The days of believing that a company's profit and loss account is the ultimate indicator of future performance are over. Investors, regulators, and other stakeholders are acutely aware that there is much more information that a company can disclose outside of the usual financial reporting. This nonfinancial data can provide a better understanding of the business' long-term risks as well as how those risks are managed.
Many companies fail to see — and leverage — the benefits that a better understanding of nonfinancial risks can have on the long-term viability of their business, known as corporate sustainability. Instead, companies either choose to ignore investor and regulatory demands for more information or pay lip service to them, regarding such requests as box-ticking compliance exercises instead of opportunities to understand, manage, and exploit nonfinancial risks for their future benefit.
Standards and frameworks have been developed worldwide to help organizations examine and understand the impact of environmental, social, governance (ESG), and other long-term risks to the business, and how they can recognize — and realize — opportunities stemming from them. In 2011, the Sustainability Accounting Standards Board (SASB) was set up to provide "an expanded accounting language that communicates what yesterday's performance means for tomorrow's prospects." The SASB has attempted to make such disclosure easier for companies, even having developed specific standards for 77 different industries so that companies can more easily identify ESG issues that are most likely to be financially material in a given industry.
Internal Auditor spoke to Jeffrey Hales, chair of the SASB Standards Board and sector chair for Financials and Renewable Resources and Alternative Energy and the Charles T. Zlatkovich Centennial Professor of Accounting at the University of Texas at Austin, about the benefits for companies — and stakeholders — of digging deeper into nonfinancial risks, and what role internal audit should play in the process.
Are companies seeing the value of nonfinancial reporting measures?
Good financial reporting is important, but I also recognize the limitations of traditional accounting. Now there is so much more information that can be drawn from to get a better understanding of corporate strategy and performance than just numbers relating to assets and liabilities. Over the past five years there has been a significant drive by investors demanding more information about companies' long-term goals and strategies, and how these organizations are assessing, preparing for, and mitigating long-term risks such as climate change. If investors think this information is important, then companies are far more likely to engage and align their reporting with investor expectations. And as soon as some leading companies make this move — and many have — more will follow.
Which industries/types of companies are the best adopters of the Standards and are living up to their spirit? Similarly, which industries are lagging?
Carbon- and energy-intensive industries — such as oil and gas, mining, and infrastructure companies — have been among the best early adopters of the SASB and other sustainability standards. This is partly because they were the first industries to come under closer investor scrutiny regarding the impact they were having on the environment and what steps they were taking for the future of the business as the world moves toward greener, renewable energy. Slower adopters include service industries that have felt that their operations do not have the same kind of environmental or social impact as large-scale mining and manufacturing companies, for example. However, as investor and activist pressure mounts, we expect to see a change in the way that they report and the information they disclose.
Five Reasons for Adoption
Hales offers these key takeaways for internal audit to help the board and executives understand why adopting the SASB Standards makes sense for both corporate governance and corporate performance. There are obvious benefits for internal auditors to push for their adoption.
- SASB Standards are focused on financial materiality and long-term value creation. They are also aligned with The IIA's mission and internal audit's professional values.
- The Standards are detailed and specific, and they provide suitable criteria for assurance. Tests also can be built around them, which means there is a strong role for internal audit involvement.
- Directors are increasingly being given oversight of ESG and sustainability issues — especially audit committees — so it is important that internal auditors support them by using a globally recognized framework to provide them with the level of assurance that they need to inform long-term decision-making.
- Investors are demanding more information about sustainability issues. Therefore, it makes sense for internal audit to push for ESG disclosures to be aligned to an established framework so that their companies' sustainability reporting meets investor expectations.
- Sustainability is not just about reporting — it is primarily about managing the risks. Naturally, internal audit, in particular, is going to play a crucial role when it comes to providing assurance, assessments, oversight, and advice related not just to the reporting of this information, but also how sustainability risks are managed internally within the company.
Are companies adopting the Standards and reporting differently based on their geography?
Adoption of SASB Standards in the U.S., Europe, and Asia-Pacific region is generally good. However, language barriers have halted progress in some regions, such as South and Central America, which is why we have been working on translating the Standards and SASB guidance into Spanish. French, German, and Japanese translations are also on the way.
European companies have perhaps been given an additional incentive over their U.S. counterparts to adopt the SASB Standards. The European Commission has been specific about the types of issues that need to be disclosed under the European Union's nonfinancial reporting directive — though it is up to companies how they do so. It has openly stated that adopting the SASB Standards — or other established ESG standards and frameworks, such as those produced by the Global Reporting Initiative and the International Integrated Reporting Council — is one way of complying with the requirements. As a result, the Commission's recommendation is a great example of a regulator telling companies that following the SASB Standards would be one way to deliver compliance in nonfinancial ESG reporting.
The U.S. Securities and Exchange Commission (SEC), however, has not been so explicit. It has said that the Standards are helpful, but has neither specified which particular standards nor has it been prescriptive about how they would help. In fact, the SEC has been more principles-based in so far as if there is a material issue, companies need to disclose it, but there are no real specifics about how they should best achieve this. For example, the SEC recently asked for more disclosure around the issue of human capital, but it did not specifically say that using SASB Standards — which have metrics to help evaluate the impact — are a way of complying with this rule. The SASB has put out guidance detailing how our Standards can help companies comply.
Rather than singling out issues for companies to report on — which potentially risks them taking a box-ticking approach to ESG issues — the SEC is relying on the idea that if it is important, you ought to be talking about it. That approach is likely to change. The SEC has recently called for comment on climate-related disclosures and what information investors need, and it has also put forward a review on the quality of climate-related disclosure to make sure that climate risks are discussed in a way that is meaningful for investors.
Are there noticeable differences in SASB adoption in different countries if national regulators endorse the Standards specifically?
Every region works differently in terms of "push and pull." In some countries, private sector efforts and investor demand have pushed companies to disclose, while in others, government has stepped in to set policy and pull corporate reporting in a particular direction. Strong government backing for companies to endorse sustainability standards is obviously a major result for any standards-setter. For example, the Securities and Exchange Board of India recently said that the top 1,000 companies need to report on sustainability issues, and specifically mentioned that the SASB Standards would be a way of helping them do that.
But even if governments or regulators do not specifically back the SASB Standards, or do not call for better or deeper ESG reporting, it does not mean that sustainability issues just sit on the backburner or are ignored. In fact, we have found that lax regulation actually leads to a greater need for information. If reporting/disclosure requirements are not mandated, investors will simply ask for the details anyway, especially if that level of disclosure is called for in other countries. There is now a much greater understanding among companies that markets are global and that there is a much broader expectation that ESG needs to be reported in a way that reflects the kind of information that investors and other stakeholders are used to getting around the world.
How has shareholder activism influenced SASB Standards?
There can be no doubt that investor demands have driven meaningful change on ESG reporting. There has certainly been a change in the expectations that investors are pushing for and the kind of disclosures that they want from companies. There is also more pressure on asset managers about the kind of ESG information they should be asking for from companies they are prepared to invest in.
There is also evidence that shareholder proposals are getting increased support around key sustainability issues from institutional investors and other large asset owners, such as pension funds. Other trends, like active portfolio management — which is used by investors to monitor which companies are positioning themselves to better manage ESG issues and how they may impact the business — are also gaining momentum and are making a significant impact.
What role can internal audit play in sustainability reporting and promoting the benefits of adopting the Standards?
Sustainability is inextricably linked to corporate strategy and not philanthropic endeavors. The management of ESG issues is at least as important as the reporting of them. Sustainability means thinking about material risks and opportunities that relate to a company's business. When you start to see it through the lens of strategy, risk, and opportunity, then the role of internal auditors comes into focus because their mission and professional responsibility is to help companies assess what those issues are and manage them through assurance, advice, and insight.
Internal auditors can play a key role in helping to assess, manage, and provide insight around key sustainability issues. They should make the link between sustainability and effective long-term corporate governance very clear, as well as spell out how material risks will impact the operations and future of the business. The function explains these issues (and the risks behind them) to the board and can recommend that management put any necessary controls in place to help mitigate potential shocks arising from them.
Over the years a much stronger focus on sustainability issues has developed at the board level; the role of the audit committee is increasingly focused on managing these issues and it is, therefore, a key opportunity for internal auditors to connect with the audit committee and help them recognize that part of the committee's responsibility is not just making sure that financial reports are high quality, but also that sustainability issues are interconnected with financial reporting and that nonfinancial information also needs to be of equal quality.
We know that so much more information is pertinent to the performance of a company than the figures relating to assets and liabilities. We now understand the importance of recognizing other sources that have implications for the financials going forward, as well as managing that information, acting on it, setting targets, and assessing performance. The accounting profession is central, but it has been a challenge — even for a professor of accounting like me — to push the importance of sustainability information. Even the CEO can be more receptive to the merits of nonfinancial reporting than the finance, investor relations, and accounting teams.