Financial reporting has evolved over hundreds of years, with the last century being the period of most rapid change. The balance sheet was joined by the income statement, then the cash flow statement, followed by other elements such as the increasingly elaborate notes. However, despite this development, financial statements still mainly discuss changes in two types of capital used to create (or destroy) value: financial capital and manufacturing capital. The other four types of capital, namely natural, human, social and intellectual capital, have not found proper representation in financial statements.
After all, value is created or destroyed by a company using all six types of capital. The lack of their recognition in financial statements has resulted in a growing gap between book value and the actual valuation of companies over the years. At the same time, despite its long work, the International Accounting Standards Board has not developed sufficiently good and widely accepted standards that would allow intangible assets to be recognized in financial statements.
New NFRD directive
The inadequacies of financial reporting in this area were realized by the EU regulator when it enacted the NFRD, or Non-Financial Reporting Directive, in 2014. It is only applied to the largest companies (in simple terms, those with more than 500 employees) and has not led to standardized reporting. During a review of the application of the NFRD last year, this was clearly pointed out by respondents to the consultation process. The new directive is intended to respond to these challenges and make company reports more in line with reality. The revised directive will specify which companies and how they are to report on sustainability issues. In practice, the changes will address four key aspects: the scope of the legislation's subject matter, the reporting architecture, the subject matter of the reports and the quality of the information.
Who will be affected by the reporting obligation?
The obligation to report on sustainability issues will be expanded, and although today we do not yet know the results of the legislative work, we can indicate with a high degree of certainty which companies should be covered by the new regulations. This is based on the opinions collected by the European Commission in the consultation process from various stakeholders, primarily financial institutions and the companies themselves. Most likely, all listed companies and large private companies will be covered by the obligation, and probably small and medium-sized companies, with SME reporting being proportionally smaller in scope.
New reports - topics, layers and areas
The subject of the reports is to cover all sustainability issues relating to the four unrecognized types of capital and their relationship to the company. These issues, arranged in three themes, will be reported on three layers in three intersecting areas. The report can thus be tried to be imagined as a stacked Rubik's cube, consisting of 27 small cubes. The three topics that the reports will cover are the so-called ESG+ topics. Area E (which stands for environment) will include climate change mitigation, climate change adaptation, water and marine resource protection, circular economy, pollution prevention and protection of biodiversity and ecosystems. Sound familiar? Yes, these are exactly the six topics to which the environmental goals defined in the Regulation 2020/852 Taxonomy are linked. Area S (for social) will include issues of ensuring compliance with international human rights standards, including the UN Guiding Principles on Business and Human Rights and the OECD Guidelines for Multinational Enterprises, labor issues, including those related to employees throughout the value chain, relations with local communities and the broader society, and customer and consumer issues. The exact structure of Area S will be agreed upon by the Platform on Sustainable Finance, which has begun work on defining the Taxonomy in the Social Area. The G+ area will include not only corporate governance issues, but also ethics, stakeholder and business partner relationship management, governance, research and innovation issues, and communications, reputation and brands.
The three layers of reporting relate to indicators that are uniform for all companies, uniform for a particular sector and company-specific. The first group, which is relatively small, will ensure comparability of reports from all companies. The second group, the most extensive, will make it possible to accurately compare companies that are similar to each other because they operate in the same industry. Thanks to them, investors will be able to determine who is doing well in multiplying capital and how they respond to identified risks, threats and opportunities. The third group will allow companies to include in their reports distinctive issues that could not be reflected by indicators uniform for all companies or for a particular sector. The three areas of reporting are issues of strategy, implementation and performance measurement. The strategy area is generally uniform across the company or group, and should include information on the company's business model and growth strategy, identified material risks, threats and opportunities regarding sustainability issues and how the company is influencing these issues, and information on corporate and management governance. For each material sustainability issue, policies, established goals and action plans and allocated resources should be described, making up the implementation area. This information, along with historical results (for the reported year or the past several years) should also lead to a presentation of the prospects the company expects for the issue in the future.
Standardization and verification of reporting
The quality of information in reports on sustainability issues will be ensured through a number of tools. One of them is standardization. Reports will be prepared in accordance with uniform European standards, rather than the way it is today, when companies are quite free to choose the standards or guidelines used. By standardizing reporting standards, it will also be possible to introduce mandatory auditing of reports. Mandatory auditing of reports was one of the most frequently raised demands during last year's consultations conducted by the European Commission. Thanks to standardization, new reports will be able to be digitized from the beginning, i.e. they will be produced in iXBRL format with the appropriate taxonomy. The EU body issuing the new reporting standards will also develop appropriate guidelines, which will specify requirements for the quality of information and data in the reports.
Changes in the next two years
The reform of the company reporting system is a huge undertaking carried out under time pressure due to the needs of investors and other financial institutions. In the next two years, we will witness the simultaneous process of enacting a revised directive, as well as the establishment of a reporting standard-setting body and the standard-setting process itself. This is all so that annual reports for 2023 (i.e., published in 2024) can be created in accordance with the new model. These two years are also the last bell for companies that today do not yet report according to the European Commission's guidelines to use the time to identify risks, develop policies and establish efficient systems for collecting and consolidating non-financial data. There will be no time for that later, and any imperfections will be picked up by independent auditors checking reports or by investors themselves, for whom comparing data from different companies will become trivial.
Work on a new system for reporting information on sustainability issues is being carried out simultaneously at the regulatory and legislative level (under the leadership of the European Commission) and at the level of standards development. A proposal for the architecture of the new reporting standards was created by a special group of experts working at EFRAG, in which I had the opportunity to work. Based on the results of our work, the institution issuing the standards will gradually develop, consult and issue them over the next two years. It is worth observing this work and gradually incorporating its effects into the companies' management information systems.
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