In the spring of 2020, more than 150 of the world’s largest corporations made a commitment to change. They promised, as part of their economic recovery plans, to “reach net-zero (carbon) emissions before 2050”.
Commendable ambitions but how is this transition paid for while avoiding the inevitable negative market reaction?
Accounting is the bottleneck to environmental progress; out-of-date accounting practices impose a series of financial disincentives to ‘doing the right thing’ by forcing companies to ‘write off’ against income all expenditures designed to reduce carbon emissions or to achieve other socially desirable goals.
Why does this matter? Expensing investments in a Green Future reduces profits on a company’s income statement. It also slashes earnings-per-share and a host of other key investor metrics. Not ideal for most corporate CEOs.
But two recent developments in normative accounting are overcoming these restrictions, positively encouraging management teams to accelerate their carbon reduction programs.
The most important advancement in normative accounting is repudiating the neoclassical concept of value objectivity. Value, as many of us know from practical experience is NOT objective, but annoyingly subjective.
In practice this means that in normative accounting, financial statements prepared for taxation purposes, for example, are only relevant for taxing authorities. They do not represent, nor are they intended to represent, the commercial reality of a business.
In normative accounting, a parallel set of statements should be prepared specifically for the stakeholder audience. These statements could, if they are truly accurate, include the capitalisation of all classes of intangible assets – the very assets which dominate the post-industrial economy but which are either missing or vastly underreported on company financials.
The second major development in normative accounting involves the treatment of carbon liabilities. Presently, companies consider carbon emissions to be externalities - in other words carbon pollution is society’s problem and not a serious threat to their shareholder equity.
Apart from recognising the rise of intangibles, normative accounting aligns itself with the public good and rising social concern around climate degradation.
Utilising an emerging suite of environmental metrics, normative accounting believes carbon liabilities should be quantified and taken seriously by management teams and their accounting executives.
Let us examine Shell’s commitment to reduce Green House Gases (GHG).
Shell is planning to reach net-zero on Scope 1 and 2 emissions. These are the carbon emissions associated with its industrial processes and the emissions associated with the power sources it chooses to employ.
To achieve all these reductions, Shell has announced its plans to use low or zero-carbon energy products, including hydrogen, biofuels, solar and wind power. It also means investing in zero-emission vehicles to replace existing fleets, switching to renewable fuels, while improving energy efficiency in buildings, facilities, and other logistical operations.
Traditional accounting would insist that the costs of these Green investments be ‘written off’ against income in the period of their expenditure. A financial penalty on this scale would likely delay the planned investment for years, if not decades. Meanwhile the environment continues to deteriorate.
How would normative accounting resolve this apparent dilemma?
To begin, utilising existing accounting standards, normative accounting would authorise Shell to both acknowledge its social obligation to reduce carbon and formalise its presently undocumented intangibles on its balance sheet.
Shell’s full suite of intangible assets would include many ‘easier to identify’ intangibles like the company’s portfolio of patented innovations, present and future design assets etc. and – more importantly – formalise its ‘harder to identify’ relational capital assets like corporate reputation.
Doing so under normative principles opens multiple options for the company’s management to capitalise the expenditures utilised to mitigate the carbon liability and build its Green Future.
Once all the assets and liabilities are identified on corporate financial statements, double entry bookkeeping essentially allows companies to store the money invested in carbon mitigation on the balance sheet, ensuring that these costs are not expensed against income, creating a win-win financial solution.
Normative accounting treatment not only strengthens shareholder equity by broadening the inventory of legitimate assets and capitalising carbon-related expenditures that build a new Green future, but also spares the company the market penalty of reduced quarterly or annual earnings on its income statement.
The post-COVID commercial reality is going to be much different from the world we knew pre-pandemic. Society is moving rapidly, and social norms are changing for business.
Business leaders need to act and for that to happen accounting needs to adapt quickly and help create a suite of 21st century accounting practices that are more closely aligned with existing accounting standards, societal norms and the lofty ambitions of a new generation.
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Rules based on yesterday’s norms are a guarantee of failure – the rules which shape our economy will only endure if they are based on social norms that will endure. This cannot be a social norm which accepts the end of life on earth.
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