Integrated reporting provides a more holistic representation of a firm’s activities, combining key financial and non-financial information, including environmental and social details. Better still, research by Gaia Melloni and her colleagues reveals that firms producing concise and easy to understand reports, in line with international guidelines, may benefit economically in terms of market value and liquidity, compared with those that do not. But with some important caveats.
Over the last decade there has been a notable increase in the inclusion of non-financial information, particularly environmental and social information, as part of corporate reporting. Indeed in many jurisdictions this kind of reporting is compulsory. The EU’s non-financial reporting directive on non-financial information (NFRD), for example, mandates reporting on sustainability for large companies.
As part of this trend, organizations are increasingly turning to a new type of reporting – integrated reporting (IR) – which brings together financial and sustainability information in a single report, outlining the strategy an organization uses to leverage various capitals (human, social, intellectual, natural, manufactured and financial) to create value.
This type of reporting invariably involves collaboration between different parts of the organization including executives responsible for financial reporting, those involved in sustainability, and external expertise, such as specialist consultants. Globally there are over 2000 firms adopting IR and it is even mandated in some countries, for example, in South Africa, for all firms publicly listed on the Johannesburg stock exchange (JSE).
While the increased emphasis on corporations engaging in socially and environmentally responsible activities is considered a positive development by most stakeholders, it has also given rise to the phenomenon of “greenwashing”. This is where organizations seek to enhance their social responsibility credentials by creating a false impression about, or obscuring the true the extent of their involvement in, socially and environmentally responsible activities.
Some benefits of integrated reporting
One way that organizations might attempt to manipulate external perception about their sustainability activities is through their corporate reporting. Consequently governance authorities try to put in place measures that prevent this. With IR, for example, the International Integrated Reporting Council (IIRC), provides a framework highlighting guiding principles for producing an IR such as conciseness and balance. Notwithstanding, such a principle-based approach, it makes recommendations covering the length of the report, the complexity of the language used, and the tone adopted in terms of its neutrality when presenting information. The aim is to make the report and its contents easy to access and understand.
Nevertheless, companies could still choose to deviate from the framework guidelines and in doing so make it more difficult to get an accurate assessment of that organization’s sustainability activities. However, companies tempted by such a course of action should note the findings of new research by Gaia Melloni (HEC Lausanne, University of Lausanne), and her research colleagues Ariela Caglio (SDA Bocconi, Italy) and Paolo Perego (Free University of Bolzano-Bozen, Italy). Their work shows that the degree of conformity with the IIRC framework has some important economic implications in terms of its effect on market value, stock liquidity.
The research used a sample of the top 160 JSE-listed firms, ranked by the market capitalization in 2015, using data on those firms for the period 2011 to 2016, after IR became mandatory. It assessed three characteristics explicitly required by the IIRC framework. These were: conciseness – the framework recommends being concise rather than overlong, to avoid overloading the reader with information; reading difficulty – the report should not be difficult to understand and the framework recommends using plain rather than complex language; and balance – the framework recommends a neutral (rather than biased) tone, which does not try to persuade the reader.
Other studies have shown that these are textual attributes which have been used to manipulate corporate reporting and disclosure. Indeed, previous research by Melloni has shown that these textual attributes have been used by companies as part of their impression management strategies, with companies more likely to use these strategies when they are performing poorly.
The study then investigated, in the case of each attribute, if and how that attribute impacted upon three economic outcomes: market value – assessed using the Tobins Q ratio (market value of assets over their book values); stock liquidity – assessed using the bid-ask spread; and analyst earnings forecast dispersion – assessed using deviation from the consensus opinion of analysts.
The findings show that non-conformity with certain IIRC guidelines is correlated with negative effects. In the case of length, there is a negative impact on the stock’s liquidity as shown by the positive and significant relation with the bid-ask spread. In the case of reading difficulty, there is a significant negative impact on Tobins Q. In other words, organizations that do not conform to the framework’s requirements IR to be concise and easy to understand pay an economic penalty, through a negative impact on market value and liquidity.
Interestingly, with tone bias, a deviation from the framework’s requirements had a positive impact on the dispersion of analysts’ forecasts. Raising the possibility that organizations could use the biased presentation of information within the report, contrary to the IIRC recommendations, for impression management purposes without incurring a penalty in terms of analyst forecasting. Furthermore, it suggests that analysts are influenced by the way information is presented within an IR.
The third-party assurance effect
The research also looked at any additional effect provided by obtaining third-party assurance of a report. As a measure intended to boost trust, might such assurance alter any negative economic impact caused by not conforming to the framework’s guidelines, for example? The findings reveal that third-party assurance does mitigate the adverse economic effects of non-conformance with the IIRC framework requirements concerning the length of the report and ease of understanding.
The research has a number of implications for stakeholders. For companies with a good record on sustainability activities and that wish to publicize those activities, the findings suggest that they should conform to the IIRC framework guidelines concerning creating a concise report using language that is easy to understand. This will create a positive economic effect in terms of market value and liquidity. At the same time it appears that they could use persuasive language (tone bias) to positively influence the perception of market analysts and without incurring financial penalties.
For firms that necessarily produce long and complex reports because of the complexity of their operations or strategy, for example, have an opportunity to mitigate the negative economic impact through third-party assurance. However the same holds true for organizations seeking to manipulate their audience. For organizations that attempt to obscure their record on sustainability and choose to do so through creating a report that is long, and difficult to understand, it appears that they can also offset any negative economic impact by obtaining third-party assurance. In other words, should they wish to, organizations could use these text attributes to manipulate perceptions about sustainability activities, and still escape certain economic penalties by using third-party assurance.
As a result it might be prudent for regulators to consider mandating that third-party assurers include an assessment of conformity to the IIRC guidelines, including those that relate to length and ease of understanding, as part of their assurance process.
Related research paper: Ariela, C., Melloni, G., Perego, P., (2019), Informational Content and Assurance of Textual Disclosures : Evidence on Integrated Reporting. Forthcoming in the European Accounting Review.