How valuable would widespread impact accounting be?
Impact-weighted accounting (or just “impact accounting”) is a concept introduced in the HBS whitepaper Impact-Weighted Financial Accounts: The Missing Piece for an Impact Economy written by HBS professors Serafeim, Zochowski, and Downing. The paper effectively argues for having line items on financial statements that translate the externalities of a company’s operations into a dollar amount of value either created or destroyed. From the linked article:
The aspiration is an integrated view of performance which allows investors and managers to make informed decisions based not only on monetized private gains or losses, but also on the broader impact a company has on society and the environment.
The idea that you are going to judge a company not just by financial returns but also by the overall value delivered to society is not new. Bridgespan and TPG developed an impact measurement metric called called “The Impact Multiple of Money” (or IMM, which I wrote about here), that essentially provides a way of assessing — for any company — the value of social benefits a company delivers, captured as a dollar rate of return. For example, an IMM of 25% says that for every $1 you invest, your investment will return impact at a rate of 25% (e.g., next year, your $1 invested generates $1.25 of impact). Thus, an investor who evaluates a firm along IRR and IMM measures considers both financial and social returns, much like the spirit of impact accounting proposed by Serafeim et al.
The critical difference between IMM and impact accounting is that IMM is a metric used by investors to forecast the expected impact rate of return. In contrast, impact accounting is a reimagining of the capabilities of a business’s financial statements to display not just financial returns, but “the broader impact a company has on society and the environment.” For now, I’m going to ignore the apples to oranges differences between IMM and impact accounting, and instead consider the two measurement systems against each other.
Potential structures of impact-weighted accounts
As an impact measurement, IMM quantifies impact returns on a standalone basis; investors then use IMM alongside IRR (financial returns) to evaluate whether or not an investment will yield a financial and social return. Impact accounting has the potential to provide a different viewpoint by serving as a unified framework, so that stakeholders see only one output that measures value. At least, that’s what I got from the HBR article before I picked up the pen and began poring over the financial statements of the few companies mentioned below.
With the exception of a few companies that have published environmental or total profit and loss accounts, impacts are not valued nor integrated in accounting statements to illustrate their value implications.
To me, the idea of a total profit and loss account suggests that managers and investors don’t look at a P&L, and it now says “net income attributable to shareholders; net societal value attributed to society.” Instead, I think the authors are just arguing for one bottom-line value figure that encapsulates societal and shareholder value.
That idea is pretty radical! For the last few decades (if not longer), the purpose of the corporate entity has been exclusively to return value to shareholders. I believe Milton Friedman most succinctly described the idea of shareholder primacy when he said, “Corporations have no higher purpose than maximizing profits for their shareholders.” Well, look where that got us! San Francisco was orange the other day because of fires! Maybe that would not have happened if there was a unified account of all value that a company creates or destroys.
The idea effectively seems like one that advocates having something an accounting framework like in either measurement system in the illustrative P&Ls below:
These P&Ls show quick and dirty calculations going from revenue down to free cash flow to the firm, and then the value of negative externalities incurred by the firm in a separate line item — but these are virtually the same. An investor assessing these financial statements would quickly understand that the firm generates $80 in financial returns and –$40 in negative externalities. It doesn’t matter that one shows the value of negative externalities in a memo, and the other shows the value of total profit from an integrated viewpoint; if someone reading these financial statements cares to understand total profit, they will do the math themselves.
Interestingly, I don’t think this does what the HBS article’s authors set out to do. As I have written about here, the issue is that unless your office has an impact mandate, you don’t care about impact. Maybe you — the investor — personally care about impact, but unless your office’s mandate stipulates that you must evaluate the impact of potential investments, then you effectively are neutral towards impact; you will continue to judge potential investments on an a priori basis for the magnitude of their financial returns.
The reality is that an investor whose office only mandates that they judge investments for financial return will stop reading the above financial statement at free cash flow to the firm, out of habit, because the rest doesn’t matter. Maybe an investor only sees two financial statements one day, and the only difference is the magnitude of negative externalities, so he considers the impact accounting framework that steers him towards the less harmful company. However, this is an unlikely occurrence!
But what if investors categorically had no way of distinguishing financial returns from impact returns? This would almost certainly never happen (though I would never say never in this day and age), but imagine a framework where it’s either impossible (or prohibitively difficult) to separate financial from social returns.
To illustrate the point quickly, let’s say that the company we illustrated in the financial statements above sells widgets, that they need one diamond to make each widget, and that each diamond comes from a mine with deplorable working conditions (some sort of Blood Diamond situation). The company has COGS of $50 (let’s say they sell 5 widgets which cost $10 each to make), and their negative externalities are valued at $40 (let’s say that this $40 is allocated at the COGS level because each diamond mined produces $8 of negative externalities. Effectively, your COGS then become $18, and your financial statement looks more like this:
Total profit is now the same thing as free cash flow to the firm because the negative externalities have been baked into the financial statement. You can’t tell them apart, and so as an investor, you are forced to look for companies that have the highest overall free cash flow to firm / total profit numbers.
The reality is that this would likely never be inseparable, so the above example can’t be used as more than a thought experiment for the time being. There would likely be a schedule somewhere in the 10-K that shows how externalities are valued and where they are placed, so an investor could back them out if they were to choose so.
However, were this system to be implemented as necessary for all companies that file a 10-K with the SEC, I do wonder about the effect on investors. If all who read 10-Ks for their day job were immediately confronted with a quantitative negative externality value, I would expect that the likelihood of trading such securities would decrease, even if marginally.
The usefulness of impact accounting
Coming back to the question: how valuable would widespread impact accounting be, there are two questions to dig into: (1) would high levels of negative externalities discourage potential investments in a firm with such a profile? and (2) would high levels of positive externalities encourage potential investments in a firm with such a profile?
(1) Would high levels of negative externalities discourage potential investments in a firm with such a profile?
I would argue that the answer is yes, but marginally so. Imagine that you run a L/S hedge fund, that you only have enough money to trade one more security, and that you are looking at the financial accounts of a profitable firm you believe to be undervalued. You are interested in taking a position in one of the firm’s securities, yet you notice that the firm destroys an inordinate amount of value to society more broadly.
Let’s assume that the firm in question is Facebook (a company which I believe has imposed an outsized share of negative externalities on the world) and that merely viewing the quantification of the negative externalities that the firm produces causes you to reconsider. After all, you believe that Facebook peddles divisiveness for profit to the ends of promoting populism and demagoguery.
You reason that although the firm generates $10B in profit (the real number doesn’t matter), the negative externalities are valued at $100B. Ultimately, these negative externalities will be so deleterious to the global population — the consumers that enable the financial system in which you trade and profit — that you would be better off by not participating in equity ownership of Facebook.
Further, if you’re first prompted with the total profit number that includes negative externalities, I believe the anchoring effect might leave some investors feeling uneasy about the investment even after backing out financial profit numbers. And further, even if you have no impact mandate, you have some discretion about which investments you make, and an ability to find equally (or more) profitable investments elsewhere. Thus, unless you think the investment in Facebook is the only profit maximizing investment, you are free to evaluate another security in which to invest. And that’s my point: if you show people total profit (including baked in value of negative externalities) then they are more likely to steer clear of firms that produce high levels of negative externalities.
Abstaining from investing in profitable companies that produce high levels of negative externalities is a bit like voting: your individual vote probably doesn’t matter, but the collective action of voter turnout is an extremely powerful force. Similarly, your abstinence probably won’t materially affect Facebook’s $xx market cap, but collective action would, and integrated impact accounting might drive some marginal collective action.
(2) Would high levels of positive externalities encourage potential investments in a firm with such a profile?
For this example, I would argue the answer is no if your mandate is strictly to maximize financial returns. Imagine a company that makes money by selling educational materials to prisons, allowing convicts to get an education superior to what they otherwise would receive by reading books from the prison library. A more comprehensive education during incarceration would allow these men and women to procure middle- and high-skill jobs across blue- and white-collar professions, rather than just low-skill, entry-level jobs for the rest of their lives! Also, let’s imagine that this company has $1mm in net income but has created $1B of value in the world from the lives it has changed. This results in a total profit of $1.1B, which is higher than Facebook’s!
However, maybe the company has 1% margins, and because of legislation looking to reform the school-to-prison pipeline, negative growth as well. You may understand that your investment could have massive social returns, but you will not realize any of those returns yourself in the form of financial returns. You are back to the situation of paying for impact, and so this investment might be what you would expect out of a Gates Foundation type investor. There’s a difference between abstaining from companies that produce negative externalities (you can simply go look somewhere else for returns that don’t impose such a high cost on society) and investing in companies simply because they produce strong social returns (generating impact but footing the bill as well).
To conclude, I think that impact accounting might be useful for deterring investors from investing in a firm that produces outsize negative externalities, but that it won’t move the needle for investors towards investing in companies generating outsize impact; the financial returns will still be of utmost importance. Hopefully, we see more investors who won’t budge when it comes to having both financial returns and positive impact
