How Should a “Sustainable Corporation” Account for Natural Capital?

Richard Barker is Professor of Accounting and Colin Mayer is Peter Moores Professor of Management Studies at University of Oxford Saïd Business School. This post is based on their recent paper.

The problem we address is that corporate accountability to shareholders is incompletely supported by existing systems of financial accounting and reporting. This is important to corporate decision-makers, to shareholders and to society more broadly, because a failure to account adequately for corporate activity is likely to correspond to a misallocation of economic resources.

In addressing this problem, we apply a conceptual analysis of the design and purpose of accounting, contrasting the “traditional” benchmark of accounting for levels and changes of financial capital (shareholders’ equity) with a system of accounting for levels and changes of natural capital, which we define as “the stock of natural ecosystems on Earth including air, land, soil, biodiversity and geological resources … (which) underpins our economy and society by producing value for people, both directly and indirectly” (NCC, 2016).

To the extent that there is no substitute for the resources provided by nature, the sustainability of economic activity depends ultimately upon the maintenance of natural capital. Accordingly, we seek to develop a system of corporate accounting that provides accountability not just for financial capital but also for natural capital, and—further—we seek to reconcile both forms of accountability within a single, integrated system, thereby providing an overall coherence of purpose, along with practicality in implementation. Specifically, we propose a system in which financial accounting is extended to record profit as a surplus with respect to financial capital, yet subject to the constraint that there is physical capital maintenance of (critical) natural capital. Such an approach draws a clean distinction between stocks and flows that are relevant to financial capital and to natural capital, while incorporating both within an integrated accounting system.

In presenting our argument, we first claim that financial viability is a necessary but not sufficient condition for a sustainable corporate sector, and that a meaningfully “sustainable” corporation is one whose activities have a non-negative impact on natural capital. This claim can be made through a shareholder-responsibility lens, and of course also through a broader lens of stakeholder responsibility. Either way, the implication is that there is a need to develop an accounting system that captures both the pursuit of profitable growth and the environmental sustainability of corporate activity.

We show that, for companies that generate negative externalities with respect to natural capital, adjustments are required to both the income statement and the balance sheet. In the income statement, we define sustainable profit as the (hypothetical) financial profit that the company would make if it internalised its externalities. In the balance sheet, sustainable assets are defined as the (hypothetical) assets that the company would own if it reinvested to ensure no depletion of critical natural capital.

Our approach to natural capital accounting is distinctive in several respects. Our design is explicitly an extension of (and thereby consistent with) a shareholder-oriented model of financial accounting; in other words, we do not characterise financial accounting as “broken” but instead as incomplete. Our design is also, however, concerned not only with the (economic) maintenance of financial capital but simultaneously with the (physical) maintenance of natural capital, and to that end our emphasis is on corporate impacts on natural capital, rather than with dependencies; in other words, we address how the activities of the corporation affect natural capital, rather than with how they are affected by it. The design also locates corporate accountability as arising up to, but not beyond, the boundary defined by the output of the reporting entity; in other words, the company is deemed to be accountable for all of its supply chain (upstream) activities, but not for the (downstream) use by customers of the company’s products or services. Finally, a further aspect of our design is that we propose a system of accounting, being the recognition of historical financial performance in a manner that is (conventionally) accepted as reliably measurable, and that we do not propose a system of valuation, which would instead be concerned with estimating and discounting cash flows that are uncertain and incremental; in other words, we are concerned with accountability, with the verifiable, ex post evaluation of performance, rather than with the uncertain, ex ante making of decisions.

The complete paper is available here.

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