatement . . . . . . . . Special Characteristics of Electric Utilities Early Efforts at Control Administrative Arrangements for Environmental Decisionmaking A Systematic Model for Decisionmaking . . . . . . Controlling the Implementation of the Decision . . Environmental Information: Needs and Sources . . Specific Reporting Requirements Information for Decisionmaking The Firm's Accounting System Matching Information Needs and Sources VIII. DECISIONMAKING BY USERS OF PUBLISHED FINANCIAL REPORTS I O O C O C O O O O O O O O O O I , C U C D The Users and Their Needs for Information . . . . The Independent Auditor's Attest Function . . . 98 99 103 104 107 109 110 119' 120 133 140 144 146 147 156 171 172 191 191 199 IX. THE ACCOUNTING FUNCTION AND ENVIRONMENTAL INFORMATION I I I I I I I I I I I I I I I I I I I I Accounting Information for Governmental, Environmental Decisionmaking . . . . . . . . . The Accounting FUnction within Environmental- Control Agencies . . . . . . . . . . . . . . . . . . . . The Accounting Function within Private Firms . . . . Appendix A: A Management Information System for a Government Agency . . . . . . . . . . . . . . Appendix B: Enlarging an Accounting System to Include Environmental Information . . . . . . . X. EXTENDING THE AUDIT FUNCTION TO ENVIRONMENTAL REPORTING I I I I I I I I I I I I I I I I I I I I I Why Audit Environmental Reports? . . . . . . . . . The Content of Published Environmental Reports . . . The Auditability of Environmental Reports . . . . . Institutional Arrangements for Performing the Audit Environmental Reporting Standards . . . . . . . . . Recommendations for Future Research Efforts . . . . BIBLIOGRAPHY I I I I I I I I I I I I I I I I I I I I I I vi 210 211 216 220 227 232 236 237 241 247 253 259 262 264 I. INTRODUCTION AND METHODOLOGY Purpose and SCOpe of this Dissertation During recent years, increased public awareness and concern about environmental disruption had led to a multitude of actions and calls for further action. Unfortunately, so many of these programs reflect a viewpoint restricted to a particular environmental problem that many people are now bewildered by the overabundance of plans and counterplans. A chief reason for this confusion is the staggering array of environmental decisions that must be made by governments, businesses, and individuals. If a truly comprehensive and coordinated approach to obtaining environmental quality is to be developed, it is mandatory that these decisions be made in a sound manner. Accordingly, they must be based upon information that is relevant, useful, and complete. In essence, the purpose of this dissertation is to investigate the ways in which the accounting function can help supply the information that is required for environmental decisionmaking. Many researchers and practitioners in the "systems" area have concluded that the best way to develop an information systenlis to have the individual who will be using the system play a.major role in specifying just what should be 1 included. At the same time, however, "systems analysts" generally recognize that the typical user is not fully cognizant of his own needs and is largely ignorant of the range of possible features that might be included in the system! Since the environmental decisionmaker's area of interest is so new and fast-changing, he is especially prone to have imperfect notions of his information needs and of potential provisions for his information system. Thus, "information Specialists" must actively help the user to Specify the system. Following this line of reasoning and in order to delineate the ways in which the accounting function relates to decisions regarding environmental disruption and its control, this dissertation will address the following four questions, in the order stated: A 1. What are the natures of the various environmental decisions made by government agencies, business managers and private individuals who use published financial reports? 2. What general kinds of information are relevant to these decisions? 3. What portions of this information might reasonably be supplied through the accounting function? 4. By what means and to what extent could accountants gather, report, and audit such information? 1John Dearden, "Systems Organization and ReSponsibility," in Managing Computer-Based Information Systems, ed. by John Dearden, F. Warren McFarlan, and William M. Zani (Homewood, Illinois: Richard D. Irwin, 1971), p.591. Prior to detailing the methodology by which these questions will be answered, some attention will be given to the characteristics and scope of the accounting function and to the reasons, cited in the recent literature, for accountants to become involved with environmental information. The Nature of Accounting A committee of the American Accounting Association has stated that "there is considerable dispute as to what is and is not accounting. Any guidelines . . . to classify information . as being 'accounting' or 'non-accounting' information would be extremely arbitrary."2 While it does seem quite unreasonable to attempt to provide a precise definition of "accounting," it is still useful to explain the general sense in which this term will be used in this dissertation. Accounting has been described "as the process of identifying, measuring, and communicating economic information to permit informed judgements and decisions by users of the information."3 Carey points out that CPAs measure and communicate . . . data largely for control and information purposes, most frequently for an economic entity--a business, a governmental unit, a nonprofit organization. Other experts analyze similar data, but 2"Report of the Committee on Non-Financial Measures of Effectiveness," The Accountinngeview, Supplement to Volume XLVI (1971). p.167. 3Committee to Prepare a Statement of Basic Accounting Theory, A Statement of Basic AccountinggTheory (Evanston,IllinoiS: American Accounting Association, 1966), p. 1. L; usually for more specialized purposes--sometimes broader, as in the case of economists in estimating national income or gross national product; sometimes narrower, as in the case of a statistician concerned wiEh only one phase of a business, such as market surveys. Accounting deals with the processing of data within, the overall reliability of, and the generation of reports from information systems. In order to provide credible information to decisionmakers, accounting embraces the notion of internal control and incorporates the audit function. In these pages, the term "accountant" will be used to denote an individual who, by virtue either of formal education or on-the-job training, holds, or is qualified to hold, a position of "staff accountant" within a government agency, a commercial firm, or a public accounting firm. Accounting_and Environmentalgguality At least three reasons have been advanced for accountants to become more involved with developing reports for environmental decisionmaking. These reasons will be discussed in the following paragraphs. Management advisory services.--The environmental area ”John L. Carey, The CPA Plans for the Future (New York: finnerican,Institute of Certified Public Accountants, 1965), pp. 117-18. 5 represents an important opportunity for public accounting firms to expand their offerings of management services. Indeed, the chairman of the AICPA'S Committee on Environmental Accounting has concluded that "during the next 10 years, environmental management engagements will afford perhaps the major new field for client service in which all practitioners can participate."5 Furthermore, two recent reports demonstrate the feasibility of accounting firms providing such services to government agencies as well as to private companies. The first report explains how, in conjunction with Pennsylvania's Bureau of Sanitary Engineering, a group of management advisory services specialists from Price Waterhouse designed an information processing and retrieval system for statewide water quality data.6 While the primary objective of the program was to "establish a workable information system for planning, directing, evaluating, and administering the water quality management program of the state as a whole;" an important second goal was to deve10p a general approach which might be followed by water pollution regulators in other states.7 The second article details how members of Touche, Ross helped plan a management information system for Detroit's 5William G. Gaede, "Environmental Management Opportunities for the CPA," The Journal of Accountancy, May 1974, p. 54. 6Henry S. Sawin, "The CPA'S Role in Restoring the Ecological Balance," Management Advisor, March—April, 1971. pp. 23-29. 7Ibid., p. 24. anti—poverty program.8 While this project did not deal specifically with environmental disruption, it did show the general possibility of quantifying social wants and needs. This same sort of assignment presumably could be performed by accountants working to solve other social problems.9 While the Price Waterhouse project is an example of applying conventional techniques to a new situation, the Touche, Ross engagement represents a conceptual extension of the accountant's role. Taken together, these two studies indicate that accountants may provide valuable management advisory services, in connection with environmental disruption problems, to government agencies. Mandatory reporting and auditingrequirementS.--As will be examined closely in later chapters of this dissertation, business firms are currently required to submit a good deal of information about disruption and abatement to various government agencies. Quite often, accounting personnel have primary reSponsibilities for the preparation of these reports. Moreover, 8Robert Beyer, "The Modern Management Approach to a Program of Social Improvement," The Journal of Accountancy, Mazxfih 1969, pp.37-46. 9There has been some debate on the extent to which zuccountants should become involved in the evaluation of social prxugrams. Some questions concerning the competence of accountants 1K) do such work are discussed in M. E. Francis, "Accounting arui the Evaluation of Social Programs: A Critical Comment," The:.Accounting;Review. April 1973, pp. 245-57. 7 independent accountants, in order to give opinions on published financial statements, must consider the adequacy of disclosure pertaining to the firms' environmental affairs. These requirements for environmental reporting and auditing seem likely to expand in the future. Social responsibilities of accountantS.-—Arguments have been advanced that the accounting function has a collective "duty" to society to become actively involved in the resolution of environmental problems. One such line of reasoning begins with the observation that the accounting function’s primary purpose in society is to provide information used ultimately as part of the basis for capital expenditure decisions.10 Since accounting has generally ignored information about the environmental disruption caused by a firm's operations, the profession has been partly to blame for the inefficient (from society's viewpoint) capital allocations which followed. In addition, there is good reason to believe that if accountants do not provide this kind of information, the task will likely be performed by individuals having weaker credentials. These concerns are clearly voiced by Beams and Fertig: Accounting as an organized profession has the responsibility to transcend the internal viewpoint of a private firm and to develop information which portrays a private firm's role in and contribution to society . . . The current concern for pollution control and environmental replenishment has 10James E. Parker, "Accounting and Ecology: A Ikarspective," The Journal of Accountancy, October 1971, p. 44. created a new urgency for the profession to accept an active role in regard to social costs. On the one hand, accounting is being criticized for contributing to the decay of our environment and, on the other hand, new organizations are being formed to provide information relating to the social responsibility of corporations . . These organizations are without standards, without discipline and lacking the prpfessionalism of accountancy with its guardian, the AICPA. Although the acceptance of accounting's social role is not unanimous, it does appear to be growing widely, as witnessed by the efforts of committees from the AICPA and the American Accounting Association.12 In Short, because of opportunities for expanding management services, mandatory reporting and auditing requirements, and their acceptance of social responsibilities, accountants are becoming increasingly involved with environmental information. The Methodological Approach The goal for this study is the specification of the potential role for the accounting function in developing the information systems required for environmental decisionmaking by government agencies, businesses, and individuals; as well as 11Floyd A. Beams and Paul E. Fertig, "Pollution Control Through Social Cost Conversion," The Journal of Accountancy, November 1971. PP. 38-39. 12A much more restricted view of accounting's function is given in William A. Paton, "Earmarks of a Profession—-And the APB," The Journal of Accountancy, January 1971. pp. 37-45. AICPA.committee efforts are described in Marshall S. Armstrong, New Thinkingpon Environmental and Social Problems (New York: American Institute of Certified Public Accountants, 1971). p- 12. (fine work of the AAA is discussed in Beams and Fertig, pp. 913., p.38. in obtaining, communicating, and auditing the actual information that is relevant to such decisions. In order to substantiate this prOposition, explicit answers must be provided to the four questions posed on page 2. Before any specific investigation of environmental decisionmaking can be begun, its general context must be understood. Accordingly, descriptions of the categories of environmental disruption and of the possible approaches to control will be supplied later in this chapter. Moreover, the next chapter will discuss current environmental regulations-—and reporting requirements thereunder—-as well as attempt to provide some feeling of where the U.S. is today, along the continuum from primitive environmental controls to mature ones. After the next chapter, the dissertation will focus more narrowly on environmental decisionmaking. At this point, however, a detailed preview will be made of the manner in which answers to the four basic questions will be obtained. Governmental decisions.——The study of decisions made at this level is crucial for two reasons. First, important environmental decisions are often made by government agencies and accountants may have a role to play with respect to the information required. Second, the study of governmental decisionmaking will provide a description of the overall context within which firms and individuals must make their decisions. This section will commence with a description of three economic models drawn from the recent economic literature. These models will be included in the dissertation to furnish (1) a conceptual lO foundation for discussing economic aspects of disruption and its abatement; (2) a basic for forecasting the effeCtiveness and efficiency of different control strategies; and (3) a concrete approach for evaluating individual benefits and costs of alternative environmental proposals. After these theoretical models have been presented, the numerous social, political, and economic constraints that face the governmental decisionmaker will be discussed. Following that, there will be an examination of the considerations underlying the develOpment of a theory of governmental, environmental decisionmaking. The use of benefit-cost analysis in the selection of public programs will be analyzed and a precise formulation of that method will be provided. 'In addition, a less-rigorous but possibly more-pragmatic approach to such decisionmaking will be outlined. The dynamic aspects of disruption control will also be covered, in terms of how government agencies can and must plan for changes in environmental regulations. Finally, attention will be given to the kinds of information needed for decisionmaking by federal and regional regulatory agencies. As a complement to the development of this broad, conceptual framework, a look will be taken at the activites <3f a particular agency responsible for maintaining air quality \Mithin a large metropolitan region. Based on the agency's Iniblished regulations and interviews with members of its staff, cxnnparisons will be drawn between the workings of the agency and the tmeoretical concepts presented earlier. 11 Decisions by firms.--The study of environmental decisionmaking by managers of private firms will be conducted in much the same manner as described above for governmental decisionmaking. Again, a conceptual structure, drawn from the literature in accounting and closely-related disciplines, will be developed. The basic objectives of firms will be examined first. Subsequently, the three general types of environmental decisions that firms must make will be delineated: \ 1. Choosing a target level of compliance with environmental regulations, 2. Selecting an approach to achieve compliance in a particular situation, and 3. Maintaining managerial control over environmental projects. After the natures of these decisions have been described, the information needs and problems of business managers will be considered. Finally, the alternative organizational structures that are being used for environmental decisionmaking will be reviewed. Following this presentation of theoretical and general notions, a close inSpection will be made of the environmental affairs of a large electric utility. Founded upon the firm's intermml.documents and in—depth interviews with accounting enui environmental managers, this case study will outline: 1. The firm's overall attitude toward disruption abatement; 12 2. The firm's management structure for making environmental decisions; 3. The Specific decision-model used by the firm; The methods used to maintain managerial control over the implementation of environmental decis1ons; 5. The characteristics of the firm's accounting system, with particular emphasis on the availability of information for environmental decisions; and 6. The ways in which the firm might match its information needs to potential information sources. Sulfur oxides.-—Although this dissertation deals with all forms of environmental disruption, the two empirical investigations (of a regional agency and of a large utility) will Specifically concern air pollution and its control. Two reasons dictate the narrowing of these case studies.. First, air pollution happens to be the only form of disruption regulated by the agency and the primary disruption problem of the utility. Second, this approach leads to an analysis that is probably more cohesive than would have been possible without the narrowing of the subject. In order to provide an even more direct link between ckecisionmaking at the governmental and firm levels, Specific ckacisions pertaining to the control of sulfur oxides will be eaxanfined closely in both case studies. In the chapter dealing wfirth.the government agency, the deveIOpment of National Ambient .Air‘ Quality Standards (by the Environmental Protection Agency) .as \Nell as specific, local compliance standards (by the regional agxnicy) will be analyzed. In the chapter concerning the utility fizvn, decisions about ways to meet specific sulfur oxides 13 regulations will be highlighted. Decisions by individuals.—-The final category of environmental decisions to be surveyed will be those made by individuals who use published financial reports. Drawing mainly upon reports prepared by authoritative bodies and recent literature pertaining to social auditing, a conceptual framework will be synthesized. This framework will describe the characteristics of users of financial statements, the types of environmental decisions they make, and their needs for information. Lastly, the role of attestation in furnishing users with information that they may rely upon will be examined from the standpoint of three different types of audits: financial, Operational, and social. Formulating conclusions.--This broad analysis of environmental decisionmaking will, in itself, furnish answers to the first two issues raised at the start of this chapter: the nature of environmental decisions and the kinds of information that are relevant. The remaining two questions will be addressed in the two concluding chapters of the dissertation: what information might the accounting function supply and the means and extent to which accountants could gather, report, and audit such information. In general, these conclusions will be drawn in either or both of two manners° One, the attributes of environmental information will be compared to characterizations of accounting information that have been presented in the literature. Two, the environmental reporting and systems 14 design tasks that are or must be undertaken by government agencies and private firms will be compared with activities traditionally included within the Accounting function. In these ways, it will be possible to Specify the potential scope of the accounting function as it pertains to environmental decisions. Research in Socio—Economic Accounting The subject matter of this dissertation overlaps, to some extent, the topic known variously as socio-economic accounting, social accounting, or social auditing. This subject has been widely discussed in the recent accounting literature and has generated a substantial amount of debate. In order that the present study's goals and methodology be most clearly understood, it seems imperative that the topic of socio-economic accounting be outlined and its connections to this dissertation be delineated. The nature of socio-economic accounting.--Professor Mobley, for one, has pointed out that accountants have not agreed upon a precise definition for socio-economic accounting. She uses the term to mean "the ordering, measuring and analysis of tme social and economic consequences of governmental and enitrepreneurial behavior."13 Dilley lists five categories of 13Sybil Mobley, "The Challenges of Socio-Economic Accxnxnting," The Accounting Review, October 1970, p. 762. 15 socio—economic accounting: "(1) the Application of Planning, Programming, Budget Systems (PPBS) to government and other non-profit entities, (2) a system of national 'Social' accounts, (3) the development of internal managerial social accounts, (4) social responsibility statements for external reporting and (5) independent audits of those statements."14 At the national-governmental level, socio—economic accounting may be generally characterized as an extenSion of national income accounting, designed to provide a more meaningful barometer of the nation's well-being than is presented by such narrow, economic indicators as gross national product. Indeed, some economists have proposed that GNP measurements be replaced by or supplemented with measurements of "net economic welfare."15 Furthermore, it has been proposed that certain psychological measurements be taken concerning "the aspirations, expectations, satisfactions, frustrations, attitudes, and values of the American population and of its major subdivisions."16 Such social measurements would potentially be quite valuable in the formulation of national social policies. Indeed, it is envisioned that a comprehensive social report to the President 1“Steven C. Dilley, Accounting for Externalities: Conducting a Social Audit and Preparing a Social Responsibility Annual Report for a Public Utility, unpublished doctoral dissertation, University of Wisconsin-—Madison, 1972, p. 70. 15Laird Hart, "'Stagflation' Reminds Economic Professors jHow Idttle They Know," The Wall Street Journal, September 9, 19749 p- 15- 16Angus Campbell, "Social Accounting in the 1970's," Michigan Business Review, January 1971, p. 6. 16 could well be prepared.17 In addition to measurements related to "net economic (or social) welfare," socio-economic accounting also encompasses the analysis of costs and benefits pertaining to individual government programs. Such work is performed at both federal and regional agencies. With respect to an individual firm, socio-economic accounting concerns multi-dimensional measurements of an entity's performance. The five dimensions proposed by the AAA's Committee on Measurement of Social Costs comprise: (1) financial performance, (2) human resource development, (3) public service, (4) environmental improvement, and (5) product quality.18 Methods have been proposed for preparing "social responsibility statements" which could be made available in much the same manner as are traditional, corporate annual reports.19 Some authors have urged that "social audits" of businesses be conducted in connection with furnishing "social responsibility" information to persons outside the firms. Such an audit might encompass the original preparation of a "social responsibility statement" by an interdisciplinary audit team, as 17Ibid. 18"Report of the Committee on Measurement of Social Costs," The Accounting Review, Supplement to Volume XLIV (1974), pp. 101-102. 19For instance, see David F. Linowes, "An Approach to Socio-Economic Accounting,” The Conference Board Record, November 1972, pp. 58-61. Also see Steven C. Dilley and Jerry Weygandt, Dkuasuring Corporate Social Responsibility: An Empirical Test," The Journal of Accountanpy, September 1973: Pp. 62-70. 17 has been suggested by Dilley and Weygandt. Alternatively, "social auditors" might attest, in a manner quite analogous to traditional, financial auditing, to a "social responsiblity report" prepared by the firm's own management. The concepts and issues related to social auditing will be examined more closely in Chapter VIII. The relationship of this study to socio-economic accounting.-—Since environmental quality is one of the dimensions of socio—economic performance; in a sense, the subject matter of this dissertation may be considered to be a prOper subset of socio—economic accounting. However, this study considers environmental decisions made at three levels (government agencies, business firms, and individuals); while most of the recent literature on socio-economic accounting, written by and primarily for accountants, has centered about the development and dissemination of reports on the social impact of corporate activities. Thus, the overlap of this study with the "main thrust" of the recent literature on socio-economic accounting pertains to reporting the environmental ramifications of corporate activities. In short, while this is not specifically a study of socio-economic accounting, that subject does have some important connections with this dissertation. With the tOpic and methodology of this investigation cltuzrly in mind, attention may now be directed toward develOping an.enmalytical framework for-the discussion of environmental decixsionmaking. This task will start with a consideration of the 18 different types of disruption and of the different approaches to their regulations. Types of Disruption and Abatement Classifying Forms of Disruption For the purposes of this dissertation, environmental disruption may be defined as any stress on a stable ecological system which ultimately has deleterious effects on humans. Although the following are not the only possible classification schemes for such stresses, they appear to be particularly useful for this study. Natural or man—made.--While many instances of environmental disruption occur in nature, the general concern here is with those instances that are either man—made or man-aggravated. Medium of disruption.--Probably the most widely-used classification scheme is one that separates environmental disruption into categories similar to the following: (1) air pollution, (2) water pollution, (3) solid waste disposal, (4) noise pollution, (5) visual pollution (scenic disruption), and (6) others.20 20Similar schemes are used by many authorities. For exanufle see Council on Environmental Quality, Environmental Quajjiqf-1970 (Washington, D.C.: U.S. Government Printing Office , 1970) . 19 Type of damage.--Environmental disruption may also be classified by naming exactly what is attacked or damaged.21 Some useful categories might be: (1) inanimate objects, (2) plants and animals, (3) human health and comfort, and (4) human aesthetic sensibilities. Possible Remedies Many different methods for reducing environmental disruption have been identified in the literature of both the physical and the social sciences. Certain methods that appear to be particularly relevant to this study will be introduced below. Analysis of these various approaches will continue throughout much of the dissertation. In particular, the economic models to be described in Chapter III will furnish a basis for discussing the relative economic merits of alternative abatement strategies. The information required for implementing these strategies will be examined in Chapter IV. Outright prohibition.--A particular type of disruption Inight be banned entirely, implying that either the production process would have to be modified so as to eliminate all disruption, or the process itself would have to be halted.22 21Ibid., p. 16. 22While the phrase "production process or consumption prtnzess" will be Shortened to "production process" throughout this semrtion, the reader should remember that the arguments apply to 21 consumption process also. 20 Many times, this second approach might be the only feasible way to comply with prohibition. Indeed, the ban is often placed directly on the process itself, as when prohibitions are made on the use of phosphate detergents or on trash burning by individuals, rather than on the resulting disruption. Restrictive standards.--Absolute prohibition may be viewed as a standard containing a 100% restriction. However, many proposed standards would not be set this high. Restrictions may be placed on certain inputs to a production process (input standards), or they may be placed directly on the disruption generated by the process (output standards). Regulations proscribing the use of high-sulfur fuels are applications of the former method, while restrictions on the quantity of sulfur oxides spewing forth from smokestacks are applications of the latter. Effluent charges.——One remedy widely recognized by economists would be to levy a tax on a producing or consuming unit based on the amount of disruption that the unit causes.23 This tax might be levied at a flat rate per unit of disruption, or at progressive rates. 23Similar charges might also be based upon inputs to the process. However, the effects of the two approaches are likely to be different as output changes would easily accomodate input substitution. Theoretically, charges based on cnrtputs are preferrable Since they are at least as efficient as chargfis based on inputs in all circumstances and they are more efficient in some. 21 Licenses.--A government agency might restrict a specific form of environmental disruption occuring within its jurisdiction by issuing a limited number of licenses or certificates, each of which would entitle the bearer to produce a predetermined amount of disruption.24 No disruption in excess of the total represented by the outstanding certificates would be allowed. Under one such scheme, the government agency would sell transferable certificates at an auction. These certificates could be either used or resold by the purchaser. Alternatively, some plans call for the use of non—transferable licenses. SubsidieS.--A government may use direct payments as an incentive to producers and consumers for reducing their disruption. Although all such payments will be classified as "subsidies" in this analysis, they may take a number of different forms such as grants, tax credits, or tax deductions. These subsidies might be based on such considerations as investment in disruption abatement facilities, reduction in certain inputs to the production process, or reduction in the amount of disruption actually caused by the process. Many plans for rates and.other conditions for these subsidies are possible. Specific legal action.——Legislation could be enacted--the “Licenses may be viewed as a combination of restrictive stzuidards and effluent charges. 22 25 state of Michigan has already done so --to encourage damage suits by individuals or governments, or as a class action which permits one individual to bring suit on behalf of himself and all others similarly damaged. Furthermore, the legal liabilities of disrupters could be more precisely delineated by statute. A summary of the kinds of environmental disruption and the alternate approaches to their abatement was presented in the above paragraphs. The next chapter will examine the development of the regulations that are currently in force. 25Michigan Public Act 127 of 1970. II. THE CURRENT STATUS OF DISRUPTION ABATEMENT In order to provide a basis for discussing decisions about environmental disruption, it is necessary to examine the present scope of control. In particular, this chapter will analyze the following topics: (1) the historical development of disruption abatement programs; (2) the major types of abatement legislation in effect today, and the administrative regulations and reporting requirements thereunder; and (3) the transition from primitive controls to the future state of nature and comprehensive controls. The Historical Context Although environmental disruption became a major, national issue in the mid—1960's, certain serious disruption problems have been recognized for centuries. Contamination (of the drinking water was a widespread problem during the Iniddle ages, and the London typhoid epidemics in the nineteenth century led to the first concerted attack on such disruption.1 Smoke—filled air in heavily-industrialized regions has been 21 public health problem since, at least, the latter part of that 1U.S. Council on Environmental Quality, Environmental Qualiiyf-1970 (Washington: U.S. Government Printing Office, 1970), :p. 29. This publication appears annually. 23 24 century.2 In 1948, a prolonged air pollution condition in Donora, Pennsylvania caused twenty deaths and nearly Six thousand cases of illness.3 That incident dramatized the problem of pollution and appears to have hastened federal action. For over a hundred years, conservation groups in this country have fought to preserve natural mineral and wildlife resources. It seems reasonable to view the development of environmental disruption into a national political issue during the past decade as having been founded upon several intertwined factors. Air and water pollution was long regarded as a purely local or regional problem. Within the last twenty years, however, there has been a gradual acceptance by the public, the Congress, and the Federal administration of the national scope of disruption abatement. In part, this changed attitude was due to a growing perception both of the pervasiveness of environmental disruption and the interrelationships among its various forms. Important too was the general expansion of federal programs under a Congress and an administration controlled 5 by Democrats during the Kennedy and Johnson years. 2In 1881, the Chicago City Council adopted an ordinance declaring that dense smoke emitted from any boat, locomotive, or chimney was a public nuisance. J. Clarence Davies III, Egg Politics of Pollution (New York: Pegasus, 1970), p. 33. 31bid., p. 34. “Environmental Quality--1970, p. 6. SSee James L. Sundquist, Politics and Policy: The IgisenhoweryKennedy, and Johnson Years (Washington: The IBrbokings Institution, 1968)Tespecially chapter VIII. 25 During this period, pollution began to be recognized as a public nuisance whereas formerly it had been usually classed as either a public health hazard or a "conservation" problem.6 Lastly, significant interactions were identified among disruption and its abatement and such national economic goals as full employment and sustained growth of the Gross National Product. One effect of these combined factors has been the application of a "systems approach" to the study of environmental disruption, wherein individual forms of disruption are treated as components of a larger, more general problem. This systems viewpoint has led to the identification of numberous forms of disruption in addition to water and air pollution, although those two forms remain the most severe and most studied. Accordingly, an analytical chronology of federal involvement in water and air pollution control will be presented at this point. Since Federal programs dealing with air pollution typically have followed and have been patterned upon Similar programs dealing with water pollution, Federal actions in 7 water pollution control will be discussed first. Water pollution abatement legislation.8--Before 1948, 6Ernest Boyce, "Air Pollution-—Nuisance or Hazard," IWichigan Business Review, May 1973, pp. 1—5. 7Davies, pp. cit., p. 37. 8This section is based largely upon the previously-cited \Norks by Davies and by Sundquist. 26 control of water pollution rested almost entirely with states and localities. Over a long period prior to this time, responsibility for control of water quality had slowly passed from municipalities to regional boards and state agencies. The impetus for this shift was the typical city's inability to control upstream sources of pollution and its disregard for downstream water quality. Within this era, only two minor federal acts were legislated to deal with water pollution. The "Rivers and Harbors Act" was intended to prevent the dumping of debris into interstate waters.9 Although recently used by the Nixon administration as a means of regulating the discharge of pollutants into waterways, the act was originally intended to enhance water navigability, not cleanliness. The "Oil Pollution Act," a largely ineffective piece of legislation, 10 In prohibited the leakage of oil from oceangoing vessels. the 1930's, the Public Works Administration provided assistance for the construction of municipal waste treatment facilities, but this activity did not result from pollution control legislation.11 In 1948, the federal government became involved explicitly with water pollution abatement. The "Water Pollution 930 Stat. 1152. 1OThe Oil Pollution Act, 1924, 33 U.S.C. 431, pp seg. 11Sundquist, pp. 01t., pp. 323-24. The years of this Inxagram, approximately 1933-39, were the only pericd since 1900 vfllen.the municipal waste treatment plant constructlon matched population growth . 27 Control Act12 " contained provisions for federal research programs, research grants to the states, grants for the planning of sewage treatment plants and low—interest loans to finance their construction, and federal intervention in pollution abatement programs. This last provision, however, while empowering the Public Health Service to hold hearings and issue recommenda- tions, permitted federal enforcement only with the permission of the affected states.13 In anticipation of the renewal of the 1948 act, President Eisenhower proposed to Congress that the enforcement provisions be strengthened. The long congressional deliberations and the final passage of forceful 14 amendments to the 1948 act constituted a significant milestone in the trend toward federal action for disruption control. Davis reports that The new provisions represented a compromise between the Department of Health, Education, and Welfare . . . and the state health agencies. They provided for a conference among the interested parties, a public hearing if the conference did not result in action within six months, and then another six-month waiting period, after which the case could be taken to court. This became the basic pattern for Federal enforcement in both air and water pollution.‘1 12P.L. 80—845. 13As reported in Sundquist, pp, cit., p. 324. Also, funds for the loan program were never apprOpriated. 14Water Pollution Control Act Amendments of 1956, PoLo 84-6600 15Davies, pp. cit., p. 41. Emphasis added. 28 While the 1956 amendments retained the state consent provision, additional amendments passed in 1961 removed that provision and extended jurisdiction of the federal government to all navigable waters. These later amendments further provided for an increased grant program and appropriations were subsequently authorized.16 Early in 1963, theSenate Subcommittee on Air and Water Pollution was formed under the chairmanship of Senator Edmund Muskie of Maine. In 1965, the "Water Quality Act," which had been vigorously promoted in the Senate by Muskie and in the House by Representative John Blatnik of Minnesota, required the states to establish adequate water quality standards or have federal standards imposed. The Clean Water Restoration Act, passed in 1966, provided massive grants for the construction of waste treatment plants and provided quality standards for the bodies of water receiving the discharge of such plants.17 Sundquist comments that Only six years after President Eisenhower had vetoed a . . . bill on the ground that water pollution was "a uniquely local blight," the CongreSS--without a dissenting vote in either House--had approved a program of full national leadership . . . with an ultimate spending rate twelve times as great as the level contemplated in the 18;pip.. pp. 41—43. Davies describes P.L. 87-88. A 21milar bill had been vetoed by President Eisenhower in 19 O. 17Sundquist, pp. cit., chapter VIII. 29 vetoed bill.18 The "National Environmental Policy Act," while not limited to the control of water pollution, established a national policy for environmental quality."19 One important provision of that act was the requirement that all proposed Federal activities that might have a Significant effect on the environment must be supported by an environmental impact statement.20 Furthermore, all Federal agencies were directed to "utilize a systematic, interdisciplinary approach which will insure the integrated use of the natural and social sciences and the environmental design acts in planning and in decisionmaking which may have an impact on man's environment."21 AS a complement to the formulation of a national policy, this act also created the Council on Environmental Quality. The "Water Quality Improvement Act of 1972" provided for stricter controls over oil pollution, pollution from ships, and pollution from federal activities.22 In October 1972, Congress passed a complete revision of the "Water Pollution 18Ibid., p. 367. 19P.L. 91—190. 20 Ibid., Sec. 102 (C). 21Ibid., Sec. 102 (A). 22P.L. 91—224. Environmental Quality-_197o, p. 44. 30 Control Act" over a veto by President Nixon.23 The revised act supercedes the original 1948 act as amended in 1956 and by the "Water Quality Act of 1965," the "Clean Water Restoration Act of 1966," and the "Water Quality Improvement Act of 1970." Title IV of the current statute, "Permits and Licenses," apparently replaces the discharge regulation procedures adopted by the Environmental Protection Agency pursuant to the "Refuse Act of 1899." Air pollution abatement legislation.—-Increasingly troublesome smog problems in Los Angeles during the late 1940's along with the Donora incident in 1948 seem to have triggered Federal efforts for achieving air quality. However, Specific Federal air pollution legislation was not enacted until 1955.24 That act provided funds to enable the Public Health Service to engage in research and technical assistance to states and localities.25 Another eight years passed before the first permanent legislation for the control of air pollution, the Clean Air Act of 1963, was adopted. The Clean Air Act established a formal procedure for Federal intervention 23"Federal Water Pollution Control Act Amendments Of 1972’" P.L. 92-5000 2”P.L. 84-159. 25Environmental Quality-—1970, p. 73. 26P.L. 88-206. 31 in interstate air pollution problems and, upon request from the State concerned, in intrastate problems as well. The long delay in enacting such legislation was due in considerable measure to the fact that air pollution had been widely perceived as a strictly local problem in which few cases of poor air quality were caused by pollution originating outside the affected geographical region.27 The Motor Vehicle Air Pollution Control Act, passed in 1965, authorized the Department of Health, Education, and Welfare to promulgate emission standards for new motor vehicles.28 Davies reports that "the automobile industry did not object strongly, because it feared fifty diverse state standards far more than a uniform Federal Standard."29 Current Federal action in the abatement of air pollution, aside from regulation of motor vehicle discharges, is based largely upon the Air Quality Act passed in 1967. That legislation set forth a method of Federal—State cooperation in developing standards and enforcement plans for air quality 30 regions. 27Davies, op. cit., p. 51. 28Title II of P.L. 89—272. Title I contains several slight amendments to the Clean Air Act of 1963. Title III is the Solid Waste Act. This description is based on ibid., p. 50. 29Ibid., p. 54. 30EnvironmentalQuality—4970: pp. 73—74. 32 The "Clean Air Amendments of 1970" authorized the Environmental Protection Agency to develop National Air Quality Standards.31 Those amendments also furnished a procedure for the States to develop plans for attaining the national standards within their own boundaries and to submit their plans to the EPA for approval. Federal efforts to control other forms of environmental disruption.-—Although water pollution and air pollution are widely considered to be ppp major disruption forms, many other do exist and Specific action has been taken by the Federal government to control certain of them. In 1965, the Solid Waste Disposal Act was adopted. This ‘ legislation made funds available for research, training, and demonstrations of new technology in solid waste disposal. Included also were grants for state and interstate solid 32 waste planning programs. In 1970, the Resource Recovery Act, providing for demonstration grants for the deveIOpment of solid waste recycling systems, was passed. This legislation also authorized the Environmental Protection Agency to deveIOp guidelines concerning both the construction and the running of solid waste systems either operated by a Federal agency or 31P.L. 91—604. 32P.L. 89-272. Environmental Quality——1970, p. 118. 33 developed as a Federally-funded demonstration project.33 A major reason for a restricted Federal role in this area is that I Unlike air and water pollution, which can befoul even distant areas, solid wastes harm only the immediate surrounding area. Thus, solid waste mismanagement primarily affects the area where wastes are dumped and 34 secondarlly the community from whlch they are collected. Federal as well as State assistance is required, however, in order to achieve COOperation among localities. Cities face two increasingly troublesome disposal problems: (1) landfill sites are becoming difficult to find and skyrocketing land values often nearly price the available Sites beyond a municipality's budget, and (2) given the level of air pollution control now required, the cost of running municipal incinerators has likewise soared.35 Obviously a special problem, the disposal of radioactive wastes had long been regulated by the Atomic Energy Commission. More recently comprehensive authority for the development of plans and environmental standards for all toxic wastes has been vested in the EPA.36 Federal action to control disruption from the introduction 3342 U.S.C.A- section 3251 pp seg. Environmental Quality—— 1971. p. 16. 34Environmental Quality-~1970, p. 119. 35Ibid., p. 120. 36Environmental Quality—-1971. pp. 16—17. 34 of pesticides into the environment began in a meaningful way with the 1954 amendments to the Food, Drug, and Cosmetic Act. These amendments authorized the Food and Drug Administration to determine safe limits for the amounts of pesticides remaining, at the time of sale, in agricultural products to be used as food for humans or animals. The Federal Insecticide, Fungicide, and Rodenticide Act requires all such substances sold in interstate commerce to carry warnings to prevent injury to persons. If labeling cannot assure a substance's safe use, it cannot be sold.37 Although this Act was passed in 1947, it did not become an important device for environmental control until 1971 when a Federal Appeals Court declared that "Congress intended any substantial question of safety_to trigger the issuance of cancellation notices," which would prohibit interstate Shipment of the substance in question.38 Pursuant to this court decision, the EPA began issuing cancellation notices for a number of pesticides, requiring that hearings be held concerning their safety. Subsequently,Congress passed the "Environmental Pesticide Control Act of 1972" which amends and strengthens the earlier "Federal Insecticide, FUngicide, and Rodenticide Act." In particular, these amendments require the registration of all pesticides, regardless of whether they are 39 used in interstate commerce. 37Environmental Defense Fund v. Ruckelshaus, 439F. 2nd 584 (D.C. Cir. 1971). As quoted in ibid., p. 15. 38Environmental Quality——1971. p- 15- 39P.L. 92-516. 34 of pesticides into the environment began in a meaningful way with the 1954 amendments to the Food, Drug, and Cosmetic Act. These amendments authorized the Food and Drug Administration to determine safe limits for the amounts of pesticides remaining, at the time of sale, in agricultural products to be used as food for humans or animals. The Federal Insecticide, Fungicide, and Rodenticide Act requires all such substances sold in interstate commerce to carry warnings to prevent injury to persons. If labeling cannot assure a substance's safe use, it cannot be sold.37 Although this Act was passed in 1947, it did not become an important device for environmental control until 1971 when a Federal Appeals Court declared that "Congress intended any substantial question of safety to trigger the issuance of cancellation notices," which would prohibit interstate shipment of the substance in question.38 Pursuant to this court decision, the EPA began issuing cancellation notices for a number of pesticides, requiring that hearings be held concerning their safety. Subsequently,Congress passed the "Environmental Pesticide Control Act of 1972" which amends and strengthens the earlier "Federal Insecticide, FUngicide, and Rodenticide Act." In particular, these amendments require the registration of all pesticides, regardless of whether they are 39 used in interstate commerce. 37Environmental Defense Fund v. Ruckelshaus, 439E. 2nd 584 (D.C. Cir. 1971). As quoted in ibid., p. 15. 38Environmental Quality-—1971, p. 15. 39P.L. 92—516. 35 Noise pollution is another disruption problem that has been left largely in the hands of State and local governments. The Council on Environmental Quality reports that while non-Federal laws to regulate noise are abundant, they are largely ineffective due to their limited scope or lack of enforcement provisions. "Qualitative" standards, prohibiting noise that is deemed to be "excessive," can generally be enforced only when there are Specific complaints from citizens. "Objective" standards, prohibiting noise that exceeds a certain decibel level, apprOpriately measured, requires expensive equipment and trained personnel for enforcement. Moreover, many technical measurement problems impede such controlf‘LO Federal action in this area began in 1969 when the Department of Labor issued standards that set allowable limits for noise pollution affecting workers. Later that year, regulations to control aircraft noise were announced by the Department of Transportation pursuant to provisions contained in Public Law 90-411 which had been passed during the preceding session of Congress.b'l The Department of Housing and Urban Development established in 1971 tolerable noise limits for housing units it helps finance. These rules also serve to prevent HUD from financing buildings in locations which 0 I I 42 have or are prOJected to have excess1ve n01se levels. uoEnvironmental Quality-—1972, pp. 208—10. 1+1Environmental Quality-~1970, p. 129. qunvironmental Quality--1972, p. 133. ‘36 The "Noise Control Act of 1972," while stressing the basic role of State and local governments for controlling noise, extends Federal activity in this area.43 Federal agencies which have authority over facilities generating noise are required to establish and enforce noise control standards. Such actions are to be coordinated by the EPA. Moreover, the EPA is instructed to develop regulations concerning the noise levels of the following types of equipment: construction, transportation, electrical or electronic, and all motors. In addition to the Specific laws and administrative procedures described above, the Federal government has sponsored environmental research of a wide—ranging nature. Most of these studies are now supported and supervised by the Environmental Protection Agency. Reporting requirements under existing legiSlation.--One conclusion that may readily be drawn from the preceding description of Federal disruption—abatement actions is that the general approach to control depends greatly upon Federal—State COOperation. With some notable exceptions such as reports on emissions tests of new automobiles and on construction and Operation of nuclear—powered electricity generating plants, the Federal government requires very little from individual firms, in the way of environmental reports. Since State governments bear primary responsibilities for implementing 43P.L. 92—574. 37 programs for attainting environmental quality, most required reports must be filed with State or local agencies. In Michigan, for example, many firms must file an annual "Air Pollution Reporting Fbrm"44 and similar reports dealing with water pollution.45 At both the Federal and State levels, agencies whose primary area of concern is not pollution, do require various types of environmental reports from specific categories of firms that are under their jurisdiction. Some of these reporting requirements will be discussed in Chapter VII (as they pertain to an electric utility) and in Chapter X (as they pertain to attestation by the independent accountant). Distingpishinngetween the Current, Transitional Period and the FUtureprature State In considering his available options, the environmental decisionmaker, either within a government agency or within a private firm, must use considerable foresight. In particular, he must realize that today's situation is one of great flux and that future environmental disruption abatement needs and standards may be quite different from those now in effect. A longerange planning horizon for environmental quality is dictated by two considerations. First, there is substantial lag (or, more accurately, series of lags) between the time an environmental nuMichigan Air Pollution Control Commission Form AP—100. 1+5Michigan Water Resources Commission Forms EDF and WRC-S o 38 problem is recognized and the time when abatement regulations become effective. Most problems require lengthy research and analysis before specific control standards can be formulated: the harmful effects from the disruption must be clearly identified and then quantified, the human costs Of the effects must be estimated, and a control strategy must be develOped. While lags Of this sort obviously affect government decisionmakers in a very direct way, such lags must also be considered by managers of firms. In deciding upon methods of complying with environmental standards, business firms must recognize potential future regulations and incorporate them into the analysis. Emerging areas Of environmental concern must be studied so that the approach to compliance taken by the firm will be satisfactory over the long run. The second consideration necessitating a long—range planning horizon is the fact that many control strategies require intensive capital investment. Once a firm embarks on such a course it may become quite difficult or costly to change either the levels or the types Of control being used. These problems are compounded for decisionmakers Operating today because the current situation with respect to environmental disruption is probably different from what will be the situation a few years hence. Differences between the current period and what might be termed the future "mature state" have important implications for both decisionmakers and accountants. In particular, accountants must be careful not to promulgate reporting standards tO be used in the future which are based 39 solely on characteristics Of the current situation. Thus, distinctions between today's circumstances and those Of the future will now be drawn. The currentgperiod Of transition.--The present situation may be characterized as one Of transition from primitive controls to comprehensive and intense controls. Prior to the mid—1960's, environmental regulations consisted of a number Of rules formulated by various agencies at the Federal, State, and local levels Of government. Typically, these rules were developed on an pp ppp basis and, thus, were designed to deal with a specific, and narrow, range of environmental concerns. NO overall framework for concerted government or private action was available. As the early part Of this chapter shows, the Federal government began to accept a major role in and develop a coherent strategy for the abatement Of environmental disruption around 1955. One might view the decade following 1955 as the period Of growing acceptance of the Federal role in abatement and starting to develop a national strategy. Similarly, the following decade, Of which we are now nearing the end, may be viewed as the period of defining and implementing national environmental strategies. Indeed, 1975 appears to be the target date for full applicability Of National Primary and Secondary Standards for air and water pollution. What are the distinguishing characteristics Of this current, transitional era? First, environmental decisionmakers at all levels now face large uncertainties such as those 4O concerning the natures Of disruption problems, the physical Size and social importance Of costs and benefits pertaining to abatement, and the effectiveness Of certain control techniques. Second, the trend toward acceptance, by American corporations in general, Of some degree Of "social reSponsibility" represents either a new or a greatly-expanded goal or constraint for the business manager. Third, government agencies are experiencing considerable problems in administering their regulations. Often, these agencies are understaffed, reporting techniques are inadequate (and audits are infrequent or non-existent), and inspection and evaluation methodologies are rudimentary. Fourth, many Of the disruption controls that have been installed to date represent modifications to existing buildings and equipment. The future: a "mature state."--In contrast to the uncertainties and rapid changes of the current period, the years following 1975 will witness the gradual maturation Of environmental controls. During this future era, decisionmaking will be quite different from that at present. With the availability of a large data base reflecting actual experience, less uncertainty will surround the analysis Of new disruption forms and new abatement techniques. Moreover, after an initial ;periOd Of "refining"--by government agencies and the Congress-- enviipnmental goals and standards, corporate decisionmakers stunxld face fewer abrupt changes in regulations. The enlarged (Lata base combined with a relatively-stable regulatory framework wiJLL permit environmental decisionmaking to be far more orderly 41 a few years hence than it has been in the recent past. Increased production costs from abatement equipment or effluent charges or both will have resulted in the closing Of marginal plants. In its 1972 report, the Council on Environmental Quality summarized several microeconomic studies Of major industries. These reports contain projections Of future cost increases due to environmental controls and the microeconomic ”6 The Council concludes that impact of such cost increases. "the long-run viability of no industry is seriously threatened solely by the pollution abatement costs estimated."47 Those plants that remain will be larger, newer, and more efficient than those that will have been forced to close. (One tentative inference which may be drawn from all this is that there will likely be increased barriers to entry into these industries. The resulting costs in terms Of an increased degree of monopoly or oligopoly cannot be reasonably estimated and appear not to have been considered by the Council.) New plants which will be built will be designed and constructed with ecology Specifically in mind. Hence, abatement equipment and methods will generally be built-in rather than added-on. As a result, it Often will be nearly impossible to separate out the cost of pollution abatement activities other 'than.by using some arbitrary, and therefore useless for 46Environmental Qualit -—1972, pp. 287-301. 47Ibid., p. 287. 42 48 decisionmaking, basis Of allocation. This situation corresponds precisely to present circumstances in which, for example, the cost of providing for the safety of workers Often cannot be separated from plant and equipment costs. Just as it may now be impossible to purchase a circular saw without a blade guard or safety clutch, so it may become impossible in the future to Obtain a blast furnace with nO pollution controls. The abatement equipment will be incorporated in the basic design of an improved modern mOdel. The unavailability of specific cost information should pose no substantial problem, however, since the cost Of environmental disruption will have become largely internalized, that is, borne by the disrupter. Despite the differences examined above, the need to continue tO improve the administration of standards is a problem that will surely carry over from the current era into the future steady state. Again, the availability Of a large, historical data base, provided that it is managed adequately and used effectively, will make it possible to refine overall environmental standards, discover lower-cost solutions for achieving them, and improve both the economic efficiency and the equity of disruption controls. In order to develop a conceptual framework for discussing environmental decisions, this chapter has examined the development Of abatement regulations, reporting requirements under those regulations, and the differences between the current, transitional “BSee Environmental Quality-~1973, p. 89, for an example Of this difficulty. 43 era and the future, "mature state." In the next chapter, the economic aspects Of disruption and its control will be inspected from a theoretical viewpoint. III. THE ECONOMIC FRAMEWORK This and the next two chapters will be devoted to en- vironmental decisions made by government agencies. The direct purpose of this discussion is the specification of information needed by government agencies to formulate, implement, and ad- minister remedies for disruption. The indirect, although equal- ly important, purpose is the demarcation of the context within which decisions must be made by firms and individuals. Since a particular decision cannot be scrutinized meaningfully unless its constraining parameters are specified, it is necessary to examine decisions of government agencies before those of firms and individuals. In this chapter, the economic framework germane to the environmental decisions of governmental agencies will be re- viewed. Theoretical economic models drawn from the recent literature will be presented to furnish (1) a foundation for discussing economic aspects of disruption and its control, (2) a basis for forecasting the effectiveness and efficiency of different regulation strategies, and (3) a concrete method- ology for evaluating individual factors under benefit-cost analysis-~the basic method by which government agencies can select among alternative environmental proposals. (The in- formation required as inputs to these models will be delineated in the next chapter, following a detailed inspection of the 44 45 benefit-cost model.) After the presentation of these specific models, the practicalities Of the ”real world" decision setting will be analyzed: what are the economic, political, and social constraints that affect which remedies will be applied to whom and by whom? This analysis will consist of an interpretive review of the relevant public finance literature. Economic Theories of Environmental Disruption When the environmental disruption problems and possible remedies mentioned in Chapter I are investigated in order to develOp the most effective solutions, two serious conceptual obstacles appear. Both of these stem from the interrelationships among various types Of disruption and their means of control. The first obstacle is the condition where the control of one type of disruption leads to a change in the amount of another type. It may be illustrated by a situation where certain harm- ful particulates are emitted from the smokestack of a manufac- turing plant. One possible way to reduce such emissions might be to "wash” the smoke in some way. While such a method might well reduce air pollution, it will also increase water pollution. Similar interdependencies pervade disruption abatement tech- nology. The second Obstacle is the need to decide the extent to which pppp particular type of disruption (and each specific kind.of source for each type) is to be reduced. For example, :mrppose that in addition to being emitted from smokestacks, the harmful particulates referred to in the previous illustration 46 are also present in the exhaust from automobiles. In this setting, some decision must be reached as to the appropriate level of control for each source. Although it seems ridiculous to attempt to restrict particulates from smokestacks completely while ignoring those discharged by automobiles, the alternative which consists of attempting to apply the same level of control to each source may be neither feasible nor desirable. No other Specific solution is Obvious. This difficulty becomes even more bothersome when additional harmful substances are considered simultaneously. The control level for particulates cannot be considered separate from the control levels for other pollutants, such as nitric oxides and hydrocarbons, which are also present in smokestacks and exhaust pipes. These interrelationships present compelling reasons for establishing a broad model for studying remedies for envi- ronmental disruption. Without such a framework, truly adequate decisionmaking is impossible. Many control measures which have already been implemented have been developed on an pp ppp basis, that is, solutions to specific problems have been adopted without sufficient consideration of them within a general framework.1 As more regulations are designed, it will become increasingly necessary to base them upon a theoretically-sound model of 1Although economists seem to have a disdain for non- optimal solutions and rightfully point out the fallacies of "second-best, " an optimality fixation would be irrelevant here: ‘Use of the ad hoc procedure, currently and in the recent past, may be justified on two grounds. First, resolution of environmen- tal disruption problems has been so urgent that some steps were required, even before a general approach could be developed. Second, partial abatement of the most damaging sorts of disruption would.almost certainly have been decided upon if a theoretically optional approach had been used. 47 environmental disruption. Intuitive approaches, or those derived within the context of a narrow framework will not suffice. Some approaches toward structuring a model for the control of environmental disruption which have appeared in the economic literature will be discussed in the following pages. The Static Microeconomic Apppoach Economists generally regard environmental disruption problems as a special case of economic externalities. An economic externality occurs when one individual's production or consump- tion has an unintended or incidental impact on another indivi- dual's production or consumption. This "spillover" effect may benefit others (an external economy), as when landscaping done by one homeowner adds to the attractiveness of the neighborhood as a whole. Conversely, the "spillover" effect may harm others (an external diseconomy), as when a steel plant emits particulates into the air, thus creating soiling and health problems for nearby residents. In the presence of an economic externality the "private" cost borne by the original producer or consumer diverges from the total "social" cost borne by society as a ‘whole.2 2On occasion, the term "social cost" is used rather Iloosely. As stated above, the social cost of producing an item“ fbr example, includes both the private costs to the pro— (ricer plus any additional costs borne by other members of society. "Social cost" is not synonymous with "cost not borne by the producer" or "external cost". Thus if social costs are added to private costs, these private costs will be double-counted. For instance, the manufacturing costs incurred by the steel company in the example above do not include the costs of the neighOors' sufferings. From society's vieWpoint, steel is un- derpriced. This situation is illustrated, for a purely compe- titive steel industry, in the following graphs: 3 5 MSC=MPC+MHq D 32 MH q p _____ ,_ ———.—.—-—.__ —————— 2 31 I P1 *""— '—"'“ — “ “ "'I " " ” "_"— MPC ' l I ' I l l Units q2 q1 Units The Steel Industry A Specific Firm These graphs are drawn in the usual way, with dollars per unit of steel shown on the vertical axis and the quantity Of steel on the horizontal axis. D represents the demand for bricks. Under purely competitive conditions; Si represents the existing supply of steel, while 82 represents the supply which would exist if the externality were internalized, that is, if the supply were based upon total social cost. MP0 is the mar- ginal private cost of producing steel, MHq is the marginal amount of harm done to other members of society by the production of steel, and NSC is the total cost to society of producing steel. The equilibrium price and quantity for steel produced by a 49 specific firm are designated p1 and q1 respectively. If for some reason pollution abatement is not possible, then p2 and 92 represent the optimal price and quantity, from society's viewPoint.3 Closely related to the concept of economic externalities is the notion of collective consumption goods. Samuelson describes these as goods "which all enjoy in common in the sense that each individual's consumption of such a good leads to no subtraction from any other individual's consumption of that good."u Furthermore, there is no way to exclude anyone from the consumption Of such a good. Thus, if each individual is to be taxed according to his stated desires, he will be inclined to understate his preference for a good of this type. He will be able to consume all that is available regardless of what he proclaims his wants to be.5 From an analytical standpoint society's demand curve for a collective consumption good must be derived by adding individuals' demand curves vertically instead of horizontally as would be done with non-collective 3More realistically, if the firm is forced to abate some of its pollution, the NFC curve will move upward. At the same time, the MH curve will shift downward since other individuals will not be Harmed as much as they had been. When the firm is abating that amount of pollution which will cause the MSC curve to drop to its lowest level, then it will be producing the optimal number of bricks from society's vieWpoint. That number will be somewhere between ql and q2. This analysis aSsumes, of course, that all other conditions for Pareto optimality are fulfills “Paul A. Samuelson, "The Pure Theory of Public Expenditure," The Review Of Economics and Statistics, XXXVI, No. 4 (November, 195 ) p. 387. 51b1d., pp. 388-89. 50 goods. This type of analysis is relevant to environmental decisions since disruption abatement may be considered as a collective consumption good. To apply these concepts more precisely to environmen- tal disruption problems, several authors have used a struc- ture similar to that shown in the following graph:6 3 MB (Marginal benefit to the firm a// from disrupting) MHa (Marginal harm or I disutility to . society from , disrupting) l 85* 81 Amount of disruption Under certain general assumptions the "Pareto-optimal" amount of environmental disruption is at, corresponding to the point at which the marginal benefit and the marginal harm are equal.7 _The MB curve may be viewed as the demand for the "right 6For instance,see Allen V.Kneese, "Rationalizing Decisions in the Quality Management of Water Supply in Urban- Industrial Areas," in The Public Economy of Urban Communities, ed. by Julius Margolis (Baltimore: Johns Hopkins Press, 1965). 7An economic state is said to be ”Pareto-optimal" if no increase in any consumer's utility or any producer's profit may be obtained without a concomitant decrease in at least one other party's utility or profit. See, for example, Josef Hadar, Elementapy Theory of Economic Behavior (Reading, Mass: Addison- Wesley, 1966), pp. 285481. The concept of “Pareto-optimality" ignores income distribution. 51 to disrupt," while the MHa curve may be interpreted as the supply. Since at the present time, however, few legal "rights to disrupt" have been clearly established, the true supply curve is often a vertical line representing the maximum amount of disruption physically possible. This line probably lies so far to the right or point a* in the diagram above that it does not even intersect the MB curve. In this case, the firm disrupts until there is no marginal benefit from doing so (at point a1); from the firm's vieWpoint, the ”right to disrupt" is a free good.8 Under this approach, the solution to environmental disruption problems consists of making the firm reduce its disruption from al to a*. For instance, an pp valorem tax equal to MHa may be imposed, thus causing the external diseconomy to become "internalized," that is, borne by the firm. In order to implement such a strategy, the government decisionmaker must know the location of the MHa curve. In addition, the private firm must know the position of its MB curve. Aggrpgative Approaches While the model described above seems to be valuable 8The role of laws regarding property rights and liability for damages caused by disruption has received considerable interest by economists interested in economic externalities. Property rights are examined closely in J. H. Dales, Pollution, Propertyl_and Prices (Toronto: University of Toronto Press, 1968). Legal liability is discussed in a famous article by R. H. Coase, ”The Problem of Social Cost," Jpprnal of Law and Economics, Vol. 3, No. 2 (October 1960), pp. 1-44. 52 for analyzing environmental disruption with respect to individual consumers, producers, or industries, it--or any other micro- economic model, for that matter--ignores macroeconomic consequences of disruption and abatement such as changes in the general price level, unemployment, consumption, investment, government spending, and income distribution. Thus, a strictly microeconomic approach is an inadequate basis for developing national (and global) strategies for protecting the environment. While many macroeconomic models have been suggested as foundations for environmental analyses, three of them appear to be especially useful and will accordingly be described below. The "disproduct" approach.--The first of these macro models centers about the notion that Net National Product, as it is now formulated, ignores the environmental deterioration that accompanies economic activity and therefore overstates the value of the goods and services produced. Accordingly, misleading inferences about changes in economic welfare might be drawn from NNP statistics. Recommendations have been made for the calculating of a more meaningful "measure of economic welfare" by adjusting NNF’for such disamenities as pollution and by making certain other modifications.9 This concept of MEW (Measure of Economic Helfare) could become embodied in the conventional macroeconomic framework just as GNP has been. 9Kenneth Stewart, "National Income Accounting and JEconomic Welfare: The Concepts of GNP and MEN," Federal Reserve Bank of St. Louis Review, April 1974, pp, 18-24. 53 The "ipput-output" approach.--Another aggregative model which may prove useful for investigating environmental problems consists of an extension of the familiar Leontief input-output analysis.10 Under this approach, the national economy is subdivided two ways: (1) "input sectors" which comprise productive industries, pollution released by the productive processes, and laborll; and (2) "output sectors" which comprise productive industries, pollution abatement industries, and households (which are also referred to as the "final demand" sector). This analysis centers around "technical coefficients," that is, the number Of units required from each of the "input sectors" in order to produce one unit in each of the "output sectors," other than households. Within this framework, once a list of final demands by households has been established, the required output in each of the other sectors is determined. Relative prices of all goods produced as well as employment in all sectors may also be derived from the analysis. A sample input-output system is described in the appendix to this chapter. The literature on Leontief input-output systems is quite extensive; the simple model develOped in the appendix may be extended in many different ways such as constructing a 10Wassily Leontief, "Environmental Repercussions and the IEconomic Structure: An Input-Output Approach," The Review of ggponomics and Statistics, LII, No. 3 (August, 19707: pp. 262-71. 11To be more precise, labor should be replaced by "value- :mdded," that is, all production costs other than inputs from other jproductive industries or pollution. See ibid., p. 265. 54 a dynamic model or including the possibility of partial 1- abatement of disruption by the productive industry itself._? The "materialsébalance" approach.--The final model to be considered here has been developed largely by Allen V. Kneese and his associates at Resources for the Future.13 This approach is based upon the physical "law of conservation of mass, which states that in a chemical changes mass is neither created nor destroyed to any appreciable extent.1 121t is interesting to note that the Leontief model may be useful in an additional way. To the extent that accounting draws upon economic theory, it uses analysis that comes from microeconomics rather than macroeconomics. Ironically, the "hot" branch of economic theory today seems to be macroeconomics. In principle, at least, the input-output analysis could be disag- gregated to the point where individual firms rather than indus- tries could be inspected. Within such a structure, financial data about individual firms-~data developed by accountants-- could be used directly as inputs to an analytical, macroeconomic model. In this way, economists might make greater use of accountants' work, while accounting theory might further utilize economic theory. This dissertation, in particular, includes but one possible application of such economic theory. Some applications of input-output analysis have appeared in the accounting literature. For a restatement of the inter- industry model, for example, see Charnes, A. p£_pl., "Economic Social and Enterprise Accounting and Mathematical Models," The Accounting Review, January, 1972, pp. 87-92. Similar analysis has been applied to the study of individual firms. 13Robert U. Ayres and Allen V. Kneese, "Production, Consumption, and Externalities," The American Economic Review, LIX, No. 3 (June, 1969), pp. 282-97. Allen V. Kneese and Ralph C. d'Arge, "Pervasive External Costs and the Response of Society, in Subcommittee on Economy in Government of the Joint Economic Committee, The Analysis and Evaluation of Public Expenditures: The PPngystepy Vol. I (Washington: U. 8. Government Printing Office, 1969), pp. 87-115, 1“Michell J. Sienko and Robert A. Plane, Chemistry, 3rd Ed. (New York: McGraw-Hill, 1966), p. 22. 55 As a result, the amount Of wastes produced by the economy which require disposal is virtually equal to the amount of material inputs to production, ignoring any investment. These wastes must either be recycled as inputs to the production process, or they must be assimilated by "sinks" in the environment. While these environmental sinks are capable of absorbing moderate quantities of most wastes without exhibiting significant signs of deterioration, they are becoming increasingly THE ENVIRONMENT: SOURCES AND SINKS Gaseous residuals which are not recycled Become Oxygen / Solids residuals Other Fuels PRODUCTION Final Liquids) if not Food a: Goods Gases recycled Raw Materials \~ - ECONOMIC PROCESSES: PRODUCTION AND CONSUMPTION \ Solid and liquid residuals which are not recycled A Materials-Balance View of the Economy15 15Adapted from a chart appearing in Kneese and d'Arge, 2E0 Cite. P. 900 56 overstrained by the Operations Of advanced economies. Under this approach, environmental disruption is treated not as an aberration of normal economic processes, but rather as a fundamental part of them. A schematic view of the economy, consistent with materials-balance thinking, is shown in the diagram on the previous page. The formal materials-balance model closely resembles the Leontief input-output model which was described in the previous section (and which is illustrated in the appendix to this chapter). Again, the "technical coefficients" of various production processes are the building blocks of the framework. This specific theory has been introduced, however, because of its central emphasis on the interrelationships between the economy and the environment. Constraintsplpvolved in Implementing the Models The models presented above represent generalized and abstract ways to view the real world. While they may serve as useful guides or short-cuts, by themselves they cannot provide a sufficient understanding of the nature of specific and app; environmental decisions. Considerable attention must also be paid.to the explicit and implicit assumptions underlying such economic models and to the complexities inherent in most actual decisionmaking situations. For to remain tied to theoretical Immiels is to invite the possibility of reaching irrelevant or erroneous conclusions as conditions vary from those implied 57 by the models. In order to provide an adequately-broad perspective for the study of complex environmental decisions and their informational requirements, the constraints which shape and condition the decisionmaking process must be carefully analyzed. These constraints fall into three broad groups which will be discussed below: economic, social and political. Economic Constraints Often the limiting assumptions pertaining to economic models such as the ones described earlier, are made quite explicit. With distressing frequency, however, certain assumptions are either unstated or forgotten. While the list presented below is not exhaustive, it includes those assumptions that are particularly relevant to the economic models described above and that seem especially critical for the purposes of this paper. Interacpipn of envippnmental actions with other econppip gpgl§.--Most of the economic models which have been prOposed for the study of environmental disruption and its control have been cast in the context of partial equilibrium analysis. As a result, the impact that environmental actions have on the five public finance functions are ignored in these formulations. These public finance functions consist of (1) allocation of social goods and services (pollution-abatement is but one), (2) provision of an acceptable distribution of income, (3) economic stabilization, (4) economic growth, and (5) control of the balance of payments 58 situation. Conversely, action to influence any of these public finance functions influences the environmental function. In the real world, decisions affecting all of these functions are made concurrently; other things do not remain constant! The conceptual and methodological difficulties present in analyzing only a limited portion of such a network of interdependencies are examined by Churchman: There is a fundamental limitation of any modeling Of a system, that the system is always embedde pp.p lar er system . . . . ConsequentI§, no mat er ow marvelous y a specific system works, in terms of a larger system it may not "work" at all. In sum, the true costs associated with any system always reflect the way in which the larger system behaves.16 As regards environmental decisionmaking, the true costs and benefits of public programs for abatement can only be measured after considering the entire socio—economic system. Hence, the obvious course of action would seem to be studying the larger system in detail. Yet, Churchman goes on to explain that . . . As one moves to consideration of larger, and larger systems, the problems of complexity'become enormous. This can be seen most clearly in the case of the measure of performance of a system . . ._. In general, we can say that the larger the system becomes, the more the parts interact, the more difficult it is to understand environmental [in the sense of being "outsidefi.the system rather than in the "ecological"sense constraints, the more obscure becomes the problem of what resources should be made available, and, deepest Of all, the more difficult bfcomes the problem of the legitimate values of the system. 7 160. West Churchman, The Systems Approach (New York: Dell Publishing 00., 1968), pp. 75—76. 17l§i§°9 PP- 76-770 59 Churchman's observations pointedly demonstrate the impropriety of implementing a decision strategy based specifically and precisely upon one of the economic models presented in Chapter III. However, questions of public policy must be resolved, the decisionmaker must follow through as best he can. A "pragmatic" approach that is consistent with the general spirit of the economic models will be described in the next chapter. Such a crude, approximate, but practicable method will be the basis for the analysis to be developed later in this dissertation. But caution remains in order: The interactions discussed above still constitute a limiting factor on the analysis. Definitional problems.--A1though a definition for environmental disruption was put forth in Chapter I, it was intended to be a tentative, working description. In particular, that definition contained at least three phrases which themselves require further definition. Two of these, "stress" and "stable ecological system" can be taken to be technical terms properly left within the realm of the physical scientist.18 :For present purposes, the reader's intuitive understanding of these phrases should be adequate: in this analysis they will be considered to be "primitive terms." However, the phrase "deleterious effects on humans" is one that a social scientist cannot avoid 18Many physical scientists no doubt would consider all ecological systems to be constantly in flux, moving towards a new equilibrium in response to stress, but experiencing a new stress before any equilibrium can be attained. This writer, while acknowledging the importance of these physical science consid- erations to the study of environmental disruption, feels that they go beyond the scope of this paper. Again, an appeal is made to the intuition of the reader. 60 cannot avoid inspecting. What is meant by an effect that is deleterious? Whose values should be applied in deciding whether a particular effect should be considered to be deleterious? While no precise answers to such questionsana possible, it may be observed that two sorts of decisions must be made. The first is a ”technical" decision as exemplified by a physician determing that smog is injurious to human health. The second sort of decision is inherently subjective in that it depends upon the perceptions'and values of individuals. What one person may consider deleterious, another might consider harmless or even beneficial. As a result, it is impossible to identify pl; pollution problems: in a sense whether a particular occurrence can be considered to be a form of environmental disruption depends upon the collective tastes of society at any point in time. Certain environmental changes,which are taking place today but are not considered to be disruptive, may be viewed as definitely harmful at some future date. These considerations, relevant to most economic analysis, are of ,particular concern with respect to environmental disruption and.its abatement, for the analysis of this subject must be dynamic and long-range. The set of all forms of recognized _'?i"3fi 'i w \_ cies and firms were discussed in preceding chapters, this chapter will concern decisions made by individuals (or, in some cases, firms) who use published financial statements, generally those included in an annual or interim report to stockholders. This survey will begin with an identification of the users of financial statements and an overview of their needs for accounting information. The second half of this chapter will consider the audit function as it affects the use made of the published statements. In particular, the underlying needs for an audit as well as the various forms audits may take will be delineated. The Users and Their Needs for Information The general topic of users' needs for accounting in- :formaticn has garnered considerable interest in recent years. biithout claiming that the numerous issues pertaining to this subdect have been resolved, the discussion here will be based Irpon the conclusions stated in the report of the.AICPA's 191 192 "Trueblood Commission."1 There are essentially two reasons for adopting this approach. First, an adequate examination of users' needs could conceivably comprise a research study in itself and, as such, goes beyond the scape of the present project. Second, the "Trueblood Commission" carried out such a study as part of its efforts. Since that study group del- ved into the general literature on this subject and since the group's members included well-known accountants with diverse backgrounds, it seems quite reasonable to accept that group's conclusions as being emminently authoritative. Indeed, in its discussion memorandum on a Conceptual Frame- work for Accounting and Reporting, the Financial Accounting Standards Board acknowledges the standing of the "Trueblood Commission's" report and concludes that further research covering the same ground would constitute "an unjustified duplication of effort."2 Which users are of concern?--The "Trueblood Commis- sion" concluded that it is the function of financial state- ments "to serve primarily those users who have limited author- ity, ability. or resources to obtain information and who rely 1Study Group on the Objectives of Financial Statements, Objectives of Financial Statements (New York: American Institute of Certified Public Accountants, 1973), p. 17. 2Financial Accounting Standards Board, Conceptual Frame- ‘work for Accountinggand Reportingg, Consideration of the Report of the Study_Group on the Objectives of Financial Statements (Stamford, Connecticut: The Board, 19ifi), p. 2. alw- 193 on financial statements as their principal source of infor- maticn about a firm's economic activities."3 While these users may be present or prospective shareholders, creditors, or employees, each must make some sort of "investment" deci- sion about a firm. Hence, they all have similar needs for information. As to the degree of sophistication such users bring to the interpretation of financial statements, the report states that "accounting information should be presented so that it can be understood by reasonably well-informed . . . u Finally, it should be re-emphasized that the users." "Trueblood Commission" considered primarily those users who make economic decisions. With respect to environmental dis- ruption, however, some users may make decisions upon a non-economic basis. This complication will be addressed more fully below. How do the users make their decigions?--Underlying each decision made by an individual is a goal or set of goals. For some decisionmakers, goals are stated in quite broad terms, if they are formulated at all! On the other hand, many decisionmakers, functioning in a more formalized fashion, have a.complex goal structure that may be well-articulated. But whether he makes it implicit or eXplicit, each decision- maker has one goal that relates to his relative preference 3Objectives of Financial Statements, p. 17. “Ibid., p. 60. Emphasis added. iQA for assuming risks.5 Other common goals pertain to the indi- vidual's preferred pattern of benefits and costs over time. With these and other goals in mind, the decisionmaker must proceed to evaluate the benefits and costs relevant to the alternatives under consideration. If such factors were amenable to precise and objective identification and measure- ment, decisionmaking would be a trivial undertaking indeedt Thus a key characteristic of all decisionmaking is the uncer- tainty about amounts and timing of costs and benefits.6 What are the characteristics of the required infor- maticn?--In A Statement of Basic Accountinngheory (ASOBAT), a committee of the American Accounting Association commented: "The utility of information lies in its ability to reduce uncertainty about the actual state of affairs of concern to the user."7 Accordingly, that committee formulated four basic standards which, taken as a whole, must be substantially ful- filled in order for some data to be acceptable as accounting information. The first standard, relevance, "requires that either the information or the act of communicating it exert influence or have the potential for exerting influence" on ‘the decision at hand. Thus, such "information must be avail- zible in a form and at a time for it to be useful." The SIbidc . p. 180 61bid. 7Committee to Prepare a Statement of Basic Accounting TTueory, A Statement of Basic Accounting Theory (Evanston, :Ellincis: American Accounting Association, T§66). p. 8. 195 committee concluded, moreover, that relevance has a "position of primacy" among the four standards.8 The second standard, verifiability, pertains to the ability of competent persons to reach "essentially similar measures or conclusions from [independent examinations] of the same evidence, data, or records."9 While verifiability is an important characteristic F“ of all accounting information, it is particularly crucial with respect to the use of accounting reports by third parties and, to a significant extent, underlies the ability of an independent auditor to render an opinion on those reports.10 The third standard for accounting information, freedom from bias. requires that the interests of no party are favored over those of other parties. Again, this standard is of spe- cial importance in external reporting.11 The fourth standard, quantifiability, "can be considered as the association of a number with a transaction or an activity where the numbers assigned obey prescribed arithmetic laws or procedures."12 ‘ Valuation in monetary terms is thus a "special case of quan- tification."13 In addition to the characteristics of accounting 8;p_i_d_.. p. 9. 9mg” p. 19. 1°;2;q,, pp. 10-11. 11;bid., p. 11. 12;§id.. pp. 11-12. 13;b;g.. p. 12. 196 information itself, ASOBAT also considers the quality of the reporting or communication process and provides five specific guidelines. The first such guideline, appropriateness to expected use, "requires that reports be prepared with the intended user's needs in mind."1u In particular, the infor- mation needs peculiar to such specific reports as income tax returns and reports to regulatory agencies should not be permitted to influence the general accounting statements. The second reporting guideline, disclosure of signi- ficant relationships, requires that the information be pre- sented in a manner that will allow the user to "understand and evaluate the underlying activity generating the data."15 This guideline concerns three potential problems. First, the appropriate degree of summarization must be determined: too much summarization has the effect of burying important details, while too little summarization may cause the reader undue difficulty in finding the significant relationships. Second, care must be taken in selecting the scheme or schemes of classification to be used. For instance, if expenses are classified in the income statement solely according to function, natural and behavioral relationships will tend to be obscured. Third, the specific procedure to be employed in aggregating the data must be chosen and reported carefully Since "many mathematical operations performed on aggregated 14 Ibid., p. 1n. 15Ib1d., p. 15. "_ 0.. 197 data yield results different from those obtained when the same operations are performed on the unaggregated data and the results then aggregated in the same manner as before."16 The third guideline for communicating accounting information, inclusion of environmental information, "requires that the circumstances and methods" underlying the preparation of the report "be disclosed if there can be any reasonable doubt about such matters in the mind of the recipient of the information."17 The fourth reporting guideline, uniformity of practice, requires that "where various alternative methods of measuring an economic activity exist, . . . the best available one be used uniformly within a firm, by different firms, and, to the extent possible, by different industries."18 Without uniformity, it seems unlikely that the standard of freedom from bias, described above, can be met. For if there are numerous alternative methods available, the parties that have authority over the preparation and dissemination of financial reports can select that method which best fits their own purposes.19 The fifth and final reporting standard presented in .ASOBAT, consistency of practice through time, pertains to 'both measurement and reporting and "should relate to basic 16M. 17l§ig.. p. 16. 18Ib1d.. p. 17. 19%. 198 concepts reflected in accounting abstractions such as the nature of business income as well as to the terminology and, perhaps to a lesser extent, to the format of reports."20 These four fundamental standards for accounting information and five guidelines for the communication process furnish a comprehensive description of the qualitative char- acteristics of the information needed by users of financial statements. Since these considerations pertain to information which is generally_useful to individual decisionmakers, they can be used as benchmarks against which may be assessed the propriety of reporting and the feasibility of auditing various types of information pertaining specifically to environmental disruption. While such analyses will be presented in the following two chapters. it seems appropriate at this point to consider the nature of decisions statement users make concerning environmental quality. Environmental decigigns of financial statement users.-— Users of published financial reports may make two different types of decisions about a firm’s environmental activities. First, such persons may desire to assess the likely impact of disruption and its abatement on the firm's financial posi- tion and its earnings potential. In other words, environmental quality may be an additional factor that affects the financial decisions traditionally made by statement users. But in 20Ibid., p. 18. 199 addition, such users may desire to guage the appropriateness and effectiveness of the firm's environmental policies. Indeed, an investor may choose not to purchase the stock of a particular firm not because of a negative financial impact of abatement requirements but because he does not support the firm's particular abatement policies. The Dreyfus Third Century Fund, a mutual fund, has pledged to invest in the securities of firms that seek to improve environmental quality 21 or other factors enhancing the quality of life. Moreover, individuals with no economic interest, actual or potential, in a firm may also make decisions concerning the firm's environmental policies. Consumer advocates, political acti- vists, or concerned citizens may take action supporting or opposing a particular firm. In short, statement users may make decisions about either the financial impact or the appropriateness of a firm's environmental activities or both. The Independent Auditor's Attest Function In the previous section, the users of published financial statements and the information they require for their decisionmaking were described. In particular, a set of qualitative standards for accounting information and guidelines for the reporting process were presented. Such benchmarks serve little purpose, however, unless the readers 21"Report of the Committee on Environmental Effects of Organization Behavior," The Accounting Review, Supplement to Volume XLVII (1973), p. 89. 200 of financial statements have some assurance that they have been adhered to. Accordingly, users generally require independent attestation to the financial reports. Three different institutional forms for this audit function seem noteworthy here; they will now be discussed. The financial audit.--The independent auditor has traditionally been called upon to render his professional and disinterested opinion concerning the credibility of a firm's financial statements. Simply put, the auditor seeks to determine whether the statements conform to generally- accepted accounting principles and thus constitute a "fair presentation." More specifically, the auditor serves as a check against "personal bias, self-interest, carelessness, or even outright dishonesty."22 In the words of the American Accounting Association's Committee on Basic Auditing Concepts: "Attestation is a communicated statement of opinion (judge- ment), based upon convincing evidence, by an independent, competent, authoritative person, concerning the degree of correspondence in all material respects of accounting information communicated by an entity . . . with established criteria."23 In developing a conceptualization of the audit 22Howard F. Stettler, Auditing Principles (Third Edition; Englewood Cliffs, N.J.: Prentis-Hall, 1970), p. 1. 23"Report of the Committee on Basic Auditing Concepts," The Accounting_Review, Supplement to Volume XINII (1972), p. 220 201 function. that committee identified two types of decisions a user must make when he receives a report. "1. The user must interpret the information content to gain knowledge of the subject matter relevant to his needs. "2. Efie user must evaluate (implicitly or exp§ficitly) e quality of the information received. The committee stated that the attest function essentially serves to aid the user in making the latter decision, since four conditions make it difficult for the user to "satisfy himself directly," while making it crucial that the question be resolved.25 First, the user will become worried "about the possibility of bias in information received" if he "perceives an actual or potential conflict of interest between himself and the preparer/source of the information . . . "26 Second, the greater the consequence of his decision, the more the user desires to ascertain the quality of the information available to him. Third, with the increasing complexity of of the subject matter and the information-processing system related to the reports he receives, the user finds it ever harder--if at all possible-—to satisfy himself about informa- tion quality. For with increasing complexity, both the chance of occurrence of unintended errors as well as the expertise zulElQ-u Po 25. Emphasis in the original. 25Ibid. 26l§l§ou p. 26. Emphasis added. 202 needed to assess information quality expand rapidly. Finally, direct satisfaction is blockedby the"separation between the user . . . and the subject matter and preparer of the information."?"7 This separation may result from lack of physical proximity, ”legal or institutional barriers to access . . . , [or by] time and cost constraints which make it infeasible for the user to perform his own audit investigation."28 The combined impact of these four conditions is that attestation by an independent third party must be considered to be a necessary component of the system for communicating accounting information to financial statement users. The operational audit.--While attestation in the con- text of the financial audit is closely linked to the indepen- dent accountant, the operational audit represents essentially an outgrowth of the function long served by the internal auditor. Operational audits "measure . . . the extent of achievement of organization objectives” and produce reports "recommending improvements to increase the efficiency and effectiveness of operations."29 With respect to audits of governmental agencies and programs, the U.S. General Accoun- ting Office has defined three distinct components.30 The 27Ibid. Emphasis added. 281cm. 29John J. Willingham and D. R. Carmichael, Auditin. _ggncepts and Methods (New York: McGraw-Hill, 1971) p. o 3OStandardsfiffior Audits of Governmental Organizations; jPrograms. Activities & FUnctions (1973 Reprint; Washington, if;C.: U.S. Government Printing Office, 1974), p. 2. 203 first of these, financial and compliance, concerns the propri- ety of the organization's financial affairs, the fairness of its financial statements, and the extent of its compliance with relevant laws and regulations. This element seems to be largely similar to the financial audit function with, perhaps, added emphasis on legal compliance. The next aspect, economy and efficiency, deals with the entity's management or utilization of its resources and seeks to uncover inefficiency-causing "inadequacies in management information systems, administrative procedures, or organizational struc- ture."31 The third facet of the audit of governmental organi- zations comprises a determination of whether the results de- sired are indeed being obtained, whether the specific objec- tives promulgated by the authorizing agency are being met, and whether the implementing organization has attempted to find lower-cost methods for achieving the desired results. These GAO standards were not intended as mere descriptions of contemporary audit practice. Rather, they purposely contain "some concepts and areas of audit coverage which are still evolving in practice but which are vital to the accountability objectives sought in the audit of governments and of governmental programs."32- As indicated above, internal auditors and governmen- tal auditors often perform operational audits. Some of these 311b1d. 321bid. 204 individuals may have backgrounds in areas other than accounting: Operational auditing is truly interdisciplinary and often requires legal, engineering, management, and computer science skills as well as accounting expertise. To a limited extent, however, CPA firms do perform some operational auditing as part of the traditional financial audit. Typically, when an independent auditor discovers possible inefficiency or ineffec- tiveness in operations, he brings it to the attention of management, although he would not mention it in his formal report unless it has a direct and material impact on the financial statements. Moreover, management consultants, whether from the management advisory services group of a CPA firm or from other types of organizations, are often engaged expressly to conduct some sort of Operational audit. Yet, the role of such outside consultants differs from that of the independent auditor: the consultant renders his report to management and has no reporting obligation to third parties. The social audit.--During the past few years, a number of proposals have been made that urge the conduction of social audits of business firms. In one sense, these audits would combine the general approach of operational auditing, although limited to the "social responsibility" aspects of firms' Operations, with some obligation for the auditor to report to third parties. David F. Linowes, who has authored several articles on "sociO-economic accounting," proposes that firms develop internally a "sociO-economic Operating N 0 U1 statement."33 This statement would provide "a tabulation of these expenditures made voluntarily by a business aimed at the 'improvement' of the welfare of the employees and public, safety of the product, and/or conditions of the environment."3u Idnowes would exclude all outlays made in order to comply with specific provisions in the law or in union contracts. Negative items would be shown on the statement "when a responsible authority brings the need for social action to the attention of management, but management does not volun- tarily take steps to satisfy such a need, even though it is of such a nature that a reasonab1y_prudent and sociallyaware business management would have responded favorably."35 While admitting that decisions concerning what should appear in the socio-economic operating statement are quite subjective, Linowes claims that such subjectivity underlies much of the traditional financial statements as well. Moreover, the author provides a set of guidelines for the identification and classification of socio-economic actions.36 Idnowes would have a small, interdisciplinary team of the firm's employees, headed by an accountant, prepare the statement. An audit would then be performed by an 33David F. Linowes, "An Approach to Socio-Economic .Accounting," The Conference Board Record, November 1972, pp. 58‘61 o 31+Ibid., p. 59. Emphasis added. 351bid. Emphasis is in the original. 36 id fl 206 outside, independent, interdisciplinary team headed by a CPA.37 A methodology similar to that of Linowes has been proposed by Professors Dilley and Weygandt.38 Furthermore, a "social responsibility Operating statement" was prepared for an actual firm as the result Of a social audit performed by one of the authors.39 Dilley and Weygandt describe four conceptual bases for the preparation of the social respon- sibility statement. The inventogy approach would provide a listing of the firm's socially-responsiblie actvities. However, the authors contend that it would be difficult to establish rules governing what should be included in such a statement and that such listings could not easily and meaningfully be 40 used as the basis of comparisons among firms. The program management approach would require disclosure of the amounts spent on each activity along with a statement of whether the program's goals are being met. The benefit-cost approach is similar, but would include a monetary evaluation of the benefits from each expenditure. Yet, the formulation of Specific objectives for social responsibility programs and 37Ibid., p. 61. 385teven c. Dilley and Jerry J. Weygandt, "Measuring Social Responsibility: An Empirical Test," The Journal of .Accountancy, September 1973, pp. 62-70. 39Steven C. Dilley, Accounting for Externalities: Conducting a Social Audit and Preparing at§ocial Responsibilipy .Annual Report for a Public Utilipy, unpublished doctoral dissertation: University of Wisconsin--Madison, 1972. uoDilley and Weygandt, pp. cit., p. 6b. 207 evaluation of benefits are both difficult to achieve. Accor- dingly, the authors recommend, as an initial step, the adop- tion of a cost or outlay approach under which a firm would describe its socially-responsible activities and state the amounts spent on each. The authors are quick to point out, however, that even this methodology presents certain concep- tual weaknesses, including the existence of alternative defi- nitions for the cost of an activity and the fact "that high dollar expenditures do not necessarily mean excellent benefits."u1 Dilley specifically addresses the question of who should conduct the social audit, discussing three possibilities. First, the auditors might be a team from the management ser- vices staff of a CPA firm.u2 While many MAS personnel do have backgrounds and skills appropriate for participating in a social audit and while certain CPA firms have engaged in 'this sort of work on a consulting basis, CPA firms might not wish to expose themselves to legal liabilities that could ensue from social auditing. Then too, a CPA firm might fear compromising the perceived integrity of its financial audit of a client if it were to perform that client's social audit as Well 0&3 “11bid.. p. 6b‘ uzDilley. 220 9220, p. 8?. “31bid., p. 88. 208 Dilley mentions the possible performance of social audits by government agencies, but he concludes that, although such agencies might prepare industry- or region-wide reports, they probably could not or would not audit individual firms.ub Lastly, Dilley suggests that independent research organizations may be a viable alternative to MAS personnel from CPA firms,‘ for the conducting of social audits. In a different report, Bauer and Fenn discuss the performance of social audits on behalf of three distinct groups.”5 First, a business may conduct a self—audit as a basis for either internal decisionmaking or public reporting of socially-relevant activities. The authors state four possible reasons why social audits might be conducted for internal purposes: (1) "satisfying the corporate conscience," (2) "anticipating and avoiding pressure" from the public or from government agencies, (3) gaining understanding that will help the firm in "solving social problems," and (u) increasing "long-range profits.“+6 Investors represent a second group that might "sanction" social audits. However, "since the social critics are likely to be concerned with a wider and shifting range of issues nu L1, 5Raymond A. Bauer and Dan H. Fenn, Jr., The Corporate Social Audit (New York: Russell Sage Foundation, 1972), especially pages #3-79. Ibid., p. 89. “51bid. 209 than the investment community might consider, investor audits may not Serve the entire range of interests of the social critics."u7 Accordingly, social audits might well be Spon- sored or conducted by a third group, public interest organi- zations. The three types of audits described above; financial, Operational, and social; may be of varying degrees of assis- tance to users of published financial statements. Moreover, the extent to which independent attestation is feasible with regard to environmental reports published by firms may depend critically upon the alternative institutional arrangements available for conducting the audit. and vice versa. These and other related considerations will be examined in Chapter X. The discussion, in this chapter, of the decions made by private individuals who use published financial reports concludes the analysis Of the nature of and the information required for environmental decisionmaking. In the next chapter, then, the focus will shift to an investigation of the potential scope of the accounting function, as it pertains to environ- mental decisions. 1”Ibid., p. 45. IX. THE ACCOUNTING FUNCTION AND ENVIRONMENTAL INFORMATION In these, the final two chapters of the dissertation, the many threads that were develOped in the earlier chapters will be drawn together to form conclusions about the present and prOSpective scope of the accounting function as it pertains to environmental decisionmaking. At this point, it is useful to recall the four issues initially raised early in Chapter I: 1. What are the natures of various environmental decisions? 2. What general kinds of information are relevant to these decisions? 3. What portions of this information might reasonably be supplied through the accounting function? 4. By what means and to what extent could accountants gather, report, and audit such information? Answers to questions one and two have been largely supplied in the preceding chapters. However, questions three and four, dealing Specifically with the role of the accounting function as it relates to environmental decisions, remain to be resolved. Therefore, the present chapter will investigate the accounting function within government agencies and firms. The following chapter will deal with the possibility of extending the accountant's attest function to published reports as well as to special reports required by Specific government agencies. 210 211 Accounting Information for Governmental, Environmental Decisionmaking The information needed for economic studies conducted 1 In this by government agencies was described in Chapter IV. section, the problems that economists encounter in the use of accounting data as inputs to their models, as well as potential solutions to those problems, will be investigated. It will be demonstrated, in a later section of this chapter, that many types of environment—related information which are or would be useful to managers and users of published statements would also be useful for economic studies by government agencies (and independent researchers!). By resolving some of the difficulties inherent in the accounting reports used by managers and outsiders, many of the economist's complaints could be answered as well. After this discussion of matters pertinent to economic analysis, a demarcation will be made of those activities which are consistent with the accounting function within government agencies. That section will draw heavily upon the empirical study, contained in Chapter V, of a regional air pollution control agency. Accounting information and economic analysis of environmental guality.--Much of the data--discussed 1See pages 92-97 above. 212 in Chapter IV--that is of interest to economists for their environmental studies pertains to financial characteristics or activities measured and recorded by accountants within individual firms. However, the manner in which such information is developed within the accounting function often poses serious conceptual problems for economic analysts. Accordingly, it is not enough merely to state the possible "topics" that might be addressed by the accounting function: the ways by which conceptual deficiencies may be overcome must also be scrutinized. Depreciation charges enter into the economic analysis of environmental quality in several ways, including such considerations as the cost of using abatement equipment, the obsolescence of manufacturing plants due to increased stringency of environmental regulations, and the possibly hastened lowering of real and personal property values due to pollution damage. Some difficulty stems from the treatment of depreciation in the Internal Revenue Code. While "book" and "tax" treatments need not be identical, depreciation calculations for a company's published financial statements are often affected by such Code provisions as the assumption of unrealistically—short service lives and accelerated depreciation methods. These influences, along with the frequent changes in the Code, greatly confuse the interpretation of reported depreciation charges.2 (William D. Nordhaus, "The Falling Share of Profits," Brookingg Papers on Economic Activity, 1:1974, p. 171-73. 213 Moreover, economists and accountants do not seem to agree on the definition for depreciation. To an economist, depreciation represents the decline in the present value of unexpired asset services; while to an accountant, it is a periodic allocation of the historical cost of an asset to expense over the asset's useful service life. However, even within the accounting profession, there is a considerable interest in moving to a current-cost basis for the valuation of assets and the calculation of depreciation, a change that would greatly improve the usefulness of such data for economic analysis. The need for current values is also important for comparisons over time of capital and Operating costs related to fixed assets and ofinventory costs. Along one dimension, price-level adjustments would be of great aSsistance in filtering out illusory changes due to inflation. Beyond this correction, however, changes in specific prices must also be considered if unwarranted conclusions are to be avoided concerning such things as the differences in a firm's Operating and investment costs before and after imposition of strict environmental regulations. Similarly, economists must consider changes in returns to providers of capital due to disruption abatement. While accountants do report interest and dividend charges separately, much more elaborate disclosure is required concerning the nature of and the returns to individual classes of security- holders: the capital structures and the nature of outstanding securities of large corporations have complexities that render 214 lesser disclosure inadequate. In essence, much more attention must be paid to the structural components of the cost of capital to a firm. The nature of individual cost factors.--Conventionally— prepared financial statements tend to obscure certain interrelationships among cost factors. An understanding of these interrelationships is crucial to economic analysis and, thus, information tending to reveal them can well be used by governmental decisionmakers. The behavior of costs as a firm's volume of production or sales varies is not readily disclosed by the conventional, published income statement, although variable-costing statements are often prepared for management's own use. The general availability of this later type of income statement would greatly facilitate economic analysis, particularly if such statements contained sufficient detail and also adequately analyzed semi-variable costs and "discretionary" and "committed" fixed costs.3 In much the same way, segmental reports showing the costs of Operation as well as the investment in assets for each of the various divisions of a firm would improve the economic usability of accounting information. The key question 3For definitions of these types of costs see Charles T. Horngren, Cost Accounting: A Managerial Emphasis (Third Edition; Englewood Cliffs, New Jersey: Prentice—Hall, 1972). pp. 943-53. 215 here is the directness of each cost item. Costs that are not directly—identifiable with a specific department or function within the firm must not arbitrarily be allocated. The current efforts by the Federal Trade Commission to secure line—of—business reports have generated some controversy among accountants as to whether such reports would be meaningful or obtainable with reasonable effort and cost.LF Once again, however, detailed segmental reports 333 often prepared for internal use within large firms. A final facet of cost interrelationships relates to the purpose for incurring each cost. Consider a situation in which a plant manager is given a chauffeur—driven limousine to get tozuuifrom work. In one sense, this cost is directly— identifiable with the specific plant. On the other hand, the plant could still be operated (at least in the short run) even if its manager had to drive his own compact car to the office. In such a situation, the limousine might really represent an addition to the manager's salary. Moreover, the company might need to make such perquisites available in order to secure the services of highly—qualified managers. Still, in trying to specify the production function for the plant it would be handy at least to know the nature of such cost items: some costs are more "essential" to a firm's basic operations than are others. u"Line of Business Reporting," The Journal of Accountancy, June 1974, p- 3- 216 Finally, some mention should be made of the fact that economic models tend to stress marginal costs and benefits while business firms usually make investment decisions based on incremental costs and revenues. Depending on the size of the firm and the project, and also on the degree of aggregation inherent in the economic model being employed, this distinction may or may not be very important. But regardless of whether any problems arise due to the use of incremental rather than marginal analysis, accounting statements, even if they include all of the modifications discussed in the preceding paragraphs, do not generate performance measures for Specific decisions. In particular, even a firm that uses a discounted-cash—flow approach to capital budgeting—-the method receiving the greatest authoritative support--to reach a specific investment decision, will still prepare subsequent financial statements under the conventional, accrual basis. Future income statements will simply not reflect the considerations that went into the capital—budgeting decision. In this setting, some supplementary, analytical information concerning opportunity costs is required. The Accounting Ennction within Environmental-Control Agencies The above discussion demonstrated the pertinence of accounting data to decisions being made by government agencies concerning economic aspects of environmental disruption and its control. With the possible exception of the specification of certain reporting rules by persons employed by government 217 units, the accounting chores related to the gathering and reporting of the required information are performed exclusively by employees Of individual firms. In this section, the role of the accounting function within government agencies will be investigated. The empirical study of the Wayne County Air Pollution Control Division will be used to guide this 5 examination. Administration of regulatory aggncies.—-The general description of the activities of the Division indicates that accounting for the administrative aspects of such agencies is fully in accord with the "conventional" accounting function. Moreover, it seems likely that this type of accounting work is now beginning to receive a good deal of priority. Many such agencies probably find themselves in the same situation as the Division, with most disruption sources in their jurisdictions either under control or progressing along a control program and with their regulatory machinery in reasonably-full Operation. Regulatory agencies seem to have progressed from a period of rapid develOpment into a phase of stable Operation, enabling them to give increased attention to the administrative aspects of their responsiblities. Settigg environmental standards.--As mentioned briefly above, accountants at governmental agencies should be involved in the design of reporting forms to be completed and returned 5See Chapter V. 218 by subordinate agencies and individual firms. Obviously, accountants with systems experience have Special skills in the general area of forms design. Furthermore, much of the information to be included in these reports is of a financial character. With respect to the analysis of the benefits and costs relating to alternative proposed regulations, accountants may be able to participate in a useful manner. In particular, the study of the potential impacts of regulations on the financial position and earning power of various types of firms is likely to involve a considerable amount of financial statement analysis, an activity that lies along the "boundary" between accounting and finance. In general, benefit—cost analysis requires an interdisciplinary approach: accountants; along with financial analysts, economists, statisticians, engineers, and others; can make worthwhile contributions. Informationtsystems design.--If the experience of the Wayne County Air Pollution Division is at all typical, it appears that major responsibilities are evolving for persons associated with the accounting function within disruption-control agencies, pertaining to the design and operation of comprehensive management information systems. Such a system must deal not only with the administrative accounting for the agency but also ‘with information that is relevant to setting and enforcing standards. Pooled data from firms under the agency's authority form, to a considerable extent, the basis for the specification of emissions limits. Moreover, in order to monitor an individual 219 firm's disruption and control actions, the agency must have an adequate and accessible historical record of the firm's past disruption levels, commitments to abatement, and violations. While much of the information handled in such an information system is not of a financial nature, the functions of continual data—processing and information—storage—and-retrieval are closely analogous to those within traditional accounting systems. Therefore, the persons who are given responsibilities for these comprehensive information systems are likely to have backgrounds in accounting work. A description of a proposed management, information system for the Wayne County Division is included as Appendix A at the end of this chapter. Grant approvals.-—Another area where accountants within government agencies may participate meaningfully is the grant approval process. It should be noted that most of this activity is carried out at the Federal level, within the Environmental Protection Agency. Specifically, accountants should take part in the review of grant applications, since budgets and other financial reports are generally submitted in support of a request for funds. In addition, accountants should prOperly be responsible for the running of performance audits to see whether Federally-funded programs at State and local agencies and demonstration projects run by government agencies or private firms are proceeding or have been completed according to plans. 220 The Accounting Function within Private Firms The previous section of this chapter dealt with the tasks which can appropriately be associated with the accounting function within governmental, disruption—control agencies. In this section, similar consideration will be given to the scope of the accounting function within business firms, as it pertains to the firms' environmental affairs. Many of the issues raised here will be linked to the discussion, in the ensuing chapter, of the extension of the audit function to environmental reporting. Throughout this section, references will be made to the empirical study (Chapter VII) of Midwest Utility, in order to establish a factual basis for the plausibility of the conclusions presented. The impact of environmental quality on the financial statements.——Perhaps the most basic and conventional role a firm's accountants can play with respect to environmental decisionmaking is to assess the impact of regulations and abatement activities on the firm's financial statements. Due to the wide-ranging nature of environmental laws combined with the considerable extent of disruption and abatement activities of most sizable producing firms, accountants must keep close tabs on a firm's environmental affairs if the statements are to present fairly either the firm's financial position or the results of its operations. Furthermore, in reports N m H to different regulatory agencies-—the Securities and Exchange Commission, the Federal Power Commission, and State pollution regulators were three examples for Midwest Utility--financial data as well as physical measures and descriptive material must be provided. While it is true that in very large firms report-preparation can become a highly specialized activity, in many businesses it is the’accounting staff that bears the primary responsibility for filing required reports of all types. Therefore, in submitting Special reports to government agencies, accountants must determine the financial ramifications of the firm's environmental actions and perhaps provide non—financial data in addition. Managerial decisionmaking.--Since environmental affairs are far from the only concern of a firm's management, decision— makers must coordinate environmental policies with overall company goals. While both quantitative and qualitative factors must be considered, financial measures are generally used as the common denominator. Similarly, in the making of specific environmental decisions, accounting data are necessary inputs. The typical abatement action involves an investment situation calling for the use of capital budgeting. For Midwest Utility, as is likely to be true for all firms, the majority of the inputs required for this sort of analysis are derived from 6 historical or forecasted financial data. 6See Appendix B at the end of this chapter. 222 Once an environmental decision has been made, some sort of managerial control must be implemented. In general, feedback is required concerning whether the financial and non-financial aspects of the project are progressing according to plan. The study of Midwest Utility illustrates most strikingly the potential contribution that could be made to such managerial control by the accounting function. There, as in most large firms, an elaborate cost accounting system is in operation. Financial budgets and analyses of variances from budgeted figures are regularly prepared for environmental projects as well as for all other operating segments of the firm. Concurrently, however, the environmental manager of that firm establishes an independent feedback system to aid his own control of environmental programs!‘ Surely there must be many ways in which these two sorts of control systems could readily be integrated. At the very minimum, time and percentage-of—completion measures could be added to the financial budgets and variance reports. Within a SOphisti- cated, computerized information system, the Special needs for financial and Operating control reports could be met from a common data base with the added advantage of improved coordination between these two functions. Information systems dcsign.-—The considerations mentioned in the paragraphs above lead quite naturally to an examination of the needs for and the development of information systems for environmental decisionmaking and reporting. In essence, a firm needs a ready and reliable 223 source of data that are germane to the planning, reporting, and controlling of its environmental affairs. At least four reasons may be identified that tend to support the view that the accounting staff should have major responsibilities for the design and Operation of these information systems. First, much of the data used in such systems are monetary in nature—-the sort of data with which accountants are traditionally associated. Second, other types of data used in these systems, while they are not monetary or perhaps even financial in nature, are still handled in a manner similar to financial data. The example, included in Appendix B at the end of this chapter, of a proposed augmentation of the fuel inventory system for Midwest Utility clearly supports the argument that the functions of gathering, processing, storing, retrieving, and reporting are essentially identical for financial and non-financial items. A third reason for heavy involvement by accountants is the fact that they tend, as a group, to have a substantial amount of experience with this general kind Of design work. The The same principles that guide the design of conventional accounting systems also underlie the structuring of a good environmental information system. For instance, consider the following systems design principles taken from a popular textbook.7 1. Reasonable cost 7James B. Bower, Robert E. Schlosser, and Charles T. Zlatkovich, Financial Information Systems (Boston: Allyn and Bacon, 196977pp. 26—h9. 224 2. Internal control, a. Reliability b. Organization structure 0. Human factors 3. Data and information flow a. Data accumulation b. Data processing c. Report 4. System utility a. Flexible, yet uniform and consistent b. Audit trail Each of these principles could be appropriately applied to environmental information systems. Finally, the likely requirement for an eventual audit of reports generated by the environmental information system implies a need for active involvement in the designing of the system by persons who understand and appreciate the audit function. Since many authorities agree that accountants will participate in audits of environmental reports, it makes sense to include accountants in the system design function as well. While much of the design work pertaining to environmental information systems is and will continue to be carried out by persons from the management accounting staffs of corporations, this area represents a significant market for the management advisory services units of public accounting firms. Such systems design work is but one example of the environmental management engagements that one practitioner has claimed will provide outstanding opportunities for client service. 8William G. Gaede, "Environmental Management Opportunities for the CPA," The Journal of Accountancy, May 1974, pp. 50—54. 225 Public accounting firms seem to be both willing and able to undertake these assignments. Some observations about disclosure.——The contention was made, at the beginning of this chapter, that the same general types of environmental information that are of value for economic analysis are also needed for decisionmaking by business managers and by users of published reports. In order to support this argument, some attention will now be given to the prOper bases for environmental reports directed toward these three groups. With regard to financial position data, all users have an interest in the investment and depreciation costs of abatement equipment. These items are most useful for decisionmaking if they are based upon current rather than historical values. (However, a substantial case can be made for supplying historical costs to managers, as supplementary information: historical costs enter into managerial decision— making through income tax and investor-reaction considerations.) Moreoever, information pertaining to the structural components of the cost-of-capital to a firm is also desirable. Considering next the data that concern the activities of a firm during a period of time, that is, data in the income statement or in the statement of changes in financial position; all users need an understanding of the specific nature of each material cost item. Cost behavior, in terms of systematic variation with changing levels of activity in both the short and long runs, should be made clear. Similarly, disclosure 226 of the segment of the firm to which each cost can be directly traced, as well as the extent to which each item is "essential” to the firm's productive activities, should be clearly disclosed. Finally, information about foregone alternatives (opportunity costs) should be included in these reports. Each of the three groups--economic analysts, managers, and "outside" users-—has a different need for detail. However, in addition to requiring the same essential sorts of financial data, each group needs narrative material. Such things as the nature of individual cost factors cannot be completely communicated by the exclusive use of the statement format. Furthermore, much of the specific financial data is not fully useful unless there is_accompanying disclosure of the underlying company goals and policies with regard to environmental disruption and abatement. In the next chapter, consideration will be given to the extension of the independent auditor's attest function to environmental reports of the sort described above as well as to special reports, of a more narrow nature, made to government agencies for regulatory purposes. Appendix A: A Management Information System 9 for a Government Agenpy The following material is an outgrowth of interviews with several persons at the Wayne County Air Pollution Division. This discussion is included here as an example of the systems design work that accountants might perform within government agencies. Recently, within the Air Pollution Control Division, there has been an increased emphasis on the administrative aspects of its operations. This direction reflects two key circumstances. First, most of the Sources of air pollution within Wayne County are now under control, and the major problems that remain have been identified and studied. Second, with the basic machinery for the enforcement of its regulations in order, the Division is no longer operating in a "crash" setting where virtually all attention must be directed towards establishing procedures needed to meet deadlines. Accordingly, the Division can now devote more effort to improving the administration of its duties. One improvement that is envisioned is a refinement of the Division's information processing and usage, or, in other terms, the develOpment of a modern, adequate, 9The author acknowledges a Special debt to Mr. Pat Garvey, Systems Analyst for the Division. While Mr. Garvey's observations certainly prompted the writing of this appendix, he is not responsible for any blunders that might be present. 227 228 management information system. In this section, the desirable features of such a system for the Division will be identified. Building_a data base.—-The complete emissions inventory for Wayne County, containing data about each individual source, would serve as the foundation for the data base. Of course, this data must be accessible for a number of purposes. Hence, a great deal of thinking must underlie the coding patterns implemented. For instance, key factors might include (1) type of pollutant emitted, (2) type of industrial or commercial process, (3) physical characteristics of plant (such as stack height), (4) ownership, (5) location, and (6) methods of abatement in use. While illustrative, this list is by no means exhaustive. The central consideration is the develOpment of a data structure within which any combination of the key factors may be referenced explicitly. With this emissions inventory stored "on the system," updates could be readily obtained from two sources. Data would be furnished both by the individual firm and by the Engineering Section of the Division in connection with each application for an Installation Permit or a Certificate of Operation. Also, data would be provided by an inspector from the Division on the occasion of an annual inspection for the purpose of renewing a Certificate of Operation. Violation processing.——The information system could be made an integral part of the handling of violations and 229 'public complaints. One benefit from such integration might be the possibility of developing or modifying a control strategy based on the Division's experience with certain types of violations. Such a change might be warranted under several different circumstances. For example, violations might point out a deficiency with respect to a specific emission limit or technical method of control: actual Operations might not conform to expectations under certain conditions. In addition, experience with violations might demonstrate the relative administrative efficiencies of various administrative approaches to control. In order to improve both its efficiency and its effectiveness in violations processing, the Division might use its information system to prepare a "perpetual" aging analysis of violations, containing details about each violation and subsequent inSpections by the Division's staff. This aging analysis would fit well with the Division's present policy of providing at least one check within twenty—four hours of a complaint. The need for rapid checks is an obvious function of the nature of air pollution problems; the situation is particularly critical with respect to complaints about odors, since odors tend to dissipate quickly. Other features.-—Many additional functions could be incorporated into the management information system for the Division; some possibilities will be discussed at this point. One obvious application would concern actions to be taken in the event of an "air pollution alert." There exists, for each 230 source in the County, a Contingency plan to be implemented upon direction from the Division in response to an unacceptably dangerous air pollution condition. Fbr any specific kind and degree of extreme air pollution, the computerized system could be used to designate the most efficient set of contingency plans possible. Furthermore, incremental changes in the Division's response, that is, the tightening or relaxing of emissions limits or curtailments of activities, could be automatically and continuously generated in reSponse to a steady flow of input data concerning ambient air conditions, emissions rates, and weather changes. Such handling of air pollution alerts would not appear even to be possible without a computer—based system. Although certainly a part of the previous application. the use of modeling and systems analysis represents an important function unto itself. The major responsibility for such work is carried by the Technical Services staff and considerable use of computing, via time-sharing, is currently being made for these purposes. However, such efforts would become more feasible and more promising if they could be integrated with the rest of the information system. For instance, although a diSpersion model is now available, it could be more fully-utilized if it could access the data base directly and if it could be used interactively for decisionmaking in situations such as the air pollution alert mentioned previously. Similarly, detailed, statistical studies of many kinds could be much more readily obtained. 231 The scheduling of annual inspections for renewals of Certificates of Operation could be incorporated into the computerized system. Efficient schedules for inspectors could be generated and provision could be made for delaying "non-critical" inspections during unusually-busy periods. Air monitoring data could also be fed into the data base to be made available to the entire system. At the present time, the Division has thirteen "air monitoring stations, each a trailer carrying equipment to run tests on ambient air quality. These stations could be directly connected to the computerized information system via telephone lines. Two groups within the Division, Technical Services and Engineering, are particularly interested in technical developments concerning air monitoring and air pollution abatement. The computerized system might therefore include an index to abstracts of relevant publications. Finally, mention should be made of the possibility of computerizing the budgetary system for the agency. Currently, the Division uses a "line item" approach to preparing its operating budget. However, elements of "program budgeting" are incorporated into the formal application made annually to the EPA in support of a Federal grant. In addition to providing such budgetary analyses as variance reports, the computerized system would facilitate the implementation of a dual-budget system: "line item" budgets would be available for dealings with the County and State governments, "program" budgets would be available for applications to the EPA, and 232 elements of both approaches could be utilized for internal purposes. The above discussion demonstrates both the need for and the potential usefulness of an advanced, computerized, information system for the Division. Moreover, the nature of the systems design work that must be performed is such that accounting personnel could make substantial and useful contributions. Appendix B: Enlarging an AccountinggSystem' to Include Environmental Information The majority of the environmental information that Midwest Utility requires for internal decisionmaking and external reporting may be classified as being operating or budgetary in nature.10 In this appendix, a case will be made for integrating these sorts of information with the firm's accounting system. While it is true that much of this information is not of a monetary nature--some would claim that it is not even "financial"—-there are some important links to information traditionally considered to be of an accounting character. A pair of examples may serve to illustrate more fully these links as well as their implications for the design of environmental information systems. The first example is drawn from the annual "air and water quality report" made by Midwest Utility to the Federal Power Commission. As was stated earlier,in Chapter VII, this 10See pages 186 and 187. 233 report includes detailed data pertaining to fuel consumed at each generating plant. One particular schedule requires the data described below:11 1. For each month and for the year as a whole a.Month COAL b. Consumption in tons c. BTU per pound d. Average percent sulfur e. Average percent ash f. Average percent moisture giL Consumption in barrels h. BTU per gallon i. Average percent sulfur GAS j. Consumption in cubic feet k. BTU per cubic foot 2. For each source of supply COAL b. Mine location 0. Quantity in tons OIL d. Supplier e. Refinery or port of entry f. Quantity in barrels Now it should be noted that at the time a purchase or purchase commitment is made for fuel, some manager at Midwest Utility presumably has all of these data and others as well. Accounting for fuel inventories requires that physical quantities and dollar amounts be recorded. However, it would appear to be a not—too-difficult task to incorporate the additional characteristics listed under item 1. above into 11Steam—Electric Plant Air and Water Quality Control Data, Part I—-Air Quality Control Data, Schedule A--Fuel Quality, pp. 2-3. Headings and identifying letters correspond to those used in the actual schedule. 234 such records. With regard to data pertaining to each source of supply (item 2. above), a reasonably straightforward extension of the accounts payable procedures should generate such information with little ado. The second example refers to the feedback control system needed by the environmental manager in order to assure himself that decisions are being implemented properly and that no unresolved problems have cropped up.12 Interestingly enough, Midwest Utility's work—order system provides this very sort of control, from a financial standpoint. Furthermore, the work—order system is already automated! Would it not be reasonable toencmnuithe work—order procedures to cover the additional types of information needed by the environmental manager? InSpection of other requirements for environmental data of a budgetary or Operating nature would, no doubt, lead to similar observations concerning close links with the conventional accounting system. When two information systems-- in this case accounting and environmental--parallel and even overlap each other to such a considerable extent, it beeames eminently reasonable to integrate them both in design and in Operation. Without such integration, duplication of effort and poorer communications among the various administrative units involved become virtual certainties. In short, the accounting system can indeed serve as a basic structure for the 12See pages 171 and 172 in Chapter VII and also page 222 in this chapter. 235 recording and reporting of many types of environmental information. X. EXTENDING THE AUDIT FUNCTION TO ENVIRONMENTAL REPORTING This final chapter will conclude the discussion of the potential scope of accounting for environmental-decisionmaking. While the preceding chapter examined the roles for accountants either as staff members Within government agencies and business firms or as consultants to such organizations: the present chapter will focus on the function of independent accountants, specifically CPA's, in helping to provide credible information to outside users of published reports. This analysis will commence by considering the motiVes underlying audits of environmental reports. Then, in order to furnish a concrete basis for further discussion, recommendations will be presented concerning the content of such reports. Next, the auditability of such reports will be discussed from the standpoints of the traditional "attest function" as well as lesser "levels of 1 Concurrently, assurance" as recently suggested by one authority. the manner in which such audits might be conducted will be addressed. Finally, the alternative institutional arrangements for performing these environmental audits and the nature of 19. R. Carmichael, "The Assurance Function--Auditing at the Crossroads," The Journal of Accountancy, September 1974, pp. 6u-72 . Y 236 237 the required standards for reporting and auditing will be studied. After this examination of the audit function has been completed, four general questions raised by the material in this and previous chapters will be considered. In particular, recommendations will be made concerning the ways in which further research efforts might provide some useful answers. Why Audit Environmental Reports? The information needs of the users of published financial statements were discussed at some length in Chapter VIII.2 Such users must, in general, make either or both of two determinations: (1) the likely impact of disruptiOn and abatement on a firm's financial position and earnings prospects and (2) whether the firm's environmental policies are effective and appropriate. The same four conditions that make it difficult for a user to evaluate the quality of conventional financial statements are present also with regard to environmental 3 reporting: 1. There exists an actual or potential conflict between the interests of the user and the preparer. 2. The decision that is based, at least in part, upon environmental reports is of significant consequence to the user. 3. The subject matter and manner of preparation of environmental reports are complex. 2See pages 194—198. 3These considerations were detailed on pages 201—202. 238 4. The user is effectively separated from both the preparer and the subject matter of these reports. As a result of these circumstances, users of published environmental reports have a definite need for some independent assurance that the reports are credible. Current requirements for attestation.--At the present time, independent accountants must attest to certain kinds of environmental information. First, they must assess the impact of existing and planned environmental regulations on the audited financial statements. While the costs of pollution control are quite significant, so are the risks associated with continuing to cause disruption. Accordingly, the auditor cannot render an opinion on the "fairness“ of a firm's financial statements without satisfying himself as to the adequacy of disclosure about environmental matters. Indeed, it has been suggested that, for some firms, the reasonableness of the "going concern" assumption may be properly questioned.“ In short, the CPA must consider the regulatory setting and the firm's responses to it. The Securities and Exchange Commission has made some of these reporting obligations quite specific. Under the terms “American Accounting Association, "Report of the Committee on Environmental Effects Of Organizational Behavior," The Accounting;Review, Supplement to Volume XLVIII (1973). p. 78. 239 of Accounting Series Release Number 5170, in filings with the Commission, disclosure is required of the material effects that compliance with environmental regulations may have on the capital expenditures, earnings, and competitive standing of a firm. Furthermore, disclosure is also required of expenditures that are material and may be traced exclusively to compliance. If a reasonable basis for calculation exists, estimates should be furnished Of the environmental-compliance portion of the capital outlays for, as one example, the construction of a new plant. Although these disclosure requirements now pertain only to reports filed with the SEC, there is reason to believe that they may soon affect corporate reports to stockholders as well. For the SEC, early this year, proposed new requirements which would, in effect, force much of this information contained in the annual report on Form 10-K to the SEC to be incorporated into the report to stockholders.5 These tentative requirements include: 1. A description of the general business activities of the firm, including information about different product lines 2. A verbal summary of operations, explaining inter- period differences in revenue and eXpense items 3. Information pertinent to an understanding of the firm's liquidity position and working capital needs 4. CPA attestation to the financial statements for the two most recent years 5Securities Act Release Number 34-10591, January 10, 1974. 240 Moreover, the SEC proposes that proxy statements inform the stockholder that a OOpy of the entire 10-K report is available upon request. While attestation to the annual financial statements sent to stockholders and to certain reports filed with the SEC is the major way in which independent accountants help to furnish credible information to "outsiders;" for those firms in the "regulated industries," accountants also attest to reports filed with such other government agencies as the Federal Power Commission or the Interstate Commerce Commission. For "power" utilities, the CPA must certify large portions of the firm's annual report to the FPC, as was discussed in the study of Midwest Utility.6 At the present time, however, independent accountants do not attest to such specialized reports as a company's federal income tax return or a utility's annual report to the FPC concerning air and water quality control.7 Thus, current requirements for CPA attestation to reports filed with government agencies provide no clear indication of whether the independent accountant might, at some future time, be called upon to certify all or portions of a firm's comprehensive report to federal or state-local environmental regulatory agencies, should such a report actually be required. Yet, if 6See pages 173-174- 7FPC Form 67. See page 174- 241 such reports must be audited, it seems likely that either the CPA or staff personnel from the regulatory agencies will perform this function. The Content of Published Environmental Reports Before discussing whether and how environmental reports might be audited, it seems mandatory to examine the likely scope and content that will be required for such reports. In general, the conclusions to be presented here are based mainly upon the previous chapters of this dissertation and the following four significant pieces from the recent literature: 1. Dilley and Weygandt's article, "Meaguring Social Responsibility: An Empirical Test" 2. Beams and Fertig's article, "Pollution Control through Social Cost Conversion"9 3. Various writings of Linowes, but most specifically, his articlg, "The Accounting Profession and Social Progress" 4. The report of the AAA's Committeflon Environmental Effects of Organization Behavior ' 8Steven C. Dilley and Jerry J. Weygandt, "Measuring Social Responsibility: An Empirical Test," The Journal of Accountancy, September 1973, pp.62-70. 9Floyd A. Beams and Paul E. Fertig, "Pollution Control Through Social Cost Conversion," The Journal of Accountancy, November 1971, pp. 37-42. 10David F. Linowes, "The Accounting Profession and Social Progress," The Journal of Accountancy, July 1973, pp. 32-40. 11 _92. Cit. 242 Background descriptions.--Beams and Fertig recommend that a standard industry note be included in the environmental report of a firm, identifying "the major pollution control problems within the industry, the goals of the industry in abating pollution, the control standards which have been imposed and the deadlines for compliance with existing standards . . . ."12 Beams and Fertig further suggest that such verbal notes might be prepared periodically by the staff of the American Institute of CPAs. The inclusion of this standard industry comment would surely help to place the environmental activities of a particular firm into context. However, the use of such a note might not be straightforward in at least two situations. First, the Operations of many conglomerate firms are so diverse as to preclude the use of a single note for one specific industry. Still, this problem is no different from the general difficulties encountered in attempting to interpret the financial statements for such firms: many issues remain unresolved in the financial reporting by conglomerates. Perhaps line-Of-business environmental reports, each with a different industry note, might be a reasonable approach. The second circumstance inhibiting the use of a standardized industry note would involve an environmental report for an atypical firm, one 12Page 42. 243 whose industry either is not major or is not clearly defined. In this instance, the best approach might be to omit an industry note altogether. The second part of the background description would pertain to the environmental affairs of the individual firm, and would address four topics. First, general disclosures would be made pertaining to the various disruption concerns of the firm: their natures, the physical quantities emitted Of different pollutants (or other appropriate measures of disruption), and the systematic relationships between different disruption forms and the levels and types Of the firm's Operating activities. Second, the regulations that cover the firm's disruption activities should be described in terms of major emissions limits or compliance standards: deadlines; noncompliance penalties; and, if material, prospective or contingent aspects of regulation.13 Third, the general goals and specific programs of abatement for the firm should be presented, including fairly detailed estimates of time-schedules and costs to be incurred. Moreover, information concerning the firm's progress toward meeting these goals and completing- scheduled projects should be supplied. Fourth, the total and overall impact of "material environmental effects on financial position, earning and business activities of the organization" should be disclosed.1u As part of such disclosure the existence 13 "Report of the Committee on Environmental Effects," p. 110. luIbid. 244 of any unrecorded liabilities or contingencies should be made clear. The environmental financial summary.——The second major part of a firm's environmental report would comprise a statement summarizing the financial aspects of abatement. This statement would include three sections, each keyed to one of the three “major" financial statements: income, financial position, and changes in financial position. Furthermore, wherever appropriate, this monetary statement would refer the reader back to the background description discussed above. In the financial summary, environmental outlays would be listed, in the manner implemented by Dilley and Weygandt for an actual firm, and these items would be linked to the statement of changes in financial position.15 It should be noted that the schedule of environmental outlays would probably contain more detail and might be aggregated along different classifications than the “funds" statement. Accordingly, for each item in the environmental schedule that is not identical to an item in the "funds” statement, parenthetical explanation Should be provided to reconcile it with the latter statement. This same approach to reconciliation would also be applied to environmental information linked to the income and position 15See the Environmental section of Dilley and Aeygandt's ‘Statement of Funds Flow for Socially Relevant Activities" on page 69 of their article. 245 statements. Environmental expenses, keyed to the income statement, should be shown basically by major lines of business, kinds of operating activities, or abatement programs of the firm. For each expense item, cost behavior and "degree of necessity" should be shown. If an expense has been incurred that is not strictly required by abatement regulations, the reasons for the firm's "voluntary" action should be made clear. Lastly, environmental assets and liabilities Should be listed, on the same segmental basis as used for expenses. These items would, of course, be keyed to the position statement. At this point, the reader should note that the recommended environmental financial summary does not incorporate either price-level adjustments or the use of current (as opposed to historical) cost as the basis for the valuation of assets. While the contention was made in the preceding chapter that these modifications could contribute to the usefulness of environmental reports to "outside" userseuswell as to managers and economic analysts, it seems that the confusion which might result from using principles in the environmental report that differ from those incorporated into the firm's regular financial statements could well outweigh the possible benefits to be had.16 Therefore, the use of such techniques in published environmental reports is not recommended until such time as 16H ,, see pages 223—226. 246 they are applied to published financial statements. However, the author considers the potential usefuln ss of price—level adjustments and current costs for environmental decisionmaking to be just one indication of the need for generally-accepted accounting principles to move in this direction. Forecasted information.-—host of the information to be includedixienvironmental reports of the type described above, as well as most of the environment-related information currently required by government agencies and generally-accepted accounting principles, is ssentially historical. However, ggpg forecasted information is required. Estimatescxfmaterial, anticipated control costs must be provided under SEC disclosure provisions and probably under GAAP as well. Furthermore, the background descriptions within the prOposed environmental reports certainly would contain some information on a projected basis. Then too, future circumstances often tend to affect the historical financial statements: as one example, abatement regulations may have the effect of hastening the obsolescence of a manufacturing plant, leading to a reduction in its expected useful life and increased current depreciation charges. While some projected information might thus be included in statements that are fundamentally historical, it does seem plausible that comprehensive forecasts could be useful to all parties concerned with environmental decisionmaking. Such forecasts could contain the same sorts of information as would the environmental financial summary described above, albeit on a projected, rather than historical, basis. While some weighty 247 issues remain to be resolved, the notion of corporations making financial forecas s available to outsiders seems to be garnering support. There is even some feeling within the public accounting profession that independent auditors could provide 17 some "assurance" with regard to forecasts. if accountants do begin to be associated with financial forecasts and if, as will soon be argued, they can extend their audit function to environmen- tal financial summaries; there would be little reason to doubt that they might audit environmental forecasts as well. The Auditability of Environmental Reports The question may now be raised concerning the extent to which environmental reports of business firms, prepared along the guidelines proposed above, would be amenable to audits by independent accountants. While Dilley's research lends some tentative, empirical support to the idea that accountants might attest to these reports, much more "field work" remains to be done.18 In this study. however, an g priori attack will be employed: the form and substance of the environmental report will be compared with the general principles described in l/ih %. CuIlWlChFCfli, "rirmuicial. Fortmxu3ts——1Jue roixuitial Role of independent CPAs," The Journal of Accountancy, September 1974, pp. 84—86. 18. , . . n , . . Steven C. Dilley, Accounting ior externalitigg: Conducting a Social Audit and Prgparing a gpcial_fipsponsibility gpnual Report for a Tublic Utility, unpublished doctoral dissertation, University of fiisconsin—-uadison, 1972. 248 A Statement of Basic Accounting Theory, while consideration . . , . . , 10 Will also be given to how the audit might actually be performed. ’ Auditing the financial summary.--5ince this section of the environmental report contains financial data similar to those that appear in the regular financial statements, it should be just as readily audited as are those statements, unless some difficulties are introduced by choices concerning either the data to be included or the methods of aggregation and the amount of detail to be used. Obviously, the data in the financial summary are quantifiable, while previous portions of this dissertation indicate that they are indeed relevant to the users' needs. Moreover, the recommended format for the financial summary was develOped with specific regard to its (1) being appropriate to its expected use; (2) disclosure of significant relationships, through its scheme of categorization and description of environmental items; and (3) disclosure of the circumstances under which it is prepared, through the inclusion of background information. Hence, the only principles, set forth in A503 T, that need be checked for applicability seen to be freedom from bias, uniformity of practice, and consistency. in order to fulfill these three principles, environmental financial summaries must be based upon reporting standards 10 . , ,. . - . . . 'Conmittee to Prepare a statement of nasie Accounting Theory, A Jtatgpent of Basic_§ppountingilhgprv (evanston, Illinois: American Accountin" Association, 1956). These principlv; were discussed earlier, on pages 194-198. 249 that provide useful definitions for various categories of data. By reference to a comprehensive set of such standards, the independent auditor could ascertain whether the proper items have been included and whether appropriate aggregation methods have been applied. If these two questions can be answered affirmatively, and assuming that the reporting standards are adequate, all of the principles for financial reporting would seem to be met. The specific nature of the required environmental reporting standards will be discussed shortly. The "attest" approach.--In light of the above discussion, it is quite reasonable to conclude that the independent auditor could perform the same function-—often called "attestation"-- with regard to the environmental financial summary as he performs 20 concerning the published financial statements. The financial summary does indeed appear to possess the attributes that the AAA's Committee on Basic Auditing Concepts deemed essential 21 for any extension of the audit function. In particular: 1. Assertions that are quantifiable and verifiable may be deduced from evidence pertaining to the items contained in the summary. For instance, the existence of a pollution—abatement device and its 20The phrase "attest function" was popularized by Herman Bevis in his article, "The CPA's Attest Function in Modern Society," The Journal of Accountancy, February 1962, pp. 22ff. dlAmeriean Accounting Association, "Report of the Committee on Basic Auditing Concepts," The Accounting Review, Supplement to Volume XLVII (1972), pp. 30-31. 250 recorded cost may be verified by physical observation and inspection of documents. Standardized definitions could be applied to determine whether the device is indeed pollution— abatement equipment. 2. The data in the summary flow from the firm's accounting information system. Principles of internal control that apply to all accounting data apply to this item in particular. 3. The set of environmental reporting standards would serve as a generally-accepted basis for evaluating the information in the summary. In addition to these three attributes of the subject matter of an audit, the AAA committee also considered two constraints related to the performance of the audit: the competence of the auditor and the language of his report or Opinion.22 If the auditor is qualified to conduct an examination of and give his opinion regarding the firm's financial statements, then he should be competent to audit its environmental financial summary as well, since it contains the same sorts of data. However, because of the specific nature of the subject matter of the summary, the auditor must to some degree rely on the technical knowledge of environmental specialists in law and engineering. As concerns his report, the auditor would essentially state his opinion as to whether the summary has been prepared in material conformity with "established environmental reporting standards." Closer looks will be taken, later in this chapter, at the role of technical experts and the nature of the auditor's Opinion. At this point, however, attention must be given to the Ibid. 251 auditability of the other portion of a firm's environmental report. Auditing_the background information: the :assurance" approach.——In contrast to the financial summary, this part of the environmental report contains much that is descriptive rather than quantitative. Also, certain information about the nature of the firm's disruption problems and its goals and programs for abatement do tend to be more subjective than the largely-historical financial summary. Accordingly, the independent auditor probably would not be able to render the same sort of opinion on this section as he could on the summary. However, as Carmichael has recently pointed out, the independent accountant's function need not be restricted to giving either no opinion at all or "the maximum assurance of an opinion audit . . . ."23 Carmichael is concerned that the term "attest," as applied to the work of auditors, has developed an overly narrow connotation of placing a "stamp of approval" on a firm's financial statements.24 He contends that "rather than imposing a framework analogous to [generally-accepted accounting principles] on all forms of information, a better approach might be to recognize that not all information can achieve the same level of reliability and to charge the auditor with different "25 levels of responsibility for various types of information. 23Carmichael, "The Assurance FUnction," p. 68. 2nlbid., p.66. 25Ibid., p. 68. 252 In short, Carmichael proposes that accountants provide varying "levels of assurance" for different types of information. In order to provide some assurance concerning the background portion of a firm's environmental report, the independent auditor must consult with legal counsel, regulatory agencies, outside environmental experts (with particular regard to the disruption problems typical of firms in this industry), and the firm's management. Further, the auditor must study internal memoranda and board minutes to satisfy himself that the firm has not blatantly misrepresented its disruption problems (both existing and potential) and its abatement goals and progress. With regard to physical measures of disruption caused by the firm, the auditor can first check with an independent expert--perhaps a consulting environmental engineer-~to see that the measuring device (or technique) is both appropriate and working correctly. Then, the auditor can proceed to test, in a manner comparable to testing financial transactions, whether the data generated by that device have been recorded and summarized prOperly. He can study the adequacy of internal control within this segment of the firm's information system. In his article dealing with financial forecasts, Carmichael proposes some questions that an auditor might address in order to provide assurances to users of the report.26 These questions can be adapted to the independent accountant's 26 Carmichael, "Financial Forecasts," p. 85. 253 investigation of the environmental background description, particularly the information included therein that pertains to abatement goals, programs, and progress: 1. Are budgets and schedules of costs incurred to date accurately compiled? That is, have arithmetic and similar errors been avoided? 2. Are all the data presented consistent with each other? 3. Are the principles upon which these schedules were prepared consistent with both generally—accepted accounting principles and the manner of presentation used in the firm's regular financial statements and in its environmental financial summary? 4. Is there adequate disclosure of the uncertainties associated with the projections being made? Institutional Arrangements for Performing the Audit The general conclusion that can be drawn from the previous section of this chapter is that environmental reports of business firms are amenable to the audit process. Moreover, independent accountants could attest to the financial summary portion of such reports and provide a somewhat lesser degree of assurance concerning the background description. In the following paragraphs, attention will be paid to the alternative institutional arrangements under which these audits might be conducted. The CPA audit.——In discussing the auditability of environmental reports, the previous section of this chapter considered explicitly the standpoint of the independent CPA. One of the critical questions that arises in connection with this 254 approach is the role of technical experts. While the specific knowledge of such persons is definitely needed, it is not clear whether their relationships to the independent auditing firm should be that of employees or outside consultants. Use of an outside consultant would probably require the auditor to assume some responsibility for his work, but with the entire subject of the auditor's legal liability currently a tepic of considerable debate, neither arrangement has a readily-demonstrable advantage. Perhaps the approach to be followed will actually depend upon the sheer volume of environmental audit work done by a CPA firm. Firms engaged in substantial amounts of such work would probably recruit or develop in-house experts. Other firms would likely turn to consultants. A second question germane to the CPA audit of an environmental report concerns the actual and perceived relationship between this audit and the conventional financial audit. If environmental reports become required, either under SEC disclosure rules or generally—accepted accounting principles, their being audited would constitute a straightforward and necessary enlargement of the financial audit. Even under these circumstances, many CPAs would no doubt be reluctant to extend their role to embrace the audit of the environmental report-—particularly the background description section--for fear of impairing investor confidence in the financial audit. Certainly, the user of published reports would be asked to distinguish between at least two different levels of assurance. However, this degree of sophistication is not too much to expect of users. Moreover, 255 the expanded wording of the auditor's report, with emphasis on the different types of assurance being given, may actually serve to better convey the true meaning of the attest and assurance functions. If environmental reports are not specifically required, but rather are provided voluntarily by business firms; and if the standards for the preparation of such reports are not as sharply defined as they would be for required reports; it is very likely that the audit personnel of CPA firms would refrain from becoming too closely associated with the audits of 27 environmental reports. Instead, the management services staff of the CPA firm may "run" the audit, using the audit staff's review of financial aspects of the environmental report as pggt of the basis for an audit opinion. Here some valid questions might arise concerning the auditor's independence with regard to both the financial and environmental audits. Further, the distinction between the audit and management services functions within a CPA firm may become blurred. While these worries are quite real and have been discussed by others, they do not seem to be insoluble.28 27If a sufficient number of firms voluntarily prepare environmental reports, before long reporting guidelines will probably be established by either the SEC or the FASB. In all likelihood, a requirement that such reports be prepared by all firms would soon follow. 28See Carmichael, "Financial Forecasts," p. 86. Also see "Report of the Committee on Environmental Effects," p. 114. 256 The social audit approach.--An alternative to extending the scope of the CPA's audit to embrace environmental reporting would be to have a separate examination conducted along social auditing lines. It is crucial to note, however, that the characteristics of social auditing have not yet been specified clearly. At one extreme, a social audit might be made of an environmental report prepared by management; such an approach might be little, if at all, different from the CPA audit of a voluntary report, as described above. On the other hand, a social audit might comprise the preparation of a report by the social audit team with the goal of stating an opinion concerning the firm's good-citizenship or social responsibility pertaining to its environmental affairs. While the CPA firms might find no serious problems in becoming involved with social audits of the former type, they probably should avoid those of the latter. For instead of giving his professional opinion about the "fairness" of a firm's statements, a social auditor in the second situation might be stating his conclusions about the firm's actions. Such a function would be closer to the financial analysis often furnished in investment newsletters than it would be to financial auditing. It is hard to imagine a CPA firm distributing its own buy, hold, and sell recommendations for the securities of various firms, including some which it serves as auditor! By analogy, serious doubts about the CPA's independence would surface if, in addition to conducting 257 financial audits, he became associated with "social responsibility judgements." While the extent of involvement by CPAs should accordingly depend upon the specific nature of the social audit to be conducted, accounting expertise would be required regardless. In any social audit of a firm's environmental activities, much financial data must be considered, the data— processing system must be evaluated, and auditing techniques must be applied. At the minimum, a trained accountant should help supervise the audit. In all likelihood, an accountant should be the leader of an interdisciplinary audit team, as 29 suggested by Linowes. If CPA firms do not become involved, perhaps independent social auditing firms of some sort will be developed.30 Whatever the structural arrangements, accountants must participate in social audits. One last observation may be made here concerning the content of a social responsibility-environmental report for a firm. Under both the Dilley—Weygandt and the Linowes approaches, only those environmental expenditures that are not specifically required by existing regulations would appear in the statement. As Linowes states: "Such expenditures required by law . . . would not be includible since they are necessary costs of doing business." While it is important that the "degree 29 Op. Cit., p. 38. 30This possibility is noted, with some favor, in Dilley, 9.9. Cit., p. 890 258 of necessity" for each of the environmental expenditures be disclosed-—this was one of the provisions suggested earlier for the environmental report——the omission of "required" items might tend to convey an imprOper impression of the full scope of a firm's environmental activities. Perhaps in the context of a full "social responsibility operating statement;' covering such social concerns as environment, employee health and safety, product safety, minority hiring, and others; the restriction of including only "voluntary" items is appropriate. However, in constructing a comprehensive environmental report, voluntary and required items must both be presented, although they should be distinguished from each other. Government auditors.--If environmental reports, submitted by individual firms, are to be used for governmental decisionmaking pertaining to setting and enforcing environmental regulations, an audit may be required. One possibility is to have government employees perform this audit. To be sure, governmental auditors now examine government agencies, tax returns, and regulated firms such as banks and insurance companies. However, even though physical inspections of abatement devices and other such checks are now and will continue to be performed by government personnel, it is not likely that there will ever be comprehensive government audits of the environmental reports of firms. Dilley has pointed out that "social and political pressures" would tend to prohibit such undertakings and that "the job of preparing such social responsibility statements 259 would probably be too large and too expensive to meet with the "31 approval of federal and state legislators. Long before a government agency would develop its own audit staff to perform such an examination, it would be likely to require CPA certification of the firm's environmental report. Environmental Reporting Standards The preceding investigation of the auditability of environmental reports, as well as the manner in which such audits might be conducted, leads naturally to a discussion of standards for the preparation of these reports. Accordingly, this section will survey the nature of the required standards and the ways in which they might be developed. These consider- ations apply most specifically to environmental reports audited by CPAs. The types of standards needed.--In order to determine just what should appear in the background description portion of a firm's environmental report, the independent auditor will have to refer to specific guidelines established by some authoritative body. Moreover, throughout the report, standardized terminology must be used; comprehensive environmental reporting represents an innovative concept and its terminology is both unrefined and ambiguous. BlIbid. 260 Thornier problems involve the establishment of categories for environmental costs. A primary question to be resolved is just what should be considered as an environmental eXpenditure? In essence, a generally-accepted definition or set of definitions are required. Furthermore, rules must be formulated for the treatment of joint costs, common phenomena in abatement programs. There does seem to be a consensus on the theoretical superiority of the incremental cost approach, as in calculating the additional expenditures associated with building a smokestack twenty feet taller than is essential to the "basic" operation of a new power plant, in order to comply with environmental regulations.32 Often, however, a "new facility may not be available without the additional environmental control components" and thus, "the solution [to the joint cost problem] could well be that no allocations are "33 appropriate. If such a condition does exist, how should it be disclosed in the firm's environmental report? Other reporting problems concern the circumstances under which liabilities or contingencies should be disclosed, whether a pollution control cost should be treated as a product or period cost, and whether losses related to such events as the early retirement of a plant because of its inability to meet 32For instance, see "Report of the Committee on Environmental Effects," p. 104. This approach was also suggested by accounting personnel at "Midwest Utility" (see pages 188—189). 4 33"Report of the Committee on Environmental Effects." p. 10 . 261 environmental standards should be shown as operating or extraordinary items. All of these considerations have counterparts in the conventional financial reporting of business firms. Once again, some authoritative body must set the groundrules. Who will set the standards?--Government agencies that regulate either environmental disruption (such as the EPA and state air quality agencies) or industries (such as the FPC and state public service commissions) generally prescribe certain practices to be followed in preparing reports to be submitted to them, but they do not set public reporting principles in general. The SEC with its broad authority, could conceivably develop specific environmental reporting standards. Yet, this area represents both a significant challenge and an important opportunity for the public accounting profession: these standards could reasonably be set by the Financial Accounting Standards Board. Such an arrangement would be especially beneficial because of the large overlaps between environmental and financial reporting. The principles underlying these two functions must be consistent! As a procedural suggestion, this author would encourage the AICPA to appoint a broad-based commission, structured along the lines of the recent "Wheat" and "Trueblood" study groups, to develop tentative principles for environmental reports. Eventually the FASB could adopt the actual standards, upon completing its formal proceedings. 262 Once environmental reporting standards have been established, the AICPA'S Committee on Auditing Procedure could set general guidelines for aanducting environmental audits. The evidence required, the technical competence of the auditor and his reliance on independent environmental experts, and the wording of the auditor's report are perhaps the three major subjects that this committee would have to deal with. Recommendations for Future Research Efforts This dissertation has raised certain questions that can and should be tested empirically. These issues will be stated and explained briefly below. How can a firm s accounting system be modified to provide environmental reports?—-In an appendix to Chapter IX, a proposal was made for integrating Midwest Utility's environmental information (of an Operating or budgetary nature) with lbs formal accounting system. A speCific illustration was provided, dealing with accounting for the firm's fuel inventory. However, the precise manner in which environmental information can be integrated into the accounting system remains to be demonstrated. Someone should actually try to do it! Preparation and audit of an actual environmental report.-—Another research project that 263 might be undertaken would comprise an attempt to prepare an environmental report in accordance with the guidelines presented in this chapter. Furthermore, an audit of this report could be tried. Such an effort is likely to help Specify environmental reporting standards in addition to proving the feasibility of reporting and auditing environmental information. Is the information contained in the envirqnmental report useful?-—If the reports accountants prepare are not useful to decisionmakers, why continue to prepare them? There is a real need to establish the usefulness of environmental reports to economic analysts, managers, and outside users. While this dissertation does provide conceptual arguments supporting the proposition that environmental information of the kinds mentioned in this and the previous chapter should be useful, some empirical evidence must be obtained. Studies could be set up to furnish reports to users and see whether the users can and do employ them in making decisions. The broad conceptual framework developed in this dissertation as well as the conclusions presented should, hopefully, aid the investigation and resolution of these and other issues. 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