ESG Analogies in Accounting Classes Make Issues More Accessible

Despite the overall decline in accounting enrollments seen across US business schools, there’s one bright spot: increasing demand for environmental, social, and governance-related courses.

Students who take these courses seem particularly interested in the measurement of a firm’s carbon emissions footprint. A desire to understand potential new regulation—such as the Securities and Exchange Commission’s recent climate disclosure laws—helps drive this interest, as does understanding firms’ climate risks more generally.

We teach our students that a key role of accounting information is comparability—that accounting information enables us to compare firms’ performance—and the same concept carries over to non-financial settings.

We also teach that strategic reporting choices undertaken because of short-term incentives can distort comparability, and in turn, that it’s important to understand the rules to understand how firms might use their discretion. These ideas aren’t unique to financial accounting, but introducing them through that lens helps students understand how and why financial and ESG accounting are related.

We’ve had a straightforward way to characterize a firm’s emissions profile, at least conceptually, into three scopes since the Kyoto Protocol. It’s easy enough to provide students with a high-level overview of each scope’s emissions and what they capture, but it gets trickier to explain the difficulties that still arise with respect to measurement within this framework.

Why do we still need to know what assumptions a firm is making in its calculation of the scopes? Why do we need to be careful even when comparing numbers that seem to be like-for-like (one firm’s Scope 1 emissions versus a direct competitor’s Scope 1 emissions)?

The underlying issues relate to the discretion afforded to firms on emissions measurement. For example, when measuring Scope 2 emissions—indirect emissions arising from the generation of electricity that companies consume—firms can use either a market-based or location-based approach.

Firms may also choose one or the other for strategic reasons, such as whether they pay their suppliers for “green” energy. This might make it difficult to compare two firms’ Scope 2 emissions.

Using financial accounting analogies can help make these types of issues accessible to students with a traditional accounting background. We teach students from their very first financial accounting courses that accounting rules are flexible enough to enable firms to communicate specific items in a way that they deem most appropriate for their underlying operations.

The potential downside is that such flexibility can facilitate strategic reporting. For example, when a firm sells a product or service as part of a multi-year contract, how much revenue will it allocate to this year versus future years? How much is that driven by a strategic desire to hit a certain earnings or revenue target in the current year?

The analogy to emissions measurement is then straightforward. The market-based approach isn’t always feasible, but firms are given flexibility so that when it is possible, they’re able to provide a more accurate picture of the carbon emissions associated with the energy they’ve consumed.

The strategic reporting element is present here as well. Why would a firm be more likely to disclose its use of the market-based approach to measuring Scope 2 emissions if it had spent money on “green” energy—and how should we account for this in comparing the reported figures for two firms using the two different approaches?

Firms may be more motivated to use the market-based approach if they’ve invested in using green energy sources. Not appropriately accounting for these strategic reporting incentives can lead us to understate the difference between two firms’ Scope 2 emissions. The location-based approach represents an average across all forms of energy generation and can understate a firm’s true Scope 2 emissions when it doesn’t pay for “green” energy but many of its peers do.

For Scope 1 emissions, or a company’s direct emissions, it’s usually impractical to have carbon sensors at every single output source. The typical firm uses activity-level emissions estimates—published by the Environmental Protection Agency and by other national regulators such as the UK’s Environment Agency—to come up with a weighted average emissions figure based on the activities it undertakes.

Why would these estimates potentially punish firms that make more proactive investment into green technology, while potentially allowing a relatively brown firm within an industry to hide its status as such? The reliance on activity-level averages in lieu of precise measurement can make it hard for firms to highlight the investments they’ve made into generating lower-than-average emissions for an activity.

Ultimately, there’s a bigger conceptual point. Firms have to disclose information on a number of different items, both financial and nonfinancial, for use by a wide set of stakeholders. There’s discretion in how many of these items are calculated, but ultimately the incentives underlying reporting choices are broadly similar.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Aneesh Raghunandan is assistant professor of accounting at Yale School of Management, with focus on financial accounting, corporate sustainability, and their intersection.

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