Integrated reporting: Concept capital

It tells the complete value creation story and helps enforce accountability of firms towards society

Business firms create customers and provide goods and services that they value. In the process, they create value for partners in the value chain, employees, investors and others who are involved in the value creation process. They use variety of capitals, which represent resources and capabilities, in the value creation process. Some capitals that firms use are internal in the sense that those are owned or controlled by them, while others are external. An example of external capital is public goods, such as, fresh air and knowledge. Other examples of external capital are natural capital and infrastructure being created by the government for common use. Draft Integrated Reporting Framework, issued by International Integrated Reporting Council (available at www.theiirc.org/consultationdraft2013) on April 16, 2013, classifies capital into financial capital, manufactured capital, intellectual capital, human capital, social and relationship capital and natural capital.

There is interplay between capitals. For example, the value of the goods produced by using plant and equipment depends a lot on the ability of the firm to manage corporate and product brand, customer relationships and relationships with networking and supply chain partners. In the value creation process firms consume or add value to capitals. For example, in the process of delivering value to customers in the form of products and services, firms consume manufactured capital (e.g. plant and equipment) and natural capital, while increasing the value of financial capital and social and relationship capital.

Business models of firms impact external capitals either positively or negatively. Negative externalities destroy value of natural capital. For example, when a firm pollutes the fresh air through its operation, it destroys value air. A firm adds value to public goods by creating positive externalities. Firms through its operations create knowledge and skills that might be available for general use for the benefit of the society as a whole. For example, many innovations in the famous Bell Lab are being used for creating goods and services across the globe for social benefits.

For long, firms have taken a narrow view of capital. They ignored consumption of or value addition to external capital while measuring success of their business models. Traditionally, they measure net profit, which is the surplus available to shareholders, for a particular period at the difference between the value of internal capital at the end of the period and that at the beginning of the period. Theoretically, distribution of surplus does not impair the earning capacity of the firm. However, in practice, it is not true because of two reasons. One is the difficulty in measuring the value of capital accurately. The second is that while measuring surplus, accountants ignore those capitals whose cost or value is not auditable.

For example, internally generated intangible assets, except software, are not counted in measuring the surplus. These drawbacks are significant. But, the most important drawback of financial reporting is that it does not provide information on firm's use of external capital.

Value of a firm is determined in the capital market. It is estimated, based on the forecasted cash flows that the firm will generate over long term and risks associated with that cash flow stream. Accounting numbers in financial statements might not have any direct correlation with the value of the firm. For example, although human capital, and social and relationship capital do not find place in the balance sheet, financial analysts, while estimating the value of a firm, consider the firm's ability to manage the same.

They also consider all other relevant factors that might affect future cash flows. Therefore, some may argue that integrated reporting, which tells the complete value creation story and explains how each type of capital will impact short-term, medium-term and long-term performance of the firm, might not improve valuation of firms in the capital market. The argument is weak. Disclosure will help financial analysts to identify and assess the risks to which the firm is exposed and thus will improve the accuracy of value estimation.

The most important benefit of integrated reporting is that it will enforce accountability of firms towards the society. Firms are expected to minimise negative externalities, maximise positive externalities and optimise the use of natural capital. But till now there is no mechanism to evaluate their performance in using external capitals. Integrated reporting will bridge this gap. It will force firms to develop business models that are sustainable. It will also enlighten the consumers how their consumption habits affect the community, natural capital and public goods. Integrated reporting is in sync with the 'responsible business' paradigm.

Affiliations: Professor and Head, School of Corporate Governance and Public Policy; Advisor (Advanced Studies), The Institute of Cost Accountants of India; Chairman, Riverside Management Academy Private Limited. Email: asish.bhattacharyya@gmail.com