We relied so far on the figures reported by financial accounting because we were focusing on asset valuation for financial reporting. For instance, to account for the depreciation of assets, we relied on the depreciation reported in financial statements; for the consumption of raw materials, we used the value of raw materials reported in the balance sheet.
However, conventions used for financial reporting (depreciated or impaired historical costs) often result in a disconnect between the book value of an asset (i.e. its net value on the balance sheet) and its economic value. The latter is more difficult to assess. It has to be estimated and financial accounting limits as much as possible its reliance on estimates. The same holds for inventory. For instance, financial accounting values the inventory of raw materials at its historical cost (value at which it was purchased) and not its current value on a market (replacement cost, which is akin to the notion of opportunity cost I will introduce in another chapter).
It is possible to argue that the actual reduction in lifetime or the actual loss in market value of an asset because of its usage, aging or obsolescence would be a better estimate for its depreciation. Following the same reasoning, the current market value of the raw materials consumed may be a considered as a better estimate of the cost of consuming this inventory. When you disconnect costing from financial reporting, it becomes possible to use these estimates instead of financial accounting figures to value the resources consumed. But keep in mind that this will allow two different sets of numbers to circulate, causing confusion.
Another limitation of financial accounting is that it only takes into account the costs for the focal company. What economists call negative externalities are not accounted for.
A negative externality is a cost that is suffered by a third party as a consequence of the actions of the economic agent. They are destruction of resources caused by the company but of which someone else (the society, the planet) bears the costs.
For instance, the social and environmental costs of providing poor working conditions or polluting the environment are often not recorded in financial accounting because there is no transaction with a third party to account for. They are only captured if the company is fined for the damage it caused others. Corporate Social Responsibility and “true cost” initiatives support the idea that such costs should be included in management accounting calculations so that managers really take into account all the consequences of their decisions, not only for the company, but for society and the planet as well. Now, here again, the inclusion of externalities is only possible if we disconnect costing from financial reporting purposes.
Environmental costs are the costs imposed by the organization on the environment.
Please indicate how clear and understandable this page was for you: