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- Challenge to current accounting principles
- A broader perspective
- Survey-based holistic reporting
- Impact on decision-making
- A better outcome
Challenge to current accounting principles
Former Chief Economist at the Bank of England, Andy Haldane, recently contributed an Opinion piece in the Financial Times in which he expressed doubts about whether the accounting principles used by the UK and EU were fit for purpose.
Briefly, he discussed whether the so-called ‘fair value’ approach to asset valuation was having a detrimental effect on corporate investment in Britain and the EU, compared with the US, which uses a historical value approach. The consequence, he suggested, quoting research by Vera Palea, Alessandro Migliavacca and himself, seemed to show that companies paid out much more in dividends and share buy-backs than would otherwise have been the case, rather than using the profits for reinvestment. These detrimental effects were compounded by pension funds being required to ‘mark to market’ their investments, resulting in a progressive move away from volatile and potentially risky equities and into more predictable bonds. He then cited superior growth rates in the US compared with Europe and suggested causation, extending his warning to the acknowledged need to provide adequate investment for green growth objectives being potentially threatened by the accounting principles currently adopted.
An accountant, going back to basics, might look at this slightly differently. For a very long time, historical accounting was used, with depreciation of assets used in the business calculated to spread the costs of those assets over the periods gaining benefit from their use. This accounting principle was extended, prudentially, by a recommendation to make sure resources would be available for the replacement of those assets when their usefulness was finished.
In the 1970s, rampant inflation arose in the UK and what was called ‘inflation accounting’ was introduced, in relation to which historical cost depreciation was adjusted by an inflation index, magnifying the annual charge and hopefully creating a provision for the replacement cost, which was going to be much higher.
However, inflation of asset values also led to the temptation to revalue fixed assets and thereby create paper profits which potentially could be distributed to shareholders, or paid out as bonuses. The restrictive guidance was that revaluation surpluses could only be made available for distribution out of realised profits, when the assets had actually been sold.
Fast forward, and after a couple of decades of moderate inflation, the discussion of asset values, and whether the balance sheets hid value and therefore didn’t reflect the true situation, led to the discussion about so-called’ mark to market’, in which an appropriate external marker would be used to judge asset values and the balance sheets would be adjusted accordingly. This led investment funds to reassess their underlying valuations and, in some cases, overdistribute, and the situation was exacerbated after the financial crisis of 2008 when interest rates dropped to near zero, and, conversely, pension funds had to provide for massive increases in their calculated liabilities. Hence ‘mark to market’ produced volatility and a combination of excessive distribution and excessive caution over investment.
A broader perspective
The duty of the board of directors under the UK Companies Act 2006, is to look after the long-term future of the company, not to favour the shareholders, or the employees, for that matter. Andy Haldane’s article doesn’t address this point, but it really is fundamental to the discussion about the effectiveness of accounting policies. Supporting ‘green’ initiatives through increased investment is worthy, but are accounting standards really responsible for the decisions of the board, not its mindset and vision?
These are clearly affected by accounting standards and other regulations, but there can be little incentive to follow the spirit, not just the letter of these, without a broader perspective which first incorporates the fundamental duties of the board and then looks across all stakeholders and the long-term future of the company – which surely must include such things as environmental stewardship. While it may be a policy of government to encourage green initiatives, any investment must be in line with the broader stewardship duties; of course if ‘green’ practices become a matter of regulation, they then become a compliance issue, regardless of the effect on the business, which is another matter.
The holistic way to approach this is, of course, to constantly review and balance the objectives of the key stakeholders in the business, particularly customers, employees and owners, since the compatibility of their individual objectives is key to the future success of the business. This is what we mean when we talk about Holistic Corporate Governance.
Now the issue which Andy Haldane raises, albeit obliquely, is the over-riding importance currently given to financial accounting in guiding the decisions of the board. Hence, his criticism of International Financial Reporting Standards (IFRS) compared with Generally Accepted Accounting Principles (GAAP), criticism which looks at the impact on corporate decisions resulting from the adoption of one set of rules (using ‘mark to market valuation) rather than the other (using historical calculation).
However, there is another way of approaching these decisions, which is to gather the views of the key stakeholders on a regular basis and assess on a continuing basis how changes in these views over time might affect the company’s goals, operational practices, and its long-term future health. The parallel would be with monthly accounts presented by the Finance Department to the board providing details of revenue, profitability, net assets and cash flow..
Survey-based holistic reporting
The three vital elements to an effective stakeholder survey system are:
- the system communicates regularly with the key stakeholder groups, dealing with issues at a high level rather than a detail level, to provide a ‘sniff test’ of potential future problems and opportunities, a prompt indication of the impact of business initiatives, and an early alert to trends
- responses are weighted according to the relative importance of the stakeholder respondents to the current corporate goals and the materiality of the subject of the survey questions so that the influence on decisions can be proportionate
- the system is administered at the highest level (the office of the chairman) to avoid capture by internal functions, be they sales, operations or finance.
Regular surveying of the key stakeholder groups provides the mechanism and channels for addressing the issues raised by Andy Haldane, which need to be put to the stakeholders, arising out of the ‘fair value’ accounting in the two broad instances summarised above – apparent excess surpluses and notional increased future liabilities. The comparison between backward looking historical accounting and forward-looking survey reporting is summed up in the diagram below, illustrating our InfoShare approach.
Impact on decision-making
Let’s look at the decisions criticised by Andy Haldane arising out of ‘mark to market’ and how they might have been approached if the boards had been served by our holistic survey system.
Issue requiring decision
Asset surpluses have arisen from ‘mark to market’ accounting
Decision required:
What to do with these paper surpluses, balancing the objectives of the key stakeholder groups and looking to safeguard the future of the business?
Stakeholder survey question to stakeholders
How would these surpluses further your objectives in your relationship with our company?
Responses
Customers potential responses:
- reduce prices
- invest to improve the product
- invest to improve distribution facilities and services
Employees potential responses:
- raise salaries
- invest to improve working conditions
- invest to enhance the business and hence security of employment
Shareholders potential responses:
- increase dividends
- buy back shares to increase share price
- invest to increase productivity and take advantage of new opportunities and hence value of the company
Decision process
Bearing in mind the directors’ duties under S272 of the Companies Act 2006, to have regard to the future of the company and the interests of key stakeholders, with the above set of responses, the proper decision would come down in favour of investment in the future, and certainly not to treat the company as a cash cow. This would, of course, entail getting shareholders to agree with building long-term value, customers to accept an improved product and service, and employees to accept a balance of improved working conditions and long-term improved security of employment. But it would be the correct decision.
Of course, the company might be entering a period of decline, where the customers were disappearing and the workforce were demoralised and the shareholders wanted to salvage some value before the company disappeared. But in that case there would hardly be any surpluses arising from ‘mark to market’.
Beyond all this, of course, is the fact that unrealised gains may enable reduced cost of capital and enhanced borrowing ability, but they are still unrealised, and increased gearing introduces its own risks, while issuing more equity potentially dilutes existing shareholders.
A better outcome
Compare this with what Andy Haldane says actually happened. The investment option which figures in each set of potential responses was apparently ignored in favour of increased payouts to shareholders (and, probably, increased executive bonuses). Instead of prioritising the long-term future of these companies, investment was shunned in favour of short-term distributions.
The preferable approach would have been to consider the results of a holistic survey of stakeholders’ views, analysed according to a framework which feeds into the company’s corporate strategy.
In summary, just as an accounting framework is set out in a chart of accounts, reflecting income, expenses, assets and liabilities, this holistic framework is constructed to feed into the corporate strategy:
- Culture, covering
- environmental impact of the company’s activities
- social and employment practices
- an ethical culture
- Business model, covering
- a goal which is compatible with the objectives of all the key stakeholders
- a practical strategy to deliver the goal
- an organisation structured to deliver the goal
- organisational and financial resources adequate to support the strategy
- controls and systems fit for purpose
- risk management appropriate to protect the company
- accountability and transparency towards the stakeholders
- Compliance, covering
- statutory and legal requirements
- the constitution of the company
- applicable corporate governance regulations
- applicable industry regulations
The regular feedback from continuously surveying stakeholders across these topics would provide the board with the forward-looking data to make the best decisions for the future of the company.
The ill-advised distribution of paper gains to one stakeholder group – the shareholders – would never emerge from a holistic survey of the views of all the key stakeholders. Nor would it make sense when the board was considering the long-term health of the company towards which they had a fiduciary duty.
So, the financial reporting needs to be complemented by stakeholder surveys to safeguard the long-term health of the business,
