As this rather extraordinary year draws to its very welcome close, we reflect on what promise financial and ESG reporting might hold for the near future.
The explanatory power of financial information reported to investors for market valuation has drastically declined in recent decades. That by itself may not quite constitute the “End of Accounting” just yet, as Baruch Lev and Feng Gu called their book published in 2016 rather dramatically.
Nevertheless, this chart from their book should give pause to every stakeholder of financial reporting (the R2 value is a statistical proxy for the explanatory power of reported earnings and book value for corporate market value between 1950 and 2013). Recent market action will only have exacerbated the trend exhibited in the chart. 
What is the kind of information that investors should pay attention to for their forward-looking decisions in 2021? Lev and Gu argue that GAAP reporting does not sufficiently account for intangibles such as internal R&D, which is why analysts increasingly consult non-accounting SEC filings. They certainly have a point.
However, what with 2020 being the year of ESG going mainstream, I would argue in a different, although related direction: While Lev and Gu’s focus on intangibles is spot-on in principle, their definition of intangibles is too narrow. I believe that a focus on financial information actively ignores an increasingly material and thus valuable source of information about a firm’s position in its environment. Financial information will only recognise that position through the distorting lense of noisy prices, or not at all if no prices exist in the first place, which is still the case for most environmental goods.
So, should investors zoom in on ESG and sustainability reports and ratings, which are increasingly plentifully supplied, both by preparers and specialised commercial ESG rating agencies? Not so fast!
There is growing evidence that current voluntary (and usually unaudited) ESG reports and ratings do not live up to the same standards of coherence and decision-usefulness that investors are used to from financial reporting. Also, it is unfair to hold them to those same standards, as the frameworks (SASB, GRI, TCFD etc) that they have been created under cater to different stakeholder groups with heterogeneous goals. It is therefore unsurprising that there will be temporal inconsistency at the reporting layer (we are yet to see a control framework for ESG reports comparable to that of financial reports), and ratings of the same firm across agencies vary widely. The signal-to-noise ratio in ESG reports and – consequently – ratings will be rather low. Nevertheless, it is encouraging that integration of ESG factors in investment processes will not lead to inferior outcomes, a now refuted belief that has long been orthodox.
Once we have beaten the ongoing pandemic into submission, the global top priority will be to address climate change. Doing that will lead to massive structural change in the global economy, for which we currently have little material guidance at a granular reporting entity level. Investors will be very keen to understand the scope and impact of that structural change. Such guidance can be provided by a mandatory non-financial sustainability reporting framework the output of which is audited and follows similar standards of comparability, quality and coherence as current financial reporting within a disciplined control framework. In order to be decision-useful, its reporting output needs to be structurally aligned with financial reporting, for instance when it comes to segment reporting and structured reporting format, i.e. XBRL. For a more in-depth discussion of this, see our IFRS Foundation consultation response.
I am reasonably confident that the currently ongoing, high-powered revision of the EU Non-Financial Reporting Directive in conjunction with the yet to be formed IFRS Foundation Sustainability Standards Board will eventually (and rather sooner than later!) lead to the creation of such a framework. I fully expect that the first decisive steps in that direction will be taken before the new year ’21 is out.
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Christian Dreyer CFA is well known in Swiss Fintech circles as an expert in XBRL and financial reporting for investors.
We have a self-imposed constraint of 3 news stories each week because we serve busy senior leaders in Fintech who need just enough information to get on with their job.
For context on XBRL please read this introduction to our XBRL Week in 2016 and read articles tagged XBRL in our archives.
New readers can read 3 free articles. To become a member with full access to all that Daily Fintech offers, the cost is just USD 143 a year (= USD 0.39 per day or USD 2.75 per week). For less than one cup of coffee you get a week full of caffeine for the mind.
—————————————————————
Christian Dreyer CFA is well known in Swiss Fintech circles as an expert in XBRL and financial reporting for investors.
We have a self-imposed constraint of 3 news stories each week because we serve busy senior leaders in Fintech who need just enough information to get on with their job.
For context on XBRL please read this introduction to our XBRL Week in 2016 and read articles tagged XBRL in our archives.
New readers can read 3 free articles. To become a member with full access to all that Daily Fintech offers, the cost is just USD 143 a year (= USD 0.39 per day or USD 2.75 per week). For less than one cup of coffee you get a week full of caffeine for the mind.