Accounting for Coronavirus Risk

As Queen Elizabeth makes her emergency address to the British people from her safe zone in Windsor Castle, and as the U.S. Surgeon General Jerome Adams warns the American people of an impending “Pearl Harbor Moment,” is it reasonable to ask why governments and businesses were caught blindsided by the coronavirus catastrophe?

Perhaps it’s unfair to expect foresight in the face of such a menace. But why weren’t health care providers and other organizations prepared to respond promptly? Why the shortages of such basic items as face masks and nasal swabs? Where was the contingency plan to increase production of such essentials at a time of dire need?

If we review the reporting standards of the Global Reporting Institute (GRI), we can find disclosure requirements that address these readiness considerations. GRI Standard 204 on Procurement Practices, for instance, states that:

When reporting its management approach for procurement practices, the reporting organization can … describe actions taken to identify and adjust the organization’s procurement practices that cause or contribute to negative impacts in the supply chain … (these) can include stability or length of relationships with suppliers, lead times, ordering and payment routines, purchasing prices, changing or cancelling orders.”

Consider the many health care providers that rely on unstable Asian suppliers to provide face masks under terms that permit long lead times, uncertain ordering routines, and the imposition of extreme price increases when products are scarce. If they are required to disclose these procurement relationships under GRI Standard 204, we would be aware of the resulting social risk.

Likewise, GRI Standard 403 on Occupational Health and Safety states that:

The reporting organization shall report … whether the (occupational health and safety management) system has been implemented based on recognized risk management and/or management system standards / guidelines and, if so, a list of the standard guidelines.”

Consider the employees of our food and delivery companies who are now protesting that their employers are not providing satisfactory protections against the coronavirus. If the employers are required to disclose the standards and systems that they utilize to keep their employees healthy and safe, we would be aware of the extent of their preparedness (or lack thereof) in the face of pandemic threat.

There are other GRI Standards that come close to addressing pandemic concerns, but that fall just short of the mark. GRI Standard 201 on Economic Performance, for instance, states that:

The reporting organization shall report … risks and opportunities posed by climate change that have the potential to generate substantive changes in operations, revenue, or expenditure, including a description of the risk … a description of the impact associated with the risk … the financial implications of the risk … the methods used to manage the risk … (and) the costs of actions taken to manage the risk.”

Although Standard 201 refers to climate change, it would represent an ideal disclosure requirement for pandemic preparedness if the GRI simply adds the words “and pandemics” to “climate change.”

It may be comforting to know that disclosure defining entities like the GRI have issued standards that address our readiness to fight the current pandemic. But we cannot reap the benefits of these disclosure requirements if organizations simply ignore their reporting responsibilities.

Creative Accounting

Many of the recent memorial tributes to the comic actor Gene Wilder emphasized his portrayal of the title character in the initial film version of Willie Wonka and the Chocolate Factory. Indeed, though that movie was never a major hit, Wilder’s “whimsical yet obscurely menacing” portrayal perfectly captured his unique brand of humor.

But did you know that Wilder was also the originator of the business world’s phrase creative accounting? He played the psychotically repressed Max Bloom in the 1967-68 cult comedy classic The Producers, portraying an accountant who conspires with the producer of a Broadway show to swindle his investors.

The phrase creative accounting was a sarcastic reference to the manipulation of financial bookkeeping practices to enable the swindle. More specifically, it involved a scheme involving accounting principles for equity capital.

So how did the swindle work? The producer, a character named Max Bialystock, raised capital by promising investors that he would launch an extremely successful Broadway show. But he intentionally created an atrocious show that was designed to be severely criticized — and then closed down — after a single Opening Night performance.

Bialystock knew that traditional accounting debits and credits are recorded in dollars and not in ownership percentages. So he sold and resold the same shares of ownership over and over, and kept recording the cash inflows as new investment capital.

Once the show closed, Max assumed that the investors would be too embarrassed about investing in such an awful flop to demand their money back. And so he assumed that he and his conspirator Max Bloom could pocket the unspent funds.

Did they get away with it? You’re welcome to watch the film and learn the answer to that question. But here’s a hint: the outcome of the movie pivoted on the hilarious reactions of the Opening Night audience.

Incidentally, if you believe that such schemes could never be perpetrated in the real world, please think again. Until a few years ago, for instance, American politicians often raised millions of dollars through Political Action Committees. Then they announced their retirements and routinely kept the funds for their personal use.

Indeed, if The Producers were to be re-made for today’s movie audiences, there’s a good chance that it wouldn’t be situated in the world of Broadway theater. Nowadays, the most audacious producers of creative accounting techniques — and many other examples of financial chicanery, for that matter — practice in the world of politics.

But that’s another story!

Sustainability Accounting

In my previous blog post, I described the history of sustainability accounting as a “fairly engaging tale (that) begins in northern Vermont on a Ben & Jerry’s dairy farm, segues over to the Alaskan shoreline on the doomed Exxon Valdez oil tanker, and then ends in the present with characters as diverse and colorful as former Mayor Michael Bloomberg of New York City and Charles, the Prince of Wales in Great Britain.”

And then what did I do? I segued into another topic! And I never returned to explain why these two places and two people played key roles in the development of sustainability accounting.

Although I can’t honestly say that I heard roars of protest over my segue, I did hear from several readers who expressed curiosity about these places and people. So I thought that I’d explain the references in this follow-up post.

First and foremost, please keep in mind that there is no universal consensus about what we mean by the word sustainability. Nevertheless, Merriam-Webster defines the word sustainable as meaning able to last or continue for a long time, and most other sources agree that it refers to the long term viability of a person, group, or organization. Or, on a very large scale, to the entire planet Earth.

So how did a dairy farm, selling milk to an ice cream producer, factor into the accounting for such a concept? In the business world, many individuals trace the discipline of sustainability accounting to Ben & Jerry’s annual issuance of Social and Environmental Assessment Reports (SEARs). Beginning in the 1980s, the firm has pioneered the process of establishing social and environmental goals and then publicly assessing its progress in achieving them.

Then, in 1989, the Exxon Valdez ran aground on the Alaskan shoreline, spilling massive amounts of crude oil onto pristine ocean beaches. As was the case during the BP Deepwater Horizon spill in the Gulf of Mexico two decades later, the clean-up activities were hampered by uncertainties over which organizations bore responsibility for various crisis management efforts.

The concept of Governance thus joined the concepts of the Environment and Society as key considerations of sustainability. As the operational complexity of the discipline grew more dense, the qualitative measurements of the SEAR reports evolved into more quantitative metrics.

Nevertheless, the two types of sustainability reporting have survived to the present day. Whereas the Ben & Jerry’s qualitative process now tends to be known as Corporate Social Responsibility (CSR) reporting, the Exxon and BP quantitative process now tends to be known as Environmental, Social, and Governance (ESG) reporting. Nevertheless, there is a significant amount of overlap between the two styles.

So where do we stand today? Well, the production of social and environmental metrics to supplement financial (or economic) profit measures has led to the development of Triple Bottom Line (TBL) reporting. Using standards and measurements promulgated by organizations like the Sustainability Accounting Standards Board (SASB), now led by Chairman Michael Bloomberg, a TBL report provides three sets of summary measures that collectively express the holistic performance of an entity.

And what of Prince Charles? He has led an effort to integrate these three distinct bottom line measures into a single integrated framework of holistic performance. His efforts helped launch the Integrated Reporting project, which created a framework called the Six Capitals model.

Here is a pictorial representation of that model. Can you see why it is colloquially called the Octopus framework? There are six tentacles on each side of the proverbial head of the octopus, with each tentacle representing a Capital, i.e. a type of resource that an entity must utilize while conducting its operational activities.

So what will come next in this history? In all honesty, who knows? With climate change causing massive disruptions to global economies, societies, and environments, many other colorful locations and charismatic personalities are sure to enter the story.

Hey, you didn’t know that the history of sustainability accounting is so interesting, did you? And given the volatility of our modern world, it’s a future that hasn’t yet been written.

Integrated Reporting and Goodwill

American corporations can now record an asset named Goodwill on their formal audited financial statements. Is it so far-fetched to believe that they might eventually be permitted to record an asset named Trust as well?

With those words, I concluded my prior blog posting. But perhaps I should have continued the posting a bit further. After all, you might be wondering:

Huh? Can American corporations really record Goodwill on their financial statements? What, exactly, does that mean? And how, precisely, is it measured?

Well, when a company acquires another firm, it sometimes pays a price that exceeds the value of that firm’s recorded net assets. Although it might simply be overpaying for the firm, it’s also possible that it is paying a premium for certain net assets of the acquired firm that are not recorded at all.

What kinds of assets are not recorded at all? Trust, perhaps. A well trained work force. A reputation for using innovative practices to avoid polluting the natural environment. Although such assets do exist, they are often very difficult to value and are thus unrecorded on the traditional financial statements.

However, when American corporations pay acquisition prices that exceed the value of the acquired firm’s net assets, the amount of the overpayment can often be recorded as Goodwill. This serves as a generic catch-all name for any such unrecorded assets.

And yet, if one doesn’t know how much of Goodwill is attributable to each specific unrecorded asset, then how can one determine whether those assets will continue to exist after the time of the acquisition? For instance, if a company records Goodwill (as a catch-all asset) during an acquisition that is made in the year 2015, how can it possibly know what the components of Goodwill are worth in the year 2016?

The answer to that question might be found in an alternative form of accounting known as Integrated Reporting. According to the <IR> framework, there are six “capitals” that companies use to produce goods and services.

Financial capital (such as cash) and manufactured capital (such as factories) are owned by companies and are recorded in the traditional financial statements. Intellectual, human, and social relationship capital are also owned by companies, but are not recorded in the financial statements.

And then there is natural capital, which refers to the environment surrounding companies. Although companies don’t own their surrounding natural environments per se, they might indeed own pollution credits or other rights to use natural resources.

Though the <IR> framework refers to these six resources as “capitals,” they also represent assets that can be utilized by companies to produce products and services. Thus, consistent with the <IR> framework, Goodwill can be sub-divided into the types of assets (or “capitals”) that do not normally appear on the financial statements, namely: intellectual, human, and social relationship assets.

Trust itself would thus represent a social relationship asset. A well trained work force would represent a human asset. And the innovative practices that prevent the pollution of the natural environment would represent intellectual assets.

Why is this classification system helpful? Well, in the very first paragraph of this posting, we asked whether an asset named Trust might eventually join Goodwill on the financial statements. Under the <IR> system, however, if Goodwill appears in the financial statements, Trust (if it exists) would reside within an implicit component of it.

Indeed, Trust would reside in the social relationship asset. And human and intellectual assets would represent components of Goodwill as well.

Still not convinced that this classification system is helpful? Then let’s look at the situation a bit differently. If you purchase a firm (or any other item, for that matter), you should always understand precisely what you are actually buying.

If a major asset within your newly purchased firm is simply called Goodwill, then you can’t possibly know with any precision what is included therein. But if Goodwill is divided into social relationship, human, and intellectual assets, then you more likely can know so.

Quantifying The Value Of Trust

Once again, I am deeply grateful to my friends and colleagues who have offered such passionate responses to my prior blog post In Corporations We Trust. In that post, as in the previous one entitled Is Trust Necessary?, I suggested that politicians and business professionals need not worry about a lack of trust between nations or organizations if verification controls are in place to monitor the activities of the parties.

Nevertheless, I also suggested that the existence of trust can be extremely beneficial, and that trust itself represents a valuable asset that is increasingly recognized by accounting and metrics organizations like the International Integrated Reporting Council (IIRC) and the Global Reporting Initiative (GRI). In fact, I noted that these organizations have directly inserted the concept of trust into their core frameworks and paradigms.

So why the passionate response from my readers? Apparently, many are skeptical that any one can place a value on trust. Although they agree that trust represents a conceptual corporate asset, they cannot see how any one could ever assign a monetary value to it. And yet, despite their skepticism, the equity markets are already doing so.

Imagine, if you will, two nearly identical companies that compete directly with each other for a single customer segment with a single product. But let’s imagine that Company A is deeply trusted to treat customers in a respectful manner, while Company B is sorely mistrusted because of a history of rude service.

Even if Company B revamps its service function, if customers remain distrustful of the firm, its equity market value would likely languish behind the comparative value of Company A. Thus, Company A’s premium value would be attributable to the value of an intangible asset called Trust.

Of course, one might argue that Company A might become so blindly committed to this asset called Trust that it might fail to pursue beneficial opportunities to roll back or outsource its customer service function. In that case, the equity market value of Company A might fall below the comparative value of Company B.

Even under such circumstances, though, trust would possess a value. Instead of representing an intangible asset of Company A, it would represent an intangible liability of Company A. And its value would be equal to the premium value of Company B’s stock in comparison to Company A’s.

In other words, to the extent that the existence of trust (or mistrust) affects the future financial performance of any corporation, it will likewise affect the current valuation of that corporation. And thus, such trust can be modeled as an asset or liability with a specific financial value.

Does that mean that the Financial Accounting Standards Board (FASB) in the United States, or the International Accounting Standards Board (IASB) in other nations, will ever permit Trust to be recorded in the formal audited financial statements as an asset or liability? Quite possibly not; after all, those accounting regulators tend to respond conservatively to any proposal that involves significant changes to the traditional accounting model.

But just as investment analysts routinely transform the traditional definition of Operating Cash Flow to the contemporary definition of Free Cash Flow, they might indeed be willing to adopt transformational definitions of assets and liabilities as well. And when they do so, trust will represent a meaningful off-balance sheet asset or liability, similar to other off-balance sheet items that can immensely impact the value of a corporation.

Furthermore, who’s to say that the conservatism of FASB and the IASB will last forever? After all, American corporations can now record an asset named Goodwill on their formal audited financial statements. Is it so far-fetched to believe that they might eventually be permitted to record an asset named Trust as well?

How Many Accounting Standards Do We Really Need?

Are you aware that two different sets of accounting standards exist around the world? American organizations follow Generally Accepted Accounting Principles (GAAP), whereas other organizations adhere to International Financial Reporting Standards (IFRS).

Although the two sets of standards share many similarities, they maintain several important differences as well. Nevertheless, one might guess that a single set of unified standards would represent a desirable goal, and that the existing two sets of standards would provide more than sufficient flexibility to satisfy every entity.

Is this your guess as well? Then perhaps you should guess again! Last week, the experts at the Financial Accounting Foundation who maintain GAAP announced that a third set of standards is now available. Small and medium sized entities can choose to follow a “non GAAP” set of standards that is much simpler than traditional GAAP.

On the one hand, it is difficult to take umbrage with the Foundation’s announcement. After all, traditional GAAP is regarded as a terribly complex accounting framework by even the largest and most sophisticated global organizations. It undoubtedly imposes an onerous regulatory burden on entrepreneurial groups.

And yet, wouldn’t it be preferable to simplify GAAP for all organizations, as opposed to developing alternative standards for various “non GAAP” organizations? Multiple sets of standards may cause inconsistency and thus confusion among financial statement users, thereby further complicating an already troublesome status quo.

Indeed, if the Financial Accounting Foundation continues to create customized “non GAAP” standards for various groups, its activities may result in chaos. So how many sets of accounting standards do we really need? The answer, perhaps, should be “as few as possible.”