With the increasing focus on climate change and carbon emissions, companies are starting to take steps to reduce or absorb their carbon emissions. Complete elimination of carbon emissions from operations through mitigation methods is not always possible. This drives demand for carbon offsets to offset all or part of the remaining emissions generated by an entity’s operations or in its value chain.

Carbon offsets can be produced by a variety of activities that reduce greenhouse gas emissions or increase carbon sequestration. In most cases, these activities are undertaken as discrete ‘projects’. A carbon offset project, for example, may involve:

The Project Developer should carefully analyse the accounting considerations for the costs incurred for the underlying project that generates carbon offsets and their contracts to deliver carbon offsets in the future.

An entity might actively purchase carbon offsets principally with the purpose of selling in the near future to generate a profit from fluctuations in the price or traders’ margin. In this instance, the entity might want to consider whether the guidance in paragraph 3(b) of IAS 2, ‘Inventories’ for commodity broker-traders applies to the carbon offsets they trade, and if so, elect to measure the carbon offsets at fair value less costs to sell with changes in fair value recognised in profit or loss.

Question 1: What is the unit of account in assessing whether an entity qualifies for the IAS 2 commodity broker-trader exemption?

The standard requires that an entity can only apply the exemption under paragraph 3(b) of IAS 2 if the entity qualifies as a commodity broker-trader. As such, the accounting policy should be applied on a case-by-case basis. This means each type of carbon offset should be separately assessed for whether:

An entity can only apply the commodity broker-trader exemption where the separate type of offsets meets all of the criteria above. Where a condition changes which might impact whether the type of offsets meets the criteria above, the entity should reassess whether the exemption continues to apply.

Question 2: When would carbon offsets be considered as a form of commodity under IAS 2?

There is a lack of definitive guidance under as to what constitutes a commodity. Judgement should be exercised in determining whether a particular type of carbon offsets can be regarded as a commodity. Carbon offsets might be considered as a commodity if:

Whether or not a type of carbon offsets is traded in an active market is subject to judgement. An entity should apply the principles of IFRS 13 in determining whether an active market exists for each type of carbon offset under consideration. See Section 2.3 for further details.

‘Revalued amount’ is defined as the assets’ fair value at the date of the revaluation less any subsequent accumulated amortisation and any subsequent accumulated impairment losses. If an entity measures intangible assets using the revaluation model, paragraph 85 of IAS 38 requires gains as a result of the revaluation to be recognised in other comprehensive income (‘OCI’) and accumulated in equity under the heading of ‘revaluation surplus’. Entities should note this difference in presentation for intangibles carried at a revalued amount versus carbon offsets included in inventory and carried at fair value through profit or loss if the broker-trader exemption is used.

Certain industries manage their business on a fair value basis and therefore may wish to provide additional fair value disclosures. If management decides to disclose separately the fair value, its financial impact (which will not have been included in net profit), or other management information regarding the carbon offsets outside the financial statements (a non-GAAP measurement), a reconciliation might be required (depending on local regulatory requirements) illustrating the differences between the IFRS balance and the non-GAAP measurement.

IAS 1 para 67 states that the standard uses the term ‘non-current’ to include tangible, intangible and financial assets of a long-term nature. Intangible assets are generally classified as non-current assets on the balance sheet on the basis that they are usually consumed over a long term. However, unlike IAS 16, IAS 38 does not prescribe that intangible assets are expected to be used during more than one period. When entities hold carbon offsets with an expectation to retire them within 12 months (or the entity’s normal operating cycle) from the reporting date, such carbon offsets will meet the requirement under IAS 1 para 66 to be classified as current intangible assets on the balance sheet.

An entity may hold carbon offsets with the expectation that some of them will be retired within 12 months (or the entity’s normal operating cycle) from the reporting date and some will be retired later. Neither IAS 1 nor IAS 38 provides explicit guidance on the unit of account for determining current and non-current classification and therefore judgement needs to be applied. In such cases the carbon offsets can be split into current intangible assets and non-current intangible assets based on the expected timing of consumption.

When carbon offsets meet the definition of inventories (see FAQs 3.2.1 and 3.2.2), the carbon offsets will be recorded in inventory initially or at some point and subsequently in cost of sales when retired. The cash outflows to acquire these carbon offsets are generally presented within operating cash flows. Commodity broker-traders also generally present cash inflows and outflows relating to the sale and purchase of carbon offsets within operating cash flows.

IAS 7 para 16 includes cash payments to acquire intangible assets and other long term assets as an example of an investing activity. Cash outflows to purchase intangible assets are generally classified as investing cash flows in the cash flow statement. This is on the basis that intangible assets are usually consumed over a long term. However, when entities purchase carbon offsets with the expectation to retire them within 12 months (or the entity’s normal operating cycle) from the reporting date, cash outflows to purchase carbon offsets in such a case might reasonably be classified as operating cash flows.

To the extent that an initial payment is made as part of a financial or non-financial investment to obtain carbon offsets in the future (see Section 3.1), the initial cash outflow is likely to be reported within investing cash flows in many cases. The settlement of the balance via the receipt of carbon offsets will not be a cash flow, but may require disclosure as a significant non-cash transaction.

An entity that classified its carbon offsets as intangible assets, measured using the cost model, needs to determine the cost of the assets upon their usage or disposal. IAS 38 has no guidance on determining the cost of an individual unit of intangible asset on its usage or disposal where the entity holds a large number of similar items.

Management should use its judgement in developing and applying an accounting policy in the absence of an IFRS that specifically applies to a transaction, other event or condition [IAS 8 paras 10-12]. As such, management of an entity can refer to the principles of IAS 2 in determining the cost of an individual carbon offset upon its usage or disposal where there are a large number of similar items. Techniques for arriving at cost, instead of using actual costs, can be used where there are a large number of similar items. The entity should consider the type of carbon offsets when assessing whether they are similar items. For further discussion regarding cost measurement under IAS 2, please refer to paragraphs 25.30 - 25.33 of the PwC Manual of Accounting.

Entities may invest directly in carbon offset projects by contracting with Project Developers. Typically, the investors will provide the project funding up front or over time and in return they may receive a share of the carbon offsets produced during the contract period. The investors should carefully assess the contract to determine whether the nature of the arrangement is financial (equity, loan, a FVTPL financial instrument including derivatives) or non-financial (a lease, an executory carbon offsets purchase contract (including a prepayment) or a purchase of an intangible asset that entitles the entity to a share of the output of a project).

As the investor(s) has the exposure or rights to the variable returns from the carbon offset project, it should evaluate the terms of the arrangement to assess whether it is involved in the relevant decisions of the project that may constitute control, joint control or significant influence according to IFRS 10, IFRS 11 and IAS 28 requirements.

If the investment does not constitute an interest in a subsidiary, joint arrangement or associate, the investor should further assess whether the contract contains a lease under IFRS 16. The contract is deemed to contain a lease if the entity has (i) the right to substantially all of the economic benefits generated from an identified asset (for example land or forest) during the term of the contract, and (ii) the right to direct the use of the identified asset. In such a case, the entity may be required to recognise a right-of-use asset and corresponding lease liability in accordance with IFRS 16.

Where the entity assesses that it has no control over the use of the project assets, further analysis depends on whether the contract has a net settlement feature and whether it is subject to any scope exceptions in IFRS 9. See FAQ 40.83.1 in PwC Manual of Accounting for more details.

Entity A wants to secure a long-term supply of carbon offsets. In order to obtain a sufficient supply, on 1 January 20X1, entity A enters into a streaming arrangement with entity B in which entity A will make an upfront non-refundable payment of C1 million to entity B and, in return, entity A will obtain the right to receive a fixed number of carbon offsets from entity B in the future.

Entity B will use the upfront payment received by entity A and other investors to fund its initiative (project R) to protect and preserve a tropical rainforest which has high carbon storage capacity.

Entity B will deliver 10,000 carbon offsets annually to entity A for a period of 10 years starting from 1 January 20X5 (C10 per offset). It is anticipated that the price of a carbon offset will exceed C10 per offset by 1 January 20X5.

There are no clauses in the contract that cause any variation of any cash flows over the contract’s term. No further payments are required over the life of the contract as the carbon offsets are delivered.

If entity B is unable to generate sufficient carbon offsets (from project R or any of its other projects), the contract requires entity B to purchase carbon offsets for delivery to entity A. There are no terms in the contract that permit entity A or entity B to settle the contract net in cash.

Entity A does not have past practice of settling similar contracts net in cash or a practice of taking delivery of the underlying in similar contracts and selling it within a short period of time to generate profit from short-term fluctuations in price or dealer’s margin.

Entity A should consider the guidance in FAQ 3.1.1 to determine the relevant accounting standards that apply to its contract with entity B.

Entity A determines that the contract does not give rise to control, joint control or significant influence over entity B or project R, because entity B makes all of the decisions related to project R, and consent from entity A is not required.

Entity A determines that the contract does not result in the purchase of an interest in any of entity B’s assets, because it does not provide entity A with an undivided interest in any of entity B’s projects. As such, by entering into the contract to purchase carbon offsets, entity A has not purchased a tangible or intangible asset. ¹

Entity A determines that the contract does not contain a lease, because it does not provide entity A with the right to receive substantially all of the outputs from any identified asset linked to any of entity B’s projects.

IFRS 9 applies to contracts to buy or sell a non-financial item where the contracts can be settled net in cash or another financial instrument or by exchanging financial instruments in accordance with paragraph 2.6 of IFRS 9 (net settleable contracts). Contracts to buy or sell carbon offsets could be examples of such contracts.

Some net settleable contracts are outside the scope of IFRS 9 where the contract to purchase or sell the carbon offsets was entered into and continues to be for the entity’s expected purchase, sale or usage requirements in accordance with paragraph 2.4 of IFRS 9. This is commonly referred to as the ‘own use’ exception.

Please refer to the examples below with differing assumptions that consider whether the contract is within the scope of IFRS 9 (to be read in conjunction with the background information above).

Assume that entity A has readily access to a liquid spot market for carbon offsets in which transactions take place with sufficient frequency and volume and prices are available on an ongoing basis. ²

As part of a diversification strategy, entity A plans on selling the carbon offsets that it will receive in the liquid spot market, with a trading objective of generating a profit from increases in the price of a carbon offset.

Would the contract described in this example be within the scope of IFRS 9 for entity A?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to purchase carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9 (refer to EX 40.83.2 in the PwC Manual of Accounting); that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

Since entity A plans on selling the carbon offsets in the liquid spot market with a trading objective, as opposed to securing the carbon offsets to meet its expected sale, purchase or usage requirements, the contract with entity B will not qualify for the ‘own use’ exception. Therefore, the contract will be within the scope of IFRS 9 for entity A.

Entity A has determined that it does not meet the ‘own use’ exception at inception of the contract, so it would not be able to reclassify the contract if circumstances change, subsequent to inception, and the entity assesses that it would subsequently meet the ‘own use’ exception. Please refer to FAQ 40.81.1 in the PwC Manual of Accounting for further details.

The contract does not meet the definition of a derivative in Appendix A to IFRS 9, because the investment of C1 million is fully prepaid at inception. The prepaid amount will be accounted for as if it were a financial asset. Since entity A has the right to receive a fixed number of carbon offsets in the future, and the fair value of credits received will vary, the contract does not meet the solely payments of principal and interest requirements under IFRS 9 as noted in PwC Manual of Accounting FAQ 40.79.1. Therefore, the financial asset is measured at fair value through profit or loss.

Assume that entity A does not have access to a liquid spot market for carbon offsets.

Entity A intends to use the offsets to offset its own emissions to achieve its own net-zero targets. Entity A does not intend to sell the offsets. In other words, the contract was designed by entity A to be used solely for its own usage requirements.

Is the contract described in this example within the scope of IFRS 9 for entity A?

The contract cannot be settled net in cash, because:

Since the contract is not net-settleable, it does not fall within the scope of IFRS 9. Instead, the prepaid amount should be accounted for as a non-financial asset – that is, a prepayment representing the right to receive carbon offsets.

Even if, at inception, the contract is not within the scope of IFRS 9, it should still be assessed to identify if there are any separable embedded derivatives that should be accounted for under IFRS 9. In this example, because there are no non-closely related embedded derivatives in the contract between entity A and entity B, there are no separable embedded derivatives in the contract.

Assume that entity A readily has access to a liquid spot market for carbon offsets in which transactions take place with sufficient frequency and volume and prices are readily available on an ongoing basis. ³

Entity A intends to use the offsets to offset its own emissions to achieve its own net-zero targets. Entity A does not intend to sell the offsets. In other words, the contract was designed by entity A to be used solely for its own usage requirements.

Is the contract described in this example within the scope of IFRS 9 for entity A?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to purchase carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9; that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

However, since entity A intends to use all of the offsets solely to offset its own emissions to achieve its own net-zero targets and does not intend to sell any offsets, entity A concludes that the purchases are in accordance with its expected usage requirements. In this case, entity A can apply the ‘own use’ exception. Accordingly, the contract is not within the scope of IFRS 9 at inception. Instead, the prepaid amount should be accounted for as a non-financial asset – that is, a prepayment representing the right to receive carbon offsets.

If, subsequent to inception, circumstances change and the contract no longer continues to be held for ‘own use’, the contract will subsequently be within the scope of IFRS 9. Refer to FAQ 40.84.7 in the PwC Manual of Accounting for further details.

Embedded derivatives would be considered in a similar manner to the discussion in Example B.

Entities may sell products that are labelled as ‘carbon-neutral’. The ‘carbon-neutral’ feature is determined based on the entity’s calculation of the quantity of emissions generated in the production process and the purchase and retirement of equivalent carbon offsets to make the production process carbon-neutral. These products have higher costs due to the purchase of carbon offsets and are usually sold at a premium versus similar products that are not carbon-neutral.

Under IAS 2, inventories include “materials and other supplies held for use in the production of inventories” or “materials or supplies to be consumed in the production process or in the rendering of services”. When carbon offsets are purchased for the sole purpose of producing carbon-neutral products, although they are not physically consumed in the production process, they could be considered to be consumed together with the production of carbon-neutral products. They would, therefore, meet the definition of inventories. An entity might need to apply judgement in this case to determine the point in time that the offsets become part of inventory, that is, when purchased or when retired as part of the production process. It might be acceptable to conclude that such carbon offsets will be scoped out of IAS 38 and classified as inventories when purchased. The carbon offsets will effectively be a raw material until the products are labelled as carbon-neutral. The classification should be applied consistently and disclosed appropriately.

The costs of the carbon offsets will be included in the cost of the carbon-neutral products when they are retired for the carbon-neutral products and included in costs of goods sold when the carbon-neutral products are sold.

As discussed under Section 2.2, IAS 38 accounting principles apply when the carbon offsets held do not fall within the scope of another standard. It might make sense to classify fungible carbon offsets that could be used either for production of carbon-neutral products or the achievement of overall voluntary emission targets as intangible assets at the time of purchase. This is because, at the time of purchase, the entity cannot reliably conclude that the carbon offsets will be used in the production of goods. Depending on their usage, entities could include their costs in the cost of the carbon-neutral products (see FAQ 3.2.1 above) or expense their costs in profit and loss when the offsets are retired to achieve overall voluntary emission targets.

However, if the group designates separate pools for its fungible carbon offsets with different purposes and have appropriate controls in place, it might also be considered acceptable to determine the classification separately for each pool of carbon offsets.

Carbon offsets usually don’t have an expiry date. If the entity holds carbon offsets only for investment purposes (that is, capital appreciation) over an extended period of time, their useful life may be considered indefinite. However, their useful life will be considered finite if they are held to be sold within a short period of time outside of the entity’s ordinary course of business. When carbon offsets are held for voluntary use, each offset has a limited usage of one retirement. In such cases, their useful life will also be considered finite.

Carbon offset intangible assets considered to have indefinite useful life need to be tested annually for impairment. Different types of carbon offset intangible assets may be tested for impairment at different times. However, carbon offset intangible assets initially recognised during the current annual period should be tested for impairment before the end of the current annual period.

For carbon offset intangible assets considered to have finite useful lives, entities should assess, at each reporting date, whether there is any indication that carbon offsets held for use might be impaired.

Carbon offsets held for voluntary use with no constructive obligation usually do not generate cash inflows that are largely independent from other assets. Entities should identify the cash-generating unit (CGU) that the carbon offsets belong to, considering the intended retirement of the offsets. For example, if the carbon offsets are intended to be retired against the emissions of a specific operation identified as a CGU for impairment testing purposes, value in use should be determined for that operation.

Carbon offsets that are part of general net zero commitments may meet the definition of corporate assets under IAS 36. This is because they are likely to contribute to future cash flows of multiple CGUs. They should be tested for impairment by applying the approach prescribed in IAS 36.102.

Other carbon offset intangible assets that are not held for use (for example held for investment purposes over an extended period of time, or sold within a short period of time outside of the ordinary course of business) generate independent cash inflows at the individual asset (unit) level and should be tested for impairment separately. Carbon offsets that meet the definition of inventories (see FAQ 3.2.1) are measured at the lower of their cost and net realisable value under IAS 2.

Cash and non-cash costs (for example depreciation of physical assets) that are not costs to build physical assets may be incurred to generate carbon offsets. Carbon offsets generated by the Project Developer for sale will be classified as inventories, which are intangible in nature. Accordingly, costs that are directly attributable to the generation of carbon offsets will be capitalised as part of the cost of the carbon offset inventories. Such costs will also include a systematic allocation of fixed and variable production overheads in accordance with IAS 2.

Determining the cost of the offsets generated in accordance with IAS 2 can be a complex exercise. It requires an understanding of the carbon absorption or avoidance process for the particular project. Further, quantifying the number of carbon offsets that are to be generated over the life of a project and allocating the period on period costs to the expected units from a project is often challenging.

Entities should also analyse operating and maintenance costs incurred to identify (i) costs that enhance the underlying assets and can therefore be capitalised, and (ii) maintenance costs that should be expensed. Additionally, some projects may generate two or more products or services (for example renewable energy and carbon offsets). Costs incurred on such projects typically need to be allocated to the multiple products they produce.

Entities should analyse the specific facts and circumstances for each such project to determine how to account for the costs incurred before allocating them to the costs of carbon offset inventories in accordance with IAS 2.

No. Carbon offsets generated by the trees do not meet the definition of agricultural produce because they are not a ‘harvested produce’ from the trees. By nature, carbon offsets lack physical substance. The certification of a carbon offset due to the capture of a tonne of carbon does not represent a harvest from the trees.

Trees that are planted to only generate carbon offsets will not be accounted for under IAS 41 or as a bearer plant under IAS 16 as the trees serve no other purpose. They are tangible assets held for use in the ‘production’ of carbon offsets over a long term and, therefore, meet the definition of property, plant and equipment under IAS 16 and will be accounted for in accordance with IAS 16.

Expenditures to establish and develop the trees and related borrowing costs need to be assessed against the capitalisation criteria under IAS 16 and IAS 23 based on specific facts and circumstances. Entities should estimate the residual value (for example scrap sales) and the useful lives of trees considering its economic life during which they can absorb carbon dioxide. They should determine an appropriate method of depreciation by considering the pattern in which carbon offsets are expected to be generated from them. The depreciation charge will be included in the cost of carbon offset inventories.

A carbon offset project developer plants timber trees that generate carbon offsets during the project life. In many cases, project developers are allowed to harvest the trees after a required period. The trees will be harvested and sold as timber at the end of the project. The developer manages the forest in accordance with the practices required for the certification of carbon offsets – that is, to generate as many carbon offsets as possible.

How should the project developer classify these trees that are managed primarily to generate carbon offsets, where they will be harvested and sold at the end of the project?

Trees that relate to agricultural activity (except those that meet the definition of a bearer plant) should be accounted for in accordance with the requirements of IAS 41. Carbon offsets are not agricultural produce (see FAQ 4.2.1), hence the trees that do not produce agricultural produce will not meet the definition of a bearer plant under IAS 16.

The developer should therefore consider whether the definition of agricultural activity is met. Agricultural activity is defined as the management by an entity of the biological transformation and harvest of biological assets for sale or for conversion into agricultural produce or into additional biological assets.

Management of the trees, even though primarily managed for carbon offsets, would typically relate to the biological transformation of the trees and contribute to the timber to be harvested at the end of the project.

IAS 41 does not provide guidance on the extent of harvest needed to qualify as an agricultural activity. In our view, the developer might analogise to the definition of a bearer plant under IAS 16 that permits incidental scrap sales (for example, fruit trees sold for firewood at the end of their lives) not to taint the definition of bearer plants. As such:

Judgement will need to be exercised on what is considered ‘incidental scrap sales’ in the context of the project – for example, by comparing the present value of the timber with the present value of both outputs (the carbon offsets and timber) to be generated from the trees.

See FAQ 4.2.4 for initial measurement of the carbon offsets generated from trees accounted for under IAS 41; and FAQ 4.2.3 for measurement of carbon offsets generated from trees that are accounted for under IAS 16.

When the trees are accounted for under IAS 16, the carbon offsets they produce are accounted for under IAS 2. They are initially measured at cost and this will include the depreciation of the trees.

When the trees that can generate carbon credits fall into IAS 41, because they are managed for agricultural activities, they are accounted for as biological assets and measured at fair value less costs to sell. This will include economic benefits related to the carbon offsets to be generated (see FAQ 33.21.3 in PwC Manual of accounting). Carbon offsets are generated over the life of the trees and they are separately recognised. The fair value of the trees is reduced by the fair value less costs to sell off the carbon offsets as the future cash flows of the trees no longer include these carbon offsets. It is therefore appropriate to treat the reduction in the carrying amount of the trees when carbon credits are generated, that is the fair value less costs to sell of the carbon credits, as the initial cost of the carbon offsets generated. The accounting outcome is similar to agricultural produce harvested from biological assets at the point of harvest.

An entity involved in developing new ‘green’ technology (such as Carbon Capture and Storage), might incur significant research and development costs. Following EX 21.32.1 – Application of recognition criteria to each stage of the product life cycle in PwC’s Manual of Accounting, management should consider the product life cycle and then apply the recognition criteria listed in paragraph 57 of IAS 38 at each stage of that cycle. There is no generic indicator of the commencement point for capitalising such internal development costs. Management needs to use judgement based on the facts and circumstances of each project.

Costs incurred in developing these new technologies may include studies regarding technological innovation, conceptual project design, technical, commercial and economic feasibility and potential locations. These activities occur before the entity moves onto more detailed front-end engineering and design (commonly known as FEED) of a pilot facility or pre-use prototype.

The entity may expect there to be significant growth opportunities in the market over the coming years since such projects are a major part of many countries’ net zero proposals. When evaluating whether these types of projects meet the recognition criteria listed in paragraph 57 of IAS 38,

The following considerations are helpful:

If the conclusion around capitalising these development costs is judgemental an entity should consider whether this should be disclosed as a significant judgement under IAS 1 para 122 in the financial statements.

As well as these intangible development costs, physical assets with a possible alternative use may be purchased as part of the development phase. These should be separately assessed for capitalisation under the recognition and measurement requirements of IAS 16 ‘Property, plant and equipment’ and depreciated over their useful economic life.

IFRS 6 states that an entity should determine an accounting policy specifying which expenditures are recognised as exploration and evaluation assets. In practice many entities in the extractive industries, for example, mining, oil and gas, have developed a policy of capitalising certain exploration and evaluation assets.

Entity A is an oil and gas entity and has incurred significant costs on researching certain carbon capture projects and investigating the feasibility of using existing technology and facilities/infrastructure owned or developed by themselves and other extractive entities in these projects.

Since the entity is itself engaged in extractive activities would it be able to develop a policy for such carbon capture under IFRS 6?

Extractive activities include:

[IASB In brief January 2022].

In many cases, green projects may involve ‘storage’ of carbon or hydrogen in existing oil and gas facilities or rehabilitation of existing mines or production sites for such other purposes.

However, the definitions in IFRS 6 confirm that exploration and evaluation expenditures are those incurred in the search for mineral resources (including minerals, oil, natural gas and similar non-regenerative resources), and in the determination of the technical feasibility and commercial viability of extracting the mineral resource, after the entity has obtained the legal rights to explore a specific area.

Although Entity A’s carbon capture project will utilise certain extractives technology or assets, the project does not generally involve the search for or evaluation of mineral resources. This is because it involves the sequestration of a gas. Therefore, the expenditure is outside the scope of IFRS 6 and should be evaluated under IAS 38 ‘Intangible assets’, which has specific guidance on the accounting for research and development costs.

However, in some cases plans may include the use of the stored CO2 for enhanced recovery techniques (refer to the International Energy Agency website for information) of resources. To the extent an entity is incurring such costs as part of the exploration of an oil field, there may be limited instances where it can be argued that these costs relate to the exploration and evaluation of oil and qualify as exploration and evaluation expenditures.

IAS 38 requires activities conducted under the research phase outside the scope of IFRS 6 to be expensed as incurred. Research is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding” [IAS 38 para 8].

Other than in the limited cases where such expenditures can be argued to be within the scope of IFRS 6, they would likely meet the definition of research and should therefore be expensed. Entity A could consider whether it is possible to capitalise any costs as development costs as the project progresses by evaluating the costs incurred each period using the criteria for development costs in IAS 38 discussed in EX 4.3.2.1.

Entity A is a carbon offset project developer and currently has multiple carbon offset projects in its portfolio at various stages of development. As an output of its ordinary activities, entity A sells carbon offsets that are generated from its various carbon offset projects.

Entity A is embarking on a new wind energy project (project W) that aims to harness wind energy potential to balance energy needs in a particular region.

Entity A enters into a long-term contract on 1 January 20X1 to deliver a fixed number of carbon offsets in the future to entity B. Entity B will make an upfront non-refundable payment of C1 million to entity A and in return entity B will obtain the right to receive 10,000 carbon offsets annually from entity A for a period of 10 years starting from 1 January 20X5 (C10 per offset). Entity B will not receive any electricity as part of the long-term contract.

If Entity A is unable to generate sufficient carbon offsets (from project W or any of its other projects), entity A will need to purchase carbon offsets for delivery to entity B. There are no terms in the contract that permit entity A or entity B to settle the contract net in cash.

Assume that entity A readily has access to a liquid spot market for carbon offsets in which transactions take place with sufficient frequency and volume and prices are available on an ongoing basis. ¹

Also assume that there are no clauses in the contract that cause any variation of any cash flows over the contract’s term. No further payments are required over the life of the contract as the carbon offsets are delivered.

Entity A should consider the guidance in Section 4.4 to determine the relevant accounting standards that apply to its contract with entity B.

Entity A determines that the contract does not provide entity B with control, joint control or significant influence over entity A or project W because entity A makes all of the decisions related to project W, and consent from entity B is not required.

Entity A determines that the contract does not result in the sale of an interest in any of Entity A’s assets, because it does not provide Entity B with an undivided interest in any of Entity A’s projects. As such, by entering into the contract to sell carbon offsets, Entity A has not sold an intangible asset. ²

Entity A determines that the contract does not contain a lease because it does not provide entity B with the right to receive substantially all of the outputs from any identified asset linked to any of entity A’s projects.

IFRS 9 applies to contracts to buy or sell a non-financial item where the contracts can be settled net in cash or another financial instrument or by exchanging financial instruments in accordance with paragraph 2.6 of IFRS 9 (net settleable contracts). Contracts to buy or sell carbon offsets could be examples of such contracts.

Some net settleable contracts will be outside the scope of IFRS 9 where the contract to purchase or sell the carbon offsets was entered into and continues to be for the entity’s expected purchase, sale or usage requirements in accordance with paragraph 2.4 of IFRS 9. This is commonly referred to as the ‘own-use’ exception.

Assume Entity A’s accounting policy is to apply ‘interpretation B’ referred to in FAQ 41.22.1 in the PwC Manual of Accounting.

Please refer to the examples below with differing assumptions that consider whether the contract is within the scope of IFRS 9 (to be read in conjunction with the background information above).

In the past, when its own projects did not generate enough carbon offsets, entity A purchased carbon offsets in a liquid spot market and delivered these carbon offsets to settle its obligations under its contracts. Based on entity A’s expectation of the carbon offsets that will be generated by project W and its other projects, and the number of carbon offsets that it has contracted to deliver in the future, entity A anticipates that it will purchase more than an insignificant number of carbon offsets to meet its obligation to deliver 10,000 carbon offsets to entity B. In other words, the contract was not designed by entity A to be fulfilled solely by its own production. Instead, the structural mismatches in the contract will require entity A to purchase a substantial number of carbon offsets from the market to fulfil its obligation under the contract.

Would the contract described above be within the scope of IFRS 9 for entity A and what would be the initial classification considerations?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to deliver carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9; that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

Entity A also anticipates that it will not generate enough carbon offsets from its projects (including project W) and will have to purchase more than an insignificant number of carbon offsets in the future to meet its obligation to deliver 10,000 carbon offsets to entity B. As noted in FAQ 40.84.2 in the PwC Manual of Accounting, ‘own-use’ means the quantity specified in the contract is expected to be sold by the entity over a reasonable period in the normal course of business. In this contract, as there are structural mismatches requiring entity A to purchase a substantial number of carbon offsets from the market to fulfil its obligation under the contract, the contract quantity is not what entity A is expected to sell over the contract period in the normal course of its business from its own production. Therefore, entity A will not be delivering all of the carbon offsets in its contract with entity B in accordance with its expected sale requirements to be derived from the output of its own production and hence the ‘own-use’ exception is not met. Therefore, the contract is scoped within IFRS 9 for entity A. The contract is accounted for as if it was a financial instrument, with cash flows imputed based on the net settlement of the delivery of carbon offsets.

As noted in PwC Manual of Accounting FAQ 40.79.4, the unit of account under IFRS 9 is the contract, hence, Entity A would not be able to split the contract into portions and assess if there is a portion of the contract which is outside of the scope of IFRS 9.

Since entity A has determined that it does not meet the ‘own-use’ exception at inception of the contract, it would not be able to reclassify the contract if circumstances change, subsequent to inception, and the entity assesses that it would subsequently meet the ‘own-use’ exception. Please refer to PwC Manual of Accounting FAQ 40.81.1 for further details.

The contract does not meet the definition of a derivative in Appendix A IFRS 9 because the investment of C1 million is fully pre-paid at inception. There is an embedded derivative in the contract as the imputed cash flows are determined so as to represent the value of the carbon offsets to be delivered. The imputed cash flows are therefore indexed to the price of the carbon offsets. The contract is a hybrid contract that contains a host contract that is a liability in the scope of IFRS 9. Entity A should assess if an embedded derivative shall be separated from the host contract and accounted for as a derivative by assessing the criteria in paragraph 4.3.3 of IFRS 9.

The separation criterion in paragraph 4.3.3 (a) of IFRS 9 requires that the economic characteristics and risks of the embedded derivative are not closely related to the economic characteristics and risks of the host. To apply this criterion, it is necessary to determine what the economic characteristics and risks of the host contract are. Paragraph B4.3.2 of IFRS 9 specifies that if the host contract is not an equity instrument and meets the definition of a financial instrument, then its economic characteristics and risks are those of a debt instrument.

As noted in the background above, Entity A’s accounting policy is if a contract is accounted for as if it was a financial instrument in accordance with paragraph 2.4 of IFRS 9, this means that the contract is scoped within IFRS 9 but does not automatically mean the contract includes a debt host contract for the purposes of applying paragraph B4.3.2 of IFRS 9. Instead, the entity should assess the contract further based on the substance of the arrangement.

The substance of the arrangement is that the contract can only be settled by entity A delivering physical carbon offsets to entity B which entity A sells as part of its ordinary activities. Therefore, entity A concludes the hybrid contract includes a non-financial host contract – specifically, a contract to deliver carbon offsets.

The embedded derivative is closely related to the non-financial host contract because the underlying economic characteristics and risks of the embedded derivative (which vary based on the price of the carbon offsets) are not dissimilar to the host contract’s economic characteristics and risks. Therefore, as all conditions per paragraph 4.3.3 of IFRS 9 are not met, the embedded derivative should not be separated from the host contract. ³

Assuming that the fair value option in accordance with paragraph 4.2.2 of IFRS 9 is not applied, the contract should be accounted for as a financial liability measured at amortised cost reflecting the estimated value of offsets to be delivered as an imputed cash outflow. Subsequently, the financial liability will be remeasured to reflect changes in the estimated value of offsets to be delivered in accordance with paragraph B5.4.6 of IFRS 9 (refer to PwC Manual of Accounting FAQ 42.123.3). Refer to EX 4.4.2 for an illustration of the subsequent accounting for such a contract.

This conclusion that the ‘own-use’ exception cannot be applied by entity A might differ from the conclusion reached by entity B – that is, the assessment for each counterparty is not symmetrical. Entity B’s accounting analysis will be made independently (and without the knowledge) of entity A’s accounting treatment based on its own facts and circumstances and business model for the carbon offsets. For further guidance, refer to PwC Manual of Accounting FAQ 40.84.5 – What factors should be considered when determining whether a contract meets the ‘own use’ exemption? Do both counterparties have to reach the same conclusion?.

Based on entity A’s expectation of the carbon offsets that will be generated by project W and its other projects, and the number of carbon offsets that it has contracted to deliver in the future, entity A anticipates that its projects will produce a sufficient number of carbon offsets to meet its obligation to deliver 10,000 carbon offsets to entity B. In other words, the contract was designed by entity A to be fulfilled solely by its own production.

Would the contract described above be within the scope of IFRS 9 for Entity A and what would be the initial classification considerations?

Entity A readily has access to a liquid spot market for carbon offsets, so the contract to deliver carbon offsets meets the requirement in paragraph 2.6(d) of IFRS 9; that is, the carbon offsets are readily convertible to cash, so the contract with entity B can be settled net in cash.

However, since entity A is expecting to deliver all of the carbon offsets to entity B from its own production, the contract will be fulfilled in accordance with entity A’s expected sale requirements (similar to PwC Manual of Accounting FAQ 40.84.3). Hence, entity A applies the ‘own-use’ exception. Accordingly, the contract is not within scope of IFRS 9 at inception.

If, subsequent to inception, circumstances change and the contract no longer continues to be held for ‘own-use’, the contract will subsequently be within the scope of IFRS 9. Refer to PwC Manual of Accounting FAQ 40.84.7 for further details.

Even if, at inception, the contract is not entirely within scope of IFRS 9 it should still be assessed to identify if there are any separable embedded derivatives that should be accounted for under IFRS 9. In this example, because there are no non-closely related embedded derivatives in the contract between entity A and entity B there are no separable embedded derivatives in the contract.

Instead, because carbon offsets are an output of Entity A’s ordinary activities, it should account for the contract as a revenue contract within the scope of IFRS 15. Entity A will account for the prepayment as a contract liability and will recognise revenue in the future when the carbon offsets are delivered to entity B. Entity A should evaluate whether a significant financing component exists within the revenue arrangement (see PwC Manual of Accounting paragraphs 11.95 - 11.110).

Assume that the background is the same as in example A in FAQ 4.4.1. However, for simplicity, assume that the contract is a two-year contract instead of a 14-year contract, and that entity B will obtain the right to receive 10,000 carbon offsets on 31 December 20X2 (in one delivery). The key background facts are reproduced below:

Assume, for the purposes of the example, that:

Similar to FAQ 4.114.4 in the PwC Manual of accounting, the accounting at the date of delivery is less clear. One approach is that the contract continues to be accounted for as a contract within the scope of IFRS 9 and not within the scope of IFRS 15 (see para 5(c) of IFRS 15), and so it does not give rise to ‘revenue from contracts with customers’ or related cost of sales.

It can, however, also be argued that, although the contract is within the scope of IFRS 9, it is nevertheless a contract with a customer to sell carbon offsets which are an output of entity A’s ordinary activities. In particular, Appendix A to IFRS 15 defines a customer as “a party that has contracted with an entity to obtain goods or services that are an output of the entity’s ordinary activities in exchange for consideration”.

Under this view, the accounting reflects that, at delivery, two transactions take place: the settlement of a liability to deliver a fixed number of carbon offsets (valued at C1,400,000, the spot price, at delivery date); and the delivery of carbon offsets (for which the carrying amount is C1,400,000).

In March 2019, the IFRS® Interpretations Committee issued an agenda decision ‘Physical Settlement of Contracts to Buy or Sell a Non-financial Item’. This guidance applies to a contract that will be physically settled by delivering an underlying non-financial item and fails the ‘own use’ exception in paragraph 2.4 of IFRS 9. Consistent with this agenda decision, entity A is neither permitted, nor required, to 'undo' the subsequent accounting of the liability (including the effective interest on the liability and the remeasurement of liability in accordance with para B5.4.6 of IFRS 9), and so revenue must be measured based on the value of the related liability, representing the transaction price, at delivery date.Even though this agenda decision only refers to not reversing derivative gains and losses, and the contract described in the background does not meet the definition of a derivative, the guidance should be applied to the other potential subsequent measurement outcomes under IFRS 9. This is because reversing the subsequent measurement entries would negate the subsequent measurement requirements in IFRS 9 without any basis to do so.²

¹ For simplicity, the illustrative journal entries do not include the journal entries for purchase of any carbon offsets. It is assumed that inventory is measured close to fair value at the spot price of C1,400,000 on delivery date.

² Depending on entity A’s accounting policy for interpreting ‘as if the contracts were financial instruments’ in paragraph 2.4 of IFRS 9 (refer to FAQ 41.22.1 in the PwC Manual of accounting), the measurement of the contract in accordance with IFRS 9 might be different. For example, the contract might be assessed to include a debt host contract and an embedded derivative that must be separated from the host contract. Alternatively, entity A might elect to apply the fair value option in accordance with paragraph 4.2.2 of IFRS 9 to the entire contract. Regardless of which of these measurement outcomes applies under IFRS 9, it is considered acceptable for entity A to recognise revenue based on the value of any related instruments representing the transaction price.