Over the last 3 decades, market value calculation of an organization has taken a gradual shift. In the past, value creation was largely dependent on tangible assets, but now, the emphasis is on the intangible assets. With a change in the dynamics of the global economy, the basis of value creation has also changed. Intangible assets like research and development, human or natural capital, brand value, or intellectual properties have become the key resources in most of the sectors. These assets are not universally recognized in financial reporting frameworks despite the fact that these assets constitute a major portion of market value.
In order to address the issue of true value creation, the concept of Integrated Reporting was introduced in South Africa in the year 2009 under the aegis of King III, the Code of Corporate Governance. To understand the crux of Integrated Reporting, it is important to know what integrated reporting is.
What is Integrated Reporting?
The idea of Integrated Reporting is to highlight the wide range of resources that contribute in creating value of an organization over a longer period of time, and it also shows the part an organization play in a particular community or country.
The core of integrated reporting lies in the fact that the value of a company is determined not only by its financial performance, but also by the nonfinancial factors, such as, its social repute, reliance it places on the environment, human capital, natural capital, and other non-financial resources. Hence, the idea of value creation is the backbone of integrated reporting.
1) Layers of Value – There are actually 3 layers of value, a value captured by an organization (financial performance), shared values, and value to society and the environment (also known as externalities). But currently, most of the organizations use only one layer, i.e., the financial capital.
- Financial Value Captured by an organization – This value is measured through financial reports and accounts, and is expressed as the increase in a stock value, or in the form of dividends.
- Shared Values – Shared value represents the stakeholders that are directly associated with an organization, for example, customers, employees, public treasury, or suppliers. This value creation is entirely dependent on factors, such as, consumer confidence or employee performance, which is intangible in nature.
- Externalities – This is a third layer of value, which shows the value created by an organization for the whole community or society, whether or not it is directly related to the business. It can either be positive, or it can also be negative depending on the impact an organization leave.
The purpose of integrated reporting is to broaden the time horizon and scope by including all the elements that contribute in value creation of each area.
2) Integrated Thinking as opposed to Silo Thinking – Integrated reporting requires companies to find out the interdependency among all the external and internal elements that materially affect the process of value creation over a period of time. In order to achieve that, the management of an organization must promote integrated thinking instead of silo thinking, and for that to happen, all the units of an organization – functional and operating – should be considered. As a result, it gives rise to integrated decision making by the management and integrated actions.
To convert integrated thinking into integrated reporting, an organization should communicate a comprehensive view of its strategy, performance, governance, and prospects. Therefore, it can be taken as a governance tool for performance oriented managers.
Need to Change Corporate Reporting
There was a time when the old ways of measuring value and overall progress of the economy were enough to provide a reasonable picture of an organization, but this is not the case anymore, because the dynamics of a global economy have changed, and the uncertainty has increased. The traditional corporate reporting style has been unsuccessful in adapting to the needs of uncertain economies and accounting for the growing contribution of intangible assets in creating value for a business.
For example, currently, GDP is used to measure economic growth of a country, but it doesn’t consider factors like environmental sustainability or social inclusion levels, which are a crucial part of any economy. Similarly, the financial information of an organization doesn’t consider all the factors that contributed in creating value.
Limitations of Current Corporate Reporting Model
According to a research conducted by ACCA in June 2013, limitations in the current corporate reporting model were highlighted, some of which are discussed below:
- • A Missing Link – The investors believe that the information provided to them is inadequate to evaluate the financial health, as there is a missing link between current reporting, risk and business strategy.
- • Harmonization of Information – There should be better harmonization of financial information and non-financial information, because the current non-financial reporting is insufficient and not relevant.
- • Qualitative Policy Statement – Although, qualitative policy statements are critical in evaluating financial materiality, yet, preference is given to quantitative KPIs.
- • Accountability Mechanism – There is no accountability mechanism in non-financial reporting, when there is a need to have one. Organizations can incorporate this mechanism in its non-financial reporting with the help of a new board oversight mechanism, shareholder approval at AGMs, or through third party assurance.
A Step toward Integrated Reporting
Leading organizations understood the importance of integrated reporting, and have adopted it, because they know that the volatility factor in valuation (that can either undervalue or overvalue an organization) can be controlled by providing more and more information to investors and other stakeholders. These organizations have taken a step toward incorporating tangible assets as well as intangible assets in their reporting, along with quantifying (where possible) the value created from environmental, social and economic factors. Key Aspects of Integrated Reporting The aim of integrated reporting is not just about providing more and more information, it’s about providing a better and relevant information. Therefore, in order to adhere to the IIRC (International Integrated Reporting Council) framework, this report should include the following:
- • Overview of an Organization – What is the core business of an organization, and under what circumstances does it operate.
- • A Business Model of an Organization – This report should also consider the business model of an organization, and assess how resilient is it.
- • Corporate Governance – What is the structure of a corporate governance, and how does it contribute in creating value for the organization in the short as well as long term.
- • Organization’s Strategy and Resource Allocation – What the overall business strategy of an organization is, and how does it intend to achieve its targets to implement that strategy successfully.
- • Opportunities and Risks – The key risk faced by an organization and the opportunities it has that affect the ability of an organization to create value in a short term, medium term and over a longer period of time. What tactics does an organization use to address these risks and opportunities?
- • Challenges and Uncertainties – The challenges and uncertainties that an organization is likely to face in order to successfully implement its strategy, and what would be its likely implication for the business model, and its prospective performance and respective outcomes.
- • Performance Outcome – How did an organization performed after executing its strategy, and what outcomes it achieved in terms of increasing its capital.
- • KPIs of the Report – How well does an organization identify the material matters on the basis of its KPIs that are included in the integrated report.
Integrated Reporting – The Multiple Capitals Approach
Organizations are required to maintain a balance between social advances, economic progress and environmental protection for the sustainable development of their businesses. Sustainability is a basis of value creation which is innate to the integrated reporting, and maintaining a balance is crucial for an organization, because a business draws from different resources and capitals that collaborate with one another to create an effective strategy and a distinctive value approach.
In this new era of uncertain economic system, this multiple capital approach is the crux of assessing a true value of an organization. Following are different capitals that play a key role in value creation:
Social and Relationship Capital – This capital include the resources that are a result of the relationship between a company and its stakeholders, for example, a relationship with a government, community, suppliers, customers, etc.
Natural Capital – Natural Capital is a foundation of the whole social and economic system, and it is not replaceable because it is a necessity for smooth running of the overall economy. The examples of natural resources are solar energy, water, agricultural crops, fossil fuel, and carbon absorption capacity (sea, air, forests, etc.) of the world to neutralize the waste released as a result of economic activities. In order to assess whether natural capital is material for value creation, an organization should see the level of reliance it places on resources, the environmental impact on its production process, and the measures it has to take to stay within the limits imposed by the environmental authorities.
Intellectual Capital – It is comprised of intangible assets, such as, business reputation, patent, copyrights, intellectual property, business procedures, protocols and brand recognition. These resources can either be beneficial for an organization, or it can leave an adverse impact on the business, for example, an organization can suffer from negative brand equity due to its key polluters or ill-reputed stakeholders.
Finance Capital – This is a traditional form of capital that is used to assess the performance of an organization. It consists of funds (both equity and debt) available for production of goods and services, and also include the capital generated with the help of an organization’s production.
Manufactured Capital – It includes the infrastructure like technology tools, machinery and equipment, or buildings. Manufactured capital can either be under the control and ownership of an organization or the third parties, and if they are properly managed, they can reduce the utilization of other resources and promote an innovative environment that leads to flexibility and long term sustainability.
Human Capital – It consists of professional skills, motivation and commitment of the employees of an organization, and also include their leadership ability to provide innovative results. The failure or success of any business is dependent on the well-being of human capital and how they are managed and motivated. If there is insufficient remuneration policies or high employee turnover in the organizations, it not only deteriorates their reputation, but can also damage their capability to generate value.
There were different organization that published Integrated Reports even before the IIRC framework was launched in December 2013. Some of these organizations include, SAP in Germany, The Crown Estate in the UK, Natura in Brazil, Novo Nordisk in Denmark, and Port of Rotterdam Authority in the Netherlands. These organizations were already incorporating the concepts, established in the IIRC framework, in their reports that clearly define the basis of how to create value for a business. Currently, the countries that are leading the trend of issuing integrated reports include, South Africa, Australia, Brazil, Finland, and the Netherlands. Although, it is still practiced by a few organizations, yet, the multinational companies are trying to adopt it year on year basis.