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Integrated reporting: the new annual report for the 21st century?

What if stakeholders could receive a single annual report that explains clearly how a company or organization creates value over the short, medium and long term? Such a globally accepted report would go far beyond existing financial statements prescribed by the FASB or IASB, and would expand its focus from short-term financial results to long-term changes in value. It would outline an organization's strategy, governance, performance and prospects, all framed within the context of its external environment. And its principles would apply to corporate, not-for-profit, and governmental entities alike.

The idea of developing an integrated report has moved from concept to reality in just five years. Begun in 2009 at a meeting convened by Prince Charles of Wales, this effort has led to the creation of the International Integrated Reporting Council (IIRC) and the December 2013 publication of the first framework for Integrated Reporting, dubbed "<IR>." The new <IR> framework does not mandate specific content, but instead encourages companies to design reports that satisfy proscribed guiding principles and information. This framework, based on an existing South African model, is now being piloted by an increasing number of companies issuing experimental integrated reports.

For a number of reasons, financial executives can play a critical role in the development and issuance of integrated reports. Most importantly, integrated reports include financial statements and other financial information. Furthermore, financial executives will need to help plan and vet new disclosures about strategic planning and corporate social responsibility that could be included in integrated reports.

The explicit objective of the IIRC is to establish a new norm for corporate reporting, and the IIRC has been working quickly toward this objective with active participation from the leaders of the FASB, IASB, the AICPA, the largest CPA firms, and many professional organizations of accountants in the U.S. and around the world. If the <IR> framework leads to a globally accepted set of standards, elements of the <IR> framework may ultimately become commonly reported within the U.S., or perhaps even required by U.S. standard-setters.

This article describes the key elements of the new <IR> framework and provides illustrations from current corporate reports on how these elements have been implemented to date.

Background and Benefits of Integrated Reporting

Integrated reporting is built on the concept of "integrated thinking," defined by the IIRC 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."

As such, integrated thinking and <IR> seek to add to corporate reporting and transparency "capitals" such as intellectual, human, manufacturing, natural resources, and social responsibility, expanding beyond traditional financial reporting standards. Furthermore, integrated thinking concerns itself with medium- and long-term performance, while existing financial accounting focuses on historic information about net income, financial position, and cash flows--all short-term performance measures.

Accounting researchers have long argued that increased transparency in financial reporting should increase share prices while making it easier for companies to raise capital. In theory, companies' voluntary reporting of <IR> and other information about corporate social responsibility increases transparency and helps investors make decisions about allocating scarce resources, thereby reducing the cost of financial capital and providing financial benefits for markets and investors. Investors who receive more information about medium- and long-term performance can use that information to make smarter investments.

The IIRC was established in 2009 to oversee the creation and implementation of an integrated reporting "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 IIRC believes this will allow investors to assess the impact of the "organization's strategy, governance, performance and prospects" more effectively. The IIRC also believes integrated reporting will benefit the reporting organizations themselves by improving their communications with stakeholders and enhancing their internal processes.

The organizational structure of the IIRC consists of a Board that takes responsibility for approving the <IR> framework; a Council that provides guidance, strategic insights and credibility to the work of the IIRC; a Working Group that develops the <IR> framework and promotes its adoption; and a permanent secretariat staff. The Council includes 48 members and two official observers drawn from corporate executives, accounting professionals, investors, government officials, and standard setters. These Council members include the chief executives of the AICPA, CIMA, EY, PwC, Grant Thornton, IASB, BDO, KPMG, Institute of Internal Auditors, Deloitte, and IFAC. FASB Chair Russell Golden is an official Council observer.

The primary focus on the IIRC has been to develop the first framework for <IR>. In April 2013, it presented a framework draft for public comment and in December 2013, it approved a final version of the framework. Over this period, the IIRC has also implemented a pilot program to encourage organizations to "discuss and challenge developing technical material, test its application, and share learning experiences." Currently, over 90 global businesses, 35 investor organizations, and 13 accounting and governmental organizations have been participating in this process.

Overview of the International <IR> Framework

The <IR> framework is a principles-based approach to defining the overall content and elements of the new integrated report. To be considered to be an integrated report that was prepared in accordance with the framework, a report must satisfy certain minimum requirements. It must be a "designated, identifiable communication" from the company and not a series of separate disclosures. It can be presented as a stand-alone document or as a distinguishable portion of a larger report to stakeholders.

The <IR> framework does not proscribe any financial statements or specific performance measures. Instead, the most critical component of the <IR> framework is identifying how the organization creates value. The framework assumes that any company creates value by using its business model to take inputs, process them, and create outcomes. The framework refers to different categories of inputs and outputs as "capitals." The increase, decrease and transformation of these capitals constitute the value creation process. Companies report on value creation in the short, medium, and long term. Figure 1 provides a generic image of the value creation process, as described by the <IR> framework, visualizing how input capitals (financial, manufactured, intellectual, human, social and relationship, and natural) are transformed by the company's business model to create output capitals. Under the framework, each organization would define this value creation process according to its unique mission and vision, business model, and capitals.

To better appreciate the <IR> model, financial executives can perhaps think of capitals as being similar to "net assets" and the business model as being something like an "income statement." However, <IR> expands the definitions of net assets and operating activities far beyond financial capital that can be measured easily.

In its integrated report, South African company Gold Fields presented its inputs and outputs from a strategic perspective, presenting performance measures of inputs and outputs for each of its strategic pillars. The company's value creation process identified six steps in "adding value throughout the gold lifecycle:" exploration, analysis, development, mining, processing, and marketing.

Other integrated reports that we reviewed described their value creation processes verbally, without a comprehensive diagram. For any diversified business with different subsidiaries that have multiple value-creation processes, we would expect this process to present significant challenges.

Focus on Capitals

The <IR> framework focuses on a more expansive set of resources than those accounted for by the traditional accounting model. Moreover, a company's <IR> analysis can include resources that the company does not actually own or control. The framework identifies the following categories of capitals: financial, manufactured, intellectual, human, social and relationship, and natural. While the first three capitals are similar to those currently recorded as assets, the latter three are typically not listed on the traditional balance sheet. These capitals were developed by the IIRC as examples; companies may classify their capitals differently, but should take into account the same set of factors.

FINANCIAL CAPITAL includes funds generated by financial or internal operations available to the company as it carries out its business activities. Cash flow from operations, cash flow from financing activities, and net income are performance measures that partially capture the change in this capital over time.

MANUFACTURED CAPITAL includes inventory, property, plant and equipment owned by the company as well as infrastructure (roads, bridges, etc.) that the company has access to and uses in its business activities. Examples of performance measures for these capitals include capital expenditures, maintenance and repair expenditures, deferred maintenance, number of miles driven, and waste water generated.

INTELLECTUAL CAPITAL consists of traditional intellectual property as well as the company's knowledge, systems, and procedures that contribute to value. In our information economy, an increasing number of firms derive most of their value from intellectual capital rather than manufactured capital. The <IR> framework ignores financial accounting's distinction between internally created intellectual capital (usually capitalized) and externally purchased capital (expensed), and treat all intellectual capital in the same manner. In this way, the <IR> emphasis on intellectual capital allows a research-oriented company to report how increases in intellectual capital create value in the medium and long term.

HUMAN CAPITAL includes the competencies, capabilities, and experiences of the company's employees. It may also include the skills of contractors and suppliers whose efforts and skills contribute to increases in value. Performance measures of human capital could include the number of employees, employee turnover, training costs, credentials earned, as well as the amount and impact of outsourcing activities.

SOCIAL AND RELATIONSHIP CAPITAL focuses on the brand reputation developed by the company. Many managers believe social and relationship capital is the most important capital to a company's long-term success. However, it may also be the most difficult to measure. This category also includes relationships between key stakeholders. Examples of the latter include long-term banking and investor relationships as well as relationships between suppliers and customers. Possible measures include customer and supplier turnover, number of repeat customers, and brand surveys.

NATURAL CAPITAL includes renewable and non-renewable environmental resources. Recently, there has been an increase in the demand for sustainability information and the Global Reporting Initiative has taken the lead in developing reporting guidelines about a company's impact on the natural resources. Working in cooperation with the Global Reporting Initiative, the <IR> framework integrates measures of environmental activity into the overall creation of value.

In its Integrated Report, prepared as part of the IIRC's Pilot project, Spain-based IT and defense company Indra identified the following capitals:

* Financial

* Manufactured

* Human

* Intellectual

* Social

* Environmental As part of its capitals model, Indra also identified the following stakeholders:

* Shareholders

* Employees

* Customers

* Suppliers

* Partners

* Environment

* Knowledge institutions

* Society

Content elements of the integrated report

Based on measuring changes in capitals and the creation of value, the <IR> report provides content about a company's mission, strategy, governance and business model. It may also include traditional financial accounting information.

The <IR> framework identifies eight content elements that should be covered in any integrated report. These content elements are not distinct and separate, such as individual financial statements. Instead, they should be linked together so the overall report presents a concise and holistic picture describing how the factors that affect the company's ability to create value combine, interrelate, and depend on each other. Such license provides accountants creative opportunities to experiment when developing reports that faithfully represent the activities of any given company in a transparent way.

ORGANIZATIONAL OVERVIEW AND EXTERNAL ENVIRONMENT --The integrated report should identify the company's mission and vision, as well as the fundamental internal and external factors that affect the company's ability to create value. These should include a description of the overall legal and regulatory environment. They may include internal culture, principal products, competition, technologies, environmental opportunities and challenges.

GOVERNANCE--The report should provide information about key leaders (including their skills and diversity) and how their compensation is linked to value creation and the change in capitals over the short, medium, and long term. The report should also describe the processes used to make strategic decisions and the impact of the company's culture, ethics and values on that process. Where relevant, the existence and impact of regulations on corporate governance should be discussed.

BUSINESS MODEL--Because it is directly linked to the use and creation of capitals, every company's business model is of key interest to shareholders. Moreover, the company's business model establishes a foundation for much of the remainder of the integrated report, including the selection of reported performance measures.

When defining the business model for <IR> purposes, financial leaders need to use "integrated thinking," and look beyond the financial statement model to consider the entire business model, including inputs, activities, and outputs.

The report should identify significant inputs that the business uses and how these inputs relate to the capitals. For example, a service business may focus primarily on intellectual and human capitals. In contrast, a manufacturing company may identify manufactured, financial, and natural capitals as the most critical to their success. A company depending on customer loyalty may focus on social and relationship capital because future success depends on maintaining excellent customer relations.

The report should also describe significant activities needed to create its key products and services. Going beyond traditional financial statements, integrated reporting expects companies to report on internal business activities that create non-financial capitals such as intellectual property, human capital and relationship capital. The integrated report should also describe internal activities that protect the company from negative impact on capitals, such as pollution controls and equipment maintenance.

Outcomes generally describes positive and negative changes in the capitals. Obviously, a net increase in capitals creates value while a net decrease diminishes value.

RISKS AND OPPORTUNITIES--The report should describe specific sources of risk and opportunities that may affect the company's ability to create value. These include risks and opportunities arising from external sources as well as internal business activities. Disclosures should include an assessment of the likelihood of each item as well as its potential magnitude. The company should also disclose business activities that help manage key risks, such as long-term purchasing arrangements and derivative hedges.

STRATEGY AND RESOURCE ALLOCATION--The report should identify the company's short, medium, and long-term strategies, discuss how these strategies will be implemented, their potential effect on business activities, and the expected change in firm value measured by how these strategies affect the various capitals. For example, a company may have a strategy to increase product research. In the short term, this will decrease financial capital. One hopes that intellectual capital will increase and pay off in the long term for companies, ultimately increasing financial capital.

PERFORMANCE--The report should provide qualitative and quantitative measures of how well the company has achieved its current strategic objectives. Performance measures should be developed for each of the key outputs identified in the business model section of the report. The report should also discuss the extent to which actual results are consistent with current strategic objectives. Companies are expected to provide performance measures on a consistent basis to allow users to compare past and current performance, and to create expectations for evaluating future organizational performance.

OUTLOOK--The report should provide forward-looking information about the expected impact of current strategic objectives on future changes in capitals and thus, on longterm value. The future outlook should be based on reasonable assumptions and disclose long-term risk factors that may affect these projections.

GENERAL REPORTING GUIDANCE--The report should explain how the company determines which matters to include in the integrated report, and how such matters are quantified and evaluated. This discussion should take into account materiality; determination of and information about capitals; short-, medium- and long-term time frames; and issues of aggregating and disaggregating information.

The South African company Gold Fields organized its Integrated Report along strategic lines, emphasizing strategic "pillars:"

* Our business

* Leadership

* Strategic analysis

* Transparency and accountability

* Pillar: Optimising our operations

* Pillar: Growing Gold Fields

* Pillar: Securing our future responsibility

* Assurance

Guiding principles of <IR>

While each Integrated Report should be unique, all reports are expected to be prepared in accordance with seven guiding principles:

STRATEGIC FOCUS AND FUTURE ORIENTATION--the company's strategy, and how it relates to the company's ability to create value in the short, medium and long term, and to its use of and effects on capital "International <IR> Framework."

CONNECTIVITY OF INFORMATION--a holistic picture of the combination, interrelatedness and dependencies between the factors that affect the company's ability to create value over time.

STAKEHOLDER RELATIONSHIPS--insight into the nature and quality of the company's 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.

MATERIALITY--matters that substantively affect the company's ability to create value over the short, medium and long term.

CONCISENESS--an integrated report should be concise.

RELIABILITY AND COMPLETENESS--all material matters, both positive and negative, presented in a balanced way and without material error.

CONSISTENCY AND COMPARABILITY--information should be presented on a basis that is consistent over time and in a way that enables comparison with other companies to the extent it is material to the company's ability to create value over time.


The integrated reporting project provides a new and unique vision of corporate reporting, augmenting the existing financial reporting frameworks with additional concepts of capitals and an innovative approach to considering medium- and long-term performance measurement. The <IR> project is still in an early experimental phase, allowing companies to experiment with integrated report disclosures voluntarily and to develop techniques for reporting this expanded information set.

That said, it remains to be seen if companies will be willing to embrace this new idea on a voluntary basis. How much will it cost to develop <IR> reports? Will the benefits of these reports exceed those costs? Are financial executives prepared to disclose information voluntarily about deficiencies in operations or outcomes not required by U.S. standard-setters and regulators? Should they voluntarily disclose information that may give away a competitive advantage? And should they accept legal responsibility for the reliability of this information?

Furthermore, we noticed that the initial reports issued under the pilot program included a great deal of information, with perhaps too much detail to be considered concise or meaningful to the typical well-informed business person. Global diversified businesses often have different value creation models and strategies in different subsidiaries. It remains to be seen how accountants can present such complexity in a concise report. We are also concerned about comparability of different companies' integrated reports, given that each company is free to develop integrated reports following its unique business model.

That said, it is not difficult to understand why shareholders would want more information about companies' strategies and value-creation processes for medium- and long-term growth. More importantly, these types of disclosures would appeal to forward-thinking regulators. Judging from the involvement of the large accounting firms and U.S. standard-setters, we would not be surprised if many of the lessons learned from <IR> will eventually be incorporated into U.S. corporate reports, or if the <IR> project will eventually evolve into a set of standards generally adopted by U.S. companies for preparing annual reports.

ABRAHAM FRIED is Assistant Professor of Accounting at Seton Hall University, MARK P. HOLTZMAN is Assistant Professor of Accounting and DAVID MEST is Assistant Professor of Accounting.
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Author:Fried, Abraham; Holtzman, Mark P.; Mest, David
Publication:Financial Executive
Date:Sep 22, 2014
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