Integrated Reporting: Relevance and faithful representation side by side

The conceptual framework for financial reporting issued by the IASB (International Accounting Standards Board) (2010) defines the qualitative characteristics of useful financial information as relevance and faithful representation. The most recent study of E&Y India (2023) on 574 purchase price allocation transactions demonstrated that 29% of the acquisition price was allocated to identified intangible assets, and non-identified intangibles (goodwill) accounted for 34%, reaching in aggregate 63% of the enterprise value. IAS 38 – Intangible Assets (IASB, 2001) defines that goodwill, brands, mastheads, publishing titles, and customer lists generated internally cannot be capitalised, except when they arise from business combinations. Therefore, it can be inferred that most of the value created by the companies is not recognised in their financial statements, thereby affecting their relevance for stakeholders. There are other intangibles that are not even accounted for in a business combination, such as human capital and digital analytics capital. An alternative proposed by the International Integrated Reporting Council (IIRC) (2021) to improve the quality of the information provided by companies is the adoption of integrated reporting, which considers the connectivity and interdependency of different factors that influence an organisation's capacity to generate value over time. This essay aims to analyse how integrated reports can help organisations improve their disclosure practices and the challenges in the implementation of this framework.

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The concepts of brand and human capital are not new. In 1991, David Aeker contended in his book "Managing Brand Equity" that, in many cases, a company's brand is its most valuable asset since it serves as the foundation for both future earnings streams and competitive advantage. Ahmed Bounfour, in 2003, defined human capital as the “set of all the knowledge and routines carried within the minds of the members of any given organisation", including “tacit knowledge, quality of teams, collective capabilities, controlled competences and internal culture”. As can be seen, the behind-the-scenes aspects of the company's financial performance, that is, the interdependence with non-financial elements, including intangibles, have been discussed for more than twenty years. Therefore, what could be the cause of the lack of widespread adoption of integrated reporting within the corporate world?

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A hypothesis raised by the International Federation of Accountants is that the lack of trust in non-financial information is impeding its use by stakeholders when evaluating the performance and long-term value generation of an organisation (Gould, 2017). This theory is reinforced by E&Y's report (2016) "The Road to Reliable Nonfinancial Reporting". According to the study, nonfinancial information usually involves diverse data sources, subjectivity and uncertainties, and different measurement criteria and estimates. Unsurprisingly, a Mazars analysis (2018) on audit reports in France, the UK, and the Netherlands indicated that estimates, assumptions under management's judgement, and uncertainty are common topics in the key audit matters section, indicating that even for financial data, confidence in estimates is a significant concern in corporate reports.

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Considering the relevance of non-financial data for stakeholders and the concern about its faithful representation, it can be stated that one of the difficulties of integrated reporting is to achieve harmony between the two forces.

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Integrated reporting structure

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Remlein (2021) claims stakeholders interested in a company's capacity to generate value all gain from an integrated report, which enhances the quality of information on capital allocation and offers a cohesive corporate disclosure. According to the author, the main elements of integrated reporting are the overview of the external environment and the business model, the risks and opportunities, the governance structure adopted by the company, the execution of the strategic objectives, and the basis of preparation and presentation, that is, the judgements taken by management in the determination of items to be included in the report. The international framework for the integrated report (IIRC, 2021) foresees the categorization of the capitals applied in the value creation process into different elements. Financial capital represents the funds used in products and services and obtained through financing transactions. Manufacturing capital refers to tangible assets such as property, plants and equipment. Intellectual capital is the know-how, systems and processes created by the company. Human capital is formed based on professionals' skills and experience. Social and relationship capital are the reputation, the brand and the common values of an organisation. Finally, natural capital comprises the relationship with environmental resources.

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In the framework, IIRC (2021) establishes the relevant guiding principles for preparing the integrated report. In relation to the strategic focus, it is important that the organisation present how short-, medium- and long-term interests are balanced and the retrospective review of the strategy's execution. In information connectivity, the objective is to demonstrate the interrelationship between the factors that affect the creation of value by the organisation, including the allocation of resources, trade-offs between capitals, revenue and expense changes, and the indicators used to measure performance. In stakeholder relationships, the organization must pay attention to the engagement with key stakeholders, including how value creation is captured by them. In materiality, the focus is on disclosing the process for identifying and prioritising relevant matters and how what should be disclosed is determined. On the topic of conciseness, attention is paid to ensuring that the length is adequate for understanding the elements of the integrated report, following a logical and objective structure. On the topic of reliability and completeness, the management must disclose positive and negative aspects in a reliable and balanced manner. At last, in relation to consistency and comparability, the report must have a preparation and presentation basis that is consistent over time.

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Opportunities and challenges in integrated reports

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In 2013, the Association of Chatered Cerfified Accountants (ACCA) conducted a study with 300 investors from the UK and Ireland and identified that 90% of respondents believe it would be beneficial to merge financial and non-financial information in integrated reports.

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According to this study, integrated reporting can clarify the interdependence between sustainability and the long-term performance of organisations in their process of creating value. Nevertheless, a relevant part of the investors understand that integrated reporting is too complex and might not achieve its goals. Notably, the benefits of an integrated report are related to delivering relevant information to decision-makers, while the challenges are related to how to make the report easy-to-read and reliable.

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The integrated report represents an important tool for executives as well. The 18th edition of the study “Corporate Governance and the Capital Market” by KPMG (2023) demonstrated that 65% of companies listed in Brazil consider some ESG indicator into account when determining the compensation of their administrators, which shows that focusing only on financial performance is no longer sufficient.

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PwC's (2023) analysis of over 350 organisations' Financial Times Stock Exchange (FTSE) reporting practices in the UK revealed a need for improvement. Only 47% and 34% of the reports, respectively, provide links between (1) strategy and key performance indicators and (2) strategy and risks. In these cases, the reader is left to determine the rationale behind the selection of the specific KPIs and risks. In 42% of the plan disclosures, a precise time period was not mentioned, which may be crucial information for understanding timeframes and future actions. According to Deloitte (2011), as a result of selecting the incorrect KPIs and risks, the reports can be unclear, useless, and wasteful of time. Many elements need to be taken into account by businesses, including the market, industry, stakeholder needs, regulations, profitability, and brand strategy. The advisory company explains that numerous organisations currently provide benchmarks of KPIs and risks that can be incorporated into reporting. Reviewing competitor reports, brainstorming with important staff, and seeking advice from trade associations, non-profit organisations, and educational institutions are further suggested techniques.

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Another important topic is related to the assurance of the integrated reports. In 2021, E&Y surveyed 320 investors and executives across the world, and more than 75% of the respondents answered that regulators and standard-setters should define mandatory independent assurance around the disclosure of ESG performance measures. An overview of comments and a call to action about the credibility and reliability of integrated reporting were released by the International Institute of Chartered Accountants (IIRC) in 2014. The documents titled "Overview of feedback and call to action", "Assurance on <IR>: an introduction to the discussion", and "Assurance on <IR>: an exploration of issues" provide an overview of the debate around assurance in integrated reporting publications. Although it doesn't see itself as a standard-setter, the IIRC (2014) recognises the importance of assurance in boosting credibility and confidence. In 2020, ACCA analysed the integrated reports of 48 members of the IIRC and identified that 63% of them had external assurance for the KPIs presented. The percentage is likely to be lower for non-members of the IIRC since they are less engaged with the integrated reporting agenda. For example, the Deloitte study (2011) identified that currently only 25% of non-financial performance reports are subject to third-party assurance procedures. Deloitte explains that there are certain restrictions on this kind of assurance, like the assessment of forward-looking statements. However, a third-party review can assist in addressing the precision of particular performance indicators, assessing the reporting's compilation process, and evaluating the completeness and accuracy of the report's claims and assertions. As an audit company, Deloitte alerts that the costs of assuring non-financial indicators can inhibit or reduce the extension of the assurance procedures.

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If the involvement of multiple company departments in the preparation of financial statements was already a constant demand for good governance practices, with attribution of this responsibility solely to the accountant being inconceivable, in the case of integrated reports, collective construction becomes an essential requirement for companies to be able to communicate assertively with their stakeholders. ?Support from the executive board is a key indicator of an integrated reporting initiative's likelihood of success, according to Deloitte (2011). In order to prevent duplication, the company also highlights the importance of utilising already-existing activity. For instance, the foundations of corporate governance — internal auditing, compliance, and legal — already monitor risks, gather information, and carry out other crucial risk management tasks. The involvement of different departments can also represent an important tool to challenge the biases in the report and question the potential consequences of issues not addressed by the company, since, as reinforced by ACCA (2019), there is a natural tendency for management to focus only on positive performance.

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E&Y (2016) presented a road map to increase the reliability of non-financial information based on lines of defence (LoD). In the first LoD (operational functions), the company should define the segregation duties in the data collection, followed by the reviews and approvals required. In the second LoD (control functions), management needs to establish the procedures and standards for processing and consolidating data. In the third LoD (internal audit), it is important to assess the conformity with the standards and to test the data trail of the information generated. Finally, in the last LoD (external audit), the non-financial information should be submitted to external limited or reasonable audit procedures. When combined, these measures can help companies prevent their reports from being inaccurate, incomplete, or misleading.

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Exploring the benefits of integrated reporting, in its Excellence in Integrated Reporting 2022 analysis, E&Y (2023) argues that embedding sustainability into the business strategy can be a key differentiation for companies, and the integrated report is a powerful resource to communicate the companies’ process of creating sustainable value. In a survey performed with participants in the Pilot Programme of Integrated Reporting by IIRC (Black Sun, 2014), more than 90% of the respondents reported an increase in the teams’ internal collaboration after the adoption of the integrated report. The study demonstrates that by clearing the connection between financial and non-financial KPI's, the companies reduced repetitions and contradictions in their corporate disclosures and promoted the link between teams working previously in silos. According to 79% of the respondents, integrated reporting helped to enhance the decision-making process by providing management with a better understanding of the process of value creation (and deterioration) in the companies, improving the systems and dashboards for performance management, and increasing the two-way communication between the board, management, and other internal areas. Another benefit mentioned by most of the companies was the improvement of their connections with stakeholders. The companies claimed that the integrated reporting provided higher consistency and transparency to external communication and increased awareness of their business strategy among bankers and investors. The interconnectivity between KPIs, performance, and strategy proposed by the integrated report can be allied to the improvement of business and financial reporting practices since recent research performed by Deloitte identified that 90% of the companies fail in the effective execution of their strategies and do not fully capitalise on the results of their engagement (Deloitte, 2015). The sense of a balance between disclosing both positive and negative performance also increased the reliability of users of the corporate report. Deloitte (2015) added as potential benefits of integrated reporting the opportunity to review the operating processes, the consideration of corporate responsibility as parties to the regular business operations, and the adoption of fresh perspectives about the company's business, particularly identifying non-financial performance indicators' drivers.

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Considering the level of complexity, estimates, and judgements involved in the preparation of integrated reports, regulatory bodies will have an essential role in consolidating a disclosure that is concise, relevant, and free from material distortions. The good news is that the International Accounting Standards Board (IASB) and the International Sustainability Standards Board (ISSB) are already committed to working together to implement a corporate reporting guideline incorporating the current principles of the Integrated Reporting Framework (IFRS Foundation, 2023). For instance, in June 2023, the ISSB launched the inaugural standards IFRS S1 and IFRS S2, which provide a shared understanding for communicating the opportunities and risks associated with companies' sustainability. As stated by the ISSB Chair, Emmanuel Faber, the IFRS S1: General Requirements for Disclosure of Sustainability-related Financial Information and the IFRS S2: Climate-related Disclosures already consider the concepts applied in the Integrated Reporting Framework (IFRS Foundation, 2023). Contrary to what could be inferred, Luca Pacioli's double entries (Bishop, Lee and Parker, 2013) are still highly relevant, especially if they are taken as the synchrony of information, in which for each "debit" of material fact that has affected or may affect the financial and non-financial performance of a company, a disclosure "credit" is necessary for decision-makers. With relevance and faithful representation side by side, the importance of one of the oldest communication systems, accounting, will be preserved.

References:

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