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Why Investors Should Care About the Next Generation of Accounting Standards

We take accounting standards for granted — whether it is the U.S.’s generally accepted accounting principles or the International Financial Reporting Standards. We shouldn’t. In the U.S., accounting standards did not come into existence until after the formation of the Securities and Exchange Commission in 1934. Prior to that, every accounting firm — and there were a lot more than the Big Four of Deloitte, EY, KPMG and PricewaterhouseCoopers — had its own accounting standards for how to measure and report on the items in the income statement and balance sheet.

Similarly, each firm had its own auditing standards, which obviously made it difficult for investors to compare companies’ performance to make investment decisions. Accounting standards, reporting requirements and rigorous auditing of the reported figures solved that problem. They also enabled companies to compare and benchmark their performance against one another, spurring competition and innovation.

The result is the deep and liquid capital markets we have today that have created enormous value. But because of a predominating emphasis on financial information, as well as an increasingly short-term focus of investors, there has been inadequate appreciation for how markets contribute to significant global problems such as climate change, excessive consumption of limited natural resources, pollution, waste and inequality. Part of the solution to these unpriced externalities created by companies’ activities is the development of accounting standards and reporting requirements for nonfinancial information: namely, a company’s performance on the material environmental, social and governance (ESG) issues that affect society and the company’s ability to create value over the long term.

This is the mission of the Sustainability Accounting Standards Board, a nonprofit organization established by Jean Rogers in 2011. Michael Bloomberg, former New York mayor, is the current chair, and former Securities and Exchange Commission chair Mary Schapiro is SASB’s vice chair. SASB’s approach is a simple but powerful one. Through a rigorous process, it identifies the material ESG information that should be reported on a company’s Form 10-K, or equivalent reporting document for non-U.S.-listed companies, and the recommended key performance indicator or metric for each issue. The ESG issues are grouped into the following five categories: environment, social capital, human capital, business models and innovation, and leadership and governance.

One big difference between financial and nonfinancial reporting is that the ESG issues likely to constitute material information are sector-specific. For example, a chemical company’s carbon emissions are material to that corporation but not a pharmaceuticals company, for which, instead, issues such as drug safety and side effects are material. For that reason, SASB has created a ten-sector classification system that comprises 79 industries. Provisional standards for all ten sectors will have been issued by the end of the first quarter of 2016.

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Mar 05 2016 at 7:49 PM EST

Bridgette Malone, CFA, FSA Candidate Level 1