Changes in corporate reporting

Piotr Biernacki

12/03/2021

In the next two years, we will witness a fundamental change in corporate reporting. It will be implemented through a revision of the directive on non-financial information disclosure but it will primarily cover the architecture of corporate periodic reports. Its main goal is to make reports follow the reality and to make investors understand how companies create value.

Financial reporting has developed over hundreds of years, but the last century has been a period of the most dynamic changes. The balance sheet was complemented by account of results, then by cash flow statement, followed by other items, such as more and more detailed notes. However, despite this development, financial statements still mainly discuss changes of the two types of capital that is used to create (or destroy) value: financial and manufacturing capital. The other four types of capital, namely, natural, human, social and intellectual capitals have not been properly represented in financial statements.

After all, the value is created or destroyed by a company using all six types of capital. Failure to consider them in financial statements is the reason why an increasing rift between the book value and the real valuation of companies has been observed for years now. At the same time, despite extensive work, the International Accounting Standards Board has not yet developed good enough and commonly accepted standards that would allow for considering intangible values in financial statements.

New NFRD

The EU regulator was aware of shortcomings of financial reporting in this area when, in 2014, it passed the Non-Financial Reporting Directive (NFRD). It was applied only to the largest companies (simply put, those with over 500 employees) and it did not lead to unification of reporting. This was clearly indicated by the respondents of the consultative process during the review of NFRD application that was carried out last year. The new directive is to address these challenges and make corporate reports meet reality to a larger extent.

The amended directive will determine what companies are to report on sustainability development issues and how. In practice, these changes will cover four key aspects: subjective scope of regulations, reporting architecture, report object and quality of information.

Who will the reporting requirement apply to?

The requirement to report on sustainability issues will be extended and, although today we do not know the outcomes of the legislative work, we can be quite sure to indicate which companies should be subject to the new regulations. This is based on the opinions collected by the European Union during its consultative process with different stakeholders, mainly from financial institutions and companies themselves. It is most likely that the requirement will apply to all listed companies and large private companies, and presumably also small and medium-sized enterprises, however the reporting of SME would be proportionally smaller in its scope.

New reporting architecture

The new reporting architecture will be based on two pillars: financial statements and sustainability statements. These pillars will be bonded with the activity statement. As a result, information on the ways of using all types of capital will be treated equally. To a similar extent, the contents of two types of statements will be precisely defined. The statement on activities will remain the document in which the management board will comment on past achievements and outline future plans. An important thing is that the current name raporty niefinansowe is planned to be retired for the sake of a wider and more independent notion of zagadnienia zrównoważonego rozwoju. We do not know yet if these Polish terms will remain because the EU-level work is carried out in English which offers the terms ‘financial statements’ and ‘sustainability statements’. ‘Sustainability’ does not have an elegant translation to Polish and zagadnienia zrównoważonego rozwoju has just the closest meaning to the English original.

New reports – topics, layers and areas

Reports are to focus their objective scope on all sustainability aspects related to four types of capital that are not covered in financial statements and their relations with the company. These issues, categorized in three topics, will be reported on three layers in three interfluent areas. We can thus try to imagine such a report to look like a solved Rubik’s cube that is made of 27 small cubes.

Three topics to be covered in reports are the so-called ESG+ topics. The E (environment) area will include issues on combating climate change, adaptation to climate change, water and sea resources protection, circular economy, prevention of pollution as well as protection of biodiversity and ecosystems. Sounds familiar?

Indeed, these are the exact same six topics which are linked to the environmental goals defined in the regulation 2020/852 on Taxonomy. The S (social) area will cover issues related to ensuring compliance with international human rights norms, including the UN Guiding Principles on Business and Human Rights and OECD Guidelines for Multinational Enterprises, labour issues, including those related to workers in the whole value chain, relations with local communities and wider community as well as issues related to clients and consumers. The detailed structure of the S area will be worked out as part of the Platform on Sustainable Finance which has started its project to define the Taxonomy in the social area. The G+ area will include not only corporate governance issues but also ethics, managing relations with stakeholders and business partners, management governance, research and development as well as communication, reputation, and brands.

The three layers of reporting are related to indicators which are uniform for all companies, uniform for a given sector and specific to a given company. The first group, which is relatively small, will ensure comparability of reports of all companies. The second group, the most comprehensive, will allow for an accurate comparison of companies which are similar to one another as they operate in the same industry. Using them, investors will be able to determine how companies deal with multiplying capital and how they address identified risks, threats and opportunities. The third group will allow companies to consider in their reports outstanding issues which were not reflected by the indicators that are uniform to all companies or a given sector.

The three areas of reporting are the issues of strategy, its implementation and efficiency measurement. The area of strategy is basically uniform for the whole company or group and should include information about the business model and the company’s growth strategy, identified material risks, threats and opportunities related to sustainability issues and the ways in which the company impacts these issues as well as information on corporate and management governance. In relation to each of the material sustainability issues, there should be a description of policies, established goals and planned actions as well as allocated resources, which accounts for an area of implementation. This information, together with historical results (for the reporting year or a few previous years) should also create the expected perspectives the company has in relation to a given issue in future.

Reporting standardisation and verification

Quality of information in sustainability reports will be ensured by a collection of tools. One of them is standardisation. Reports will be prepared in accordance with uniform European standards, contrary to what takes place today when companies can quite freely choose what standards or guidelines to apply. Thanks to unification of reporting standards, it will also be possible to introduce an obligatory verification of reports. An obligatory audit was one of the most common demands raised during the last year’s consultation carried out by the European Commission. Thanks to standardisation, it will be possible from the very beginning to digitalize the new reports, i.e., they will be prepared in the iXBRL format using the applicable taxonomy. The EU institution issuing the new reporting standards will also create relevant guidelines which will outline the requirements regarding the quality of information and data included in reports.

Changes in the coming two years

The reform of the corporate reporting system is an enormous project which is carried out under time pressure stemming from the needs of investors and financial institutions. In the next two years we will witness a simultaneous process of passing the amended directive and establishing an institution to set reporting standards and the very process of standards creation. The aim of all this is for annual reports for 2023 (published in 2024) to be prepared in accordance with the new model. These two years are the last call for companies which today do not prepare reports in line with the European Commission’s guidelines, so that they could spend that time to identify risk, build policies and establish working systems for collecting and consolidating non-financial data. There will be no time to do so later on and all shortcomings will be spotted by independent auditors who verify reports or by the very investors for whom comparing data reported by different companies will be very simple.

Work on the new sustainability-related information reporting system is carried out simultaneously at the regulatory and legislative levels (led by the European Commission) as well as at the level of designing the standards. The proposed architecture of the new reporting standards was created by a special group working by EFRAG, which I had the pleasure to be part of. Basing on the effects of our work, the standards will gradually be designed, consulted, and published in the coming two years by the institution issuing the standards. It is worth to keep an eye on this project and gradually introduce its outcomes in corporate management information systems.

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