By Rob Worthington-Smith
November 2014
The IIRC’s proposed assurance model for Integrated Reporting, while aiming to promote behaviour and actions that create value, may actually perpetuate the corporate tendency to tick boxes and legitimise the general trend towards boiler-plate compliance-driven reporting. This article takes a closer look at the definition of assurance in the financial and non-financial worlds, before recommending an approach that rates the maturity of management’s response to material issues.
IIRC proposal for assurance based on the financial reporting world
The IIRC’s proposed assurance model seeks to achieve the holy grail of ‘investment grade’ information, similar to that strived for when auditing financial reports. There are differences, one being the possible use of levels of assurance, such as ‘reasonable’ and ‘limited’. We know from experience that the latter is of such limited value as to be practically useless to the reader. Worse, it allows the reporting organisation to tick the assurance box and close off the reporting cycle, not to be given any further consideration for another year.
More importantly in terms of this discussion, according to the IIRC, assurance with respect to <IR> presents an independent conclusion on whether an organisation’s integrated report presents its strategy, governance, performance and prospects in accordance with the Framework.
Financial reporting is defined by numbers relating to the past performance of the organisation. Further, there is a long-established set of principles that prescribes exactly how organisational performance is defined and measured. It is indeed the preciseness of the measures employed, such as monetary value, production units, etc., which has allowed accounting standards to become fairly complex, while at the same time still reasonably ‘accountable’ and auditable, leaving little room for ambiguity and uncertainty.
When reporting on the financials, the role of assurance, via external audit, is to provide, as near as possible, a yes/no assessment of the validity of the information (answering the ‘whether’ question). We should bear in mind that even in the financial world, this is not always achieved. However, it is mathematically possible. The numbers can be made to add up, leaving only certain assumptions, generally found in the ‘notes to the financials’, to be defined within certain boundaries and tolerances. Thus the entire system strives for this goal, justified in its belief that it can be attained.
Assurance of the financials results in an ‘unqualified’ report 99% of the time. If you are an analyst acting on behalf of a shareholder, the rules of reporting ensure that the information required to understand the financial health of the organisation is present. It may not be arranged by materiality, but the system relies on the principle that numbers cannot easily lie. Enough digging and working with the calculator will enable the analyst to describe the financial health of the organisation.
It is usual for external auditors to sit with a company’s internal accountants checking and cross-checking until all the numbers are correct. At this point, the report is ‘investment grade’ and the numbers can be trusted. It is all or nothing. Indeed, it is regarded as a dismal failure of reporting if the external auditors are forced to produce a qualified audit statement. This is the world of financial reporting.
The world of non-financial reporting
This is not, in the second decade of the second millennium, the world of integrated reporting, where the impact on the non-financial capitals of the business needs to be described. Taking one example: How accurately can you describe the financial health of your banking customers seeking unsecured loans? There will nearly always be uncertainty. Proxy measures are often the stock in trade, leaving plenty of room for interpretation. I would argue that ‘investment grade’ is the distant end of a severely graded scale. If the best companies currently score 5 on the scale out of 10 for the ‘grade’ of their non-financial information, a full 10 score is practically unattainable.
While strict auditing of the financials can with near certainty guarantee the factual correctness of the numbers, when reporting on non-financial capitals, all reporting entities are at least partially ‘creative’ in their disclosures, employing narrative to spin the desired message to the reader. The poor definition of indicators and difficulties in standardising between entities, even within the same industry, makes it even harder to achieve ‘investment grade’ information.
We need to add to the list of challenges the abundant room for gaming the system. In emerging economies, for example, income disparity between executive management and the average employee is an important societal issue. Some management teams, realising the potential threat to their remuneration packages, outsource the most menial jobs in the business, thus removing these workers from the payroll and artificially/ creatively raising the average employee wage.
Over time, in a decade or two perhaps, the definition of the various measures – for what constitutes an employee for example – may become accurate enough to close most of the loopholes. But for the foreseeable future, these problems will remain.
The absence of investment grade assurance does not indicate failure
Despite these misgivings relating to the ability of assurance to put a stamp of ‘investment grade’ on the integrated report, it is wrong to conclude that the aims of the <IR> are not likely to be achieved. The <IR> aims are to “improve”, “promote”, “enhance” and “support” (as per section 2.2. of the Assurance on <IR> document). These are graduated, not absolute verbs.
The <IR> Framework is an excellent guide to reporting that should one day become the corporate norm. The reality is that it is a long journey, one that will take a number of years before so-called investment grade communication is achieved. It would be a real pity if the <IR> Framework, used in conjunction with a classic assurance scorecard, were to result in the same kind of degradation we have seen with GRI reporting, where the report becomes no more than a compliance exercise, ticked off, item by item against a checklist.
Given that integrated reporting is going to be a long journey, I propose that we look at an interim role for assurance, a role that assists the organisation on its journey towards investment grade communication.
It is proposed therefore is that the assurance statement should provide the reader with a qualitative assessment of where the reporting organisation is on the journey towards investment grade communication.
An interim approach to non-financial assurance
In this transition phase, during which the IIRC has a clear mission to embed integrated thinking and reporting, an interim approach should admit that there are grades between ‘yes’ and ‘no’ in the world of non-financial reporting. This should be aimed at determining grades for the truth that lies behind the narrative, descriptive statements and ‘spin’. Assuring hard indicators is also for now impractical – they are not nearly as well developed enough to provide clarity, completeness and comparability. Thus business and society would be far better served by offering an independent insight into the degree to which the organisation has achieved the communication of investment grade information using the <IR> framework.
The Credence Model
I propose a model with the working title ‘Credence Model’ that would consist of two parts:
Part One: Assessment of materiality
This is the first step towards assurance. If no other assurance is done on an integrated report, at least the reader should be given some indication of:
- How credibly the organisation has derived its material issues using the <IR> Framework,
- How the issues identified match up against the material issues that are generally recognised to be applicable to the specific industry (sources for this could include the work done by SASB in the US and Trialogue in South Africa), and
- The degree to which each material issue, thus identified, is given prominence through the report relative to non-material issues.
Considering the importance of materiality, no assurance statement should omit an assessment of materiality. Before the organisation can score any ‘marks’ for the accuracy or veracity of its assertions and disclosures, it should at the very least have applied its mind to identifying and understanding the material issues relevant to its industry and its unique situation in the marketplace and in society.
Part Two: Assessment of management response
At this second level, the assurance model should align with the thinking of the investment analyst representing the shareholder. The model recognises that when reporting on non-financial capitals (the intangible value of a business), investors are more interested in the maturity of management than in the actual status of performance, given that non-financial indicators are so unreliable and non-comparable at this early stage in the no-financial reporting era.
Maturity of response should not impossible to rate. On a scale between ‘denial of the issue’ to ‘winning with fully committed organisational DNA’, it should be possible to judge the degree of accountability, oversight and response, strategy and action of the organisation. The <IR> principles, such as materiality and connectivity of information can likewise be applied to assist in the rating of the report’s credence.
Maturity of response indicates maturity of management: A high quality, mature management, prepared to recognise, consider, devise a strategy and work towards overcoming a challenge represents a far better bet to the investor than a management that exhibits pride in its status (which may even be relatively good at the time), but is not prepared to listen, consider, recognise or tackle challenges.
Not only does the Credence Model provide a qualitative assessment of where the company is on its reporting journey, but by assessing the maturity of management, it speaks to both the investment analyst (representing the shareholder) and to the company’s leadership. This direct engagement with leadership is destined to be the most powerful lever driving change and improvement in both reporting and actual management of the non-financial capitals of the business.
The FarSight Model of Leadership Maturity
From our research into decades of corporate reporting, and noting the significant difference between how mature leaders report against these five actions compared to immature leaders, FarSight developed a model for assessing leadership maturity in terms of how well companies respond to their most material issues. Every two months we analyse a sector of around eight companies on the JSE and submit our findings to the asset management industry through our channel partner, Legae Securuties, the first B-BBEE Certified Stock Broking firm in South Africa. Summaries of these findings, and how the model works, can be found at www.FarSightFirms.com
* Rob Worthington-Smith is the founder of FarSightFirms.com. The FarSight model analyses leadership maturity based on the IIRC’s Integrated Reporting Framework, an international standard designed to guide companies towards better reporting of their value creation story. In the SA asset management market, FarSight has an exclusive working partnership with Legae Securities.