The importance of Integrated Reporting for internal decision making

Posted
24 January, 2017

While much of the focus on Integrated Reporting has been on the needs of external stakeholders, the needs for better internal decision making can be significantly improved through utilizing the six capitals approach. As an example in 2014 I worked with a US industrial service company which serves the steel industry, to incorporate a checklist into their strategic planning process through which the impact of all six capitals was considered especially as it pertained to the risk of investing or not investing financial capital in order to sustain competitive capability and advantage. The approach was simple and assessed several aspects of each capital as high (red), medium (amber) or low risk (green); this simple approach quickly identified that there were several areas where lack of sustainable financial investment had increased the level of risk in several non-financial capitals. The company earnings had been consistently in the upper quartile but the negative impact of focusing on maximizing financial earnings quickly showed up through the depletion and increasing risk of non-financial capital sustainability.

This simple application quickly attracted the interest of the board and provided help to management when presenting their business plan for discussion and approval.  This approach demonstrated the importance of ensuring that financial resources needed to be applied to build intangible assets even those these did not appear as increases on the balance sheet and impacted financial earnings in the short term; however failing to make these “non-financial capital” additions would gradually impact the ability to generate earnings and at some point would become critical.

Business leaders are starting to realise that whilst the output of Integrated Reporting may be a report, the real value lies in the process of reporting – in developing a clear understanding of the business model through which some or all of the capitals are utilized. There is a need for internal adoption of the six capitals as a driver for improved decision making around the effective deployment of financial capital through which overall organizational value is created. Without the involvement of management, integrated thinking will probably remain a process of populating a “new scorecard” with metrics that provide greater insight into core aspects of ESG (Environmental, Social and Governance i.e. principally legislated or required by stakeholders and supported by organization’s such as SASB) needs rather than creating a new and enhanced understanding of value creation and sustainability. In addition management, who is judged on its effectiveness in areas such as cost containment will see the allocation of resources towards integrated reporting as a “tax on the business” further driving up what may be considered unnecessary overhead. Thus the deployment of resources will be around satisfying the “minimum possible” rather than developing a new understanding of a value creation model.

The International <IR> Framework provides an opportunity for management to “tell a better story” to its shareholders and other external parties who otherwise may continue to rely primarily on its financial performance together with what minimal information they can gain, to understand what is “behind the numbers.” For reporting to move beyond a tick box, compliance exercise, and become a real value to the business, management need to really grasp integrated thinking. This is not just about ‘doing the right thing’, it is about securing the long term sustainability of the business through adopting a new mindset. In many cases I have seen examples of management frustration with board directives and decisions that they believe fail to take into account the levels of necessary investment for sustainability in areas such as human capital. Accounting perpetuates this problem through treating all labor costs as expenses even when they are deployed to create and enhance other capitals such as social and relationship, intellectual and possibly others. As a result such deployments of financial capital result in apparent depletion of earnings and balance sheet equity even though the “invisible” capitals such as human capital are being enhanced and developed. At worst the board may come to realize this too late when financial performance declines due to lost competitive advantage caused by the continual focus on maximizing earnings and financial capital while other capitals are being depleted.

To “win” in the long term both management, the board and investors must embrace the value provided by the International <IR> Framework and the adoption of integrated thinking. While Integrated Reporting will enhance societal understanding of corporate behavior only integrated thinking will offer the long term opportunity for better decision making; this is in the interest of both investors and management.