Sunday, May 7, 2017

Integrated reporting and shareholder value

In February 2017, Securities and Exchange Board of India (SEBI) had issued a circular advising top 500 listed companies, which are required to publish Business Responsibility Report (BRR) annually as a part of their annual report, to voluntarily adopt integrated reporting from 2017-18. The International Integrated Reporting Council (IIRC) has issued Integrated Reporting Framework. IIRC is a global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs.
Integrated report is directed to investors, but is useful to other stakeholders as well.  It tells the complete story of value creation holistically in a concise manner. It provides investors with information that is relevant for assessing the sustainability of the business model of the company. Integrated Reporting Framework identifies five types of capital (resources): financial capital, manufactured capital, intellectual capital (including organisational capital), human capital, social and relationship capital, and natural capital (e.g., air, water, mineral, forest, bio-diversity and eco-system health). All the resources that a company uses to create value are not owned by it. For example, government or some third party might own infrastructure (e.g., ports and bridges) that is used by the company. Some natural resources (e.g. air) are not owned by anyone.  In the process of creating value the company transforms one form of capital into another form of capital and increases value of some capital while reducing that of others. A company creates value only if the net outcome is positive. The term ‘value as used in integrated reporting may be perceived as ‘social value’, which is the total of value created for shareholders and value created for other stakeholders. A business model that destroys social value is not sustainable. It is true that in most situations it is difficult to quantify the outcome, but a qualitative assessment is possible. Therefore, integrated report provides a blend of quantitative and qualitative information.
Integrated report focuses on future and describes how well the company is managing environmental, social and governance (ESG) issues. For example, integrated report provides insight into how the company is managing its relationships with its key stakeholders, including how and to what extent the company understands, takes into account and responds to their legitimate needs and interests. Similarly, it provides insight into how the business model affects natural capital.
Integrated report also provides information on how the firm integrates different components of the organisation and how it integrates short-term, medium-term and long-term strategies.
Integrated Reporting Framework requires that the report should include a statement from board of directors (hereafter board) that includes: an acknowledgement of its responsibility to ensure the integrity of the integrated report; an acknowledgement that it has applied its collective mind to the preparation and presentation of the integrated report; and its opinion or conclusion about whether the integrated report is presented in accordance with the Integrated Reporting Framework. Board’s involvement with the preparation of the integrated report adds value to the board’s performance as it compels the board to understand the complete process of value creation and ESG issues and inculcates the culture of ‘integrated thinking’. This culture percolates down to the lower levels in the organisation.
The construct of ‘social value’ is not in conflict with the construct of ‘shareholder value’. The fundamental value (also called intrinsic value) of a business does not depend on its ability to generate short-term profits. It depends on the perceived ability of the business to generate free cash flows (FCF) over a long period. FCF refers to the cash flow that is available to owners for spending on purposes other than the business purposes. If forces (e.g., government, pressure groups, regulators, courts of law) that relate to ESG issues are going to be material to the business, the board, management and investors have to worry about those and the board and the management have to decide what to do about those issues. Eventually, those things will affect FCF. Therefore, a company that fails the address ESG issues and does not create ‘social value’ would not be able to create the shareholder value.
Integrated report is an excellent tool to communicate to investors clearly how the company is managing ESG issues. In absence of that clear communication the value of the equity in the capital market lags the fundamental value of the company, as investor perceives higher risks arising from poor management of ESG issues.
Integrated reporting is evolving globally. The SEBI move will accelerate the evolution. Over time, integrated report should replace Management Discussion and Analysis and Business Responsibility Report, both of which, at present, form part of the annual report.