When organisations are connecting their sustainability and financial data this has implications for the annual report, including where information is located. Here we explore the positions of different reporting standards and why it is unlikely to lead to complete integration.
Location, location, location
Given how sustainability and financial information differ, this has implications for where information is located within the general-purpose financial statements. For example, CO2 emission values will not appear in the financial statements, first and foremost because they are not measured in a currency, rather are measured in tonnes of carbon dioxide equivalent (tCO2e).
However, their value in dollars may be calculated by using a price per carbon ton, which could be included within the value of inventory (ie, on the balance sheet).
Sustainability through the prism of financial reporting
When it comes to connecting sustainability and financial performance information in disclosures, companies use a typical financial thought process sequence as follows:
Level |
description |
Example |
|---|---|---|
First level |
Information is disclosed in the MD&A, minimally within the risks and uncertainties section. | Water scenario analysis projections for all manufacturing site locations materially dependent on access to water; these projections carry estimation risk given uncertainty around climate (e.g., rainfall, water tables), government-imposed water restrictions, or population growth projections. |
Second level |
In addition to the above, information on the sources of estimation risk, significant judgments (IAS1), or contingencies that meet the criteria of liability disclosures under IAS 37 will be disclosed in the notes to the financial statements. | Site restoration costs for a plant that may be abandoned in 10 years’ time or may be refurbished and run for another 10 years or more; although the company expects to incur a cash outlay in 10 years’ time, it is not yet reasonably measurable, nor has the event leading to the contingency been taken (i.e., the usage decision); disclosure occurs in the footnotes (in accordance with IAS 16 Property, Plant and Equipment). |
Third level |
An event triggers an update to the above disclosure approach, which results in a financial measurement such as an asset impairment or a liability provision reported in the balance sheet. | A decision is made to close a factory in five years rather than 10 years which requires incremental site restoration costs of $10M; the additional expected costs are added to the balance sheet value of the factory asset, and then an immediate assessment of possible impairment follows; the change in the useful life and estimated restoration costs for the plant, as well as the additional impairment analysis are disclosed (in accordance with IAS36 Impairment of Assets). |
Understanding this journey helps illuminate where different levels of information pertaining to sustainability matters may find themselves in relation to financial performance, and ultimately financial disclosures.
It helps explain why sustainability information is often found in regulatory disclosure documents, yet remains outside of the financial statements themselves, either because it’s non-financial, or it is financial yet fails to meet the requirements of financial reporting standards (ie, it is not measurable yet).
Furthermore, sometimes the financial implications of sustainability performance are so deeply intertwined with financial performance metrics that they cannot be separated out. One such example could be higher productivity rates resulting from strong employee engagement levels.
It helps us contextualise why most financial information on sustainability matters within the financial statements tends to be negative in nature. This is because accounting reporting standards are skewed towards downside risk and contingencies.
In other words, the probability threshold for recognising risk-related negative outcomes such as losses or impairments is easier to meet than the corresponding threshold for recognising opportunity-related positive outcomes, such as incremental assets, revenues, or cost savings. As a result, contingencies are recognised for expected losses, however, opportunities are generally only recorded when they materialise.
In any event, both negative and positive performance information pertaining to material sustainability matters remains relevant and important to disclose.
What the disclosure standards say
Article 21 of IFRS S1 states that information disclosed should enable users to understand the connections:
- between different material sustainability matters,
- between different sustainability information, and
- across sustainability information and financial information.
Similarly, ESRS 1 states that companies must connect narrative elements, such as governance, strategy, risk management, performance metrics and performance targets for a specific sustainability matter, with its counterpart in the financial statements, whether in narrative or quantitative form.
It states: “For example, in providing connected information, the undertaking may need to explain the effect or likely effect of its strategy on its financial statements or financial plans or explain how its strategy relates to metrics and targets used to measure progress against performance.
“Furthermore, the undertaking may need to explain how its use of natural resources and changes within its supply chain could amplify, change, or reduce its material impacts, risks and opportunities. It may need to link this information to information about current or anticipated financial effects on its production costs, to its strategic response to mitigate such impacts or risks, and to its related investment in new assets.”
This is entirely consistent with existing financial reporting standards, which specify that any material quantitative information must be accompanied by narrative explanation.
In its climate disclosure rules adopted in March, the US Securities and Exchange Commission (SEC) takes a very similar approach. In fact, these rules are even more explicit about detailing the required financial information on climate-related issues, perhaps because of the very deliberate care the SEC has taken to stay within its remit in the face of intense scrutiny and pressure.
For example, in addition to requiring companies to disclose climate-related risks that can have an impact on their business strategy, results of operations, or financial condition, the rules also require disclosing: “…material expenditures incurred and material impacts on financial estimates and assumptions that directly result from [...] mitigation or adaptation activities.”
Furthermore, it requires disclosure of: “…capitalised costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions”, and “…capitalised costs, expenditures expensed, and losses related to carbon offsets and RECs, subject to disclosure thresholds.”
The rules explain that these capitalised costs, expenditures expensed, charges, and losses “represent quantitative information that is derived from transactions and amounts recorded in a registrant’s books and records underlying the financial statements”.
The SEC requires registrants to disclose these financial statement effects in a note to the financial statements, indicating where within the balance sheet and income statement these capitalised costs, expenditures expensed, charges, and losses are presented (rule 14-01).
Connected and combined, but not integrated!
The evolution towards interdependent sustainability and financial management is likely to close the debate on whether we need both types of information, for the same reporting period and scope, delivered at the same time. But will it also close the debate on separate documents?
On one hand, the EU’s Corporate Sustainability Reporting Directive (CSRD) and its European Sustainability Reporting Standards (ESRS) are prescriptive, requiring a specific format for sustainability statements to be included in the regulatory annual management report, which includes narrative on governance and strategy, business activities, MD&A, sustainability statements, financial statements, and the auditor’s report.
On the other hand, the IFRS Sustainability Disclosure Standards (SDS), while requiring sustainability-related disclosures to be part of general-purpose financial reports, have avoided requiring them to be in the same document as financial statements. Domestic securities regulators and legislators that mandate adoption of the IFRS SDS may further prescribe the location of sustainability information.
Given the interconnectedness of sustainability and financial performance information, there can be little doubt that best practice places all material information in a single document.
However, this is very different from an integrated report produced following the Integrated Reporting Framework, for which the IFRS Foundation has assumed responsibility following the consolidation of the Value Reporting Foundation in 2022.
Both the International Accounting Standards Board (IASB) and the International Sustainability Standards Board (ISSB) have confirmed their lack of appetite for any near-term work on integrated reporting.
The natural place for information on the connectivity of sustainability and financial performance appears to within the MD&A, as a companion to structured sustainability statements and financial statements.
This was the intent of IASB’s 2021 project to overhaul the Management Commentary by developing ”a comprehensive set of requirements and guidance that would enable companies to bring together, in a single, concise and coherent narrative, information about financial, sustainability-related and other factors that are fundamental to the company’s ability to create value and generate cash flows, including in the long term”. Thankfully, the IASB decided in its June 2024 Board meeting to finalise this project after a prolonged period of it being on hold.
Perhaps Larry Bradley, Global Head of Audit at KPMG, said it best in a post on ESG Today: “A company’s report provides a window on its business. The financial statements provide one window; sustainability disclosures another; and MD&A another. Three windows on the same business.
“In my opinion there will be true connectivity when investors can recognise the same business model and strategy through all three windows – and when there is a consistent narrative that connects the dots between the financial and non-financial information presented in those windows.”
Further guidance
Connecting sustainability and finance
Accountants must take the lead on joining the dots between sustainability and finance information, performance and disclosures to ensure organisations are able to make the transformative changes needed.
More support
Read the rest of our guidance on connecting sustainability and financial information, disclosure and performance.
Download in fullAbout the authors
This guidance on connecting sustainability and finance information, performance and disclosure was created by Marie-Josée Privyk, Founder and ESG Advisor, FinComm Services, and David Wray, Board Member & ESG Working Group Chair, ICFOA & Founder, DW Group.
