Lessons learned from financial accounting standardization for ESG

Guest Authors:  Matthew Billet, Caitlin Heising, Abeda Iqbal, Ilaria Scaramuzza, Maria-Theresa Sanchez

The history behind the drive to standardize financial reporting internationally can provide lessons learned for the Impact Management & Measurement (IMM) space. While it officially took centuries to coalesce around the present-day accounting standards, developments since the Great Depression are most relevant for this  analysis. 

Financial Accounting Foundations & Moving toward Standardization 

The Gatsby days of the roaring twenties are often defined by ‘economic exuberance’, but a lack of uniform and consistent financial reporting methodology also underscored this period. After ignoring accounting standardization through the stock market crash, U.S. President Roosevelt’s New Deal, which included the creation of the Securities and Exchange Commission (SEC) in 1934, attempted to restore consumer confidence in the economic system. The foundation for international standardization decades later was established that year by requiring  the independent auditing of publicly traded companies. However, early domestic standardization was not straightforward and contributed to the decades long wait for an international accounting body. While the goal of financial reporting  standardization was to reduce “informational externalities arising from lack of comparability”, “small differences in definitions, timing and methods created subtle variations that significantly  undermined” this effort. Rather than disrupting the process of  standardization, these variations were ultimately managed and embraced by domestic regulators . 

The International Accounting Standards Committee (IASC) was founded in 1973 by accountancy body agreements in many developed countries globally and understood the importance of  bounded flexibility. Instead of imposing strict, uniform rules as the baseline  for international standards, IASC handed most of the responsibility to firms themselves.  Because financial reporting is not perfectly comparable between businesses in various industries,  over time IASC recognized (within reason) different valuation approaches and forced users  to comprehend how their choice impacted important metrics. 

Yet, the IASC’s  job was far from complete. It still had to  put pen to paper and promote its use amongst a diverse group of countries. The Committee created the  structure for developing each standard, which included giving the responsibility of determining the objectives and scope of each proposed standard to multiple steering committees. This disciplined system led back to the full Committee for final  approval following a public comment period and allowed for a straightforward, systematized  standard setting process to evolve.  

After years of publishing standards absent of official authority, IASC received the push it needed from the G7. In 1998, delegations from the seven largest economies in the world officially recommended that IASC put forward a full set of internationally agreed upon standards to further improve the broader international financial system. This helped push IASC to become  an official board (International Accounting Standards Board) by 2001 and spur the adoption of International Financial Reporting Standards (IFRS) by major jurisdictions, including the European  Union, Hong Kong, and South Africa within a few years, and over 140 at present. 

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Parallels between IMM and Financial Accounting 

There have been two recent attempts to mirror impact indicators to financial accounting-style  approaches: 

Sustainability Accounting Standards Board (SASB) 

The name and structure of this non-profit organization is no coincidence. Following its financial  accounting predecessor, SASB was founded in 2011 and has published dozens of industry-specific and financially relevant ESG disclosure topics in order to improve the comparability of impact  metrics. However, SASB’s key distinguishing factor is financial relevance, which is highly  subjective and unique to each corporation, thus diminishing comparability from the outset  . 

Despite its close relationship to financial reporting and its support from a number of premier  asset managers, only 120 companies worldwide utilize SASB’s disclosure topics when reporting  ESG metrics as of 2019. The already fractured IMM marketplace is likely contributing to the limited SASB adoption. The Global Reporting Initiative (GRI), founded in 1997  and affiliated with major international organizations such as the Organization for Economic Cooperation and Development (OECD) and IFC, employs a similar ESG disclosure framework.  

Impact-Weighted Financial Accounts (IWFA) 

Rather than simply following financial reporting standardization, one IMM initiative seeks to integrate the two. The IWFA initiative is a drive to highlight a company’s financial, social, and environmental performance through an easily comparable accounting-style framework. This is an effort to distill various indicators from numerous sources into a commonly understood monetary unit (i.e. dollars).  The ability to seamlessly  compare impact risk versus reward trade-offs and accurately assess impact performance could significantly improve corporations’ impact decision-making processes.  

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Conclusions 

The financial accounting standardization story brings about three important observations for  IMM: 

1. Importance of Structure and Coherence  

Similar to financial accounting where domestic governing bodies followed their own methodologies for decades, multiple thought-leaders have concurrently driven the IMM  conversation. Key players are enthusiastic about aligning with the latest IMM initiatives. For example, despite already contributing to IRIS+ and to the Harmonized Indicators for Private Sector Operations (HIPSO), prominent development banks such as the CDC Group in the UK and the Netherlands Development Finance Company recently signed on to support the Joint Impact  Model (JIM), a newly developed impact measurement approach that strives to harmonize impact input data. While the financial accounting space ultimately coalesced  around IASC, the continuous interest in the latest approaches and tools may further divide the already complex and crowded IMM service provision marketplace. 

2. Bounded Flexibility 

While it is challenging to compare black and white numbers such as revenue, costs, and  depreciation to complex impact indicators, there is an important takeaway: impact indicators are inherently flexible. International financial reporting standardization only took place after  bounded flexibility became the bedrock of accounting standards.  

3. Support and Demand from Recognized Authorities  

It is feasible that the IMM market is not yet fully developed or the ambiguity of impact metrics  makes standardization extremely challenging. Alternatively, similar to the financial accounting  industry, it may be the case that IMM requires a push from an international organization, such  as the G7, WEF, or UN, to achieve standardization. 

Sources:

Ashwell, Ben. “More than 100 companies using SASB standards.” Investor Relations Magazine, 2019. 

Ball, Ray. “International Financial Reporting Standards (IFRS): Pros and Cons for Investors.”  Accounting and Business Research, Forthcoming, 2006. 

Camfferman, Kees, and Stephen A. Zeff. Financial Reporting and Global Capital Markets: A  History of the International Accounting Standards Committee, 1973-2000. Oxford  Scholarship Online, 2007. 

Ruff, Kate and Sara Olsen. “The Next Frontier in Social Impact Measurement Isn’t Measurement  at All.” Stanford Social Innovation Review, 2016. 

Serafeim, George, Katie Trinh, and Rob Zochowski. “A Preliminary Framework for Product  Impact-Weighted Financial Accounts.” Harvard Business School, 2020.

Tucker, Tracy. “It really is just trying to help: The history of FASB and its role in modern  accounting.” North Carolina Journal of International Law and Commercial Regulation 28,  no.4 (2003).

Welch, M. “The Sustainability Accounting Standards Board: Connecting Businesses and Investors on the Financial Impact of Sustainability.” Sustainability Accounting Standards Board, 2019.