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| Incorporating environmental issues into financial reporting procedures | |
| 9th October 2006 Companies are increasingly aware of the impact that environmental factors can have on the bottom line, either directly through increased energy costs or indirectly through mismanagement of environmental risk. But less obviously, such factors can affect the value of intangible assets, shareholder valuation and longer term financial performance. In the first of a series of articles, FSN writer Niki Leahy, suggests that companies should have processes in place for identifying, reporting and managing the financial aspects of the environment, regardless of external reporting requirements.  Effective management of environmental issues is widely recognised to be a significant contributor towards excellence in overall business performance. Companies that measure and manage their environmental risks and uncertainties and that communicate their environmental performance to their stakeholders recognise that such stewardship is not only important in the day to day management of their business, but to their longer term corporate sustainability. Whilst many companies have begun to subscribe to the principles of sustainability and corporate social responsibility, (as reflected in the growing numbers of companies who annually publish Corporate Social Responsibility Reports) they are often strongly criticised for rarely meeting the information requirements of the financial stakeholder. As such CSR reports usually fail to disclose quantifiable, robust and comparable data on those environmental issues, risks and uncertainties which are of relevance to a company's current performance and to its ability to generate future profits. Environmental issues are of interest to financial investors where they are material to the company's past and future economic performance, where they can be seen to enhance longer term shareholder value, and where they are related to the company's unique economic growth opportunities, and are integrated into the company's business and operational strategies. While financial analysts and investors have always focused on how environmental issues are related to specific financial costs, they are increasingly assessing the contribution that environmental issues have on intangible corporate values, such as brand value, customer loyalty and retention, and corporate reputation. Financial stakeholders want companies to disclose information about how they have performed in this value creation process, how they have maximised the value of their intangible assets and how they anticipate that they will continue to create lasting, sustainable commercial value. So companies need to include narrative reporting of relevant environmental issues in their annual accounts and reports, using both financial and non financial key performance indicators – and to combine this with increased disclosure of related operational strategies. The demand for greater transparency and dialogue about the effects of environmental issues on company performance is related to the increased liability and exposure of investors, lenders and shareholders to the financial risks that arise from inadequate management of environmental risks, as well as a more demanding regulatory environment. This has coincided with rising environmental costs; (including energy consumption, water usage, and waste management charges) so that as a result, environmental issues have become both more expensive and complicated to manage. Whilst financial stakeholders require consistency in the standard and quality of the environmental information disclosed by companies, particularly with regard to the use of non financial key performance indicators, there is little in the way of published and accepted standards. The ASB's (Accounting Standards Board) reporting standard RS1, brought out to accompany the now defunct OFR, went a long way to providing some guidance but has been demoted to a statement of best practice. Even less guidance is available around the quantification of environmental impacts in internal management accountancy procedures and the greater disclosure of environmental costs and liabilities in the balance sheet and in cash flow forecasts. This demand for greater transparency in the disclosure of environmental and social issues has occurred as standards of corporate governance have grown in importance, and socially responsible investment, (SRI) has increasingly encroached into mainstream proprietary valuation models. While analysts and investors want evidence that companies are making a positive contribution to society and that they are minimising their effect on the environment, they also increasingly want to know about those environmental and social issues that the company judges are material to its to future financial performance. Investors want companies to disclose the quantifiable link – where it exists - between environmental issues and corporate performance, so as to assess the direct and indirect influence of environmental performance on the company's value creation process. They want to evaluate non financial key performance indicators which relate to the management of environmental impacts, and which set out quantifiable targets for future reductions in the output of these impacts. As well as assessing quantitative financial data that relates to environmental issues, investors are also looking at the impact of qualitatitive factors on the effective management of environmental risks – this means investors seek evidence of high quality decision making in relation to relevant critical issues such as the strategic management of the environmental risks. Sustainable growth in shareholder value is recognised to be inextricably linked to the effective management of environmental risk – and the minimising of such risk upon the company's strategic, operational and financial objectives. The accountancy profession has a significant role in play in helping to achieve and demonstrate the efficiencies that companies can lever from sustainable business practices. Long term corporate sustainability depends on the generation, analysis, reporting and assurance of robust and accurate financial and non financial information. More specifically, companies need to account more fully for their internal environmental costs and their external environmental impacts, regardless of how they choose to disclose this information to their financial stakeholders. But how should internal processes change? For a start, businesses need mechanisms for accurately identifying and allocating internal environmental costs so as to maximise cost saving opportunities and improve decision making with regard to, say, product mix and pricing, and to maximise potential paybacks from future investment decisions. Furthermore, the emphasis of performance monitoring should focus on managing the most effective use of environmental resources as opposed to managing and minimising the consequences of environmental impacts. It is also advisable to develop internal valuation methods that measure the costs to the company of the environmental impacts it has, so that these may be related to measures of corporate profitability. Finally, for many organisations the balance of reporting should shift from the ‘simple' reporting of corporate environmental policy and activities, to the disclosure of quantifiable environmental performance indicators that detail levels of environmental inputs, such as energy and material resources, as well as levels of environmental outputs such as emissions to air, water and land, equating this information to financial performance indicators where possible. With these process changes in place companies will be equipped better toevaluate and quantify how environmental activities contribute towards the operational and strategic value of the company and to develop a systematic approach towards the management of environmental risks, so that future unforeseen costs or anticipated increases in environmental costs are identified and accounted for. |
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