Addressing shortcomings in current corporate reporting

Investors don’t have access to all the information they need today. Raj Thamotheram, Mark Van Clieaf and Alan Willis ask: why aren’t investors (and their clients) demanding it?

Without relevant, timely and reliable information, investors are unable to make informed long-term investment decisions. The efficiency of capital markets in allocating invested funds – the only real value of markets today – is thus compromised.

The consequence is that money goes where it shouldn’t; economic growth is impaired; the market focus shifts to things that don’t matter in anything other than the short-term (such as total shareholder return [TSR] growth and relative returns); and at worst, society impedes government and companies in what they need to do, such as: hiring and training engaged staff; investing in innovation and in research and development; investing in infrastructure; investing in future-oriented – not just maintenance – capex; and mitigating and adapting to climate change.

The legitimacy of democratic capitalism is ultimately at risk and the recent European elections are an early warning of how fast public sentiment can change.

Historical statements

Historically, investors’ decisions have been based on historical financial statements. But such information gives an incomplete and at times dangerously misleading, picture of a company’s health and future potential to create value over the longer term

In the 1970s, more than 80 per cent of a company’s value was linked to its physical and financial assets. By 2010 this figure had fallen to less than 25 per cent, with “intangible” assets – and what are often termed environmental (E), social (S) and governance (G) factors – playing an increasingly central role in driving market value.

These factors are often called, rather inaccurately, “non- financial”, when clearly they are anything but non-financial – as those who have examined “preventable surprises” like Barclays, BP, Citibank, Enron, Lehman, Rentokil and WorldCom know only too well.

They include both internal intangible assets (such as innovation capacity, management structure design, incentive pay design, human capital management and employee engagement) and external ones (such as constraints on natural resources, brand value/reputation, and social license to operate).

Investors sort of know this is important, having experienced the surprises and collapses, but today can still get away with claiming such blow-ups are “exogenous risks” when in fact the reality is that many are preventable surprises

For example, consider two high street retail companies. One has a change in management and starts to show a big drop in employee engagement and twice the staff turnover of its competitors. No loss of customer sales…yet. These feedback loops impact revenue, but with a delay. So shouldn’t a long-horizon investor want to know about these leading versus lagging indicators of risk to revenue and cashflow?

Comparable information

A big part of the problem is investors don’t have ready access to comparable information about these “non-financial” issues in the same way they have access to financial statement data, presented according to well-established measurement and disclosure standards, and then independently audited.

A 2014 Ernst & Young study found that two-thirds of global investors evaluate non-financial disclosures. However, only half of this group uses a structured process to make their assessments.

We need a standardised way of getting this other information to investors in a user-friendly format that readily links it to data about longer-term financial performance, risk and company valuation.

Some companies have been reporting on E&S performance for a considerable time, but often for the benefit of stakeholders other than investors, with too much focus on good news, photos of happy children, green flora and fauna, and so on. Similarly, there is some reporting on G performance but with a tendency toward box ticking.

Measurable disclosure

What investors need are reliable, measurable disclosures from which to create insights and recognise trends. The fact that so few companies disclose any decision-useful information on investment in R&D or human capital or capex should be of concern to long-horizon investors and their clients. And these disclosures need to be in accordance with global standards for global capital markets.

The good news is that it’s not an insignificant group of investors who should want this. More than 10 per cent of mainstream institutional investors have signed up to the Principles of Responsible Investment (PRI), making a formal commitment to integrating ESG factors.

Moreover, there are good reporting initiatives underway. But sadly they are often regional: the Sustainability Accounting Standards Board (SASB) in the United States (the SASB now has additional leadership by Michael Bloomberg and Mary Shapiro); the European Federation of Financial Analysts Associations (EFFAS); or the European Union’s new directive on ESG disclosures.

No way to manage

This is no way to manage global financial markets. Moreover it repeats the same mistakes from the debate about financial reporting, where we have had so much trouble harmonising different standards (Financial Accounting Standards Board versus International Accounting Standards Board). In the case of SASB, while its intention is undoubtedly good, its standards are too disconnected from disclosures about core finance drivers such as return on invested capital (ROIC), effective capex, innovation, or management layering disclosures and their impact on cash flow sustainability over the longer term, i.e. enterprise viability. Companies can’t really be sustainable if they are not financially viable.

Consider a company that has five years or more net negative ROIC – that is, where the ROIC is less than the weighted average cost of capital (WACC). Such a five-year plus cumulative negative economic profit is clearly not a financially viable business model for long-horizon investors. Add in the known, likely or potential impacts of material ESG risk and performance factors, or a better, deeper understanding about the lack of R&D or capex investments (investing to maintain assets versus new investment in assets). Surely investors in this company would want to know about these additional dimensions of risk and performance?

There are many voluntary disclosure initiatives but the bottom line is they haven’t delivered and, by themselves, can’t. Governments have to show they want these accounting and disclosure shifts to happen, and soon. Short of government action on a global scale (unlikely any time soon), the Sustainable Stock Exchange Initiative (SSEI) may be a far more promising step towards the necessary disclosure requirements. The SSEI is global in reach, and engages key committed international institutions and a growing number of national exchanges to implement suitable disclosure rules.

Integrated business report

We certainly don’t need a complementary reporting system or additional reports. Rather, we need a new type of integrated business report which takes into account economic value creation, core innovation and core value creation metrics like revenue growth and ROIC as compared to the cost of capital – not to mention other ESG factors and impacts on other forms of capital (such as human, social and natural) that may be key value drivers but which never appear in financial statements. The IIRC’s December 2013 Integrated Reporting Framework is an important step in this direction, already being experimented with by several major corporations globally, including in the US.

How soon will responsible investors – those responsive to the true interests of clients and beneficiaries – really demand the information they need, not only from the companies they invest in but also from the capital markets and financial standards regulators who set the disclosure standards and rules?

As public scrutiny of fiduciary investors increases, this demand must surely grow to meet the need for better investment returns, balanced by more effective, comprehensive risk management and stronger corporate governance.

Dr Raj Thamotheram is chief executive officer of Preventable Surprises. Mark Van Clieaf is a partner and chief knowledge officer of Organizational Capital Partners. Alan Willis, CPA, CA, is an independent adviser on sustainability and business reporting. The co-authors are members of the Network for Sustainable Financial Markets (NSFM).