Accounting reform: Too much activity is focused on non-productive gains

By David Hatherly

The slide in the value of Sterling against major currencies has pointed up the fact that British economic policy following the 2007-8 financial crisis has relied on ultra-low interest rates and bond purchases to maintain demand with the hope that higher demand will stimulate the supply side of the economy.

However, if the stimulus to demand exceeds the stimulus to supply, the result is likely to be a widening trade gap that stores up problems for the future. The UK trade gap is not temporary, but is substantial, persistent and growing, signalling the underlying problem of weak production and productivity associated with inadequate investment in people, R & D and equipment.

This weakness pre-dates the financial crisis, itself the consequence of too much economic activity focused on non-productive gains divorced from productive investment.

Many commentators feel the option of monetary policy is exhausted and support is growing for increased government spending on infrastructure. No doubt some further investment would help, but infrastructure spending is nevertheless a long and uncertain route to increased productivity in the corporate sector. It normally comes at a price to the environment and the quality of life for those impacted. In stakeholder terms there are losers as well as gainers making the politics tricky.

Government activity, whether monetary or fiscal, is more effective in managing demand than it is in managing supply. The attached paper is an attempt to introduce new thinking, or at least expand our thinking through a focus on the incentives that drive corporate decisions. The argument is that macro-economic policy must be accompanied by accounting reform that clearly separates non-productive from productive corporate activity.

Company incentives are dominated by accounting profit and profit-influenced performance measures such as earnings per share, return on equity and total shareholder return. Arguably current accounting and hence its derivative performance measures do not adequately separate out profits that come from non-productive activity. A forthcoming paper from myself and colleagues will address this issue.

Too often it is easier for management to achieve profit through transfers to shareholders from other stakeholders than it is to achieve profit through productivity gains that have the ability to benefit all stakeholders. Indeed some of this non-productive transfer activity is an unintended consequence of low interest rates, which first transfer gains to shareholders at the expense of lenders.

Other examples that can benefit shareholders at the expense of other stakeholders include the increasing price pressure on their suppliers exerted by powerful retailers, the move to outsourcing and zero hours contracts and the switch from defined benefit to defined contribution pensions. There are also cases of increased tax avoidance and a widespread practice of offering new customers better terms than existing customers so that the company can exploit existing customer loyalty.

Our paper will discuss examples of transfers and the difficulties that arise in making the distinction between their productive and non-productive effects. For example, if a large retailer puts pressure on its suppliers to reduce prices this is prima facie a non-productive transfer, but can have productive consequences if it forces the supplier to be more efficient.

The paper envisages that markets continue to match supply and demand but where market power is exploited (unequal power relations) any price change should be treated as a transfer unless the loser on price is compensated by equivalent efficiency and volume gains. One effect is to moderate size as a source of market power and to focus an assessment of takeovers on whether there are genuine economies of scale or synergy.

Transfers are not limited to current stakeholders. In the paper we argue that transfers from future stakeholders are recognised by treating as non-productive transfers any gains to reported profit that flow from reductions in investment whether in people, R and D or equipment.

Once separately identified all non-productive transfers should be excluded from reported profit and from profit used in performance measures every year until the price change or reduction in investment giving rise to the transfer is reversed.

Such excluded profit is referred to in the paper as having been ‘turned off’. It is not paid to any stakeholder but is taken to a stakeholder fund and invested in the business for the benefit of all stakeholders. Hence performance measures for management focus on the productive and there must be a parallel change in the performance measures for fund managers.

The intention is that share prices will come to reflect only current productive performance plus prospective gains in efficiency and volume. Management remains accountable to and appointed by, shareholders since it is the shareholders who continue to carry the residual risk and appropriate return. Capitalism is amended in the sense that the residual risk is reinterpreted – but capitalism is preserved.

An important element of the paper is the discussion of global and other companies that invest internationally and the consequent tension between such corporations and local communities represented for instance by nation states. Politically it is far more acceptable to have large companies committed to the maintenance of local communities and economies than it is to have companies that trade one community off against another.

Protection of this ideal can be built into the accounting by assigning a nationality or locality within the stakeholder definition, so that for instance UK stakeholders are seen as a different category to China stakeholders etc.

In relation to tax avoidance the nation state itself may be designated a stakeholder. Any corporate activity that benefits one (national) stakeholder at the expense of another is treated as a non-productive transfer. The accent is on the free movement of knowledge and capital rather than the free movement of people or goods since production is encouraged to take place in local communities.

Distributed knowledge is inspired and enabled by the internet but requires patent protection to the extent needed to promote its development. These ideas have much further to go but illustrate the potential of accounting to operate at a far higher level of relevance to the political and economic issues of the day.

David Hatherly is Emeritus Professor of Accounting, University of Edinburgh Business School.