2.15 Conclusion: what sustainability reporting can learn from the development of the International Financial Reporting Standards

Chapter 2 suggests that the development and practice of financial standards can be instructive to the development of sustainability reporting. It described the main events of the development of financial reporting standards and the historical context in which these developments took place. The analysis of this topic from an historical point of view concludes with the lessons sustainability reporting can learn from the development of financial reporting standards and how these lessons can help shaping the future implementation of a globally recognized set of principles for sustainability reporting.

The shortcomings sustainability reporting is facing during its development have much in common with the early development of financial reporting during the 18th and 19th centuries. Similarly to sustainability reporting today, financial reporting early development also faced challenges such as, the lack of a global and legitimate standard- setter, the lack of a global set of reporting standards, the lack of comparability and credibility of the information disclosed and lack of regulation both of the content of the reports and of the verification of the information disclosed (assurance). As acknowledged by literature and practice, before the IFRS each country had its own reporting practices and the diverse national accounting practices were useful for the development of financial reporting. Financial reporting was not yet harmonized and companies could choose amongst the existing different standards, the most suitable reporting standards to their interests.

The development of financial reporting standards and standard-setter organizations were part of a particular political and social context that changed over a period of more than eighty years (from 1929 until today). A few historical events were central in the process of shaping financial reporting standards and shaping the role of its institutions. The financial crisis of 1929, the US corporate scandals of Enron and WorldCom and more recently, the financial crisis of 2008. These triggered new regulatory acts and all represent landmarks in the development of international financial accounting standards.1

The developments of the accounting practice until 1929 do not contribute significantly to the future of sustainability reporting. However, we must retain the event of creation of the double-entry method in the 15th century and the fact that it is still today the basic accounting model used in financial reporting. Financial reporting as we know it has been developed upon the basic model of the double- entry method. There is no similar precedent model for sustainability reporting. However, sustainability reporting can learn from the current financial reporting’ infrastructure, in particular from its institutions, practitioners (e.g. accounting firms), accounting and auditing standard-setters, reporting tools (build on the accounting and auditing standards)2 and regulatory oversight (e.g. European Commission, national Governments, Securities regulators, Stock Exchanges). Accountants have the expertise to understand and influence an “organization’s ability to create and preserve value over time.”3 As we can see further in chapter 4, an accurate representation of a company’s ability to succeed in the future, including Environmental, Social and Governance and financial risks and opportunities, is possibly better accessed through integrated reporting. Financial reporting is already practiced by accountants, it seems logic to involve the accountants during the process of development of sustainability reporting. Moreover, accountants have already embraced sustainability reporting and have already include it amongst their services. Accountants are equipped with the financial knowledge to make the necessary link with companies’ ability to succeed in the future. Although not sufficient skills in itself for addressing sustainability reporting, as other expertise such as industry-specific knowledge, accountants seem to have made themselves useful in the sustainability reporting and assurance practices.

Although financial reporting and sustainability reporting are very different, the development and practice of financial standards can be instructive to shaping the future implementation of a globally recognized set of principles for sustainability reporting. This is due to facing similar challenges, for example, on how to provide credibility to the information disclosed through effective oversight and governance, and how to communicate clearly to ensure transparency.4 It makes good sense to interconnect both reporting methods, and learn from the current financial reporting infrastructure set-up which ensures the applications and monitoring of the IFRS.

The history of financial reporting may be useful to anticipate future challenges, opportunities and new trends during the development of sustainability reporting.

This chapter has reached 10 lessons sustainability reporting can learn from the development of financial reporting standards. These lessons aim to contribute to the further development of sustainability reporting.

As we saw with the Fourth and Seventh directives, when company law was under development, the EU did not have sufficient political support for passing stricter legislation. Reaching an agreement on the lowest common denominator was the only thing feasible at the time. It was now once again the only possibility for passing the non-financial disclosure requirements in December 2014.11 There will always be opposition and lobbying when new regulation is implemented. It should not stop the efforts to develop a transparent, reliable and well-functioning financial market through “strong leadership and commitment” from all the stakeholders involved in the process of responding to this challenge.12 The EU has set the minimum reporting requirements and other players have important roles, as the stock exchanges, investors and finance providers, which can require more specific requirements in addition to the regulation in place.

Both financial and sustainability reporting need to be able to respond to the current and future demands from international capital markets. They are expected to be able to credibly show the link between the information disclosed and the business strategy and risk, and also prove the link between sustainability reporting and higher financial returns in the long-term. Besides, it is crucial to show how reliable the information is through improved accountability mechanisms, such as third party assurance.

The study of the development of financial reporting standards indicates the importance of transparency for the well-functioning of financial markets. Through a transparent market we can understand how oversight and centralized uniform standards contributed to increasing trust in financial markets. Finally, the mainstreaming of financial reporting standards facilitated transparency in capital markets.

More than how to achieve transparency, the question is how to maintain trust in reporting organizations and ultimately, in financial markets.13 Conducting a responsible and transparent business contributes to building trust in the reporting organization.14 Nurturing relationships with stakeholders through engagement and transparency, contributes to enhancing and developing trust. Overtime, it is expected that this responsible corporate approach will reduce risks (Environmental, Social and Governance risks but also competitive, legal and reputational risks) and increase business opportunities. As recognized in July of 2017 by Gerben Everts (AFM’s board member) and Mohamed El Harchaoui (AFM’s supervisor of accountancy organizations) in a column about integrated reporting in the Dutch Corporate Law magazine, companies need to be transparent not only on financial but also on non-financial performance.15 Besides being beneficial for companies, a responsible corporate approach is expected to benefit the environment and society (increasing societal value).

The development of sustainability reporting’ regulation will likely help maintaining a high level of transparency in capital markets.16

Managing political, social and financial influences over the development of financial reporting standards has always been a challenge for the standard-setter expert groups and organizations; it is anticipated that managing these influences over the development of sustainability reporting standards will be even more challenging given the subjectivity, descriptive and qualitative nature of sustainability disclosure. Any regulatory changes and innovations are always directly dependent on the current political support. The International Accounting Standards Board has the remarkable capacity of maintaining its technical expertise from national and international political interference, namely from the EU, SEC, Financial Accounting Standards Board and national Governments.17 The key for the International Accounting Standards Board’s independence is its Governance model. The International Accounting Standards Board is an independent standard- setter body yet accountable to the public interest, through the work of its Trustees and the Due Process Oversight Committee. Public accountability is also ensured by the Monitoring Board, to which the Trustees are accountable, and which provides a link between the latter and the public authorities. These discussions, both in theory and in practice will always be controversial. As we have seen above (in section 6) the key is to find the right balance between the International Accounting Standards Board’s legitimacy and efficiency, through maintaining its independency, oversight and public accountability.

How the International Accounting Standards Board achieved and maintains its independence is one of the most relevant lessons from the development of financial accounting standards for the development of sustainability reporting. Looking at this example, by creating a competent sustainability reporting standard-setter under the umbrella of a legitimate institution it is not an easy task. Although the members of the monitoring board have legitimacy as national (or EU) regulators of financial reporting it is less obvious who could be the national bodies with a clear mandate to oversee sustainability reporting and thus, to oversee an international sustainability reporting standard-setter. However, looking at the International Accounting Standards Board’s Governance model may contribute to creating a similar Governance model for sustainability reporting, maintaining the independence of technical expertise from external influence.

Sustainability reporting does not have just one recognized body of experts, the sustainability reporting expertise is currently developed and part of different specialized organizations, as among others, the CDP (former Carbon Disclosure Project), Global Reporting Initiative (GRI), Organization for Economic Cooperation and Development and United Nations Global Compact. Even if these organizations would have their frameworks and approaches aligned, appointing a single leading, legitimate and independent organization would not be an easy task. It is not easy to determine which of the organizations has the potential of becoming the internationally recognized sustainability reporting standard-setter. Sustainability reporting is different from financial reporting, as it reflects a political judgment on how socially responsible a business should be. So the standard setting process should accommodate these particularities.

Despite the current widespread and global use of the IFRS, the development of the US financial reporting standards was pivotal and the starting point of the development of the IFRS in Europe. Although a high quality financial standard, the US- GAAP is seen as very detailed and complex. Its detail and complexity were fundamental for developing the IFRS as an alternative financial standard but with an international reach. Until today there is no similar development of such a rigorous reporting system that can be such a triggering starting point and a benchmark for developing an international framework for sustainability reporting. Looking only at an eight year period between the Sarbanes-Oxley Act in 2002 and the Dodd-Frank Act in 2010 we can conclude the following: i) the US government regulatory initiatives of financial reform and investor’s protection have been (at the least) triggered by a financial crisis; ii) the level of corporate responsibility required has increased over time; iii) the level of financial transparency also has increased over time; iv) the monitoring of the audit profession and of credit ratings not only has increased but also became stricter over time and finally, v) the level of regulated sustainability reporting is, despite the exception of the efforts of a few voluntary initiatives and corporate engagements, very low (as discussed further in chapters 3 and 4).

In Europe, as soon as the EU endorsed the IFRS in 2002, these standards became required by all European listed companies. This reflects the influence that the EU’ support had in accelerating the development of financial accounting standards. This indicates how a similar endorsement of a particular framework for the disclosure of non-financial information, such as, the GRI or the International Integrated Reporting Council (IIRC) could positively trigger the development and mainstream of sustainability reporting. Such initiative could foster the mainstream and standardization of sustainability reporting. The lack of support of the US (also mentioned further in chapters 3 and 4), or possibly any other major economy, will likely not hinder sustainability reporting from succeeding and from acquiring the international status of a globally accepted framework for the disclosure of corporate Environmental, Social and Governance impacts.

Despite the US influence on the developments of financial accounting in Europe, and the fact that they did not adopt the IFRS until today, did not stop the IFRS from becoming the world’s mainstream financial reporting standard. The success of a framework for sustainability reporting is not necessarily dependent of the support of the US, or possibly any other major economy for that matter, and of its national sustainability reporting regulatory developments.18

Financial reporting is practiced in the interest of investors as it focuses on their protection. The ACCA, has found in a 2013 survey that 63% of investors have reported that they “place greater value on information or commentary generated outside the company rather than as part of corporate reporting”. Financial statements are necessary but seem not sufficient to evaluate the performance of corporate managers and motivate them to perform in the interests of shareholders, as well as to decide whether to buy or sell shares in corporations.19 For a complete understanding of a company’s financial condition and position in capital markets, investors would likely benefit from looking beyond the mainly historical overview provided by financial reports. They should consider all impacts of a given company, including past and potential future financial and Environmental, Social and Governance impacts.20 On the one hand, for the future of sustainability reporting, policy makers and regulators should take the investors’ needs into account; on the other hand, investors and analysts should communicate their demands and give feedback about the process of development of a framework in a clear and transparent way. If investors call for more Environmental, Social and Governance information, and as sustainability reporting also has its focus on the protection of investors, the disclosure of reliable, credible and comparable Environmental, Social and Governance information seem to be in the investor’s interest.

At first, European financial regulation had its focus on the protection of the creditors and shareholders. It was only in reaction to a number of financial crisis that financial regulation shifted towards the protection of the investors. The investors are still today the key audience of financial reporting and also one of the main stakeholders of sustainability reporting. Similarly to financial reporting, sustainability reporting also does not focus on the protection of creditors but on the protection of the investors. Large investors, such as large pension funds are the game changers with potential to shift the pressure to deliver short-term results to long-term performance.21

Some of the challenges faced by financial reporting, such as the lack of comparability of information, lack of a global set of accepted standards, multiplicity of frameworks, the fears of too much influence of national standard-setters, the pace and timing of the process, technical independence and political interference, are also faced by sustainability reporting. These challenges did not and do not present an obstacle to the development of financial reporting, as financial reporting standards and ultimately capital markets continue to be updated and improved. As it happened with financial reporting it is expected that the further development of sustainability reporting may be also dependent of lessons learnt from practice.

Looking at the initial harmonization efforts and more recent convergence efforts of the International Accounting Standards Board and the Financial Accounting Standards Board, one may question whether similar convergence’ efforts may take place between different sustainability reporting standards-setters. The Sustainability Accounting Standards Board is developing in the US and it is focusing on US markets, others, as the GRI and the IIRC have a global target audience and a more global reach. The difference is that in practice none of these standards has similar legitimacy to the International Accounting Standards Board because none of those standards is formally supported by an international body with unquestionable legitimizing power and international influence.

On the one hand, one cannot discard the potential benefits of a natural selection of sustainability reporting standard-setters followed by a healthy competition between the two internationally most accepted standards. On the other hand, one may also not discard the potential benefits of one single most accepted and standardized sustainability reporting standard-setter. As we saw in sections 7 and 8 (above) the increased harmonization of financial reporting standards with the use of the IFRS resulted in increased comparability of international financial reporting practices, reduced information costs and reduced information risk for investors. However, concerns with the uneven implementation and enforcement of the IFRS remains, as it might jeopardize comparability of information and risk reduction. International convergence of accounting standards is important for the protection of investors. This was recognized in the US by the Sarbanes-Oxley Act. The Sarbanes-Oxley Act called on the SEC to designate an accounting standard-setting body which “considers, in adopting accounting principles, … the extent to which international convergence on high-quality accounting standards is necessary or appropriate in the public interest and for the protection of investors” (Sec. 108 (b)(1)(A)(v)).”22

Looking at these results one may consider the same would be possible if a harmonized single set of sustainability reporting standards would be formally endorsed by the EU. Convergence of the IFRS and the US-GAAP was not yet possible but that does not mean that a globally accepted set of sustainability reporting standards will not be successfully developed. Efforts for the initial harmonization and possibly later convergence of sustainability standards should continue to minimize differences between the different standards and to simplify the reporting of material information to stakeholders (mainly investors). The key seem to be implementation and enforcement, which should be thoroughly executed. At this point there is no enforcement’ structure comparable to financial reporting but sustainability reporting can learn from the enforcement structure of financial reporting as a starting point. Harmonization of standards will facilitate comparison of information disclosed, consistent application of standards, reduce costs and thus help investors to make better informed investment decisions.23

The IFRS are a financial reporting instrument whose standards are based in principles and on professional judgments rather than solely based in detailed rules.The distinction of ‘principles-based’ versus ‘rules-based accounting standards was coined by Sec Chairman Harvey Pitt and Chief Accountant Herdman in four speeches given in February and April 2002 (Camfferman & Zeff, 2007 pp. 73). As in Camfferman & Zeff (2007) pp. 73: Pitt, H.L.”Remarks at the Winter Bench and Bar Conference of the Federal Bar Council”, 19 February 2002; and ‘Remarks at the SEC Speaks Conference’, 22 February 2002. Herdman, R.K. “Improving Standard Setting to Advance the Interests of Investors”, 11 April 2002; and “Moving Toward the Globalization of Accounting Standards”, 18 April 2002 , http://www.sec.gov. Developed by the International Accounting Standards Board, these principles were supported by the International Organization of Securities Commissions and endorsed by the EU. The benefits of the principles-based standards were explained earlier in the chapter.24 The IFRS’ principles-based nature, openness and flexibility are the conditions responsible for its large global acceptance as the mainstream financial reporting tool. These characteristics are responsible for facilitating the application of these standards in countries with different legal systems and diverse cultures.25

Looking at the development and use of the IFRS in financial reporting it seems that principles have worked better than rules. Sustainability reporting is very subjective, it can be analyzed from very different angles, with different approaches, therefore, principles are expected to better accommodate these differences and be more efficient. Besides, it is easier to have a majority agreement in a principles-based framework than to reach an agreement in endless rules.

However, the rules-based US-GAAP system continues to exist in the US and it is uncertain for how long it will continue to be used. What one can say is, that it is not the global preferred accounting system currently used. Its endless rules are not appealing to the companies and the IFRS is largely preferred globally. As explained above in lesson 4 “Despite the US influence on the developments of financial accounting in Europe, and the fact that they did not adopt the IFRS until today, did not stop the IFRS from becoming the world’s mainstream financial reporting standard. The success of a framework for sustainability reporting is not necessarily dependent of the support of the US and of its national sustainability reporting regulatory developments.”

On the one hand, national regulatory initiatives have a more embracing reach, able to regulate all companies irrespective of size, national and international based in a given country. On the other hand, international legislation through multistakeholder involvement, such as, engagement, public consultation (following the International Accounting Standards Board’s example) is, in a globalized world, developed to face current and future challenges in a harmonized way. However, international standards mainly reach to the largest companies. These are likely to be the most financial capable to respond to regulatory change, as for example, with sustainability reporting, they may already be reporting on environmental, social and governance impacts. This is still beneficial because the largest companies can become an example of how to conduct a profitable business in a responsible way.26 As we have seen with the development of financial reporting standards, the implementation and enforcement of the IFRS is dependable of national judgments which are influenced by national and international politics, economics, regulation, society and culture. Therefore, until a certain degree, inconsistent implementation and enforcement of the IFRS is expected.

Investors are the primary audience of financial reports and are also the most affected by misleading or false non-financial information and lack of transparency in the market. As the most affected stakeholders of sustainability reporting of listed companies, investors should also be the primary audience of integrated reports.27 Providing authentic financial and non-financial information in the same report and in a timely manner would benefit investors the most. Investors would then be equipped with all relevant information about a company in a single document to help them to better evaluate how agile a business is when responding to change and make better informed investment decisions.

The integration of financial and sustainability reporting can bring benefits to the users of this information and to the reporters. As pointed out in July of 2017 by Gerben Everts (AFM’s Director) and Mohamed El Harchaoui (AFM’s supervisor of accountancy organizations) in a column about integrated reporting in the Dutch Corporate Law magazine “Via integrated reporting, companies can increasingly meet this [non-financial] information need of the stakeholders and also play an important role in the transition to a more sustainable business model and a more sustainable economy.”28 International integration and harmonization of financial29 and sustainability reporting regulation is required to increase integration of information. Financial and sustainability integration have the potential to boost efficiency, investment and growth in the international capital markets but will never give all the answers that investors need to make more informed investment decisions.30

Even though investors have expressed their concerns about sustainability reporting and integrated reporting, either directly in surveys or through lack of interest in reading those reports, there is a growing support among investors for sustainability and more recently, for integrated reporting (Association of Chartered Certified Accountants, survey June 2013). Investors have also reported to see integrated reporting as too complex and are not convinced that it will achieve its goals.

The implementation of a uniform set of sustainability and integrated reporting standards will be an experiment. Finding a balance between the use, auditing, assurance and enforcement will be a challenge. Only experience through practice will tell what is the optimal degree of uniformity and internationalization needed, which bodies should be involved and how influential should national governments and international organizations be in the future of sustainability and integrated reporting.

Sustainability assurance is a term to designate the verification of Environmental, Social and Governance information disclosed in a sustainability or in an integrated report. Through this process, and similarly to a financial audit, the assurer organization, such as an accountancy firm, attests the reliability and credibility of the information disclosed. The studying of financial reporting also showed the importance of both the accountants’ job and its influence in the development of financial reporting. Sustainability reporting is multidisciplinary in nature and the accountants may provide valuable insights for identifying, measuring and managing Environmental, Social and Governance impacts. An accountant can also provide external assurance of sustainability and integrated reports. Given the specialized expertise and experience of accountants, it is likely that sustainability reporting would benefit from including accountants in the team of professionals involved with the development of sustainability reporting and the management of Environmental, Social and Governance impacts. The feedback provided by accountants when developing sustainability reporting may be helpful for developing an auditable framework.

The weight of audits in assuring the trustworthiness of financial statements for investment decisions has been attested by investors and by literature.31 With the inherent limitations of what sustainability assurance is and how it can be best carried-out, as we have seen with financial reporting, sustainability assurance is also meant to increase investors’ trust on the reliability of the information disclosed. As we saw in section 11 above, in the US, the Sarbanes-Oxley Act introduced the requirement of attesting the auditors’ report by both the CEO and CFO personally to confirm that they have reviewed it and that it “does not contain any material untrue statements or material omission” or any misleading information. This requirement contributed to a more rigorous financial disclosure to ensure the highest quality of financial reporting by a given company. The importance of top management commitment and proactivity has been promoted by the GRI and the IIRC, and should be taken into consideration by the EU in the development of future regulation in this field.

For accountability to take place mandatory sustainability assurance is most likely needed. Financial audits carried-out by the Big 4 in the Netherlands has not been perfect. As reported by AFM’s director Gerben Everts, in June of 2017, “the quality of statutory audits is still too often insufficient”. After a combined study into both the introduction of 53 quality-enhancing measures proposed by the accountancy sector itself and the quality of statutory audits during the financial years 2014 and 2015, it was concluded that “the promised changes are made too slowly”.32 However, Gerben Everts recognizes the Big 4’s motivation to change and the sector’s active initiative to propose measures to improve. 33In any case, these firms have been involved in sustainability reporting and assurance since its beginning, their involvement has been promoted and supported both by accounting professional bodies (among others, the International Auditing and Assurance Standards Board, the European Federation of Accountants (FEE), the Royal Netherlands Institute of Chartered Accountants (NBA), Association of Chartered Certified Accountants and Institute of Chartered Accountants in England and Wales) and by international sustainability organizations such as, the GRI and the IIRC.34

Very early the Big Four accountancy firms saw a new market developing and a business opportunity with the possibility of generating great profit. These firms have had the remarkable capability to adapt their services to current demands.35 Not only focusing in their primary field of expertise, the financial services but always able to expand their knowledge and services to the state of the art.See, O’ Dwyer, B. “The Case of Sustainability Assurance: Constructing a New Assurance Service”, Contemporary Accounting Research Vol. 28 No.4 (Winter 2011) pp. 1230-1266. This ability to adapt to new demands and circumstances has been possible given, among others, the willingness and skills of the accountants. Accountants have been able to turn pure financial models into non-financial models, which resulted in specializing in sustainability services (amongst which are sustainability consulting and assurance).36 In addition, the Big Four have set-up multidisciplinary teams, combining the expertise of professionals in tax, audit, sector specialists, supply chain and others to provide a service tailored to the client’s diverse needs.37

According to KPMG (Survey 2013), in 2013 the Big Four accountancy firms were responsible for 67% of sustainability reports’ assurance, compared with 64% in 2011.38 External assurance is growing amongst the G250 companies, 59% of these companies invest on external assurance (compared to 46% in 2011), and two thirds of those companies that invest in assurance choose a major accountancy firm.

In the bigger picture, the history of financial reporting shows that society has taken away the responsibility for setting accounting standards from the audit profession (e.g. with the creation of the Financial Accounting Standards Board, change from the International Accounting Standards Committee to the International Accounting Standards Board), because it was not seen as sufficiently independent. However, sustainability reporting would possible benefit from the financial reporting infrastructure in place, which accommodates the work of the accountancy firms, make use of their expertise and experience with financial reporting and auditing to further develop and mainstream the practice of both sustainability reporting and assurance.