A new age of accounting
Accounting and reporting are undergoing fundamental changes. It is important to be aware of these. Accounting at present predominantly relates to the financial and physical assets of a firm. However, a growing proportion of firms’ assets are intangible rather than tangible - human, social and natural - rather than physical assets. In addition, companies are increasingly having impacts outside their legal boundaries. The dependencies and impacts of firms on other parties – communities, nature, supply chains etc – are expanding.
Accounting has not kept pace with these developments. As a result, it distorts reporting of the allocation of resources and investments (Barker, R (2020) ‘Accounting for Natural Capital’ in Mayer, C and Roche, B (eds), Putting Purpose into Practice: The Economics of Mutuality, Oxford University Press). There is inadequate recognition of the investments associated with expenditures on people, societies and environments outside as well as within firms in their supply chains, local communities and natural world.
These are assets which companies do not necessarily own but are still critical to the successful functioning of a company and fulfilment of its purpose. A failure to recognize them as assets rather than current expenditure leads to an overstatement of their costs and an understatement of their contribution to the productive potential of a firm. In other words, it results in a deficient allocation of resources to these activities.
What is being suggested here differs from many current proposals to reform accounting and reporting which emphasize valuations of assets as present values of projected future benefits and detriments. These are subject to serious problems of measurement, accuracy, validation, and discounting that fail to meet normal standards of objectivity of accounting. Instead, what is proposed is that actual expenditures be used rather than projected benefits and detriments at hypothesized prices. In other words, it is essentially conventional cost-based accounting.
This is also relevant to performance measurement. Currently, performance is measured in relation to profits net of the costs of maintaining physical assets of firms. However, the growing impacts that companies have on their environment, societies and supply chains means that profits should be measured net of the costs of maintaining human, social and natural as well as physical assets. The maintenance of their productive potential is as important to the firm as its physical assets (Eccles, R and Laurent, F (2020), ‘Implementing a Mutual Profit and Loss’ and Eccles, R and Stroehle, J (2020), ‘The Impact of Mutual Profit on Business Behaviour’ in Mayer, C and Roche, B (eds), Putting Purpose into Practice: The Economics of Mutuality, Oxford University Press).
Performance should be measured in relation to the company’s success in fulfilling its purpose.
More generally, performance should be measured in relation to the company’s success in fulfilling its purpose. Failure to do so should create a requirement to provide for the expenditures needed to remedy the deficiency. By so doing, the company reduces its stated profits and its earnings available for distribution to its shareholders. It therefore creates a reserve to rectify underperformance.
Barby et al (2021) describe the three steps involved in doing this (Barby, C; Barker, R; Cohen, R; Eccles, R; Heller, C; Mayer, C; Roche, B; Serafeim, G; Stroehle, J; Younger, R; and Zochowski, R (2021), Measuring Purpose: An Integrated Framework). The first is the determination of motives of the company as reflected in its purpose – why it exists – and the relation of that to its mission as reflected in its strategy, its vision of where it aspires to get to, and its values that underpin how it operates.
Figure 1: Motives, metrics and money
Step 1: Motives
- Purpose (why the company exists)
- Mission (what is the strategy)
- Vision (where it aspires to be)
- Values (how it operates)
Step 2: Metrics
- Inputs (what the company uses)
- Outputs (what it produces)
- Outcomes (what changes)
- Impacts (effects on well-being)
Step 3: Money
- Enterprise cost-based approach
- Societal valuation-based approach
(Source: Barby, C et al (2021))
The second step is to measure the company’s inputs, outputs, outcomes ,and impacts, and the third is to convert them into monetary terms in cost-based accounts that are predominantly used for internal management purposes. Particularly important in this is the derivation of company’s profits in their accounts.
Traditional cost-based accounting attaches specific and identifiable financial costs and revenues to inputs and outputs. In the context of corporate purpose, however, cost-based accounting also needs to account for the impacts of a company on financial and non-financial resources. It records the costs that a company incurs in remedying the detriments it causes and delivering the solutions that are associated with fulfilling its purpose.
To avoid profiting from causing harm to others, a company determines the costs it incurs in remedying the detriments it imposes on human, social and natural resources, and sets these against financial profit in measuring its performance. Conversely, if a company invests in assets that confer benefits on other parties which extend over more than one year, it tracks these outcomes in a way that parallels its treatment of capital expenditure in a conventional balance sheet.
In other words, a company’s accounting extends beyond financial statements to report costs of maintaining and enhancing human, social and natural resources in the delivery of its purpose, irrespective of whether they fall within or outside the legal boundaries of the firm.
Accounting is therefore destined to extend beyond traditional legal boundaries of the firm to its effective boundaries in terms of its outcomes and impacts. This redefines boundaries from legal delineations to relevant operational considerations in relation to fulfilling a company’s purpose of delivering solutions and avoiding detriments, classifying expenditures in the process as current or capital in nature.
This article draws on a forthcoming article by Colin Mayer entitled “The Governance of Corporate Purpose” to be published in Ronald Gilson et al (2021), Festschrift in Honour of Rolf Skog, Norstedts Juridik. It is currently available as an ECGI working paper no. 609/2021