Putting the wrong kinds of numbers in P&L won’t help save the planet

Many companies will need to spend a lot of money reshaping their businesses to help save the planet. Some environmental campaigners say that companies should book all that spending as liabilities today. They argue that booking that spending today would make investors focus on that information and that investors would then put pressure on companies to act more quickly and more effectively.

This post notes that future spending affects the amounts reported in the balance sheet and in profit or loss only if the spending will arise from a liability the company already has, or if the spending triggers an impairment loss on assets the company already holds.

Many companies will need to spend far more than is captured by those effects on reported liabilities and impairment losses. Investors need prominent information about that further future spending, but that information does not belong in the balance sheet and in profit or loss. Putting that information in the balance sheet and in profit or loss:

  • would not necessarily make investors focus on the information; and
  • would damage the disciplined structure and clarity of those reports and make them less useful to investors.

Because investors need information about that further future spending, companies will need to find another prominent way to provide it. The new International Sustainability Standards Board will, doubtless, work on how they can do this.

Background

Many companies will need to spend a lot of money in the coming years and decades to reshape their businesses to help save the planet. Some environmental campaigners say that companies should book all that spending as liabilities today. They argue that booking that spending today will induce investors to put pressure on companies to take more timely and more effective action. Those arguments seem to rest on two unjustified beliefs:

  • 1st unjustified belief: that putting information in a company’s profit and loss statement and balance sheet will automatically make investors focus on that information.
  • 2nd unjustified belief: that all information about large amounts of future spending belongs in the balance sheet.  

Investor focus on primary financial statements

Some people argue that putting information in a company’s profit and loss statement and balance sheet will automatically make investors focus on that information. They argue that investors pay attention to numbers that companies report in their primary financial statements: profit and loss statements and balance sheets. Therefore—the argument goes—if companies start including numbers about future spending in their primary financial statements, investors will automatically pay attention to those numbers. Investors will then start putting pressure on companies if they feel that companies aren’t doing the right thing, or aren’t doing enough.

There is a gap in that logic. It’s true that putting numbers in a primary statement makes those numbers more prominent. But why do investors don’t pay attention to numbers in a primary financial statement? It isn’t just because the numbers are in such a statement. Instead, it is because those numbers tell investors about the company’s financial performance for the year and about its financial position at the end of the year. Those numbers are part of the information that investors use in building and testing their understanding of the amount, timing and uncertainty of a company’s future cash flows.

Indeed, many investors don’t even look at every number that is already in the primary financial statements today. They don’t look at numbers that they think won’t help them understand a company’s financial performance or financial position or its prospects for future cash flows. For example:

  • many investors pay little attention to income or expense reported as part of ‘other comprehensive income’.
  • many investors ignore numbers for ‘deferred tax’. (In my view, investors miss useful information by ignoring the deferred tax numbers, please see Myths about Deferred tax – Accounting Miscellany)

Cash flow statement

Balance sheets and profit and loss statements aren’t the only statements that companies produce. They also produce cash flow statements, but this post does not need to talk about cash flow statements. That is because those statements report only cash flows that have already occurred. This post focuses on information about future cash flows.

What information belongs in the primary financial statements?

Information belongs in a company’s primary financial statements if it tells investors about the company’s financial position or financial performance. To serve that purpose, primary financial statements have a precise and disciplined structure:

  • the only things that can appear in the balance sheet are assets, liabilities and equity. These 3 ‘elements of financial statements’ tell investors about the company’s financial position.
  • the only things that can appear in the profit or loss statement are income and expenses. These other 2 elements of financial statements tell investors about the company’s financial performance.

The fact that primary financial statements contain only 5 elements is not a mere technicality. Those statements are not just listings of the elements that appear in them:

  • the numbers attached to those elements are added up to form sub-totals and overall totals.
  • the balance sheet and profit and loss statement are tightly inter-linked: income or expense is reported only if there is a change in the carrying amount of an asset or liability. Also, if the carrying amount of an asset or liability changes, there is at the same time also: (a) income or expense; or (b) a change in the carrying amount (i) of another asset; (ii) of another liability; or (iii) of equity.

Adding a new (6th) element?

Could we add to the 5 elements shown in the primary financial statements by finding some other 6th element covering future environmental spending? I have heard or read nothing to make me think that a suitable 6th element exists—or that one could be invented.

By ‘suitable’, I mean an element that:

  • would provide useful information to investors; and
  • could be added to the primary financial statements without damaging their tightly disciplined structure.

Future environmental spending and primary financial statements

A company’s primary financial statements do reflect some information about future environmental spending that:

  • relates to a liability that already exists; or
  • results in an impairment of the company’s assets.

Liabilities that already exist

A company already has a liability—and generally reports (‘recognises’) the liability in its balance sheet—if the company already has an obligation to pay cash (or to pay using other assets) at some future date, without receiving any goods or services in return for that payment.

In the year when the liability first arose, the company will also recognise an expense in its profit or loss statement.

Example of future cash payments resulting from liabilities that already exist
Company A has polluted the environment. A law already in force obliges company A to pay a fine for having caused the pollution. Company A must recognise as a liability its obligation to pay the fine. (except perhaps if there is some doubt about whether company A caused the pollution or about whether it must pay the fine) 

Conversely, even if a company expects to incur environmental spending in the future, the company does not yet have a liability to incur that spending if, for example, the company:

  • does not yet have an obligation to pay cash;
  • already has an obligation to pay cash, but in exchange will receive goods or service of similar value; or
  • will have to make payments so that it can continue operating its factory, but has no obligation to make those payments. Nevertheless, those payments affect the future net cash inflows that will arise from operating the factory. So the company must consider those payments in assessing whether the factory is ‘impaired’ (see separate discussion of impairment below).
Examples of future cash payments for which no liability exists yet
A law already in force will oblige company B to pay a fine if it causes pollution. Company B expects to cause pollution in the future, but has not yet done so.
Thus, no obligation (and, hence, no liability) exists yet.

A law will oblige company C to pay a fine if it causes pollution after the law comes into force in 3 years. Company C has caused pollution in the past. It expects it will continue causing pollution after the date (in 3 years) when the law will come into force. But company C has not yet caused pollution subject to a fine.
Thus, no obligation (and, hence, no liability) exists yet.

Company D expects to reshape its business over the next few years to make it more sustainable. The change will involve major costs for changes to, for example, manufacturing equipment, supply chains, product lines and distribution channels. Company D expects to incur those costs, and perhaps cannot avoid incurring them if its business is to survive. Nevertheless, when company D incurs those costs in the future, it will receive benefits (goods and services) in exchange.
Thus, company D does not yet have a liability to incur those costs. But company D does consider those future costs in testing its assets for impairment.

A new law is now in force and now obliges company E to fit smoke filters to its factory. Company E has an obligation to fit the smoke filters and it plans to fit them soon. Nevertheless, when company E incurs the obligation to pay for the smoke filters, it will receive the smoke filters in exchange.
Thus, company E does not yet have an obligation to pay for the smoke filters, which it has not yet received. But company E does consider those future costs in testing its assets for impairment (this example continues below under discussion of impairment).

Impairment of assets

Future environmental spending is one factor that affects a company’s impairment testing of its assets. Impairment testing is likely to be important for physical assets, such as factories and oil and gas reserves. It may also be important for intangible assets (including goodwill) acquired when buying other companies. (But company balance sheets do not include numbers for intangible assets—including goodwill—generated by the company itself, so companies do not test those assets for impairment.)

Background: impairment testing
Companies test assets for impairment by estimating the net cash inflows (inflows less outflows) that the asset will generate. If the present value of those net cash inflows is less than the asset’s ‘carrying amount’, the asset is ‘impaired’ and the company needs to recognise a loss (an ‘impairment loss’) in its profit or loss statement. The carrying amount is the number attributed to the asset in the balance sheet. For a group of assets that work together, the impairment test is carried out for the group as a whole, not separately for each asset within that group.

If a company comes to a new conclusion that it will need to spend a lot more in making its business sustainable, that new conclusion will affect impairment tests of the company’s assets. Whether that new conclusion triggers an impairment loss will depend on the circumstances, as shown in the 2 examples that follow.

Example: impairment testing
Fact pattern
To comply with a new law, company E plans to fit smoke filters to its factory soon at a cost of £20. As discussed above in the first part of this example, company E does not yet have a liability to pay for the smoke filters.
The total carrying amount of all assets in the group of assets containing the factory (a ‘cash generating unit’) is £100.
Before company E knew that it would have fit the smoke filters, it estimated that the present value of the future net cash inflows was £115. The cost of the smoke filters will be £20 and company E estimates that there will be no other changes in future cash flows.

Result of the impairment test
The present value of the net cash inflows is now £95 (£115 – £20). This is less than the carrying amount of £100. So the factory is impaired and company E recognises an impairment loss of £5 (£100 – £95).
Example: impairment testing (2)
Fact pattern
Company F has the same fact pattern as company E, except that the total carrying amount of all assets in the cash generating unit containing the factory is £70.  

Result of the impairment test
After updating its estimated future cash flows to reflect the cost of fitting the smoke filters, their revised net present value (£95) still exceeds the total carrying amount of all the assets (£70). Consequently, company F does not recognise an impairment loss.

Where should companies tell investors about future environmental spending?

Companies need to tell investors about future environmental spending. That information may be important in several cases:

  • if the amount is large
  • if the amount is small but relates to major changes in the company’s business
  • if the amount is small because the company does not plan major changes to its business, but investors assume that the company needs to make major changes.

The primary financial statements are the place to tell investors about future environmental spending that will result from a liability that already exists or that will trigger an impairment loss on the company’s assets.

Information about other future environmental spending may need to be prominent, but it does not belong in the primary financial statements. It belongs in other places:

  • perhaps some of it in the notes to the financial statements.
  • much (and perhaps all) of it in management commentary or in separate environmental reports

The recently formed International Sustainability Standards Board will be developing standards for reporting information relating to the natural environment and other aspects of sustainability.

Conclusion

Companies need to tell investors how they will change their businesses to make them sustainable. Many companies will need to spend a lot of money in doing that. Estimates of that future spending might affect a company’s profit or loss statement and balance sheet today—if the company already has a liability to spend that money or if the prospect of that future spending triggers an impairment loss on assets the company already holds.

Many companies will need to spend far more than is captured in liabilities and impairment losses already reported. Although information about that further spending does not belong in the company’s primary financial statements, that information is important to investors and needs to be given prominently in other places.

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