Question

If a major Australian mining company reports record profits, is this profit figure misleading if the same company has polluted various river systems and has emitted toxic substances into the air, and has not placed a cost on these externalities? Explain! What is an externality, and why do financial accounting practices typically ignore externalities?

Answer 1

Meaning of Externalities-

Externalities are the impact, whether positive or negative, of any activity, on the party who is not associated with the activity. Externalities may be in the form of cost or benefit.

Reason for the ignorance of externalities in financial accounting practices is -

1. The nature of financial accounting, that is the subject is more concerned about financial data.

2. If it does not affect the company / organization directly or indirectly, it is not recognized in the accounts. Since, externalities are not affecting the organization, they are not accounted for.

If a major Australian mining company reports record profits, this profit figure is MISLEADING, if the same company has polluted various river systems and has emitted toxic substances into the air, and has not placed a cost on these externalities.

Keeping in mind, the effect of the pollutants, it is very important to penalise the company if it crosses the standards. The company is also obligated towards the society and environment.

The profits are also misleading as there are chances that the company may suffer the legal implications in near future. Though financially, the profits are not misleading but considering the social obligation, the profits are misleading.