Bringing a finance mindset into sustainability reporting: What lessons can we learn from the Conceptual Framework for Financial Reporting (CFFR)?
This blog was written by Jeremy Nicholls, member of the A4S Expert Panel, Assurance Framework Lead for the UN Development Program's SDG Impact Standards, and Co-chair of the Capitals Coalition’s Value Commission.
Reporting should meet the needs of users
For many accountants, we are so busy doing accounting that we don’t have time to step back and think about core concepts – and it’s often a long time since we’ve had to. The Conceptual Framework for Financial Reporting (CFFR), issued in March 2018, wasn’t even available when many of us trained.
Recent years have also seen a rapid growth in sustainability accounting and reporting. Which I think we can classify as a ‘good thing’.
I have now had the luxury – and, perhaps worryingly, the pleasure – of reading the CFFR at length. In doing so, I have been struck by the clarity it provides on what information is useful for the users of financial reporting.
When I compare CFFR’s clear focus on users and the generalized purpose behind their decisions with what we tend to see in sustainability (or ESG) reporting, I think there is a big gap. I struggle to see how current practices in sustainability reporting are providing the kind of information users need. The ongoing debates on improving practice – for example, discussions around financial or ‘double’ materiality – are important but mean we may be missing other equally critical issues.
Towards a social and environmental profit and loss account
The CFFR states that existing and potential investors, lenders and other creditors need information about:
- The economic resources of the entity, claims against the entity and changes in those resources and claims
- How efficiently and effectively the entity’s management and governing board have discharged their responsibilities to use the entity’s economic resources
The balance sheet and the profit and loss account, if you like.
Sustainability reporting generally either shows how social and environmental considerations affect the company’s financial reporting or shows the social and environmental impact of the company’s business model (or it does a mix of both).
Neither of these approaches to reporting are equivalent to a balance sheet, capturing social and environmental ‘assets and liabilities’, or to a profit and loss account, reflecting the social and environmental consequences of management’s stewardship of both economic resources and social and environmental dependencies. However, users of sustainability reporting – including those responsible for holding the entity to account – would surely find this kind of information useful, if not fundamental.
In particular, the profit and loss account doesn’t just show the business’s financial returns. It is effectively a summary of management’s decisions about how those returns are generated, all of which involved trade-offs. These trade-offs might include balancing the contractual interests of employees, suppliers, owners and government and the non-contractual interests of communities and the environment. In management accounting, we can quantify and compare the trade-offs, which helps us to make commercial decisions.
We need a sustainability ‘profit and loss account’ that does the same thing.
Transparent trade-offs in decision making
Making decisions about trade-offs when it comes to social and environmental impacts can be tricky.
Let’s imagine a ‘simple’ decision. In this scenario, a company is choosing between two options: Option A and Option B. Both are expected to have a positive impact on social and human capital – but a negative impact on natural capital. In deciding to go ahead with Option A, management has implicitly decided that the value of its positive impact is higher than its negative impact, and that this result is also better than they would achieve with Option B.
It is an uncomfortable fact that this is going to be the case for most decisions where the consequences will be a mix of positive and negative impacts.
It might be possible to measure both, using some standardized indicator. Choosing appropriate indicators is the subject of much debate, so let’s use a simple example. We can say that social and human capital improves by x and natural capital gets worse by y. In deciding to go ahead, then, the company has decided that the benefit to one capital of x outweighs the loss to another of y.
Imagine it were possible to ascribe a specific value to the loss, instead of a measure, and let’s say this value is 10. Then in Option A, the value of increase in capital is implicitly at least 11.
If those making the decision start to grapple with this reality, I suspect they would want the value to be more than 11 before they feel comfortable making the choice – but how much more? Another 10? Twice as much as this? More? And then what should be done about any negative consequences?
Now let’s think beyond this simple example. Imagine you could do this kind of analysis for all your business decisions and their associated trade-offs, using a common unit for quantifying relative values. It would then be possible to aggregate and report your results to show the overall effectiveness of management’s decisions. Even though there are few norms or rules to help us judge what an acceptable trade-off looks like – or determine that some trade-offs are not acceptable at all – at least users would get transparency about management’s decisions (and assumptions) and be able to act accordingly. And this would provide users with information similar to what they get from a profit and loss account in a financial report. We could call this a sustainability profit and loss account.
Enhancing the analysis of trade-offs
The CFFR recognizes that financial reporting is largely based on estimates, judgements and models rather than exact depictions. Equally valuing impacts is not going to be about finding the right answer to these decisions – it is about estimating the implicit and inescapable trade-offs, making them transparent and then aligning decisions with socially determined acceptable values.
There are now a growing number of approaches we can use to further develop the one we applied in the very simple example above. One possibility is to value the impacts from the perspective of the people that experience them. Applying this approach and using a common unit still can’t solve all the difficulties of interpersonal or even intergroup comparisons – but it does mean that our analysis of trade-offs can be informed by those most affected. Surely this would lead to a better result than decision makers reviewing their options behind closed doors based only on their personal perspectives.
I suspect that, to many of you, this is starting to sound like an impossible task. But the positive and negative consequences are hard to ignore.
I am a director of a company that sells furniture and reports on – and has had audited – the positive social impact of doing so. As our furniture includes cotton, we recognize that as well as the positive impact from our supply of furniture there are likely to be human rights abuses somewhere in the supply chain. Yet as a board, we have decided the positive impact arising from a business model that uses cotton outweighs the negative impact. And although we are now actively seeking to prevent and mitigate these impacts, and are considering how we could best make remediation in line with UN General Principles for Business and Human Rights, who are we to say one outweighs the other?
We do measure and seek to value our impact, informed by the people experiencing the impacts (our stakeholders) – so far we have measured both positive and negative impacts but have only valued positive impacts. And we accept that we do not get information from all our stakeholders, just a sample, and this is going to be imperfect. We think our imperfect approach is still better than if we failed to consider the impact of our decisions on our stakeholders at all. Better in helping us increase our impact. Better in making us think about how we can provide remedies for those who are experiencing negative impacts. Better in making us consider whether our business model and value proposition need to change.
How to get started
Start with the A4S Natural Capital and Social and Human Capital Accounting Maturity Maps, which will help you to assess what you are currently doing and how you can progress towards integrating natural, social and human capital into business strategy, decision making and disclosure.
There are more in depth tools and standards to help you value and report on your social and environmental impacts, including the Natural Capital Protocol and Social and Human Capital Protocol from the Capitals Coalition and the Social Value International Standards. You will also find examples of organizations using these and similar approaches on the A4S Knowledge Hub, and others collated by Capitals Coalition and Social Value UK.
These resources can help you develop a sustainability profit and loss account – or we can call it an impact account or even a well-being account – built on the same logic CFFR applies to making financial reporting more relevant for users. An impact account may have more uncertainty and serve a different purpose, but it would be a useful document that provides insight into how an organization deals with trade-offs. Developing such a report is certainly more useful for your stakeholders than saying nothing about how you balance the positive and negative consequences of your decisions.
This can be done and accountants are well-placed to take their knowledge of credible, transparent and user-friendly financial reporting and apply this to developing impact accounts in their own organizations. Accounting has been critical in supporting investment decisions that generate financial returns. It could, and should, make the same contribution to sustainability.