Paul Druckman’s speech at EY’s Financial Reporting Outlook

Posted
17 November, 2014

Paul Druckman, CEO, IIRC delivered the following speech at the Financial Reporting Outlook 2014 conference,

I was reading about someone the other day who was meticulous about reducing waste. So particular was he that each morning he would squeeze the toothpaste tube so hard that his fingers would hurt. Then, one day, he realised that while he was doing this to conserve toothpaste, he was leaving the tap running with water. Of course, he felt ridiculous when he realised his actions were inconsistent with his goal to reduce waste. In all honesty, how many of us have done the same thing? In simple terms, this is a story about value – the value the individual placed on toothpaste, which he had paid for, and the water, which he perceived as a free good. It is also a story about measurement, behaviour, relevance and consistency.

Now I ask you to amplify that story in your minds, and apply this very simple observation about human behaviour to the world of business. A business that has a mission, perhaps even an articulated strategy, but the behaviours, actions, management and performance are not aligned to the strategy.

 Alignment is important. Why? Because the successful execution of strategy depends on everyone working to the same goals. In an era of radical transparency there can be little room for difference between what you say and what you do. Trust of stakeholders impacts on the viability of the business model. The ability to execute your strategy influences the value investors place on your business and whether you can attract capital in the first place.

This internal alignment of strategy, execution and performance is what we call integrated thinking and it is the foundation of integrated reporting.

 Cohesion is also vital. It is no longer enough to communicate in long, disjointed blocks of information, in the hope that the reader will piece all the relevant data and screen out irrelevant data. We live in an information age. If you obscure relevant information, there will be a price in terms of cost of capital, share price performance or market volatility. It is no longer a question of whether the information is financial or non-financial – but whether the information is strategic or non-strategic. Is it core to the organization’s ability to create value over time?

 Relevance is the third piece of the jigsaw. This came home to me starkly when I visited a bookshop recently and I scanned the titles in the business section. It provided a real insight into how the world is changing.

Three titles stood out to me:

 “Flex” – which is about driving the value of innovation through effective management of people. In praising the book, Kees Kruythoff, US President of Unilever North America, said “As you drive growth through innovation for your business, you must connect with the hearts and minds of the people inside your organization. [The authors] Hyun and Lee are the first to move away from “the safety zone” of other management books by showcasing real people who embrace differences as they lead across the barriers of culture and generation”. This is the new world of business.

Six Simple Rules – how to manage complexity without getting complicated” – which draws on work by the Boston Consulting Group which shows that while business complexity has increased six-fold in the last sixty years, organizational complicatedness (the structures, systems and processes put in place by management) has increased by a factor of thirty-five. This is stifling competitive advantage and innovation. The book has been endorsed by Mukesh Ambani, Chairman and Managing Director of Reliance Industries, who said: “We do not want best practices; they are not good enough for us. We want the next practices, and that is what the six simple rules are about”.

Big Bang Disruption” by Larry Downes and Paul Nunes. This book argues that every business must learn to deal with “the inevitable truth…The inevitable truth details the death of one incarnation of the industry and its participating enterprises and the emergence of a new one, driven by new technologies that may not be ready for prime time but which, everyone knows, are just a few generations of development away from taking over”. It is described by Dick Costolo, CEO of Twitter as, “Everything you need from business school in one very direct book….it elegantly and simply identifies why innovation happens in some new companies and how you can embrace and harness this new way of thinking”.

Other titles that stand out are “The Good Jobs Strategy”, “Absolute Value – what really influences customers in the age of (nearly) perfect information” and “The Power of understanding People” – how to unlock the value of relationships.

The keen eyed among you will notice that there are only two books that are in what might be described as the “financial capital” space. They are “Capital in the 21st Century” by the French economist Thomas Piketty, which seeks to take an intellectual hammer blow to the current capitalist system. And “Flash Boys” by Michael Lewis, which has been very controversial on Wall Street and is expose on what the author describes as the worst excesses of high frequency trading.

I say all this to put corporate reporting and financial reporting into context. Hope that <IR> can reveal more about the relevance and strategic importance of financial information.

When we talk about communicating strategy, we are promoting, not relegating, the value of financial reporting: putting financial information into a broader context makes it more useful to decision-makers across the business – those units managing resources day-to-day.   And it makes it more useful to the ultimate users of the information – providers of financial capital and other stakeholders.

Integrated Reporting also addresses the challenge laid at the door of those working in finance functions by Professor John Kay, who produced an extremely detailed report for the UK government two years ago on tackling equity market short-termism. To summarise, Professor Kay’s view is that capital markets no longer serve their original purpose of helping businesses to raise risk capital to grow. He argued that too much capital market activity was focused on transferring financial capital within the system itself rather than allocating capital towards productive enterprise. And that this behaviour is perpetuating short-term behaviour. The question is whether this cycle can be broken – and what role is there for the finance professional in growing the size of the cake, rather than just cutting the cake in different ways.

To do this, I think the financial reporting community needs to look again at management and disclosure horizons. Over what time frame you manage resources will determine the scope of your thinking and the actual resources you manage. Mark Carney, Governor of the Bank of England and Chairman of the Financial Stability Board recently talked about the “tragedy of horizons”, which is the risk of market failure brought about by the short-term thinking of business and investors through an inadequate response to future challenges – even when those challenges are known to be a great risk to economic stability.

 <IR> and the Strategy Report

The IIRC and FRC have worked closely over the last couple of years and I believe there is a clear alignment between the intentions of the strategy report and the aspirations of Integrated Reporting. I am very happy that this was articulated in the FRC’s guidance on the strategy report, and increasingly this alignment is being seen by the market. Our experience to date, and expectation about the future, is that company boards and reporting teams, when considering their response to the new strategy report, will also take account of the International Integrated Reporting Framework and work towards adopting both. Certainly the FRC has made clear that it does not want the legislative requirement to produce a strategy report to become a barrier to businesses adopting integrated reporting.

Now I do have some challenges, as you might expect:

1)    I do hope over time that “strategy” in the context of the strategic reports will become more than “financial strategy” reports – that they will encompass value creation in the broadest sense to bring about the cohesion we think is necessary, both to increase the relevance of reporting to providers of financial capital and reduce clutter. If this is to be the case, concepts like materiality, value and connectivity of information, key principles of Integrated Reporting, will become more important for the financial reporting community to understand and embed within their reporting practices. I see this as a major opportunity for the financial reporting community. I therefore hope the FRC will take this on board and work with us and other stakeholders to build awareness and understanding of these themes and concepts in a way that is not disruptive and enables best practice to spread easilyacross the market. Just as the UK has been at the forefront of the debate around governance and stewardship, there is a significant opportunity to take a lead on corporate reporting reform.

2)    I think this collaborative approach will help to embed the new concept of forward looking “viability statements” which I know has been the most hotly contested issues in the recent amendments to the Corporate Governance Code. I will be interested to see how the market responds to this provision, but my sense is that it will be a multi-year journey and sharing best practice examples might be the most useful way of embedding future oriented information. The IIRC has lessons to share, both from the UK market and internationally. Again, I hope this is less about making isolated “financial projections” and more about a consideration by the company of the resources it might need to execute its strategy and meet the challenges of the future as well as the industry trends that will impact its business model. After all, if a business has a three, five or even ten year strategy, it should be able to articulate at least in basic terms how it seeks to meet its strategic goals, and what consideration it is giving to accessing the resources needed to meet its goals. This is about basic risk mitigation, as well as building a stronger dialogue between the business and its investors as part of effective company stewardship. But I do stress the importance of collaboration between business, investors and regulators, because the purpose not be to leave good businesses exposed, but to strengthen economic resilience through an understanding about how companies are building long-term value.

3)    Third, I think businesses need a sense of what the “end game” is – or at least a sense of the long-term vision for corporate reporting. We need to think about market incentives to encourage the adoption of best practice, and awards such as the EY South African reporting awards are a testament to how it is possible to build demand and support for best practice. I also believe more work is needed to develop a common understanding of core concepts such as materiality and value.

Integrated Reporting is the cousin of effective corporate governance and stewardship – in many ways we see <IR> as the information bridge between the two, because relationships need information to flourish. <IR>, as international best practice, is conducive to establishing the basis of engagement between boards and investors based on the strategic informationrelevant to value creation over time. We therefore support strongly the birth of stewardship codes, and the closer dialogue this will bring about between companies and investors. By having a more established framework to underpin these discussions, the market will become better informed, information asymmetry will be reduced and there will be much richer, value relevant dialogue.

The UK has a good story to tell in terms of leadership in the world. Particularly across Europe, and now in Asia, we are seeing the emergence of stronger corporate governance and stewardship codes. I think this strengthens the case for an international framework for corporate reporting that knits together these national initiatives and provides overarching principles for the provision of information to capital markets.

 LEADING BY EXAMPLE

The philosopher Albert Schweizer said, “Example is not the main thing in influencing others, it is the only thing”.

It is in that spirit that the IIRC has launched a global Business Network, the successor to our 100-strong Pilot Programme of businesses from 25 countries around the world that contributed to the development of the Framework. Here in the UK businesses like HSBC, Marks & Spencer, ARM Holdings, Interserve and the Crown Estate have played a vital role in developing the concepts and in many cases evolving their own reporting at the same time.

CONCLUSION

From Cadbury to Kay, the UK’s response to past crises and emerging challenges has been robust. But until now it has been one dimensional, driven often by considerations of short-term financial factors, or amendments to specific standards and regulations. This has often added to compliance and volume – trends I am determined we must reverse. What I invite you to do – and I invite you to come on this journey with us – is to expand your range of thinking to embrace value in its broadest sense. By doing so, you will become an active partner and leader in navigating the strategic and management issues that will determine the future success of your business and our economy in the years ahead.

The question I leave you with is this: are we equipped as businesses, an economy and society only to run a series of short economic sprints, interrupted by periods of damaging decline, or are we building the capacity for the economic marathon that will sustain progress into the future? If we imagine it, how do we envisage that path into the future? A series of short sprints, or do we want to run the marathon?

And what does it take to be an economic marathon runner? Well, it is a question that Mark Carney posed recently. And in his view, long term prosperity “requires not just investment in economic capital, but in social capital” too. He believes that a broader view of how value is created is essential for the long-term viability of capitalism and capital markets themselves.

That is the contribution corporate reporting reform can make to securing greater financial stability alongside sustainable development.

 

Thank you.