Reporting in Europe breaks new ground

This year the first directive mandating non-financial corporate disclosures is due to take effect across the EU which breaks new ground in corporate reporting requirements. Elisabeth Jeffries reports

It has been described as historic. The first directive mandating non-financial corporate disclosures, due to take effect across the EU next year, breaks new ground in corporate reporting requirements. A cynic might describe it as fodder for European paper mills. Yet there is a case for lauding its introduction.

Firstly, it extends the CSR probe to Europe’s furthest boundaries. Mandatory reporting on some environmental, social and governance (ESG) issues already exists in major economies. The UK’s 2006 Companies Act, for example, requires UK quoted companies to report greenhouse gas emissions in their directors’ reports. France’s Grenelle II law obliges many companies listed on French stock exchange to incorporate information on the social and environmental consequences of their activities into their annual reports. In Germany, a Sustainability Code known as DNK covers many of the directive’s obligations.

But many of the EU’s newer members or less developed countries will need to integrate the directive into their statute to introduce their first non-financial reporting rules. At the same time, companies that have withheld information will need to supply it. “It will require 6,000 companies across Europe to disclose certain ESG information, and many of these companies have never done so before,” says Elaine Cohen, Sustainability Reporting Consultant at CSR consultancy Beyond Business.

The new law also makes a major leap from previous ESG reporting rules, which mainly targeted the extractive industries as part of a clampdown on corruption and bribery. Companies in the sector had to disclose more information about payments to governments. One implicit aim was to stop EU businesses from trying to bribe officials in resource-rich developing countries. The illegal sale of hardwood, for example, would then be used to fund civil conflict within that country. “In some countries, this might be the only way the local population could find out what their government was up to,” observes an executive at a professional accounting organisation.

The directive broadens and strengthens the existing accounting law, which set quite high-level conditions open to interpretation. It covers a far wider range of corporate responsibility concerns than the previous legislation, as well as much national legislation. This includes bribery, human rights, employee diversity and environment.

But as a tool for greater transparency to guarantee accountability to the general public, its merit will take many years to prove. The directive originally proposed to cover a far wider spectrum of business activity, aimed at around 20,000 companies, but this intention was diluted during the legislative process.

Meanwhile, accounting processes continue to be dissatisfactory. Social or environmental impacts are most commonly buried in the hard numbers in the financial statements. Typically, those numbers only indicate responsibility when misconduct is exposed. “The costs associated with being found out relate perhaps to general loss of reputation, reduced sales and potential litigation. Litigation risk can later turn into contingent liabilities or recognised provisions,” points out Peter Pope, professor of accounting at the London School of Economics.

Bad news may leave a financial scar on the company’s profit and loss account despite a clean CSR report, as the recent emissions debacle at Volkswagen shows. Sales in some countries fell while the company’s share price halved. Not surprisingly, the underlying software use was not revealed in the company’s 2014 sustainability report. Any investor reading it might have found it impressive.
Dense pages printed in a literary style and interesting font suggest thought leadership and Germanic introspection. “It’s not about growth at all costs,” states one heading. An article entitled “SUVs – where emotion meets reason?” justifies its role in the SUV market through lightweighting and electric vehicle innovation.

As Elaine Cohen points out, the report set high standards. The Global Reporting Initiative, a standards organisation, confirmed it included material disclosures. “Volkswagen disclosures have been consistently in line with reporting expectations and the company received recognition from many ranking and rating organizations including the Dow Jones Sustainability Index”, she says.

Clearly, the new legislation in itself will not put a stop to commercial conjuring tricks or pollution incidents. Mainstream auditing procedures may shine a bright beam on particular activity while failing to detect dark matter surrounding it. They may focus on final sales, for example, rather than operational decisions supporting them. As Pope explains, a sustainability report can well be accurate while presenting the company through a particular lens.

“CSR reports may sometimes reflect the perceptions of the board of directors, whose perspective on actual business practices might not correspond to reality because they don’t know the fine detail. Management control in complex organisations can be problematic,” he says.

The transparency and reliability of the non-financial statement in the management report, when it becomes mandatory, is thus likely to be compromised. The record of previous laws on disclosure also suggests compliance may be limited. The adoption of the International Financial Reporting Standards (IFRS), made obligatory by the EU in 2005, is a case in point. “Enforcement of IFRS in financial reporting is much patchier than policy makers had intended. It is a major problem,” notes Peter Pope. Meanwhile, miscreant directors rarely suffer severe penalties or imprisonment.

The influence of the law is likely to be indirect, nudging companies to improve their corporate culture, creating a level playing field and raising the standards of member states with lower requirements. “The European Commission’s motivation for a directive of this kind is to protect the single market and improve its rationalisation and harmonisation,” comments an executive from a professional accounting organisation. A single accounting code will help support that objective now that CSR reporting has become commonplace.

At present, CSR analysts perceive poorer performers through unsubstantiated numbers or shifting methodologies from one year to the next.

“A company has many ways of communicating its activities, not just a sustainability report. In general, however, there are certain frameworks and expectations of sustainability reporting at a global level, and it’s fairly easy to note if a company is not achieving this expected level of transparency,” says Cohen. Now that non-financial reporting is to become law across the EU, it is reasonable to expect those failings to become more evident.

Activists have high hopes for methodology guidelines published in December 2015. By embedding a consistent approach, they will help investment analysts detect poor performance more easily. However, non-financial reporting is unlikely to grow full teeth unless ESG matters are fully recognised as material to the business and ESG externalities incorporated into the accounting system.