What information does an investor want from a company? The financials are important, but investors are generally more concerned with prospects than with historical data. Accounting figures might be the foundation for future business, but they don’t represent a company’s full story – or even its full value.
To appreciate the extent of this problem, consider Ocean Tomo’s annual study of the composition of equity market value. In 1975, tangible assets accounted for 83% of the market value of S&P 500 firms, with the balance relating to intangibles. By 2009 these proportions had practically reversed – now the implied intangible asset value was 81%. “Where is this reflected in the financial statements?” asks Paul Druckman, CEO of the International Integrated Reporting Council (IIRC) and a past president of ICAEW.
The IIRC addressed this question with its International IR Framework, a template for integrated reporting, which was issued in December 2013 and based on a three-year pilot programme of companies and investors. “We wanted to make sure we didn’t do this outside the market,” says Druckman, who adds that NGOs, standard setters and regulators were also consulted when drafting the framework.
“Companies want to look longer-term and tell the story about their business model. Integrated reporting is enabling them to do that”
Market value sits front and centre of integrated reporting’s focus – how an organisation creates value over time. Research results released in September this year suggest pilot programme participants are already seeing the effects: an IIRC-Black Sun study found 92% of respondents think adopting integrated reporting has improved their understanding of value creation. “That doesn’t mean they didn’t have an understanding before – rather that using integrated reporting is helping their understanding,” says Druckman. “The whole point is behavioural change. In many cases companies want to look longer-term and tell the story about their business model. Integrated reporting is enabling them to do that.”
GEARED TO INVESTORS
The reporting is geared towards investors with a clear link between value creation and a more efficient and productive allocation of capital. Recent research conducted by PwC found that nearly two-thirds of the investment professional respondents believed that the quality of a company’s reporting – on strategy, risks and other value drivers – could have a direct impact on a company’s cost of capital. “Investor primacy is vital,” says Frank Curtiss, head of corporate governance at pensions firm RMPI. “Other stakeholders have needs, and I don’t deny that. But if investor primacy were undermined, investors could lose interest.”
So how does integrated reporting work? Its core is about presenting a more holistic view of a company’s prospects, says Matt Chapman of KPMG’s Better Business Reporting Group. “Financial performance is a central part of that story, but integrated reporting recognises that business depends on many other factors for success. A company’s earnings capability will depend on whether it has the right staff, the right supplier relationships, factories in the right places…”
So the framework introduces the concept of six capitals – financial, manufactured, intellectual, human, social and relationship, and natural – which the IIRC suggests companies use as a basis to describe the resources and relationships which it uses to create value. “Financial capital is underpinned by these other capitals,” explains Becky Fell of Deloitte’s UK national accounting and audit practice. “The premise of integrated reporting is that it’s critical for an organisation to consider these broader capitals on which it depends and which may affect its ability to create value, particularly if you want to look to the medium and long term.”
Integrated reporting doesn’t try to allocate a value to the non-financial capitals. “A common misconception is that all these capitals need to be brought onto a grand balance sheet of business assets,” says Chapman. “That’s not the case.”
The starting point is for an individual company to consider the capitals which are appropriate to its business model, then to apply the basic principles of the framework to establish how best to tell their story. “It is principles based,” says Jeremy Osborn, who leads integrated reporting at EY. “It requires innovation and creativity for companies to see how these principles are applied. Companies will draw on the six capitals to a greater or lesser extent, and we’ve seen companies applying the principles in different ways in the pilot programme.”
A good integrated report, Osborn thinks, will explain the company’s business model and strategy, and include a mix of KPIs that show how well the strategy is being delivered. “Many annual reports have anodyne statements about people being the company’s biggest asset without any information about what it is doing to recruit, train, retain and manage them. The integrated report brings this information together to help investors and other stakeholders understand the company better.”
Very often the efforts management are making simply aren’t clear to an outsider, Chapman adds. “If they are not visible, it’s hard for an investor to distinguish between a company that’s investing in its long-term future and one that’s prioritising its short-term earnings. And we’ve all seen the consequences of that.”
The process has to start with integrated thinking within an organisation. “Integrated reporting is not just about a report – it’s about a process for embedding integrated thinking internally into decision-making and process,” says Fell. “Then there will be a consistency of reporting, which is what investors are looking for.”
One of the companies to have been involved in integrated reporting from the start is HSBC. Russell Picot, group chief accounting officer at the bank, says that applying the six capitals can be challenging, “particularly when issues of materiality are taken into account and companies have to comply with legislative formats which take a similar but slightly different approach to corporate reporting. Adopting an integrated approach leads companies to hold discussions around key issues such as the long-term sustainability of the business and its value to society.”
He thinks integrated reporting’s strength derives from its principles base. “Detailed lists of requirements tend to encourage a checklist mentality in which the communication of the company’s story can be lost. It is worth putting in the time to achieve a coherent narrative, but it won’t happen overnight.”
The idea of following principles rather than rules might seem vague, but Curtiss says: “You can still have rigorous metrics for certain kinds of non-financial information. Financial reporting has been around for centuries and accounting standards are well established. It will take time for more rigorous metrics to develop in the other capitals. But it won’t be enough to say, for example, that a good return on social and relationship capital will excuse a poor return on financial capital. That’s misreading the situation.”
While integrated reporting is an international initiative, UK-listed companies are already following its ideas. In its guidance on the strategic report released in June 2014, the Financial Reporting Council provides companies and their advisers with a principles-based approach to implementing corporate reporting reforms introduced last year in a way that owes much to the IIRC’s framework. “The FRC gets it,” says Druckman. “The strategic report is not integrated reporting, but it’s very much on the journey.”
Another part of that journey started this autumn when the IIRC moved from the pilot programme to a phase which Druckman calls “early adopter”. While any company that wants to can adopt integrated reporting, the IIRC wants to maintain a connection with some of them through its recently-formed Business Network. “We want a one-to-one connection with the leading businesses,” he says. “Otherwise we become technical gurus that don’t understand the rationale and processes companies need to go through. We need to stay in touch with leading practice, and demonstrate to the rest what best practice looks like.”
Druckman’s eventual goal is for integrated reporting to be at the centre of corporate reporting for all companies, not just listed ones. “I’m looking at innovation in reporting and a new way of interpreting value,” he says.
The International Integrated Reporting Council (IIRC) last month launched a new initiative to discover in more detail how information systems can and should feed into the integrated reporting process. At a launch event at the World Bank in New York, the IIRC spelled out four objectives for the initiative:
To evaluate how technology is currently – and potentially could be – used to facilitate corporate reporting and could cover the whole reporting value chain, from preparation through to consumption.
To provide the IIRC with a better understanding of how technology might enhance integrated thinking.
To create a collaborative network for tech companies to show leadership on this subject, liaise with peers, and implement integrated reporting in their product and service offerings.
To act as a research vehicle focusing on technology and corporate reporting to deliver examples of how technology is employed to meet the challenges created by integrated reporting and thinking.
Technology companies interested in finding out more and joining this initiative can contact the IIRC at email@example.com