Towards Integrated Reporting

The topic of Integrated Reporting <IR> is new for the CMA Part 1 exam. The subject was added to the syllabus because IR is to corporate reporting as blockchain is to IT – both touted as the next BIG THING. Blockchain is also new for CMA, but for now, we limit our discussion to IR.
So, if IR is the next BIG THING, then let’s find out why. To understand why, we begin by looking at the evolution of corporate reporting.

The Evolution of Corporate Reporting

We begin our discussion of Integrated Reporting with the evolution of corporate reporting. This will give us a better idea of where IR fits in the corporate reporting process.
It would not be an understatement to say that the corporate reporting process has gone through a FEW changes these past few decades. Even the very idea of corporate reporting has changed dramatically over the years. As an example, if we go back to the 60s, as indicated by Table 1 below, corporate reports were primarily concerned with the basic financial statements (i.e. balance sheet P&L statement, cash flow statement). However, over time, the corporate reports became much more content-oriented, including management commentary, and governance and remuneration reports. This was because investors and other external users wanted more and more detailed information about what was going on in the company.
From there, by the early 2000s, sustainability/corporate social responsibility reports were being included with a company’s financial information in the annual report.

Table 1: Evolution of Corporate Reporting

From the table above we can see that there is a coordinated push towards IR. So, how would an Integrated Report compare with a company's other reports? Let's look at Table 2 below for a comparison based on focus, key drivers, target audience, and legal requirements.

Table 2: Corporate Report Comparison

From the table, you can see that integrated reports are more forward-looking than the other reports. Integrated Reports include both financial and ESG (environmental, social, and governance) results. Let’s dive a bit deeper into the concept of IR.

What is Integrated Reporting? 

The idea of IR goes back several years, but it took off back in 2010 with the founding of the International Integrated Reporting Council (IIRC). The council was made up of a global coalition of regulators, investors, companies, standard setters, accounting professionals, and NGOs. Their purpose was to promote IR as an alternative form of reporting.
If you to IIRC’s website homepage, it says integrated reporting is “A process founded on integrated thinking that results in a periodic integrated report by an organization about value creation over time and related communications regarding aspects of value creation.”

Underneath this definition, it goes on to say that an integrated report is “A concise communication about how an organization's strategy, governance, performance, and prospects, in the context of its external environment, lead to the creation of value in the short, medium and long term.”

We can see that the common denominator of these two definitions is the term ‘value creation.’ Calls for business reporting to focus more on factors including non-financial factors that create longer-term value date back some years. This makes sense because if a business isn’t able to create value for its investors, customers, and others, then what’s the purpose of the business?

Value Creation vs. Profit Creation 

Value creation is a widely used term but most agree that it is about businesses “focusing on the factors that create longer-term value.”

Apple’s CEO Tim Cook said this about value:

"I’ve always deeply felt that people should have values. A corporation is nothing more than a collection of people, and therefore by extension, a corporation should have values."

However, not all believed in Cook’s concept. Milton Friedman (American economist) said:

"…there is one and only one social responsibility of business to use its resources and engage in activities designed to increase its profits so long as it stays in the rules of the game, which is to say, engages in open and free competition, without deception or fraud."

Friedman's statement seems to make a great deal of sense; however, profit only assesses value creation through the process of exchange in markets which sets prices and expresses the quantified worth of goods and services. In the current business environment, there is a request from society to account for the social, economic, and environmental value that results from a company’s activities.
There’s no doubt that running a company in today’s business environment is more difficult than during Friedman’s time. Businesses are expected to be successful on three fronts, including economic, social, and environmental, not just on the economic one (profit). Businesses realized over time that their responsibility extended beyond just maximizing shareholder wealth. 

Integrated reporting is based on the idea that a company’s annual report should explain to providers of financial capital how the company creates value over time, not just show how much profit the company made (or lost). How it does this is by providing insight into the company’s resources and relationships that are known as the CAPITALs and how the company interacts with the external environment and the capitals to create value.

Главные уроки многократно подтверждены:

• Международной историей скандалов и банкротств, в том числе: Enron - $65 млрд., Wordcom - $180 млрд., Wirecard (2020) - €24 млрд.;
• Трижды доказаны нобелевскими премиями по нейроэкономике – иррациональным механизмам принятия управленческих решений:
2017 Richard Thaler, 2002 Daniel Kahneman, 1978 Herbert Simon;
• Ежегодно подтверждаются статистикой исследований ACFE, Ассоциация "Объединение сертифицированных специалистов по расследованию хищений" из 125 стран мира.

The Integrated Reporting Capitals 

As mentioned, Integrated Reporting is about explaining to financial capital providers how the business creates value over time. The best way to do this is through a combination of quantitative and qualitative information, which is where the six capitals come in.
The six capitals identified by IIRC are (1) Financial, (2) Manufactured, (3) Intellectual, (4) Human, (5) Social & Relationship, and (6) Natural.
Money is important (of course), but a company can only build and sustain value if it manages its available capitals. Across these six categories, all the forms of capital the business uses or effects should be considered. Below, we discuss each capital in greater detail:

1. Financial capital is the pool of funds available to an organization to use in the production of goods or the provision of services. It is funds obtained through financing activities such as debt, equity, or grants or generated through the reinvestment of funds gained from operations.
2. Manufactured capital is the physical objects that are available to an organization for use in the production of goods or the provision of services, including buildings, equipment, and infrastructure (such as roads, ports, bridges, and waste and water treatment plants). It also includes assets manufactured by the reporting organization for sale or when they are retained for its use.
3. Intellectual capital results from employees’ efforts that generate intangible assets. Thus, it is intellectual property such as patents, copyrights, software, rights, and licenses. It is also “organizational capital” such as knowledge, systems, procedures, and protocols.
4. Human capital is the skills, capabilities, and experiences of people.
5. Social & relationship capital derives from the relationship between a company and the society from which it secures its license to operate. It is the institutions as well as the relationships within and between communities, groups of stakeholders, and the ability to share information to enhance individual and collective well-being.
6. Natural capital is renewable and non-renewable natural and environmental resources such as air, water, land, forests, and minerals that provide goods or services supporting the past, current, or future prosperity of an organization. Natural capital also includes the health and biodiversity of the ecosystem.

When considering a company’s capitals, remember that not all capitals are equal in their relevance for a company. If you are developing an Integrated Report you need to decide which of the capitals are important for your company and then report on them.

As an example, if your firm is a software company then manufacturing and natural capital will probably not be important; however, intellectual and human capital will be. On the other, a mining company that is heavily invested in land, buildings, and equipment (manufacturing capital) will be very concerned with pollution and waste (natural capital); however, the processing activity may be so basic that intellectual capital may not be as important.

The Value Creation Process

Above, we talked about the importance of value creation. We now want to talk about the process itself, instead of just telling you it’s important. Figure 1 below is the IIRC’s value creation process.
 
Figure 1: The IIRC Value Creation Process 

The IIRC value creation model above draws on various capital inputs and shows how its activities transform them into outputs.
The figure above shows us

• On the left side of the figure are the six capitals which are the inputs to the value creation process.
• At the top of the figure are the company’s mission and vision which identifies the organization’s purpose and intentions.
• Governance involves creating an oversight structure that supports the company’s ability to create value.
• The business model is at the core of the company. The business model is the system of using its business activities to transform inputs into outputs and outcomes to fulfill the company’s strategic purposes and create value over the short, medium, and long-term.
• The outcomes are the transformed capitals that are depicted in the figure emerging from the right side of the process.
• Information about performance is required for decision-making.
• Outlook leads to revisions and refinement to make improvements.

In our next article, “Integrated Reporting: Theory to Practice,” we put the IR model to use by examining a South African mining company, KUMBA Iron-ore Limited. In the article, we look at how KUMBA uses IR to communicate its value creation to financial providers.

About Carl Burch
Carl Burch holds an MBA, CMA, CIA, and ACCA and is an instructor of CMA, CIA, ACCA prep courses in Moscow. 

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