Environmental, social and governance (ESG) or sustainability reporting has been evolving for many years to reflect the need for improved information around organizational resilience and sustainable development. Integrated reporting has developed since 2010 with a goal of integrating information and reporting on value creation. Several voluntary guidelines and standards have been developing for ESG and sustainability reporting such as those from SASB, GRI, and CDP. Attention has now shifted to a achieving a global baseline of investor-focused sustainability standards to deliver comparable and reliable information to investors. A key challenge that must be addressed is that investors can find it difficult to understand the true sources of value creation, and opportunities and risks to value creation. Today a significant driver of value creation comes from the cash being assigned to creating intangible “assets”.
For many years, financial reporting has played a leading role in governance and accountability because financial performance was, by its nature the main “integrator” of organizational resources. The income statement told us what revenues were earned and how money had been spent to earn that income. It also informed investors about the quality of management's efforts to manage resources effectively and earn a profit. The balance sheet informed us of what assets and liabilities existed that underpinned the ability to earn income. This has changed; many of the “assets” that an organization uses to earn income are no longer on the balance sheet, which is one reason integrated reporting identifies both financial capital as a key resource for value creation and adds to this five other non-financial capitals - natural capital, social and relationship capital, human capital, intellectual capital, and manufactured capital all of which are key to the business value creation model. Yet there is little linkage between the use of financial capital in creating and sustaining these other non-financial capitals. Executives and investors know this and the gap between financial assets and organizational value has significantly increased. Likewise, the spending reflected on the income statement no longer accurately reflects funds which have only been used to earn current income.
Today, organizations spend significant amounts of money in building and sustaining intangible assets, many of which are the sources of value of their business model. Compliance with accounting standards directs that such spending does not create an asset that can go on the balance sheet, and so the spending is charged against income, which, in effect depletes the investors equity - when in reality, it is building value for the organization. These intangibles, which are embraced by the “other capitals” are at the heart of integrated reporting. To develop, manage and sustain these intangible “capitals” requires financial investment, and wise and effective CEOs are directing billions in funding on a continuing basis to develop, manage and sustain these items. Yet for the purposes of financial reporting almost all of these expenditures are invisible.
What is equally concerning is that the accumulated “spend” or the amortization of these intangibles is not tracked or reported. The International Integrated Reporting Framework states that “The primary purpose of an integrated report is to explain to providers of financial capital how an organization creates, preserves or erodes value over time. It therefore contains relevant information, both financial and other.” This lack of transparency around intangibles creates a significant risk for investors.
While FASB has announced that “issues around reporting of goodwill” is to be a key topic for discussion in 2021, the real underlying issue is the growth in the underlying intangibles that form a significant portion of organizational goodwill when a buy, sell or amalgamation takes place. This impacts both goodwill on the balance sheet as well as the management of these intangible assets that, handled poorly, often results in major impairment charges. It is the impairment of these same “non-financial capitals” that are at the heart of the drive for integrated reporting.
It would be a mistake to change the conservative nature of financial reporting standards in order to assign value to the intangibles that have grown in importance, so what is to be done? Money seems to be a continuing common denominator. People must be paid; does financial reporting provide an adequate explanation of what is current expenditure, versus the creation and sustaining of human capital? Relationships must be built and maintained; is there enough visibility into this expenditure? Even addressing natural capital requires ongoing investment. The challenge for the accountancy profession is not to necessarily try and build these changes into standards, but to develop a financial reporting framework that builds a bridge between financial resource management and the other, equally strategically critical, non-financial capitals.
The underlying challenge for both management and investors is to optimize the quality and strength of ALL capitals that are material to the execution of organizational purpose. This first requires investment to ensure compliance, but beyond that, the task is to manage all resources to optimize current performance without negatively impacting future capability. At the heart of this, is to avoid the risk of maximizing financial performance, if that depletes other, unreported intangible capabilities.
The “G” in ESG stands for governance; clear accounting and financial transparency, and complete and honest financial reporting are often considered key elements of good corporate governance. Given the major shift of corporate resources being assigned to intangibles, one would expect that the impact of spending on intangibles and the ongoing health and value of these “unseen assets” would be addressed? Yet in most cases there is no obvious connection with the non-financial performance indicators for the other capitals and the financial information being disclosed.
The challenge with current reporting is that investors “just don’t know” either where the money went or what the health and thus risk of the non-financial assets is. If there were some type of notional opening and closing balance sheet of all “assets employed” - not just financial one’s, and the expenditures shown as “to earn income” were further developed to provide insight into current and non-current aspects this might start to develop an improved understanding of the whole “system” or business model from a financial perspective. This would start to provide reality to integration and improved governance.
One simple step would be to start applying financial information to human resources metrics. An organizations employee turnover sets in motion expenses for hiring and re-training, and often causes operating cost increases. The financial cost of employee turnover could be calculated and reported. Once this was known an ROI could be calculated on initiatives to reduce turnover by making changes in the workplace. This would seem to be more valuable than trying to calculate the value of the workforce, when this value means nothing as a stand-alone resource base, set apart from the other aspects of the business model, or reporting how many hours of training were completed.
Interest in addressing this need for a bridge between financial management and non-financial capitals is starting to develop, such as an initiative led by the IMA and supported by WBCSD and IFAC, which is asking the question about the adequacy of current approaches to management accounting and what might be hanged or developed to improve the linkage and understanding.
This article is based on the authors recently released book “How Accountants Lost their Balance - how the profession has drifted away from reality and must adapt to an intangible world.”