Introduction

Many factors have contributed to the rapid growth of international trade over the last 30 years. Most notable is the fall of the Berlin wall, which marked the end of a bloody cold war between neighbours and ushered in a period of peace and reduction in investment in military and heavy ammunition; hence, facilitating the “four freedoms” of movement of people, goods, service and money. The period also witnessed the emergence of the “BRICS: Brazil, Russia, India, China and South Africa” that provided the world with low-cost labour and reduced production cost. However, China and India, from South East Asia, are the members of BRICS that provide the world with low-cost labour and lower production cost with global significance. China, for instance, became the hub for manufacturing and India became a global force in IT outsourcing. Furthermore, the launch of the “worldwide web” in the early ’90s on a royalty-free basis and its subsequent availability for everyone everywhere sparked a global wave of creativity, collaboration and innovation never seen before. Consequently, marketing was changed from a “bricks and market” to a “clicks and market” system. It allowed startups to exist alongside large enterprises, making consumption and utilisation of materials more accessible. 

It is instructive to note that the financial deregulation across many countries in the ’80s contributed to rapid growth in the world’s industrial output. This period was also remarkable for low cost of capital and movement of capital across countries making more capital available for investment in production. According to World Trade Organisation trade statistics, the value of world merchandise exports rose from US$ 2.03 trillion in 1980 to US$ 18.26 trillion in 2011, which is equivalent to 7.3 per cent growth per year on average in current dollar terms. This increase in trade also meant an increase in the rate at which the world’s resources were drawn, and global pollution rose to its all-time highest.  Fast-forward to the early 2000, the adoption of the International Financial Reporting Standards by government of various nations, Europe showing leadership in 2002, contributed to cross-border movement of investment capital. This is because international investors benefited from a reduction in asymmetrical information and improvement in comparability of financial reports. These factors, and possibly some others, combined to increase the production output of companies and countries

The rise in consumption was not without adverse consequences on the non-renewable resources of the world. A report produced by the International Resource Panel (IRP), part of the UN Environment Programme, says rising consumption driven by a growing middle class has seen resources extraction increased from 22 billion tonnes in 1970 to staggering 70 billion tonnes in 2010, with the richest countries consuming on average 10 times as many materials as the poorest countries and twice as much as the world average. Unfortunately, the situation was exacerbated by the rapid advancement in digital technology that stemmed from the 2008 global economic meltdown. 

Against this backdrop, it is evident that the current trend and pace of drawing the world’s finite resources is not sustainable, therefore giving rise to loud calls for a better and efficient management of resources to retain value in the materials for as long as possible. In the face of this sharp decline in global non-renewable resources, coupled with pollution and distortion in the balance of our ecosystem, there emerged the concept of a “Circular Economy model“, i.e. an economy with a closed-loop whereby input, processes and output are in a circuitous motion. 

How does the circular economy model work? In talking about circular economy, we must stress the two elements of the model individually: The word circular means an intelligent way to reuse and recycle resources and materials currently employed in our economies. At the same time, the economy reflects the system needed to enable such circularity of our resources. This is in contrast with the general linear approach that involves “making and breaking” stuff.

The circular economy model is such that products are designed and developed for durability, upgradeability, reparability, and reusability, of materials after reaching their end of life. This economic model reduces resources consumption and waste and generates employment opportunities. In 2015, the European Commission adopted an ambitious Circular Economy Action Plan, which includes measures that will help stimulate Europe’s transition towards a circular economy, boost global competitiveness, foster sustainable economic growth and generate new jobs. Generally, we can confidently say that this model is economically viable (in that it makes more profit for business owners), financially viable (that is, it generates cash flow) and enhances efficient and productive use of resources.

One would observe that even nature maintains some cyclical order, from the earth’s revolution around the sun to the food web, water cycle and metabolic processes such as the Krebs cycle etc. Nature has understood the importance of reutilising resources to eliminate waste. Likewise, the practice of waste re-utilisation or creating secondary use of a company’s by-product is not entirely alien to human existence. For instance, Molasses, a by-product of sugar, is used to manufacture alcoholic drinks; Glycerol from soap production is used to produce hand sanitiser. The new thing is that we are in a dispensation in which scaling up this model is indispensable for environmental sustainability, to obtain maximum benefit from resources and improve bottom-line. An article published on the Ellen McArthur Foundation webpage tells us how the visionary German chemist Michael Braungart and his American colleague, Architect Bill McDonough, developed the “Cradle to Cradle concept” and certification process. The “Cradle to Cradle” design borrows from the safe and productive means of nature’s ‘biological metabolism’ to develop a “technical metabolism” flow of industrial materials, and this is what we now refer to as the “Circular Economy Model.”

As more and more organisations continue to become circular in their business practices, accountants and finance professionals need to look critically at how related transactions would be recorded in the books and their impact on the financial statements. In this article, I have provided detailed background to the circular economy concept and explained how it differs from the linear model.   It is impossible to provide proper accounting treatment for a transaction that one does not understand; hence, I have provided a detailed explanation of how the model works for organisations that have adopted it. I concluded by enumerating the various benefits and drawbacks of adopting this circular economy model. 

Why the current linear economy model is not sustainable?

There would be no need to champion a new global economic model if there were no significant faults with the existing one. The proponents of the circular economy model believe that the “take-make-use-dispose” model – also known as “cradle to grave” – is not sustainable. With this method, the value created is subsequently destroyed as the products reach their end of life (that is, we extract resources and use them to manufacture products until discarded and disposed of as waste). Hence, more value is generated only by maximising the number of products produced and sold.

This linear model is over-exploitative, and it places a significant strain on the world resources; it disregards the social cost of doing business and accelerates the depletion of the world’s finite resources, waste generation, and environmental destruction. This model is more expensive to run and entails higher risk.

The consequences of over-exploitation of mineral wealth and its severe, drastic, and immense damage to the entire biosphere cannot be overstated. For instance, on April 2, 2019, the New York Times reported that more than 48 pounds of plastic, including disposable dishes, a corrugated tube, shopping bags and a detergent package with its bar code still visible, were found inside a dead sperm whale in Italy. In addition, the Ellen MacArthur Foundation disclosed in 2013 that in terms of volume, some 65 billion tonnes of raw materials entered the economic system in 2010, and this figure is expected to grow to about 82 billion tonnes in 2020. Furthermore, in the International Energy Outlook 2016 reference case, world energy-related CO₂ emission increased from 32.3 billion metric tonnes in 2012 to 35.6 billion metric tonnes in 2020 and this is expected to increase to 43.2 billion metric tonnes in 2040, a significant increase from the pre-industrial era. There is an increase in sea level, a decrease in Arctic ice and a growing number of weather-related catastrophes, including storms, floods, and droughts. These, to mention but a few, are the harmful environmental implications of the overarching linear economic model.

How does a linear economic model disregard the social cost of doing business? The social cost is the expense to the entire society because of the actions, inactions, events, and policies of a person — whether individuals, business or government. The social cost is a cost that all socially responsible business providers should consider. The negative impacts on the environment, climate and urban and natural landscapes that result from raw material extraction and transformation, waste landfilling and incineration, the social cost of linear business model cannot be over-emphasized. Hence the need for an economic system where waste is turned into money.

Why is the linear economy model more expensive and risky for business owners? With increasing volatility in raw materials prices and unreliable supply, businesses are beginning to appreciate the high exposure risks of a linear system; security and safety associated with long, elaborately optimised global supply chains appear to be increasing. As this challenge is more accurate now than ever, business operators must look out for a better way to hedge against their exposure risk and the circular economy model better meets this need.

The circular economy — A disruptive and innovative Model

What is circular economy again? In brief, we are currently living within a linear economy of “take, make, and waste”. We get raw products from the earth, make them into “stuff”, then dispose of them after we have finished using them. However, with only a certain amount of raw materials on our earth, this model is wasteful and means we consume more than our planet can support – with disastrous consequences! 

Khaled Soufanie et al in an article titled “Roadmap to Circular Economy in EU Defence…” defined circular economy as a resource-oriented economic model that focuses on efficiency through restorative and regenerative design and structure. It is a model designed to eliminate waste in toto by turning it into a fresh input for the same production process or secondary process. It aims for a system where products are produced to maximise their utilisation capability and extend their useful economic life. Therefore, resources only move within the system; hence, the term “Circular”.

For this model to work effectively, companies and institutions must collaborate and design the model. For instance, a company can work with its stakeholders such as suppliers, customers, and waste management agencies to design a model that ensures that values are retrieved from its waste streams. It could also be such that the suppliers serve as a collection point and end-users are incentivised to return damaged or used products; likewise, the suppliers are rewarded for the quantity of waste returned. Similarly, the company could arrange with the waste agencies to identify each ingredient of the company’s product and send them back to the company in exchange for cash consideration. In this way, the entire ecosystem derives the maximum value from using resources; hence, less waste is generated.

The circular economy model is disruptive, innovative, and regenerative by design, and it is intended to use as few resources as possible, for as long as possible, and extract value from those resources as efficiently as possible, and then recover and regenerate as much from those materials and products. It encourages consumers to change their consumption and disposal habits to allow for easy waste retrieval. That is, consumers must imbibe the culture of effectively using and disposing of products so that they can be reused or, if economically or technically impossible, they could become secondary materials that enter a new production-consumption cycle. Some achieve circular economy by changing the business model from the sale of products to generating revenue streams from services, thereby efficiently using resources.

The 21st century ushered in waves of disruptive technological innovations never seen since the Industrial Revolution. Technologies such as Artificial Intelligence, Machine Learning, Augmented Realities, Internet of things, Neuron network, advanced data analytics etc. Process improvement with Lean and Six sigma became more popular and the circular economy business model gained adoption. There is no doubt that we are in an era of change and a change of an era.

Examples of Circular Economy Business Model and Their Accounting Treatment

Circular economy business models come in all shapes and sizes, depending on where they occur in the value chain. This diversity is what makes a circular economy dynamic and genuinely circular. In this section, I want to discuss the circular economy business model in vogue, examples of businesses practising them and finally provide suggested accounting treatments.

Leasing or hire model

A lease is a contract or part of a contract that conveys the right to use an asset from the lessor to the lessee for a period of time in exchange for consideration. This arrangement provides an opportunity for people who need “stuff” for a one-time or short-term event to lease it and return after use rather than purchase it.

Leasing is a business practice that has been around for a long time as a way for organisations to acquire assets without necessarily buying them. This is common in aviation, construction, mining, and other industries where capital-intensive assets are employed. As the circular economy model continues to gain relevance, the concept of leasing is being extended to include low-value items such as clothes, books, children toys, women handbags etc. that before now are purchased outrightly, used and disposed of. This method espouses a philosophy where success is defined not by the abundance of things owned but by life experience and connection with others.

Listed below are few examples of organisations that have adopted the leasing model for low-value everyday items:

• MUD Jeans: This organisation allows leasing rather than buying jeans materials.
• Library of Things: This organisation affordably rent out household and holiday items like drills, sound systems and sewing machines, holiday tents from local spaces.
• Hurr – This is a platform for renting various brands of fashion products.

Let us take a hypothetical illustration: Bob was chosen by his friend to be his best man at his wedding ceremony that comes up in two months. To avoid disappointment, he plans to hire a tuxedo now and return it after the wedding. However, he could not foresee any use of the tuxedo after the wedding. Upon brief research on the internet, he found an Online Store that leases tuxedos and enters a contract to hire it for the two months starting from 01 June 2021; he is expected to return the tuxedo on or before 31 July 2021. The price per month and duration of the lease were specified in the lease contract and Bob is to pay the full price in advance before the tuxedo can be couriered to him. In addition, the contract does not restrict where, when, how and the number of times Bob can wear the tuxedo within the contract period. How should this transaction be treated in the books of the Online Store, and which IFRS standard would apply?

Regarding the above scenario, two standards are relevant: IFRS 15: Revenue from contract with customers and IFRS 16: Leases. We might be quick to conclude that IFRS 16 would not apply simply because low value and short-term items such as tuxedo, snickers, women handbags, have been scoped out of the standard. However, this scoping out is relevant from the perspective of the lessee. That is, a lessee is not permitted to capitalise a low value or short-term asset as a “right-of-use” asset in the statement of financial position. However, the scenario under discussion relates to accounting for tuxedo in the lessor’s books, and since the lessor’s accounting models are essentially unchanged from the defunct IAS 17: Leases, the Online Store should capitalise the tuxedo as lease asset on the statement of financial position, present it under property plant and equipment and depreciate it over the asset’s useful life. The depreciation to be charged should reflect the pattern of consumption of the asset, hence a reducing balance method would be appropriate, and this is because the value of the tuxedo is expected to diminish as it passes from one customer to another.

The Online store should apply the provision of IFRS 15, to recognise lease revenue as soon as performance obligation is deemed to have been satisfied. Since performance is satisfied over time; hence, the company should recognise revenue over two months. Below is the suggested accounting treatment:

• Upon acquisition of tuxedo and subsequent leasing out of the asset to Bob (here, Bob may or may not be the first customer to lease this asset). 

Debit: Lease asset (property, plant, and equipment)  

Credit: Bank (or other modes of payment)

With the full amount paid to acquire the tuxedo

• Treatment of depreciation (based on reducing balance method) over the useful life of the tuxedo.

Debit: depreciation expense (income statement)

Credit: accumulated depreciation (property, plant, and equipment)

With the amount of depreciation recognised for the period

• Revenue recognition at the beginning of the lease arrangement 01 June 2021

Debit: Bank (or other modes of receipt)

Credit: Unrealised (unearned) income

With full amount of the lease payment received in advance.

• Revenue recognition at the reporting period 30 June 2021

Debit: Unrealised (unearned) income

Credit: Revenue

With 50% of the transaction fee received.

• Revenue recognition at the reporting period 31 July 2021

Debit: Unrealised (unearned) income

Credit: Revenue

With the final balance of the transaction fee received.

2.      Collaborative consumption model

This circular economy business model involves a shared use of goods or services by groups, unlike a regular consumption where an individual pays the full price. This model leverages a peer-to-peer network of users to derive maximum value from the use of an underlying asset. The following examples are organisations using the collaborative consumption model: 

• Airbnb (a community platform that connects individuals who rent all or part of their homes to guests such as travellers on a short-term mission) 
• Blablacar and Via (a carpooling platform that connects drives and passengers wishing to share a car trip and associated cost) 
• Techspace (a platform that connects individuals or organisation wishing to share office space and associated cost)
• Kane Logistics (sharing of a warehouse). 

The questions are how do we treat transactions of this nature, and which IFRS standard would apply? We must first understand where the control lies to be able to treat the transaction appropriately. Using a co-working space (such as the services provided by Techspace) as an example, where does the control lie? To treat this appropriately, we need to ask ourselves the following questions. First, is the owner providing the office space only without any additional services? Second, is the owner providing a package of services that include things like the office space, cleaning services, IT services, furniture and fittings, maintenance etc.? Third, what is the significance of the ancillary services when compared to the cost of leasing the space only? If no other services are provided by the owner other than leasing the space, or if the value of the ancillary services is insignificant, and it is established that the co-occupants have control as to the use of the co-shared space, then this arrangement would be seen to be a lease arrangement. Hence, the provision of IFRS 16 would be more appropriate. However, where the owner provides a service package, and the value of ancillary services are considered significant, this would be seen as a contract of service under IFRS 15. Most co-working space arrangements come as a service package with several other significant services rendered to the customers.

For leasing arrangement, the treatment will be the same as the “leasing or hire model” described in “1” above. However, if a contract of service is established and performance obligation is satisfied, the accounting treatment would be as this:

Debit: Bank account

Credit: Revenue 

Note, if performance is fulfilled over time, a liability account should be created to house the unrealised portion of the transaction price.

Debit: Bank (with the total transaction price received from customer)

Credit: Revenue (with the portion of the transaction price realised)

Credit: Unrealised income/deferred income – liability account (with the portion not yet realised)

3. Dematerialised services model

Circular Economy Practitioner Guide defines “dematerialisation” as delivering the same product or service using a portion or none of the mass of material types. Dematerialisation is achieved in two ways: one, by digitising the product and selling online or electronically and two, by offering utility of the product as service rather than selling it to customers. Popular examples of industries leveraging dematerialised services business model are:

• New media: Provides subscription-based access to digital news contents, hence, reducing the need for new papers, e.g. New York Times and Wall Street Journal
• Movie streaming: Provides subscription-based access to streamed video contents and therefore eliminating the use of VHF and DVD, e.g., Netflix
• Music streaming: Provides subscription-based access to streaming music, eliminating CDs and DVDs, e.g. Spotify, iTunes.
• Public Cloud computing: Provides remote access to computing resources, including database management, without customers having to acquire physical servers, e.g. Amazon AWS, Microsoft Azure, Google Cloud, Oracle Cloud etc. 

How do we account for transaction under this business model? Notice that these are also software as a service (SaaS) or platform as a service (PaaS) business model. The software or platform provided by the business should be capitalised and recognised as intangible assets in line with IAS 38. Furthermore, the subscription fee or platform use charges received from customers would be recognised as revenue in line with IFRS 15.

4. Incentivised returns model

This means offering financial or other incentives for the return of ‘used’ and/or damaged products. The returned products can be refurbished or recycled and re-sold. This method reduces dependence on virgin resources and ultimately reduces the extraction of the earth’s finite resources. Popular examples of organisations or platforms leveraging incentivised return business model are:

• Cex: A UK-based company that buys, sells, exchanges, and repairs different categories of product.
• Car Phone Warehouse: This is an online platform where old phones are repaired or traded for new ones.
• Ikea: Ikea offers money incentive for returned items and items refurbished are sold at a reduced price.

How would a transaction involving the return of used products be treated in the books of the trader or manufacturer? In this scenario, two standards come to mind, IFRS 15: Revenue from contract with a customer and IAS 2: Inventory. 

• When an item is sold to a customer anew, the seller recognises revenue as soon as ownership is transferred.

Debit: Bank or other modes of receipt

Credit: Revenue

• When a customer returns a used product only for money incentive. IAS 2 requires that inventory should be recognised at the lower of cost and net realisable value. Hence, the inventory of used or damaged items returned would more likely be valued at the amount the company paid for it. This would be treated as follows:

Debit: Inventory of used and damaged materials

Credit: Bank or other modes of payment

Benefits and challenges of the circular economic model

As exciting as the circular economy business model sounds, it is not without significant drawbacks. In this section, I will enumerate the benefits and challenges associated with the adoption of the model.

Benefits

1. The model can reduce industrial emissions, reduce the production of and exposure to hazardous substances and contribute to climate change mitigation.
2. The model makes raw material input cheaper and available and contributes to the reduction of the overall cost of production.
3. The circular economy model stimulates innovation and creativity and brings about the development of secondary process and products.
4. The model facilitates the achievement of the Strategic Development Goals, especially in reducing CO2 emission and global warming.
5. The model contributes to improvement in employment opportunity.

Challenges

1. The business ecosystem is traditionally tailored towards the make-use-dispose concept, and it will require significant investment for the new model to become mainstream.
2. Regulations, markets, investment tools and practices, including financial risk assessment, are tailored to linear models. 
3. The business sector’s main argument is that the financial sector cannot assess the benefits of circular approaches and increases the risks associated with circular business models. The financial sector argues that circular economy projects applying new technologies and business models are inherently risky and often not bankable.

Conclusion

The circular economy concept has seen increased adoption over the last ten years. When we check the websites of many commodities trading or manufacturing companies, many of them are involved in one or more circular economy projects. This portends that adoption is likely to keep increasing. This article identified the popular circular economy models already in use in different industries and provided the accounting treatment of related transactions under the International Financial Reporting Standards (IFRS). That the circular economy model is disruptive, innovative, and regenerative is not in doubt, the pertinent question was whether it could be economically and financially viable. This article showed that the circular economy model, if fully adopted, could improve a company’s overall bottom line and change the nature of our economies and societies.