When: 5 November 2019
Where: Eumedion Annual Symposium, Utrecht, Netherlands
Translated into English from Dutch. Read the original in Dutch.
It’s my great pleasure to be here talking about what the future of financial reporting may hold.
Eumedion is one of the chief supporters of the IASB and the IFRS Foundation. In Europe, we are often asked to ‘smooth off the sharper edges of our Standards’, in the interests of long-term investments. The desire to ignore the volatility of market values is a favourite topic, even when it comes to listed shares.
Eumedion consists of real long-term investors and as a Dutchman I am very proud of how strong our institutional investors are. The message from Eumedion to the IASB is always crystal clear: accounting must reflect the economic reality, even if that reality is turbulent. Real long-term investors need the ‘unvarnished truth’ so that they can adjust their strategy in time, if necessary.
And giving the ‘unvarnished truth’ is the great strength of IFRS Standards. The discipline of our Standards ensures that risks are clearly visible to investors. Lease obligations are now clearly present on the balance sheet; the claim that remuneration in shares and options is free cannot be sustained. That is why I am convinced that the financial statements according to IFRS Standards will always remain a very important anchor for investors.
At the same time, I must acknowledge that there is much going on in the world of reporting. In addition to the financial statements, a great deal of additional, often more up-to-date, information has become available to investors, including from data aggregators. The knowledge economy stimulates enormous value creation, without too many investments in assets that can be found on the balance sheet. The popularity of non-GAAP has risen sharply and there is growing interest in broader reporting, particularly in the area of sustainability.
In the light of these developments, the IASB constantly asks itself how it can strengthen the relevance of IFRS Standards in this changing world.
Today, I want to comment on two projects that aim to do exactly this. First, I will talk about the Primary Financial Statements (PFS) project, which looks at improving the structure and communication effectiveness of the financial statements. Next, I will discuss our Management Commentary project, which is our most important means of linking new developments, such as sustainability reporting, with financial reporting.
The purpose of the PFS project is to improve the structure and content of the financial statements. The IFRS income statement is currently relatively form-free. We define revenue, we define profit or loss, but not so much in between. This is one of the reasons why non-GAAP has become so popular.
So what do we propose to do?
First, we will define a number of subtotals in IFRS Standards, so that the comparability of these types of figures is improved. For example, we have developed a definition for the most commonly used subtotal: ‘Operating Profit’. We will define this operating measure as profit before income and expenses from financing, taxes and investments. Many investors regard this figure as a reasonable reflection of the main business activities of a company.
Another important subtotal that the we want to define is what we call ‘Profit before Financing and Tax’. This subtotal excludes income and expenses from financing and taxes to make it easier to compare the financial performance of companies, regardless of the extent to which they depend on debt financing. Companies with different capital structures thus become more comparable.
The PFS project will also ensure greater transparency and discipline in the use of non-GAAP measures. We want to compel companies to include their most important non-GAAP measures in a single note in the financial statements to make such information easier for investors to find. As it stands, they often have to search for this information, both inside and outside the financial statements.
At the same time, the disclosure of the non-GAAP measures in this note will be subject to discipline. For example, a reconciliation must be provided between the non-GAAP figure and the closest IFRS subtotal. This will help investors better understand how the company arrived at a particular figure. By including non-GAAP measures in the notes to the financial statements, they also come into the scope of audit, which will further strengthen the discipline.
I expect that the impact of our PFS proposals on the income statement will be quite large. They will create more structure in the income statement and improve comparability, making it easier for users to find the components they need for their analysis. The improved structure will also facilitate the digital consumption of financial information.
The fact that IFRS Standards will define subtotals, combined with the increased discipline around non-GAAP, will probably reduce the use of self-defined profit measures. I think that this is pure gain for the investor, who now has to find his or her own way in the current jumble of self-defined performance measures. All in all, I expect the PFS proposals to promote the relevance of traditional financial reporting.
In addition to the field of traditional financial reporting, a range of broader reporting initiatives has been developed over time. It is an area where there is a lot of confusion and that is difficult to capture in a clear definition or name.
The commonly used term ‘non-financial reporting’ is comprehensive, but not precise. There is indeed a lot of non-financial reporting, such as about the impact of a company on the environment, about performance in the area of diversity, etc. But this type of ESG reporting certainly does not cover all the information provided outside the financial statements.
Much of the information that is provided outside the financial statements—usually in the annual report—is indeed financially relevant for investors. Information about the business model; forward-looking information; information about a company’s economic environment; information about the financial impact of climate change: all of these topics are, at most, partly reflected in the traditional annual reports. Because of their financial relevance, they still deserve a place elsewhere in the annual report. The ‘non-financial reporting’ flag does not cover all this type of information. I'd rather talk about ‘broader financial reporting’ if we are talking about this type of financially relevant information.
The IASB sees ‘broader financial reporting’ as part of its mission to provide financial information to capital market actors. We also acknowledge that it is impossible to include all financially relevant information in the financial statements. For that reason we developed our Management Commentary Practice Statement in 2010. In essence, it is a manual for writing the management report.
For various reasons, the IASB recently decided to revise this Practice Statement. First, there is the sharp increase in interest in intangible assets. In the modern knowledge economy, intangible assets—such as technology, customer base and the business model of a company—are increasingly important.
Although intangible assets are important, most cannot be found on a company's balance sheet. One of the reasons for their absence is that they are very difficult to measure. While accounting per se is more of an art than a science, this applies to an extreme extent to the valuation of intangible assets. The graveyard of the capital markets is full of failed acquisitions based on incorrect estimates of intangible assets. These assets can also be very volatile. Think of Nokia and Blackberry: the value of their technological intangibles seemed enormous, until they were swept away by a new generation of smartphones in a very short time.
For these reasons, I think the management report is the best platform for providing investors with information about intangible assets. We will therefore devote ample attention to this in our Management Commentary Practice Statement. We will ask companies to identify the intangibles that are important to their earnings model. They will also have to address the major environmental risks for those intangible assets and explain their strategy for dealing with those challenges.
A second—important—reason for revising our Practice Statement is the sharp increase in interest in the impact of sustainability issues on business and the enormous flight that ‘sustainability reporting’ has taken. Our existing Practice Statement is silent about the possible impact of sustainability.
The increased interest in the ecological sustainability of our economy can easily be explained. The Great Barrier Reef is already half dead, the polar ice is melting on all sides and—apart from a politician here and there—everyone agrees that human actions are the main cause of these disturbing developments. In this light, it is not surprising that the attention for sustainability reporting has increased enormously, also at Eumedion.
Two main streams can be distinguished in the world of sustainability standards. Some standards, such as those of the Global Reporting Initiative (GRI), are primarily focused on the external impact of a company on society and the planet. These standards have a multi-stakeholder perspective; they do not primarily focus on investors. They aim to encourage companies to adopt socially responsible behaviours by providing more insight into the social consequences of their policies. These standards are especially important for investors who want to promote behavioural change.
The second main stream is more focused on the company and its investors. These are standards and frameworks such as those of the Sustainability Accounting Standards Board (SASB), the Climate Disclosure Standards Board (CDSB) and the Taskforce for Climate-related Financial Disclosures (TCFD) that allow a company to describe the potential financial impact of sustainability issues on the company itself. This type of standard is particularly important for companies that are sensitive to the financial effects of climate change.
Although both types of standards pursue a legitimate interest, I would nevertheless like to make some reservations about the effectiveness of the first main stream, which primarily aims to promote socially responsible conduct of business.
First, the multi-stakeholder sustainability standards have no financial materiality thresholds and easily lead to an enormous information overload. A country like France has laid down very detailed ESG requirements in its legislation. The average size of a French annual report is almost 400 pages, about 50% more than the average German annual report.
Second, sustainability miracles cannot be expected in terms of behavioural change. We do not need sustainability reporting to know that aviation is bad for the environment. But with the exception of a small number of real heroes, such as Greta Thunberg, we all buy extremely cheap airline tickets for our increasingly frequent city trips. The only thing that would really help is hefty pricing for the externalities of flying; considerably more expensive airline tickets will do much more than the sustainability report from Ryanair, AirFrance or KLM.
For the same reason, socially responsible investing also has its limits. It is easy for institutional investors to exclude cluster bomb makers from their investments; it would be much harder to do the same with large oil companies, for example. If you decide to do so, other investors will be waiting in the wings, very willing to take your shares from you, knowing that four of the 20 largest dividend payers worldwide come from the oil industry. The recent bond issue of the Saudi oil giant Aramco was overwritten more than eight times, a historic record!
ESG reporting can help raise awareness about long-term sustainability issues, but I believe that legislation and financial incentives will ultimately be decisive.
The capital markets are tough and ultimately both companies and investors must earn money to stay afloat. That is also the reason why companies such as BP and Shell are openly in favour of pricing CO2 emissions. Only effective pricing will make it rewarding for them to initiate the transition to sustainable energy.
The second main stream of sustainability standards is particularly relevant for the update of our Management Commentary Practice Statement. Standards that focus primarily on the (potential) financial effects of sustainability issues for the company itself. These standards—with a clear financial materiality threshold—also fit well within the mission of the IFRS Foundation to provide financially relevant information to investors.
The financial impact of climate change can already be felt in the insurance industry; other industries will follow, especially if public regulation really starts to bite. This type of information is essential for investors who want to form an opinion about the long-term viability of companies. Our Management Commentary Practice Statement will therefore also become a vehicle for financially relevant sustainability information.
In my speech so far I have addressed a number of topics that are contained in Eumedion's green paper, Towards a global standard-setter for non-financial reporting. Finally, I would like to make a few specific comments on this.
The main message of your discussion paper is that there is an urgent need for consolidation in the current maze of non-financial reporting. The alphabet soup of organisations and standards that deal with sustainability reporting drives many people into despair. It is difficult for companies and investors to understand the multitude of organisations and standards. I therefore fully subscribe to Eumedion’s call for consolidation.
Your green paper also suggests that the IFRS Foundation plays an important role in the intended consolidation. I naturally feel flattered by your appreciation for our independence and governance, but you will understand that I will not be able to comment on this in very concrete terms at the moment. This is really primarily a matter for the Trustees of the IFRS Foundation.
At the same time, I hope to have made it clear to you that our thinking has evolved considerably. Our work on the Management Commentary Practice Statement makes it clear that we look beyond the financial statements alone and that we also include broader financial information as part of our mission. From the perspective of Eumedion, this is, I hope, an important step forward.
Your green paper contains important thoughts for the future, no matter how it looks. I will therefore bring your green paper to the special attention of our Trustees. I am convinced that they will give it the attention it deserves and that they will also closely follow the reactions of your stakeholders.
Thank you very much for your attention.