In this article I’m going to be looking at one of the most important developments in financial reporting in recent years: the idea of “Integrated Reporting” or, as it has come to be abbreviated, IR.
If you haven’t heard of this initiative, you soon will because it is the hottest of hot topics at the moment. This is because IR has far reaching consequences and implications for how qualified accountants perform their roles and if it gains traction then you are likely to be directly affected in some way or other.
In 2013, following a three month global consultation process across 25 different countries, the International Integrated Reporting Council (IIRC) released a framework which described how an organisation should produce an “integrated report” on its performance which would more comprehensively and more meaningfully show how an organisation creates value over time.
Unlike traditional “financial statements” consisting of Balance Sheets, Profit and Loss Statements and Cashflow Statements which focus almost exclusively on providing owners with a picture of the financial performance of the entity, this new integrated report would provide a much wider picture of value. How has the organisation added value to stakeholders of the entity – employees, customers, suppliers, business partners, local communities, legislators, regulators, policymakers as well as owners?
At this point there’s a chance you’re either thinking “boring as hell” or “what a waste of time and effort”. You could be right on both counts. All the indications are, however, that IR will change the way businesses report on performance. So what does it look like practically?
An integrated report shows how value has been created over time by focusing on Six Capitals. Information on each of these capitals is provided for stakeholders to see how the organisation has performed from multiple perspectives not just a financial one. Taking each of the Six Capitals in turn:
This would look at the pool of funds made available to the organisation, including debt and equity finance or the financial “inputs”. It would then describe how these funds have been used to generate returns for investors using traditional measures such as profit, market capitalisation, interest payments dividends and also the company’s tax contributions. The financial “outputs”, banks and owners will have particular interest in this capital.
2. Manufactured capital
This refers to the human-created, production-oriented equipment and tools used in production or the provision of services. For example buildings, equipment, infrastructure and inventories. These are the “inputs”. The report would then show how the organisation has used these to generate products, services, assets or goods for sale, the “outputs” of the process.
3. Intellectual capital
This capital describes intangible value creation. R&D, innovation, human resources and external relationships, all of which can underpin the organisation’s basis of competition. Investments in new ideas, new solutions to human problems, new research into medical cures perhaps. These “inputs” can add value to external stakeholders in the long term by creating future products, patents, licenses, trademarks or other “outputs” which generate prosperity for the organisation.
4. Human capital
This capital examines the knowledge, skills and experience of the company’s employees and managers. In knowledge driven organisations it will be particularly important to show how value has been created through better training and skills development in the workforce. How have the recruited “inputs” in terms of human employees generated value over time. What are the value-adding “outputs” from their endeavours?
5. Natural capital
This refers to the use of natural resources or environmental assets. Minerals, gases, fossil fuels, trees, fish, animals are all “inputs” which can be turned into profit but what are the “outputs” of this process? Environmental footprints may be reported on through metrics based on CO2 emissions, wastage, recycling or re/de-forestation through the organisation’s activities. Wider community stakeholders will be particularly interested in such information.
6. Social and relationships capital
The last capital comprises the relationships between an organisation and its external stakeholders. These relationships should enhance both social and collective well-being. If the organisation has used its “inputs” to make it a net contributor to society through good deeds, community projects, charitable work or social improvement then value is created in this way.
At the moment IR adopts a principles-based approach – organisations can choose whether or not to embrace it in their performance reporting structures. Some do, many don’t. But many commentators are beginning to see both the inevitability of this initiative and its benefits so at the time of writing its growing force appears to be irresistible.
Andy Booth is a trainer for AAT Mastercourses on Financial Performance, Management Reporting, and Budgeting topics.