Integrating sustainability reports into financial statements: an experimental study

The concept of “Integrated Reporting” suggests that company reports that meaningfully combine financial and sustainability aspects provide a more realistic picture of a company’s risks and opportunities and thus help investors to arrive at better investment decisions. So, what exactly are the effects of on the process of valuation for investment decisions? Financial and sustainability reports have traditionally been published separately with little connection to one another. However, the rising discussion about integrated reporting (IR) has shifted the focus to a more holistic representation of company performance. In 2010, the Prince’s Accounting for Sustainability Project (A4S) and GRI announced the formation of the International Integrated Reporting Committee (IIRC), which comprises a host of globally leading organizations in the area of company reporting standard setting and accounting. It aims to create a globally accepted accounting framework for sustainability combining financial and sustainability information: “in a clear, concise, consistent, connected and comparable format”. So far, however, there is no empirical evidence on how this combination affects decisions by professional financial statement users.
To explore this, Markus Arnold and Alexander Bassen – both from Hamburg University – along with Ralf Frank of the DVFA Society of Investment Professionalsin Germany, set up an experiment with mainstream investment professionals without expertise in sustainability. Conducting experiments (as an alternative to other empirical methods such as surveying investor requirements) has proven to be an effective research method in accounting to prove cause-effect relationships. The experiment prepared two company test cases based on an actual company to examine what impact integrated reports would have, how investment professionals would use them and whether investors assigning a valuation score to a company would arrive at different results compared to investors using conventional separate reports. One test case combined good financial performance with bad ESG performance (GFBE); the other test case (BFGE) combined the reverse i.e. bad financial with good ESG performance. For each of the two test cases, three sets of information were provided: a text-based company profile, a financial report and a sustainability report. The financial report consisted of 33 items from the income and cash flow statements, a three-year history, ratios on output/sales and annual changes in % – all presented in a table format. The sustainability report was prepared from 63 pre-selected items based on the Global Reporting Initiative’s G3 format, at application level A+. A pre-test was conducted with 15 senior investment professionals with expertise in
sustainability to condense the 63 items to a suitable number. Thirteen items were retained for the sustainability report data set, those of the 63 items ranked ≥ 75% “important” or “very important”. Note that stock data (share price, share price development, free float etc.) were deliberately omitted in order to avoid having the participants’ valuations biased by market expectations. The experiment, administered via the internet, involved 60 mainstream investment professionals, predominantly from internationally well- respected brokerage houses, investment companies and capital market firms based largely in Europe. Approx. 88% of the participants had more than 5 years work experience. Participants were instructed to read the company information and form an opinion on the quality of the company. Specifically, they were asked to assign a score from 0-100 (absolutely not investable – excellent investment) to the company. Investment professionals who participated in the experiment with separate financial and sustainability reports were asked to assign a score after they had been given the financial report (INITVALUE). Then, they were given the sustainability data and asked to either assign a new score (FINALVALUE) or keep the former score. Participants receiving integrated reports were asked to assign a score after reading the package including financials and sustainability (INITVALUE = FINALVALUE).
Results show that integrated reports can make a difference for investment decisions, albeit depending on the investment case at hand! For the test case with bad financial and good ESG performance (BFGE) investors assign a higher value score to the company when financial and sustainability reports are supplied in a single package (integrated) than when reports are supplied separately. Moreover, when in the BFGE tests investors assess reports separately i.e. read thefinancial report and assign a valuation score, good sustainability performance does not impact the final valuation score any more. In simple terms: once bad financial performance has led to a valuation score, good sustainability data consumed next does show any impact. For BFGE tests, investors supplied with an integrated report gave the company an average valuation score of 45.20 points. In the case of separate reports, the initial score of 34.50 points (based on assessment of financial performance only) remained unmodified after a sustainability report was provided for all of the users! In essence, once investment professionals “anchored“ on the bad financial performance, good sustainability performance could not shift them away from their initial judgment. In contrast, investors using integrated reports took the good sustainability performance into account when making their performance judgment. Thus, identical information, presented in different formats, lead to different performance judgements. The results look different for the reverse case, i.e. good financial but bad sustainability performance. Here, subjects arrived at almost the same valuation score irrespective of whether reports were supplied separately or in an integrated form. In the treatment with separate reports, the initial mean score of 75.80 assigned after assessing the financial report was reduced to a mean score of 60.67 after the report with poor sustainability performance was considered. For the integrated report, subjects assigned a mean score of 57.31.
So, what are the key takeaways from the experiment? First of all, it seems that investment professionals indeed do read and use sustainability information for company valuation, provided that they are proactively supplied with the sustainability information (and do not have to search for it). The fact that our participants
with a mainstream background did look at the sustainability reports and did modify their valuation scores when presented with a sustainability report clearly emphasizes how important it is that sustainability reports are provided to investors in the format and granularity they are accustomed to from financial reports. However, companies can and do control what they provide investors with, and it is recommended that companies start to provide rather than suggest sustainability reports to their investors (Again, of course, in the same format and granularity as financial reports). Secondly, it seems that integrated reports matter most when companies cannot produce what most investors love: strong growth that translates into “bottom line“ results, consistently and continuously over several periods and accelerated through increasing order intake. Many companies do not or cannot show such performance, be it because they operate in stagnating or slow growing industries, because of constraints through economies of scale, or because they are in turnaround situations. Also, some companies are considered “controversial“ because of past scandals they were involved in or simply because of mistrust against the management. To those companies which fail to produce overall financial momentum or are involved in controversy, we clearly recommend implementation of integrated reporting in order to ensure that investors recognize their sustainability activities (of course, only if these companies invest significantly and effectively in sustainability!). Finally, companies with excellent financial performance but perhaps not too impressive sustainability performance should stop short and avoid drawing the wrong conclusions from the experiment. It is true that, given the current reporting regime, investors in many instances will not even know or be aware of poor sustainability performance.So, it could be asked: “Don’t separate reports assist in expectation management by helping to hide a bad ESG profile? Won’t this benefit an otherwise tainted company value and lower the risk profile (hence improving cost of capital) as compared to the real risk?” This, however, would be a rather short-term view. Firstly, such an attitude underestimates the substantial risk potential of untamed growth at the expense of sustainability. The market is awash with examples of companies that “all of a sudden“ found themselves under attack by NGOs because of perfunctory supply chain management or breaches of environmental laws that resulted in consumers going on strike. Second, the trend toward increased transparency, corporate governance and investors’ appetite for scrutiny makes it a simple matter of time until poor sustainability management (i.e. risk management) becomes visible. More research is needed to explore the effects of integrated reporting. Investment trades are largely triggered by stock price movements, especially when a perceived undervalued stock appears to show a trend towards a price increase. Therefore, assigning a valuation score is only one aspect of investment decisions. Buying or selling a stock is influenced by several other factors, some of which have been explored thoroughly by adjacent disciplines such as behavioural finance and economics.
While some valuable insights were gained on how important it is to provide sustainability data, other aspects of integration – e.g. the role played by presentation (narrative vs. tabular) or how to integrate and display company data on financials and sustainability at the level of content – also suggest themselves for future testing.

Ralf Frank is managing director of DVFA, the society of investment professionals in Germany. He is also global coordinator of ESG related activities of EFFAS, the European Federation of Financial Analysts Societies.
The full draft paper is available at: Link