When an organization undertakes an activity which impacts upon the external environment then this affects that environment in ways which are not reflected in the traditional accounting of that organization. The environment can be affected either positively, through for example a landscaping project, or negatively, through for example the creation of heaps of waste from a mining operation.
These actions of an organization impose costs and benefits upon the external environment. These costs and benefits are imposed by the organization without consultation, and in reality form part of the operational activities of the organization. These actions are however excluded from traditional accounting of the firm, and by implication from its area of responsibility. Thus we can say that such costs and benefits have been externalized. The concept of externality therefore is concerned with the way in which these costs and benefits are externalized from the organization and imposed upon others.
Such externalized costs and benefits have traditionally been considered to be not the concern of the organization, and its managers, and hence have been excluded from its accounting. It must be recognized however that the quantification of the effect of such externalization, particularly from an accounting viewpoint, is problematical and not easy to measure4, and this is perhaps one reason for the exclusion of such effects from the organization’s accounting. It is probably fair to state however that more costs have been externalized by organization than benefits.
Hence a typical organization has gained from such externalization and the reported value creation of such an organization has been overstated by this failure to account for all costs and benefits. This is achieved by restricting the accounting evaluation of the organization to the internal effects. Indeed one way in which an organization can report, through its accounting, the creation of value is by an externalization of costs, which are thereby excluded from the accounting of the organization’s activities.