The Institute of Public Auditors in Germany (Institut der Wirtschaftsprüfer in Deutschland) has released a position paper on the future on corporate reporting, (only available in German). IDW’s Matthias Schmidt shares some insights into their thoughts on the future of reporting.
Financial statements alone do not sufficiently display companies’ market value:
- The book value of SAP is 25 billion euros, while the market value is 125 billion Euro. Apparently, the capital market suspects values of 100 billion Euro which are not displayed on the balance sheet.
- RWE’s market value is 11.2 billion euros. The RWE has an 80 percent shareholding in Innogy. Innogy’s market value is 20.3 billion euros, of which (20.3 x 80% =) 16.2 billion Euro belong to RWE: Thereafter, RWE’s market value (excluding Innogy) is (11.2 ./. 16.2 =) ./. 5 billion euros.
- Despite record profits and rising share prices, car manufacturers VW, BMW and Daimler are among the cheapest companies in the DAX30: measured by the price-earnings ratio (VW: 6.0, Daimler: 6.7, BMW: 7.4, only Lufthansa 5.2 has a lower P/E ratio).
Corporate reporting should evolve to better display differences between market and book value.
As part of the Sustainable Finance Action Plan, the EU Commission is evaluating whether the external reporting framework is (still) fit for purpose in the 21st century, especially with regards to their contribution to sustainable development. Without question, greater consideration of environmental, social and governance issues in financial reporting makes sense: these issues are “non-financial”, but by no means “un-necessary for an understanding of the undertaking’s development, performance or position”. Integrating ESG issues into management reports makes sense to the extent that these issues pose risks to the business.
- It is necessary to have concise, investor-focused disclosures on how ESG issues are affecting a company’s position, both now and in the future (risks to the business), integrated into the management report.
- Moreover, it makes sense to have additional reporting on the impact of the business in the sense of a transparency report or a license-to-operate report to a wider stakeholder audience (risks to society).
- Both reports will cover the same topics, but with different levels of detail, depending on the report purpose, reporting requirements and intended audience.
- The big picture can then be shown in an integrated report, according to the International <IR> Framework, or a core report as envisaged by Accountancy Europe. Such high level reports are already being published today: either powerpoint files by companies themselves or analyst reports (thus by outsiders) – both unregulated with regards to contents and governance.
Better reporting can lead to better capital allocation, and there are also promising, market-driven approaches, such as appropriate emissions trading schemes or green taxes. If such mechanisms lead to internalization of externalities, they would go directly into P&L accounts and would be considered immediately by all active Investors.
However, the future of reporting will be more than “Annual Report + Sustainability”. It would also be worth considering the following:
- Companies could enhance financial statements by using tables with estimates of key P&L-metrics for the next three to five years, analogous to the content of analyst reports. These should build upon scenario analyses. Some companies are already publishing so-called consensus reports with such estimates (from analysts, not the company itself) on their website.
- Companies could also complement financial statements with a reconciliation from book to market value or vice versa by quantifying e.g. peer group development, brand value, human capital, R&D-pipeline, customer loyalty etc.
Both evaluations should be displayed as tables, with further explanations in the notes.
In addition, in an increasingly digital world, accounting for internally generated intangible assets should be reconsidered as these values often make up three-quarters or more of the company’s market value. Is it appropriate, if balance sheets only display the debt coverage potential of the individual assets (without synergies) rather than their value creation potential?