A few weeks ago, I had the opportunity to visit Zermatt, in Switzerland. The village is one of the most prominent mountain destinations in the world. And for sure the one hosting the most famous trademark of Switzerland: the Matterhorn.
The shape and the uncontestable beauty of the mountain have made it one of the most pictured spot in the world.
Zermatt had the chance to face the most beautiful side of the mountain. The touristic development of the destination is uncontestably associated with the presence of the Matterhorn.
How many people would be visiting the site if the mountain was not there? Without hesitation, we could say significantly less. The alpine village has been gifted with the presence of this natural masterpiece that has made the fortune of the villagers.
The economic importance of the Matterhorn for Zermatt is crystal clear. In which other situations the presence of rare, localized resources is creating a competitive advantage? In other contexts, such resources are humans.
Think about the local know-how developed in some areas associated with industrial clusters, like watchmaking in Switzerland or shoemaking in Italy. Again, companies can leverage on a competitive advantage just for being in specific regions and relying on local resources.
How do companies identify and manage such elements? Understanding the existence and importance of human, natural resources is not always as straightforward as with the Matterhorn. Even when those elements are identified, how do companies account for them?
Currently, there are significant limitations in managing these resources and such limits are reflected in the financial system.
THE CURRENT LIMITS OF FINANCE AND ACCOUNTING
In the last decades, the market value of the companies has been slowly shifting between a valuation based on tangible assets, such as financial and manufactured capital, to one focused mainly on intangible assets, as the human, intellectual and natural capital.
Currently, around 80% of the market value of the S&P 500 companies is determined by intangible elements. These assets are mostly not recognized in their financial reporting standards despite representing the most significant part of the market value.
Under International Financial Reporting Standards (“IFRS”), the most used accounting standards globally, the reference to intangible elements is limited.
For instance, the only accounting standard specifically dedicated to natural resources is IFRS 6 “Exploration for and evaluation of mineral resources”. However, the scope of the standard is limited to mineral, oil, natural gas and other non-regenerative resources.
International Accounting Standard 38 (“IAS 38”) is detailing the cases when an intangible asset, whether purchased or self-created, can be recognised in financial reporting. IFRS 3 Business Combinations is defining the accounting treatment when an acquirer obtains the control of a business (e.g. an acquisition or a merger). In this case, the accounting valuation of the company purchased is relying also on intangible elements as human capital.
Nevertheless, the level of detail provided by IFRS and IAS concerning intangible assets is limited and thus, creating significant difficulties in considering them in current accounting practices.
The difficulty to account for elements as human, intellectual and natural capital is partially built in the standards. For instance, under IFRS, an asset is a resource that is controlled by the entity as a result of past events (for as purchase or internal development) and from which future economic benefits (inflows of cash or other assets) are expected.
The concept of the ability to control the asset is making more rigorous and certain the application of the accounting standards but it is limiting their reach.
Consider the case of a highly qualified workforce. In many occasions, a motivated workforce is the most valuable asset of a company. Still, workers can quit the company whenever they want. Thus, human capital is not recognized as assets under IFRS as it cannot be controlled by the company.
It may seem obvious that a company is not “owning” a worker. Nevertheless, by hiring a person, a company is borrowing his knowledge and capabilities which are lost when the employee is quitting.
The main accounting impact of valuable employees leaving a company can be identified in the variation of the goodwill. The goodwill is an intangible asset quantifying the value of a company including elements as the brand name, good customers and employee’s relations. Still, determining such value in accounting terms is a challenging task and is applicable only in limited cases (e.g. again in an acquisition or a merger).
The failure to account for externalities is another relevant shortcoming. From an economic perspective, an externality is a consequence of an industrial or commercial activity which positively or negatively affects other parties without properly being reflected in market prices.
In this case, externalities can be managed and controlled by companies. Nevertheless, since externalities generally do not have a market price, they are not impacting the bottom line of companies and are not reflected in accounting.
CLOSING THE EVALUATION GAP
Integrated Reporting was created to provide a framework to close this evaluation gap. The core concept of Integrated Reporting is that the value of a company is determined not only by the financial performance but also by non-financial factors as the reputation, the reliance it has on the environment, human and natural capital and other non-financial resources.
All companies are increasing, decreasing or transforming capitals with their activity. Independently from the fact that the capitals are owned or controlled by the company.
The framework has the objective to substitute financial and sustainability reporting and it requires companies to adopt a new perspective. Where companies are using these types of capitals to transform them into financial, social and environmental ones.
Integrated Reporting is closing this gap as it targets to communicate a clear, concise, integrated story on how such resources, defined as capitals, are being used to create value.
South Africa is leading the way in Integrated Reporting as it is mandatory for companies listed on Johannesburg Stock Exchange since 2009.
FROM REPORTING TO MANAGING
Integrated Reporting is not only a tool to be used by finance and reporting functions. It is representing a new way of thinking. The base for Integrated Reporting is integrated thinking as a principle that should be embedded into the organisations.
For companies to be efficiently managed, it is crucial to recognize what are the capitals that are contributing to the value creation process and how such process is taking place.
You cannot manage what you cannot measure
The ability to fully understand the value creation process for all the different types of capital considered is bringing the following advantages at the corporate level:
- Breaking-down the silo between the different departments and providing a more comprehensive way of thinking at the different levels of the organisation
- Better internal monitoring, understanding of the business and greater clarity at a strategic level
- Enhanced management of stakeholder relations and ability to satisfy their interests
A significant challenge can be identified from finance professionals. It relates to the need to guarantee comparability in standards and measures to monitor the performance concerning intangible capitals.
The existing accounting standards have the objective to limit such variability in the evaluation and ensure comparability between different companies and industries. To subsequently being able to identify relevant KPI’s allowing to provide companies with a compass to define the direction to follow.
From this perspective, an increasing number of initiatives and standards are being set-up to provide a frame of reference for the evaluation of intangible elements in the reporting practice.
Relevant examples are GRI (Global Reporting Initiative), SASB (Sustainability Accounting Standards Board) or the Natural Capital Protocol. Offering the possibility to be included into Integrated Reporting and with the aim of providing a frame of reference to efficiently manage, account and report for such elements.
HOW: A PRACTICAL APPROACH
The first step is related to internal and external stakeholder engagement. It is required to understand the different capitals, the existing interdependencies between them and how they contribute to the value creation process of the company. Awareness creation is a first important step that has the potential to bring significant improvements.
The focus is on material elements for which the impacts are deemed to be more relevant for the company. This is taking into consideration also the perceptions as they may have a significant business consequence (e.g. decrease in customer demand).
The concept of materiality is representing one of the very few occurrences in which finance and sustainability professionals are relying on a similar vocabulary. Despite slightly different perspective and nuances, the term refers to both classes to the need to focus on the most impacting elements.
The ability to find analogies and define a common vocabulary is representing a crucial challenge to gain internal traction in Integrated Reporting and sustainability initiatives in general.
A descriptive assessment of the capitals used is representing the base to subsequently quantify and qualify the impacts of the activities of the company on the capitals. With the objective to identify relevant KPI’s that can be integrated into the corporate decision-making process.
The last step is related to the monetization of the capitals and impacts. This is allowing to define a bottom line that is considering the use of the different capitals and thus, externalities.
Such approach represents also a risk management tool allowing to monetize the potential financial impacts of new compliance requirements (e.g. related to climate change).
The choice between descriptive, qualitative, quantitative or monetary analysis is highly dependent on the type of capital being considered. Starting from a descriptive narrative, the objective is to progress with an increasing internal level of maturity in the integrated thinking process.
To subsequently manage to perform qualitative, quantitative and when possible, monetization analysis related to the stock and flow of the different capitals.
HOW: SPECIFIC CASES
As an example, consider the case of a company that after stakeholder engagement identifies the following material capitals which are crucial for its value creation process.
Financial and manufactured capital are not included in the example due to the fact that the current accounting standards and industry KPI’s can be used.
How do companies manage to define relevant measures to monitor such capitals and integrate them into their decision-making process?
- Human capital
The cost to replace an employee is representing a valid approximation that includes all the direct and indirect costs incurred to find a substitute. Direct costs are the recruitment cost necessary to find a replacement. Indirect ones relate to the cost of the on-the-job learning and the time spent to acquire the knowledge to reach full autonomy and potential of the employee. KPI’s: turnover, absence rate and employee satisfaction
- Natural capital
CO2 Life Cycle Analysis and accounting software are allowing to determine the emissions associated with different activity levels. High emissions have the potential to financially impact companies for lower customer retention, decreased brand-value and compliance risks (e.g. carbon emissions credits). KPI’s: energy efficiency, waste production and use of renewable sources.
- Intellectual capital
For innovating industries the patents are possibly the most important element with a direct impact on sales and brand value. KPI’s: spending in R&D, employee retention, new products developed.
The degree of complexity to account for each capital is significantly different. Yet, currently, such elements are not accounted for despite representing the most relevant part of the market value of the companies.
The approach used may have limitations and significant variability. Depending on the approximation used and the assumptions made. Nevertheless, it is offering the opportunity to integrate such measures in the decision-making process of the companies as in internal controlling and monitoring functions.
Furthermore, as mentioned earlier, an increasing availability of standards and references is existing to account for such elements and to decrease their variability in the evaluation.
“Knowing yourself is the beginning of all wisdom.”
Managing an asset like the Matterhorn may not seem possible. Even so, it can’t be denied that the success of Zermatt is strongly correlated with the presence of an amazing intangible: the Matterhorn itself.
In other situations, the existence of valuable capital is not so easy to determine. As it is the case with different types of capital, as human, relationships, or other natural capital. Which are the ones that are ultimately responsible for the existence and the success of companies?
Business life should be regulated by the same principles of personal development. What are the distinctive qualities and traits that are making you successful (or not)?
The effort to understand yourself, your strengths and weaknesses and the relation with the context in which you operate is one of the best investment you can make.
After all, would you be confident in managing yourself when you are not aware of most of the variables that are determining your success?
Michele Soavi is an independent consultant supporting companies in creating value and innovating from a financial, social and environmental perspective by leveraging on the analysis of their business model, financial information and data