Economic theory depends on accounting – yet it ignores the role of accounting in distributing value. Why does that matter? Because it limits the potential contribution of economics in resolving today's social and environmental crises, says our columnist.
First published in Pioneers Post
On 1 June 2009, Air France 447 stalled on a flight from Rio de Janeiro to Paris, killing all passengers and crew. The external environment and technical issues initially caused the problem. But black box recordings suggest it was the crew's inability to then correctly understand and resolve the problem that led to a loss of control. Accounts based on these recordings reveal that one of the pilots apparently continued to pull back on the side stick in an attempt to climb – the opposite of what was needed to recover. By the time his more experienced co-pilots realised what he was doing, it was too late. Much like that flight, we are trying all sorts of solutions to address global challenges of climate change and inequality, but we are not addressing the underlying issue. If we don’t realise that accounting is pulling us down, we will go down. If we do realise that a small change would re-engineer the driver of investment decisions, we can take the right action to climb up to safety. It’s perhaps not surprising we miss the importance of accounting. But perhaps more surprising that this is also a blind spot for economic theory. As a consequence, we have limited the policy options for addressing the significant challenges faced by our global economy. The solutions are hiding in plain sight. Accounting is causing us to stall and crash. Redistributing value
According to Investopedia, the difference between accounting and economics is as follows: “Accountants track the flow of money for businesses and individuals. Economists track the larger trends that drive money and the resources that money represents. Both help businesses and governments plan for the future, make sound financial decisions, and set fiscal policies.”
Another common view is that accounting measures how value is being created (or lost) through profit, and then economics provides insights into how that value can be optimised, leaving decisions on how that value should be distributed to politicians.
Not quite.
Accounting provides the main input that creates these trends. It is the bedrock and economics would not
exist without accounting. This is consistently ignored by economic theory and by economists, whether from the political left or right.
Why is this? Accounting does measure the creation of value, but it also distributes value. How we account determines the scope. By excluding some costs as out of scope, profits are calculated for some people that exclude costs being incurred by others. It means value is also being moved from those that have less to those that have more. Accounting redistributes value long before politicians get a look in.
I recently went back to the books I used to learn about microeconomics, which take a broadly neoclassical perspective. Everything starts with markets and how demand and supply vary with price. The graph below shows that there is a price where the quantity of a product bought is the same as the quantity sold. Yes, it is a simple model, and there is nothing wrong with that. But the problem is in the supply side.
Above: relationship of price to supply and demand (source: Encyclopaedia Britannica, republished under creative commons 4.0 license)
The supply depends on how much it costs to produce the product or service. There are then lots of other demand and supply relationships which set the price for everything that is required in the production of that good or service. These feed into a production function which shows how much product you will get from so much input.
The blind spot is deciding what is required for that production.
The simple answer is the inputs that you need to pay for: employment costs, perhaps raw materials, perhaps plant and machinery. And you’ll know how much these cost because you have contracts for them. And the person selling you something will have worked out their own costs in agreeing to enter into a contract. And so on.
But who decides what is included in establishing the cost? Is it limited to existing contracts? Are the costs then limited to whatever costs were agreed in a contract?
At this point in the development of economic theory, the answer to these questions is yes. Economists do realise that this approach gives rise to other costs and describes them as externalities and this understanding allows us to develop policies that seek to internalise these externalities. Though it remains unclear when and how these costs become recognised, let alone addressed. And it always seems as though there are only big externalities, rather than a nearly infinite number from small to large, some noticed, others not, all affecting how resources are being allocated and all influencing what products and services are viable in a market economy.
It is our accounting standards that tell us what costs should be included.
But the starting point is to accept the costs that come from those contracts.
This is a massive assumption, akin to that idea that two parallel lines never meet. So obvious that it doesn’t need consideration.
And the basis for this starting point is of course accounting. It is our accounting standards that tell us what costs should be included. From the perspective of an investment manager seeking to make financial returns for their clients, these are effective standards. From the perspective of society seeking to allocate scarce resources to competing demands, it is proving an unmitigated disaster.
Accounting standards recognise some costs but, conveniently, exclude many others. They are (a bit) better than the simple economic model we started with. They recognise that factoring in cost operates along a continuum from money already spent buying inputs, to money that might be spent at some point. And they recognise the problem with a continuum: that the point at which costs will be included or excluded is then a judgement. It’s worth exploring how accounting considers this question as economics then takes for granted. The starting point is the judgement required to decide whether or not there is an obligation to consider. The IFRS’s Conceptual Framework for Financial Reporting states that a present obligation arises from an unavoidable duty of responsibility to transfer an economic resource as a result of past events (para 4.2).
It does not need to be certain or even likely that the entity will make a transfer, but it must relate to past events where the entity already has obtained economic benefits or taken action (para 4.37).
That done, whether the obligation is recognised is influenced by the level of certainty that the obligation exists, whether it will be paid and the amount that will be paid. Too uncertain and the obligation goes away.
But there is some good stuff here. It is possible that the duty to transfer an economic resource arises from an entity’s customary practices, published policies or specific statements (para 4.31). And the obligation can be constructed from performance against targets arising from policies or statements, where those targets have generated the expectation that actions will be taken.
This is good.
And it is possible to construct an obligation to transfer resources to those people even when the recipient has not been identified (para 4.29) or the probability of making the transfer is low (para 4.38).
Even better!
But this all increases the risk that costs will be recognised that reduce profits. There is a huge conflict of interest between those experiencing costs and those who might have to pay, especially where those paying them have had too much influence on how accounting standards are developed. When a company’s investors are rewarded on profit performance and stock values, it is not going to be in their interests to recognise costs that reduce those rewards, let alone support accounting standards that make that more likely.
And so, just in case, a final judgement is required which ensures this won’t happen. If the entity has a practical ability to avoid the obligation, then the obligation does not need to be recognised. The obligation only exists if the entity has no ‘practical ability’ to act in a manner inconsistent with those practices, policies or statements (para 4.31).
Hmmm – what is a practical ability?
Practical ability is informed by the entity’s duty or responsibility, which could arise from social norms. The nature of duty or responsibility, and the timescale over which the economic consequences are assessed is not clear and therefore the judgment of what constitutes an entity’s ‘practical ability’ in relation to discharging its responsibility depends on whether the decision to avoid liability was reasonable, informed by an assessment of stewardship or depended on a legal requirement.
It’s not defined, but there is an example. If you pay more for avoiding the liability than you would by meeting it, then it is not practical to avoid it (para 4.34). Which feels more like a statement of the obvious than a judgement around practicality. The idea that statements by a company that gave rise to a constructed obligation might themselves be a practical constraint to avoiding the obligation isn’t given as an example – and yet, for example, there are many legal cases where people’s religious beliefs run up against other legislation which constrain practice. And practice, if anything, is surely what we mean by being practical – in practice I cannot avoid the obligation. If practice falls back on economics with no reference to other social norms, this becomes a circular argument. Which perhaps is implicit in the origins of accounting practice. Provide the chimera of judgement in determining an obligation, realise what that might mean, and so, systemically, pull the rug from under us or pull the wool over our eyes.
Global group think
Of course, the lawyers are all over this. Any sign that a company recognises an obligation increases the chance it will have to pay it – which means less money for all the other contracts and less money for investor returns. So the judgement is going to err on the side of there not being an obligation or even if there is (and as we have seen above, this is unlikely), it still being too uncertain.
It was all going so well…
But here perhaps we have found that invisible hand. This is the one that Adam Smith wrote about and people still use today. As he put it:
“Every individual... neither intends to promote the public interest, nor knows how much he is promoting it... he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention.”
More (dangerously) dull than invisible, as it turns out.
This very selective perspective of Adam Smith’s thought (there is less enthusiasm for his critique of rentier income) has contributed to a global groupthink that helped those accounting standards along.
We don’t even need to ask what he meant by value. We can find another quote from his Theory of Moral Sentiments:
“However selfish man may be supposed, there are evidently some principles in his nature, which interest him in the fortune of others, and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it.”
Follow Smith’s thinking, and it’s clear that we’re not just interested in financial returns…
And yet the idea that investors are only interested in financial returns is the central premise of financial reporting (para 1.3).
So this is the basis for how accounting determines costs, which is then taken as granted by economics. All those early economists – Smith, Ricardo and Marx – pay little attention to the question of which costs are accounted for. Fair enough, as capitalism was in its early stages when they were writing. The consequences of capitalism were being recognised, or at least some of the immediate larger consequences, through public policy, trade unions and education to name a few. A few major ones that had to be fought for, by widening democracy and, at times, by taking to the streets. Accounting seems a long way a way from the action.
Early economists paid little attention to the question of which costs are accounted for... it seems modern economists have continued in this vein.
I confess I haven’t done a full literature review but on a quick look it seems that the modern economists have continued in this vein. Piketty, Stiglitz and Mazzucato do not dwell on how accounting standards limit the costs that are included in deciding whether a product or service is viable in a market economy. Stiglitz, in The Price of Inequality, refers to accounting standards’ contribution to rising inequality through how benefit packages for ‘senior’ management are accounted for, but the depth and scale of the problem is missed. There is some hope in the recent Doughnut Economics report, What Doughnut Economics means for business: Creating enterprises that are regenerative and distributive by design. This includes a reference, in the governance section, to the annual accounts. And while this is not immediately going to mean that directors will include costs that accounting standards have tended to exclude, it does at least open the door. As the report puts it: “The governance structure of a business determines how decisions are made. This covers who is represented on the board, how trade-offs are navigated, transparency of the business, what information and metrics are included in annual accounts, and the use of internal incentives to pursue the company’s purpose.”
But leaving profit to be calculated based on existing accounting standards will push businesses out of the doughnut (ie, beyond the boundaries within which humanity can thrive) far faster than this guidance can bring them in.
Up to the politicians
The fundamental issue is that how profit is calculated isn’t actually up to accountants, despite what they may think. It is up to politicians.
Sir Keir Starmer, leader of the UK Labour party, gets his fair share of criticism for not setting out his vision, but it seems pretty clear from his website.
“Another future of a just and more equal society is possible. A just and more equal society means everyone can achieve a decent standard of living; the opportunity to get on and do well; and the right to be cared for with dignity when you need it most.
“A just society means that no matter who we are or where we come from, all of us should have the right to an equal chance to prosper. A just society gives everyone the right to healthcare, education and social security, free at the point of need.
“A just society means being part of thriving communities and workplaces where citizens and workers have the right to a real say at work and the place they live in. We can no longer accept that a child’s life chances are determined at the moment of birth. Public policy must seek to prevent problems from happening in people’s lives, rather than seeking to manage them once they’ve happened. That requires a wholesale switch to providing help and support as early as possible.”
These social rights would need to be matched with some social responsibilities and not be undermined by financial accounting standards. This needs us to consider an approach to financial accounting that would reflect those rights and responsibilities (an approach explored by the Capitals Coalition). If economics saw accounting as a driver rather than simply a reflection of an economy, it would be possible to explore alternative approaches to accounting and to develop new policy options that would reflect Starmer’s vision. If we realise that the purpose of accounting can be more than just information for the expectation of financial returns, we would get holistic accounting. One that allocated resources to entities based on their ability to contribute to that vision, where financial returns are an important part of guiding allocation, but not the only guide.
The pilots of that Air France flight didn’t have enough time to work out the problem. We have more. But first we have to recognise the problem and then we can imagine a solution. For a long time it was a basic tenet of geometry that parallel lines don’t meet. Imagining that they might do gave us the geometry of the globe. Imagining a different basis for accountancy could give us a more holistic accountancy.