Developing Standards for ESG and integration with National Accounts (Second Part of ASSOCHAM address)

 

RETHINKING ENVIRONMENTAL, SOCIAL AND GOVERNANCE

IN FINANCIAL ACCOUNTING AND REPORTING

FOR COMPANIES IN THE DIGITAL AGE

 

(Part of the Keynote Address at the ASSOCHAM International Virtual Conference on Financial Reporting and Control on 6^th May 2021)

 

SUBHASH CHANDRA GARG

ECONOMY, FINANCE AND FISCAL POLICY STRATEGIST AND FORMER FINANCE, ECONOMIC AFFAIRS SECRETARY GOVERNMENT OF INDIA

 

Companies generate bulk of profits and also about half the gross value added in the economy

Raison d’etre of the business, as is commonly understood, is to earn profits for the owners by producing and distributing goods and services of value to its consumers. The gross value created by the businesses generate incomes for the workers and taxes for the Government, besides generating profits for the owners. Wages, taxes and profits, which make up the sum total of the GDP of an economy, all flow from the businesses.

Companies are the most prominent form of businesses. Globally, corporate profits are estimated to be around $10 trillion and corporate taxes around $2.5 trillion. Global economy is of the order of around $90 trillion. Global corporate profits thus make up more 10% of global GDP. Size of Indian economy is of about $3 trillion. Government’s collections from corporation taxes is about $80 billion. Assuming 25% to be net effective corporate tax rate in India, the profits of companies in India should be around $300-$325 billion, roughly about 10% of GDP. The corporate profitability in India is thus similar to general global standards.

Companies in India contributed gross value added of Rs. 83.76 lakh crore in 2019-20, out of the total GVA of Rs. 184.61 lakh crores, generating a share of over 45% of India’s total value of goods and services produced. Corporations’ expenditure of Rs. 29.38 lakh crore, out of the total gross capital formation of Rs. 60.46 lakh crore in 2019-20, also amounted to 48.6% of total gross capital formation in India[1]. The rest of the economy- agriculture, small businesses in mining, construction, manufacturing and services- is highly informal and unorganised. Most of the organised sector GDP, wages, profits and taxes come from the companies.

Current accounting and financial reporting standards are for the bygone industrial era

The accounting and financial reporting standards mandated by the Government and/or the professional accounting bodies in India, for that matter, all over the world, are primarily meant for the companies, which were the growth engines of the industrial era. Present standards were thus meant largely for the industrial age. The paper based accounting and financial reporting system is also meant for serving the needs of that time.

I wrote about two developments last week. First, digitalisation sweeping across services, including accounting and financial services and the urgent need for evolving new standards for complete digitalisation of accounting, financial reporting and auditing for the companies and shifting all 1.3 million Indian companies to digital only accounting, auditing and financial reporting. Second, fast evolution of digital assets companies own has been changing over last few years. Earlier, the change the need for evolving standards for mainstreaming digital assets and digital liabilities in the accounts and balance sheets of the companies.

There are two more big developments impacting companies and their businesses.

First, the societal and non-financial regulatory demands on the companies are expanding fast. There have been significant inclusion of disclosures of these demands in the financial statements and reports. Companies are adopting integrated accounting standards developed globally voluntarily. Environment, social and governance (ESG) have become major global concerns. There is, however, absence of organised/ streamlined Indian standard on ESG and other desirable standards set by official companies regulators in India. Development of such standards would be quite helpful.

Second, companies make more contribution to the societies than producing goods and services and earn profits for the owners.

The most significant contribution of the companies to the society is to generate incomes for millions of workers. Likewise, a significant share of overall tax revenues of the government for undertaking provision of public services comes from the companies. In the absence of these contributions being presented adequately in the company accounts, the companies end up getting generally negative feedback from society.

These attributes are bought out in aggregate in the national accounts. Redesigning of companies financial accounts to bring out these contributions will not only bring right visibility to the companies but would also integrate companies accounts with the national accounts.  There is need of integrating financial accounts with the national accounts.

In this piece, I propose to focus on these two broad themes.

ESG accounting and reporting standards

There is global focus on environmental, social and governance (ESG) standards and compliance thereof by companies. The investors, especially the pension and sovereign funds, are increasingly insisting on adherence to ESG standards by companies they invest in. The companies in coal businesses, for instance, are being denied funding.

Some informal and some formal standards covering ESG are flooding the reporting requirements. International Integrated Accounting Council (IIRC) have released their standards which include ESG concerns in a major way. Many Indian companies have also decided to adopt IIRC standards voluntarily and have reconfigured their annual accounts and report accordingly. The Sustainability Accounting Standards Board (SASB) has their standards as well. Now, the two are merging which will redefine the value businesses create.

Indian regulators have also been including certain ESG concerns in the financial reporting system. Energy consumption related reporting is part of that effort. However, the Indian regulators are still to come up a well-designed and comprehensive ESG standards and compliance requirement for companies.

Instead of allowing the matter to dither and confusion to prevail, it would be most advisable for the MCA and the ICAI to come up with a comprehensive ESG standard, designing it in such a manner that it encourages business as well as addresses legitimate environmental, social and governance concerns.  

Integrating company accounts with national accounts to make a complete image make over

Profit and loss account and the balance sheet are the heart and soul of the companies. The profit and loss account is meant to throw up the profit or the loss made by the providers of capital/owners by engaging in the business of the company. The balance sheet is designed to convey the true and fair state of the health of the owners invested capital. The accounts of the company and their financial reporting today are depiction of the serving of the interests of the owners/capital providers. This singular focus on profit and state of capital invested in the financial statements of the company contributes to the hate which the larger civil society develops towards the companies being interested in only their owners’ well-being.

The national accounts bring out what other stake-holders also get, although the over-emphasis on GDP headlines most of the times ignores. The national accounts also bring out how much of the GDP went to workers as their wages, salaries and in other forms of income, how much businesses contributed to the Government as taxes, how much capital investment was made in the economy and the like.

For getting these macro-economic numbers, the National Statistical Office (NSO) operates a separate system of accounting and data collection. It carries out an Annual Survey of Factories to collect data about turnover, value added, wages paid, profits made, taxes paid, number of employees and many other useful parameters. NSO also uses the quarterly accounts filed by the companies with the registrar of companies to cull out some of these information to generate quarterly GDP data.

The accounting of business transaction have all the data/information required by the NSO to prepare the national accounts originating from companies. But, the financial reports, profit and loss account and the balance sheet prepared today does not readily allow it to be used for generating national accounts aggregates.

National accounts use the concept of gross value added, which is the difference between the turnover and expenses of inputs other than wages paid. Financial accounts, prepared from the owners’ perspective only treat wages as input as well. The concept of profit in the national account is the share of gross value added which accrues to the capital. In this sense, it is gross value added minus wages minus taxes paid. The financial accounts uses the same concept except it excludes depreciation as well. National accounts identifies taxes paid in two parts- production taxes and income taxes. Company accounts also does so.    

By redesigning the financial accounts somewhat, not only all the information which gets generated today for the owners and regulators, requisite additional information for national accounts can also be generated easily. Following design changes would be required:

First, make Inputs-Outputs account as Part A of the P&L account. Inputs may be divided in four sections- a. raw material and intermediate goods purchased from outside, b. all kinds of wages, salaries and other compensations paid to all kinds of workers, staff, managers etc., c. cost of non-equity financial inputs mainly interest paid and d. production taxes like excised duties and GST. Output value/ turnover minus a, c and d would be gross value added (GVA). GVA minus b is Input/Output Balance or Operating Profit. The Input-Output Account may be called Operating Profit Account as well. It is better to use Input-Output Account to drive away the impression that businesses exist only for making profits.

This Part A would yield GVA, Wages paid to workers and also Operating Profit.

Second, Input/Output Balance or Operating Profit is shared between two remaining stakeholders- government and owners/capital providers. The Government gets income taxes and owners get profit. The Part B of the P&L Account depicts the share which these two stake holders get.

In the Part B of the P&L Account, Input/Output Balance/Operating Profit minus income/corporation taxes and minus depreciation is known in traditional accounts as Net Profit.

In the national accounts GVA plus production taxes minus subsidies becomes Gross Domestic Product or GDP. Assuming subsidies received by any company is taken into the turnover, adding production taxes to GVA would bring the GDP contribution of the company concerned.

For the purpose of GDP, the depreciation is not deducted from the GVA. Only for net national product (NNP), depreciation is reduced from GDP. Therefore, net profit plus depreciation is the economic profit of the owners/capital. Production taxes and income taxes put together is the tax share of government in the GDP contributed by the company.

To summarise, Output value minus all material inputs, all interest cost, all wages paid and all production taxes is the Input/output balance or operating profit of a company. Operating profit plus wages is the gross value added. GVA plus production taxes is the GDP contribution of the company. GDP is shared in three stakeholders- workers get wages in all its forms, government get taxes (both production taxes and income taxes) and owners/capital get profit which equals net profit plus depreciation.

With some tweaking, the financial accounts of the companies can be integrated with national accounts. It is worthwhile to do so.

Standards for companies need to be rightly designed for the emerging digital economy and also in consonance with national economy and sustainable economy

There is rapid transformation taking place of industrial economy into digital economy. There is also serious societal consciousness for companies to be good citizens by integrating their operations with national economy and running their affairs in line with sustainable standards. Digitalisation is the force which would eventually change all economic activities tremendously. Digital accounting, auditing and reporting, integrated with the ESG concerns, would make companies better citizens. Using the power of digital accounting and reporting, it is time to integrate company accounts with national accounts and with globally acceptable environmental, social and governance standards.

SUBHASH CHANDRA GARG

NEW DELHI 17/05/2021

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[1] Data in this paragraph are from the National Accounts Statistics 2021