Change or die – financial accounting faces two options

The financial accounting system we use today is hurtling towards irrelevance, undermined by the very inequality to which it has contributed. It's time to change how profit is calculated, says our columnist – before it's too late.

Until the 18th century the middle class was a very small proportion of the total population. Then industrialisation, colonialism and enslaving other people massively increased demand for new specialised skills operating between the producer and the consumer – mostly a middleman, often administrative. The end of feudalism and the rise of the bourgeoisie. The rise of people whose wealth was not tied to land, but to trade and to money. Money that needed to do something. And so to the increase in investing and to secondary markets for those investments, stock exchanges.

Accounting was the tool that the rising middle class needed to invest in businesses where they didn’t know the owners. After all, as the number of people with money to invest goes up, the need for common standards for holding businesses and managers to account for what they did with that money goes up. This was also true for the government and the wider public sector, which also grew rapidly especially during two world wars. As the public sector grew, so did the need to ensure that these new sources of income were being taxed and that profits being made from public contracts were reasonable.

 

Read: Will accountants save the world? and more articles in Jeremy's Nicholls & Dimes series 

 

This drove the shift for accounting from book-keeping, to protecting creditors following a liquidation, to protecting investors (private and public). Stock exchanges and public procurement drove the need for audit (a third-party opinion on a financial statement’s compliance with international standards).  

Inevitably profits come with consequences for equality and climate change that are not accounted for

This accounting system has been very effective: it has kept capital markets running and provided the starting point for company taxes. But it only accounts for one of the consequences of running a business, the financial returns. Inevitably profits come with consequences for equality and climate change that are not accounted for, consequences that continue to be far worse than most of us realise. Capital markets, operating in the ‘public interest’, have been super effective at concentrating wealth in the hands of a few. All this inequality has contributed to mental health issues at scale. Even billionaires always want a little bit more money before they can be happy.

But a world long dominated by the middle class has now changed and the type of financial accounting that ran alongside that domination is starting to wither. Accounting is being undermined by the very inequality to which it has contributed.

 

Widening inequality – despite the middle class

As inequality increases, so more and more of that wealth is invested by a smaller proportion of people. Capitalism does what it says on the tin, it replaces labour with capital and uses labour to do it. Initially this was the working class, a community of people who organised and supported each other. A class that drove social and economic revolutions. A class now broken by globalisation and the race to the bottom, watching the erosion of their hard-won rights and the erosion of the commons, being replaced by zero-hours contracts and reduced social support.

Now it is the turn of the middle class to be eroded by capital. Those barriers to entry of professional qualifications and selective recruitment that supported lawyers, doctors, estate agents, surveyors, architects, journalists, computing specialists and, how ironic, accountants, are all being eroded by capital, only this time it’s capital as information technology.

Many of these jobs have shifted with globalisation, from Europe and the US to India and China. These jobs will continue to move geographically and, with increasing digitalisation and changes in working practices, continue to decline. And as they decline, so the need for financial accounting – developed for these middle classes – will decline as well. Of course, there is still a lot of it about, but my series of articles has been arguing that until accounting sorts some things out it will not be useful to investors, nor to anyone else. But the fact that it’s not useful won’t matter, because as wealth is more concentrated, investors and their advisors can go back to the old ways, to non-standard, non-public approaches to getting useful information, and accounting becomes mere book-keeping again.

Until accounting sorts some things out, it will not be useful to investors, nor to anyone else

Financial accounts will tell us how much profit can be added to the wealth of a few, except for any tax that governments are able to hang on to. Not that the very wealthy need be that bothered. Like modern slavery we now have modern feudalism. An altogether shinier version where your modern feudal lords and ladies have no responsibilities for their serfs, and no connection to a physical nation. The world is their oyster.

In The Price of Inequality, Joseph Stiglitz runs through the implications of widening inequality for an economic system based on competition. The checks and balances to limit rent-seeking, to avoid monopolistic practices, to ensure transparency are undermined directly in markets and indirectly as the wealthy increase their influence over politics. This is what economists call ‘regulatory capture’, to the point that governments simply pay the already rich. Free market democratic economies, in which accounting practice played a part, sought to counter this: to create transparency that reduced the risk of monopolies and of public bodies overpaying for services. Not so much now.

 

Feudalism is back

Are we really returning to a feudal society? Surely the middle class is on the up? Branco Milosevic’s famous elephant curve shows that while the global top 1% experienced around a 60% increase in income between 1988 and 2008, the income of the global middle class increased by 70-80%, predominantly due to increases in India and China.

Chart, line chart

Description automatically generated

But this is income. The real issue is changes in wealth. As the graph below shows for the United States, this is more cobra than elephant.

Chart, bar chart

Description automatically generated

The class that suffers is, as ever, the working class, the class of people that sell their physical labour. While the proportion of people earning less than US$1.90 a day has gone down, the absolute number is pretty much the same in 2010 as it was for the equivalent of $1.90 in 1850. Numbers dipped slightly below 1bn but are now increasing again, partly as a result of the Covid-19 pandemic and global conflicts. 

Chart, histogram

Description automatically generated

What this graph doesn’t show is that the number of people earning between $1.90 and $10 a day has soared in line with population growth, a growth which is strongly correlated with those low incomes. Hard to call whether global wellbeing has increased between the 19th and 21st centuries, given the number of people living on the edge is so high. Especially with the increases in conflict in recent decades.

Who represents people in these groups in all the discussions about what accounting standards should or shouldn’t be? Surely they should have a voice? I have argued that they are all potential investors, or at least potential suppliers, and as such primary users as defined by IFRS (the International Financial Reporting Standards Foundation). The IFRS’s Conceptual Framework for Financial Reporting (CFFR) could be using the word ‘potential’ for either a) people who may have the money to invest one day, or b) people who have the money to invest today. If it’s the latter it would exclude those not in a position to invest directly but whose lives and human rights are affected by decisions made in capital markets. They should also have a voice in determining whether accounting standards should require entities to account for wider consequences of their operations as part of the calculation of profit. Otherwise, some people will benefit from profits at the expense of cost to the lives of others.

Who represents people in these groups in all the discussions about what accounting standards should or shouldn’t be?

Opportunities to increase your wealth do not depend on secondary markets, where accounting is so important. And they do not depend on shared standards for reporting on the performance of investments either. Private investors can make their own assessments. And have many reasons to avoid the harsh glare of transparency that comes with public markets.

Increasingly, inequality has returned us to a type of feudalism, a type that is even worse than the medieval type. At least the lord and lady of the manor had responsibilities for their serfs. Now the wealthy have no responsibilities to the people who suffer the consequences of their wealth and their investments. Accounting standards and complex company structures, with the legal pretence that the entity is a person and therefore responsible, allow rich individuals to hide from any accountability. So much for transparency. Philanthropy and impact investing are very poor replacements for overhauling financial accountability.

 

Worrying changes in financial markets

Stock markets, where the public can invest through intermediaries in businesses where they will never know the managers, are one of our great social innovations. But increasing inequality is reflected in the shift of importance from public to private markets. This is an increasing concern since it has implications not only for concentration of wealth but also for innovation, as the investment opportunities for the remaining investors decline. The large liquid pool of capital that has driven growth in GDP is declining. Dark pools are increasing: in 2021, the president of the SEC, Gary Gensler, referred to over 50% of the US stock market being traded through dark pools – privately managed, practically unmonitored marketplaces – with significant risks to public interest.

There is also a decline in traditional IPOs, the way in which investment opportunities are brought to the market, supported by underwriters and with due diligence. Companies are increasingly using mergers with special purpose acquisition companies (SPACs) avoiding due diligence, that in part comes from accounting standards, further weakening investor protection.  

Then there was the growth in shadow banking – financial intermediaries carrying out banking activities but outside banking’s regulatory oversight. The international Financial Stability Board assessment in 2017 reported that this had declined significantly, but warned that new forms of shadow banking were likely to develop in the future. Though at least that money does go through a market. The UN estimates that laundered money now represents 2% to 5% of global GDP.

 

Widening inequality: financial accounting becomes less useful

All of these trends mean that the proportion of investment owned by a middle class is going down, and so inevitably there is a declining need for the international accounting standards that supported their investments.

Even in public markets, most investment is handled by investment managers. They still need to be able to assess the potential for future cashflows but can take a portfolio approach to risks and returns in a global economy with declining, more variable returns and risky returns. Accounts are just one source of information. Even for the public sector, whose interest is in maintaining tax income to finance public services, financial accounting is becoming less important as the proportion of income from corporation tax goes down. Recent pressure on government to address inequity in corporate tax payments has come more from public pressure than from its own financing requirements. In the UK, for the tax year 2019/20 only 16% of the tax gap, the difference between what was expected and what was received in tax, was down to shortfall of corporation tax. 

The more that wealth inequality increases, and there seems no end to it, the less important accounting will become. Accounting standards just aren’t as useful as they were.

 

Why accounting standards are shooting themselves in the foot (the technical bit)

Financial accounts are not statements of objective fact. Yes, I know that may come as a surprise. Money is money.

The CFFR recognises that most accounts are estimates, whatever non-accountants may think. Paragraph 1.11 of the CFFR says: To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions.

This is a good thing.

All the items in a business’ financial statements relate back to expected cashflows because that is the purpose of those statements. And these are unknown because they are future cashflows and so there is always going to be uncertainty. Even in the cash balance, if the cash is in a different currency to the share price, there will be exchange rate uncertainty. Even if it is in the same currency, try getting your hands on it if the government decides to stop access. And the extent to which amounts repayable by debtors become cash depends on their ability to pay. Because of this, accounting practice recognises the need for a provision to be made against debtors. Accountants cannot see into the future.

Pause. Shock. The provision is a guess, albeit an educated guess. It is intangible.

Who decides the level at which certainty shifts so that the intangible becomes tangible, the point at which obligations and assets would be included? This is socially constructed (ie, made up) but to listen to some people talking about intangibles – or ‘externalities’, another word that also means that important things are not being measured and reported – and you would think that tangibles are knowable, quantifiable and objective. You’d have to decide whether people who say we can’t account for externalities because they are too subjective don’t want to,  and have become part of that regulatory capture; or should know better, and don’t realise how much subjectivity already exists.

There is much that is excellent in the CFFR despite the flawed starting point. It has three types of uncertainty (which require subjectivity): existence, outcome and measurement. It uses the language of economic phenomena, which might feel a little vague but brings this back to the example of people that owe us money. There is some uncertainty as to whether the debts exist, whether the money can be recovered, whether they agree with the amount we have recorded. The level of uncertainty is not prescribed. It is an inescapable judgement. The accounting system has been built to deal with this in ways which are both pragmatic and effective. The third-party audit is critical as it addresses the risk of material misstatement, and the audit partner is responsible for assessing audit risk and ensuring the work done brings this risk down to an acceptable level. In the end the buck stops there.

Since accounting standards do not define this mysterious level of acceptable uncertainty, this begs some questions. Who is responsible for defining this? Who has power to do this? Are they the same?

This focus on a particular level of certainty in reporting financial transactions has also been associated with a decline in the proportion of market value that is explained by the reported financial statements. The gap is intangible assets. Critically intangible liabilities (the ones discussed above) do not show up on either financial statements or market values because they do not affect expected future cash flows. The gap of intangible assets is only half the story. But what is important here is the use of the word intangible. Not measurable.

Intangible assets (and liabilities) are just those where the uncertainty is too high for the amounts to be included in the accounts. They can be estimated (just like that provision and just like the CFFR recognise that estimates are fundamental to accounting). 

The problem is the fixation with a particular level of certainty, to the extent some people talk as if it were objective. “We cannot include these intangibles or externalities because they are subjective and because we need stability in markets,” they say. Stability in markets. That hasn’t gone so well. Perhaps this would mean something if there were targets for this. Stability in maintaining the share of investment in public markets perhaps. Stability in not accruing systemic risk to levels that significantly affect our global society. What level of shifts in share prices is ok?

What if we accepted a level of uncertainty that allowed a higher share of intangible assets and liabilities to be recognised in financial statements?

What exactly would be the effect on any measure of stability if we accepted a level of uncertainty that allowed a higher share of intangible assets and liabilities to be recognised in financial statements? This would change the levels of reported profit. If these statements included these ‘externalities’ and reduced the risk of reporting profits with some undisclosed costs on others, it would help redress inequality. Investments would move to companies which had lower levels of these now disclosed costs. 

 

Change, or die?

We can carry on as we are. The edifice of accounting standards will continue to develop standards and now has a whole new area of sustainability standards to look forward to. Generating information that is less and less useful to fewer and fewer people.  

Or we can change accounting so that it contributes to sustainability. This is not about adding something on under the International Sustainability Standards Board. This is about changing accounting standards. Its structure and logic are excellent. We just need to change the scope to cover all the material consequences of a business (yes, that’s double materiality determined in context and not just the consequence of expected future cashflows) and change that level of uncertainty – and job done.

We cannot expect the current managers of capital markets, increasingly conflicted between public interest and the interests of the very wealthy, to sort this out. No surprise that there is an initial focus on climate, as the wealthy realise that climate change just might affect their lives too. It is going to have to be representatives of all people, acting in the interests of all people, to sort this out. Not just the few, living in la la land of an economic system where maximising private wealth and leaving consequences up to personal ethics and public taxes is the best, even only, approach to allocating global resources. 

This has got to be the representatives of people who experience the consequences, and that means our governments. In fact, they also have accounting standards, set by the International Public Sector Accounting Standards Board, and unlike private accounting standards, the purpose of these is the maintenance and enhancement of wellbeing of residents, tax-payers and service users. So, very much the people who experience the consequences.

Adding some non-financial information isn’t going to cut the mustard

Private accounting standards are also going to have to be shaken up a bit more if they are going to contribute to the solution. Adding some non-financial information isn’t going to cut the mustard. We can use the same thinking to create useful information but we’re going to have to use the foundations of public accounting, with a purpose of maintaining and increasing wellbeing, to create a private sector accounting system that allows us to hold organisations to account for their contribution to sustainability, to the wellbeing of people and planet, where financial returns are part of the picture – but only a part.

Policymakers are going to have to take back responsibility for accounting so that it is designed in the public interest, and not just some of the public’s interest, for a public interested in financial returns and social and environmental consequences of those returns. For a public that wants to know the value of the resources a business has at its disposal without hiding intangibles in the too-hard-to-measure cupboard. This would then mean rewriting the IFRS’s Conceptual Framework to reflect those interests. If this was the basis for accounting, accounts would provide that information in one place and calculate profits accordingly – perhaps with more measurement uncertainty than now, but with a lot less existence and outcome uncertainty.  

As we all recognise at least some of our global challenges, it has become popular to talk about the need for systemic change. ‘Systemic change’ is what we used to call revolutionary change, revolutionary because that’s the sort of change that shifts power and those with power don’t tend to jump at that opportunity and so resist the change. But using the phrase ‘systemic change’ risks pretending that we can change enough without any shifts in power, in a gentle incremental flow. It means we can forget that shifting power will necessarily be a struggle. And that incremental means giving those that want to resist change time to get their act together. Think back to the struggles for women’s emancipation, the struggles for workers’ rights, the struggles to stop slavery, all of which are still ongoing. Struggles that are not a fair fight with a referee, but struggles where every trick in book will be used, from direct suppression to a subtle, and not so subtle, take-over of language, to redirecting some of those seeking change towards activities which leave us busy… but ineffective.

A necessary, if not sufficient, requirement for a sustainable, well, it's time to say regenerative, society is a revolution in our approach to calculating value and that means changing the way in which profit is calculated. Before it’s too late.  

 

National Bureau of Economic Research data visualisation created by the Institute of Policy Studies / Inequality.org

Thanks for reading Pioneers Post. As an entrepreneur or investor yourself, you'll know that producing quality work doesn't come free. We rely on our subscribers to sustain our journalism – so if you think it's worth having an independent, specialist media platform that covers social enterprise stories, please consider subscribing. You'll also be buying social: Pioneers Post is a social enterprise itself, reinvesting all our profits into helping you do good business, better.