Sunday, October 9, 2016

Boards must adopt integrated reporting framework


International Integrated Reporting Council (IIRC) had issued the Integrated Reporting Framework in December 2013. Integrated report communicates the complete story of value creation concisely to enable investors and other stakeholders to assess the ability of the company to create value over long term. It tells 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. Enlightened-companies use the term ‘value’ in much broader sense than what is understood by the term ‘shareholder value’. Shareholder value is created when the company is able to generate return on financial capital that is higher than the cost of capital over a long period of time. Enlightened-companies realise that the ability to create shareholder value hinges on the ability to create societal value. This perception is captured in the Companies Act 2013, which states: “A director of a company shall act in good faith in order to promote the objects of the company for the benefit of its members as a whole, and in the best interests of the company, its employees, the shareholders, the community and for the protection of environment.”

Integrated Reporting Framework identifies six types of capital (resources) that companies use to create value. Those capitals are, financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital and natural capital. Those include capitals that are not owned or controlled by the company. For example, manufactured capital includes roads and other infrastructures not owned or controlled by the company. None owns some items of natural capital (e.g., clean air). Companies through its activities and outputs create, reduce and transform capitals. A business model is sustainable only if it results in accretion to the net value, taking all the capitals together. Therefore, the management and the board of directors (here after, Board) need to understand the interdependencies and tradeoffs between various capitals and how their availability in future would affect the long-term sustainability of the business model.

One of the guiding principles in the Integrated Reporting Framework is ‘connectivity of information’. Connectivity of information is logical. It is about connectivity between: external environment; governance, opportunities and risk, strategy and resource allocation, business model, performance, and, future outlook; past, present and future; the capitals; financial and other information; qualitative and quantitative information; management information, Board information and information reported externally; and information in the integrated report, information in company’s other communications and information from other sources.

Connectivity of information can be achieved only through ‘integrated thinking’. Integrated thinking refers to holistic approach in decision-making. The Integrated Reporting Framework describes integrated thinking 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.”

In addition to establishing right processes, changes in behaviours, culture and leadership styles are required for implementing ‘integrated thinking’. Sharing of information across the organisation and consideration of fresh perspectives presented by employees in decision-making are essential for integrated thinking. These require building greater trust between leaders and employees. Close collaboration between different units and functions are required to draw right knowledge and experience and develop holistic view in decision-making. Strengthening the engagement with external stakeholders is necessary to understand stakeholders’ perspective and value in order to ensure that the strategy is sustainable for the long term in changing external contexts. Transparency in decision-making is necessary to develop a shared understanding the business model and broader strategy to enable employees to work for a common goal.

The concept of ‘integrated thinking’ is logical and simple, but it is challenging to apply the concept in practice. The traditional mind set of focusing on shareholder value, financial information and quantitative data and hierarchical leadership style make adoption of integrated thinking difficult. It takes years to fully embed integrated thinking in decision-making. The Board has to take the responsibility of overseeing that the company is moving towards developing necessary processes and culture to support integrated thinking. The Board should deliberate on all material factors that significantly affect the ability of the company to create value in the short-term, medium-term and long-term. It might be a good idea for Boards of companies to start the journey by adopting Integrated Reporting Framework for internal reporting to the Board. Companies should aim issuing integrated report to investors as early as possible in order to build trust with wider stakeholders.