Sunday Brunch: What we call things really matters

Accounting is the language of business - Warren Buffett

I appreciate that talking about accounting, even climate accounting, is a big risk. I know many sustainability professionals, especially those who are not accountants, are already starting to switch off, maybe checking your phone. Because accounting isn't important to you.

But it should be. Because as Warren Buffet says, accounting is the language of business, and it's business we want to change. So we need to learn their language. So please stick with me - climate accounting really matters. And to understand why it's important, you don't need to know any accounting.

What we call things, and the way we ask questions, really matters.

We talk about this a lot in the context of home heating & cooling. If you ask 'how do I replace my gas boiler'? you get a very different answer than if you ask (the better question) , 'how do I best heat and cool my home?'

And it's the same in accounting for sustainability. Historically, we have accounted for sustainability related spending as a cost. And that comes off a company profits.

But is that the right approach? If a company has a sustainability strategy that positions them for a profitable future, then that is an investment. In accounting terms that creates an asset. And that creates, rather than destroys financial value.

Something is stirring in the conservative world of accounting standards that could really make a difference to how companies treat their sustainability plans. Turning them from costs to assets. And, in turn this new approach means shareholders are better placed to hold the companies to account.

And the more of us that understand it, the more we can use this to accelerate change. What we call something matters.

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Accounting matters, even if it's boring

I want you to hold a question in your head - is a promise to reduce GHG emissions a cost or a benefit? Not to society, to the company.

Your answer matters a lot. We like benefits, we hate costs. And that is as true of accountants and investors as it is for everyone else. So we would normally want to invest more in a benefit, even if it's in the future, than we would want to spend on a cost.

Ok, now that question is fixed in your head, back to accounting. Even people I used to work with in the finance industry found accounting boring. And complicated.

But it matters. How we describe the financial detail of what a company does is important.

Accountants, or more strictly the accounting reporting bodies, have been working hard over the last few years to bring a whole range of sustainability issues into how companies report. Some of you may have read about the work of the International Accounting Standards Board to incorporate sustainability and climate information.

One big move hides under the boring title of a 'rule clarification in relation to International Accounting Standard 37" - also known as IAS 37. Charlotte O'Leary and the team at Pensions for Purpose wrote about this recently.

What is this about. First, an apology to accountants, there is almost no accounting language in this blog.

IAS 37 deals with events in the future that will probably result in the company having to spend money or receive a benefit, but they don't know exactly how much and exactly when. Accountants call this Provisions, Contingent Liabilities and Contingent Assets.

It's often used to account for legal cases, but some of you will also have spotted that targets to reduce greenhouse gas emissions also involve a future event. And for most companies their climate related plans involve a degree of uncertainty. We know that the impact will happen, but we don't know exactly when, or how much companies will need to spend. And we don't know exactly what benefits might come from them.

This is important because IAS 37 is not just about future costs (liabilities to accountants). It's also about future benefits (assets).

How should we think about companies climate commitments?

Most of the time climate commitments are treated as a cost. When companies promise to cut GHG emissions, that imposes a cost on them. And so it's an accounting and profit negative.

But is it really a cost? The answer might seem simple to non accountants, of course it's a cost. The company spends money, so it's a cost. But, there is a big group of things that companies also spend money on that are not costs, they are investments. Yes, that's new factories and developing new products ... investing for the future of the company.

Investments are not a cost, they are about creating a future asset

For many companies, cutting GHG emissions is a benefit. It might help them meet future regulation. Or it might open up new markets. Either way, it makes them more likely to survive as a profitable business.

Let's make a comparison. Let's say you run a consumer goods company, you produce and sell beer, or maybe wine & spirits. And you decide to launch a new product, maybe a new Irish whiskey brand.

You spend quite a lot of money developing this, and even more on marketing. But that's alright, because you know (believe) that this new brand will become profitable over time.

Your accountant calls this spending an asset, not a liability. It's an investment not an operating cost. And because it's an asset you don't take the cost of it off your profits this year. You do what's known as capitalising them.

Put simply, the money you spend on developing this new Irish whiskey gets added up and put on your balance sheet, along with your factories and your other brands. Because that's what it is. It's an investment you have made that will contribute to future profits. It's no different from investments you make in factories or new equipment.

And because you have capitalised the costs, your profits are higher.

So how are your climate commitments any different?

Companies make these climate commitments because they believe that there will be a future benefit. Yes, we don't know exactly when that benefit will arise, or exactly how big it will be in financial terms. But we know that making those investments makes it more likely we continue to exist as a profitable business.

That sounds to me like a 'contingent asset' under IAS 37 ? And the IFRIC appears to agree. The link takes you to a recent IFRIC meeting, when they discussed this very issue. If you go to 6 mins 55 sec into the video, you can see Brian O'Donovan, from KPMG talking about this very issue, in accounting speak.

Going back to the question right at the beginning of this blog - are climate commitments costs or benefits. Because what you call it matters.

Increasingly it looks like climate change commitments might, from an accounting perspective, become benefits, not costs. Which feels like it better matches how most normal people think about them.

I want to finish on a note of caution, because nothing in accounting is totally straightforward. And change doesn't often happen overnight.

To quote Real Economy Progress

"While IASB’s rules (on IAS 37) haven’t changed as a result of today’s decision – it was made by the interpretation committee, which is banned from altering the content of the standards - the verdict may mean that companies will revisit the business activities they’ve committed to as part of their transition plans and decide whether they are being treated appropriately in their financial reports."

You can read more about the accounting details of the decision here, in a paper from Rethinking Capital.

And of course, companies have to decide if their climate commitments are about creating a long term benefit, and in some cases they may decide they are not.

And to leave you with a last thought - maybe accounting does matter.

Please read: important legal stuff.