Graham Terry discusses a new era in corporate governance and management
It always amazes me that humankind can believe in an accepted “truth” for long periods of time without really challenging the foundation on which it is built. There are many examples in history, but for purposes of illustration I mention one: the belief that the world is flat. This view prevailed for centuries and at times individuals who suggested otherwise could end up facing a very cruel death. One can perhaps excuse such beliefs held during the Middle Ages because people in those days lacked the education and facilities to disprove the prevailing wisdom. However, even in this age there are people who believe that the world and the universe are merely a few thousand years old, ignoring vast evidence to the contrary.
I must say that I am not immune to this phenomenon. I too have believed in accepted truths only to find out later that I had been duped. In today’s world and in our own profession there is a widely held truth that is rapidly being exploded and that is that everything in business can be synthesised into financial terms and therefore you can run an organisation based solely on financial indicators.
I was brought up in an era when financial information was the measure of corporate performance, but over the years I have begun to realise that financial perspectives are important but they do not present a comprehensive picture. Accounting standards should give us a clue to the limitations because they exclude anything that cannot be measured reliably such as intangibles. Indeed, if an accountant values a business for sale he or she would usually recognise the intangibles to arrive at a reasonable price. The irony is that many people do not see evolving picture and still use financial metrics as the mechanism for measuring performance.
In 2011, the International Integrated Reporting Council published a very interesting graph in a discussion paper entitled “Towards integrated reporting: communicating value in the 21st century”. The graph illustrates dramatically how intangibles have contributed more and more to enterprize value over the past 30 years.
The graph shows the proportion of physical and financial assets to the capitalisation value of companies included in the S&P 500. In 1975, 83% of capitalised value was represented by physical and financial assets. By 2009 physical and financial assets represented only 19%. This should send a strong message that factors other than tangible assets are important in assessing the value and performance of organisations. From this one can deduce that directors and managers of businesses need to focus on a much wider range of factors than they did 50 years ago.
The International Integrated Reporting Framework (<IR> Framework), which was issued by the International Integrated Reporting Council in 2013, provides a strong signal as to how organisations should be reporting to provide a more holistic picture of performance and prospects. The <IR> Framework suggests that organisations use or are affected by six forms of capital. These include financial and manufactured capital that would normally be reported on in financial statements, but it identifies four other forms of capital. These are:
- Social and relationship
These are not new ideas. Indeed, most organisations have recognised the importance of these capitals to some degree for a long time; however, few have managed them as diligently as they manage financial capital.
What does all of this mean? It means that we are entering a new era in measuring performance and assessing prospects and in managing organisations. No longer are the traditional measures enough, because they only show part of the story.
Deficiencies in corporate reporting have been an issue for many years. Criticisms for obvious reasons become more vociferous in the wake of corporate collapses. We only have to look back to the effects of the Enron collapse to see this. After each collapse, regulators amend legislation and standard setters tighten standards in an attempt to prevent future collapses.
The problem with this is that they tend to address the specifics that caused that particular collapse and not the bigger problem.
If one looks at annual reports over the last few decades, they have become progressively thicker and heavier. People have jokingly referred to the “thud factor” as a measure of the quality of the report. The problem was that companies have realised that they need to provide more information about the business over and above the financial information, but this has generally been done in a way that has made them incomprehensible.
The IIRC embarked on a project to assist organisations to present information about performance and prospects in a more meaningful way so as to allow stakeholders to make important decisions. The outcome was the <IR> Framework and many companies globally are adopting the principles of integrated reporting.
What flowed from this project was the realisation that integrated reporting cannot happen effectively without the organisation organising itself and running itself in a connected and integrated way. In addition it was crucial that this process began at board level and took into account the short-, medium- and long-term time frames. This concept was described as integrated thinking in the <IR> Framework. One can only surmise that if companies are unable to present key information to their stakeholders in a well organised and understandable manner that internally they are also struggling to make sense of it at a management and certainly at a board level.
The <IR> Framework makes it very clear that effective integrated reporting is dependent upon the degree to which companies have embraced what it calls integrated thinking. Integrated thinking is described as “the active consideration by an organisation of the relationships between its various operating and functional units and the capitals that the organisation uses or affects”.
It says that integrated thinking leads to integrated decision-making and actions that consider the creation of value over the short, medium and long term.
It goes on to say that integrated thinking takes into account the connectivity and interdependencies between the range of factors that affect an organisation’s ability to create value over time, including the following:
- “The capitals that the organisation uses or affects, and the critical interdependencies, including trade-offs, between them
- The capacity of the organisation to respond to key stakeholders’ legitimate needs and interests
- How the organisation tailors its business model and strategy to respond to its external environment and the risks and opportunities it faces
- The organisation’s activities, performance (financial and other) and outcomes in terms of the capitals – past, present and future”
How does this translate into practice? It is difficult to explain this in a few words, but I have set out some thoughts below.
- Integrated thinking must begin at the board level and the board must understand the integrated picture of the organisation. Clearly management also needs to understand the integrated picture as it implements integrated thinking, which ultimately needs to become part of the DNA of the whole organisation.
- Successful businesses generally employ robust business models to create value. Embracing integrated thinking does not mean changing or adapting the business model, but it may, if the leadership detects future constraints arising from implementation of integrated thinking.
- The leadership should endeavour to build strong relationships with the organisation’s critical stakeholders so that it can understand their needs and work with them to create value for the organisation and stakeholders in the short, medium and long term.
- The leadership should understand the organisation’s key capital needs and ensure that they are measured and managed with the same rigour as financial capital. The leadership will need to ensure that the capital requirements are built and used so as to achieve the value creation objectives. It also needs to understand and measure the interrelationship between the capitals. For example, to build human capital, the organisation may have to invest significantly amounts in training which would erode financial capital in the short term, but it should result in benefits in the future. These relationships can be very complex. Some of the key capitals may reside in the supply chain and these capitals also need to be recognised as such and managed appropriately.
- The leadership needs to review the opportunities, risks and strategy in the light of the capitals. Does the organisation have the resources and relationships to achieve its strategic goals? Has it identified and defined the risks implicit in the whole value chain, including matters such as waste disposal and community relations?
- Ensuring that the leadership receives reliable and relevant financial and non-financial information on a timely basis is essential to effective decision-making.
- Complex organisations may use models and special techniques such as systems thinking to assist them in managing the capitals and understanding relationships between them.
The development of integrated reporting has had an interesting side effect, which may well be more important than the transformation of reporting. It has highlighted the need for integrated thinking within organisations. Viewing performance and prospects through a financial lens is not enough anymore, and this applies not only to external corporate reporting but also to the way in which organisations are governed and run. Integrated reporting is very new and it will take several years to achieve maturity. Integrated thinking began its life even later and it too will take time to be fully understood, but those organisations that see the light are creating a competitive advantage for themselves. ❐
Author: Graham Terry CA(SA) is Senior Executive: Strategy and Thought Leadership