Lecture 2: Value Relevance of Non-financial info

Question 1

Describe the expanding domain of corporate reporting and the objective of providing increased disclosure?

Answer 1

Expanding domain of corporate accounting can be demonstrated through the increased narrative/textual disclosure in GPFR through notes; increasing commonness of providing sustainability reporting and also integrated reporting.

The main objective of providing increased disclosures is to improve decision usefulness of information. This is because greater disclosure help current and future investors understand financial statements better by discussing information not fully reflected in the FS; discussing important trends and risks including those affecting future performance. As such, provides information about the quality (and potential variability) of earnings and cash flows.

Question 2

Tutorial 3 Q1:

Why do corporations disclose environmental information in their financial reports?

Answer 2

• Reason 1: facilitates accuracy of firm valuation
  By making voluntary disclosures, firms are conveying their ‘inside’ information to investors on the outside, enabling a more accurate valuation of the firm (as shown in the share price). This is the information hypothesis—that the estimation risk associated with estimating the firm’s future performance and hence future cash flows is lowered by more and better information about the firm’s environmental (and social) impacts—disclosure is needed because many important aspects of proactive environmental strategy are unobservable
• Reason 2: Signalling
  Also motivated to disclose information as a means of signalling their proactive strategy and relatively superior environmental performance. Sustainability reports, particularly if they are assured, are costly and credible signals of a firm’s quality. High-quality firms can afford to produce and assure these reports; the marginal benefit is in attracting and keeping investors as capital providers.
• Reason 3: Legitimacy Theory
  Firms can also be seen to produce these reports to demonstrate their legitimacy; that is, that they have an implicit social contract, which is their social ‘licence to operate’. Firms are viewed as legitimate if they purse socially acceptable goals in a socially acceptable manner. Whereas if firms behave in non-sustainable ways with a pure profit objective, their ‘licence’ can be removed.

Question 3

Tutorial 3 Q2:

Do capital markets value corporate environmental information?

Answer 3

Yes, according to many research studies that have examined this issue, on balance it appears that capital markets do incorporate this environmental info. in their valuations, i.e. it is value-relevant.

• Firm’s environmental impacts can be positive (e.g. reducing resource inputs footprint and therefore costs) or negative (e.g. oil-spill, dam burst or breach of regulations). Whether positive or negative, there is an impact on future cash flows—reduced cash outflows through improved efficiency or increased cash outflows through fines, remediation costs and compensation payments.
• These impacts are factored into the capital market value (share price multiplied by outstanding shares) of the firm.

Question 4

Tutorial 3 Q3:

The need to incorporate sustainability information and examples of techniques to achieve this?

Answer 4

• Key idea is that business’s environmental impacts have traditionally been externalities. Business consumes water, forests, minerals and fossil fuels, realising the benefits but not paying the full cost of resource depletion and GHG emissions and other pollution.
• Therefore these environmental costs should be internalised; that is, priced and incorporated into business reporting and decision-making.
• In doing so, business is:
  • Improving their operating efficiency and therefore costs by being more resource efficient
  • Responding to consumer and investor demand; and therefore,
  • Gaining competitive advantage and
  • Ensuring their legitimacy and long-term sustainability as business

Examples of techniques to do so:
- Value chain analysis, which involves consideration of the environmental, social and sustainability factors all the way through the value chain
(strategy–>product design–>sourcing inputs–>manufacturing–>selling–>after sales services), since sustainability has implication throughout the organisation.

• Life cycle costing, that is, understanding of the costs that occur from activities undertaken through the value chain. (‘Closing the loop’ and reducing waste by improving system design and optimising operational and maintenance support)
• Balance scoreboard, which is a strategic planning and management system used extensively in business and industry, government and non-profit organisations to: align business activities to vision and strategy of organisation; improve internal/external communication; and monitor organisational performance against strategic goals. This system adds strategic non-financial KPIs to traditional financial metrics to give managers more ‘balanced’ view of organisational performance.
• Incorporating a carbon price into capital investment decision making and budgeting.

Question 5

Tutorial 3 Q4:

What are ‘stranded assets’ and why are they relevant to corporate accounting?

Answer 5

• Stranded assets are assets that have suffered from unanticipated or premature write-downs, devaluations or conversions to liabilities.
• They can be cause by a range of environment-related risks and these risks are poorly understood and regularly mispriced, resulting in a significant over-exposure to environmentally unsustainable assets—E.g. reserves of fossil fuels such as coal
• Current and emerging risks related to environment represent a major discontinuity of these assets, and are able to profoundly alter their values across rage of sectors.
• Some of these risks include:
  • Environmental challenges like climate change, water constraints;
  • Changing resources landscapes
  • New government regulations (carbon pricing)
  • Falling costs of clean technology
  • Evolving social norms and values and consumer behaviour
• The relevance for corporate accounting is that internally, managers must recognise and manage these strategic, operational and financial risks, and embed them in the performance measurement and control systems. Investors need to price their investments and are demanding this info, so there must be recognition of the impairment of asset valuations in the external financial reports.
• Managers and accountants’ skill-sets must include knowledge of these environment related risks.

Question 6

What is assurance engagement?

Answer 6

An engagement in which assurance practitioner expresses a conclusion designed to enhance the degree of confidence of the intended users, other than the responsible party, about the outcome of the evaluation or measurement of a subject matter against criteria.
–> Whether the financial report is prepared in accordance with a financial reporting framework.

Effect of assurance is to increase credibility and reliability of information for better decision making by users and more efficient allocation of scarce resources.

Question 7

Tutorial 3 Q5:
Outline key elements of sustainability assurance engagement.
What are the key challenges that an assurance practitioner faces in a sustainability assurance engagement?

Answer 7

5 Key Elements of assurance engagement:

• A Three-party relationship, involving an assurance practitioner, responsible party (manager responsible for preparing the sustainability report) and intended users (stakeholders)
• Appropriate Subject Matter. Note that subject Subject matter for sustainability reporting is much wider than financial reports CSR, GHG emissions, water, OHS
• Suitable Criteria, which are the benchmarks (reporting frameworks) against which the subject matter is evaluated.
  • Should exhibit the following characteristics: relevance, completeness, reliability, neutrality, understandability
• Sufficient Appropriate Evidence, that is, information that is material—info which if omitted, misstated or not disclosed has potential to adversely affect decisions about allocation of resources by users
• Written Assurance Report in the form appropriate to the reasonable assurance or limited assurance engagement.
  • Reasonable assurance? Objective is the reduction of engagement risk (risk of giving wrong opinion) to acceptable low level as basis for positive form of opinion. High but not absolute level of assurance AUDIT
  • Limited assurance? Objective is reduction of engagement risk to acceptable level, as basis for negative form of opinion. Moderate level of assurance REVIEW

Key challenges faced by assurance practitioners:

• Unlike financial statement audits, there is no government-guaranteed monopoly to the accounting/auditing profession. It is a competitive market.
• The intended users of the information (the stakeholders) are much broader than the intended user of the traditional financial statement (primarily shareholders) and having different information needs
• The subject matter (GHG emissions, water, human rights etc) is complex and requires specialist expertise
• Subject matter is measured using many different metrics, not just ‘dollars’
• Given these different metrics, the difficulty in judging materiality and whether a measure may be materially misstated
• The lack of a single mandatory reporting framework creates a lack of comparability and consistency across reports
• Constant changes in the regulatory environment (e.g. around carbon pricing)
• Effectively communicating the level of assurance provided to the users of the report