Professional Judgment Beats at the Heart of Project and Investment Appraisal for Sustainable Value Creation
Stathis Gould | May 4, 2015 |
In today’s world, it is no longer sufficient for investment decisions to be appraised on financial criteria alone. To ensure that projects and capital investments support the creation of value over time, decisions need a blend of supporting data and analysis covering economic, environmental, and social (often referred to as sustainability) considerations. A wide set complex opportunities and threats potentially impact the success of an investment and achieving objectives.
Many professional accountants are directly involved in project and investment appraisal in their organizations and should be thinking how they can encourage better decision making, ways to manage uncertainty, and complexity in the decision process. Their professional judgment will be critical in facilitating a rigorous decision process.
The good news is that there is guidance to help accountants improve project and investment appraisals.
The Prince’s Accounting for Sustainability Project (A4S) Chief Financial Officer (CFO) Leadership Network has published four guides to help the finance and accounting community address the practical issues of integrating sustainability into their business processes and decisions.
The guides were developed by the A4S CFO Leadership Network and their teams (comprising senior finance, risk, internal audit, investor relations, and sustainability professionals), A4S, and other specialists. Each guide is supported by case studies from Network members that demonstrate practical applications of the approaches and techniques set out in the guides.
One of these guides, CAPEX: A Practical Guide to Embedding Sustainability into Capital Investment Appraisal, complements IFAC’s earlier Project and Investment Appraisal for Sustainable Value Creation.
The new guide from the CFO Leadership Network provides useful practical guidance with examples covering:
- Why consider sustainability in capital investment decisions;
- Who to involve and governance: establishing accountability, and capabilities;
- What to assess: identifying and prioritizing sustainability issues to consider;
- How to assess: methods for appraising sustainability;
- How to decide:
- Setting decision making criteria; and
- Choosing between investment options;
- Stages of the journey: assessing where you are on your journey.
During all these steps, accountants will need to apply professional judgment to many subjective factors that can affect the outcome of a decision-making process. As is set out in IFAC’s guidance, all assumptions used in evaluating proposed investment projects should be supported by reasoned judgment, particularly where factors are difficult to predict and estimate.
Some key areas in which professional judgment is critical include:
- Understanding and incorporating sustainability issues: professional judgment can be supported by stakeholder and/or expert opinion. “Analyzing Sustainability Impacts” shows stakeholder engagement and input can help ensure that a full range of sustainability issues are identified and understood, and related potential costs and benefits included in decision making. The stakeholder engagement process will also help estimate costs and benefits.
- Cash flow estimates require professional judgment. Professional judgment is applied by probing behind cash flow estimates to understand both the nature of a return on investment, and the source of value over the opportunity cost of capital. Professional judgment is particularly needed where environmental and social aspects can be particularly difficult to quantify. Monetization is more straightforward for areas that are tangible and have a market price or regulatory cost. Many sustainability issues have an indirect financial impact on an organization leading to a change in the value of its “intangible assets,” such as corporate reputation, employee engagement, or license-to-operate. Quantifying this “intangible” value involves more complex techniques and generally requires reaching out to other experts. In some cases, indirect financial impacts can be valued using a proxy measure. For example, the value at risk from poor employee engagement could be linked to unplanned absenteeism, which can in turn be monetized in terms of the costs for temporary cover, overtime, or the loss of productivity.
- Professional judgment is required where accurate valuations would be overly costly or difficult to undertake. In some instances, there will be high costs associated with data collection as well as practical issues of inconsistent and incomplete data. Testing the assumptions and estimations, potential consequences of errors, and doing more analysis on the key items are important parts of project evaluation. These aspects should be exposed to decision makers and not concealed.
- The characteristics of good information include: accuracy, relevancy, reliability, consistency, completeness, and timeliness. All of these can be important in project and investment appraisal, but usually not all can be included in decision making. Therefore, accountants will be faced with deciding which of these characteristics could be the most important, given a specific context, and judging the trade-offs between characteristics. One of the more difficult issues to deal with is bias, typically optimism bias, affecting information flows. Professional accountants will often also need to respond to the rush-to-solve bias where decision makers are eager to make a decision without fully considering all available information.
- The choice of cost of capital becomes more critical to a valuation decision the longer the time period over which the cash flows occur. A criticism of discounting is that it places lower importance on the needs of future generations and, therefore, has implications for intergenerational equity. Furthermore, traditional financial analyses may not always reflect the long-term value created, particularly if the assessment period is short. If the period of the financial analysis covers only the near term, then sustainability projects that deliver stronger returns in the long term may be disadvantaged when compared to faster payback projects with shorter lifespans. Adjusting the assessment period might be necessary, particularly where significant residual ecological impacts can cause reputational damage or become subject to regulation. In some industries, it might be necessary to include, as part of the evaluation, details of activities that will deal with negative ecological impacts.
- Organizations considering an investment with high specific risks often use a high investment hurdle rate rather than using the organization’s discount rate, therefore departing from a lower cost of capital. Alternatively, some organizations might apply lower hurdle rates for investments in projects with wider sustainability benefits to reflect a lower risk profile or to account for intangible benefits that have not been possible to quantify. As there is no theoretical basis for setting a high or low hurdle rate to compensate for specific risk or opportunity, professional judgment can be supported in various ways. For example, by calculating the probability-weighted expected value of cash flows of an investment. This could be achieved by developing several scenarios and assigning them probabilities of realization, including a probability of a project failure if applicable. A minimum threshold might be applied to each significant sustainability impact or risk, or for the project overall, such as a minimum threshold for negative impact. The development of a qualitative risk and threshold analysis alongside discounted cash flow calculations can ensure broader factors for consideration are explicit in the decision process. Some of those companies involved in the A4S CFO Leadership Network calculate the shareholder value of sustainability in financial models and present this as a separate figure alongside the traditional financial analysis. This approach enables decision makers to see how the sustainability costs and benefits affect the value of the investment.
Accountants need to consider how they apply their professional judgment in various contexts and support rigorous decision making—this is the hallmark of being a professional. In many cases, their professional skills already embrace necessary and useful tools and techniques, such as sensitivity analysis to identify and model key variables to reflect worst, most likely, and best case scenarios. In many instances, accountants will have to consider new, emerging or more complex methods, such as lifecycle assessment and analysis, as well as better approaches to structured decision making, such as multi-criteria analysis that emphasize the judgment of the decision-making team in establishing performance criteria and determining the relative weight or importance of different criteria.
Ultimately, professional accountants are expected to adopt a business mindset without sacrificing the objectivity and skepticism required to challenge potentially imprudent managerial decisions. This is a significant part of the value-add of a professional accountant.