There is increasing recognition that the economic system needs to change if the catastrophic effects of climate change, biodiversity loss and widening inequality are going to be avoided. While there has perhaps been more focus on climate change, biodiversity loss and increasing inequality also threaten social stability, as the IMF points out, the SDGs include both poverty and inequality.

“Last year, 82% of wealth created worldwide went to the top 1%. The poorest half saw no increase at all. All over the world, the economy of the 1% is built on the backs of low paid workers, often women, who are paid poverty wages and denied basic rights.” (Oxfam, 2018)

This realisation is not entirely new, even as growth in wealth inequality has gone alongside an ever-increasing range of government interventions designed to limit wealth inequality at international, national and regional levels.

One of the fundamentals of our economic system that will need to change is the way in which resources are currently allocated by their owners to generate returns. And financial accounting is one of the main sources of information through which the system signals where resources should be allocated, both in terms of historical and expected financial returns.

The global approach to financial accounting and reporting has contributed to both the environmental crises and inequality, since historically these “externalities” did not lead to costs which “matter” in financial accounting. Financial accounts are prepared in order to meet a particular purpose and, from International Accounting Standard 1, that objective is:

“To provide information about the financial position, financial performance, and cash flows of an entity that is useful to a wide range of users in making economic decisions.” (IFRS IAS1)

The IFRS conceptual framework is more specific about these decisions and the users:

“To provide financial information that is useful to users in making decisions relating to providing resources to the entity. Users’ decisions involve decisions about; buying, selling or holding equity or debt instruments; providing or settling loans and other forms of credit; voting, or otherwise influencing management’s actions. To make these decisions users assess prospects for future net cash inflows to the entity and management’s stewardship of the entity’s economic resources.” (IFRS and IASB Conceptual Framework for Financial Reporting)

This purpose has developed over time alongside the development of capital markets. It is based on assumptions. One assumption is that the primary purpose of financial accounts is to provide information for economic decisions, and that either users are not interested in the wider social or environmental consequences of their investments or, if they are, they would have to look elsewhere. In reality, investors are interested in the wider consequences of their decisions. Research by Social Value UK suggested that 85% of people were interested in more than simply the financial returns of their investments. At its simplest, we do not want financial returns if the consequences of those returns are the destruction of forests and an increase in child labour. In addition, any country which has policies to address social and environmental issues, for example, which supported an inclusive growth strategy, should be concerned if the approach to financial accounting undermined that policy. Currently there is no comparable legal requirement to produce information to help users make social and environmental decisions according to international standards or to an equivalent idea of true and fair.

It is easy to forget that the decision on the purpose of financial accounting and the requirement for what constitutes accounts is a public policy decision. It would, therefore, be possible for public policy to require companies to produce accounts for investors that are interested in financial, social and environmental value. The accounting profession would then have to work out how to do that, to provide investors with good enough information to make resource allocation decisions for this new purpose. This would be a significant change; it would likely require accounting to include valuations as opposed to being based on historical costs, and it could be that a lower level of accuracy would be adequate in providing investors with confidence they require that these wider effects had been accounted for.

There are now a growing number of approaches that value social and environmental outcomes:

• The Natural Capital Coalition (NCC) released the Natural Capital Protocol (NCP, 2013) to harmonise existing best practice and produce a standardised, generally-accepted, global approach to including natural capital in decision-making which includes guidance on how to value changes to natural capital. The NCP defined valuation as: “The process of estimating the relative importance, worth, or usefulness of natural capital to people (or to a business), in a particular context. Valuation may involve qualitative, quantitative or monetary approaches, or a combination of these.” Natural Capital Protocol, (2016:37)
• Reporting 3 is another coalition that has produced blueprints for future and more integrated approaches to reporting. Blueprint 2 (Reporting 3, 2017) relates to accounting and seeks to redefine accounting to include financial transactions but also the risks and opportunities relating to other capitals. The Blueprint recognises that this will need innovative approaches that include monetisation and alternative forms of profit and loss accounts and balance sheets.
• Social Value International (SVI) has supported a principle-based approach to accounting for social and environmental outcomes since 2007. The principles include valuation and, where financial proxies are used for valuation, the application of the principles is known as Social Return on Investment. SVI has also produced guidance on approaches to valuing social outcomes and reviewed approaches in a discussion document on the Valuation of Social Outcomes (SVI, 2016).
• Both the Value Balancing Alliance and the Impact Weighted Accounts Initiative at Harvard are exploring the value of social and environmental impacts and the options for more integration with financial profit and loss accounts.

These voluntary approaches do not, however, fully integrate this additional information in the calculation of profit. As a result, investment decisions are less likely to be affected by this information, if at all, and investors will not be able to easily assess the relative importance of what is included in this information or have assurance that it is materially complete, whether they are making investment decisions for solely financial return or attempting to take social and environmental issues into account.

More fundamentally, these approaches would not be applicable under current accounting standards, primarily because of the focus on economic resources and financial returns. In order to require assets and liabilities, and revenue and expenditure to be defined to include wider impacts, or for legislation to require non-financial outcomes to be included and valued, accounting standards would need to change.

Without this change to accounting standards, the risk is that resource allocation that is made by solely financial signalling continues to create problems at a faster rate than any voluntary initiatives designed to reduce those problems.

A significant change to the foundations of accounting standards is unprecedented, but not impossible. Most countries have primary legislation that requires companies to produce accounts, and yet rely on international (secondary) accounting standards to determine the basis for producing accounts, outsourcing the decision to the IFRS. For example, in the UK Companies Act 2006 section 395 states:

“(1)   A company’s individual accounts may be prepared—

(a)   in accordance with section 396 (“Companies Act individual accounts”), or

(b)   in accordance with international accounting standards (“IAS individual accounts”).

Section 396 includes the requirement that the accounts should be true and fair although this is not defined in the legislation.

As demand for greater transparency grows, and as voluntary standards get more accepted and refined, a change to the Companies Act or International Accounting Standards becomes both possible and potentially even requested.

Financial accounting is generally neither seen as part of the problem or as something that society can determine. The first step needs to be to increase recognition that we, as a society, can determine the purpose of accounting, and it is then for accounting to meet that purpose.

Jeremy Nicholls is a leading expert on accounting standards, social value and social return on investment. You can read more about him here.