Enhanced Transparency Using Narrative Reporting

Key Challenge

Using narrative reporting to provide greater transparency on business performance and to ensure that sustainability related information is useful to investors.

Background

Narrative reporting supplements and complements financial information by providing insights into an organization's performance that financial statements may not provide. Explaining how sustainability performance affects organizational performance and value can be best achieved with supporting narrative disclosures.

IFAC's 2008 report, Financial Reporting Supply Chain Survey: Current Perspectives and Directions, captured the importance of an increased emphasis on narrative reporting. Many respondents to the survey were pleased with the increased emphasis on narrative reporting, for example, by having an expanded management commentary in the annual report which included topics such as business strategy, risk management, business performance and more future oriented information. As one respondent put it, "Business reports better express what is creating value, where value is coming from, and what might threaten the value creation,".

Narrative disclosures are often provided within a structured management commentary (MC), although narrative reporting can refer to all financial and non-financial reporting not included in the financial statements or accompanying notes that informs investors on business performance.

The IASB's 2005 discussion paper Management Commentary defines it as:

Information that accompanies financial statements as part of an entity's financial reporting. It explains the main trends and factors underlying the development, performance and position of the entity's business during the period covered by the financial statements. It also explains the main trends and factors that are likely to affect the entity's future development, performance and position.

In different jurisdictions, MC is referred to as operating and financial review, business review, management discussion and analysis (MD&A), or management reporting. In its appendix B, the IASB's discussion paper usefully summarizes existing MC requirements covering the work of the International Organization of Securities Commissions, as well as country developments in Australia, Canada, Germany, New Zealand, US, UK, and the wider European Union. Many jurisdictions have created guidance for the narrative reporting that accompanies financial statements, and some jurisdictions mandate certain disclosures.

For example, in the UK, the Companies Act 2006 requires all companies, other than small ones, to include a business review within the directors' report. In the case of quoted companies, the directors are required - to the extent necessary for an understanding of the business - to report on environmental matters, the company's employees, and social/community issues. Where appropriate, the review should contain environmental performance indicators.

Narrative reporting is an opportunity. The PricewaterhouseCoopers 2007 survey of the Fortune Global 500 companies' narrative reporting found that the best reporters were companies providing relatively more contextual and non-financial information about their performance and prospects. Narrative reporting helped enhance transparency because it cut through the complexity and partial opacity of today's financial reporting. Its relevance for sustainability issues is that it is an opportunity to improve non-financial reporting on sustainability issues and therefore providing evidence that management recognizes both the strategic importance of sustainability, and how risk/opportunities may translate into future impacts on financial reports and statements. However, the 2008 KPMG International Survey of Corporate Responsibility Reporting shows that, despite the growth in corporate responsibility reporting, the majority of annual reports are issued without any environmental or social information. The survey report predicts over the next decade a greater demand and aptitude for environmental and social data by traditional financial report readers.

Although disclosure about the financial impact of sustainability issues, including climate change, might be included in financial statements, additional disclosure in narrative reporting (either in MC and MD&A or more generally) provides management with an opportunity to explain the context in which sustainability issues have impacted, or may impact, financial conditions and results. Unfortunately, disclosures in MC and MD&A are often criticized for providing only superficial explanations and too much positive spin. The key considerations are focused on enhancing the usefulness of reporting in MC. These are generic and can apply to narrative reporting more generally. However, there are good examples of narrative reporting on sustainability issues at http://corporatereporting.com, PricewaterhouseCoopers' corporate reporting initiative which examines common themes emerging around narrative reporting.

Two notable good practice examples (published in Trends 2006) are:

Novozymes, a world leader in bio-innovations, was recognized as providing a clear link between its sustainability and financial performance. The Group presents graphics to outline trends across key financial and non-financial indicators over the last five years, describes efforts to increase the measurability of non-financial targets for sustainability and discusses the wider financial and environmental benefits of improving production efficiency.

Gap Inc uses its annual report to summarize the Group's commitment to social responsibility and its importance in attracting employees and delivering long-term shareholder value. In its corporate reporting it also articulates the importance of supply chain relationships to its future sustainability, supported by a candid discussion of supply chain performance (see Engagement of Suppliers).

The IASB plans to issue Guidance on Management Commentary in 2009. In the meantime, its 2005 discussion paper Management Commentary offers useful advice on purpose, preparation, and content. Caption 33 also includes helpful questions management might want to ask when deciding what issues to disclose related to climate change (but are also useful questions when considering other sustainability issues).

Key Considerations

Defining the audience: Although MC is viewed by some as a communications vehicle for a broader set of stakeholders, most jurisdictions define its users as shareholders - the providers of risk capital. Some jurisdictions acknowledge the relevance to a wider set of stakeholders, although shareholders are typically recognized as the primary audience, whose needs are therefore paramount. To have a shareholder perspective, MC should not be seen as a replacement for other forms of reporting addressed to wider stakeholder groups, such as sustainability and corporate responsibility reports. Therefore, materiality (see Determining Materiality) should be viewed in the context of what information management believes is important enough to enable an investor to understand the financial statements. This can be challenging and requires an assessment of the potential significance that might reasonably be expected to influence investors' decisions. For example, an environmental and/or social impact may take time to develop. Therefore, management should be cautious and identify any doubt about materiality in favor of disclosure but at the same time avoid disclosure of immaterial information.

Avoiding over disclosure: As is the case for other aspects of business reporting, the challenge for sustainability-related disclosures in the MC (or in separate reports) is to avoid disclosing too much information. For example, disclosing all risks that an organization faces could reduce the visibility, and therefore the relevance and understandability, of key risks. The relative importance of various issues and risks can be conveyed in a meaningful way. IFAC's recent Financial Reporting Supply Chain survey found that although respondents felt that the financial reporting process had improved, the usefulness of financial reporting had not. Respondents supported the inclusion of more non-financial information. In particular, they felt that companies needed to improve their reporting on corporate social responsibility issues and environmental issues. It was commented that, "We have done the financials to death but left the other important aspects of reporting untouched."

A practical way to improve disclosure is to ensure clear presentation. For example, Nedbank Group Limited, the South African banking group, according to PricewaterhouseCoopers' corporate reporting initiative, makes extensive use of charts and diagrams to make its risk section more engaging and easily accessible. The group clearly explains, with the aid of a diagram, how its risk management process is one of its 12 strategic objectives. The group then sets out, in a table, its key risk metrics and supports each one with a definition, measurement methodology and target for the level of exposure the group are willing to accept - defined as its risk appetite.

Ensuring a forward-looking orientation: the MC and narrative discussion is an opportunity for management to express its perspective on the direction of the organization. This allows investors to assess the strategies of an organization and the likelihood that those strategies will be successful. MC provides an opportunity to highlight those strategies and goals related to sustainability, and how they currently, and might in the future, impact performance. Management can also use the MC to explain what they are changing in their strategy in response to a changing risk profile. In relation to climate change for example, MC can help companies with significant environmental risk exposure to provide contextual information that cannot be effectively captured in financial statements. Such narrative reporting complements the historical information required by users to make economic decisions.

Connecting reporting to performance management: The quality of reporting in both the MC or in wider stakeholder reports is connected to an organization's process of performance management, measurement, and performance reporting. As far as possible, systems and processes used to provide information for internal decision-making should be integrated into external business reporting. Data and information collected internally should therefore be managed in a way that satisfies both internal and external reporting needs. Some professional accountants argue that the information needs of directors are broadly similar to those of investors, differing only in the level of detail required. The challenge is to ensure that both internal and external reporting demonstrate a cause-and-effect relationship between both financial and non-financial drivers, and business outcomes.

Identify the benefits of integrating sustainability reporting into annual reporting: The 2008 KPMG International Survey of Corporate Responsibility Reporting highlights that many advocates of corporate responsibility reporting contend that such data are helpful to analysts, investors, senior management, boards, and other users of annual reports because it helps to show a more three-dimensional view of the company's current value and future potential. The survey shows that there seems to be progress toward integrating economic, environmental, and social data in annual financial reports. Results show that 20 percent of the largest companies in Brazil and South Africa integrating their sustainability (corporate responsibility)and annual reports, and Switzerland, France, Australia, and Norway not far behind. But overall, integration in large companies remains the exception not the rule.

Caption 34 covers investor oriented climate change disclosures in Japan. The research usefully shows how it is necessary to think about how disclosures should be assigned to each report (i.e. the annual report including MC and other narrative disclosures and a separate sustainability report). Companies may need to consider policies and approaches that help them place disclosures, and to improve them, for example improving the explanation on emissions boundaries. Despite low levels of full reporting integration, the KPMG survey found that nearly half the Global Fortune 250 companies that issue stand-alone corporate responsibility reports are making reference to key environmental and social data in their annual reports. This reflects the growing interest and demand for sustainability data from analysts, investors, and company leadership.