Challenges and Opportunities for Disclosure

I have already blogged about the importance of gathering and disclosing ESG data (environment, social and governance) and how it affects operational and investment decisions. In this blog, I repeat some of the most salient facts and suggest that ESG should be taught to students. I believe the best courses to use are auditing, because of the coverage of assurance, advanced managerial accounting, because of the importance of operating systems in gathering and evaluating the data, and accounting ethics, because of the need to balance stakeholder needs with the usefulness of the data and how it can impact decision making.

ESG reporting provides a specific framework for evaluating and measuring a company’s sustainability performance. It assesses a company’s ESG-related risks and opportunities by providing a standardized approach for stakeholders, including investors, creditors, regulators and society in general, to assess corporate sustainability.

The Views of the SEC

For years now, a debate has been held between the SEC and business community about the reporting of events related to corporate social responsibility (CSR). The SEC has examined the potential economic effects of mandated disclosure and reporting standards for CSR, environmental, social, and governance (ESG) criteria and sustainability. There is no agreement about mandated disclosures just yet, but it may be forthcoming with climate disclosures. However, there are some important points to make that argue for disclosures in the annual report  

ESG are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.

The critics of ESG disclosure requirements often point to the costs associated with preparing the disclosures. Consideration of such costs is important, as is getting clear about their causes. But just as important is the recognition of the costs associated with not having ESG disclosure requirements. For investors, despite an abundance of ESG data, there is often a lack of consistent, comparable, and reliable ESG information available upon which to make informed investment and voting decisions.

The SEC is also looking at whether ESG disclosures should be mandatory or voluntary. The SEC’s existing system contains some mandatory ESG disclosure requirements (e.g., disclosure of how a company’s board considers diversity in identifying director nominees). It permits significant differences in how companies respond to a variety of “mandatory” requirements, including in many cases disclosing items if and only if they are material. The system contains “comply or explain” requirements (e.g., if a company does not have an audit committee financial expert, it can explain why, and where the ability to explain makes the requirement less than rigidly mandatory and for some companies potentially more informative).

Finally, companies generally are mandated to make disclosures as needed to prevent other disclosures from being materially misleading. As companies continue to disclose more in sustainability reports, they should already be evaluating those disclosures considering existing anti-fraud obligations.

On April 11, 2024, the SEC disclosed that it would temporarily halt implementation of its anticipated climate reporting regulation amid ongoing legal disputes concerning the rule’s legitimacy. This strategic pause is intended to reduce the unpredictability surrounding the regulation as the court battle unfolds. The agency had the option to challenge a recent temporary injunction from an appeals court but chose to focus its efforts on legally defending the regulation’s validity instead. 

The SEC affirms its belief in the legality of the rule and its authority to enforce it, emphasizing that this temporary suspension will aid in a more organized legal review process and help the appellate court concentrate on assessing the rule’s legal challenges thoroughly.

The Purpose of ESG Reporting

The goal of reporting on ESG (Environment, Social, Governance) is to use data to measure how a company’s ESG initiatives compare with industry benchmarks and targets. It also provides stakeholders with valuable insights that can inform decision-making, highlighting potential opportunities and risks that might affect the valuation of a company.

Sustainability and ESG are similar, yet differences exist. Sustainability is an overarching principle, while ESG provides a practical approach for evaluating and reporting on sustainability performance. Sustainability reporting communicates an organization’s non-financial performance to its stakeholders by disclosing relevant information about environmental, social, and economic impacts, as well as its governance practices.

One of the main differences between ESG and topics like sustainability or corporate social responsibility (CSR) is the notion of motivation versus outcomes. Sustainability and CSR function as the business model or methodology that motivates a company and its employees to act in the best interest of civil society. ESG reporting, on the other hand, is the outcome of those initiatives and provides stakeholders with the ESG data needed to inform decision-making.

ESG reporting is becoming increasingly important to companies, not just to comply with regulations, but to respond to the demands of stakeholders. The EU’s new Corporate Sustainability Reporting Directive (CSRD) affects approx. 60,000 EU and non-EU companies who will have to meet the European Sustainability Reporting Standards (ESRS) for financial year 2024. On a global level, the inaugural IFRS Sustainability Disclosure Standards (ISSB) will require companies to communicate the sustainability risks and opportunities they face over the short, medium, and long term.

Given the changing state of ESG reporting, it’s little surprise that companies differ greatly in how they organize ESG reporting responsibilities for gathering, processing and disclosing their ESG performance data. Depending upon the company, the organization of ESG reporting may vary in terms of organizational structure, company statement, and the distribution of tasks – as well as varying sizes of teams responsible for disclosure.

The ESG Reporting Challenge for Companies

KPMG addresses the reporting challenge for companies. According to its report, the arising challenge is twofold. On the one hand, companies are obliged to report on ESG at ever-increasing levels of detail across a widening range of areas. As a result, metrics and targets are likely to stretch to the hundreds. On the other hand, similar to financial reporting, the CSRD expects companies to offer independent assurance over their ESG reporting. This places considerable pressure on companies to produce a fluid process for setting targets and measuring performance, to meet appropriate standards and adapt to the new requirements coming down the line. Meeting these extensive and growing requirements is a major, complex challenge that makes it imperative to transform ESG reporting, according to Jan-Hendrik Gnandiger, Global Head of ESG Reporting for KPMG International,

KPMG’s 2022 Global Survey of Sustainability Reporting found that 78% of the 250 world’s biggest companies by revenue (G250), now adopt GRI Standards for Reporting (up from 73% in 2020).[1]

Deloitte reports in its December 2022 Survey Findings on ESG Disclosures and Preparedness the following findings:[2]

• As companies begin to prepare for the U.S. SEC disclosure requirements, they are beginning to shift from commitment to action to address evolving stakeholder expectations. They are starting to see the strategic benefits that can be realized through enhanced ESG governance, controls, and disclosure.
• While most companies are taking meaningful steps towards enhancing their ESG disclosures, they continue to face challenges with data accuracy and availability.
• Rather than waiting to react to future disclosure requirements, many companies are proactively implementing changes to help accelerate readiness. This includes creating new roles and responsibilities and plans to invest in more technology and tools over the next 12 months.
• Companies utilize a range of frameworks and standards for ESG disclosure.
• Chief sustainability officers (CSOs) are primarily responsible for managing ESG disclosure.

One problem with ESG reporting is the information may not be comparable and consistent between companies and industries. Moreover, transparency may be lacking. This is due in large part to the challenges in adopting one generally accepted method to account for and report non-financial information related to sustainability in the global environment. The result is that investors may have problems evaluating the information and making investment decisions.

Frameworks for ESG Reporting

The Deloitte report identifies five frameworks for reporting ESG data as follows:

• Task Force for Climate-related Financial Disclosures (TCFD)  56%
• Sustainability Accounting Standards Board (SASB)                    55%
• Greenhouse Gas (GHG) Protocol                                                     50%
• International Integrated Reporting Council (IIRC)                      48%
• Global Reporting Initiative (GRI)                                                      47%

Sustainability reporting continues to accelerate globally, and it is a growing requirement for large and listed companies around the world. The two comprehensive and internationally recognized sustainability standard-setters for corporate reporting—GRI and SASB—provide standards that are complimentary and help organizations meet stakeholder needs.

Transparency is the best way to create trust among organizations and their stakeholders, including investors. For this reason, companies focus on disclosures that assist these user decision-making needs. Companies can use both the GRI Standards and SASB Standards. The latter are evolving and should be carefully monitored by organizations to ensure they meet both the form and spirit of non-financial requirements.

ESG data is important not only for CSOs but also the following: chief operating officers (COO), who need to know how the reporting requirements might affect operational decisions; CFOs, who oversee financial reporting and disclosures; internal auditors, who evaluate reporting systems and whether they are operating as intended; and external auditors, who often are called upon to provide assurance that the systems are working in accordance with internal control requirements. The audit committee also has a key role to play.

Student Needs

Given the importance of ESG reporting, it is important for students to understand the purpose of the standards, what are their goals, specific reporting requirements, relationship to financial reporting, and the role and responsibilities of management, especially the CEO, CFO, and Chief Sustainability Officer, if one exists The internal auditors and audit committee have an important role to play as well. Finally, the external auditors need to understand and evaluate the operational systems and whether they are working to gather sustainability data and meet the needs of investors for transparency. 

Students also need to be aware that companies should gather ESG data and report to investors. Companies want such data because of their commitment to sustainable business practices. The decision shouldn’t be made from an investment perspective, that is, enhancing return on equity or return on assets, but an operating one, which means CEOs, CSOs, CFOs, internal and external auditors, and the audit committee all have a role to play in ensuring the data is accurate and reliable and will meet stakeholder needs now and into the future.

Posted by Steven Mintz, Ph.D., aka Ethics Sage, on May 8, 2024. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/.