Getting ESG Risk in Financial Statements May Need Investor Muscle

A Dutch non-profit focused on socially responsible investing wants ESG risk issues in financial statements. They may need investor help.

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Despite the rise in prominence of environmental, social and corporate governance issues, many corporations still do not include ESG risks into their financial performance. GRI, an Amsterdam-based non-profit focused on ESG, aims to change that.

Seventy percent of corporations, investors and rating agencies already use GRI’s framework for guidance in their sustainability reports, which are often an addendum to their financial reports.

Now GRI is working closely with accounting organizations like the American Institute of CPAs (AICPA) and the International Federation of Accountants (IFAC) to achieve this aim. Amy Pawlicki, a New York-based director of business reporting, assurance and advisory at the AICPA, tells Institutional Investor that they are focused on the “integration and conductivity” to ensure that the framework can be easily integrated into financial statements. AICPA takes a very broad view of sustainability; it reflects not just ESG issues but sustainability of the entity and long-term cash flow potential.

Pawlicki, however, declined to comment further on the specifics of the discussions as they are in their early stages. Nevertheless, they suggest major changes afoot at the AICPA, which is celebrating its 125-year anniversary this month.

Julie Desjardins, a regular advisor to Canadian Institute of Chartered Accounting, highlights the old adage that you manage what you measure. “There is clearly a lot of a company’s value that’s not captured within financial statements alone. So, you have this large intangible amount or large goodwill amount, some of which may be environmental and social issues that aren’t recorded on companies’ balance sheets and income statements,” she says.

When investors do want to quantify their ESG risk, they have no consistent framework of standards and regulations. Besides GRI, countries like New Zealand and South Africa have their own sustainability frameworks, while large accounting firms like Ernst & Young have their own proprietary model. And companies often disclose ESG risks in sustainability reports separate from their financial statements, while others like Munich-based financial services firm Allianz have integrated them into the management discussion section in their annual reports. The data tends to vary significantly by industry. Both Allianz and Wal-mart, for example, report emissions and green energy standards. However, Wal-mart also discloses figures around its certified sustainable seafood since it’s in the business of selling the product. Allianz is not.

The accountants who spoke to II do not believe there will not be a near-term solution within the next year or two. “The hard part is adoption. It’s very hard to mandate these types of disclosures. They tend to vary vastly by company and by industry in terms of what’s relevant to the stakeholder group,” says AICPA’s Pawlicki.

The first priority is to have a robust framework. There are efforts to set industry standards and harmonize the various standards globally. London-based International Integrated Reporting Committee (IIRC), which is working closely with GRI, is the most prominent example. The IIRC expects to release a prescriptive integrated framework that provides guidance details for measurements by industry sector by mid-to-late next year. Prior to that, GRI will publish their own prescriptive, but not as detailed, framework by next May.

Last November it released its own first guidance on the topic signalling a sense of urgency. Sir Michael Peat, chairman of the IIRC, said in a release that “the range of issues of issues – economic, environmental and social – which determine an organization’s success has never been broader or more pressing. It is for this reason that we need an approach to reporting that is fit-for-purpose in the 21st century. The world has changed – reporting must too.”

GRI is hopeful, but the IASB and the AICPA will move at a slower pace. For now, they’re focusing on the the E of ESG -- the environment. Recent work has revolved around climate change. Next week at the IASB’s board meeting in Connecticut, participants will discuss accounting interpretations for emissions trading schemes as a priority research project. “We are currently engaged in our agenda setting process and will be considering a paper on [ESG issues] at our board meeting next week. To date we have not made any decisions on ESG,” notes Ian Mackintosh, London-based vice chairman of the IASB.

There are other challenges besides the accounting boards’ slow approach. Ann Brockett, Calgary-based Americas climate change and sustainability leader for assurance at E&Y, explains that some of the hindrance may come from within the companies. First, all companies are going to need a strategy around implementing and integrating ESG risks, she says. Then they will need the processes and controls to collect the data. “I would say on the evolution as it sits today if you were to take sustainability processes and compare them to the financial reporting process, you would find virtually all companies have a very long way to go,” she says. “There is some work to do there to even pull the data to do it.” The process is not a quick one.

Desjardins points to compensation as another deterrent to progress. “The compensation of the managers of funds, and this is in accounting too, reflects a very short-term perspective. What have you done for me this month? This quarter? This year?” she queries. “Sometimes we need to take a longer term perspective on this, because sometimes there’s a bit of investment that need to be and there may be a cost to do it in the next quarter or year.” She suggests that basing compensation on quarterly or annual performance may be too short a time frame for ESG issues.

A final deterrence may be the investor community themselves. “One of the biggest challenges that we face is kind of an ironic one,” says Pawlicki, “is getting the investment community to demand this stuff in a consistent manner. If it is not coming from regulators, it has to come from somewhere.” Although many may have a clear idea of the way forward, they might not be able to agree on a standard. It may be up to a few active ESG investors to push changes at the board level.

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