Building the Bridge Between Non-financial and Mandatory Reporting

BP

CEO Bernard Looney’s courageous announcement that BP will transition to becoming a green energy pioneer shows the need for a new supporting logic for a standard measurement system. If BP is prepared to publicly commit to do the right thing, as society wants it to, then the logic must evidence and incentivise BP’s investments made to transition, otherwise it must have an inherent flaw.

Rethinking Capital and the Impact-Weighted Accounts Initiative at Harvard Business School have developed a normative accounting approach for intangibles and impact to provide this logic. It is designed to increment non-financial reporting and act as a bridge between non-financial and mandatory reporting.

Codifying BP’s Logic

Codified through the lens of intangibles and impact, what is BP doing in its decisions to transition?

• Mitigating risk to reputation by decisions to do the right thing, and to break free from the association of its reputation with legacy Big Oil
• Recognising a constructive obligation to reduce its emissions to conform with social norms
• Investing to mitigate this liability and to strengthen its social licence
• Properly discharging the fiduciary and other duties of decision-makers to manage assets, liabilities and risks.
• Before moving on, please read this logic again. Does it make sense? If so, then reverse this logic by placing ‘not’ before each of these four statements. It then becomes clear that decision-makers deciding not to transition are at risk of not properly discharging their fiduciary and other duties.

Non-financial reporting may find a solution to apply this logic into a standard measurement system through the growing number of alignment initiatives, committing to reach common standards during 2021, but this is a very crowded area with competing philosophies which may prove hard to reconcile.

Rather than yet another framework, would it not make more sense to first determine the extent to which technical accounting and the double-entry system could be applied? Current accounting practice will damn BP for doing the right thing by treating its investments into making the transition as an expense on the Income Statement or investments into depreciating equipment and therefore a deterrent to BP’s management.

There is another way for accounting to fairly show BP’s decision logic. But finding it means first understanding how capitalism got into this mess in the first place and why accounting practice has lost its way.

Root Cause Analysis

Why is the world systematically unfair?

“We’ve gone back to the root cause,” says Robert McGarvey, co-founder of Rethinking Capital and author of Futuromics: A Guide to Thriving in Capitalism’s Third Wave: ”We believe that systemic inequity is a consequence of the historic paradigm shift from an industrial to an intangible economy and the failure of economic theory and its derivative systems to adapt to the commercial reality. By derivative systems we include accounting, auditing and reporting each of which take their lead from economic theory. Neoclassical economics and its dated orthodoxies, including the now discredited law of scarcity, misdirect capital and incentivise the wrong kind of growth; it’s no surprise that the effects include systemic climate and social inequity.”

The intangible economy already exists but has yet to be secured into rules, systems and norms. Specifically, the Balance Sheet has lost its relevance as the primary resource for management and other stakeholder decision-making. Without the Balance Sheet, decision-making has instead focused on the Income Statement and the short-term. Rethinking Capital believes that this has led to a belief system that is quite literally upside down, rewarding and incentivising bad behaviours whilst giving no credit for and often punishing good ones. Imagine the chaos if that approach was applied to disciplining children or a pet.

The Practice of Accounting in 2020

Current accounting practice will treat BP’s investments as costs on the Income Statement or short-term depreciating assets, reducing Balance Sheet equity and profitability. This is both illogical and plainly unfair. BP is investing into its reputation and into its social license, thereby mitigating a strategic risk, and into an asset.

Current accounting practice has not kept up with the change in the economy and does not recognise intangibles as accounting grade assets. Analyst consensus is that between 30-40% of SG&A is not really SG&A but could instead be classified as investments into intangible assets. Deductive logic says therefore that accounting practice is showing a substantially unfairly negative view of assets, equity and profitability.

Globally it is estimated that more than $108 trillion of intangible value not properly recognised on Balance Sheets. A Rethinking Capital analysis of Bayer AG identified over €129 billion of undisclosed equity in just one division alone, illustrating a point of view that although an eye-wateringly large number, even $108 trillion materially understates the true scale of the intangible economy.

Current accounting practice is also failing to properly recognise intangible liabilities, including climate risk, on Balance Sheets and arguably not properly applying IAS37 (the International Accounting Standard on Provisions, Contingent Liabilities & Contingent Assets). IAS37’s logic is simple: If a liability (‘the potential for future economic outflows as a result of past events’) exists, then one of three actions must be taken.

If the liability is remote (according to the Cambridge Online dictionary the probability of Martians landing on Earth is remote) then the entity does nothing. It the liability is possible, it must disclose a contingent liability in a note including details of the financial exposure. If probable, it must recognise a provision as an entry in the financial statements.

In giving their respective true and fair view statements, directors and auditors appear to be concluding that liability for climate risk is either remote or incalculable.

It is surely near impossible to credibly reach a conclusion that climate risk is a remote liability for Big Oil. It also seems very hard to conclude that the liability is incalculable. Do the largest carbon emitters not have internal scenario analyses that could be disclosed? Could comparables not be applied? Big Tobacco would be a fair comparable, having paid out nearly $300 billion in settlements. Unlike climate risk where there is no choice but to breathe, the Big Tobacco was able int111o successfully argue that punitive damages settlements should be mitigated by the user’s choice to smoke. In which case $300 billion would be on the low side for Big Oil.

This current accounting practice of not properly accounting for intangible liabilities, is therefore showing a material unfairly positive view of liabilities, equity and profitability.

If, for whatever reason, the practice of accounting is not fairly showing the assets and liabilities of an organisation, what can be done? The answer from the accounting profession and audit firms has been to call for Standards change. But in fact, when read in detail, the principles-based International Accounting Standards on intangible assets and liabilities are actually a very good place to start.

The Most Simple Corrective Action

Concluding that the problem is not the Standards but the practice of accounting and realising that accounting practice is steadfastly refusing to show a fair view of the intangible assets and liabilities of an organisation forces us to rethink.

A promising solution is provided by the concept of normative accounting. Normative accounting has been theorised in academic literature since the 1950s representing:

‘theories of accounting, based on deductive reasoning or logic that prescribe the accounting procedures that should be followed rather observing or describing those that are followed in practice’.

As all value is subjective from the perspective of each stakeholder, normative accounting enables multiple alternative fair views to be shown.

Having established BP’s decision logic, normative accounting treatment has many clues in existing accounting standards.

Digging deeply into IAS37, we concluded that the IWAI’s annual climate impact costs could be properly recognised as a contingent liability on the Balance Sheet.

And that the definition of an ‘Asset’ under the IASB Conceptual Framework (‘a resource controlled by the entity…..from which there is potential for future economic benefits’) could treat transition costs as investments into BP’s reputation and social license on the Balance Sheet.

Further model-matching established how to apply IAS38 and impact measurement to determine the boundaries of the firm.

The outcome is believed to be the first framework that incorporates impact into traditional accounting. And the first to apply existing GAAP, to update double-entry bookkeeping and be informed by existing International Accounting Standards and the IASB Conceptual Framework. The result is to properly recognise and show the current value of all intangible assets and liabilities.

This is a leap for impact measurement and has created a methodology that can be applied to represent other impact costs as liabilities, including product costs and a living wage, areas where the IWAI has focused its energy.

The elegant logic of the framework is that investments made to reduce climate and social equity will increase Balance Sheet equity, and decisions that increase climate and social inequity will reduce Balance Sheet equity.

What Next?

The ambition is to create a standard for normative accounting of intangibles and impact. There is a long way to go.

The framework is being tested with companies. Encouragingly, it is already being described as ‘logical’,’ intuitive’, ‘familiar’ and ‘common sense’.

Resistance to a technical accounting solution is expected. Resisting though means having to explain why the logic is wrong.

Author: Andrew Watson

Author: Robert Zochowski

By Rethinking Capital co-founder Andrew Watson and Rob Zochowski, Program Director, Impact Weighted Accounts Initiative at Harvard Business School