Connectivity matters

How can a company that tells a positive overall story in the front of its annual report present a loss in its financial statements? And why has a newly announced net-zero strategy had no effect on asset values in a company’s financial statements? These are the types of questions investors ask themselves when they look at a company’s report.

Companies report essential strategic, sustainability and financial information to the capital markets, but too often the information in these three elements appears to be disconnected.

When this happens, investors lose confidence in the company’s reporting, which may result in a breakdown of trust between management and the company’s investors. Connectivity matters.

So, what do I mean by ‘connectivity’? The term is sometimes used in a narrow sense when discussing climate-related risks. Investors want to know how the climate-related risks they read about in the front of a company’s annual report have been reflected in its financial statements. I’ve written about that previously.

But I want to encourage a broader perspective on connectivity with the company’s business model and strategy at its heart.

A company’s report provides a window on its business. The financial statements provide one window; sustainability disclosures another; and management’s discussion and analysis (MD&A) another. Three windows on the same business. In my opinion there will be true connectivity when investors can recognise the same business model and strategy through all three windows – and when there is a consistent narrative that connects the dots between the financial and non-financial information presented in those windows.

Of course, investors also expect a company’s annual report to be consistent with its other capital market communications, including earnings calls.

So, what should companies be doing today? They need to take a good, hard look at the story they’re telling in the front part of their annual report and how their disclosures deliver a coherent and connected narrative. There are two actions companies can take now.

Firstly, remember that financial statement disclosures matter. Good-quality disclosures help investors relate the figures and information they see in the financial statements back to the underlying business – for example, when describing how the key financial judgements and assumptions reflect the circumstances of the business. The financial statement disclosures should also help connect the dots with the front part of the annual report, including the MD&A. These disclosures should help investors understand the financial implications and connectivity with the company’s strategy and business model.

Secondly, think about the reporting process. If the various elements of an annual report are developed in silos, it’s unlikely to deliver a coherent narrative. To achieve connected reporting, a single view of the business model and strategy should underpin the whole report. When investors can’t see this, they begin to question the clarity and focus of the business. So, I would encourage the various groups involved in preparing the annual report – finance, investor relations, risk management, sustainability personnel, etc – to work hand-in-hand to ensure connectivity, consistency, clarity and understandability.

To help companies provide connected information the world needs connected standard setting.

Corporate reporting has developed piecemeal around three separate pillars¹. Today, two ‘sister’ boards within the IFRS^® Foundation – one focused on accounting, one focused on sustainability disclosures – set the standards. Their joint meetings are an opportunity to help solidify the direction for connected standard setting. They have a strong base to work from because the standards share a common investor-focused objective.

The boards can focus on the complementary nature of their standards. The value of the financial statements is enhanced by the longer-term insight provided by sustainability disclosures. Equally, the value of the sustainability disclosures is enhanced by having the foundation of the financial statements and the broader context provided by the MD&A. Together, the boards can ensure their disclosure requirements help investors to recognise the same business through the window of each report and to see the relationships and interconnectivity of financial and sustainability disclosures.

There have been various suggestions for measures the boards could take. However, connectivity should not require management to publish its prediction of the financial consequence of inherently uncertain sustainability risks and opportunities. Nor should it result in the artificially accelerated recognition of sustainability-related risks in the financial statements. Neither would be helpful for investors.

But companies don’t need to wait for the standard setter. They should be demonstrating connectivity across their reports already – while keeping up with the current thinking of the boards.

Just to be clear, I am not advocating non-compliance with IFRS Accounting Standards. Some users demand things that are not required by, and are sometimes inconsistent with, IFRS Accounting Standards. What’s described in the front of the annual report won’t always be mirrored in the financial statements in the way they expect. It is important that companies both comply with the IFRS Accounting Standards and connect the dots between financial and non-financial information.

Get this right, and the annual report can build trust between  management and investors.

A version of this article previously appeared in ESG Today.