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Telling the story of long term value creationInsights to the IIRC’s Integrated Reporting Framework Consultation

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Telling the story of long term value creation - Insights to the IIRC’s Integrated Reporting Framework Consultation

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Content

Introduction ....................................................................................3

2. Fundamental concepts...............................................................5

3. Guiding principles......................................................................8

4. Content elements ....................................................................12

5. Preparation and presentation ..................................................16

6. In closing .................................................................................18

Contacts ........................................................................................19

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Introduction

The International Integrated Reporting Council (IIRC) published a Consultation Draft of the Integrated Reporting Framework (Framework) for public comment on 16 April 2013. Comments are due by 15 July 2013. This Framework was developed based on the comments received by the IIRC on the 2011 Discussion Paper “Towards Integrated Reporting – Communicating Value in the 21st Century” and constitutes the next step in the process to issue the International Integrated Reporting Framework later in 2013.

The Framework is to be welcomed as it presents a much clearer picture of the required approach, considerations, inputs and disclosures to generate an effective and meaningful Integrated Report. Although the Framework is based on the Discussion Paper, it encompasses both a refinement and elaboration of the applicable concepts and principles which inform and underlie Integrated Reporting (IR) and the Integrated Report, as well as the various content elements which should be addressed in the Integrated Report.

The Framework makes it clear that a principle based approach should be followed in the preparation of the Integrated Report. Rather than to provide a list of detailed disclosures, the Framework sets the scene and provides the underlying principles and considerations that should guide the approach to IR and the publication of the Integrated Report.

In essence, the Framework proposes that the company should explain to its stakeholders how it creates and sustains value in the short, medium and long term. The explanation should adhere to the fundamental concepts and guiding principles in describing the business model used to create value. In doing so, the company should discuss and link all content elements. This should all be underpinned by the strategic objectives of the business.

A number of new focus areas or concepts are introduced or explained. The Framework explains:

• The concept of the six capitals (inputs or resources utilized by a company to create and store value)

• The need to describe the company’s business model and the manner in which this should be done, and

• The meaning of value created or destroyed by the company.

1 The Consultation Draft of the Integrated Reporting Framework can be access at http://www.theiirc.org/consultationdraft2013/

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With respect to the audience of the Integrated Report, the Framework proposes that the Integrated Report should be prepared primarily for providers of financial capital in order to support their financial capital allocation assessments. This constitutes a departure from the suggested approach of the Integrated Reporting Committee of South Africa (the draft Discussion Paper) which was released during 2011. In terms of the latter approach, all key stakeholders of the company should constitute the audience of the Integrated Report.

The approach to the concept of materiality is somewhat different from that in earlier publications. In terms of the Framework, materiality is determined, not only by the needs of the users of the Integrated Report, but also by the views and needs of the Board. The information required by the Board to make strategic decisions is regarded as material. The broader definition of materiality emphasises the importance and role of governance, not only for purposes of the Integrated Report, but also for the Board’s role to guide the business of the company.

The Framework makes it clear that any communication purporting to be an Integrated Report should comply with the minimum reporting standards identified in the Framework.

This publication provides a high level overview and contextualisation of the Framework, and where appropriate points out departures and differences with the draft Discussion Paper.



IR is about telling the story of how the organisation plans to create and sustain value in the long term. In order to tell that story, it is important to recognise that value is not created by or within an organisation alone, but is influenced by the external environment, created through relationships and dependent on the availability, affordability, quality and management of various resources.

The Framework focusses on the need for an Integrated Report to provide a broader explanation of performance than traditional financial reporting by describing, and measuring where practicable, the material elements of value creation and the relationships between them. To ensure that this is well explained, the Framework introduces three fundamental concepts:

• The concept of the six capitals

• The need to explain the organisation’s business model

• Value creation and destruction over time.

The capitals

The capitals are explained as stores of value on which the organisation depends for input into its business model. They are categorised in the Framework as: financial, manufactured, intellectual, human, social and relationships, and natural capital. Not all capitals are owned by the company. They may be owned by others, for example rented facilities, or not owned at all, for example, access to unpolluted air. Although the use of the word “capital” to define these inputs has been the subject of debate, the concept of being conscious of and providing an account of the resources the organisation creates, transforms or destroys through its business model is sound. Explaining this in the Integrated Report is key to the organisation’s value creation story.

Capitals Examples

Financial capital Equity, debt, grants

Manufactured capital Buildings, equipment, infrastructure

Intellectual capital Patents, copyrights, software, licences, systems, procedures, protocols

Human capital Employees’ competencies, capabilities and motivations to innovate

Social and relationship capital

Shared norms, common values, behaviours, stakeholder relationships and dependencies

Natural capital Air, water, land, minerals, forests, bio-diversity and ecosystem health

2. Fundamental concepts

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Although the Framework does not require that all categories of capital identified above are applicable to all organisations, it recommends that the categories identified above are used as a benchmark to ensure that the organisation does not overlook a capital it uses or affects. Required disclosures about the capitals include:

• the factors that affect the availability, quality and affordability

• the organisation’s expectations of its ability to produce flows from them to meet future demands

• the use of and effects on capitals explained through either qualitative or quantitative information

• material trade-offs and interdependencies between capitals.

The business model

An organisation’s business model is described as its chosen system of inputs, business activities, outputs and outcomes which aim to create value over the short, medium and long term. It can be considered as the “heart” of the Integrated Report.

Although most Integrated Reports in South Africa have in the past included a description of the activities of the company, the Framework includes a more prescriptive manner through which the business model should be explained. It requires specific disclosure of the key inputs and the material capitals or resources on which the organisation depends.

The Framework also recommends the disclosure of business activities. These include the core activities i.e. the planning, design and manufacture of products or deployment of specialised skill, but also those activities that contribute to the long term success of the business such as innovation, employee training and relationship management.

Outputs include not only the key products and services, but also by-products and waste (including emissions). These need to be discussed in the Integrated Report depending on their materiality. Although we do not believe that this constitutes a significant change from current practice, it is interesting that the Framework includes a specific reference to materiality in the context of output. It follows that if carbon emissions and waste is not a material issue in the business, there is no requirement to disclose these matters. This approach builds on the need for the Integrated Report to focus on the material matters that substantively could affect the organisation’s strategy, its business model or the capitals it uses and influences.

Outcomes are defined as the internal and external consequences for the capitals as a result of the company’s business activities. For example, the Framework requires that both positive and negative outcomes be explained. Examples of positive outcomes include efficient infrastructure, loyal customers, productive and skilled employees. Conversely, negative outcomes may include out of date infrastructure, dissatisfied customers, and sub optimal or reduced performance due to lack of training.



Source: Consultation Draft of the International <IR> Framework

Value creation

Although the Framework acknowledges that the providers of financial capital are focussed on value in the form of financial return, it argues that those returns are also dependent on inter-relationships between the various types of capital. The Integrated Report should provide information that enables the providers of financial capital to assess the ability of the company to create value over time. Value for the purpose of IR includes all forms of value created through the increase, decrease or transformation of the capitals, each of which may ultimately impact financial return. This is a change from the traditional meaning of value which has been narrowly associated with the present value of expected future cash flows.

The diagram below neatly draws together the concepts of the capitals, business model and value creation:

Governance

Inputs Business activities

Outputs

Business model

Mission and vision

Opportunities and risks

Strategy and resource allocations

Performance Future outlook

External environment

Financial

Manufactured

Intellectual

Human

Natural

Social and relationship

Financial

Manufactured

Intellectual

Human

Natural

Social and relationship

Organisation

Society

Org

anis

atio

n

Soci

ety Outcomes

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3. Guiding principles

Similar to accounting and other sustainability reporting frameworks, the Framework is principle based. The Framework identifies and describes the Guiding Principles that should underpin the preparation, inform the content and guide the presentation of the information of the Integrated Report.

This approach is not a departure from the original discussion paper issued by the IRC of SA, but rather provides more detailed guidance as to how these principles should be interpreted. It should be noted that the Framework clearly expresses the requirements that all the principles should be applied consistently throughout the Integrated Report.

The guiding principles as defined in the Framework are:

3.1 Strategic focus and future orientation

An Integrated Report should provide insight into the organisation’s strategy, and how that relates to its ability to create value in the short, medium and long term and to its use of and effects on the capitals.Strategic focus should be a theme throughout the Integrated Report. The strategic objectives of the business should be linked to every aspect of the organisation’s unique value creation story, and explain the various strategies to ensure delivery on the objectives.

As per the previous discussion papers, the Integrated Report should adopt a forward looking approach and indicate how the continued availability, quality and affordability of material resources and inputs (capitals) contribute to the company’s ability to achieve its strategic objectives in the future.

With respect to future-oriented information, uncertainty is not considered a reason to exclude such information from the Integrated Report, but it does mean that key estimates and significant assumptions used by management, together with possible risks, should be included so that users can properly evaluate such information.



3.2 Connectivity of information

An Integrated Report should show, as a comprehensive value creation story, the combination, inter-relatedness and dependencies between the components that are material to the organisation’s ability to create value over time.The Framework promotes ‘integrated thinking’ – the better ‘integrated thinking’ is embedded in the organisation, the easier it would be for management to report on the connectivity of information. The Integrated Report needs to demonstrate connectivity between:

• The six capitals

• The past, present and future of the organisation

• Financial and non-financial information

• Quantitative and qualitative information

• Management information, Board information and information reported externally

3.3 Stakeholder responsiveness

An Integrated Report should provide insight into the quality of the organisation’s relationships with its key stakeholders and how and to what extent the organisation understands, takes into account and responds to their legitimate needs, interests and expectations.Even though the Framework proposes that the providers of financial capital are the main audience of the Integrated Report, it remains important for the organisation to identify its key stakeholders and ensure regular and meaningful engagement with those stakeholders. Effective stakeholder engagement assists the organisation to:

• Understand how stakeholders perceive value

• Identify future trends that may not yet have come to general attention, but which are increasing in significance and impact

• Identify opportunities and risks

• Develop and evaluate strategy

• Implement action, including strategic and accountable responses to material matters.

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The better integrated thinking is embedded in the business, the more likely it is that the key needs of stakeholders will be incorporated as an ordinary part of conducting business.

It is important that the Integrated Report should not attempt to be everything to everybody - by focusing on matters that are most material for the long term success of the organisation, the Integrated Report will provide stakeholders with the relevant information they require.

3.4 Materiality and conciseness

An Integrated Report should provide concise information that is material to assessing the organisation’s ability to create value in the short, medium and long term.The Framework provides a new, more closely defined, definition of materiality. In terms of the new definition information is regarded as material if it could substantively

• influence the assessments and decisions of the organisation’s highest governing body, or

• change the assessments and decisions of intended users with regard to the organisation’s ability to create value over time

The unique feature here is that the definition also takes into consideration matters that have the ability to substantively influence the assessments and decisions of the organisation’s highest governing body, not only the intended users, as with most other previous materiality definitions and descriptions.

In determining whether or not a matter is material, senior management and the Board consider whether the matter substantively impacts, or has the potential to substantively impact, the organisation’s strategy, its business model, or one or more of the capitals it uses or affects. This is an interesting development, as it emphasises the role of the Board in determining materiality. The principle here is that, if the Board needs certain information to take key strategic decisions, this point to the materiality of the information. As such, the Board agenda and Board pack may provide a very clear indication of what information is regarded as material by the Board. Or put differently, the Board should assess whether all forms of capital are adequately discussed at Board level, and use that to guide their assessment of materiality.

The Framework provides guidance of the process to be followed when considering the materiality of matters (see the discussion in section 5 below). The process entails the identification of relevant matters, assessment of the importance of relevant matters in terms of their known or potential effect on value creation, and the prioritisation of such relevant matters. The consideration of importance requires an assessment of the magnitude of a matter’s effect on the organisation’s strategy, business model and capitals, as well as an assessment of the likelihood of occurrence.



An important change to note is the fact that where material information is not disclosed (as a result of the unavailability of reliable data, competitive harm or specific legal prohibitions) this fact should be disclosed and explained.

Disclosures about material matters should include concise information that provides sufficient context to make the disclosures understandable and should avoid information that is redundant. Even though the Framework requires the disclosure of much information, the Integrated Report should still attempt to present the information in a concise manner. Additional detailed information can be provided separately on the organisation’s website or in other forms of communication.

3.5 Reliability and completeness

An Integrated Report should include all material matters, both positive and negative, in a balanced way and without material error.The principle is in essence the same as in the original discussion paper – information should be reliable, i.e. complete, neutral and free from error. Also, the Integrated Report should be balanced. There should be no bias in the selection or presentation of information. Information in the Integrated Report should not be slanted, weighted, emphasized, de-emphasized, combined, offset or otherwise manipulated to change the probability that it will be received either favourably or unfavourably by the intended report users.

Information included in the Integrated Report is by nature central to running the business. As a result, when an organisation finds that material information is not available, it may highlight areas where better systems are required for managing the business. For that reason, the cost/benefit argument to omit information should be interrogated by the Board.

3.6 Consistency and comparability

The information in an Integrated Report should be presented in a way that enables comparison with other organisations to the extent it is material to the reporter’s own value creation story, and on a basis that is consistent over time.The Framework emphasises the importance of comparability. The Integrated Report should be written in a way that allows for it to be compared to other Integrated Reports in the same industry. Reporting policies should be followed consistently from one period to the next unless a change is needed to improve the quality of information reported. This includes using the same KPIs to report on the same matters if they continue to be material across reporting periods. Where possible, the Integrated Report should reference industry standards, benchmarks, and quantitative indicators commonly used by other companies in the same industry. Although this may be difficult at first, it is accepted that comparability will improve over time as organisations start to compare their own Integrated Report to those of other companies.

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Source: Consultation Draft of the International <IR> Framework

The Framework includes well defined content elements which can be described as the pieces of the puzzle that the organisation puts together to express its unique value creation story, while making connections between the different content elements clear to the reader. The content elements are fundamentally linked to each other and are not mutually exclusive. The diagram below illustrates the content elements bounded by the guiding principles demonstrating the interrelationship between them.

4. Content elements

It will be difficult for an organisation to produce a standalone report if all of the content elements are not included in the Integrated Report. Each content element should be appropriately considered, and explained within the organisation’s specific operating context (industry, footprint, value chain, regulations).

Organisational overview

and external environment

Business modelOpportunities and risks

Governance

Strategy and resource

allocation

Performance Future outlook

Strategic focus and future orientation

Connectivity of information

Cons

iste

ncy

and

com

para

bilit

y

Reliability and completeness

Stak

ehol

der re

spon

sive

ness

Materiality and conciseness



The Framework contains detailed considerations for each content element. In answering the question posed for each content element, organisations should take note of specific aspects that are either new, or receive additional emphasis in the Framework as set out below.

4.1 Organisation overview and external environment

What does the organisation do and what are the circumstances under which it operates?Companies may find it challenging to determine the appropriate disclosure level to meet the proposed requirements while keeping the report concise.

The proposed disclosure of the organisation’s competitive landscape and market position may be deemed sensitive as it may require the disclosure of a potential competitive advantage.

A new component to this element is the external environment including legal, commercial, social, environmental and political considerations. While the Chairman’s statement often includes commentary on external factors, organisations may find this a challenge in addressing the industry, regional, social and environmental context in the report.

4.2 Governance

How does the organisation’s governance structure support its ability to create value in the short, medium and long term?Within the South African context, organisations have generally complied with most of the governance reporting requirements through the application of King III and the Companies Act requirements.

Through the introduction of the concept of capitals, the Framework has highlighted the remuneration and incentives linked to value creation, including the organisation’s use of and effect on the capitals. What the Framework is recommending is a clear link between strategy, business model, executive KPIs and capital creation or destruction.

4.3 Opportunities and risk

What are the specific opportunities and risks that affect the organisation’s ability to create value of the short, medium and long term and how is the organisation dealing with them?The Integrated Report should provide the reader with information pertaining the material risks and, importantly, opportunities that are specific to the company. Opportunities have often been neglected in many Integrated Reports up to now. The Framework indicates that the Integrated Report should provide information related to the source of the risks or opportunities (internal, external or a combination of the two), the likelihood of these materialising and the potential magnitude of its effect if it does materialise, and the steps to create value from such opportunities or mitigate key risks. The discussion of key risks and opportunities should relate to the company’s impact on, as well the continued availability of the six capitals.

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4.4 Strategy and resource allocation

Where does the organisation want to go and how does it intend to get there?The Framework requires companies to provide detail on its strategic objectives, and the strategies required to achieve such objectives. To some extent, this becomes the underlying theme of the Integrated Report. The Framework now requires more information pertaining to the relation between the strategic objectives and the business model, the impact of the external environment as well as the key risks and opportunities, and the effect of the latter on the company’s strategy and on the various capitals.

4.5 Business model

What is the organisation’s business model and to what extent is it resilient?The business model can be considered as the central element of the Integrated Report, and is described earlier in this document. An organisation can demonstrate its business model graphically by using a diagram and narrative flow that is logical and specific to the organisation’s circumstances. The positioning of the organisation in the entire value chain is an important consideration that should also be emphasised.

4.6 Performance

To what extent has the organisation achieved its strategic objectives and what are its outcomes in terms of effects on the capitals?Organisations should disclose the effects (both positive and negative) on the different forms of capital, including material effects on capitals up and down the value chain. A demonstration of the connectivity of financial performance with performance of other capitals should also be included as far as possible (e.g. financial impact of business interruption due to a specific health and safety incident, the impact on staff morale, reputational impact).

Organisations should also disclose performance against previously reported targets, forecasts and commentary that contextualise past performance, and how this impacted the setting of future targets.



4.7 Future Outlook

What challenges and uncertainties is the organisation likely to encounter in pursuing its strategy, and what are the potential implications for its business model and future performance?Although commentary on the future outlook has been an element of IR since inception, the Framework asks for a transparent analysis of the Board and senior management’s expectations about the external environment the company is likely to face in the short, medium and long term. This analysis also needs to include how it will affect the company and how the company is currently equipped to respond to critical challenges.

The disclosure should provide the reader with an understanding of the main assumptions and possible risks and opportunities, and should provide lead indicators, target KPI’s, forecasts and projections where practicable. It is important to see this content element in the context of the guiding principles, specifically the principles of materiality, reliability and consistency. In other words, the rules around disclosure relating to omissions based on unavailability of reliable data, legal prohibitions and competitive harm should also be applied when determining the extent of disclosure of information relating to the future outlook.

In addition to the content elements, the following should be disclosed:

• The organisation’s materiality determination process

• The governance body with oversight responsibilities for Integrated Reporting

• The reporting boundary and how it has been determined

• The nature and magnitude of the material trade-offs that influence value creation over time

• The reason why the organisation considers any of the capitals identified in this Framework to be immaterial given its particular circumstances, if that is the case.

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5. Preparation and presentation

Relevance

Importance

Prioritization

Identify relevant matters

Based on effect on the organisation’s ability to create value over time; considering past, present or future effect on the organisation’s strategy, its business model, or the capitals it uses or affects.

The Framework specifically focuses on providing guidance on how organisations should implement the Guiding Principles and Content Elements. This section of the Framework provides the “how to” guide and therefore details some of the more difficult concepts that organisations have been grappling with.

The preparation and presentation guidance includes the materiality determination process and disclosure, involvement of governance bodies, credibility through assurance regime and report boundary setting. Other topics that are of interest include the aggregation of information and the use of technology.

Materiality determination process:

A defined approach to the determination of materiality has been provided, very much linked to the GRI Technical Protocol. The Framework’s approach is explained in the diagram below:

Assess importance

By assessing the magnitude of effect and likelihood of occurrence.

Prioritise

Based on importance; if necessary revisit the materiality threshold.

It is important to note however that the determination, regardless of the thresholds and measurement criteria, will need to be approved by Board. This will enable senior management to then prioritise matters based on an approved materiality framework.



Materiality disclosure

The Framework also sets out the nature of the disclosure per material matter and allows for judgement to be applied. It recommends that an explanation of the matter and effect on the organisation’s strategy, business model and capital; the relevant interdependencies, the organisation’s view on the matter, and extent of control over the matter is disclosed.

If there is uncertainty surrounding a matter or if key information is considered indeterminable disclosure regarding this should be made.

Involvement of the governance bodies

The Framework clearly highlights the role and responsibility of the governance structures in the IR process. The Board has a responsibility to ensure effective leadership and decision making regarding the Integrated Report as well as oversight of the employees actively involved in the IR process. This may elevate the nature of the engagement between those charged with governance and employees involved in the reporting process.

Credibility

As in previous guidance, the Framework has highlighted credibility of the report as an important consideration. In order to achieve this credibility the Framework recommends assurance over the Integrated Report or elements thereof in order to enhance the integrity of the information. The assurance process has two distinct levels, being internal audit or a similar internal process and independent external assurance. This concept of obtaining both internal and external assurance is aligned with the three lines of defence as presented in King III.

Reporting Boundary

The primary determination factor in the boundary setting process is the financial reporting boundary as defined by financial reporting standards. This is in line with acknowledging that the primary user of the IR is the provider of financial capital. In certain instances the boundary may be expanded based on opportunities, risks and outcomes attributable to stakeholders beyond the financial reporting boundary that have a material effect on the company’s ability to create value. The strong link to the financial reporting boundary is a change from the previous guidance, might impact previous reports and may be inconsistent with how the principle was previously applied. For example, the concept of assets under management rather than assets under control has in some instances been used as the boundary for carbon emissions.

Aggregation and disaggregation

Interestingly, the aggregation or disaggregation concept asks organisations to determine the level of aggregation, by considering what the level of information needed by senior management and the Board is in order to effectively manage the organisation and its operations.

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The Framework does not fundamentally deviate from what has been practiced by diligent reporters in the past. It does however provide more clarity on certain hotly debated issues and sets out the minimum requirements to claim “Integrated Report” status.

The clear focus on the role of the Board in determining materiality, selecting matters to be reported on and preparation oversight role, will contribute to the standing of the Integrated Report in future years.

The Framework promotes the need to answer the important questions around long term value creation – and in a world where financial instability and longer term sustainability threatens the wealth and welfare of society in general, this further push towards improved corporate transparency is definitely welcomed.

6. In closing



Contacts

Nina le RicheDirectorCell: 082 331 4840Email: [email protected]

Johan ErasmusDirectorCell: 082 573 2536Email: [email protected]

Jaco PretoriusAssociate DirectorCell: 083 270 9470Email: [email protected]

Claire HoyAssociate DirectorCell: 083 410 2139Email: [email protected]


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