Impact of Integrated Reporting (IR) on Accounting and Finance

2015Cambridge Business & EconomicsConferenceISBN : 9780974211428

Impact ofIntegrated Reporting (IR) onaccounting and finance

By

Kamala Raghavan, DBA, CPA, CFF, CGMA, CFP

Associate Professor

JHJ School of Business, Texas Southern University

Houston, Texas 77004

(713) 313-4202

Impact of Integrated Reporting (IR) on accounting and finance

Abstract

The International Integrated Reporting Council (IIRC), a global coalition of accounting professionals, regulators, investors, organizations, standard setters, and non-governmental organizations,defines Integrated Reporting (IR)as “a process that results in communication by an organizationabout how its strategy, governance, performance, and prospects lead to the creation of value over the short, medium, and long term”. IR combines the organization’s business model, strategy, governance, performance, and prospects to expand the information content to stakeholders and to encourage long term strategic thinking. It is based on the concept of "integrated thinking," defined as "the active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects. Integrated thinking leads to integrated decision making and actions that consider the creation of value over the short, medium and long term."IR helps managers to understand the dependencies and interconnectivity of organizational factors that can impact short, medium, and long term value creation.Investors and regulators demand integrated reporting on all financial and non-financial assets used to create value.Integrated thinking and IR enhance corporate reporting and transparency of all types of "capitals". IIRC released the IR framework to guide organizations on their reporting on December 8, 2013. It is a key step in the development of IR to enhance the relevance and usefulness of information to capital markets. The framework is a principles-based approach to defining the overall content and elements of the new integrated report. Since the framework is tested and driven by market forces, the probability of its acceptance by the users is almost certain. It is essential for accounting and finance professionals to understand the framework and ensure the usefulness of the reports, and educators to prepare the students for success in the global marketplace. This paper looks at the potential future impact of IR on the accounting and finance professionals, and current reporting technologies.

Introduction

The International Integrated Reporting Council (IIRC), a global coalition of accounting professionals, regulators, investors, organizations, standard setters, and non-governmental organizations, defines Integrated Reporting (IR) as “a process that results in communication by an organization about how its strategy, governance, performance, and prospects lead to the creation of value over the short, medium, and long term”. IR combines the organization’s business model, strategy, governance, performance, and prospects to expand the information content to stakeholders and to encourage long term strategic thinking. It is based on the concept of "integrated thinking," defined as "the active consideration by an organization of the relationships between its various operating and functional units and the capitals that the organization uses or affects. Integrated thinking leads to integrated decision making and actions that consider the creation of value over the short, medium and long term." It helps managers to understand the dependencies and interconnectivity of organizational factors that can impact short, medium, and long term value creation. Investors and regulators demand integrated reporting on all financial and non-financial assets used to create value.IIRC released the IR framework to guide organizations on their reporting on December 8, 2013. It is a key step in the development of IR to enhance the relevance and usefulness of information to capital markets. The framework is a principles-based approach to defining the overall content and elements of the new integrated report. Since the framework is tested and driven by market forces, the probability of its acceptance by the users is almost certain. It is essential for accounting and finance professionals to understand the framework and ensure the usefulness of the reports, and educators to prepare the students for success in the global marketplace. This paper looks at the potential future impact of IR on the accounting and finance professionals, and current reporting technologies.

Recognizing the need for IR, a global coalition of accounting professionals, regulators, investors, organizations, standard setters, and non-governmental organizations formed the International IR Council (IIRC). The IIRC was established in 2009 to oversee the creation and implementation of an IR "framework within which more long-term decisions can be made, unlocking financial capital for investments as well as providing a more holistic picture of how value is created over time." The AICPA and the Chartered Institute of Management Accountants (CIMA) are members of the IIRC Council. The mission of IIRC was to enable IR to be embedded into mainstream business practice in the public and private sectors ( The organizational structure of the IIRC consists of a Board that has overall responsibility for the IR framework, a Council to provide guidance and strategic insights, a Working Group to develop the IR framework, and support staff. The IIRC Pilot program participants included over 100 organizations from various sectors from 23 countries, and over 35 global institutional investors. It was designed to enable organizations and investors to share experiences and create a framework of concepts and principles to be used for preparation of future integrated reports. Starting in October 2011 the business participants applied the concepts and principles underlying IR into practice to help develop the framework, and the institutional investors tested the draft framework to ensure that IR added value by supporting decision making processes. Based on 350 responses from the participants, the framework to guide organizations on their reporting was released on December 8, 2013. The release of an approved framework was a key step in the development of IR to enhance the relevance and usefulness of information to capital markets. The Framework is currently being used and tested by a large number of global organizations in various industries (Microsoft, PepsiCo, Southwest Airlines, Unilever, Danone, Eni, Coca-Cola, Volvo, BASF, HSBC, Natura, SAP, and Repsol, to name a few).

Organizations in IIRC pilot program found that effective IR promotes integrated thinking and decision making, and helps to strengthen communication between business units responsible for strategy, internal control, systems, investor relations, finance, sustainability, communications, human resources and many others. They found that IR will prompt them to think differently about reporting frameworks and standards that are not rule-based, but using it will provide them with better financial reporting across business activities, and helps management to make strategic decisions based on consistent, reliable, and complete data and create synergies.

Integrated thinking and IR enhance corporate reporting and transparency of all types of "capitals" including financial, intellectual, human, manufacturing, natural resources, and social responsibility. Integrated thinking concentrates on short, medium and long-term performanceas opposed to current financial reporting that concentrates on historic, short term performance. The recent financial crisis and the growing income disparities across societies have caused many observers to blame the short term focus of organizations for the social, environmental, and economic problems. If organizationswant to achieve the goal of a sustainable society, a changed paradigmrequiring management to integrate innovation, competitiveness and sustainability by using integratedthinking and IR willbe needed. IR provides a holistic view of the business by looking at the financials, strategies, operations, risks and opportunities, future outlook, and governance

The IIRC believes that IR will allow investors to better assess the impact of the "organization's strategy, governance, performance and prospects" more effectively, as well as to benefit the reporting organizations by improving their communications with stakeholders and enhancing their internal processes. By enhancing the information relevance to financial capital providers, IR will enable better allocation of capital and create concise communication about the impact of the organization’s strategy, governance, performance, and prospects in the context of its external environment on its value creation. A fundamental concept of IR is the consideration of six types of capital: financial, manufactured, intellectual, human, social and relationship, and natural.

The IR Framework

The IR framework is a principles-based approach that defines the overall content and elements of the new integrated report, and treats internally created and externally purchased capital in the same manner. It strives for a balance between flexibility and prescription and provides the fundamental concepts, guiding principles, and content elements that should be featured in an integrated report. It represents a meaningful and reliable way to communicate the business’ value-creation over the short, medium and long term which is a vast improvement over the current financial statements prescribed by the FASB or IASB. The new IR framework does not mandate specific content, but encourages organizations to design reports which outline an organization's strategy, governance, performance and prospects within the context of its external environment. The framework’s principles would apply to corporate, not-for-profit, and governmental entities alike.

To be considered to be an integrated report according to the framework, it must satisfy certain minimum requirements. It must be a "designated, identifiable communication"focusing on the connectivity and interdependencies among internal and external factors in the business model that have a material effect on their value creation over time. IR results in a periodic, concise integrated report 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. Although providers of financial capital are the primary intended users, an integrated report should be designed to benefit all stakeholders- including employees, customers, suppliers, business partners, local communities, regulators, and policy makers- interested in an organization's ability to create value over time. The key objective of IR is to enhance accountability and stewardship with respect to the broad base of tangible and intangible capitals and promote understanding of their interdependencies. This innovative and integratedapproach to reporting offers interesting opportunities to management accountants and finance professionals who will be called upon to leverage their existing skills and acquire new ones as the adoption of Integrated Thinking and IR continues over time. Accounting researchers have long argued that increased transparency in financial reporting should increase share prices while making it easier for organizations to raise capital. . Figure 1 shows IIRC’s guiding principles and content elements for integrated reporting framework.

The fundamental concepts of IR are represented by the capitals that an organization uses and affects, as well as the process of creating value over time. At the heart of IR are 6 tenets of better reporting:

1. Communication about value creation: understanding and articulating the resources (capitals) used by organizations that are critical to long term value creation of value. Research shows that traditional financial statements account for only 20% of the value of a business and intangible factors such as intellectual and human capital make up a greater proportion of its value proposition.

2. Concise and clear communication to enhance clarity and readability.

3. Articulation of strategy: A clear articulation of the business strategy and the risk management and performance indicators will help providers of financial capital understand more about the business and give long term commitment, while helping the business increase its performance.

4. Connectivity of information: the recognition of the inter-connectivity and dependency of different parts of the business, and breaking down the traditional silos will lead to less duplication in the reporting process and greater efficiency.

5. Future orientation: Most of today's corporate reporting is based on historic data, while investors are looking for the business’ future plans to enhance value in a sustainable way. IR encourages an increased mix of historical and future-oriented information which provides a qualitative assessment of the risks and opportunities.

6. Understanding the external environment: Many corporations have surpasses countries in their size, and have increased their power, economic, social and environmental impact in the last few decades.IR requires that the impact of external environment on a business' ability to create value be reflected in the reports.

FIGURE 1

IR GUIDING PRINCIPLES AND CONTENT ELEMENTS (SOURCE: IIRC)

The framework defines 6 guiding principles of IR:

1. Strategic focus and future orientation:Reports should provide insight into the organization’s strategy and the effect on its short, medium and long term value creation.
2. Connectivity of information: Reports should take a holistic view of the business and show the inter-relatedness and dependencies between the organization’s value-creating factors.
3. Stakeholder relationships: Reports should offer insight into the organization’s relationships with stakeholders and its responsiveness to stakeholders’ needs and interests.
4. Materiality and conciseness: Reports should be concise and eliminate duplication. They should disclose information that materially affects the organization’s value creation over short, medium and long term horizons.
5. Reliability and completeness: Reports should include “all material matters, both positive and negative, in a balanced way and without material error.”
6. Consistency and comparability: Reports should be consistent over time and be comparable to industry. Figure 1 shows the guiding principles and content elements of the framework.

According to the framework, the integrated report should address 7 key content elements which are linked together to present a concise and holistic picture of value creation. The report includes a description of the business model, the external factors affecting the business, management's strategy for developing the business, and discussion on the performance, prospects, and governance of the business. Based on capital changes and value creation, the report content elaborates the organization's mission, strategy, governance, business model and financial accounting data. Accountants can use the flexibility of IR to prepare reports that are transparent and informative to the user. The content elements are:

1. Organizational overview and external environment reports should address the organization’s mission and vision, culture and values, ownership and operating structure, main activities and markets, competitive landscape, revenue and staffing numbers, and external factors such as legal, political, and environmental aspects.
2. Governance reports should detail the organization’s governance structure including leadership, strategic direction, risk appetite, and the impact of compensation structure of key personnel on value creation, and the change in capitals over the short, medium, and long term. The report should describe strategic decision making process and the impact of the organization's culture, ethics and values on that process. Where relevant, the existence and impact of regulations on corporate governance should be discussed.
3. Business model reports should identify the organization’s key inputs, business activities, and outputs, and how they relate to the capitals. For example, the intellectual and human capitals are critical to the success of a service business while manufactured, financial, and natural capitals are critical to a manufacturing organization. The report should describe activities needed to create the key products and services, non-financial capitals such as intellectual property, human capital and relationship capital, as well as activities that protect the organization from negative impact on capitals, such as pollution controls and equipment maintenance. Outcomes would describe positive (creating value) and negative (decreasing value) changes in the capitals.
4. Strategy and resource allocation reports should identify the organization's short, medium, and long-term strategies, and their impact on the organization’s value creation.
5. Future outlook reports should describe the organization’s forward-looking information about the expected impact of current strategic objectives on future changes in capitals and thus, on long term value. The future outlook should be based on reasonable assumptions and disclose long-term risk factors that may affect these projections. The reports should summarize the organization’s method for determination of materiality, and significant frameworks and methods used to determine material events. General reporting guidance reports should include disclosures about material matters, capitals, and policies for aggregation and disaggregation.
6. Performance reports should outline the qualitative and quantitative overview of an organization’s ability to achieve its strategic objectives. The reports should assess the organization’s key performance indicators tied to the key outputs identified in the business model section, and presented on a consistent basis to allow users to compare past and current performance.
7. Opportunities and risks reports should describespecific risks and opportunities from external sources and internal business activities which could affect the organization's value creation,and the organization’s risk responses. Disclosures should include an assessment of the likelihood and potential magnitude of each item, and impact of business activities that might help manage/ deflect key risks.

The IR framework proposes that an organization creates value by using its business model to process inputs to create outputs and outcomes. The capitals that an organization uses and affects are embodied in the value that it creates through its business model. The business model represents the fundamentals of an organization’s activities and structureinteracting with the external environment and capitals to create value over time. The business model draws on various capitals as inputs and, through its business activities, converts them to outputs (products, services, by-products and waste). These outputs lead to outcomes that affect the capitals. The organization and society share both the cost of the capitals used as inputs and the value created by business activities. An integrated report should reveal the challenges and uncertainties that an organization is likely to encounter in pursuing its strategy, and the potential implications for its business model and future performance.