April 18 (Bloomberg) -- This week, the International Integrated Reporting Council introduced a draft of a new framework for corporate accounting that would require companies to go beyond reporting just financial capital and also encompass environmental, social and governance risks.
The structure -- known as “integrated reporting” -- is a response to the realization brought on by the 2008 financial crisis and increasing environmental stresses that we need a new accounting paradigm for the 21st century. The limits of current national-accounting practices were acknowledged in 2012 when the United Nations adopted a new international standard to give “natural capital” equal status to gross domestic product as a gage of a nation’s economy.
These aren’t the first such paradigm shifts in the history of accounting. At the end of the 18th century, the double-entry account-keeping practices developed by Italian merchants in the Middle Ages were updated for the new industrial era.
The first signs that double entry could be adapted to the new age of factories, wage labor and large-scale capital investment appeared in the north of England, in the works of the renowned potter Josiah Wedgwood.
An entrepreneurial and marketing genius, Wedgwood built the world’s first industrialized pottery factory. His customers were the new upwardly mobile classes whose insatiable wants were described by political economist Nathaniel Forster in 1767: “The perpetual restless ambition in each of the inferior ranks to raise themselves to the level of those immediately above them,” he said, caused the demand for luxury goods to spread “like a contagion.”
Among the most coveted luxuries of the day were Wedgwood’s vases. So ravenous was the appetite of the monied classes that Wedgwood called it a “violent Vase Madness.” He wrote to his partner Thomas Bentley in 1769 that their new London showrooms were so crowded there was “no getting to the door for Coaches, nor into the rooms for Ladies & Gentlemen.”
Wedgwood’s products became so popular that he could charge high prices and the profits rolled in. But during an economic downturn in 1772, demand for the vases slackened. With serious cash-flow problems and an accumulation of stock, Wedgwood turned to his accounting books to solve this dilemma: Should he cut production or reduce prices?
And so he made a “price book of workmanship,” which included “every expence of Vase making” from the crude materials to the cost of the retail counter in London. This led him to discover the distinction between fixed and variable costs. The greatest manufacturing costs were modelling and molds, rent, fuel, bookkeepers, and wages. “Consider that these expences move like clockwork, & are much the same whether the quantity of goods made be large or small,” he told Bentley. “You will see the vast consequence in most manufactures of making the greatest quantity possible in a given time.”
Wedgwood used the findings of his cost analysis to make management decisions. He revised his policy of soliciting special commissions and made-to-order sales; lengthened his production runs for certain products; varied his usual high-price policy; reduced his stock in market downturns; and kept a careful eye on sales and marketing costs.
Many successful businesses failed during the financial crisis of 1772 -- but Wedgwood’s survived, thanks to his innovation.
His detailed cost appraisals also revealed something unexpected: a history of embezzlement, blackmail and dissipation in his company. He discovered that his head clerk had been fiddling with the books and that his cashier had been fiddling with the housekeeper. He fired the culprits and introduced weekly accounting reports to keep a closer watch on his finances.
A huge shift in outlook was required to move the double-entry accounting system beyond its mercantile origins in an exchange economy (where it recorded the exchange of goods, what it owed and was owed, paying and collecting debts) to manufacturing, where the emphasis is on the production of goods (the conversion of materials and labor into products).
Two books on account-keeping for factories published soon after Wedgwood’s early forays show the conceptual difficulties posed by the need to incorporate new elements -- labor and materials per unit of production -- in the calculation of the cost of each unit. Factory production presented another challenge: How to track the way that labor and materials were converted into a new product, which was then sold for cash to pay those who had contributed to its production?
It took a century to devise an accounting process for factory production and for accountants to join commerce and manufacturing into one coordinated system of books.
The accounting systems we use today were designed for the industrial era, so it’s no surprise they’re proving inadequate to the new electronic age. The challenge is to integrate nonfinancial information into corporate accounts and to account for new value, such as social and environmental performance. This will require a revolutionary shift in outlook. But as early factory accountants such as Wedgwood demonstrated, crisis can be the mother of accounting invention.
(Jane Gleeson-White is the author of “Double Entry: How the Merchants of Venice Created Modern Finance.” The opinions expressed are her own.)
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