Financial reporting standards stand at a crossroads

Why current methods for reporting companies' value – and values – must be revisited

Financial reporting standards stand at a crossroads

In recent years, conversations surrounding corporate purpose have taken a transformative turn, with more voices calling for companies to take a multi-stakeholder rather than exclusively shareholder-fixated mindset. Against that backdrop, some are proposing that long-held financial reporting standards are due for an overhaul – though it will by no means be easy.

“The explanatory power of the financial information reported to investors for market valuation has plummeted in recent decades,” said Christian Dreyer, CFA in a blog post published by the CFA Institute.

Referring to a chart from The End of Accounting and the Path Forward for Investors and Managers, he said that the explanatory power of reported earnings and book value with respect to corporate market value has deteriorated from 1950 to 2013. The authors of the book, Lev and Gu, proposed that GAAP reporting standards do not effectively capture the contributions of intangible assets such as internal research and development, which is why there’s an increasing tendency among analysts to consult non-accounting SEC filings.

“While their focus on intangibles is spot-on in principle, Lev and Gu’s definition of intangibles is too narrow,” Dreyer said. “I believe that focusing on financial information actively ignores an increasingly material and thus valuable source of information about a firm’s position in its environment.”

He argued that financial information, couched in terms of prices, offers a “noisy” picture of a firm’s environmental position. Since most environmental goods are not priced at all, he added, traditional financial reporting often fails to even capture that position.

However, he acknowledged that a focus on ESG and sustainability reports would not be feasible in the current context. ESG reports and ratings today are by and large voluntary and unaudited, with growing evidence to show that they “do not meet the standards of coherence and decision-usefulness that investors expect from financial reporting.” The frameworks underpinning ESG-related disclosures, he added, have been tailored to the “heterogeneous goals” of different stakeholder groups.

“We have yet to see a control framework for ESG reports that compares to that of their financial counterparts,” Dreyer said, noting that a single firm sees widely varied ratings across different agencies. “The signal-to-noise ratio in ESG reports and — consequently — ratings will be rather low.”

But on a hopeful note, he recognized that ESG integration in investment has been seen not to lead to inferior outcomes. Given that, he argued that once the ongoing pandemic crisis has been overcome, climate change will emerge as the top global priority, requiring a massive structural change in the world economy that will ultimately depend on a mandatory non-financial sustainability reporting framework.

“The output would need to be audited and follow similar standards of comparability, quality, and coherence as current financial reporting within a disciplined control framework,” Dreyer said. “I fully expect that the first decisive steps in that direction will be taken before the new year [2021] is out.”

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