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Externalities - Accounting for Social Costs

By Edited Jul 29, 2016 0 0


The traditional function of accounting in society has been the identification, measurement, analysis and communication of economic information to parties to enable informed and ‘rational’ resource allocation decisions (Hamilton, Garner, Black and Jackson, 1993). This traditional role of accounting is still essential to the operation of a modern society, however, society’s views on how the planets limited resources are managed and the information required to account for this impact is changing (Chua, 1990).

As a consequence of this growing concern about the environment and social issues, society has begun to demand businesses become more accountable for the resources they use and the impact they have upon society itself. This has led to the further development of social accounting, which moves away from the traditional economic and financial based accounting system to include the process of disclosing the total impact that an organisation has upon its environment, i.e. the social costs and benefits (Ng, 1985).

The purpose of this essay is to examine different perspectives of accounting for externalities, the problems faced in providing practical solutions and what models have been developed to internalise them into the accounting system.



Externalities may be defined as:

Benefits or costs incurred in the production or consumption of goods and services that do not accrue to the producing or consuming unit, but rather to the remainder of society (Sharp and Leftwich, 1986, p. 404).

The important distinction between externalities and private benefits and costs is that the later accrue to the entity directly investing in the resources and the former are incurred by all of society.

Externalities cover both social benefits and social costs. Social benefits are all benefits generated from the creation of a product or service, such as employment and technology. Social costs are all costs incurred by society as a whole in the creation of goods and services, e.g. pollution (Pearce and Sturmey, 1966).

Although social benefits are as important in the study of externalities, the scope of this essay will focus on the area of social costs.



The purpose in incorporating social costs within the macro and micro economic models and decision systems is: to utilise resources efficiently, to maintain social equity, and to enhance the quality of life (Chua, 1990, P. 3).

Three economic perspectives or paradigms have emerged as to provide a solution to the problem of incorporating and reporting of social costs. The first is the socialists perspective which states that the solution does not lie within the capitalist framework, but within a shift away from market control to government control. The second paradigm is the Pigovian school of thought which states that the solution to the social cost problem lies in modifying the market system so value is placed on social costs. The third and final paradigm is the free market approach, which in contrast to the socialist perspective, maintains the position that the capitalist system can provide the answers to social costs. (Freedman, 1975).



The whole basis of the socialist thought, in contrast to Pigovian and free market, is social costs are incorporated into and are a typical part of the capitalist based market mechanism (Freedman, 1975). They form part of the market mechanism because traditionally the areas of social costs, such as water ways and air, are considered “free goods”. As these goods are free, there is no reason for an entity to monitor and use these resources efficiently and in an environmentally friendly manner (Meister, 1991). Therefore, since social costs are very much excluded from the current economic models, a new system of resource allocation must be developed, replacing the capitalist system. This shift in decision models is required because of the need to have social costs incorporated into all investment decisions (Kapp. 1972).

Kapp (1972) goes onto to suggest that the setting of minimum economic and environmental standards which both public and private organisations must meet would be more effective and efficient use of resources than through the imposition of taxes and subsidies, as advocated by the Pigovian position. Minimum standards would be more effective through ensuring resource allocation is directly targeted, unlike indirect methods using the market mechanism as the means of allocating resources.

In effect, Kapp (1972) is advocating much more of a command economy through regulation and control of industry. His primary reason for this appears to be his belief that:

firms will not take into account the possible social costs that might result from a particular action unless they are forced to do so (Kapp, 1972, p. 18).

For this reason, Kapp (1972) recommends the replacement of the capitalist system, because under such a system there is no incentive to consider social costs in business decision making due to the emphasis upon profit and shareholder wealth maximisation. As Meister (1991) states a producer is “free to use a river as a waste disposal sink [ rational economic behaviour dictates that full use should be made of that free resource for waste discharge” (p. 4). Therefore penalties must be imposed on public and private organisations creating social costs above prescribed levels.

As a result of the need in controlling and regulating industry through both direct and indirect methods, two steps must be carried out. The first involves the setting of society’s priorities (Kapp, 1972). This would mean establishing economic, social and environmental priorities and goals; and achieving the right combination of all three. The second step would involve establishing the process of causation for social costs. As Kapp (1972) states:

Only if we view the process of causation correctly can we hope to make headway with the urgent task of controlling this disruption or at least limiting its most destructive effects (p. 16).

How such a process of successfully carrying out the two steps could be done Kapp (1972) does not specify. Due to the increasing changes in technology and complexity of modern societies, the process of setting society’s priorities and causation of social costs appears daunting at best. However, this is not to suggest it should not be attempted at all.



The Pigovian paradigm is based on the early work on social costs by A.C. Pigou (1948). Proponents of the other three paradigms generally agree on Pigou’s analysis of social costs and their origins. However, only one group agree on Pigou’s solution for eliminating social costs and they are refered to as the Pigovian school (Freedman, 1975).

The Pigovian school of thought believes that the market based system of resource allocation can still be used in a solution for social costs (Pigou, 1948). Unlike the socialists who consider that it is necessary to replace the capitalist system. As Freedman (1975) states: the social cost problem lies in modifying the market system so that a value is placed on social costs p.’8-9).

Pigou (1948) suggested that the imposition of taxes or some other form of costs could be used in placing value on the social costs - which under the (unmodified) market based system have no value.

Three options that are generally available under a taxation approach are licensing, subsidies and taxation (Van Meer, 1993).

Through the assignment of taxes a surrogate price for social costs can be made: This would then allow the price mechanism to efficiently allocate resources based on the new prices. By allowing the markets to allocate resources, unlike the socialist approach, the Pigovian school of thought believes the pursuit of profit and shareholder wealth maximisation will create the maximum social benefits and the least social costs (Pigou, 1948). By incorporating or internalising the social costs within goods and services through such a tax system would lead to a “socially optimal allocation of services” (Freedman, 1975, p. 13).

A common problem with the socialist and Pigovian approaches is the identification and quantification of social costs. Under the Pigovian system the market mechanism will only efficiently and effectively allocate resources if the right tax system is established to allow it to do so. This means a careful process of identification and quantification of social costs before imposition of any tax system Pigou, 1948). This process is very important as it enables the best alternative to be established that will maximise the net social benefit to society (Freedman, 1975).



The free market position views the solution to social costs can be achieved through the use of the market mechanism (Freedman, 1975). Unlike the Pigovian perspective, the free market states social costs can be dealt with through the process of negotiation (Freedman, 1975); in which all parties involved with the social cost would negotiate a “fair” settlement between themselves (Wellisz, 1964).

The basis of the free market perspective is the that market mechanism operating under the capitalist philosophy can achieve the optimum allocation of resources for society. Free market proponents argue against the Pigovian approach of government intervention because of the resulting sub-optimal resource allocation through market distortions.

Government intervention would result in the ineffective and inefficient operation of the market because of the difficulty, if not impossibility, of specific identification, quantification and measurement of social costs. Free market proponents contest that government intervention through taxes, subsidies or any other form of indirect or direct control cannot achieve an optimum position and in fact the process, in many cases, in trying to achieve this position outweigh any possible gains (Turvey, 1963).



The economic and accounting perspectives reviewed above provide an outline to different approaches to accounting for social costs caused by the presence of externalities. However, Nobiernsto the implementation and execution of these approaches are present. Three of the major difficulties are outlined below.


Without some form of standards or regulations organisations will generally not report or include social costs in decision making (Chua, 1991). The main reason for this situation is the current market mechanism does not encourage the inclusion of social costs. What it does encourage is minimising private costs to enable maximum profit and shareholder wealth.

The absence of regulation for social costs leads to other problems, even if organisations do report, of measurement and valuation. Determining which measurement and valuation techniques to employ is very subjective due to the possible number of processes and techniques available. Individual organisations are left to their own devices in devising which measurement and valuation techniques best suit their needs.

This situation leads onto the area of attesting for the social cost information disclosures. If there are no regulations or guidelines, no satisfactory audit can be achieved, as there is no benchmark to determine whether the statements present a “true and fair view• of an entity’s performance and position. This results in the problem of distinguishing between information and pure advertising.

The final concern is the actual use of disclosed social cost “information” to the user. If there is no audit or process of validating the information, users could not place any reliance upon its value. Comparisons between firms would be difficult, if not impossible, and users could not determine whether the techniques of measurement and valuation were appropriate or not.


The first process of identifying social costs possess few problems, because it is generally a simple process in establishing whether a social cost is being incurred or has been incurred, e.g. traffic congestion which creates, among other costs, air and noise pollution. Although problems in identification can arise as knowledge and technology advance, and previous processes or levels once considered safe are questioned.

The American Accounting Association Committee on Social Costs (1975) developed a three level form for measurement of social costs. The three levels provide a progressive process, from simple identification and description through to the measurement and valuation of social costs. Level I of the measurement structure involves the identification and description of social costs within the total environment. At present this is the most “objective” part of the process. However, problems are still present, for example the current and on ongoing debate over extremely low frequency (ELF) electromagnetic radiation (EMR) produced from most cathode ray visual display terminals (VDT) (Keall, 1993). A five year study conducted involving women who worked in front of VDT’s found an almost five-fold increase in brain tumours (Keall, 1993). Despite this and many other studies it is groups still argue that this radiation does not pose any health risk, e.g. the Health Departments National Radiation Laboratory (Keall, 1993). The resulting question must be is this a social cost or not?

The second level of measurement takes the process one step further in terms of measuring the social costs identified and converting them into non-monetary units. For example, the volume of smoke or noise produced by a factory (Mathews and Perera, 1993).

The final step is level III, which involves the conversion of the measures developed in level II into valuations of estimated financial costs. This level could be considered the most subjective in terms of determining the estimated financial costs of the identified social costs, for example what are the costs of traffic congestion caused by industry.


These two issues are considered separately because of the questions that each raises in terms of the identification, measurement and valuation of social costs.

A question that must be answered if standards and guidelines are to be produced is what is an appropriate time interval between the event that caused the social cost and the subsequent costs or damage (Mathews et. al., 1993)? The example of EML radiation from VDT ‘s used earlier clearlyt illustrates this situation. It is increasingly being recognised now that the EML radiation from these screens is harmful to peoples health (Keall, 1993). An example of this is the increasing number of VDT’s appearing on the market that are “low radiation”. As Keall (1993) states “only six months ago, a low-radiation monitor was a novelty. Since then

there’s been a sudden proliferation in big-name vendors offering a “low-radiation” monitor option with their PC’s “ (Keall, 1993, p. 85).

The second issue of distance raises the question of physical distance between the event and the possible effect (Mathews et. al., 1993). The main issue with this question of distance is in dealing with national -and to a lessor extent regional and state boundaries. How can the effects of pollution from one country e.g. the United States of America be ascertained or even enforced for the damage caused in Canada? Setting measurement and valuation standards for one authority would be difficult enough, however setting standards that two or more authorities would agree on could be nigh impossible.



Despite the problems outlined above, a number of models have been developed in order to value, measure and disclose social costs. Discussed below are six models developed that illustrate various approaches to the valuation, measurement and disclosure of social costs.


In 1972 Linowes produced a model based on an operating statement of the socio-economic impact of an organisation upon society. This impact was divided into three groups, relations with people, relations with environment and relations with product (Mathews, 1993).

In providing a quantitative approach to disclosing the social costs of an organisation Linowes (1972) neglected a number of important aspects in dealing with externalities. These deficiencies included the operating statement not providing an estimate of future social costs and benefits and unable to reflect the interaction of the organisation with its environment (Mathews, 1993).


Uliman (1976) developed a model that used a non-monetary basis of measurement (Mathews, 1993). This is equivalent to the American Accounting Association on Social Costs (1975) level II measurement stage. The model’s purpose was to measure the environmental impact of an organisation and so was named the corporate environmental accounting system (CEAS) (Mathews, 1993).


The model developed by Estes (1976) adopts a different approach in contrast to Ullman, in that the model measures an organisations impact upon the environment (Mathews, 1993). The model uses present value cash flows in its disclosure of the social costs and benefits (Mathews, 1993).

Gray, Owen and Maunders

A conceptual model advanced by Gray, Owen and Maunders (1987) provides a representation of the interrelationship of an organisation and its environment (Mathews, 1993).

Dilley and Weygandt

The funds flow statement presented by Dilley and Weygandt (1973) demonstrates the relationship of a utility company and its surrounding environment. The statement is made up of actual and current costs and so excludes future and estimated social costs (Mathews, 1993).


Eichhorn (1979) put forward a conceptual model of the externalities of an organisation and society. A profit and loss statement is used to outline the social costs and benefits (Mathews, 1993).



The issue of externalities will continue to grow and develop as society’s awareness and understanding about the impact of human activity upon the surrounding environment, increases. However, a solution to accounting for the social costs derived from externalities will not come until the prob1ems and valuation for these costs is resolved.

The three economic paradigms examined provide an outline of possible avenues in dealing with social costs. Each position has its own solutions to social costs, however tackling them in different ways, from the “left” position of the socialists to the “far right” free market position.

The problems in incorporating externalities into the decision and reporting systems of organisations were also discussed. These highlight some of the real problems in taking the reporting of social costs and benefits above the stage of identification.

The final section briefly reviewed some of the models that have been developed to internalise externalities into private costs and benefits. Most of these models were developed in a time when this issue held greater importance and so are some what dated, however)they still provide a guide to these complex issues and the problems that need to be overcome in order to account for social costs.



Chua, F.C. (1990). Externalities: one of the most difficult aspects of social accounting. Discussion Paper No.104 Department of Accountancy, Massey University.

Freedman, M. (1975). An analysis of industrial social costs: a taxonomic approach. Thesis University of Tllinois.

Hamilton, F.S.B., Garner, R.M.. Black, C.G., and Jackson, B.C.C. (1993). Accounting Information a Decision Perspective Melbourne: Prentice Hall.

Kapp, K.W. (1972). Environmental disruption: general issues and methodological problems. Social Science Information IX, 26.

Keall, C. (1993). The facts about low-radiation monitors. New Zealand PC World International Data Group: New York.

Mathews, M.R. (1993). Socially Responsibility Accounting London: Chapman and Hall.

Mathews, M.R. and Perera, M.H.B. (1993). Accounting Theory and Development (2nd ed.) Melbourne: Thomas Nelson.

Ng, L.W. (1985). Social responsibility disclosures of selected New Zealand companies for 1981, 1982, and 1983. Occasional Paper No.54 Massey University: Palmerston North.

Pearce, D.W. and Sturmey, S.G. (1966). Private and social costs and benefits: a note on terminology. The Economic Journal, XLVI (3), 152 -157.

Pigou, A.C. (1948). The Economics of Welfare (4th ed.) London: MacMillan and Co.

Sharp, A.M. and Leftwich, R.H. (1986). Economics of Social Issues Texas: Business Publications Inc.

Van Meer, G. (1993). Taxation as an instrument to control/prevent environmental abuse. Discussion Paper No.133 Department of Accountancy: Massey University.

Wellisz, S. (1964). On external diseconomies and the government assisted invisible hand. Economia XXI, (11), 354-62.




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