Accounting Rules Disincentivise Investment in People and Planet
Traditional accounting frameworks like GAAP and IFRS have been pivotal in shaping the financial reporting landscape for companies. However, there’s a significant misalignment between these standards and the evolving business paradigms that prioritise sustainable and people-centric growth.
When a firm channels resources into 'produced capital', such as tangible assets (like factories) or intellectual property, it can 'depreciate' that investment over its useful life. Consider a scenario where a firm invests $10 million in modernising a facility. Instead of reflecting a massive $10 million expense in the year of investment, it’s spread over 10 years, with only $1 million impacting the P&L annually. This structure not only smooths the profit and loss statement but also provides tax incentives.
But what about investments in ‘human’ or ‘natural capital’?
Suppose a company spends an identical amount on employee training, an investment in human capital. The benefits from this investment will surely span several years, reflecting in the improved productivity and skills of the workforce. Yet, accounting rules dictate the entire $10 million be fully expensed in the year of the training, incentivising firms to underinvest in training, which hurts the business long-term. Wharton Professor Peter Capelli expands on this in his article, How Financial Accounting Screws Up HR.
The story is no different for investments in natural capital. Corporate investments in sustainability yield significant benefits for the company, society, and the broader economy over many years. Yet, current rules require these to be expensed upfront. A notable instance is Nestlé’s billion-dollar investments in their cacao and coffee supply chains, aimed at technical support, premiums, and loans for farmers. Despite the long-term benefits, such investments face scrutiny from shareholders due to immediate impacts on profitability, as highlighted by Nestlé’s head of public affairs at the 2023 World Biodiversity Summit.
Until the accounting rules are updated to reflect the modern reality of corporate dependence on human and natural capital, what can firms do to overcome this limitation?
Depreciation is an accounting mechanism that incentivises and enables companies to make investments that balance short-term and long-term profit objectives. Until the accounting rules are updated to reflect the modern reality of corporate dependence on human and natural capital, what can firms do to overcome this limitation?
Companies should include in their financial reports information that is material to understanding their business. This includes highlighting investment in human and natural capital, and tying it to long-term outcomes for the business. Don’t let those investments be hidden in the accounting, highlight them in the reporting and celebrate successes.
