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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.

SASB is focused on information useful to investors. In identifying the likely material information, it looks for impacts on revenue, such as demand for core products and services; costs, such as operational efficiency and cost structure; assets and liabilities, such as valuation; and cost of capital, as affected by governance, license to operate and risk.

Once widespread adoption has occurred, investors will be able to make the same kind of apples-to-apples comparisons of companies’ nonfinancial performance that they do with financial performance. Managers will be able to transform their financial models into more comprehensive business models that include the relationships between financial and nonfinancial performance. Such a development will be fundamental to the rapidly growing trend of ESG integration, which stems from asset owners’ putting increasing pressure on asset managers to take into account ESG risks and opportunities. The extent to which they are able to do this in a credible way — there’s a lot of so-called greenwashing in the investment community, just as there is in the corporate community — depends upon having relevant and reliable performance information.

Companies will benefit from SASB’s work as well. They will be able to focus on a limited number of sustainability issues, those most likely to impact value — on average, SASB standards have five topics per industry. They will also be able to compare their sustainability performance against competitors’, spurring efforts to improve. Boards of directors will also benefit, as they are under increasing pressure from investors and other stakeholders to take responsibility for more than a company’s financial performance. Since their duty is to the corporation and not shareholders alone, they need to find a way to exercise this responsibility. Information supplied by management to the board will enable them to do so.

SASB’s work has identified some of the major sustainability themes that are important to investors. Not surprisingly, the leading one is climate change, affecting 93 percent, or $33.8 trillion, of the U.S. equity market. Climate change issues vary across sectors, however, and include carbon intensity of oil and gas reserves, impact on crop yields, vulnerability of real estate, insurance, and event readiness in health care. Product alignment and safety issues — such as counterfeit drugs, food quality and nutrition, car and airline safety, responsible gambling and drinking, and product research and design — affect 80 percent of the equity market. Resource intensity and scarcity, such as round-the-clock health care facilities and data centers, fuel management in transport and rare earth materials in manufacturing, affect 75 percent of the U.S. equity market.

SASB’s work will contribute to the creation of the capital markets we need to ensure a sustainable society. One of the clear outcomes of the December United Nations climate change meetings in Paris (COP21) is an acknowledgment of the critical role the investment community has to play. The same can be said for the 17 Sustainable Development Goals ratified by the U.N. in September 2015. Standards are a necessary starting point but insufficient by themselves. They will have value only if companies adopt them, if investors use the information made available by them and — in the end — if they are subject to the same rigorous reporting and auditing requirements we have for financial information.

We should begin with the enforcement of existing regulation around Form 10-K disclosures. Ultimately, additional rulemaking will be necessary — as it was for financial accounting and reporting. Now is too soon, but with sufficient uptake of the SASB standards by companies and use of information based on them by investors, the follow-up could happen in the next three to five years.

Today’s priority is for companies to start using the SASB standards in their external reporting and for investors to encourage them to do so. In order for this to happen, the so-called quarterly reporting dialogue needs to change to a more meaningful conversation. As companies and investors start using information based on these standards, areas for improvement will be identified. Once a significant capital market “share” has been reached for SASB’s standards, the SEC can consider how best to make them mandatory.

Companies and investors only stand to gain by adopting SASB’s standards, and society and future generations will as well. It’s time to get on with it.

Robert Eccles is the chairman of  Arabesque Partners  an ESG-quant investment firm with headquarters in London and a research group in Frankfurt.  He is professor of management practice at Harvard Business School, and was the founding chairman of SASB.

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Brilliant!!!

Mar 05 2016 at 7:49 PM EST

Bridgette Malone, CFA, FSA Candidate Level 1