Sustainability: Missing the Mark

There is a fundamental problem in the use of the word “sustainability” as it is being applied to corporate reporting: there are two, vastly different, issues at play. For many adherents to the concept, sustainability is about the evolution of corporate accountability and reporting. They also recognise that sustainability and corporate social responsibility (CSR) both came out of the same egg: the need to reconcile economics and profitability with societal legitimacy. An alternative perspective, for some of us, is that sustainability is about the ability of an organization to continue as a “going concern” in an “asset light” world; a term used by Warren Buffett to describe the development of business models requiring less capital intensity to produce huge levels of profit. The work of The Maturity Institute embraces the philosophy of CSR but sees a much bigger issue here, relative to the sustainability of the corporation itself.

CSR evolved to address the growing reality that corporate capitalism, as currently practiced, is in danger of destroying the very societies in which it has to operate and, ultimately our planet. Behaviour had to change and reporting on the environment and broader economic and social impacts had to be included, so that investors would have a clearer view of risk management and performance. This is welcome and there has been some good progress, over the last 40 years, since increased public attention started to put pressure on the corporate world. However, another equally important set of changes has been taking place, in parallel, that has not made anywhere near as much progress. It is this area that The Maturity Institute sees as critically important.

Traditional annual accounts, based heavily on financial information, have become incomplete, misleading and total inadequate for risk assessment; for two reasons. Financial materiality is no longer an adequate test for assessing what is important; 40 years ago the average S&P 500 company (as well as FTSE and other leading trading sites) had 80% of its investors value – what they paid for a share in the company, represented by financial assets. Therefore, a financial focus was relevant and revealed a large part of the organizations ability to be a “going concern”. In fact, the test for “a going concern”, as applied today, still focuses on being “able to pay debts and obligations as they become due.” Today, however, only 20% of an organization’s value is represented by financial assets. Investors pay the other 80% (often much more than 80% in fact) for the organization’s ability to continue to create value in terms of future earnings. They are buying a “system” that has been brought together to create value. So how do investors assess the “system risk” from an annual report?

Standards used for financial reporting have been developed and applied for almost 100 years and continue to be changed and improved. A minimal level of non-financial reporting is required by legislation (although this varies from country to country). However, various supplemental reports have been produced by many organizations to try and present a more relevant picture. In 2012 it became obvious that the financial and non-financial data should be integrated to one report and the concept of “integrated reporting” was introduced. Standards for items within the non-financial aspects of the reports have been developing aided by organizations such as SASB and the GRI. However there remains a large “risk gap” for investors because most of these integrated reports fall far short of demonstrating how the “system that generates the earnings” is performing and what underlying risks and opportunities exist. These reports are not integrated because they fail to provide whole system performance information.

The <IR> framework, that is becoming the de facto standard for integrated reports, has at least developed an effective business model framework that clearly demonstrates that a “whole system” approach depends on both financial capital but also requires the prudent management of other capitals including human, manufactured, social and relationship, intellectual and natural. Every one of these capitals plays a part in the integrated model for generating earnings and wealth. However, they are all inter-dependent and trade-offs are constantly being made by management between each of the capitals. Unless investors have visibility on how all these capitals are being balanced and optimized, between current earnings and future capability, they face the risk of having one capital “maximized” and others depleted. This is the issue at the heart of a short-term earnings focus and few investors know about the depletion because it’s not reported or visible.

If corporate reporting is to evolve in a way that addresses the need of an “asset light” economy, it must address all aspects of the business system. The OMINDEX®, developed by The Maturity Institute, is a leading system indicator of integrated performance but, for transparency and risk assessment, it must be supported by clarity and reporting on all of the capitals that contribute to that system. Current approaches used by many users of the <IR> are a dismal failure, presenting a mix of interesting indicators around the various capitals but in almost no situation is there visibility into whether the 5 non-financial capitals are being enhanced or depleted. Until investors know this, the risk of failure remains higher than necessary. Had KPMG’s scope of its materiality and going concern assessment covered all 6 capitals, one wonders whether the collapse of Carillion would not have been more obvious. In retrospect, all the signs were there for an analyst to see – but only if they asked the right questions. Carillion was NOT a mature corporation or a sustainable organization.

Nick A Shepherd, FCPA, FCGA FCCA, FCMC – Council Member, The Maturity Institute.

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