Right now, company directors’ reliance on international accounting standards means that sustainability issues are reported separately, if at all. In some part this is because guidance last updated almost a decade ago is not aligned to the global social and environmental issues that we now all face. But there are steps that directors and trustees can take to change this – and potentially better meet their legal responsibilities.
First published in Pioneers Post
ESG, SDG, ISSB, EFRAG, TFCD, etc, etc, etc. These are busy times for company directors. But not because of the sustainability-related alphabet soup or even because there are too many ways of ‘doing sustainability’. Directors are used to complexity and virtually any specialism comes with its own TLAs (Three Letter Abbreviations). And virtually any thriving market has competitors whose different products come with special benefits. And the more important these specialisms are for a company’s business model, the more the market will provide experts – the keepers of the holy flame – and the more the company boards will start to employ people with some of that expertise.
No, these are busy times for company directors because of challenges in ensuring supplies, flurries of new regulations, employees’ salaries not being enough to live on, pressure from competitors, declining demand in some sectors, increasing barriers to international trade, shifting consumer preferences, threats from hacking, from IP theft, cost of capital and on and on and on. And, of course, from another perspective all of these could be called sustainability-related issues and managing them well just might lower that cost of capital. Might.
Among all the things that directors must do, one of the more important is to produce financial accounts. Every country has legislation that has this requirement (except perhaps the Vatican). And generally, these accounts should provide information on the financial position and performance of the business. Dull stuff. And so what happens? The legislation makes it easier by telling directors they can use international accounting standards. There are lots of experts (accountants) that know how. And the directors delegate this responsibility to these experts in accounts. And later on, an auditor checks that they comply with those international accounting standards and the directors sign them off. And the sun rises and the sun sets.
The true and fair requirement trumps international accounting standards
It almost seems to have been forgotten, in all the excitement about non-financial reporting, that it is directors’ responsibility to produce those financial accounts. Delegation doesn’t remove that responsibility. And even more forgotten that, in many countries, the responsibility is to produce accounts that provide a true and fair view of the financial position of a company. A true and fair view. The words change a bit, the scope changes a bit. But it is still there. In the UK’s Companies Act this is stated specifically. True and fair is also recognised in Article 2 (3) of the 4th Company Law Directive and Article 16 (3) of the 7th Company Law Directive issued by the European Commission.
The true and fair requirement trumps international accounting standards. Put another way, using these standards is not a guarantee that the accounts provide a true and fair position.
In the UK, what true and fair means is not legally defined, and so the Financial Reporting Council provides guidance based on a barrister’s opinion, which was last updated in 2014.
True and fair in the 21st century
Since this guidance was published, the world has woken up to the environmental and social challenges that are being faced. Not just the challenges of the environment, collapsing ecosystems, degradation and overuse of resources, rising carbon and methane levels, but also to the challenges to people’s human rights as laid down in the UN Declaration of Human Rights and as recognised by the UN in the 2030 Sustainable Development Goals.
The world has changed since 2014. All those sustainability issues are now at a critical point… Critical to an understanding of the true and fair position of a company
The problem is that the world has changed since 2014. All those sustainability issues are now at a critical point. Critical to our global society, dependent as it is on a collapsing environment and on society's systems that provide us with a living, free from the risk of war and other disasters. Critical to businesses – dependent on customers, customers increasingly divided between the poor and the ridiculously rich, for the business’ competitive position and the viability of its business model. Critical to an understanding of the true and fair position of a company. True, and, Fair.
International accounting standards have been the basis for true and fair but I believe that the gap between these and what would be true and fair now is very wide. At least wide enough that we need a new legal opinion. Directors could never fully rely on international accounting standards to meet their legal responsibilities. As the Financial Reporting Council’s True and Fair report states:
"True and fair is not something that is merely a separate add on to accounting standards. Rather the whole essence of standards is to provide for recognition, measurement, presentation and disclosure for specific aspects of financial reporting in a way that reflects economic reality and hence that provides a true and fair view."
A set of annual accounts that doesn’t provide appropriate coverage, weight and integration of sustainability issues can surely not meet the requirement to be true and fair
But now, a set of annual accounts that doesn’t provide appropriate coverage, weight and integration of sustainability issues can surely not meet the requirement to be true and fair. And auditors need to give more consideration to whether accounting standards, even properly applied, can meet the true and fair requirement. The table below is taken from Financial Reporting Council’s True and Fair report, highlighting the importance of professional judgement.
This professional judgement is all-important. It applies at all stages of preparation of the accounts, for example:
Where there is a choice of accounting policies allowed under accounting standards, ensuring that those selected are appropriate (indeed, under UK GAAP, that they are the most appropriate), taking into account the circumstances of the company (see for example FRS 18 and IAS 8)
Establishing accounting policies for items not specifically covered by accounting standards or where they are ambiguous. In such circumstances the approach in IAS 8 to consider standards dealing with similar items may be appropriate; however reliance on an approved accounting treatment of a different kind of item will not necessarily give a true and fair view.
Making judgements, for example about valuation, aimed at giving a true and fair view.
Not using detailed accounting rules as an excuse for poor accounting.
Considering what is and what is not material.
Giving appropriate disclosures even where not specifically required by accounting standards.
Ensuring that significant information is not obscured by immaterial or irrelevant disclosures (see for example ASB Statement of Principles paragraph 3.29)
Standing back at the end of the accounts process and making sure the accounts overall do give a true and fair view.
Source: The Financial Reporting Council’s True and Fair report
This is not just a legal nicety. The dominant company structure today is the limited liability company and it has been the bedrock for an extraordinary growth in investment and subsequently value created for customers over the last 200 years. It reflects a social contract. You can have limited liability as a company and as its owners and in return you must provide information that it is a true and fair position of the value you have created. For a long time now the distribution of the value created has been a problem, but now the question is whether harm being caused to people and the environment is more than the financial returns. Undermining that social contract undermines the basis of our society and inevitably undermines the competitiveness and resilience of businesses to these external shifts.
There are directors that are recognising these challenges, directors of companies who are updating their business models and their approach to value generation. Directors, for example, who have started social enterprises, embraced the SDGs and transferred ownership to the employees. Let’s look at some examples.
Kering is the holding company for major international brands including Puma, Bottega Veneta and Gucci. Kering produces an annual environmental profit and loss account which calculates the group’s negative effect on the environment, and values it. For 2021 this was €521m, 8% of EBITDA. In other words, the directors recognise that the profit they made for shareholders, and value gained by their customers and employees, came at a cost to the environment. This environmental cost that will have negative impacts on people’s lives. Yet it is a cost that does not need to be factored into the financial accounts, according to international accounting standards. Is that true? Or fair?
The Furniture Resource Centre Group is a business in Liverpool that provides furnished housing solutions and bulky household waste services, with a turnover in 2020 of £12m. The company produces an annual impact report which is set out as the directors’ report to the annual accounts. For internal management processes it produces both a financial and a social value budget and is now seeking to recognise the negative consequences of its operations more completely, and to report on the value gained and lost within the impact report.
The directors of both these companies (I am a director of FRC Group) are required to produce annual accounts which are true and fair. One can only hope that Kering’s directors are considering whether the profit they report following international accounting standards gives a true and fair view of the position of the company in the context of that cost to the environment. FRC Group’s directors will have to consider whether the profit they report presents a true and fair view of the position of the company in the light of any value created or destroyed that is reported in the directors’ report. As a registered charity, FRC Group are required to do so to meet UK government guidance on public benefit. And our auditors will have to consider whether there are any inconsistencies between the directors’ report and the financial accounts as a result.
What this means for directors
So, while directors are running around doing responsible things, putting some ESG indicators into a document or employing someone to get them through the B Corp application process, perhaps they should consider whether the information they are using to run their business, all wrapped up in management accounts, and later on tidied up to meet the needs of their external users (investors if they have them, the tax authorities either way), is helping them remain competitive and maintain resilience in turbulent times. And for those who also want seriously to manage any non-financial positive and negative consequences of their business – let’s call them contributions to sustainable development – and see the link but can’t quite quantify it, perhaps they need to internalise as many of these consequences as possible in the calculation of profit, in both their management accounts and their annual financial statements.
Currently investment is being directed to activities that undermine sustainability and this has consequences for business as well as the rest of us. It may be difficult to recognise some of the costs of the type Kering are reporting on in the annual accounts, but they could easily be brought into management accounts. With a bit of will and some leadership, they could at least be disclosed in the notes to the accounts. This would allow the directors to consider strategy, business plans and operations taking these consequences into account and maintaining their competitiveness in a far more direct way than moving from reading the financials to reading a separate ESG report, itself rarely designed as an operational management supplement to those management accounts. And they would be wearing their responsibility on their sleeves and pushing their auditors on the back foot to have to tell the directors why this information isn’t necessary for the accounts to be true and fair.
The Financial Reporting Council's guidance is pretty powerful.
The beauty of this guidance is that it would seem that information that is included over and above international accounting standards to meet the requirements of true and fair doesn’t have to meet those standards. For businesses that argue that they are doing their best to be sustainable, to operate responsible businesses, to make a positive contribution to the SDGs, this is critical. It cannot be responsible, or ethical, to book profits that come with unaccounted-for costs, only not recognised because the people experiencing those costs have little or no chance of accessing and gaining compensation. And those accounting standards, specifically IAS37 (on Provisions, Contingent liabilities and Contingent assets), let you off the hook. As the conceptual framework for financial reporting states:
"An obligation is a duty or responsibility that an entity has no practical ability to avoid."
Having a practical ability to avoid an obligation doesn’t make it fair in the general sense of fair. The directors could though override those accounting standards if they needed to, to show a true and fair position – especially if the directors believed that social norms, their public statements and ethical requirements meant they did not have a practical ability to avoid the obligation. As the guidance states, ‘accounting rules are not an excuse for poor accounting’. It is time to account for those obligations, at least in the notes if not on the balance sheet.
Although uncomfortable, this is now also necessary for a business’ resilience and competitiveness. And it is not that hard. Accounts can already include accounting estimates and be based on models. Whether your estimates and your valuations of these obligations are good enough to be true and fair is a discussion between the directors and their auditor. If you want to rise above the challenges of sustainability reporting, just start by estimating those obligations. This will very quickly force those boardroom discussions on how to remove them, and quickly drill these down to managers’ decisions at all levels. It would operationalise sustainability overnight.
If you want to rise above the challenges of sustainability reporting, just start by estimating those obligations… Better to bite the bullet now. Or bury your head in the sand and hope your investors aren’t catching up too
Legislation and social norms are slowly catching up. Better to bite the bullet now. Or bury your head in the sand and hope your investors aren’t catching up too. Certainly legislators are beginning to; for example, in the context of typhoon Haiyan, the Philippines Humans Rights Commission concluded that world’s most polluting companies were morally and legally liable for the impacts of the climate crisis because they had engaged in willful obfuscation of climate science and obstructed efforts towards a global transition to clean energy.
How does the new International Sustainability Standards Board (ISSB) relate to true and fair?
This is not just me. The IFRS, the largest standard setter for financial accounts, the standard that 150+ countries refer to, is in the process of launching sustainability disclosure standards under the ISSB to sit alongside the existing International Accounting Standards Board (IASB). If the IFRS says that information on sustainability topics is useful for primary users, it surely cannot be possible for accounts based only on IASB standards to meet the requirements of true and fair.
If true and fair now means annual accounts that meet international accounting and international sustainability disclosure standards then primary legislation – for example, section 395 of the UK Companies Act – may benefit from a change to recognise this. But it doesn’t actually have to, since true and fair trumps those accounting standards. And ISSB shifts the goal posts on what is now true and fair. The genie is out of the bottle.
It also won’t be long before someone recognises that the IFRS trustees’ aim that the information produced under IASB meets the information “needs of the maximum number of primary users” (para 1.8 of the Conceptual Framework for Financial Reporting) can’t be true if IFRS now argues that users need the information that would be provided under ISSB. And that this would mean collapsing IASB and ISSB into a single reporting framework.
What can directors (the ones who produce some form of sustainability/impact/ESG report) do?
1. Read the FRC guidance on true and fair.
2. Read some of the research on the overlap between sustainability and financial reporting; for example, the Capitals Coalition’s report on disclosing impacts on capitals in the financial statements.
3. Go over the minutes of the Audit and Risk Committee and the information they have been sent flagging up issues, many of which will relate to sustainability.
4. Then have a discussion about whether last year’s accounts are true and fair.
5. Identify one or two of the negative consequences (or impacts) of running a business that are not already in the financial statements. Avoid saying things like they would happen anyway.
6. Realise that this means profits are being made at someone else’s cost and that this amounts to an obligation that is being avoided only because of how practical ability is being construed.
7. Make a statement that the board's commitment to sustainability means there is no practical ability to avoid these obligations.
8. Decide that these should be disclosed in some way, preferably with an accounting estimate of their value – remembering FRC guidance that they should make judgements about those valuations.
9. Have an argument with their accountant about this disclosure, remind them that they produce accounts for the directors but producing the accounts is not their legal responsibility.
10. Have another argument with the auditors, ask auditors to refer to guidance they are using that stops this information being included (share with me if you find any).
11. Include the estimates of the obligations in the management accounts while this argument is going on and make sure that board decisions are now considering profitability taking these obligations into account.
12. Although true and fair goes beyond international accounting standards, it is still as well to stick to their logic. Obligations can be constructed without knowing who would be paid or when but some payment can be made to someone on account.
13. Record all this as evidence that the board is meeting the requirements for s172 of the Companies Act in the UK, and of FRC guidance in relation to s172 (the duty to promote the success of the company making decisions which have regard for the consequences of those decisions on others).
14. If you are a trading charity and you are trustees, breathe a sigh of relief that you are now meeting government requirements for charities to have evidence that any benefits outweigh (yes, outweigh) any negative consequences.
15. Sleep better.
True and fair – a technical note
Before we get into how accountants think about this, it is worth starting with the Cambridge English Dictionary definitions.
True: ‘Being what exists, rather than what was thought, intended, or stated’; and
Fair: ‘Treating someone in a way that is right or reasonable, or treating a group of people equally and not allowing personal opinions to influence your judgment’
Against these definitions, financial statements can be fair in relation to a particular group of people – but not to all people. But they cannot be true, since para 1.11. of the Conceptual Framework for Financial Reporting starts with:
‘To a large extent, financial reports are based on estimates, judgements and models rather than exact depictions.’
And so, for accountants true and fair becomes interpreted as financial statements that are free from material misstatements and faithfully represent the financial performance and position of the entity. International Accounting Standards (IAS) have been developed to meet this requirement.
The critical sections of the UK Companies Act are:
Section 393
(1) The directors of a company must not approve accounts for the purposes of this Chapter unless they are satisfied that they give a true and fair view of the assets, liabilities, financial position and profit or loss—
(a) in the case of the company's individual accounts, of the company;
(b) in the case of the company's group accounts, of the undertakings included in the consolidation as a whole, so far as concerns members of the company.
(2) The auditor of a company in carrying out his functions under this Act in relation to the company's annual accounts must have regard to the directors' duty under subsection (1).
Section 395 Individual accounts: applicable accounting framework
(1) A company's individual accounts may be prepared—
(a) in accordance with section 396 (“Companies Act individual accounts”), or
(b) in accordance with UK-adopted international accounting standards (“IAS individual accounts”).
Section 396
Companies Act individual accounts must state—
(a) the part of the United Kingdom in which the company is registered,
(b) the company’s registered number,
(c) whether the company is a public or a private company and whether it is limited by shares or by guarantee,
(d) the address of the company’s registered office, and
(e) where appropriate, the fact that the company is being wound-up.
(1) Companies Act individual accounts must comprise—
(a) a balance sheet as at the last day of the financial year, and
(b) a profit and loss account.
(2) The accounts must—
(a) in the case of the balance sheet, give a true and fair view of the state of affairs of the company as at the end of the financial year, and
(b) in the case of the profit and loss account, give a true and fair view of the profit or loss of the company for the financial year.
Section 397 IAS individual accounts
(1) IAS individual accounts must state—
(a) the part of the United Kingdom in which the company is registered,
(b) the company’s registered number,
(c) whether the company is a public or a private company and whether it is limited by shares or by guarantee,
(d) the address of the company’s registered office, and
(e) where appropriate, the fact that the company is being wound-up.
(2) The notes to the accounts must state that the accounts have been prepared in accordance with UK-adopted international accounting standards.
In summary, the true and fair requirement overrides the use of IAS; their use will generally but not necessarily result in accounts that are true and fair, which depends on legal opinions.
The Financial Reporting Council originally asked for these opinions in 1983 and 1984; these were updated in 1993 and then again in 2014 by a QC, Martin Moore. His opinion confirmed the centrality of the true and fair requirement to the preparation of financial statements in the UK.
If the directors believe that a departure from those standards is necessary to provide a true and fair view they are legally required to do so. It will not be sufficient for either directors or auditors to decide that their accounts present a true and fair view simply because they were prepared in accordance with applicable accounting standards.
FRC’s associated guidance sets out the key requirements for those preparing and auditing accounts as:
Always to stand back and ensure that the accounts as a whole do give a true and fair view;
To provide additional disclosures when compliance with an accounting standard is insufficient to present a true and fair view;
To use the true and fair override where compliance with the standards does not result in the presentation of a true and fair view; and
To ensure that the consideration they give to these matters is evident in their deliberations and documentation.
And provides examples:
Making judgements, for example about valuation, aimed at giving a true and fair view.
Not using detailed accounting rules as an excuse for poor accounting.
Considering what is and what is not material.
Giving appropriate disclosures even where not specifically required by accounting standards.
Ensuring that significant information is not obscured by immaterial or irrelevant disclosures.
Standing back at the end of the accounts preparation process and making sure the accounts overall do give a true and fair view.