Intangible Balance Sheet

14 June, 2018

To transform governance, accountability and decision making to a framework based on the six capitals of the integrated reporting model, will require investors, boards and management to give as much attention to non-financial capital to that traditionally given to financial capital. What might hasten this transition is to apply the traditionally proven approaches of financial reporting to the new and broader capitals framework. Before ‘sustainability purists’ discard this out of hand give me a moment to explain what I mean.

Financial reporting focuses on three principle statements. The balance sheet which tracks the assets and liabilities of an organization at the start and end of the reporting period; the income statement that demonstrates the results of the operations of the organization during the reporting period, and finally the “source and application of funds” or cash flow statement that reconciles the income statement and balance sheet with the changes in cash on hand between the start and end of the period. Historically the advantage of financial reporting was that it reflected everything as one common measure – money. This worked well when the major assets and liabilities were money (financial capital) and when the major driver of value creation was the payment to mostly semi-skilled workers to convert material inputs to outputs and the measure of effectiveness was financial profit. The concept of “asset depletion” in this environment focused on depreciating property, plant and equipment as it was “used up” over time and would eventually need replacing.

In today’s world where only 20% (on average) of an organizations value is now reflected by financial assets, it doesn’t mean that the concept of a balance sheet no longer works – it just means that investors must think of their investment in terms of the integrity of both financial and non-financial assets, and the protection (i.e. monitored depletion) of these assets in terms of their ability to continue to hold and create value. The central argument against the focus on financial reporting is its’ inability to disclose more than short term performance.

To build integrated thinking we need to reflect on the IIRC’s capitals as components of the both the opening and closing balance sheets where the goal has always been to ensure that there is no “loss of value” i.e. the results from annual operations contribute an increase in overall value that more than offsets the depletion of resources being consumed. The result being that the “net worth” of the enterprise continues to grow. So how about we think about starting to build a set of statements that reflect both financial and non-financial assets (note – I say statements and NOT accounts!)?

As an example, if one thinks about the effectiveness with which an organization utilizes human capital, one would want to know how much was used for the “pure” conversion of inputs to outputs (i.e. the operational process that creates revenues and hopefully profits thus operational “value”) and how much of it was used to create continuing value in terms of intellectual capital (innovation, R&D, improvement, process development, IT systems) and relationship capital (solidifying internal relationships thus employee engagement through leadership training and development, supplier relationships and mutual value creation, customer relationships, channel relationships, and even regulatory relationships). All non-financial capitals have a value at the start of the reporting period and all have a value at the end of the period and if management is optimizing their overall use of capitals then all capitals would appreciate during the year (or any increases or decreases would be explained e.g. layoffs increased financial capital but had what management believes is a short term negative impact on human capital). Human capital also contributes in many organizations to the enhancement of manufactured capital and the protection / enhancement of natural capital.

This thinking might help those using integrated reporting to shift its strategic planning and resource allocation towards a more balance approach utilizing the six capitals and help eliminate metrics that might be thought of as “informing investors” but which have little real reflection of the enhancement of the non-financial capitals from a continuing value basis. As an example, reporting number of hours of training is interesting but measures activity and not outcome and has no direct linkage to proven enhancement to the value of human capital. Just a thought?