Research Handbook on Financial Accounting (Research Handbooks on Accounting series) 1803920580, 9781803920580

Table of contents :
Front Matter
Copyright
Contents
Contributors
Introduction to the Research Handbook on Financial Accounting
Part I Globalization and accounting convergence
1. The benefits and detriments of global accounting convergence
Part II Earnings management, accrual manipulation, fraud, and social responsibility
2. Corporate Social Responsibility reporting and accounting
3. The impact of earnings management and the economic cycle on stress test results
4. Non-GAAP financial reporting: an ethical analysis
5. Comprehensive red flag model for accounting fraud detection using qualitative and quantitative variables
Part III Sustainable accounting
6. Financial accounting and the natural environment: the case of climate change
7. Sustainability reporting regulation: current situation and future developments
8. EFRAG roadmap for new developments in ERS reporting
9. Materiality in sustainability and integrated reporting contexts: an application of logics
Part IV Fair value and intangibles in accounting
10. Outlining commitment and resistance to dominant accounting paradigms
11. Value-relevance of intangibles – a structured literature review
Part V New trends in financial accounting
12. The use of non-financial information in financial reporting
13. The role of the public interest in shaping corporate reporting: challenges for accounting research
14. The importance of corporate governance information and disclosure for investors
15. Typology and classification of crypto-assets based on the MiCA regulatory framework: contributions and limitations
Index

Citation preview

RESEARCH HANDBOOK ON FINANCIAL ACCOUNTING

RESEARCH HANDBOOKS ON ACCOUNTING This new and exciting series brings together authoritative and thought-provoking contributions on the most pressing topics and issues in accounting. Research Handbooks in the series feature specially commissioned chapters from eminent academics, and are each overseen by an editor internationally recognized as a leading name within the field. Chapters within the Research Handbooks feature comprehensive and cutting-edge research, and are written with a global readership in mind. Equally useful as reference tools or high-level introductions to specific topics, issues, methods and debates, these Research Handbooks will be an essential resource for academic researchers and postgraduate students. For a full list of Edward Elgar published titles, including the titles in this series, visit our website at www​.e​-elgar​.com​.

Research Handbook on Financial Accounting Edited by

Luz Parrondo UPF Barcelona School of Management, Spain

Oriol Amat Universitat Pompeu Fabra, Spain

RESEARCH HANDBOOKS ON ACCOUNTING

Cheltenham, UK • Northampton, MA, USA

© Luz Parrondo and Oriol Amat 2024

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2023949640 This book is available electronically in the Business subject collection http://dx.doi.org/10.4337/9781803920597

ISBN 978 1 80392 058 0 (cased) ISBN 978 1 80392 059 7 (eBook)

EEP BoX

Contents

List of contributorsvii Introduction to the Research Handbook on Financial Accounting1 Luz Parrondo and Oriol Amat PART I 1

GLOBALIZATION AND ACCOUNTING CONVERGENCE The benefits and detriments of global accounting convergence Madeline Trimble and Xiaoxiao Song

PART II

5

EARNINGS MANAGEMENT, ACCRUAL MANIPULATION, FRAUD, AND SOCIAL RESPONSIBILITY

2

Corporate Social Responsibility reporting and accounting Seraina C. Anagnostopoulou

25

3

The impact of earnings management and the economic cycle on stress test results 45 Gregorio Labatut-Serer, Elisabeth Bustos-Contell and Salvador Climent-Serrano

4

Non-GAAP financial reporting: an ethical analysis Steven M. Mintz, William F. Miller and Tara J. Shawver

5

Comprehensive red flag model for accounting fraud detection using qualitative and quantitative variables Pilar Lloret Millán, Núria Arimany Serrat and Oriol Amat

62

87

PART III SUSTAINABLE ACCOUNTING 6

Financial accounting and the natural environment: the case of climate change Elena Carrión, Carlos Larrinaga and Antonio Mateo

106

7

Sustainability reporting regulation: current situation and future developments Soledad Moya

121

8

EFRAG roadmap for new developments in ERS reporting Luz Parrondo

138

9

Materiality in sustainability and integrated reporting contexts: an application of logics Dannielle Cerbone and Warren Maroun

v

156

vi  Research handbook on financial accounting PART IV FAIR VALUE AND INTANGIBLES IN ACCOUNTING 10

Outlining commitment and resistance to dominant accounting paradigms Wayne van Zijl and Warren Maroun

172

11

Value-relevance of intangibles – a structured literature review Olga Grzybek and Elena-Mirela Nichita

185

PART V

NEW TRENDS IN FINANCIAL ACCOUNTING

12

The use of non-financial information in financial reporting Jordi Martí Pidelaserra

13

The role of the public interest in shaping corporate reporting: challenges for accounting research Begoña Giner and Araceli Mora

14

The importance of corporate governance information and disclosure for investors251 Raffaele Manini

15

Typology and classification of crypto-assets based on the MiCA regulatory framework: contributions and limitations Luz Parrondo

214

233

264

Index283

Contributors

Oriol Amat, Professor, Universidad Pompeu Fabra, Spain Seraina C. Anagnostopoulou, Associate Professor, University of Piraeus, Grece Núria Arimany-Serrat, Senior Lecturer, Universitat de Vic UVIC-UCC and Universitat Oberta de Catalunya, Spain Elisabeth Bustos-Contell, Associate Professor, Universidad de Valencia, Spain Elena Carrión, Researcher, Universidad de Burgos, Spain Dannielle Cerbone, Associate Professor, University of the Witwatersrand, South Africa Salvador Climent-Serrano, Associate Professor, Universidad de Valencia, Spain Begoña Giner, Professor, Universidad de Valencia, Spain Olga Grzybek, Researcher, University of Economics in Katowice, Poland Gregorio Labatut-Serer, Associate Professor, Universidad de Valencia, Spain Carlos Larrinaga, Professor, Universidad de Burgos, Spain Pilar Lloret-Millán, Researcher, Universitat de Vic UVIC-UCC and Universitat Oberta de Catalunya, Spain Raffaele Manini, Assistant Professor, University of Warwick – Warwick Business School, UK Warren Maroun, Professor, University of the Witwatersrand, South Africa Jordi Martí Pidelaserra, Associate Professor, Universitat de Barcelona, Spain Antonio Mateo, Senior Lecturer, Universidad de Cádiz, Spain William F. Miller, Professor, University of Wisconsin, Eau Claire, USA Steven M. Mintz, Professor Emeritus, California Polytechnic State University, San Luis Obispo, USA Araceli Mora, Professor, Universidad de Valencia, Spain Soledad Moya, Senior Associate Professor, ESADE Business School, Spain Elena-Mirela Nichita, Researcher, Bucharest University of Economic Studies, Romania Luz Parrondo, Senior Lecturer, UPF Barcelona School of Management, Spain Tara J. Shawver, Professor, King’s College, Wilkes-Barre, PA, USA Xiaoxiao Song, Associate Professor, Southern Illinois University Edwardsville, US vii

viii  Research handbook on financial accounting Madeline Trimble, Associate Professor, Illinois State University, US Wayne van Zijl, Associate Professor, University of the Witwatersrand, South Africa

Introduction to the Research Handbook on Financial Accounting Luz Parrondo and Oriol Amat

INTRODUCTION The process of globalization has brought significant changes to the world economy, and accounting is not an exception. As businesses increasingly operate across borders, there is a growing need for accounting standards that are consistent across different countries. Accounting convergence aims to harmonize accounting standards to enable businesses to operate on a level playing field. The goal of accounting convergence is to create a single set of high-quality global accounting standards. However, there are challenges in achieving accounting convergence, including differences in legal systems, cultural values, and political ideologies. Despite these challenges, many countries are working towards accounting convergence, and there is growing interest in developing a single set of high-quality global accounting standards. The International Financial Reporting Standards (IFRS) are an example of global accounting standards that are increasingly being adopted by countries worldwide. This Research Handbook examines the costs and benefits of adopting International Financial Reporting Standards (IFRS) by local Generally Accepted Accounting Principles (GAAPs). Supporters of IFRS adoption argue that it can improve efficiency in valuing foreign mergers and acquisitions, simplify accounting practices for multinational enterprises, and enhance the overall quality of accounting worldwide. On the other hand, opponents contend that the transition costs are often high, and there are concerns about losing control over an essential part of the economy to a supranational organization. The text also explores the suggested benefits of IFRS adoption, as proposed by global accounting standards and supportive users and preparers, as well as the actual benefits achieved in countries that have already adopted IFRS. In addition, the book provides an overview of research on Corporate Social Responsibility (CSR) and its integration into accounting research. The term CSR refers to a firm’s efforts to achieve business sustainability by avoiding harmful actions towards stakeholders or promoting causes beneficial to them. The adoption of the Corporate Sustainability Reporting Directive by the EU is expected to change the Non-Financial Reporting Directive to explicitly state sustainability reporting, and the mandatory reporting for large and medium firms is expected to be audited. Accounting research consistently shows that CSR performance and reporting are significantly associated with financial and firm performance outcomes, highlighting the importance of integrating financial and sustainability information. This research supports regulatory changes by emphasizing the importance of providing adequate assurance about the quality of sustainability information and the reduction of subjectivity in accrual accounting. The book also discusses accrual manipulation and fraud, which are serious issues that can have significant economic and social consequences. Accrual manipulation, that is intentioned subjectivity within accrual accounting, can be difficult to detect and can have serious consequences for investors, creditors, and other stakeholders. To prevent accrual manipulation, 1

2  Research handbook on financial accounting companies should implement strong internal controls and conduct regular audits. Companies should also ensure that their financial statements are prepared in accordance with generally accepted accounting principles (GAAP) and international accounting standards. In addition, regulators should enforce penalties for companies that engage in accrual manipulation. On the other hand, fraud is a serious issue in accounting that can have significant economic and social consequences. Financial fraud involves the intentional misrepresentation of financial information for personal gain. Fraud can be perpetrated by individuals within a company or by outside parties. Companies have a social responsibility to prevent fraud and to ensure that their financial statements are accurate and reliable. To prevent fraud, companies should implement strong internal controls and conduct regular audits. They should also promote a culture of ethical behavior and encourage employees to report any suspected fraud. Companies should also disclose their anti-fraud policies and provide training to employees on how to identify and report fraud. Beyond the improvement of financial reporting, companies should be mindful of sustainability reporting (SR) and its regulation in Europe, specifically the Corporate Sustainability Reporting Directive (CSRD) and Environmental, Social, and Governance (ESG) reporting standards. Sustainable accounting, a new area of accounting, focuses on the social and environmental impacts of business activities, acknowledging that companies have a responsibility to address issues such as climate change, resource depletion, and social inequality. Sustainable accounting entails measuring and reporting a company’s sustainability performance, including its environmental and social impacts. This information can help investors, regulators, and other stakeholders make informed decisions about a company’s sustainability practices. To support sustainable accounting, companies should identify and measure their environmental and social impacts and disclose this information to stakeholders. Additionally, regulators should encourage companies to disclose their sustainability performance, and investors should use this information to make investment decisions. The EU has expanded the scope and requirements of SR, and the European Financial Reporting Advisory Group (EFRAG) is developing a comprehensive ESG reporting framework that improves the quality, comparability, and relevance of ESG reporting. EFRAG recognizes materiality’s importance in ESG reporting and is developing guidelines for data quality, quantity, and consistency. The book discusses fair value accounting and its association with a neoliberal objective in financial accounting. The IASB’s “Conceptual Framework” includes both stewardship and neoliberal paradigms, causing confusion among accountants. The article examines South African examples of commitment, opposition, and flexible adherence to fair value accounting, along with challenges and resistance. The importance of intangible accounting and disclosure is also highlighted. Companies should disclose information on their intangible assets and the methods used to value these assets to provide transparency. The article also explores the problematic nature of the “public interest” concept in corporate reporting, which varies over time, among stakeholders and jurisdictions, and is open to interpretation. Accounting serves the “public interest” in governance, accountability, and ethical aspects of professionals’ behavior. Changes in corporate reporting goals and stakeholder importance challenge the “public interest” notion and require further research. Finally, the accounting profession is constantly evolving, and there are several emerging trends that are likely to shape the future of the industry. One trend is the increasing use of technology, including artificial intelligence, machine learning and distributed ledger technologies to automate routine accounting tasks. This technology has the potential to reduce the time and

Introduction  3 cost of accounting tasks and provide more accurate and reliable financial information. The final chapter discusses the classification of crypto-assets and proposes an accounting guide for practitioners to adapt current IFRS standards to blockchain-based tokens. The proposed definitions address some of the concerns raised by the EFRAG Discussion Paper and aim to provide an accounting guide for financial disclosure. Overall, the topics covered include globalization of standards, quality of financial reporting, fair value and sustainable accounting, public interest in corporate reporting, emerging trends in accounting, and the need for companies to disclose information on their intangible assets and sustainability performance to stakeholders.

PART I GLOBALIZATION AND ACCOUNTING CONVERGENCE

1. The benefits and detriments of global accounting convergence Madeline Trimble and Xiaoxiao Song

INTRODUCTION Effective, evidence-based decision-making often involves quantifying and weighing costs versus benefits. The same is true when countries or territories decide if and when to converge their local generally accepted accounting standards (GAAPs) with the uniform International Financial Reporting Standards (IFRS). As globalization grows, the decisions and outcomes related to adopting globalized accounting standards remain hotly debated and relevant today. Standard setters are interested in the triumphs and failures of adoptions and the perceptions of preparers. Investors and analysts demand high-quality standards for information searching and decision-making. Finally, academics continue to explore whether this global endeavor has produced net benefits and suggest ways to improve the process. Proponents of global accounting convergence cite improved efficiency in valuing foreign M&A (mergers and acquisitions) targets, expedient accounting practices for multinational enterprises (MNEs), lowered costs when cross-listing on foreign exchanges, thus reducing the cost of capital, ease of utilizing staff across borders, and an overall increase in the quality of accounting worldwide. Critics argue, however, that the nominal and political costs of transition are often too high. Or they are concerned about losing sovereignty over an essential component of their economy to a supranational organization. The applicability and feasibility of developing globalized standards are also often mentioned. Another potential downside to standardized rules is that they omit environment-specific, potentially valuable relevant information. Lastly, the demand for globalized accounting varies by country; those countries with already functioning efficient capital markets have less need for the proposed benefits (versus the known costs) relative to transitioning and emerging markets with less developed or non-existent markets. Despite these diverging opinions, over 140 countries and territories around the world have, in some form, internationalized their accounting standards. This chapter explores the proposed benefits of IFRS adoption as suggested by global accounting standards and supportive users and preparers as well as the achieved benefits in adopting countries. For countries that have chosen not to adopt IFRS or did not realize the benefits of adoption, this study examines the costs that outweigh the benefits in their unique situations. This chapter is organized as follows: the next section provides a brief history of the creation of IFRS, its intended goals, and its widespread adoption today. The third section compares the benefits of adopting countries and explores the conditions necessary for realizing the proposed

5

6  Research handbook on financial accounting benefits. The fourth section discusses the costs of convergence and the fifth section provides a summary and outlook on the future of accounting convergence.1

BRIEF HISTORY, OBJECTIVE, AND USE OF IFRS The Development Timeline of the IASB and IFRS Before World War II, accounting was highly varied worldwide (Nobes, 1983). The growth in the internationalization of commerce following the war as well as the emergence of MNEs caused the demand for globalized accounting to rise. The first major step in this direction was the establishment of the International Accounting Standards Committee (IASC) in 1973. There were ten countries represented by the Committee, including Australia, Canada, France, Germany, Ireland, Japan, Mexico, the Netherlands, the United Kingdom, and the United States. The committee’s goal was to draft base standards, known as International Accounting Standards (IAS), on the presentation of financial position and performance that served the public good.2 From its inception through the 1980s, IASC focused on accounting standards harmonization in major markets around the world without asking them to sacrifice their local GAAPs. The IASC issued 26 basic IAS guidelines that provided great flexibility to accommodate local reporting environments (Zeff, 2012). In the late 1990s, IASC started accounting convergence through the adoption of uniform accounting standards by major markets. Nevertheless, by the early 2000s, few countries had adopted IAS as their national accounting standards. Furthermore, the IASC was criticized for its lack of transparency, independence, technical expertise, enforcement, and governance policies. As a result, the IASC was reconstituted in 2001 as the International Accounting Standards Board (IASB) and began issuing standards and amendments under the name International Financial Reporting Standards (IFRS) instead of IAS. The Board includes 14 technical expert Board members. Governance policies, strategic goals, and oversight come from the IFRS Foundation Trustees, while the IFRS Foundation Monitoring Board is responsible for public accountability. Part of the IFRS Foundation’s mission is to “ensure a broad international basis” by promoting global representation across the bodies (IFRS Foundation, 2018). Additionally, the IASB has an Advisory Council that advises the Board and Foundation, as well as an Interpretations Committee that provides direct feedback on the Board’s outputs.3 With this evolution, IASB officially shifted its focus from harmonization to convergence, which would involve the major markets adopting a uniform set of high-quality standards as their national GAAPs. Like UK GAAP, IFRS was created in the Anglo-Saxon accounting style with a capital market orientation, instead of a tax orientation as is common in Continental European accounting (Zeff, 2012). Despite the common basis, the standards themselves differ

Recent literature reviews on the role and outcomes of IFRS can be found in the work by De George et al. (2016) and Becker et al. (2021). 2 For the definitive history of the creation of the IASC/IASB, please see Camfferman and Zeff (2007, 2015) and Zeff (2012). 3 https://​www​.ifrs​.org/​about​-us/​our​-structure. 1

The benefits and detriments of global accounting convergence  7 significantly from the vast majority of major GAAPs on the market, especially in the treatment of goodwill and in the use of fair value measurement (Barth et al., 2014). One of the first major endorsements of IFRS adoption came on June 7, 2002, with EC Regulation No. 1606/2002,4 which required all listed companies in the European Union (EU) to prepare consolidated financial reports in accordance with IFRS by 2005. The EU was motivated to adopt a unified set of accounting rules due to the necessity for capital-market-oriented financial statements following the influx of former Soviet bloc companies seeking financing and to discourage European firms from adopting US GAAP to access US markets more quickly (Haller, 2002; Zeff, 2012; Camfferman and Zeff, 2015). In response to this endorsement, other major markets, such as Australia, Hong Kong, and South Africa, began requiring IFRS adoption in some form around the same time. In that same year, the IASB and FASB signed the Norwalk Agreement,5 which marked a monumental step toward global accounting convergence. The agreement’s main goal was to identify areas of divergence between IFRS and US GAAP, develop convergence projects to eliminate these differences, and establish joint standards going forward. While efforts to converge IFRS and US GAAP have cooled, and cooperation, as opposed to convergence, is the current focus, the agreement was a substantial endorsement and quality signal for the emerging global standards. The Objective, Proposed Benefits, and Basis of Globalized Accounting The mission of the IFRS Foundation is “to develop IFRS Standards that bring transparency, accountability, and efficiency to financial markets around the world. Our work serves the public interest by fostering trust, growth, and long-term financial stability in the global economy”.6 To comprehend the three-part mission of transparency, accountability, and efficiency of markets, we first have to understand why globalization is a goal. Globalization as measured by foreign direct investment (FDI) and international trade has grown exponentially over the last half-century. As of 2020, world trade amounted to US$22 trillion, which is a growth of 4300 percent since 1950.7 Several factors contribute to this trend, including investors’ demand for more opportunities to diversify their positions outside of their country, firms’ search for the least expensive and best capital-raising markets, and companies’ desire to expand and enter new markets through FDI to identify competitive and comparative advantages and/or cut costs. The intertwining of markets facilitated by economic unions and the globalization of accounting and finance provided these opportunities that were scarce and costly in the past. Concerning accounting’s role and the mission of IFRS, these standards support globalization by promoting transparency. In comparison with some local GAAPs, IFRS requires enhanced disclosure to ensure more comparable, uniform recognition and measurement

https://​eur​-lex​.europa​.eu/​legal​-content/​EN/​TXT/​?uri​=​CELEX:​32002R1606. https://​www​.fasb​.org/​page/​showpdf​?path​=​memorandum​.pdf​&​title​=​The​%20Norwalk​ %20Agreement. 6 https://​www​.ifrs​.org/​about​-us/​who​-we​-are/​. 7 https://​www​.wto​.org/​english/​res​_e/​statis​_e/​trade​_evolution​_e/​evolution​_trade​_wto​_e​.htm and https://​www​.wto​.org/​english/​res​_e/​statis​_e/​wts2021​_e/​wts2021chapter02​_e​.pdf. 4 5



8  Research handbook on financial accounting guidelines. Barth (2015) defines comparability in accounting as when firms represent similar (different) transactions and events with similar (different) accounting amounts. Comparability of accounting information is believed to benefit firms individually as well as networks of firms that interact with each other, increasing overall accounting quality (Hail et al., 2010). The improved quantity and quality of disclosure and enhanced comparability aid investors and M&A teams in making more informed capital allocation decisions (Hope et al., 2006). Accountability is proposed to increase the amount and quality of financial information available to preparers and users (Easley and O’Hara, 2004; Li, 2010). Furthermore, enhanced disclosure requirements facilitate corporate governance and better assess managers’ stewardship of investor resources (Wu and Zhang, 2009). Taken together, market efficiency could be increased by offering capital providers more opportunities to better assess risk and reduce the burden associated with cross-border capital flows. The increased capital flows are theoretically expected to boost global wealth (Barth et al., 1999). MNEs also can benefit from reduced foreign reporting, translation, and consolidation costs (André and Kalogirou, 2020) as well as lower cost of capital through high-quality, transparent, and accountable information sharing (Daske et al., 2008). The Use of IFRS Standards Around the World As of 2022, according to the IASB, 159 jurisdictions around the globe have committed to IFRS with 146 requiring IFRS for nearly all listed companies and another 13 permitting their use among other options.8 Zeff and Nobes (2010) and Song and Trimble (2022) emphasize the need to clarify the extent of IFRS adoption at the jurisdictional level. The idea that global standards will serve every country or jurisdiction uniformly is impractical. Consequently, adopting territories often adopt the standards in a variety of ways, such as full adoption of IFRS as issued by the IASB, converging IFRS with their existing local GAAPs (e.g., China, India), adopting IFRS for only certain firm types or industries (e.g., Saudi Arabia), adopting IFRS that are modified to omit certain standards (e.g., EU) or add certain standards (e.g., Brazil and Russia), permitting IFRS among other choices (e.g., Japan and Switzerland), and only allowing foreign-listed firms to use IFRS (e.g. United States). The process and timing of adopting the standards can also vary between countries. In some countries, all standards and amendments that are issued by the IASB are adopted without consulting the national standard setter, whereas others adopt IFRS on a per-standard basis into law with the option of evaluating it first at the local level in case adjustments are needed. At the national level, the decisions of whether to adopt IFRS and in what form are complex. Common-law countries are more likely to realize the accounting and capital market benefits, compared with code-law countries with historically less demand for disclosure (Ball et al., 2000; Nobes, 2011; Trimble, 2018). Countries with higher education levels that suit sophisticated standards (Judge et al., 2010) and developed capital markets and investor protections that demand high-quality accounting disclosures (Hope et al., 2006; Houqe et al., 2012) are more likely to adopt IFRS. Furthermore, countries seeking to renegotiate better trade agreements (Botzem, 2012), emerging markets wanting to signal credibility and attract FDI, and



8

https://​www​.ifrs​.org/​use​-around​-the​-world/​why​-global​-accounting​-standards/​.

The benefits and detriments of global accounting convergence  9 countries aiming to establish networking benefits with IFRS-following countries (Ramanna and Sletten, 2014) are ideal candidates for adoption. IFRS adoption is sometimes more of a necessity than a choice. This is especially true in countries that depend on colonial trade (Zeghal and Mhedhbi, 2006) or have aid stipulations from the World Bank and International Monetary Fund (IMF) (Lamoreaux et al., 2015), Additionally, many subsidiaries of MNEs are required to follow the reporting regimes of their parent companies, which is often IFRS (Ezzamel and Xiao, 2011). Some countries avoid adopting IFRS for valid reasons. Countries with theocratic legal systems, such as those with Sharia Law, may find IFRS principles, such as accounting for interest on debt, contrary to their beliefs and environment (Mohammed et al., 2016). As IFRS continues to get more complex to meet the needs of emerging developed economies, the cost of implementation (e.g., education, staff training, technologies) and compliance in audits and enforcement may outweigh the benefits of IFRS in some countries (Ezzamel and Xiao, 2011; De George et al., 2013; Barth, 2015). Countries may fear IFRS will disrupt stability and efficiency in their budding economies (Benston et al., 2006). It is possible for some countries to have political activities that are not aligned with supporting open markets (Ball, 2006), while for others, a non-governmental standard-setting body may not be comfortable, especially if they do not feel the IASB composition adequately represents their demands (Ramanna, 2013). Finally, countries where English is not the language of business might have high initial and subsequent translation costs (Evans et al., 2015; Jeanjean et al., 2015).

BENEFITS OF ACCOUNTING CONVERGENCE Global accounting convergence is an essential step to internationalize capital markets, simplify valuation in foreign company acquisitions, decrease financial reporting costs for foreign-listed companies, ease capital access, facilitate international staff transfers, and improve the overall quality of international accounting practices. In this section, we will explore what benefits of accounting convergence have been realized and discuss any conditions necessary to reap those benefits. A clear understanding of the adoption format is the first step in discussing IFRS adoption benefits. Some countries and territories have limited or flexible governance that allows them to choose to adopt IFRS voluntarily whereas others are mandated by their reporting body, an oversight body, or government to adopt the global standards. It is obvious that incentives and benefits differ in each of these cases. We will explore voluntary adoptions first. Bartov et al. (2005) examine pre-2005 German listed firms that could choose to adopt IFRS (IAS at the time) early or choose to report under US GAAP or German GAAP. Ultimately, they find that the value relevance of the disclosures was higher for firms using IAS or US GAAP relative to German GAAP. They did not find a statistically significant difference between IAS and US GAAP-reporting firms. In the same setting, Gassen and Sellhorn (2006) find that voluntary adopters of IFRS in Germany have more persistent and conservative earnings, thus improving the information environment and lowering bid-ask spreads. In terms of market reactions, Leuz and Verrecchia (2000) find that German firms that chose to adopt IAS or US GAAP had lower bid-ask spreads and higher share turnover relative to those that chose to use German GAAP. They explain that these former adopters should have lower information asymmetry and greater liquidity under IAS and US GAAP than under

10  Research handbook on financial accounting German GAAP. Leuz (2003) compares the stock liquidity (proxied by bid-ask spread and share turnover) of the German firms that adopted IAS and those that chose to adopt US GAAP and finds insignificant differences. As these results show, adoption alone is not sufficient to reap market benefits since strong enforcement and aligned reporting incentives are also necessary. Barth et al. (2008) match voluntary IFRS adopters with local GAAP firms across 21 countries and find overall benefits from IFRS adoption. These positive consequences include decreased earnings smoothing, reduced earnings management toward a target, and more timely loss recognition. The authors, however, warn that the adoption event may be conflated with other institutional changes made to promote globalization around the same time. In addition, the voluntary adoption of IFRS has an inherent self-selection bias regarding firms’ incentives to adopt IFRS, either legitimately or merely as a label (Daske et al., 2013). Christensen et al. (2015) explore Barth’s model in the German setting where firms were initially voluntary and later mandated adopters. Their results reveal that despite both samples having documented benefits, voluntary adopters experienced greater increases in earnings quality than mandated adopters. Similarly, research that attempts to standardize the institutional and economic characteristics within the sample also finds generally positive accounting benefits of voluntary IFRS adopters cannot be generalized to mandatory adopters (Hung and Subramanyam, 2007). In terms of coverage by foreign investors, Covrig et al. (2007) document that foreign mutual funds invested extensively in voluntary IFRS-adopting firms. This suggests that foreign investors are now more familiar with the globalized standards rather than foreign local GAAPs, which increases the visibility and information quality of IFRS-adopting firms. These results are particularly strong in regional funds that previously had a lot of dispersion in GAAPs, such as Western Europe. Mandatory IFRS Adoption – Proposed Benefits Following the framework of Brüggemann et al. (2013), we outline the proposed benefits by orders of magnitude starting with financial quality benefits as prepared by firms following IFRS, capital market benefits as realized by analysts and investors interpreting financials prepared under IFRS, and finally the macroeconomic benefits of jurisdictions that adopted IFRS. First order: financial reporting quality benefits Financial reporting quality (FRQ) is not easily defined, nor is it directly observable and easily captured through commercial databases. This fact, along with the heterogeneous political, economic, and legal environments of adopting countries has led to mixed findings regarding increased FRQ in IFRS-related research. An indicator of the FRQ benefits is improved comparability. Ball et al. (2000) examine the shareholder model versus the stakeholder model, the former of which IFRS was modeled after. They find that economic losses were reflected more quickly, or firms were more conservative, under the shareholder model, reasoning that the same would be true for IFRS. Barth et al. (2012) investigate the accounting comparability under IFRS and US GAAP and find the value relevance of earnings and book value of equity increased following IFRS adoption when compared with a matched sample of US firms. Similarly, Barth et al. (2014) compare the value relevance of reported financials under local GAAPs in 15 European countries and find the IFRS-reconciliations are value relevant to users.

The benefits and detriments of global accounting convergence  11 Comparability can be measured indirectly by analyzing across-boarder information flows. Wang (2014) examines information transfers between 46 countries from 2001 to 2008, dividing the sample into pre and post-IFRS adoption periods. Using earnings announcements and price reactions of non-announcing foreign companies, she finds that non-announcing peers react to earnings announcements more strongly when both the announcing and non-announcing firms use IFRS. This is especially true for firms with strong enforcement and reporting incentives, demonstrating the importance of supportive institutions in achieving the benefits of IFRS. Yip and Young (2012) find similar results when exploring indirect comparability in similar and dissimilar industries across 17 EU countries. Using measures of the volume of information transfer and similarity of information content and accounting functions, they notice unanimous improvements in comparability across all measures, with the strongest results in information shared between countries with common law legal origins and within the same industry across countries. Continuing in this vein, it is important to note that the findings are, in part, conditional on other factors besides IFRS adoption. Jayaraman and Verdi (2013) find that comparability increases among EU countries are greater for countries that adopted the Euro compared with the non-Euro-adopting EU countries, implying that similar economic conditions and integrations are necessary for realizing IFRS benefits. Furthermore, Cascino and Gassen (2015) find that comparability results are weak unless disclosure compliance or commitment to standards are considered. They find through the hand-collection of disclosure compliance, that comparability benefits are best achieved by firms that comply with the standards. Exploring FRQ in terms of a more aggregate measure, Chen et al. (2010) and Zeghal et al. (2011) use the 2005 IFRS adoption shock in the EU, Australia, South Africa, and Hong Kong, and generally find an increase in accounting quality through higher quality accruals, more timely reporting, and a lower likelihood of artificially meeting reporting thresholds. Nevertheless, it is important to note that their findings are dependent on the magnitude of differences between local GAAPs and IFRS, dubbed “accounting distance” by Bae et al. (2008). However, continuing with the EU setting, Ahmed et al. (2013a) document an increase in earnings smoothness, benchmark-beating activities, and the level of discretionary accruals following the change in accounting regulation. Callao and Jarne (2010) find that firms listed on 10 out of the 11 EU stock markets report an increased level of discretionary accruals following IFRS adoption. Furthermore, using a sample of 28 EU countries, Capkun et al. (2012) find an increase in earnings smoothing for both voluntary and mandatory IFRS adopters citing amendments that increased the flexibility of the IASs prior to 2005. Exploring a more global setting, as is the mission of the IASB, Houqe et al. (2012) investigate the effect of mandatory IFRS adoption on discretionary accruals in over 40 countries. Overall, they find that IFRS adoption improves accounting quality by reducing absolute discretionary accruals, but only in environments with strong investor protection. Similarly, Cai et al. (2014) use a sample of 31 IFRS-adopting countries and find that earnings smoothing ratios decrease most for firms in environments with high accounting distance and with high levels of enforcement. Additionally, outside of the EU, Liu et al. (2011) examine changes in financial reporting quality following the convergence of Chinese Accounting Standards (CAS) and IFRS in 2007 and document a decrease in earnings management and an increase in value relevance, especially among firms with Big 4 auditors. In contrast, a study of Canadian firms with IFRS adoption in 2011 by Liu and Sun (2015) finds no significant differences in the quality of accruals, the level of small positive earnings, or

12  Research handbook on financial accounting the persistence of earnings. Given the volume and variation of IFRS literature, a meta-analysis on reporting quality following IFRS adoption by Ahmed et al. (2013b) finds no substantive change to discretionary accruals, even when taking country-specific characteristics, such as legal origin and enforcement, into account. Taken together, many of the benefits described in the studies above are conditional on the country’s enforcement infrastructure (Holthausen, 2009; Christensen et al., 2013) as well as firm-level corporate governance and incentives (Verriest et al., 2013). Second order: capital market benefits The proposed increase in accounting quality in part documented above is projected to have positive market consequences due to increased comparability and transparency of financial statements globally. Theoretically, these efficiencies should lead to lower costs of capital and increases in liquidity and market share. Increased comparability resulting from IFRS adoption has been associated with positive market outcomes. Brochet et al. (2013) explore the UK setting, where the pre-existing UK GAAP was very similar to IFRS accounting functions. As a result, they attribute adoption-related market benefits for UK firms to greater comparability with firms outside the UK that are also following IFRS. They find that the abnormal returns of insider purchases decreased following IFRS adoption. These results are premised on the fact that IFRS lowers the amount of information asymmetry between internal and external players, reducing the internal players’ advantage to exploit internal information. Firms with the greatest improvement in comparability had the largest reduction in abnormal returns, thus supporting their arguments. Young and Zeng (2015) explore comparability in multiples-based valuation following IFRS adoption in EU countries and find that pricing accuracy increases by 2 percent annually following IFRS adoption, to enhance comparability among IFRS-adopting countries. They examine the mechanisms for the improvement and discover that firms with the largest differences between local GAAPs and IFRS have the greatest increases in pricing accuracy because of better peer selection from the globalized accounting standards. Measuring market effect by abnormal return volatility and abnormal trading volume, Landsman et al. (2012) find more volatility around European earnings announcements from 2002–2007. The results indicate a greater amount of information being disclosed, causing investors and analysts to adjust their predictions. They conclude that IFRS adoption is positively associated with earnings information quality, or information content. Increased liquidity as reflected in stock turnover and lower bid-ask spreads indicates lower transaction costs for international financial users. Daske et al. (2008) examine the liquidity effects of mandatory adopting countries at the 2005 adoption event and find, on average, similar results. Their cross-sectional analyses reveal that voluntary early adopters, EU member firms, and firms from countries with strong investor protections enjoy greater benefits. The enforcement condition was later explored in more detail by Christensen et al. (2013) who find the change in enforcement levels is a better driver than the general level of enforcement strength. Li (2010) explores the cost of capital effects for EU adopters by comparing the early voluntary adopters to mandated 2005 adopters. Results suggest that IFRS adoption is significantly associated with costs of capital, particularly in countries with strong enforcement and supportive legal institutions.

The benefits and detriments of global accounting convergence  13 The changes in access to capital have also been studied. Chen and Khurana (2015) document a decrease in listing costs as a result of firms not having to prepare dual reports for cross-listing. The IPOs of IFRS-adopting firms tend to have less underpricing and are more likely to be sought after by foreign investors (Hong et al., 2014; Byard et al., 2021). Finally, firms that adopt IFRS are less likely to begin paying dividends or increase existing dividends following adoption (Hail et al., 2014). Another area of IFRS adoption research focuses on how financial analysts interpret and apply converged standards. Byard et al. (2011) find that forecast errors and dispersion decreased following IFRS adoption. The authors attribute this to the higher quality and more uniform disclosures that result in more comparability and, therefore, better forecasts. Interestingly, the adoption of IFRS has been shown to increase the coverage of adopting firms by foreign analysts who also use IFRS and by local analysts with expertise due to covering voluntary or foreign firms already using IFRS (Horton et al., 2012); however, the increase in forecasts accuracy was only limited to foreign analysts (Tan et al., 2011). The majority of the existing literature focuses on equity market benefits, but some studies examine the debt market benefits. In theory, IFRS could improve the quality and reputation of reporting, thus decreasing borrowing costs and debt restrictions; however, the increased flexibility inherent in the principles-based standards could pose greater risks to borrowers, working against the proposed benefits. Florou and Kosi (2015) find that following IFRS adoption, firms borrowed more debt and the risk premiums on corporate bonds decreased, however, the cost of debt evidence varies with adoption type. Voluntary adopters were found to have lower interest rates on loans (Kim et al., 2011) whereas mandatory adopters experienced increases in interest rates and decreases in loan maturity (Chen et al., 2015). Evidence on whether IFRS improved credit decision quality is mixed. Studies have found that IFRS adoption can either add value to lenders (Florou et al., 2017), be less valuable to lenders (Kraft et al., 2020), or result in no change at all (Bhat et al., 2014). Third order: macroeconomic benefits The macroeconomic benefits of IFRS adoption are perhaps the most challenging to isolate. Using mandated adopters as the sample, DeFond et al. (2011) explore how improved comparability under IFRS lowers the barrier to foreign entry and facilitates across-boarder investments. The findings show a moderate increase in foreign holdings. However, their results are conditional on what they call “implementation credibility” and on whether firms report more uniformly under the converged standards. IFRS adoption is also positively associated with capital investment efficiency. Schleicher et al. (2010) and Biddle et al. (2017) find a decrease in investment cash flow sensitivity and an increase in investment value, especially in newly opened insider economies. Chen et al. (2013) demonstrate improved investment efficiency of foreign peers following IFRS due to the enhanced IFRS disclosures required of peers. Amiram (2012) documents an increase in foreign equity investments following IFRS adoption across 60 countries, especially in countries with strong investor protections, low corruption, and where the foreign investor’s home country also requires IFRS. However, Beneish et al. (2012) were unable to identify foreign equity or debt investment effects for 17 adopting countries over a similar time period. Francis et al. (2012) report an increase in the volume and magnitude of M&A after IFRS adoption in a country-pair analysis. Louis and Urcan (2015) supplement this work by finding that foreign acquisitions of listed firms are more likely to occur in IFRS-adopting countries

14  Research handbook on financial accounting than in non-IFRS countries. In a study by Gordon et al. (2012) comparing FDI inflows in IFRS and non-IFRS countries, they discovered that the former had greater inflows if the World Bank classified them as developing countries. Chen et al. (2011) and Márquez-Ramos (2011) also investigate FDI investments and both note an increase, especially in countries with lower pre-IFRS conformity and in countries with medium or high uncertainty avoidance. Taken together, these studies suggest IFRS are succeeding in achieving the goal of helping countries develop their economies.

COSTS OF ACCOUNTING CONVERGENCE In the prior sections, we outlined the expected and conditional benefits of accounting convergence. Despite IFRS literature being vast, one aspect that has not received much attention is the costs of abandoning or altering local GAAPs to converge with global accounting standards. When discussing the costs associated with adopting a globalized set of accounting standards, it is important to consider whether the costs are one-time or recurring in nature. As with any new practice, there are transition costs for first-time adopters of IFRS in terms of upskilling their expertise related to the new, oftentimes foreign, accounting standards (Barth et al., 1999). These costs stem, in part, from training and retraining employees and updating technologies. Often, transitions require expensive consulting services. In many cases, the reports themselves are longer and more complicated, increasing the amount of time and cost that accounting and auditing have to invest. Beyond the initial adoption costs, the standards themselves are highly complex and are constantly evolving to meet new market needs. Although these updates are likely important, they require ongoing, additional costs (Ball et al., 2015). It is often the case that the undoubtedly high costs of IFRS adoption are not fully incorporated into existing IFRS literature (Larson and Street, 2004; Jermakowicz and Gornik-Tomaszewski, 2006). In fact, it has been shown that these high costs result in noncompliance with some IFRS applications (Haller and Wehrfritz, 2013). Regarding transparency, there is no doubt that IFRS enhances the volume, uniqueness, and complexity of disclosures relative to most local GAAPs, resulting in greater reporting costs (Lang and Stice-Lawrence, 2015; Saha et al., 2019). However, the question remains whether these additional disclosures provide high-quality information, or information overload and possibly more opportunities for earnings management through principles and alternatives inherent in the globalized standards. As disclosure, complexity, and compliance requirements increase, auditing costs are expected to increase as well. De George et al. (2013) document an average of 23 percent transition cost related to audit fees for Australian IFRS-adopting firms. Furthermore, they estimate an 8 percent abnormal increase in yearly audit rates after adoption. Using the same setting, Pawsey (2017) estimates that Australian adopting firms have an increased accounting and compliance cost of about 20 percent due to AIS changes, staff training and development, education for financial statement users, and additional staff time allocated to the complex standards. In a similar vein, the environment of the jurisdiction adopting the standards is inherently different. As such, management incentives, corporate governance, legal structures, and enforcement levels may vary significantly in ways that could potentially undermine the objectives of

The benefits and detriments of global accounting convergence  15 IFRS (La Porta et al., 1997; Ball et al., 2000; Leuz et al., 2003). In the absence of accurate alignment between country-level institutions and firm-level incentives, long-term inefficiencies and costs can occur and convergence objectives can be degraded (Wysocki, 2011). By nature, IFRS is more principles-based than other GAAPs, which means there is more room for alternatives and professional judgment (Nobes, 2013). While honest management can provide users with more high-quality information by dictating how they want to report their performance and position, there is evidence that principles-heavy IFRS offers limited comparability and more flexibility for earnings management (Schipper, 2003; Ball, 2006). One prominent example is the IFRS rules related to fair value accounting. These rules are based on the assumption that markets are developed, liquid, and efficient (Laux and Leuz, 2009). When the environment is suitable, fair value can provide highly relevant and timely information on important asset and liability classes. However, for constituents from countries with no or small capital markets, and without adequate volume or oversight, the application and quality of outcomes of fair value accounting are often lacking (Fiechter and Novotny-Farkas, 2015). As a result, users may have to rely on modeling to calculate fair values, which requires enhanced professional judgment and reduced comparability and reliability. Overreliance on fair value can also increase volatility in reporting and market reactions. Local GAAPs that were based on historical cost are not accustomed to recognizing appreciation in value beyond the initial cost and reversing re-evaluations when necessary. This can lead to less conservatism in reporting and more short-term perspectives from both preparers and users. Furthermore, critics argue that the adoption of IFRS at one point does not guarantee the future success of IFRS in that country. Beyond the firm, the jurisdiction might also need updated company laws, tax laws, and regulatory agencies to enforce the new standards, which can be costly and politically challenging. Part of the reason for this is that the national economic authority has been entrusted to a supranational organization such as the IASB. It is unclear how a supranational organization can serve the public good or interests when its public is so vast. Therefore, many countries, but not all, still have national standards setters who review the IASB’s standards to ensure they align with local incentives and reporting requirements. Economic theory dictates that competition should lead to higher-quality outputs and lower costs for users. There will, however, be limited competition among standard setters due to the convergence of accounting regimes. Dye and Sunder (2001) argue that this limits incentives for innovation and removes valuable information about differences in standards, implementation, and outcomes among GAAPs. Nonetheless, the existence of other large, sophisticated GAAPs, such as US GAAP and Japanese GAAP, among others, means that there is still a possibility that global stakeholders may use different GAAPs to prepare statements and to evaluate firms’ performance, which undermines the comparability objective of the IASB (DeFond et al., 2011).

CONCLUSION AND FUTURE OUTLOOK The globalization of accounting standards through the creation and use of IFRS is a milestone in accounting history and is hailed as an essential driver of globalization. This chapter outlines

16  Research handbook on financial accounting the inception of global accounting convergence, proposed and realized benefits, and associated costs. Looking forward, the majority of the world has evaluated and decided to embrace IFRS in some form. However, there are still decisions to be made and changed in developing countries and transitioning economies. These environments have markets that differ from those countries that designed IFRS, specifically an abundance of small and medium-sized enterprises (SMEs). Additionally, there are differences in attitudes and demands related to qualitative, sustainability reporting. We will discuss both frontiers in this section. IFRS for SMEs To better align with the needs of their constituents, the IASB developed a simplified version of IFRS called IFRS for Small and Medium-Sized Enterprises (IFRS for SMEs). While the definition of an SME varies from country to country, it usually refers to relatively smaller firms with 1–500 employees and/or total revenues under $100 million. According to the OECD, 99 percent of firms worldwide are considered SMEs and contribute more than half of the GDP in high-income countries (OECD, 2017). Adoption of IFRS for SMEs usually reduces burdensome requirements and improves comparability, completeness, rigor, credibility, and overall quality of financial reporting. Similar to full IFRS, IFRS for SMEs is designed to help companies to increase their capital flow and resource allocation by being able to judge creditworthiness better, improve their local GAAPs through spillover effects, and enhance their investor protection reputation through more effective regulation and signaling (Albu et al., 2013). Given the significant economic impact of SMEs, and the lack of guidance for such firms locally, the issuance of IFRS for SMEs in 2009 and its subsequent adoption or permission in 86 territories across the globe9 serve as an enormous accomplishment for the Board. Early analyses indicate that, generally, countries with weak governance (Kaya and Koch, 2015; Sellami and Gafsi, 2018), common law legal systems (Bonito and Pais, 2018; Zahid and Simga-Mugan, 2019), no or weak local GAAPs (Kaya and Koch, 2015; Bonito and Pais, 2018), openness to foreign investment (Zahid and Simga-Mugan, 2019), and the significant presence of SMEs (Sellami and Gafsi, 2018) are more likely to adopt IFRS for SMEs. IFRS for SMEs can be recommended or prescribed by foreign lenders, who suggest that national standard setters should work with the IASB and learn from its process rather than developing or amending their own standards. The World Bank and IMF strongly recommended Moldova, Latvia, and Kyrgyzstan adopt IFRS for SMEs to improve reporting transparency and access to external financing.10 IFRS for SMEs, however, also presents some challenges. The EU voted to not adopt IFRS for SMEs due to the complexity of the standards, the lack of demand from users and preparers, and the potentially high adoption costs. As a result, countries with EU colonial legacies and trade agreements that seek to align with EU Directives often reject IFRS for SMEs adoption.

https://​www​.ifrs​.org/​use​-around​-the​-world/​use​-of​-ifrs​-standards​-by​-jurisdiction/​#analysis​-of​-the​ -use​-of​-the​-ifrs​-for​-smes​-accounting​-standard. 10 https://​www​.imf​.org/​~/​media/​Files/​Publications/​CR/​2018/​cr18361​.ashx and https://​documents1​ .worldbank​.org/​curated/​en/​291391468054236962/​pdf/​62579​0WP0P10080​0Box036148​6B0PUBLIC0​ .pdf. 9

The benefits and detriments of global accounting convergence  17 The principles-based approach of IFRS for SMEs is uncomfortable and costly to gain a sufficient knowledge base, especially when shortfalls reference full IFRS (Gassen, 2017). Micro and small companies might still lack the professional skill and judgment required to apply IFRS for SMEs. Hiring external accountants and consultants to assist in complying with the standards will add to the cost. Additional costs include the cost to train regulators and auditors to mandate and assure financial reports. The consequences of IFRS for SMEs adoption are largely unstudied due to a lack of data from small, private firms and details on country-level adoption dates and practices. Future research in this area would be beneficial. SASB Standards The IASB has accomplished a great deal regarding the globalization of quantitative accounting standards. Looking ahead, on November 3, 2021, the IASB announced the creation of a new board, the International Substantiality Standards Board (ISSB), which indicates a new focus for globalized standards. The Board aims to “deliver a comprehensive global baseline of stainability-related disclosure standards that provide investor and other capital market participants with information about companies’ sustainability-related risk and opportunities to help them make informed decisions”.11 In a similar manner to IFRS, the globalized sustainability standards, called SASB standards, are designed to provide investors and other stakeholders with in-depth, transparent, and comparable disclosures related to environmental, social, and governance (ESG) topics. While most regions do not yet require the reporting of sustainability activities by firms, according to KPMG, as of 2021, 96 percent of the world’s top 250 companies report some form of sustainability disclosures12. The research in the area of sustainability actions by firms is vast, yet the research on sustainability reporting is still emerging.13 These more qualitative disclosures are documented as being demanded and valuable to users of financial statements (Cohen et al., 2015). Additionally, positive market reactions can be observed for the issuance of sustainability reports, but only if they are deemed high-quality in terms of disclosure level (Guidry and Patten, 2010). However, the literature also indicates that the voluntary nature of the reporting lacks comparability (Bernow et al., 2019), includes boilerplate information in regulatory filings (Christensen et al., 2018), and that the assurance of sustainability reporting lags the growth in qualitative reporting (Alsahali and Malagueno, 2022). Increased regulation is a potential solution to improve the information quality of these reports. The ISSB, along with other regulatory initiatives such as the Global Reporting Initiative (GRI), United Nations, and national regulators, aim to provide a framework for sustainability reporting to help enhance the comparability and quality of the disclosures. However, given the global diversity in ESG practices, users’ needs, objectives, measurements,

https://​www​.ifrs​.org/​groups/​international​-sustainability​-standards​-board/​. https://​home​.kpmg/​xx/​en/​home/​insights/​2022/​09/​survey​-of​-sustainability​-reporting​-2022/​global​ -trends. 13 See Christensen et al. (2021) for an excellent literature review and analysis of the status of CSR (corporate social responsibility) and sustainability reporting. 11 12

18  Research handbook on financial accounting and enforcement, implementing this framework may prove to be a more arduous task than globalizing financial reporting. Future research into the ISSB’s role and outcomes is necessary.

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20  Research handbook on financial accounting Christensen, H. B., L. Hail, and C. Leuz (2021). “Mandatory CSR and sustainability reporting: economic analysis and literature review”. Review of Accounting Studies, 26: 1176–1248. Cohen, J. R., L. Holder-Webb, and V. L. Zamora (2015). “Nonfinancial information preferences of professional investors”. Behavioral Research in Accounting, 27(2): 127–153. Covrig, V. M., M. L. DeFond, and M. Hung (2007). “Home bias, foreign mutual fund holdings, and voluntary adoption of international accounting standards”. Journal of Accounting Research, 45(1): 41–70. Daske, H., L. Hail, C. Leuz, and R. Verdi (2008). “Mandatory IFRS reporting around the world: early evidence on the economic consequences”. Journal of Accounting Research, 46(5): 1085–1142. Daske, H., L. Hail, C. Leuz, and R. Verdi (2013). “Adopting a label: heterogeneity in the economic consequences around IAS/IFRS adoptions”. Journal of Accounting Research, 51(3): 495–547. De George, E. T., C. B. Ferguson, and N. A. Spear (2013). “How much does IFRS cost? IFRS adoption and audit fees”. The Accounting Review, 88(2): 429–462. De George, E. T., X. Li, and L. Shivakumar (2016). “A review of the IFRS adoption literature”. Review of Accounting Studies, 21(3): 898–1004. DeFond, M. L., X. Hu, M. Hung, and S. Li (2011). “The impact of mandatory IFRS adoption on foreign mutual fund ownership: the role of comparability”. Journal of Accounting and Economics, 51(3): 240–258. Dye, R. A. and S. Sunder (2001). “Why not allow FASB and IASB standards to compete in the U.S.?” Accounting Horizons, 15(3): 257–271. Easley, D. and M. O’Hara (2004). “Information and the cost of capital”. The Journal of Finance, 59(4): 1553-1583. Evans, M. E., R. W. Houston, M. F. Peters, and J. H. Pratt (2015). “Reporting regulatory environments and earnings management: US and non-US firms using US GAAP or IFRS”. The Accounting Review, 90(5): 1969–1994. Ezzamel, M., and J. Z. Xiao (2011). “Accounting in transitional and emerging economies”. European Accounting Review, 20(4): 625–637. Fiechter, P. and Z. Novotny-Farkas (2015). “The impact of the institutional environment on the value relevance of fair values”. Review of Accounting Studies, 22: 392–429. Florou, A. and U. Kosi (2015). “Does mandatory IFRS adoption facilitate debt financing?” Review of Accounting Studies, 20(4): 1407–1456. Florou, A., U. Kosi, and P. F. Pope (2017). “Are international accounting standards more credit relevant than domestic standards?” Accounting and Business Research, 47(18): 1–29. Francis, J. R., S. X. Huang, and I. K. Khurana (2012). “The role of international GAAP in cross-border mergers and acquisitions”. (Working Paper). Maastricht University, Arizona State University, and University of Missouri at Columbia. Available at: https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​ _id​=​2131472 Gassen, J. and T. Sellhorn (2006). “Applying IFRS in Germany: determinants and consequences”. (Working Paper). Humboldt University of Berlin and Ludwig-Maximilians-Universitaet. Available at: https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​906802. Gassen, J. (2017). “The effect of IFRS for SMEs on the financial reporting environment of private firms: An exploratory interview study”. Accounting and Business Research, 47(5): 540–563. Gordon, L. A., M. P. Loeb, and W. Zhu (2012). “The impact of IFRS adoption on foreign direct investment”. Journal of Accounting and Public Policy, 31(4): 374–398. Guidry, R. P. and D. M. Patten (2010). “Market reactions to the first-time issuance of corporate social reports: Evidence that quality matters”. Sustainability Accounting, Management and Policy Journal, 1(1): 33–50. Hail, L., A. Tahoun, and C. Wang (2014). “Dividend payouts and information shocks”. Journal of Accounting Research, 52(2): 403–456. Hail, L., C. Leuz, and P. Wysocki (2010). “Global accounting convergence and the potential adoption of IFRS by the U.S. (Part I): conceptual underpinnings and economic analysis”. Accounting Horizons, 24(3): 355–394. Haller, A., and M. Wehrfritz (2013). “The impact of national GAAP and accounting traditions on IFRS policy selection: evidence from Germany and the UK”. Journal of International Accounting, Auditing and Taxation, 22(1): 39–56.

The benefits and detriments of global accounting convergence  21 Haller, A. (2002). “Financial accounting developments in the European Union: past events and future prospects”. European Accounting Review, 11(1): 153–190. Holthausen, R. W. (2009). “Accounting standards, financial reporting outcomes, and enforcement”. Journal of Accounting Research, 47(2): 447–458. Hong, H. A., M. Hung, and G. Lobo (2014). “The impact of mandatory IFRS adoption on IPOs in global capital markets”. The Accounting Review, 89(4): 1365–1397. Hope, O. K., J. Jin, and T. Kang (2006). “Empirical evidence on jurisdictions that adopt IFRS”. Journal of International Accounting Research, 5(2): 1–20. Horton, J., G. Serafeim, and I. Serafeim (2012). “Does mandatory IFRS adoption improve the information environment?” Contemporary Accounting Research, 30(1): 388–423. Houqe, M. N., van Zijl, T., Dunstan, K., and A. W. Karim (2012). “The effect of IFRS adoption and investor protection on earnings quality around the world”. The International Journal of Accounting, 47(3): 333–355. Hung, M. and K. R. Subramanyam (2007). “Financial statement effects of adopting international accounting standards: the case of Germany”. Review of Accounting Studies, 12(4): 623–657. IFRS Foundation (2018). “Constitution”. Available at: https://​cdn​.ifrs​.org/​-/​media/​feature/​about​-us/​legal​ -and​-governance/​constitution​-docs/​ifrs​-foundation​-constitution​-201​.pdf ? la=en Jayaraman, S. and R. Verdi (2013). “The effect of economic integration of accounting comparability: evidence of the adoption of the Euro”. (Working Paper). University of Rochester and Massachusetts Institute of Technology. Available at: https://​papers​.ssrn​.com/​sol3/​papers​.cfm​?abstract​_id​=​2286699 Jeanjean, T., H. Stolowy, M. Erkens, and T. L. Yohn (2015). “International evidence on the impact of adopting English as an external reporting language”. Journal of International Business Studies, 46(2): 180–205. Jermakowicz, E. K. and S. Gornik-Tomaszewski (2006). “Implementing IFRS from the perspective of EU publicly traded companies”. Journal of International Accounting, Auditing and Taxation, 15(2): 170–196. Judge, W., C. Lesage, and H. Stolowy (2010). “National adoption of international accounting standards: an institutional perspective”. Corporate Governance: An International Review, 18(3): 161–174. Kaya, D. and M. Koch (2015). “Countries’ adoption of the international financial reporting standard for small and medium-sized entities (IFRS for SMEs) – early empirical evidence”. Accounting and Business Research, 45(1): 93–120. Kim, J., J. S. L. Tsui, and C. H. Yi (2011). “The voluntary adoption of international financial reporting standards and loan contracting around the world”. Review of Accounting Studies, 16(4): 779–811. Kraft, P., W. R. Landsman, and Z. Shan (2020). “Effect of mandatory IFRS adoption on accounting-based prediction models for CDS spreads”. European Accounting Review, 29: 1–28. La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. W. Vishny (1997). “Legal determinants of external finance”. The Journal of Finance, 52(3): 1131–1150. Lamoreaux, P. T., P. N. Michas, and W. L. Schultz (2015). “Do accounting and audit quality affect World Bank lending?” The Accounting Review, 90(2): 703–738. Landsman, W. R., E. L. Maydew, and J. R. Thornock (2012). “The information content of annual earnings announcements and mandatory adoption of IFRS”. Journal of Accounting and Economics, 53(1–2): 34–54. Lang, M. and L. Stice-Lawrence (2015). “Textual analysis and international financial reporting: large sample evidence”. Journal of Accounting and Economics, 60(2–3): 110–135. Larson, R. K., and D. L. Street (2004). “Convergence with IFRS in an expanding Europe: progress and obstacles identified by large accounting firms’ survey”. Journal of International Accounting, Auditing and Taxation, 13(2): 89–119. Laux, C. and C. Leuz (2009). “The crisis of fair-value accounting: making sense of the recent debate”. Accounting, Organizations and Society, 34(6–7): 826–834. Leuz, C. (2003). “IAS versus U.S. GAAP: information asymmetry based evidence from Germany’s new market”. Journal of Accounting Research, 41(3): 445–472. Leuz, C. and R. E. Verrecchia (2000). “The economic consequences of increased disclosure”. Journal of Accounting Research, 38(Supplement): 91–124. Leuz, C., D. Nanda, and P. D. Wysocki (2003). “Earnings management and investor protection: an international comparison”. Journal of Financial Economics, 69(3): 505–527.

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PART II EARNINGS MANAGEMENT, ACCRUAL MANIPULATION, FRAUD, AND SOCIAL RESPONSIBILITY

2. Corporate Social Responsibility reporting and accounting Seraina C. Anagnostopoulou

INTRODUCTION The purpose of this chapter is to summarize research on Corporate Social Responsibility (CSR) efforts and investments made by firms, and how relevant research topics have been incorporated within accounting research in a conceptual and empirical manner. During the last few decades, the term CSR has been widely used in order to describe explicit firm efforts to attain business sustainability, which can be manifested in the form of (a) efforts to avoid corporate actions and behaviors which harm stakeholders to the firm other than capital providers, i.e. relating to environmental or social issues, and (b) actions which explicitly aim at promoting causes beneficial to a set of stakeholders beyond the providers of financing. Research in accounting in relation to CSR has been widely associated with the CSR performance of firms, rather than disclosures about such activities, referring to CSR reporting in this case. For this reason, an explicit differentiation between the two notions (performance and disclosure) is made in this chapter, along with consideration of research that focuses on various CSR performance versus disclosure outcomes. At this point, it should be mentioned that the accounting and finance literature and professional practice have used a number of different terms in order to express firm performance and efforts relating to sustainability. These include Environmental, Social and Governance (ESG) reporting and performance, CSR disclosure and performance, non-financial reporting – in this last case, according to the terminology employed by the Non-Financial Reporting Directive (NFRD – Directive 2014/95) of the EU (which mandates the reporting of non-financial information for very large, or over 500 employee public interest entities within the EU), and finally, sustainability reporting, as explicitly stated by the Proposal for a Corporate Sustainability Reporting Directive (CSRD) by the EU in 2021.1 The CSRD was approved by the EU Parliament on November 10, and approved by the EU Council on November 28, 2022, implying that the first application should be in 2024 covering financial year 2023 onward (Hummel and Jobst, 2022). In relation to last point, the European Lab Project Task Force for the elaboration of potential EU non-financial reporting standards (PTF-NFRS) explicitly mentions in its early 2021 report that a positive terminology is preferable, and suggests making reference to sustainability information (and corresponding reporting), as opposed to non-financial information, given that the former better captures:

1 For an excellent and very detailed review on sustainability reporting regulation in the EU, see Hummel and Jobst (2022). Sustainability information according to the CSRD should be reported in the management report (Article 1, par. 3 and 7), so this directive proposal does not prescribe the preparation of a separate sustainability report (Hummel and Jobst, 2022).

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26  Research handbook on financial accounting (i) the interactions between the reporting entities and their stakeholders (the ways they may affect each other’s interests) and (ii) their mechanisms of value creation that are not covered by financial reporting. Sustainable business is based upon those two complementary dimensions.2

This chapter first presents a literature overview on the definition and meaning of what is known as CSR activities. It then critically reviews research on the impact of CSR activities on firm performance, earnings management and conservative reporting, by explicitly discussing issues and research that differentially focus on CSR performance versus reporting, and also CSR reporting and assurance. This chapter further covers issues of CSR measurement in accounting research, which further involves the extent to which governance-related performance (or the ‘G’ in ESG) can be combined with other aspects of sustainability performance, i.e., social and environmental performance. The chapter finally covers theoretical aspects and empirical evidence relating to accounting research on integrated reporting practices.

CORPORATE SOCIAL RESPONSIBILITY: AN OVERVIEW During the last 30 years, firms have been systematically engaging in issues and matters in favor of social and environmental causes, well and above their motivation to achieve profit maximization These involve environmental protection, community support, and fair labor practices, all of which are characterized as CSR (Gao and Zhang, 2015; Ioannou and Serafeim, 2015; Anagnostopoulou et al., 2021). According to the probably most well-known definition of CSR: ‘The social responsibility of business encompasses the economic, legal, ethical, and discretionary expectations that society has of organizations at a given point in time’ (Carroll, 1979: 499). Nevertheless, no uniform definition for CSR exists, although the general understanding for CSR-oriented firms is that they should strive to make a profit, obey the law, be ethical, and also be good corporate citizens by financially supporting worthy social causes (Gao and Zhang, 2015). CSR orientation represents a multi-stakeholder approach, as it constitutes a deviation from the strict shareholder wealth maximization objective, in order to perform some societal good (Goss and Roberts, 2011). This is because the beneficiaries of CSR include employees, the local community, and the society as a whole, through commitment, for example, to the protection of human rights or to sustainable development. CSR orientation implies that the management is committed to transparency and enhanced accountability towards stakeholders, while the firm is intrinsically more committed to its institutional role (Bozzolan et al., 2015). CSR can help minimize transaction costs and conflicts between the firm and its various stakeholders (Freeman, 1984), so ultimately work towards reducing important sources of risk, in case conflicts with stakeholders translate into significant corporate losses (e.g., if they lead to class actions; Becchetti et al., 2013). CSR can further help firms build a strong corporate reputation (Kim et al., 2012). The ethical approach to CSR supports the view managers have incentives to do what is right because relevant actions work towards the very benefit of the firm (Carroll,

2 Final Report Proposals for a Relevant and Dynamic EU Sustainability Reporting standard setting, February 2021, European Reporting Lab @EFRAG, https://​ec​.europa​.eu/​info/​sites/​default/​files/​ business​_economy​_euro/​banking​_and​_finance/​documents/​210308​-report​-efrag​-sustainability​-reporting​ -standard​-setting​_en​.pdf (accessed: March 6, 2022).

Corporate Social Responsibility reporting and accounting  27 1979; Donaldson and Preston, 1995; Jones, 1995; Phillips et al., 2003), while this effect should be stronger over longer time horizons (Brammer and Millington, 2008). On the other hand, a firm’s multi-stakeholder orientation implies participation by different interest groups in the decision-making process, combined with the existence of multiple objectives by those who share corporate control. In this direction, a stream of research has considered CSR to be a product of agency conflicts between managers and shareholders. According to this line of reasoning, CSR engagement and investment should be viewed as an agency cost of equity, with managers inclined to overinvest in CSR, as it may provide private benefits of reputation-building, making them look like good global citizens, possibly at the expense of shareholders (Barnea and Rubin, 2010). In this way, CSR practices may be linked to over-investment, in which case firm performance and value will be adversely affected by CSR engagement (Harjoto and Jo, 2011), if the latter is driven by agency considerations (Jensen and Meckling, 1976). According to this stream of research, control concentrated in the hands of just one stakeholder (for example, shareholders), could be preferable to the same amount of control distributed among different groups of stakeholders (Prior et al., 2008). According to Friedman’s (1970) legendary (and subject to different interpretations) quote that ‘the ethical responsibility of business is to increase its profits’, a firm is socially responsible if it is first and foremost responsible towards it shareholders. Friedman’s (1970) view directly follows from Levitt (1958: 47), arguing that ‘government’s job is not business, and business’s job is not government’. When multiple managerial objectives exist, as the latter arise from claims by different stakeholders, this very fact can imply the existence of no main corporate objective at all (Jensen, 2001, 2002). This is because, in such contexts, managers cannot be held accountable for not achieving corporate goals, because of obvious trade-offs among these objectives (Cennamo et al., 2009). Managerial decisions directly affect all stakeholders groups, so the manager can be viewed as the stakeholders’ agent, rather than just a shareholders’ agent (Jones, 1995; Prior et al., 2008). In this way, by adopting this stakeholder-agency perspective through taking a CSR orientation, a firm is conceived not as a bilateral relationship between shareholders and managers, but as a multilateral set of relationships amongst stakeholders (Prior et al., 2008), given that agency problems between owners and managers may become more pronounced if managers act on behalf of non-shareholder stakeholders (Williamson, 1993; Jensen, 2001; Tirole, 2001). Other research suggests that corporate ethical behavior can actually represent a windowdressing effort to satisfy personal interests by the management, when the latter invest in CSR by taking a multi-stakeholder approach possibly at the expense of shareholders. CSR may be used as a management compensation mechanism towards stakeholders, as the management tries to build its own reputation through engagement in such activities, so that it increases its job security and avoids scrutiny by satisfied stakeholders (Prior et al., 2008, who obtain this result for regulated, but not for unregulated firms). Managers may also want to reward stakeholders, e.g., their employees, by showing generosity which actually represents a form of self-defense, so that they avoid pressure from financial markets via hostile takeovers (Pagano and Volpin, 2005). According to this line of reasoning, CSR may primarily benefit managers who, at the expense of shareholders, earn a good reputation among key stakeholders (Krüger, 2015). In this case, positive news about CSR might be actually bad news for shareholders (Krüger, 2015). Other researchers also reach a similar conclusion that a CSR orientation may not always be beneficial. For example, McWilliams et al. (2006) argue that managers use CSR activities

28  Research handbook on financial accounting to achieve personal career goals and self-interested benefits, in line with Fritzche (1991). Petrovits (2006) obtains evidence that managers strategically use philanthropical contributions so that they meet financial reporting goals, and Hemingway and Maclagan (2004) argue that CSR adoption may work as a cover-up tool for corporate misconduct. This approach considers CSR to be a form of reputation insurance, as it can give firms’ management a ‘license to operate’ when possibly engaging in actions harmful to shareholders (Kim et al., 2012). The agency view on CSR considers this investment as a possible misuse of corporate resources that could be alternatively directed towards internal projects with added value, or be returned to shareholders, in the absence of another type of alternative. Under this view, CSR can be used by managers to advance their personal development and career perspectives, thus reducing CSR into an executive perk (McWilliams et al., 2006).

THE IMPACT OF CSR ACTIVITIES ON FIRM PERFORMANCE: THEORY AND EVIDENCE A number of studies have theoretically and empirically examined the association between CSR and corporate financial performance. According to one stream of theory, based on neoclassical economics, CSR may unnecessarily raise a firm’s costs, and thus put the firm in a position of competitive disadvantage with reference to its competitors (Friedman, 1970; Jensen, 2002, as summarized by Cheng et al., 2014). At the same time, agency theory further predicts that the commitment of valuable firm resources to CSR activities results in significant managerial benefits, rather than shareholder benefits (Brammer and Millington, 2008; Cheng et al., 2014). In contrast to the above, CSR has also been theoretically associated with improved access to resource markets, ability to attract valuable employees, improved marketing efforts and advertising efficiency, and the attainment of social legitimacy (Cheng et al., 2014). CSR has been further identified as the practice that permits the simultaneous efficient management of multiple stakeholders, and this context can reduce the possibility to attract negative regulatory, legislative, or fiscal action (as summarized in Cheng et al. (2014). Cheng et al. (2014) also provide theoretical and empirical evidence that CSR reduces capital constraints, as CSR performance is linked to better stakeholder engagement, by limiting, in this way, the likelihood of short-term opportunistic behavior, and reducing contracting costs, confirming a relevant prediction made by Jones (1995). At the same time, CSR reporting is expected to communicate the long term-focus of a firm to the markets, increase transparency about corporate impact on the society and the environment, as well as firm governance, and also improve the reliability of reporting, thus reducing information asymmetry between insiders and outsiders (Cheng et al., 2014). In response to the above argument as to whether CSR activities should be beneficial or not for firm performance, empirical work on the effect of CSR on financial performance has reached rather inconclusive evidence, and has observed both a positive, as well as a non-significant or even negative effect on performance (Margolis and Walsh, 2003; Margolis et al., 2011). An important theoretical and empirical question at this point is whether CSR positively affects firm performance, as predicted by instrumental theory (Donaldson and Preston, 1995; Jones, 1995), or whether CSR is actually the result of financial robustness, as predicted by the slack resources hypothesis (Waddock and Graves, 1997), with financial robustness to enable the engagement in this type of investment. Another possible case is for CSR and

Corporate Social Responsibility reporting and accounting  29 firm performance to be working in a synergistic way and forming a so-called virtuous cycle (Waddock and Graves, 1997; Surroca et al., 2010). More recently, Lys et al. (2015) provided evidence on firm engagement in CSR investments in anticipation of future stronger financial performance, while they received no evidence that CSR actually improves future financial performance. In a similar vein, Zhao and Murrell (2016) replicate the study by Waddock and Graves (1997), and do not confirm a positive bidirectional relationship between CSR and performance observed in the original study, as their evidence indicates that prior financial performance is related to subsequent CSR performance, but not the other way round. In relation to the impact of CSR intensity on market performance, Lins et al. (2017) find that CSR intensive firms experienced significantly higher stock returns (and were also more profitable and growth-intensive, with an enhanced ability to raise debt), compared with firms with lower such intensity during the 2008–2009 financial crisis. They interpret their evidence as suggestive that trust developed between firms and their stakeholders and investors – when firms are CSR-intensive or invest in social capital – becomes particularly value-relevant when the overall level of trust in firms and markets experiences a negative shock.

CSR PERFORMANCE VERSUS CSR DISCLOSURE What must be noted at this point is that the vast majority of research on CSR-related issues in accounting relates to CSR performance, as opposed to CSR-related disclosures. Christensen et al. (2021) define CSR reporting as ‘the measurement, disclosure, and communication of information about CSR or ESG topics, activities, risks, and policies’. Some early research has examined outcomes relating to the very fact that firms may or may not engage in CSR, manifested in the form of whether a firm is covered or not by a CSR performance scoring database, e.g. Harjoto and Jo (2011), however, research during the last decade has strongly examined corporate outcomes relating to firms’ CSR performance. This research conceptually associates firms’ CSR investment, expressed in the form of CSR performance (by considering that CSR investments should support CSR performance), expected to reflect the CSR orientation of firms, and links this sustainability performance to various corporate outcomes. Depending on the jurisdiction, and on whether CSR reporting is or is not mandatory, firms can disclose their CSR investment and performance information within their annual report, or provide a separate CSR report, known as a sustainability, corporate accountability, or non-financial report (Christensen et al., 2021). Exceptions to this research include attempts to measure the amount of disclosures about sustainability extracted from annual reports, or communicated by firms more generally, by focusing on CSR disclosures rather than performance. Cho et al. (2020) very recently make use of CSR press releases extracted via manual collection, in an effort to identify CSR disclosing firms. Their approach goes one step beyond other research which has attempted to collect CSR-related disclosures from firms’ annual reports or standalone CSR reports. They argue that they choose this approach because the extraction of CSR-related information from annual reports makes it difficult to distinguish CSR news from other reported financial information, while standalone reports pose similar issues, as they normally disclose annual CSR activities or future plans that are more likely to be publicized via communication channels before firms actually make their reports public (Cho et al., 2020).

30  Research handbook on financial accounting In this way, they build on a line of research which has extracted CSR disclosure information from standalone CSR reports. This research has focused on information reported by firms themselves about their CSR activities, e.g., by explicitly going through firms’ CSR reports to collect data and construct CSR disclosure scores via systematizing the type and amount of information included in the reports (Martínez-Ferrero et al., 2015; García-Sánchez et al., 2019). Older research has used less detailed approaches for measuring CSR disclosure; for example, Dhaliwal et al. (2011) measure CSR disclosure in the form of a binary variable indicating whether a firm discloses a standalone CSR report for the first time in a given year or not, or whether a firm produces a standalone CSR report or not (Dhaliwal et al., 2012, using an international sample). About mandating CSR information disclosures at the level of the jurisdiction, Krüger et al. (2021) examine the value-relevance of country-level mandatory ESG disclosure regulation enactment for a large global sample, by explicitly tracking when this kind of regulation became enforced on a country-by-country basis. They receive motivation by Christensen et al. (2021), who comment on the fact that evidence on the real effects of mandating CSR reporting is very limited, when they discuss this issue in their review paper on ESG disclosure. Krüger et al. (2021) find that mandating ESG disclosure in a given country helps increase both the availability and the quality of ESG reporting, particularly for firms with low ESG performance, and further observe positive effects on analysts’ earnings forecasts (through increased accuracy and decreased dispersion), and a lower incidence of negative ESG incidents, and, finally, a reduction in stock price crash risk. Consequently, they conclude that mandating ESG-related disclosure in a country results in both information, as well as real benefits.

CSR MEASUREMENT The vast majority of research on CSR-related accounting issues has focused on the US market (Velte, 2020), while the database of choice for this research has been the KLD (Kinder, Lyndenberg and Domini) database, followed by ASSET4 by Thomson Reuters (currently Refinitiv ESG data). These types of databases provide scores for sustainability performance, either proprietary-constructed (e.g., ASSET4), or by providing standardized information about sustainability performance strong or weak points (KLD), as elaborated by the analysts of respective firms who perform extensive sustainability analyses for large firm samples. KLD reports CSR strength and concern data for a wide range of categories, e.g., community, diversity, employee relations, environmental issues, human rights, or product, and also weaknesses in so-called exclusionary screen categories, which do not associate with corporate discretionary activities (Kim et al., 2012), referring, for example, to alcohol, firearms, gambling, or military contracting. Firm coverage from KLD has been on the increase since the early 1990s, and the same applies for the former ASSET4 database since the first year that this database began reporting data – that is, year 2002. The majority of accounting studies on CSR have made use of KLD data to measure the CSR performance of firms (Huang and Watson, 2015). These studies have typically used a combined score for CSR performance, defined as CSR strengths minus weaknesses or concerns (often scaled by the mean value of the total number of strengths/concerns in the sample for a given year), e.g., Jo and Harjoto (2014), or Kim et al. (2012). Other scholars, however, have explicitly distinguished between CSR strengths and weaknesses, and have calculated separate scores, or a measure for the strength of CSR per-

Corporate Social Responsibility reporting and accounting  31 formance based on CSR strengths only (Arora and Dharwadkar, 2011; Becchetti et al., 2013; Goss and Roberts, 2011). Ioannou and Serafeim (2015) provide arguments against the use of a combined score for CSR strengths and weaknesses. They bring forward the argument that positive CSR engagement reflects strategic corporate choices to adhere to the expectations of stakeholders. At the same time, CSR and Corporate Social Irresponsibility (CSiR) should be distinct and separate theoretical constructs, and this very fact should be measured empirically by explicitly reflecting this distinction (Ioannou and Serafeim, 2015). This separation between CSR and CSiR is based on the view that ‘doing good’ is different (theoretically, and also strategically) from ‘doing no harm’ (Ioannou and Serafeim, 2015); thus, empirical measures of CSR should differentially treat CSR positive versus negative performance manifestations. This research has typically used CSR concerns as a control variable in relevant empirical settings (Ioannou and Serafeim, 2015). This approach is consistent with other research indicating that very often, CSR and CSiR tend to move towards the same direction, with firms trying to be more responsible when they are simultaneously more irresponsible (Kotchen and Moon, 2011). Despite the prevalence of the term ESG performance in financial markets, accounting research has typically treated the ‘G’ component of ESG performance as a separate construct, with reference to the ‘E’ and the ‘S’ components. This is because, as Kim et al. (2012) argue, corporate governance can be perceived as a distinct construct from CSR, while corporate governance has been extensively examined in the literature in terms of potential outcomes on a standalone basis (indicatively, Klein 2002; Bergstresser and Philippon 2006; García Lara et al., 2009). According to Kim et al. (2012), good corporate governance ensures that the firm operates in the best interest of shareholders, but ‘because CSR includes activities that improve social and environmental conditions and serve interests of all stakeholders, depending on how one defines shareholders’ best interest, corporate governance and CSR may or may not be two completely different constructs’. At the same time, the association between corporate governance and CSR may also depend on CSR incentives: in case, for example, CSR is motivated by managerial opportunistic behavior, good corporate governance should work as a disciplinary mechanism for reducing this kind of behavior, resulting in a negative association between high quality corporate governance and CSR performance in this type of context (Kim et al., 2012). In the same direction, Lys et al. (2015) explicitly separate governance from social, combined with environmental performance, when constructing their CSR measurement proxy, with similar approaches followed by Attig et al. (2014) and Habib and Hasan (2019). Other research has made use of the ASSET4 database, recently renamed into Thomson ESG Refinitiv, which reports sustainability performance data for US and also international firms. ASSET4 reports a combined score for ESG performance, and separate scores for environmental, social, and governance performance. This dataset has been used by a number of studies, e.g. Cheng et al. (2014), Lys et al. (2015), Hawn and Ioannou (2016), Schons and Steienmeier (2016), Fauver et al. (2018), El Ghoul et al. (2019), referring to sustainability-related research, which actually goes beyond the boundaries of accounting research, while this database is also discussed in Huang and Watson (2015) in their literature review paper on CSR and accounting research. In their international sample, Bozzolan et al. (2005) conducted their analysis using CSR data sourced from the EIRIS database, which measures CSR use to a consistent and objective set of criteria primarily designed for the use of investors. This database has previously been utilized in management and accounting research, as demonstrated by Brammer et al. (2006), and Cox et al. (2004, 2007) (Bozzolan et al., 2015).

32  Research handbook on financial accounting It is interesting to discuss the approach for CSR measurement introduced by Lys et al. (2015), who decompose CSR performance, expected to represent a proxy for any CSR-related expenditures incurred by firms, into a so-called investment, or economically justified component, and a second component unrelated to economic-based factors, expected to work as a signal for managerial expectations. They refer to the first component as ‘optimal’ CSR, and to the latter as ‘deviation’ from optimal CSR. CSR decomposition is performed by expressing CSR performance as a function of firm and industry factors, where optimal CSR (deviation from optimal CSR) for each firm is measured via the fitted value (residual) from this equation. Deviation from optimal CSR is expected to indicate managerial expectations about future firm performance, and represent a signal about the strength of performance that the management expects for the future by deciding to invest in non-economically justified CSR (Lys et al., 2015). This way of measuring CSR gives researchers the opportunity to distinguish between different CSR components depending on their function, i.e., if they are investment-related versus residual, and, therefore, signaling in nature, as opposed to differentiating CSR expenditures depending on their nature, e.g., environmental-related or philanthropic, etc. This last point reflects research that has distinguished between different components of CSR depending on their nature, by differentially classifying the different categories of KLD, e.g., into ‘strategic’ versus ‘tactical’ in nature (Habib and Hasan, 2019). In this last case, different CSR outlays are differentially classified depending on their nature, i.e., environment, employee, product, and diversity categories represent so-called ‘strategic CSR’, while the community category represents ‘tactical CSR’ (Habib and Hasan, 2019).

CSR AND EARNINGS MANAGEMENT/ACCOUNTING QUALITY A significant amount of research has been dedicated into examining the association between CSR and earnings management (EM) practices undertaken by firms, strongly focusing on the US market (Velte, 2020). There have been two (contradicting) theoretical hypotheses developed: (a) on one hand, CSR-oriented firms should not be expected to engage in EM, because a corporate CSR orientation could affect managerial financial reporting discretion by favoring incentives to be transparent towards outsiders (Bozzolan et al., 2015; Kim et al., 2012), at the same time as CSR-oriented firms are also expected to be more committed to their institutional role to create value for shareholders, and be transparent (Bozzolan et al., 2015) and (b) on the other hand, in case agency theory and stakeholder theory hold about incentives to undertake CSR activities, then firms prone to EM may engage in CSR to reduce the likelihood of attracting scrutiny by stakeholders who are satisfied. This last stance is predicted by Prior et al. (2008), who argue that CSR is the result of a principal–agent problem, with managers representing agents who use CSR as a tool to maximize own private benefits (Calegari et al., 2010). An argument expressed in the literature, conflicting with this last view, is that CSR forms part of a firm’s corporate culture, so it has been institutionalized within firms in a way unrelated to any agency issues (Calegari et al., 2010). The first stream of arguments is in accordance with the so called ‘myopia avoidance hypothesis’, as developed by Chih et al. (2008), predicting that CSR-oriented firms will be less likely to engage in aggressive EM. The second stream of arguments is in accordance with Chih et al.’s (2008) ‘multiple objective hypothesis’, which favors agency theory motivations behind the decision to engage in CSR, positing that CSR may aggravate agency problems, by giving

Corporate Social Responsibility reporting and accounting  33 insiders increased motivation to engage in EM to mask their rent-seeking activities from outsiders. This is consistent with arguments and evidence obtained by Prior et al. (2008) on the strategic use of CSR by regulated firms to disguise EM. Petrovits (2006) provides evidence on the strategic use of corporate philanthropy programs to achieve earnings targets, and Kim and Venkatachalam (2011) show that ‘sin firms’ (belonging to gaming, tobacco, and alcohol sectors) actually exhibit superior financial reporting quality relative to their control group. The most comprehensive study on CSR and EM is probably the one by Kim et al. (2012), who examine the association between firms’ CSR performance and accrual-based and real EM, and also the probability for a firm to be the subject of SEC investigations. They express two conflicting hypotheses, about whether CSR should be associated with EM positively (based on ethical, political, integrative, and instrumental theories about CSR, which suggest that managers have incentives to be trustworthy and honest, leading to the formulation of the ‘transparent financial reporting hypothesis’), or negatively (if engaging in CSR represents a form of reputation insurance, then engagement in CSR reflects opportunistic incentives, leading to the formulation of the ‘opportunistic financial reporting hypothesis’). Their empirical findings indicate that a CSR orientation by firms constrains the use of EM, when the latter can take a number of different forms. Recent research has further confirmed a tendency of CSR-intensive firms to engage less in EM by classification shifting as well (Hwang et al., 2021). In this case, results on a negative association between CSR and bottom-line profit-oriented EM are also confirmed for profit manipulation related to misclassifying core expenses as special income-decreasing special items. This evidence is interpreted by Hwang et al. (2021) as an indication that socially responsible firms behave ethically in their financial reporting practices. Overall, research on CSR and EM, with a few exceptions (e.g. Prior et al., 2008) has used argumentation and obtained evidence in support of a negative association between EM and CSR, referring to studies by Calegari et al. (2010), Hong and Andersen (2011), Litt et al. (2014), and Scholtens and Kang (2013). At this point, Bozzolan et al. (2015), Huang and Watson (2015), and Kim et al. (2012) provide excellent reviews of the literature on EM and CSR. Most of the abovementioned research (with the notable exceptions, of Prior et al., 2008, and Choi et al., 2013, using Korean data) has made use of measures of EM as the dependent variable, and has treated CSR as the independent variable of interest in the empirical methodology used each time. This setting implies that EM should be driven or explained by CSR, while the expected direction of causation between CSR and EM is not generally discussed. A notable exception is the study by Calegari et al. (2010), who explicitly test for the direction of causality between EM and CSR using an appropriate Granger causality test. They hypothesize that in case ethical behavior is embedded into corporate culture, then CSR should be driving a no-EM behavior, but in case an agency motivation holds for CSR engagement, then EM should be a driving factor for CSR, so that the latter can work in the form of an impression management mechanism: ‘If the principal-agent theory is correct, then CSR represents a product of Earnings Quality (agency issue). However, if CSR represents corporate culture, then CSR influences Earnings Reporting Quality instead of vice versa’ (Calegari et al., 2010: 2). Their empirical testing indicates that CSR ‘drives’ (the lack of) EM, rather than the other way round. According to this evidence, the empirical approach taken by the majority of studies on CSR and profit manipulation is correct, with reference to whether CSR should represent the independent, as opposed to the dependent variable, in relevant research settings.

34  Research handbook on financial accounting Departing from the US context, Velte (2019) estimates equations when both (a) real and accrual-based EM and (b) environmental, social and governance performance metrics act as the dependent or independent variables, interchangeably, for firms from Germany. The negative association between EM metrics and sustainable performance is confirmed no matter which of the two variables is set to be the independent variable of interest; however, no explicit test about the direction of causality is performed for this German sample. Nevertheless, Velte’s (2019) findings constitute evidence that the causal nature of the association between EM and sustainable performance may not run in one direction only.

CSR AND ACCOUNTING CONSERVATISM Ruch and Taylor (2015) made a call in their review paper on accounting conservatism about the need to examine the association between CSR and conservative practices in reporting. Although extensive research has focused on the association between EM and CSR, EM is fundamentally different from accounting conservatism (Chen et al., 2018; Anagnostopoulou et al., 2021), both conceptually and also in terms of measurement. This is because EM relates to achieving shorter term profit targets, which should, at some point, be subject to reversals (Francis and Martin, 2010; Kim et al., 2013). However, conservatism represents firms’ response to more permanent financial reporting incentives, choices and relevant commitment, referring to corporate policies on comparatively recognizing good versus bad news (Ettredge et al., 2016), as opposed to the need and efforts to achieve shorter-term profit targets, reflecting EM. According to Watts (2003), EM cannot actually explain important findings about accounting conservatism, particularly in the longer run. This perception of conservatism is consistent with research showing that conditional conservatism tends to be stable and sticky, and slow-changing over time (Beatty et al., 2008; Khan and Watts, 2009; García Lara et al., 2016). Francis et al. (2013) are probably the first to examine the association between CSR and conservatism. They make use of a proxy for unconditional conservatism, and predict and find a positive association between this type of conservatism and corporate social performance. Then, Cheng and Kung (2016) examine the association between CSR and conservatism through the use of a firm-specific proxy for conditional conservatism, used as their dependent variable. In this way, they expect that CSR should work as an explanatory variable or a determining factor for asymmetric news timeliness. Their sample market is China, where, however, firms report on their CSR activities mandatorily, implying that there exists no discretion about disclosure of sustainability activities given that the reporting of such activities is mandatory. Using the US as the sample market, Gao et al. (2018) then examine the association between timely loss recognition and CSR by focusing on demand for conservative reporting from the side of debtholders. Their findings point towards improvements in borrowing firms’ risk profiles thanks to a socially responsible culture. They anticipate that this type of culture should reduce debtholders’ concerns about how secure their claims are, and, as a result, reduce demand for conservatism. Similar to Cheng and Kung (2016), their evidence show a negative association between CSR and asymmetric news timeliness. During the last few years, research on accounting conservatism and CSR has been on the increase. Burke et al. (2020) and Guo et al. (2020) obtain evidence on a negative association between CSR performance and conditional conservatism for the US. Cho et al. (2020) focus

Corporate Social Responsibility reporting and accounting  35 on CSR-related press releases, and find that financial reporting conservatism negatively and significantly correlates with both the quantity and frequency of CSR disclosures, extending beyond the examination of CSR performance examined by Burke et al. (2020) and Guo et al. (2020). Anagnostopoulou et al. (2021) also generally confirm a negative association between conservatism and CSR, but focus on the role of stakeholders in shaping the association between conservatism and CSR. They examine how the association between conservative reporting and CSR orientation develops in the presence of differential pressure from investors and other financial stakeholders. Their evidence shows that under unfavorable macroeconomic conditions and financial constraints, and increased levels of outside pressure from debt and equity holders, firms prioritize reporting conservatively over engaging in CSR. For their full sample period, starting in year 2000, higher levels of conservatism are found to negatively associate with a CSR orientation by firms. However, they observe a significant reversing trend for the effect of conservatism on CSR, coinciding with the post-financial-crisis period, given that the association between conservatism and CSR is found to be positive (negative) for the years before (after) the financial crisis. They interpret their evidence as suggestive that, under monitoring pressure from financial stakeholders, firms prioritize commitment to accounting conservatism over the needs of non-financial stakeholders and other interest groups. The above studies generally take the stance that CSR performance should represent the independent variable of interest, or the triggering factor for the level of conditional conservatism exhibited by firms. Anagnostopoulou et al. (2021) form an exception to this research, as they use CSR performance as the dependent variable, and conditional conservatism as the independent factor of interest. They expect that conditionally conservative reporting should be strongly embedded in companies’ business model, and should have existed before the introduction of any explicit CSR practices, while CSR policies can be more frequently adapted to current-year choices depending, for example, on available resources to invest in CSR. They perform explicit controls about the direction of causality, and cannot preclude that causality between conservatism and CSR could work in both directions.

CSR REPORTING AND ASSURANCE As of year 2022, the applicable EU Directive 2014/95/EU (NFRD) does not prescribe that non-financial reporting information (which must be disclosed by very large public interest entities, with more than 500 employees, according to this Directive) should be assured by any external party on a mandatory basis. On April 21, 2021, the Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which should amend the existing reporting requirements of the NFRD, expected to require the assurance or auditing of sustainability information reported by firms when the new legislation is enacted.3 Companies seeking to enhance the credibility of their reports and build their corporate reputation are more likely to get assurance for their sustainability reports on a voluntary basis, no matter if the assurer is an auditor or not (Simnett et al., 2009). On a global scale, it is not compulsory that CSR reports go through a compulsory audit, as is the case with financial information. This fact raises issues about the credibility of these reports for investors and 3 https://​ec​.europa​.eu/​info/​business​-economy​-euro/​company​-reporting​-and​-auditing/​company​ -reporting/​corporate​-sustainability​-reporting​_en (accessed: March 5, 2022).

36  Research handbook on financial accounting various stakeholders, in the absence of assurance that they have been prepared according to the standards they claim to adhere to each time. Credibility of CSR reporting may be even more important than for financial information because of specific features of this type of information (Christensen et al., 2021, summarizing Hasan et al. 2003; Pflugrath et al. 2011; and De Meyst et al. 2018). Interestingly, compared with financial data, mistakes in sustainability reporting are more likely to be made, and less likely to be discovered prior to reporting (Michelon et al., 2019). CSR voluntary assurance associates with a lower cost of equity capital and lower analyst forecast errors and dispersion for US firms, and this result becomes even stronger if the third-party assurance is provided by an accounting firm (Casey and Grenier, 2015). Voluntary assurance of sustainability reports by US-listed firms is also found to associate with increased sustainability restatements, relating to errors, rather than methodological updates (Michelon et al., 2019). Accounting and consulting firms may also differ in the way their assurance is perceived by outsiders (Christensen et al., 2021). Pflugrath et al. (2011) find that assurance value is larger for accounting firms. More recently, Michelon et al. (2019) provide evidence of differential characteristics of assurance provided by auditors versus consulting firms, as they find that the likelihood of restatements due to methodological updates and non-material amounts relates only to consultant (and not to accounting) assurance. Their evidence underlines the existence of interprofessional competition between accounting and consulting firms acting as assurers of sustainability information, thus raising the question of potential regulation of which party is more efficient in conducting such assurance reviews. Maso et al. (2020) use a global sample and comparatively examine audit firms that provide financial audits only, and audit firms that provide both CSR assurance and financial audits for the same client. They find that the latter group tend to issue more frequent going-concern opinions, have clients that recognize larger environmental and litigation provisions, report more persistent and value-relevant earnings, while this group does not comparatively charge higher audit fees or total fees. Their findings constitute evidence on improvements in audit quality when the same auditor simultaneously provides assurance services for financial and sustainability information. This evidence lends support for the view that financial and sustainability information can be interconnected, with repercussions about the efficiency of any fragmentation of the two audit processes.

INTEGRATED REPORTING Integrated reporting () has been suggested as the holistic approach to report financial and nonfinancial information in a way directly linked to the company’s strategy (IIRC, 2013; Baboukardos and Rimmel, 2016; Barth et al., 2017). Since the creation of the Integrated Reporting Committee (IIRC) in 2010, the practice of has been more and more widely used and understood as the strategy that should induce both managers and providers of financial information to consider the long-term consequences of a broader set of capitals (De Villiers et al., 2017). Integrated reporting is promoted by the IIRC as a method to communicate in a concise way how an organization can achieve value creation in the short, medium and long run (Sulkowski and Waddock, 2014). To date, has been mandated by law only in one jurisdiction, that is South Africa, starting in 2010 (‘apply or explain’ why the practice

Corporate Social Responsibility reporting and accounting  37 was not adopted), while adopting remains voluntary for firms based in other countries. Nevertheless, there exists calls in research in favor of making mandatory (Bernardi and Stark, 2018, as summarized in Barth et al., 2017; and Slack and Tsalavoutas, 2018). is expected to go beyond the scope of CSR reports that accompany the publication of financial results, given that CSR reports have been criticized as disconnected from firms’ strategy, from the corporate business model and financial performance (Serafeim, 2015). A number of studies have examined the value-relevance of such reports, and their quality, with reference to market valuation and analyst forecast accuracy for the South African context (Baboukardos and Rimmel, 2016; Lee and Yeo, 2016; Barth et al., 2017; Zhou et al., 2017). This research suggests that the adoption of positively relates to firm value creation (Baboukardos and Rimmel, 2016; Lee and Yeo; 2016; Barth et al., 2017), and that the quality of disclosures in integrated reports positively associates with analyst forecast accuracy (Zhou et al., 2017; Bernardi and Stark, 2018). According to this research, could be beneficial to shareholders if it improves the quality of information available to capital providers, by better articulating the linkages among the firm’s strategy, business model and value creation (Lee and Yeo, 2016). On the contrary, could be value-damaging and costly for shareholders if this kind of disclosure reveals proprietary information (Lee and Yeo, 2016). Barth et al. (2017) examine the channel behind the association between quality and value creation, and identify both a capital market and a real effects channel. They find a positive association between the quality of and firm liquidity, supporting the capital market channel, but no evidence of a relation between quality and cost of capital. They also observe a positive association between quality and expected future cash flows, as well as investment efficiency, in support of the real effects channel. They interpret their findings as supportive of the need for firms to report about the longer term, by making their internal processes more future-oriented. Criticism addressed to is that the very fact of adoption may not be very informative about the exact quality of integrated reports (Zhou et al., 2017). For this reason, studies about the South African mandatory adoption context have explicitly examined the market value-relevance of the quality of reports, measured in a number of ways. All of Lee and Yeo (2016), Barth et al. (2017) and Zhou et al. (2017) focus on the quality of , or level of conformance of company reports with the framework, as opposed to the mere fact of adopting this reporting practice. In relation to quality, governance mechanisms such as the board and the audit committee are found to positively relate to the reporting quality of and credibility-enhancing mechanisms more generally (Wang et al., 2020). The need to incorporate the quality of disclosures is justified by the fact that the framework is principles-based, providing a certain degree of balance between flexibility and prescription, while those responsible for the preparation and presentation of the integrated report within the firm will need to exert judgement when determining which matters are material and how they are best disclosed (Zhou et al., 2017). All of this above-mentioned research calls for the need to consider the quality of integrated reports, given the discretion that exists regarding compliance with the framework, as well the amount of discretion associated with relevant disclosures. In contrast to the above studies, other recent studies have focused on the voluntary adoption of integrated reporting practices outside of the South African context, using international samples. Arguelles et al. (2017) focus on firms voluntarily adopting around the world and find that firm size, return on assets, and the values of measures used as proxies for

38  Research handbook on financial accounting capitals are significant determinants of the decision to become an adopting firm, while capital markets are found to value the signal of being an early-moving firm. Maniora (2017) also focuses on global voluntary adopters and finds that companies do not actually significantly benefit from a switch from standalone ESG reporting to integrated reports. Overall, her evidence contradicts the general notion of as a superior reporting mechanism. In a similar direction, Mervelskemper and Streit (2017) obtain evidence for firms participating in IIRC’s pilot program (that is, firms voluntarily adopting the international Framework), indicating that ESG performance is valued more strongly (in a positive way) when firms publish an ESG report, irrespective of whether this is standalone or integrated one. In relation to the above, there exists calls in the research in favor of making mandatory, in the spirit of Bernardi and Stark (2016), who conclude that the mandatory presentation of integrated reports improves the understanding of firms by financial analysts (as also discussed in Barth et al., 2017; and Slack and Tsalavoutas, 2018). In the opposite direction, there have been expressed some skeptical views about from a conceptual point of view (Flower, 2015; Rowbottom and Locke, 2016), with more recent evidence by Slack and Tsalavoutas (2018) on the limited relevance of in terms of decision-usefulness for equity investors, consistent with representing a reporting fad, not yet embedded into mainstream investment thinking (Slack and Tsalavoutas, 2018). Very recently, Obeng et al. (2021) focused on voluntary adopters from 35 countries around the world and examined whether practicing integrated reporting can reduce agency problems between managers and investors, and also help lower agency costs. Their measurement of high versus low integrated reporting engagement by firms is based on a relevant measurement score by the ASSET4 database, following Serafeim (2015). They find that firms that more extensively apply integrated practices in their reporting are associated with lower levels of agency costs, and also stronger year-to-year reduction in agency costs, while the association between the intensity of integrated reporting practices and agency costs becomes more negative in countries with a stronger stakeholder versus shareholder orientation. Recent research has also examined whether integrated reporting practices associate with lower levels of managerial myopia, as the latter is manifested through the absence of any accrual-based and real EM, and thus induce firms to follow a more long-term orientation. Wu and Zhou (2022) (again using the relevant integrating reporting practice measurement score by the ASSET4 database) use a global sample and find that firms that apply an integrated approach in their reporting engage in less accrual-based EM, but actually practice more real activities EM. Their evidence indicates that the opportunistic practice of managing earnings is lower in countries with mandatory adoption of integrated reporting practices, and where capital markets are more developed. These counties are South Africa, and the authors consider the United Kingdom to possess legislation working in the same mandatory direction regarding integrated reporting, due to the mandate for ‘strategic reporting’ in the country since 2013 (Wu and Zhou, 2022: endnote 5). In the case of research making use of non-South African samples of integrated reporting adopters, scholars tend to rely on other ways to identify whether firms practice integrated reporting, or how intensive firms are in their integrated approach. For example, Wu and Zhou (2022) and Obeng et al. (2021) base the identification of firms applying integrated reporting approaches on Serafeim (2015), who uses a relevant data item from the ASSET4 database measuring firms’ adoption of higher or lower levels of integrated reporting practices, but do not verify the adoption of the framework by firms in an official manner. Criticism

Corporate Social Responsibility reporting and accounting  39 about identifying integrated reporting adoption by firms using this method has been made by De Villiers et al. (2017: 947). Maniora (2017) identifies problems regarding the reliability of the information on integrated reporting provided by CorporateRegister.com, which she uses to identify adopters, where companies do not use the label ‘integrated report’ (Eccles and Serafeim, 2014), as a limitation of her study. In a similar way, Arguelles et al. (2017) make use of firms from the GRI reports list as of 2014, relying on the expectation that once a firm declared itself as an integrated reporter, it would continue to be one for all years subsequent to the year of its first self-declaration.

CONCLUDING REMARKS CSR, and, more generally, sustainability reporting research has provided systematic evidence on the value-relevance of sustainability performance and relevant disclosures about various corporate outcomes during the last few decades. Although the way to disclose information and reporting practices about this type of information has taken various forms during these years – ranging from reporting relevant information within annual reports, or in a standalone CSR report, or through an integrated report – and the mandatory nature of the provision of this information has depended on the jurisdiction, the future of sustainability reporting appears to develop in the direction of mandatory prescription to produce relevant reports for large, as well as medium firms, with these reports to be mandatorily audited. The same applies with regard to the standards to follow when producing reports about firm sustainability policies and practices, which are not, for the moment, standardized across jurisdictions, in the same way as financial reporting standards have been, to a great extent, around the world, i.e, through the widespread adoption of IFRS. The auditing of sustainability reports also appears to be on the track of becoming mandatory, to increase assurance for investors about the validity of this (not so easy to validate) corporate citizenship information. Accounting research on CSR, which has been the predominant term used over the last three decades about corporate sustainability efforts and reporting, has provided support for these anticipated regulatory changes. This has been done by providing consistent evidence that CSR performance and reporting significantly associate with financial reporting and firm performance outcomes, as well as evidence about the value-relevance of reporting to stakeholders by integrating financial with sustainability information, and the importance of providing adequate assurance about the quality of sustainability information.

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3. The impact of earnings management and the economic cycle on stress test results Gregorio Labatut-Serer, Elisabeth Bustos-Contell and Salvador Climent-Serrano

INTRODUCTION Years after the demand-driven 1929 stock market crash and the supply-driven 1973 oil crisis, the global economy has been heavily affected by a third crisis, which originated in the financial sector (Rodrik, 2016). The overwhelming loss of confidence in the financial sector, which is highly sensitive to public sentiment, has led to the widespread use of stress tests among banks. The goal of these stress tests is to boost confidence in the financial markets by increasing transparency (Climent-Serrano, 2016). Stress tests consist of estimating banks’ performance under different economic scenarios. Specifically, performance is estimated for two scenarios: a baseline scenario and an adverse scenario. Stress tests thus estimate accounting profit based on possible changes in key macroeconomic variables. Accordingly, stress tests are an important tool for banking regulators (Sahin and de Haan, 2016). They also offer useful information for investors because they estimate potential losses by banks (Quijano, 2014). However, stress tests are a recent development, and their estimates are complex. Therefore, these estimates are often inaccurate, meaning that these tests fail to achieve their primary goal (Climent-Serrano and Pavía, 2015). Errors in the predictions made by stress tests are due to numerous factors. For example, the methodological foundations are flawed because a single model is estimated for the baseline and adverse scenarios.1 Thus, the effect of income and loan loss provisions is proportionally identical in both scenarios. For example, if a 2 percent increase in GDP reduces the rate of non-performing loans by 1 percent, then a 2 percent decrease in GDP increases the rate of non-performing loans by 1 percent. These results raise serious concerns regarding the effectiveness and validity of the methodology behind stress tests. Stress tests have a further weakness in that they consider only the effects of the state of the economy on banks’ results, while they overlook other factors that may also affect profit forecasts. Such factors include the economic cycle and earnings management, defined as the ability to increase or decrease

1 Two cases exemplify errors in stress test estimates. First, during the IPO of the Spanish bank Bankia in July 2011, the European Banking Authority (EBA) published an official document, based on the results of the 2011 European stress test, assuring investors that in the adverse scenario for 2012, Bankia met the minimum capital threshold. In 2012, however, Bankia was bailed out with €22.5 billion of taxpayers’ money. Second, according to the Oliver Wyman stress test (Wyman, 2012), published on 28 September 2012, the capital requirements of another Spanish bank, Banco de Valencia, were €1.8 billion. On 27 November 2012, however, Banco de Valencia received a public bailout of €4.5 billion to boost its capital (Climent-Serrano and Pavía, 2015).

45

46  Research handbook on financial accounting reported net income at will (Copeland, 1968, p. 101). These weaknesses of the stress test (i.e., biased modeling methodology and the limited use of factors that affect financial firms’ performance) justify the relevance of this research. The aim of this research is to determine whether the stress tests designed by the European Banking Authority (EBA) suffer from flaws that prevent them from providing an accurate picture of banks’ annual accounts. To achieve this aim, we first analyzed whether the banks in the sample smoothed their earnings. Although the existence of earnings management in the banking sector has been widely shown by previous research (Bhat, 1996; Bouvatier, 2014), we considered it necessary to check for the existence of earnings management for our sample of Spanish banks. We were thereby able to frame this study within the existing literature. Next, we studied whether this behavior and the scale of earnings management depended on the economic cycle. Finally, we introduced these variables into the stress test, forcing us to specify a new model to reflect the situation faced by banks and the phase of the economic cycle. We were thus able to improve the efficiency of the stress test results. To achieve our research aims, we performed sequential analysis of how earnings management affects estimates of non-performing loans in banks according to the economic cycle. Thus, we examined the way in which earnings management affects accounting profit in the context of stress tests. We used the methodology described in the EBA’s methodological note to estimate non-performing loans and losses in stress tests that were conducted in 2016 (EBA, 2016). This chapter contributes to the literature by examining the interrelationships between stress tests, the economic cycle, and earnings management. During the literature review, we found no studies that examined these variables together. This chapter thereby adds value to the literature. Furthermore, the empirical focus in this chapter is also novel in that it follows the EBA’s guidelines by using two models while also confirming the results using a third model. In addition to covering earnings management, this third model includes three estimates based on which period is considered: the entire study period, the growth period, or the period of economic recession. This paper has the following structure. The next section establishes the theoretical framework based on a review of the literature. The third section describes the method, sample characteristics, and variables used in the study. The fourth section introduces the models. The fifth section presents the results of the analysis. The sixth section discusses these results and presents the primary conclusions of the study.

BACKGROUND According to Schuermann (2014), the technical discipline of risk management started in 1994 with the publication of the RiskMetrics technical document. The free distribution of part of this technical document, which was written by the investment bank JP Morgan, and daily estimates of the variance–covariance matrix of the performance of the main class of assets popularized methods based on Value-at-Risk (VaR). Variations of VaR have since become the most widespread quantitative approximations for measuring the market risk associated with banks’ credit portfolios. In the 1990s, the vulnerability of many countries’ financial systems attracted the interest of numerous academics. During this period, scholars began to analyze stress tests (Čihák, 2007).

The impact of earnings management and the economic cycle on stress test results  47 Notable studies of earnings management in the broader business context include Jennifer’s (1999) study, which reports how managers use imports and exports for earnings management. Dechow et al. (1995) conclude that all models produce well-specified tests for a random sample of event-years. However, when samples of firm-years with extreme financial performance are considered, the models produce misspecified tests. Frankel et al. (2002) studied audit fees, reporting that non-audit fees are positively associated with earnings management. Han et al. (2010) affirm that the extent to which managers smooth earnings is related to the cultural values and legal system of their country. Recently, Boecking et al. (2015) analyzed the effectiveness of the German accounting enforcement system to detect and limit earnings management. Finally, Lazzem and Jilani (2018) report that leverage increases provide incentives for managers to manipulate earnings. Numerous studies have also examined earnings management in the banking sector. Xie et al. (2003) argues that the composition of the board and, more specifically, the audit committee is related to the likelihood that the company exercises earnings management. Chung-Hua and Hsiang-Lin (2005) affirm that two thirds of banks perform earnings management, reporting that earnings management increases when earnings rise and that stronger investor protection and greater transparency reduce earnings management. Cornett et al. (2009) report an inverse relationship between the independence of the board and earnings management. Kanagaretnam et al. (2010) found that both auditor type and auditor industry specialization influence earnings management. De Boskey and Jiang (2012) found evidence that US banks apply earnings management. However, audit specialization restricts this type of action. Earnings management also affects the quality of the financial system depending on different factors. In a study of banks inside and outside the Eurozone, Curcio and Hasan (2015) observed that the managers of banks with a greater concern for the quality of their credit portfolio do not use earnings management. In contrast, the managers of banks outside the Eurozone use this type of instrument to a greater degree. Almadi and Lazic (2016) affirm that institutional factors influence earnings management. Accordingly, banks in the UK or Australia, which reportedly have greater investor protection, smooth earnings to a lesser degree. In their study of US banks, Gombola et al. (2016) found that earnings management by banks was achieved through loan loss provisions estimated by non-performing loans. Likewise, Cummings and Durrani (2016) studied 23 Australian banks, also finding evidence of the use of losses due to non-performing loans in earnings management. Cummings and Durrani (2016) conclude that managers were using their discretion to establish loan loss provisions and thus alleviate the impact of fluctuations in credit market conditions on their lending activities. In addition, Cummings and Durrani (2016) report that the new Basel III framework lets banks estimate expected losses using their own credit-risk models, a practice that encourages managers to use their discretion when making decisions regarding loan loss provisions. Scholars have linked earnings management through loan loss provisions to numerous factors. For example, based on a study of 113 US banks, Ahmed et al. (1999) found that loan loss provisions were used for capital management rather than earnings management. Laeven and Majnoni (2003) found that banks defer loan loss provisions to magnify the effect of the economic cycle on the bank’s income and capital. Kanagaretnam et al. (2004) report that earnings management decisions are related to the need for external financing and to profits and losses in the stock market. After studying a sample covering 87 percent of Australian banks’ assets, Anandarajan et al. (2007) observed that Australian banks were using loan loss provisions for capital manage-

48  Research handbook on financial accounting ment and earnings management but failed to find evidence that the Basel framework changed this behavior. Perez et al. (2008) studied a sample of Spanish banks covering 95 percent of assets, reporting similar findings to those of Anandarajan et al. (2007). Fonseca and Gonzalez (2008) found that earnings management depends on the protection, disclosure, regulation, and supervision of investors, the financial structure, and financial development. Leventis et al. (2011) analyzed a sample of European banks for the period 1999 to 2008, finding that earnings management fell following the implementation of International Financial Reporting Standards (IFRS). Basu (2011) reports that stress tests cannot work as a strategy if loan loss provisions are probabilistic. Because of this limitation and scholars’ interest in linking the macro economy to the financial sector, regression techniques have been used to establish explicit relationships between non-performing loans and macroeconomic fundamentals (Foglia, 2009; Sorge, 2004). In our study, just as in the studies by Curcio and Hasan (2015), Dechow et al. (1995), Degeorge et al. (1999), and Frankel et al. (2002), the findings in relation to earnings management differ depending on numerous factors. In this case, that factor is the economic cycle. Thus, our hypotheses relate to how earnings management in the Spanish financial system differs according to the phase of the economic cycle. In this case, we also expect the results of the stress tests to differ in periods of growth and in periods of recession. This chapter builds on the studies cited earlier, particularly Agarwal et al.’s (2007) study. Despite not examining stress tests, Agarwal et al. (2007) analyzed accounting data for 78 Japanese banks to study earnings management variations according to the economic cycle. As in the present study, Agarwal et al. (2007) simultaneously examined both factors. However, our study differs in that it focuses on stress tests. As shown in the literature review, earnings management is common in many sectors, including the banking sector. Thus, the first hypothesis of this study investigates whether the banks in our sample smoothed earnings through loan loss provisions. This hypothesis is necessary to lend robustness to the conclusions of the study. The existence of earnings management gives rise to the second hypothesis, which investigates whether the impact of earnings management on stress tests differs in periods of growth and recession.

DATA AND METHOD Sample We studied earnings management in Spanish banks. We focused only on Spanish banks because of the serious difficulties in performing studies that cover banks from multiple countries. Such difficulties include variations in the structure and organization of different national financial systems, differences in national financial regulations, and the frequent regulatory changes that occur at different moments in different countries. In addition to these difficulties, we also encountered operational barriers. The commercial databases typically used in academic research pose considerable limitations in terms of coverage. For example, BankScope covers only 47.56 percent of banks in Spain, 24.68 percent in the UK, 11.41 percent in Portugal, 48.72 percent in France, and 18.99 percent in Luxembourg (Foos et al., 2010, p. 2931).

The impact of earnings management and the economic cycle on stress test results  49 According to Beck and Demirgüç-Kunt (2009) and Bhattacharya (2003), attempting to study a group of countries with the aforementioned limitations would lead to biases in the variables that relate to the market structure. Furthermore, variations in the rate of coverage over time may affect the results of comparisons (Ibáñez et al., 2014). Further supporting this argument, the EBA’s methodological note (EBA, 2016) recommends accounting for the characteristics of each country. In this kind of study, it is therefore advisable to focus on just one country. Notably, however, the Spanish financial system is part of the European Monetary System of the Eurozone. Therefore, the data obtained are applicable to any country with a developed financial system. Furthermore, the Spanish financial system suffered the effects of the international financial crisis after a lag of two years (Ontiveros and Berges, 2010). In Spain, three stress tests have been performed on Spanish banks. The first test was performed by the IMF as part of the Financial Sector Assessment Program (FSAP) in 2012. The second test was the top-down stress test (at the macroprudential regulation level) performed by two external consultants, Roland Berger and Oliver Wyman, in 2012. The third test was a bottom-up stress test (at the individual level), which was conducted by Oliver Wyman in September 2012. We analyzed data for 2004 to 2015, both years inclusive. This period spanned two phases of the global economic cycle: growth and downturn. The data were gathered from financial accounts and the annual reports of banks within the Spanish credit system. We gathered data for approximately 95 percent of total assets. The sample comprised 75 entities. Method To estimate the dependent variables, we followed the recommendations in the 2016 EU-wide Stress Test methodological note (EBA, 2016). Table 3.1 summarizes these recommendations. In EBA notation, non-performing loans are referred to as probability of default (PD), and loan loss provisions are referred to as loss given default (LGD). Table 3.1

Recommendations by the EBA

Point 29

The stress test is conducted on the assumption of a static balance sheet.

Point 33

Banks are required to project the impact of the defined scenarios but are subject to constraints and reviews.

Point 40

The estimation of impairments requires the use of statistical methods and includes the following main steps: estimating starting values of the risk parameters, estimating the impact of the scenarios on the risk parameters, and computing impairment flows as the basis for provisions that affect the profit and loss.

Point 88

For the estimation of projected parameters, banks should use models rather than resort to benchmarks to determine stressed PDpit and LGDpit parameters (under both the baseline and the adverse scenario). Banks’ models will be assessed by competent authorities.

Note: PDpit: Probability of default = non-performing loans (NPLs); LGDpit: Loss given default = loan loss provisions (LLPs).

In the 2016 EU-wide Stress Test methodological note (EBA, 2016), the model to estimate the flow of impairments on new defaulted assets at time t+1 is given by: Gross Imp Flow New (t+1) = Exp(t) × PDpit(t+1) × LGDpitNEW(t+1) As per EBA nomenclature, Exp(t) refers to exposures (i.e., loans granted to customers); PDpit(t+1) refers to the probability of default due to exposures for year t+1; and LGDpitNEW(t+1)

50  Research handbook on financial accounting refers to estimates of loss given default for year t+1. We adopted the following nomenclature from the literature: PD refers to non-performing loans (partially or fully defaulted loans) and LGD refers to loan loss provisions, namely the percentage of non-performing loans entered into the accounts as losses in the profit and loss statement. This percentage depends on the time since the last loan default. Based on the static model defined by the EBA, we used ordinary least squares (OLS) regression to develop two models: one for PD and one for LGD. Each model comprised three sub-models: a, b, and c. Table 3.2 describes the data period and the variables covered by each model. Table 3.2

Definition of models

Models

Sub-models

Variables

PD/Loans

Sub-model 1a: Covers data for the full period (2004–2015)

Explanatory variables:

(model 1)

Sub-model 1b: Covers data for the growth period (2004–2009)

EBTLGD/Assets

Sub-model 1c: Covers data for the downturn (2010–2015)

(PD/Loans) (t–1) Dependent variable: PD/Loans

LGD/PD

Sub-model 2a: Covers data for the full period (2004–2015)

Explanatory variables:

(model 2)

Sub-model 2b: Covers data for the growth period (2004–2009)

EBTLGD/Assets

Sub-model 2c: Covers data for the downturn (2010–2015)

(LGD/PD) (t–1) Dependent variable: LGD/PD

LGD/Loans

Sub-model 3a: Covers data for the full period (2004–2015)

Explanatory variables:

(model 3)

Sub-model 3b: Covers data for the growth period (2004–2009)

EBTLGD/Assets

Sub-model 3c: Covers data for the downturn (2010–2015)

(LGD/PD) (t–1) Dependent variable: LGD/PD

Notes: For the PD models, EBTLGD/Assets refers to the ratio of earnings before tax and losses from loan loss provisions to total assets; (PD/Loans) (t–1) refers to the one-period lagged ratio of non-performing loans to total loans in the credit portfolio; and PD/Loans refers to the ratio of non-performing loans to total loans in the credit portfolio. For the LGD models, EBTLGD/Assets refers to the ratio of earnings before tax and losses from loan loss provisions to total assets; (LGD/PD) (t–1) refers to the one-period lagged ratio of loan loss provisions to non-performing loans (percentage of loans leading to losses); and LGD/PD refers to the ratio of loan loss provisions to non-performing loans (percentage of loans leading to losses). The GDP and 12-month Euribor were included in all models as control variables.

The unit roots hypothesis was accepted for the dependent variables PD/Loans and LGD/PD, so the dependent variables were cointegrated of order 1 – i.e., C(1). We therefore included the one-period lagged variables in both models, so these models were dynamic. In models 2 and 3 of the LGD model, we included an additional dummy variable, which took the value 1 in 2012 and 0 otherwise. In 2012, new legislation entered into force to substantially increase loan loss provisions due to non-performing loans. Thus, the percentage of loan loss provisions that were applied as losses in annual accounts increased considerably. This variable was included to capture the effect of changes to Spanish regulations on loan loss provisions. These changes affected companies’ annual accounts from 2012 onward.2

2



This change exemplifies the differences between different countries’ regulatory frameworks.

The impact of earnings management and the economic cycle on stress test results  51

SPECIFICATION OF MODELS All models in the study were estimated by OLS using unbalanced panel data, with the 75 banks in the sample varying over the study’s 12-year period. The proposed models were as follows: ​  PD  )   ​  ​​  ​  ​=  ​β1​ ​  +   ​β2​ ​ E ​ BTLGD​it  ​  +   ​β3​ ​   ​PD​i​  (t−1) ​​  +   β ​ 4​ ​ GDP  +   β ​ 5​ ​ Euribor12m  +   ε​ it​  ​  ​ (_ Loans

 ​(Model 1) ​

LGD ​ (​ _  ​  ​ 2​ ​ ​EBTLGD​it  ​  +   ​β3​ ​   ​LGD​ i​ (t−1) ​ ​  +   ​β4​ ​   ​Dummy 2012​ it​  +   ​β5​ ​ GDP  +   β ​ 6​ ​ ) ​​  ​  ​=  ​β1​ ​  +   β ​ PD it        ​ ​ Euribor12m  +   ​εit​  ​

​ (Model 2) ​

it

Models 1 and 2 were consistent with the EBA guidelines presented in Table 3.1. To expand the scope of the study, however, we specified a third model, whose dependent variable was the ratio of loan loss provisions to loans. LGD ​ (​ _    ) ​  ​​  ​  ​=  ​β1​ ​  +   ​β2​ ​ E ​ BTLGD​it  ​  +   β ​ 3​ ​   ​LGD​i​  (t−1) ​​  +   ​β4​ ​   ​Dummy 2012​ it​  +   β ​ 5​ ​ GDP  +   ​β6​ ​ ​ Loan it        ​ ​ Euribor12m  +   ε​ it​  ​

​ (Model 3) ​

To examine how the economic cycle affected the stress test, each of the three models was estimated three times: once across the full period (2004–2013), once for the economic growth period (2004–2009), and once for the period that was characterized by a reduction in loans and profits among Spanish banks (2010–2015). We used 2010 as the cut-off year. In 2010, the financial crisis altered the trend in banks’ financial characteristics. For instance, the volume of loans, profits, and equity began to decrease following several years of steady growth. To identify differences between the two sub-samples, we performed the test of differences between coefficients for the samples corresponding to 2004 to 2009 and 2010 to 2015 and the Chow (1960) test for structural change, taking 2009 as the structural break year. The year 2009 was chosen as the structural break year because, initially, Spain was not heavily affected by the subprime mortgage crisis (Ontiveros and Berges, 2010). However, Spain did encounter serious problems due to other issues such as an excess of property investment. Therefore, the effects on the Spanish financial system were felt later than they were elsewhere in the global financial system. Proof of this lag is that the largest capital injection made by the government to banks took place in 2010 as a result of the banks’ 2009 accounts. To control for heteroscedasticity, the regressions were estimated via White’s model with robust standard errors and cross-sectional weights. We detected no autocorrelation between residuals.

RESULTS Table 3.3 presents descriptive statistics for the sample.

52  Research handbook on financial accounting    

Table 3.3

Descriptive statistics

 

DP

LGD

EBTLGD

DP/LGD

GDP

12M Euribor

Mean

4.655%

1.082%

1.213%

40.20%

1.75%

2.52%

Median

3.097%

0.607%

1.181%

29.79%

3.16%

2.27%

Maximum

33.831%

19.249%

8.986%

551.46%

4.17%

4.83%

Minimum

0.074%

–0.369%

–6.562%

–12.43%

–0.36%

0.16%

Std. Dev.

5.142%

2.067%

1.066%

41.16%

2.49%

30.49%

Observations

531

531

531

531

531

531

Results of Models 1a, 1b, and 1c: PD/Loans Figure 3.1 shows how the variables in the PD models changed over time. In these models, we studied the ratio of non-performing loans to earnings before tax and losses from loan loss provisions.

Figure 3.1

Changes over time in variables in the PD models

According to Figure 3.1, during the growth period (2004–2007), the non-performing loans were at a historical low, and EBTLGD was high (equivalent to almost 2 percent of assets). From 2007 onward, however, non-performing loans increased, while EBTLGD decreased. Non-performing loans then continued to increase until 2013, whereas EBTLGD began to increase in 2012, even though the real increase actually began in 2011. Therefore, although non-performing loans did not directly affect accounting profit, the way each variable behaved differed depending on the economic cycle. This difference can be clearly observed in regression model 1. Table 3.4 shows the results for the three versions of model 1 and the test of differences between coefficients.

The impact of earnings management and the economic cycle on stress test results  53 Table 3.4

Models 1a, 1b, and 1c (PD/Loans) PD/Loans Model 1

 

Differences between coefficients

 

Model 1a

Model 1b

Model 1c

 

 

2004–2015

2004–2009

2010–2015

 

C

0.008***

0.019***

0.000

 

(0.002)

(0.003)

(0.004)

 

–0.462***

–0.124***

–0.406***

0.282***

(0.053)

(0.054)

(0.159)

 

0.969***

0.909***

0.985***

0.076***

(0.023)

(0.061)

(0.004)

 

–0.446***

–1.602***

–0.252***

1.350***

(0.022)

0.114)

(0.173)

 

0.595***

1.273***

1.030***

0.243***

(0.039)

(0.100)

(0.214)

 

Adjusted R2

0.900

0.943

0.853

 

F-statistic

1020.08

1248.73

211.44

 

Durbin-Watson

1.839

2.006

1.969

 

n

455

305

150

 

EBTLGD PD (t–1) GDP 12M Euribor

Notes: Robust standard deviations in parentheses; *, **, and *** denote significance at 10%, 5%, and 1%, respectively; PD = non-performing loans; Loans = customer credit portfolio.

There was a high level of inertia in the dependent variable. This inertia was stronger during the growth period than during the downturn. The negative sign of the coefficient for the variable EBTLGD implied that the relationship between PD and EBTLGD was inverse and that this relationship was greater during the economic downturn than during economic growth. The adjusted R-squared showed that the model was a good predictor of PD, and the Durbin-Watson statistic implied the absence of autocorrelations among residuals. Results of Models 2a, 2b, and 2c: LGD/PD The second variable that the EBA includes in the model to estimate losses due to loan loss provisions is LGD/PD, which indicates the percentage of non-performing loans that become losses. Figure 3.2 shows how this relationship developed over time. Contrary to what was expected, Figure 3.2 shows that the relationship between LGD and PD was non-linear. According to the Bank of Spain’s regulations and the Central European Bank’s regulations, loan loss provisions depend on non-performing loans and the time since the default occurred. Consequently, loan loss provisions should follow a straight line with respect to the horizontal axis (Climent-Serrano, 2017). As Figure 3.2 illustrates, however, from 2004 to 2007, loan loss provisions increased considerably, whereas EBTLGD was high and increasing. One possible cause for this observation is the implementation of generic provisions in Spain in 2000. Jiménez et al. (2012) found that generic provisions increased loan loss provisions by 19 percentage points between 2005 and 2008. We observed that in 2004 loan loss provisions equated to 46.91 percent of non-performing loans, whereas in 2006 loan loss provisions equated to 78.90 percent of non-performing loans, 32 percent higher than in 2004. From 2007 onward, however, loan loss provisions decreased heavily, and in 2011, loan loss provisions equated to only 11.99 percent of non-performing loans.

54  Research handbook on financial accounting

Figure 3.2

Changes over time in variables in the LGD models

This pattern is difficult to explain because loan loss provisions are a fixed percentage of non-performing loans and the time elapsed since default. Nevertheless, during the downturn, loan loss provisions fell from 78.90 percent to 11.99 percent (i.e., less than one sixth of their original value). Some banks were probably hiding their loan loss provisions, meaning they were not complying with the Bank of Spain’s regulations on loan loss provisions. This would explain why all banks that were bailed out by the Bank of Spain due to insolvency restructured their accounts, causing considerable loan loss provisions to surface. A notable example is Bankia (Climent-Serrano and Pavía, 2015). This abnormal behavior occurred during a period in which the international financial markets expressed a general lack of confidence in Spanish banks, some of which were bailed out by the European Commission in 2012. The year 2012 also bore witness to atypical behavior because loan loss provisions increased almost fivefold (from 11.99 percent to 53.64 percent) in just one year. This increase is due to a change in Spanish regulations on the percentage of loan loss provisions allocated in assets for both non-performing loans and other loans that are considered risky. From 2012 onward, loan loss provisions dropped once again, reaching their lowest value of 8.34 percent in 2015. Table 3.5 shows the results for the three versions of model 2 and the test of differences between coefficients. The data in Table 3.5 reveal inertia in the dependent variable, although less so than in model 1. This inertia was more intense during the growth period than during the downturn. In fact, during the recession, this inertia was negligible, as illustrated by the coefficient of 0.059.

The impact of earnings management and the economic cycle on stress test results  55    

Table 3.5

Models 2a, 2b, and 2c (LGD/PD) LGD/PD Model 2

 

Differences between coefficients

 

Model 2a

Model 2b

Model 2c

 

 

2004–2015

2004–2009

2010–2015

 

C

0.114

0.043

0.098***

 

(0.082)

(0.035)

(0.023)

 

4.480*

10.495***

–3.476***

13.971***

(2.331)

(2.440)

(2.034)

0.336***

0.462***

0.395***

0.059

 

(0.071)

(0.066)

(0.048)

 

0.032***

 

0.361***

 

(0.066)

 

(0.08)

 

4.959***

23.776***

–1.677***

25.443***

(2.120)

(3.308)

(0.406)

 

-4.132

–20.751

1.508

22.259

(4.421)

(3.320)

(1.052)

 

Adjusted R2

0.515

0.697

0.665

 

F-statistic

95.61

172.50

60.26

 

Durbin-Watson

2.018

2.726

2.016

 

n

455

305

150

 

EBTLGD LGD/PD (t–1) Dummy 2012 GDP 12M Euribor

Notes: Robust standard deviations in parentheses; *, **, and *** denote significance at 10%, 5%, and 1%, respectively; LGD = loan loss provisions = Loss given default (LGD); PD = non-performing loans; Loans = customer credit portfolio.

Unlike in model 1, the positive coefficient for EBTLGD offers evidence of income smoothing, which implies that earnings management was taking place. Just as Agarwal et al. (2007) observed, however, this earnings management disappeared during the economic downturn, as illustrated by the change in the coefficient of EBTLGD. This coefficient had a positive value of 13.105 during the growth period but a negative value of –4.196 during the downturn. Agarwal et al. (2007) suggest some possible causes for this change, including an increase in loan defaults and changes in the law. Other factors that were missing from the model and that were difficult to detect and measure might also have exerted an influence. Such factors include the quantification of normative change, measured by the dummy variable, which contributed 27.9 percentage points of the 41.65 percentage point increase in loan loss provisions. The adjusted R-squared fell, indicating the existence of other factors that affected the dependent variable but that were missing from the model. Finally, the Durbin-Watson statistic confirmed the absence of autocorrelations between residuals. Results of Model 3a, 3b, and 3c: LGD/Loans Models 1 and 2 followed the EBA guidelines, which establish procedures for analyzing the variables in the first two models. To complete the study, we developed a third model that addressed the relationship between the variables LGD/Loans and EBTLGD/Assets. Figure 3.3 shows how this relationship behaved over time. Figure 3.3 illustrates the results presented earlier. Table 3.6 shows the results for the three versions of Model 3 and the test of differences between coefficients.

56  Research handbook on financial accounting

Figure 3.3

Changes over time in the variables LGD/Loans and EBTLGD/Assets

Table 3.6

Models 3a, 3b, and 3c (LGD/Loans) LGD/Loans Model 3

 

Difference between coefficients

 

Model 3a

Model 3b

Model 3c

 

 

2004–2015

2004–2009

2010–2015

 

C

0.009***

0.005***

0.016***

 

(0.001)

(0.000)

(0.003)

 

–0.312***

0.112***

–0.988**

–1.1***

(0.109)

(0.052)

(0.339)

 

0.162***

0.583***

0.141***

0.442***

(0.052)

(0.066)

(0.043)

 

0.040***

 

0.037***

 

(0.000)

 

0.001)

 

–0.059

0.583***

0.141***

0.221***

(0.042)

(0.019)

0.032)

 

0.074**

–0.188***

–0.200

0.388***

(0.037)

(0.120)

(0.064)

 

Adjusted R2

0.660

0.718

0.719

 

F-statistic

177.56

194.65

77.57

 

Durbin-Watson

1.673

1.726

2.237

 

n

455

305

150

 

EBTLGD LGD(–1) Dummy 2012 GDP 12M Euribor

Notes: Robust standard deviations in parentheses; *, **, and *** denote significance at 10%, 5%, and 1%, respectively; LGD = loan loss provisions = Loss given default (LGD); PD = non-performing loans; Loans = customer credit portfolio.

There was inertia in the dependent variable. This inertia was greater during the growth period than during the downturn. Similarly, the data provide evidence of earnings manage-

The impact of earnings management and the economic cycle on stress test results  57 ment with income smoothing during the growth period and during the downturn, albeit with the opposite sign. The dummy variable indicated that, owing to the new regulations, loan loss provisions equated to 3.7 percent of total loans in the credit portfolio. The adjusted R-squared indicated that the model was unable to explain certain factors. Finally, there was no autocorrelation among residuals. As in Models 1 and 2, the structural stability was tested using the Chow (1960) test. The structural break year was set to 2009, with one sample spanning the years 2004 to 2009 and the other spanning the years 2010 to 2015. The null hypothesis of structural stability was rejected for all three models, thereby reaffirming the results presented earlier.

DISCUSSION AND CONCLUSIONS This study examined whether additional factors besides macroeconomic variables could affect the stress tests designed by the EBA. Specifically, we studied whether banks use earnings management and whether the scale of this earnings management differs according to the phase of the economic cycle (growth or recession). This study is valuable because it is the first to relate earnings management to the economic cycle in the context of stress tests. Prior to conducting this research, we confirmed the lack of such studies in the literature. We therefore sought to study the impact of earnings management and the economic cycle on stress tests. The analysis of the econometric models presented herein provides evidence of earnings management in the Spanish banking sector through the management of loan loss provisions. Our findings imply that banks adopt different earnings management practices depending on the phase of the economic cycle. Consequently, these variables should be included in the stress tests so that they reflect the reality of banks’ accounting. Following this reasoning, we included the management of loan loss provisions and the different phases of growth and recession in the stress test models designed by the EBA. For both the first EBA model (probability of default) and the second EBA model (loss given default), we specified three sub-models. Thus, for each of the two models designed by the EBA, we specified three sub-models. The first sub-model included loan loss provisions for the sample over the whole study period, the second sub-model included loan loss provisions for the sample during the growth period, and the third sub-model included loan loss provisions for the sample during the period of recession. We observed that during the growth period, the econometric models that we developed yielded a negative coefficient for non-performing loans and a highly positive coefficient for loan loss provisions. Similarly, income smoothing was highly evident for loan loss provisions but was practically non-existent for non-performing loans. This difference in the behavior of the coefficients for non-performing loans and loan loss provisions indicates that during the growth period, there was intense earnings management with excessive loan loss provisions that were unjustified given the rate of defaults during this period. Thus, our findings imply that during periods of economic growth, banks make loan loss provisions that are significantly larger than they should be given the actual default rate. This difference in behavior has a major impact on accounting profit. Non-performing loans are not considered expenses. They only figure in the notes to the annual accounts. In contrast,

58  Research handbook on financial accounting loan loss provisions appear as expenses in the profit and loss statement, thereby reducing profit without justifying the scope of this reduction. Our findings were markedly different for the downturn. The sign of the coefficient for the loan loss provisions variable during the downturn differed from the sign of the coefficient during the growth period, although the sign of the coefficient for the non-performing loans variable did not change. Furthermore, income smoothing disappeared in loan loss provisions and was non-existent in non-performing loans. These findings indicate that during crises, banks release their loan loss provisions, thereby reportedly increasing their profits even though the reality is quite different. These behaviors reflect the diverse loan loss provisions practices that banks follow during different phases of the economic cycle. Furthermore, they reflect the discretion that managers have to use loan loss provisions to manipulate company accounts. With this combination of accounting practices, banks enjoy two major advantages. First, manipulating the accounts to reduce profit during periods of growth reduces corporate tax, deferring the tax burden to periods of recession. In doing so, banks do not reduce their overall tax bill, but they do manage to delay the payment of taxes. Second, they are able to massage profits during recessions. Doing so allows a bank to portray an image of solvency, protect its corporate reputation, and avoid a decrease in its stock price, thereby avoiding a decrease in its value (Mellado-Cid et al., 2018). The new Basel III framework favors earnings management. As noted by Cummings and Durrani (2016), this framework grants banks the freedom to design their own risk models, a practice that increases managers’ discretion when applying loan loss provisions. Likewise, modifications to accounting regulations have also encouraged the use of earnings management based on criteria applied by managers (Ewert and Wagenhofer, 2016). This study substantially enriches the literature on stress tests by proposing a third model that brings together the two models designed by the EBA and that, as shown, yields the same results. For the third model, we adopted the same approach, specifying three sub-models to include earnings management through loan loss provisions, growth, and economic recession. This proposed model allowed us to simplify the two EBA models into a single model while also improving the model by introducing two relevant variables to ensure that the stress tests performed by banks reflect the reality of their economic and financial situation. In conclusion, we note that the stress tests designed by the EBA have certain shortcomings that affect their efficiency. These shortcomings have major implications for regulators of the banking sector, market regulators, banks, investors, and, ultimately, the economy as a whole. First, the earnings management that occurs during economic growth may be associated with weak regulations, incentivizing banks to grant loans with high chances of default (Francis et al., 2016). Second, earnings management exacerbates information asymmetries in the stock market (Abad et al., 2018) and consequently distorts companies’ value and market capitalization. These banking practices lead to a lack of confidence and cause instability in the financial markets (Amiram et al. 2018) to the detriment of the economy. We therefore encourage the EBA to rethink the way it defines its recommended stress test model. According to our findings, the EBA should include earnings management and the economic cycle as factors in their models for estimating non-performing loans and loan loss provisions. Regulators should also heighten their vigilance to reduce the discretion that bank managers are able to exercise when

The impact of earnings management and the economic cycle on stress test results  59 applying loan loss provisions. Regulators would thus be able to improve the predictions of stress tests and, crucially, preserve investor and customer confidence in banks. Finally, this chapter is also of interest for scholars because it provides valuable conclusions regarding earnings management in the banking sector during periods of growth and economic recession. Furthermore, this paper enriches the literature on stress tests.

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4. Non-GAAP financial reporting: an ethical analysis Steven M. Mintz, William F. Miller and Tara J. Shawver

INTRODUCTION The use of non-GAAP financial metrics to report items of income and expense that are added to or deducted from net income have been increasing in recent years. Public companies make these adjustments when they believe the generally accepted accounting principles (GAAP) used in financial reporting and disclosures in the US do not portray the whole story about the company. They may believe that non-GAAP amounts are more useful to investors, financial analysts, and others who rely more on an adjusted earnings amount. The reason may be that these users believe non-GAAP amounts portray a more accurate and comprehensive picture of the core financial performance of the company. Pro forma or non-GAAP reporting largely results from the shortcomings of the financial statements, which provides retrospective but not future-oriented information. In reality, some managers revise and adjust GAAP financial results in an attempt to convert historical performance measures into forward-looking information. Thus, items in the income statement which are extraordinary and non-recurring may be adjusted to predict future performance, reduce information asymmetry, and communicate managers’ informed view of the transitory nature of these elements (Arena et al., 2021). The adoption of regulations for the presentation and disclosure of non-GAAP amounts was first established by the US Securities and Exchange Commission (SEC) in the Sarbanes-Oxley Act (SOX) of 2002. The Act requires the SEC to address financial information that is calculated and presented based on methodologies other than those in accordance with GAAP. Over the years, the SEC has been increasingly concerned that investors may be misled by the disclosure of non-GAAP measures, so they have progressively intervened to discipline the non-GAAP reporting practices (Sherman and Young, 2018). This has been accomplished by applying Regulation G, Regulation S-K Item 10(e), and Compliance & Disclosure Interpretations (C&DIs). Non-GAAP reporting declined after Regulation G with respect to non-GAAP earnings usage and a decline in meeting or beating analysts’ forecasts (Heflin and Hsu, 2008). However, the trend has reversed course since then and has increased in usage (Brown et al., 2012). The proliferation and variation in non-GAAP reporting has led the SEC to tighten up the regulations to control for firms that use such amounts opportunistically and at the detriment to investors and financial analysts. An in-depth study by Audit Analytics revealed that 97 percent of companies in the Standard & Poors (S&P) 500 used non-GAAP financials in 2017, up from 59 percent in 1996, while the average number of different non-GAAP metrics used per filing rose from 2.35 to 7.45 over two decades. This has led to a growing divergence between the earnings calculated according 62

Non-GAAP financial reporting: an ethical analysis  63 to GAAP and the “earnings” presented in press releases and analyst research reports (Ryan, 2019). Calcbench (2021) took a close look at S&P 500 companies’ use of both GAAP and non-GAAP numbers in 2020. The firm measured the difference between net income, in dollar terms, for 60 companies with the biggest difference between GAAP and non-GAAP metrics. It found that the group’s non-GAAP net income exceeded GAAP net income by $132.2 billion – and that was more than double the reported GAAP net income of $130.7 billion (Linnane, 2021). Calcbench (2022) in conjunction with students from Suffolk University examined the earnings releases for 123 companies in the S&P 500 comparing GAAP to non-GAAP net income. They found that reported non-GAAP net income exceeded reported net income by $86 billion in 2021 with amortization of intangibles representing the single largest difference reported at 50.63 percent. Stock based compensation at 16.11 percent and restructuring charges at 13.73 percent rounded out the top three reconciling items. The use of non-GAAP measures has an ethical component to it because investors, financial analysts and other users rely on the accuracy of these numbers for decision making. An ethical concern is that judgment is used regarding which non-GAAP amounts should be shown and those judgments should be informed by ethical values such as consistency, comparability, transparency, and usefulness for its intended purpose. This chapter proceeds as follows. The next section reviews the early literature on non-GAAP reporting. This is followed by a detailed discussion of SEC regulations and how they affect the disclosure and presentation of non-GAAP amounts. Following that is a discussion of the role of corporate governance systems including the role of top management, the audit committee, and auditors in ensuring that non-GAAP amounts conform to SEC regulations. We then provide a cost-benefit and ethical analysis to better understand whether the usefulness of non-GAAP disclosures exceed the costs to gather and report the information, and how basic ethical values affect disclosures. The chapter concludes with observations about non-GAAP reporting and suggestions for future research.

LITERATURE REVIEW The earliest1 research surrounding firm disclosure of non-GAAP earnings numbers primarily focuses on the quantity and quality of numbers reported and the motive for their use. The early research on non-GAAP earnings disclosure suggests that the use of non-GAAP earnings increased dramatically over the previous decade (1990–2000) (Bradshaw and Sloan, 2002) and are considered by both analysts and investors as more predictive of future firm performance than GAAP earnings (Bhattacharya et al., 2003; Brown and Sivakumar, 2003). However, this research also suggests that more items added back to GAAP earnings in the calculation of non-GAAP earnings is predictive of negative future cash flows and returns and that investors do not fully appreciate this relationship (Doyle et al., 2003). In addition, some literature suggests that management may decide to adjust GAAP earnings by adding back items because they consider them to be non-recurring items that would not impact future earnings, or for 1 The earliest studies cover reporting periods prior to the SEC’s issuance of guidance in 2001 on the disclosure of non-GAAP earnings figures.

64  Research handbook on financial accounting strategic purposes such as to meet or beat an analyst’s estimate or to positively impact investor perception of the firm (Schrand and Walther, 2000; Reason and Teach, 2002; Bhattacharya et al, 2003; Lougee and Marquardt, 2004). The SEC issued guidance to firms about the disclosure of non-GAAP metrics in 2001 and then issued Regulation G and amended Item 10(e) of Regulation S-K to include guidance on non-GAAP metrics in 2003. As a result, the focus of research surrounding non-GAAP measures changed post regulation, focusing primarily on the impact of this guidance and regulation on the quantity and quality of the disclosure of non-GAAP metrics. Exploring whether investors’ perceptions of non-GAAP (pro forma) earnings numbers have changed following the increased regulations on reporting non-GAAP numbers by the Sarbanes Oxley Act (SOX) and Regulation G, Black et al. (2012) find investors are paying more attention to non-GAAP metrics. The authors find that the quality of pro forma earnings reporting has improved (managers are less likely to adjust GAAP earnings for recurring items). The authors also find that while investors discount aggressive pro forma earnings (those including recurring items) pre-and post-SOX and Regulation G, they discount aggressive earnings more post regulation. Thus, they conclude that investor perceptions have changed as a result of the increased regulation. However, they also find that the use of pro forma earnings after initially declining post SOX and Regulation G has been on a steady increase since 2008. Baumker et al. (2014) analyze management’s disclosure of one-time gains following enactment of Regulation G. The authors find that while managers generally disclose the existence of gains, they are much less likely to provide a non-GAAP earnings figure excluding the gain. However, they find that as the size (materiality level) of the gain increases, the level of disclosure increases as well. They find this increase in disclosure to be true for firms that also experience one-time losses along with gains. They conclude management selectively includes or excludes gains and/or losses from non-GAAP earnings calculations for opportunistic reasons to demonstrate improved performance. They find that while 88.5 percent of managers mention the gain in an earnings statement, only 34 percent report non-GAAP earnings per share summary figures explicitly excluding transitory gains. This is significantly lower than the 62 percent of managers who excluded these gains from non-GAAP earnings pre-Regulation G. The authors suggest that Regulation G may have had the unintended consequence of allowing managers to omit mention of transitory gains since there is no requirement to release non-GAAP earnings numbers. Black et al. (2017) study the period from 1998 through 2006 and find that firms reporting non-GAAP measures post-SOX and Regulation G are less likely to exclude more or different items then analysts would or use non-GAAP measures to meet strategic earnings goals because they were going to miss a GAAP earnings measure. While overall they find a decrease in the use of aggressive non-GAAP reporting post SOX and Regulation G, some firms continue to do so, potentially misleading investors. In addition, they find that the exclusion of interest, taxes, and stock-based compensation to increase post-SOX and Regulation G non-GAAP versus GAAP earnings, while the exclusion of depreciation and amortization decreases it. Bond et al. (2017) analyze the use of two data sets of non-GAAP earnings for the periods five years before and five years after implementation of Regulation G in 2003 and five years before and five years after implementation of SEC’s Compliance and Disclosure Interpretation (CDI) update in 2010, relaxing some of Regulation G’s disclosure requirements. The authors find that the quality of non-GAAP earnings improved after both SEC interventions. Regulation G led to a decrease in the quantity of exclusions from GAAP while the CDI partially reversed

Non-GAAP financial reporting: an ethical analysis  65 that, and while the earnings response coefficients (ERCs) increased for non-GAAP reporters over GAAP reporters after Regulation G, they decreased for non-GAAP reporters after the CDI. In easing the administrative burden, the SEC’s CDI appears to have had a negative unintended consequence. The research surrounding the use of non-GAAP earnings figures and the impact of SEC regulation, finds increased regulation to have positively impacted the quality and quantity of non-GAAP earnings disclosures (Bowen et al., 2005; Marques, 2006; Entwistle et al., 2006; Heflin and Hsu, 2008; Kolev et al., 2008; Zhang and Zheng, 2011; Jennings and Marques, 2011; Yi, 2012; Black et al., 2012; Black et al., 2017; Bond et al., 2017). However, some research suggests that Regulation G resulted in some negative unintended consequences suggesting more regulation may be needed (Baumker et al., 2014; Selling and Somers, 2016). None of this research suggests that SEC regulations eliminated the use of non-GAAP disclosures for opportunistic reasons. As the impact of the regulations became understood with an opportunistic abuse of pro forma earnings, research in the area started to focus more on the nature of the abuse and ways in which it could be more easily identified. In a study of the types of adjustments managers add back to GAAP earnings to calculate non-GAAP earnings, Black and Christensen (2009) find the three most common addbacks to GAAP earnings are research and development, depreciation & amortization and stock-based compensation. Badertscher (2011) finds that some firms resort to what he calls ‘the worst form of earnings management’, which is non-GAAP earnings management once within-GAAP options have been exhausted. Barth et al. (2012) find that managers exclude stock-based compensation from non-GAAP earnings for opportunistic reasons while analysts exclude it from street earnings for informativeness (predictive ability). The types of addbacks and links to earnings management depends on the frequency of adjustments of GAAP income for items such as recurring items, with companies that more frequently report pro forma earnings less likely to include recurring items and are less aggressive in their approach (Black and Christensen, 2009). Research shows that inclusions and exclusions of items such as stock-based compensation depends on whether opportunistic reasons drive the decision to meet or beat analyst expectations or informativeness (predictive ability) (Barth et al., 2012; Doyle et al., 2013; Curtis et al., 2014). In summary, a link was found between managers’ desire to opportunistically disclose non-GAAP metrics to positively affect the perceptions (intentionally mislead) of investors and analysts (Black & Christensen, 2009; Badertscher, 2011; Barth et al., 2012; Doyle, 2013; Curtis et al., 2014; Young, 2014; Isidro and Marques, 2015). Some investors discount the value they place on certain non-GAAP earnings disclosures, less sophisticated investors do not (Bhattacharya, 2007; Frederickson and Miller, 2004; Doyle, 2013; and Reimsbach, 2014). Concern about the growing use of non-GAAP metrics led the SEC to issue C&DIs starting in 2016. The improper use of non-GAAP metrics topped the list of SEC comment letters in 2016 and 2017 (McKeon and Usvyatsky 2017).

SEC REGULATIONS The SEC regulatory framework (discussed in detail below) surrounding the use of non-GAAP measures is comprised of Regulation G (issued 2003), Item 10(e) of Regulation S-K (amended to include guidance on non-GAAP reporting 2003), Compliance and Disclosure Interpretations

66  Research handbook on financial accounting (started in 2016) and SEC issued Comment Letters. Figure 4.1 depicts the framework for regulation of non-GAAP reporting used by the SEC.

Figure 4.1

Framework for SEC review of non-GAAP financial measures and disclosures

SEC Regulation G and Item 10(e) of Regulation S-K define a “non-GAAP financial measure” as a numerical measure of historical or future financial performance, financial position, or cash flows, that (SEC, 2003): ● excludes amounts that are included in the most directly comparable measure calculated and presented in accordance with GAAP; or ● includes amounts that are excluded from the most directly comparable measure so calculated and presented. The SEC regulations further provide that the definition of a non-GAAP financial measure is intended to capture all measures that have the effect of depicting either: ● a measure of performance that is different from that presented in the financial statements, such as income or loss before taxes, or net income or loss as calculated in accordance with GAAP; or ● a measure of liquidity that is different from cash flow or cash flow from operations computed in accordance with GAAP. Regulation G Regulation G applies to any entity required to file financial reports pursuant to the Securities Act and is not limited to the registrant’s written public filings. If a non-GAAP financial

Non-GAAP financial reporting: an ethical analysis  67 measure is made public orally, telephonically, by webcast, by broadcast, or by similar means, then the reconciliation requirements under Regulation G would exist if (SEC, 2003): ● the required information (i.e., presentation and reconciliation) is provided on the registrant’s website at the time the non-GAAP financial measure is made public; and ● the location of the website is made public in the same presentation in which the non-GAAP financial measure is made public. Based on regulatory requirements, if a company takes a defined GAAP measure (such as GAAP net income) and thereafter “adjusts” for (i.e., excludes or includes) one or more expense or revenue items that are components of that GAAP measure (i.e., excluding a restructuring expense identified as “non-recurring”), then the resulting measure (i.e., “adjusted net income”) is a non-GAAP financial measure. One common non-GAAP measure is EBITDA (earnings before interest, taxes, depreciation, and amortization). Other variations include EBIT (earnings before interest and taxes), EBITA, EBITD, EBITDAR (earnings before interest, taxes, depreciation, amortization, and restructuring costs), adjusted EBITDA, and so on. Regulation S-K Item 10(e) Regulation S-K Item 10(e) requires additional disclosures when companies include non-GAAP financial measures in SEC filings. The disclosures are in addition to the requirements of Regulation G, which also apply to SEC filings. However, unlike Regulation G, Item 10(e) applies only to SEC filings. Thus, Item 10(e) does not apply to press releases or other public announcements containing material non-public information regarding a company’s results of operations or financial condition for a completed fiscal period that must be furnished to the SEC within five business days under Item 12 of Form 8-K. Item 10(e) applies to the same non-GAAP financial measures as Regulation G but contains additional disclosure requirements and prohibitions (SEC 2003). Box 4.1 summarizes the requirements, prohibitions, and rules of Item 10(e). In summary, Item 10(e) of Regulation S-K deals with the presentation and disclosures of non-GAAP reporting. It addresses the acceptability of non-GAAP reported amounts, and restrictions with respect to the presentation as financial measures. Further, it covers the form and presentation of non-GAAP measures and its relation to GAAP numbers.

BOX 4.1 REGULATION 10(E) REQUIREMENTS, PROHIBITIONS AND RULES Item 10(e) of Regulation S-K requires SEC registrants using non-GAAP financial measures in filings with the SEC to provide (SEC 2018b): • a presentation, with equal or greater prominence, of the most directly comparable financial measure calculated and presented in accordance with GAAP; • a reconciliation (by schedule or other clearly understandable method), which shall be quantitative for historical non-GAAP measures presented, and quantitative, to the extent available without unreasonable efforts, for forward-looking information, of the differences between the non-GAAP financial measure disclosed or released with the

68  Research handbook on financial accounting most directly comparable financial measure or measures calculated and presented in accordance with GAAP; • a statement disclosing the reasons why the registrant’s management believes that presentation of the non-GAAP financial measure provides useful information to investors regarding the registrant’s financial condition and results of operations; and • to the extent material, a statement disclosing the additional purposes, if any, for which the registrant’s management uses the non-GAAP financial measure that are not otherwise disclosed. Item 10 of Regulation S-K and Item 10 of Regulation S-B prohibit the following: • excluding charges or liabilities that required, or will require, cash settlement, or would have required cash settlement absent an ability to settle in another manner, from non-GAAP liquidity measures, other than the measures EBIT and EBITDA; • adjusting a non-GAAP performance measure to eliminate or smooth items identified as non-recurring, infrequent or unusual, when (1) the nature of the charge or gain is such that it is reasonably likely to recur within two years, or (2) there was a similar charge or gain within the prior two years; • presenting non-GAAP financial measures on the face of the registrant’s financial statements prepared in accordance with GAAP or in the accompanying notes; • presenting non-GAAP financial measures on the face of any pro forma financial information required to be disclosed by Article 11 of Regulation S-X; and • using titles or descriptions of non-GAAP financial measures that are the same as, or confusingly similar to, titles or descriptions used for GAAP financial measures. Regulation S-K Item 10(e) lists 11 rules that are applicable to non-GAAP disclosures (PricewaterhouseCoopers, 2021). 1. 2. 3. 4. 5. 6. 7. 8. 9.

The non-GAAP measure taken together with the accompanying information cannot be misleading. The most directly comparable GAAP measure must be disclosed. A reconciliation of the non-GAAP measure to the most directly comparable GAAP measure must be included. The GAAP measure much be presented with equal or greater prominence than the non-GAAP measure. Management must disclose why it believes the non-GAAP measure is useful to investors. If material, management must disclose the additional purposes, if any, for which it uses the non-GAAP measure. Charges or liabilities that require cash settlement cannot be excluded from any measure of liquidity. A measure cannot be labeled as nonrecurring or infrequent (or any similar title) if it excludes amounts resulting from an event that has occurred in the last two years or is expected to occur again in the next two years. Non-GAAP measures cannot be presented on the face of the financial statements or in the notes.

Non-GAAP financial reporting: an ethical analysis  69 10. Non-GAAP measures cannot be presented on the face of any pro-forma financial statements. 11. Non-GAAP measures must not use titles or descriptions that are the same as, or confusingly similar to, GAAP titles. Taken together, these requirements, prohibitions and rules provide a blueprint for public companies to follow to ensure they comply with SEC 10(e) requirements. Compliance and Disclosure Interpretations (C&DIs) The SEC established new requirements for corporate reporting in 2016 by issuing C&DIs because the number of companies using non-GAAP disclosures had increased. The Commission sought to slow the proliferation of non-GAAP numbers and rein in the worst offenders. The SEC allows companies to use non-GAAP numbers to supplement their reporting, but they must give equal or greater prominence to GAAP numbers and explain how the two are reconciled. In 2010, the SEC’s chief accountant of the Enforcement Division, Howard Scheck, called non-GAAP metrics a “fraud risk factor” (Leone, 2010), and the SEC formed a task force in 2013 to scrutinize whether they could be misleading (Rapoport, 2013). The former SEC chairperson, Mary Jo White, expressed concern that non-GAAP metrics “may be a source of confusion” (Teitelbaum, 2015; Cohn, 2016). Consequently, the SEC issues C&DIs to clarify its position on non-GAAP reporting (SEC, 2016). The C&DIs address the SEC’s concerns on a variety of issues regarding the use of non-GAAP measures, including (Kaplan et al., 2016): ● ● ● ● ● ● ● ●

Use of misleading non-GAAP financial measures; The prominence of non-GAAP financial measures; Non-GAAP revenue recognition; Use of non-GAAP per share measures; Presentation of free cash flow; Income tax effects related to adjustments; EBITDA reconciliation; Presentation of funds from operations.

The C&DIs reflect the historical experiences of the SEC, including its interpretations of the rules and regulations on the use of non-GAAP financial measures. According to the SEC, whether a non-GAAP measure is more prominent than the comparable GAAP measure generally depends on the facts and circumstances in which the disclosure is made. The staff consider the following examples of non-GAAP measures as more prominent (SEC, 2018b). ● Presenting a performance measure that excludes normal, recurring, cash operating expenses necessary to operate a registrant’s business; ● Adjusting a particular charge or gain in the current period and for which other, similar charges or gains were not also adjusted in prior periods unless the inconsistent presentation is disclosed and the reasons for it explained; ● Excluding certain non-recurring charges but not non-recurring gains in a period; and ● Tailoring recognition and measurement methods including certain adjusted revenue measures.

70  Research handbook on financial accounting The C&DIs often expand on the SEC regulations using a question-and-answer format related to key issues surrounding the use of non-GAAP metrics (SEC, 2018b), and they are updated periodically. Question 102.10 addresses concerns when a directly comparable non-GAAP amount is presented. Box 4.2 summarizes the SEC guidance contained in Question 102.10.

BOX 4.2 C&DIS’ GUIDANCE ON NON-GAAP METRIC PROMINENCE The following summarizes the guidance in C&DIs when the non-GAAP amount would be more prominent than the GAAP amount, thereby violating the regulations (SEC, 2018b). • Presenting a full income statement of non-GAAP measures or presenting a full non-GAAP income statement when reconciling non-GAAP measures to the most directly comparable GAAP measures; • Omitting comparable GAAP measures from an earnings release headline or caption that includes non-GAAP measures; • Presenting a non-GAAP measure using a style of presentation (e.g., bold, larger font) that emphasizes the non-GAAP measure over the comparable GAAP measure; • A non-GAAP measure that precedes the most directly comparable GAAP measure (including in an earnings release headline or caption); • Describing a non-GAAP measure as, for example, “record performance” or “exceptional” without at least an equally prominent descriptive characterization of the comparable GAAP measure; • Providing tabular disclosure of non-GAAP financial measures without preceding it with an equally prominent tabular disclosure of the comparable GAAP measures or including the comparable GAAP measures in the same table; • Excluding a quantitative reconciliation with respect to a forward-looking non-GAAP measure in reliance on the “unreasonable efforts” exception in Item 10(e)(1)(i)(B) without disclosing that fact and identifying the information that is unavailable and its probable significance in a location of equal or greater prominence; and • Providing discussion and analysis of a non-GAAP measure without a similar discussion and analysis of the comparable GAAP measure in a location with equal or greater prominence. A survey was conducted by Debevoise & Plimpton to determine the impact that the C&DIs had on company disclosure practices and related developments. The survey included 100 earnings releases issued by Fortune 500 companies since May 17, 2016, the date the C&DIs were issued. The survey covered about six months, including one fiscal reporting period. The authors found that 79 (about 16 percent) of the companies modified their non-GAAP disclosures when compared with the disclosures in the prior fiscal period’s earnings releases. Table 4.1 lists the impacts of C&DIs on company disclosure practices reported by the respondents (McCann, 2016).

Non-GAAP financial reporting: an ethical analysis  71 Table 4.1

Impact of C&DIs on company non-GAAP disclosure practices

Non-GAAP presentation changes

Percentage surveyed

Presentation of GAAP and non-GAAP metric reordered to present GAAP metric first

36

Non-GAAP metric replaced with comparable GAAP metric in same location

29

Augmented/modified non-GAAP reconciliation disclosure

29

Supplemented non-GAAP discussion with GAAP metrics

18

Non-GAAP metric no longer discussed or highlighted in CEO quote

15

Non-GAAP metric omitted from entire earnings release and/or replaced with a comparable GAAP metric

10

Added disclosure indicated that an omitted non-GAAP reconciliation was not available without “unreasonable

10

efforts” Consolidated disclosure of non-GAAP metrics or non-GAAP discussion moved to less prominent location

9

Removed guidance on a particular non-GAAP metric (while continuing to provide guidance on other metrics)

9

Added a non-GAAP reconciliation that was previously omitted

SEC Comment Letters In addition to the regulations and C&DIs, the SEC provides comment letters when the Commission wants additional information about non-GAAP disclosures, including explanations of how those amounts have been determined. SEC guidance on these issues, which pertains to all matters including non-GAAP financial measures, were set out in a bulletin that was modified on April 18, 2011 (SEC, 2011). A key explanation of the purpose of comment letters follows. In issuing comments to a company, the staff may request that a company provide additional supplemental information so the staff can better understand the company’s disclosure, revise disclosure in a document on file with the SEC, provide additional disclosure in a document on file with the SEC, or provide additional or different disclosure in a future filing with the SEC. There may be several rounds of letters from the SEC staff and responses from the filer until the issues identified in the review are resolved. These letters set forth staff positions and do not constitute an official expression of the SEC’s views. The letters are limited to the specific facts of the filing in question and do not apply to other filings.

An area of concern to the SEC is whether a registrant presents a non-GAAP measure that employs an individually tailored accounting principle that may be misleading. An example is the 2016 non-GAAP disclosures by Tesla. The company used GAAP revenue plus deferred revenue for its non-GAAP measure and compared it with GAAP revenue (SEC, 2018a). The problem is deferred revenue should not be included in any measure of earnings except ratably over time. Box 4.3 provides the detail of the SEC Comment Letter to Tesla and Tesla’s response. We note that Tesla failed to provide an adequate quantitative reconciliation from GAAP earnings to the non-GAAP amount and did not provide the disclosures required in such situations, a significant deviation from SEC requirements.

BOX 4.3 DETAIL OF 2016 SEC COMMENT LETTER TO TESLA AND TESLA’S RESPONSE The following was included in Form 8-K furnished to the SEC on August 3, 2016, and the SEC’s comments that were addressed by Tesla in a letter to the SEC on September 19, 2016

72  Research handbook on financial accounting (Wachtell, Lipton, Rosen & Katz 2016). SEC Comment We note that you adjust your non-GAAP measures to add back the deferred revenue and related costs for cars sold with resale value guarantees and where you collected the purchase price in cash, which substitutes an individually tailored measurement method for those of GAAP. Please describe the changes you expect to make to your presentation in light of the new guidance in Question 100.04 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016.

Tesla Response As noted in the Company’s Second Quarter Updated dated August 3, 2016, the Company is currently in the process of evaluating the updated Compliance and Disclosure.

The SEC also commented on other non-GAAP disclosures, which show the broad scope of problems that companies may encounter if they fail to comply with SEC regulations and its C&DIs. The following also pertained to the non-GAAP information provided to the SEC by Tesla. SEC Comment We note that you omit a quantitative reconciliation with respect to your forward- looking non-GAAP guidance, but you do not provide the disclosures required when the reconciliation is omitted. In your next earnings release, please follow the guidance in Question 102.10 of the updated Compliance and Disclosure Interpretations issued on May 17, 2016. Please tell us how you plan to comply with this guidance.

Tesla Response In the Company’s next earnings release, it will follow the guidance in Question 102.10 of the updated Compliance and Disclosure Interpretations issued by the Staff on May 17, 2016.

SEC Comment We note that your current disclosure about the usefulness of your non-GAAP measures appears to be boilerplate. In your next earnings release, please provide a substantive discussion of how your non-GAAP measures are useful to investors. Refer to Item 10(e)(1)(i)(C) of Regulation S-K.

Tesla Response The Company respectfully directs the Staff’s attention to its disclosure which states that the Company’s management believes that it is useful to supplement its GAAP financial statements with certain non-GAAP information because “management uses such information internally for its operating, budgeting and financial planning purposes” [emphasis added]. The Company also discloses that its non-GAAP financial measures help to facilitate both management’s internal comparisons to its historical performance and comparisons to the operating results of other companies. However, in the Company’s next earnings release, the Company will provide a more substantive discussion of how its non-GAAP financial measures are useful to investors.

Non-GAAP financial reporting: an ethical analysis  73 SEC Comment Please retitle “cash flow from core operations,” which includes significant financing cash flows, so that it is not confused with a measure of operating cash flows and label it as non-GAAP measure where presented.

Tesla Response In the Company’s next earnings release, the Company will retitle “cash flow from core operations” and label it as a non-GAAP measure where presented.

Bozanic et al. (2017) find that firms enhance their disclosures following the SEC comment process, and that firms’ requests for confidential treatment and negotiations to avoid making substantive disclosure changes lessens this effect. The authors also document improvements in disclosure in response to SEC comment letters that are associated with decreases in information asymmetry and reductions in litigation risk. Gomez et al. (2017) studied whether SEC comment letters affect firms’ non-GAAP disclosures to see if the letters affect information asymmetry and the informativeness of non-GAAP earnings. The authors point to four issues that the SEC comment letters address: (1) full non-GAAP income statements, (2) non-GAAP to GAAP reconciliation, (3) explanation of non-GAAP earnings, and (4) presentation of non-GAAP earnings. The authors find little or no evidence that information asymmetry increases and informativeness of non-GAAP earnings decreases in these four issues except for the way firms comply with SEC requests to stop disclosing full non-GAAP income statements. (Gomez et al. 2017)

Jo and Yang (2020) explore comment letters that address firms’ use of non-GAAP measures in SEC Forms 10-K, 10-Qs, and earnings releases. The authors find that firms that experience poor GAAP performance and emphasize non-GAAP measures are more likely to receive non-GAAP comments and are more likely than other firms to abandon non-GAAP measures in future filings. Also, when these recipients continue to report non-GAAP measures, they provide more justifications for its use and reduce the prominence of these measures. This is an important study because the findings suggest that comment letters are effective in reducing deficiencies in non-GAAP reporting. Unfortunately, even with all this regulation in place, the use of non-GAAP financial measures continues to be of great concern to the SEC. The topic addressed most frequently by the SEC in all the comment letters issued for both GAAP and non-GAAP matters that were issued for the year ended June 30, 2021, was non-GAAP financial measures. Non-GAAP financial measures comprised 37 percent of all comment letters issued by the SEC for the reporting period (EY 2021). It has been over 20 years since the first guidance and regulations surrounding the use of non-GAAP measures was issued. Regulations are only a part of the overall organizational control environment which needs to be in place to ensure that these regulations are followed. Perhaps we need to look to corporate governance systems for a solution.

74  Research handbook on financial accounting

CORPORATE GOVERNANCE CONSIDERATIONS Companies primarily distribute non-GAAP financial information through press releases and conference calls with financial analysts. There can be a great deal of latitude in the content and format of these distributions. Companies need to have disclosure controls in place to ensure that non-GAAP amounts are presented consistently over time, disclosures are informative, and these amounts are not misleading. It is up to the company’s management, internal auditors, and audit committee to be cognizant of SEC requirements under Regulation G, Item 10(e) of Regulation S-K and C&DIs issued by the SEC. The external auditors should discuss matters of concern about non-GAAP measures and disclosures with the audit committee. Corporate governance and ethical behavior go hand and hand. Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs), as well as other managers, should set an ethical tone at the top to ensure GAAP financial and non-GAAP financial measures are presented in an accurate and reliable manner and disclosures provide useful information. These officers are responsible for the presentation of accurate and reliable non-GAAP amounts that are fully disclosed as part of a company’s reconciliation with GAAP amounts. In their role of managerial discretion regarding the decision to adjust GAAP measures, managers might mislead investors by opportunistically excluding some negative events from income to artificially inflate investor expectations of future profitability. In addition, managerial discretion when adjusting GAAP to non-GAAP earnings has the potential to diminish the usefulness, comparability and transparency of accounting information (Arena et al., 2021). Audit committees should ensure that non-GAAP measures meet SEC standards including being presented in accordance with the regulations. In this regard, they may choose to discuss the matter with the external auditors. Henry et al. (2020) suggest that: “Greater audit committee oversight could increase investor trust in non-GAAP measures and thwart apprehensions of opportunistic reporting.” The authors believe that audit committees “should assist accountants in presenting a fair account of non-GAAP earnings.” The goal should be to enhance reporting quality “of non-GAAP earnings and other financial measures should provide investors with better insight into a company’s performance.” Audit committees play an important role in ensuring that non-GAAP financial information conforms to related GAAP amounts. Recently, regulators have highlighted the influence audit committees should have over unaudited non-GAAP disclosures. For example, Bricker (2018), a former chief accountant of the SEC, emphasizes the need for audit committees to ensure compliance with the SEC’s requirements for non-GAAP disclosures. Moreover, the Center for Audit Quality (CAQ) recently released publications emphasizing the important role of an audit committee in ensuring compliance with Regulation G and presenting non-GAAP disclosures fairly (CAQ, 2018a, 2018b), yet very little is known about what that role should be. CFOs are expected to develop and execute business strategy and communicate with stakeholders. They are charged with providing key information to enable management to run and evaluate the business. This may result in deciding to use non-GAAP measures to meet their burden. Measures such as EBITDA may be more useful than GAAP because it eliminates deductions from GAAP net income that are non-operating or do not require a cash outlay. Another useful non-GAAP measure is “free cash flow (FCF).” FCF represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. This may be important if a company intends to expand its operations and requires substantial cash to do so.

Non-GAAP financial reporting: an ethical analysis  75 Professional standards (PCAOB Standard 2710) requires that auditors only read other information in a document containing the financial statements and accompanying audit report. There are no requirements for auditors to test non-GAAP disclosures, which are presented outside the financial statements, in earnings releases, or in the Management Discussion & Analysis (MD&A) section of periodic filings. Consequently, the external auditor’s opinion on the company’s financial statements and, when required, the effectiveness of the company’s internal controls do not cover non-GAAP measures (Public Company Accounting Oversight Board, PCAOB, 2003). External auditors do have an obligation to disclose when the non-GAAP numbers presented in the annual report do not line up with those previously reported to investors. If material inconsistencies exist, the auditor should consider whether the other information needs to be revised and communicate the matter to the client. If so, if the information is not revised to eliminate the material inconsistency, the auditor should communicate the material inconsistency to the audit committee and consider other actions, such as revising the audit report to include an explanatory paragraph, withholding the use of the report, and withdrawing from the engagement (PCAOB, 2003). The PCAOB has been debating whether to expand auditor responsibilities regarding non-GAAP financial metrics. One possibility is to include a greater emphasis on whether the other information omits or obscures information necessary for a proper understanding of important matters. Auditors could also perform a compliance examination on whether the company complied with SEC rules and regulations related to non-GAAP financial measures. Anderson et al. (2022) examined whether non-GAAP measures have information value and the implications for auditors. The authors presented investor-participants with a non-GAAP measure that should be used when making investment judgments (more informative) or should not be used when making investment judgments (less informative) and is either audited or not. The authors found that when participants view a non-GAAP measure that is more informative, they appropriately use the non-GAAP measure in their investment-related judgments, regardless of whether the measure is audited. However, they also found that participants inappropriately do use the less informative non-GAAP measure in their investment-related judgments when it is audited. The authors conclude that audits of non-GAAP measures signal more than is intended, evidenced by investors perceiving an audited non-GAAP measure as being useful in their investment decisions when the measure is less informative to them. Given all the steps that companies must take in reporting and disclosing non-GAAP amounts and comparing them with their GAAP equivalents, a reasonable question to ask is: Is there an expectation gap because users might expect that external auditors have reviewed earnings releases or are attesting to the company’s internal controls over non-GAAP measures, when they generally do not (PCAOB, 2003). Arena et al. (2021) review the research on non-GAAP reporting with respect to corporate governance and find that an enlarged role for corporate governance can be attributed to the maturing of non-GAAP disclosures and numerous ways to present non-GAAP metrics. The greater responsibility of corporate governance means that audit committees, board of directors, and the incentive-effect of stock-based compensation needs to be monitored by corporate governance mechanisms to ensure consistency and transparency and the full and fair disclosure of non-GAAP amounts. The SEC has brought enforcement actions against companies that do not portray GAAP earnings as prominently as non-GAAP earnings.

76  Research handbook on financial accounting ADT’s Non-GAAP Reporting On December 26, 2018, the SEC (2018a) settled with ADT Inc. over how it portrayed disclosures of non-GAAP earnings. ADT did not afford equal or greater prominence to comparable GAAP financial measures in two of its earnings releases containing non-GAAP financial measures for the quarters ended March 31, 2018 and 2017, and the 12 months ended March 31, 2018. As shown in Box 4.4, ADT’s earnings release provides non-GAAP financial measures such as EBITDA, adjusted net income, and free cash flow before special items, without giving equal or greater prominence to the comparable GAAP measures in the headline of its earnings release. ADT reported adjusted EBITDA was up 7 percent year-over-year for the first quarter of the reporting period and they disclosed it without measuring ADT’s net income or loss (the comparable GAAP financial measure) in the headline (ADT, 2018).

BOX 4.4 MAY 9, 2018, ADT EARNINGS RELEASE Total revenue and Adjusted EBITDA up 5% and 7% year-over-year, respectively. Operating Cash Flow up 23% vs. prior year; Free Cash Flow before special items of $187 million. Continued momentum driven by improvements in customer retention, subscriber acquisition cost efficiency, and commercial expansion. FIRST QUARTER 2018 HIGHLIGHTS • • • • • • • • •

Total revenue of $1,116 million, up 5% Adjusted EBITDA of $620 million, up 7% Adjusted Net Income of $249 million, up 26% Adjusted Net Income per share of $0.34, up 10% Operating cash flow of $505 million, up 23% Free cash flow before special items of $187 million, up 7% Trailing 12-month gross customer revenue attrition of 13.6%, an improvement of 90 bps Paid first quarterly cash dividend of $0.035 per share; declared second dividend today Formally agreed to July redemption of $750 million of Koch Preferred Securities

ADT Inc. and subsidiaries. US GAAP to non-GAAP reconciliations (unaudited)  

For the three months ended March 31,

Twelve months ended

(in millions) Net (loss) income

2018

2017

2018

$(157)

$(141)

$327

Interest expense, net

174

181

726

Income tax benefit

(8)

(32)

(740)

Depreciation and intangible asset amortization

484

461

1,886

Merger, restructuring, integration and other costs

8

21

52

Financing and consent fees

–

62

2

Foreign currency losses / (gains)

1

(3)

(20)

March 31,

Non-GAAP financial reporting: an ethical analysis  77  

For the three months ended March 31,

Twelve months ended

(in millions)

2018

2017

Loss on extinguishment of debt

62

1

65

Other non-cash items1

–

13

–

Radio conversion costs2

1

4

9

Amortization of deferred subscriber acquisition costs

13

10

54

Amortization of deferred subscriber acquisition revenue

(17)

(9)

(55)

Share-based compensation expense

49

2

58

Management fees and other charges Adjusted EBITDA

9

7

30

$620

$577

$2,395

Adjusted EBITDA Margin (as percentage of M&S

60.9%

57.8%

59.2%

March 31, 2018

Revenue)

Notes: Amounts may not add due to rounding. 1 Represents other charges and non-cash items. 2020 included recoveries of $10 million associated with notes receivable from a former strategic investment. 2 Represents net costs associated with replacing cellular technology used in many of our security systems pursuant to a replacement program.

ADT Inc. and subsidiaries. US GAAP to non-GAAP reconciliations (unaudited) Adjusted Net Income

For the three months ended March 31,

(in millions, except per share data) Adjusted EBITDA

2018

2017

$620

$577

Capitalized SAC

(279)

(278)

Cash taxes

2

(2)

Cash interest Adjusted net income

(94)

(100)

$249

$197

Adjusted net income per share

$0.34

$0.31

Diluted weighted-average number of shares outstanding

729

641

Note:

Amounts may not add due to rounding.

Fast forward to 2021 and we can still see that ADT did not disclose comparable earnings amounts in the press release. However, their numerical reconciliation does provide useful information and meets the reconciliation requirements. ADT disclosed the following in its March 1, 2022 press release (ADT 2022): FOURTH QUARTER 2021 (variances on a year-over-year basis) ● ● ● ●

Total revenue of $1.4 billion, up 5 percent End of period recurring monthly revenue (“RMR”) of $359 million, up 5 percent Sequential and year-over-year net subscriber growth; total subscribers of 6.6 million Customer retention with gross customer revenue attrition at 13.1 percent and revenue payback of 2.3 years ● GAAP net loss of $58 million, or $(0.07) per share and adjusted net loss of $25 million, or adjusted diluted net loss $(0.03) per share ● Adjusted EBITDA of $574 million.

78  Research handbook on financial accounting FULL YEAR 2021 (variances on a year-over-year basis) ● Total revenue of $5.3 billion ● Gross RMR additions grew 16 percent ● GAAP net loss of $341 million, or $(0.41) per share and adjusted net loss of $191 million, or adjusted diluted net loss $(0.25) per share ● Adjusted EBITDA of $2.2 billion ● Results met or exceeded full-year guidance, with total revenue and adjusted EBITDA above the high end of ranges provided. If we look at the way non-GAAP disclosures were made in the early part of the press release, GAAP amounts are disclosed but not directly compared with each other. However, as Table 4.2 shows, ADT did provide a numerical reconciliation of GAAP to non-GAAP earnings using Net Loss (prepared under GAAP) to adjusted EBITDA (ADT, 2022). Taken together, these disclosures might be confusing to investors and financial analysts. Table 4.2

ADT, Inc. and Subsidiaries. US GAAP to Non-GAAP Reconciliations (unaudited)

 

Years ended December 31,

(in millions)

2021

2020

2021

2020

Net loss

$(58)

$(112)

$(341)

$(632)

Interest expense, net

110

139

458

708

Income tax benefit

(38)

(13)

(130)

(147)

Depreciation and intangible asset amortization

491

474

1,915

1,914

Amortization of deferred subscriber acquisition costs

35

27

126

97

Amortization of deferred subscriber acquisition revenue

(49)

(34)

(172)

(125)

Share-based compensation expense

15

21

61

96

Merger, restructuring, integration, and other

19

5

38

120

Loss on extinguishment of debt

—

5

37

120

Radio conversion costs, net1

40

28

211

52

Acquisition related adjustments2

12

(1)$

13

—

Other, net3 Adjusted EBITDA

(2)

(5)

(3)

(4)

$574

$533

$2,213

$2,199

Net loss to total revenue ratio

(4.2)%

(8.5)%

(6.4)%

(11.9)%

Adjusted EBITDA margin (as percentage of total revenue)

41.6%

40.5%

41.7%

41.4%

Notes: Amounts may not sum due to rounding. Represents net costs associated with replacing cellular technology used in many of our security systems pursuant to a replacement program. 2 Represents amortization of purchasing accounting adjustments and compensation arrangements related to acquisitions. During 2021, primarily related to the Sunpro Solar Acquisition. 3 Represents other charges and non-cash items. 2020 included recoveries of $10 million associated with notes receivable from a former strategic investment. 1

An examination of the amounts in Table 4.2 indicate that GAAP net loss became an adjusted EBITDA amount indicating an increase of over 900 percent. While it is true the majority of the increase is due to adding back depreciation and amortization, there still are amounts in the reconciliation that are not part of the “usual” GAAP to non-GAAP adjustments, including radio conversion costs, acquisition related adjustments, and other amounts. ADT does explain what these numbers represent. Still, the question is whether investors might be confused by these amounts and whether they affect decision making.

Non-GAAP financial reporting: an ethical analysis  79

COST-BENEFIT AND ETHICAL ANALYSIS The literature review at the beginning of this paper cites research that deal with ethical issues and non-GAAP financial reporting. Briefly, the early studies focus on the quality of non-GAAP measures reported and the intent in their use. One’s intention establishes the basis for ethical reporting. Is it to pull the wool over the eyes of investors, financial analysts, and others who rely on these numbers for decision making? Reason and Teach (2002) highlight how non-GAAP earnings figures can be used to mislead investors. They use the SEC’s first enforcement action against a company for what they called a “materially misleading” quarterly earnings release by Trump Hotel & Casino Resorts Inc. as an exemplar. Trump’s Q3 1999 reported pro forma profit of $14 million excluded a one-time charge of $81.4 million which led to them exceeding analyst estimates by $0.54 per share. However, they report Trump failed to disclose or properly exclude a one-time gain of $17.2 million from the termination of a lease agreement in that same estimate. Jennings and Marques (2011) found that prior to the issuance of Regulation G, investors in companies with weaker corporate governance were misled by non-GAAP earnings releases but this does not persist post regulation. Moreover, when strong corporate governance systems exist, there is no evidence of investors being misled pre or post regulation. These findings imply that the quality of pro forma earnings has improved post regulation because managers are less likely to adjust GAAP earnings for recurring items. Yi (2012) found that firms with opportunistic motives are less likely to report non-GAAP earnings compared with those with information motives that are more likely to report these amounts. Young (2014) suggests that additional regulation can increase transparency, consistency, and comparability of non-GAAP measures. Ventner et al. (2014) suggest that additional regulation in the US with respect to the disclosure of non-GAAP metrics may be of value. This finding confirms the potential usefulness of C&DIs. Regulations G and S-K 10(e) and the C&DIs are intended to ensure that investors, financial analysts, and the public at large are not misled by how non-GAAP measures are determined and disclosed. An ethical analysis starts with assessing the reasons for management disclosing non-GAAP measures. In ethics, one’s intent in taking an action says a lot about whether the actions are ethical or unethical. For example, if management intends to ‘maximize’ GAAP earnings by adjusting it for chosen non-GAAP amounts, and not because doing so provides useful information for decision making, then the motivation to do so is self-serving and not in the best interests of investors, financial analysts and others. Ethically, the basic question is whether the non-GAAP measures are accurate, reliable, and useful for decision making. Given that auditors are not obligated to review these numbers unless presented in the MD&A or elsewhere in the annual report, the users place their trust in management to ensure all disclosures are meaningful and have informative content. Otherwise, the users of non-GAAP financial information may be making decisions based on false and misleading data, thereby compromising its information value. According to Mintz and Miller (2023), it is possible that some managers turn to non-GAAP reporting because they are unable to produce GAAP earnings that meet or exceed earnings targets or expectations – even after engaging in earnings management. It may be difficult for an auditor to make this determination without understanding management’s motivation in disclosing non-GAAP amounts and in selecting one type of non-GAAP measure over another. In general, external auditors need to assess motivation, look for pressures on management to

80  Research handbook on financial accounting disclose earnings numbers that make the company look profitable when it may not be. More specifically, auditors need to be aware of other factors that might incentivize management to find alternative ways to present operating performance that also portray them in the most positive light. There are costs and benefits to gathering and reporting non-GAAP financial metrics and presenting them to stakeholder groups. As previously stated, the question from an ethical perspective is: Do the benefits of the information outweigh the costs to provide it to users to aid in their decision making? Benefits In its analysis of the costs and benefits of disclosing non-GAAP measures, the SEC (2003) points out that CFOs should know that non-GAAP measures can be a powerful tool for communicating with investors and analysts and can play an important role in delivering a view of the company’s financial or operational results to supplement what is captured in the financial statements. Non-GAAP measures can be more useful to investors because they may be a better representation than GAAP numbers of how managers carry out their responsibilities. One caveat is that the use of adjusted earnings may show higher figures than GAAP and boost the company’s stock price. This could be one reason why there has been a significant increase in their use in recent years. Brown (2020) suggests that non-GAAP measures can provide a useful perspective of a company’s ability to generate repeatable or recurring streams of income. She believes this is especially important for initial public offering (IPO) firms that accrue significant amounts of expenses during their growth phase. The Council of Institutional Investors (CII) contends that current non-GAAP financial measures can be used effectively to determine executive compensation. Non-GAAP targets seek to align executive compensation with shareholders’ long-term interest and GAAP may not be able to achieve this result. The CII believes that the proxy’s statement related to a Compensation Discussion and Analysis (CD&A) is the most important source of information used by investors in evaluating executive compensation. The influential investor group “said it wants companies, among other things, to comply with the rules that govern non-GAAP measures when they determine CEO pay to make sure that the metrics are not misleading” (Thomson Reuter, 2021). Costs The SEC has stated that the costs to present non-GAAP measures will be minimal and points to the comments received on the requirement for a reconciliation of a non-GAAP financial measure with the most directly comparable GAAP financial measure. The Commission observed the following in communications with users of non-GAAP information. The commentators stated that, in most cases, for historical measures, registrants have the most directly comparable GAAP financial measure available at the time they prepare or release a non-GAAP financial measure.

Non-GAAP financial reporting: an ethical analysis  81 According to the SEC, the cost of reconciling a non-GAAP financial measure with the most directly comparable GAAP financial measure is not significant because most of the commentators already do the reconciliation for either internal use, external use, or both. (SEC, 2003)

In analyzing the costs and benefits of non-GAAP financial measures, Brown identifies that a significant cost or the downside of these metrics is when they are used for ‘window-dressing.’ The opportunistic use of non-GAAP measures may lead “investors to be skeptical about management’s underlying motives and the value of these measures” (Brown, 2020). Non-sophisticated investors may misinterpret the adjustments used to calculate non-GAAP amounts. They may be confused about whether to rely on non-GAAP earnings or the related GAAP amount. The key is for managers to ensure consistency and transparency in reporting non-GAAP amounts. The audit committee should be involved in these actions as a necessary part of good governance. In his ethical analysis of non-GAAP measures, Verschoor (2014), addresses the drawback of non-GAAP measures. He says, it is “too easy for companies to turn poor GAAP earnings into great non-GAAP earnings by simply designing their own performance measures that can readily be adjusted to unethically report successful accomplishment of the goals created using those same measures.” He concludes that non-GAAP reporting should be limited to when current GAAP does not reflect economic reality. He would limit non-GAAP disclosures only when they could demonstrate the necessity to provide adjusted numbers and communicate meaningful and unique reasons for doing so. Verschoor (2014) provides an example of the abusive use of non-GAAP earnings by pointing to Groupon, Inc. that used a non-GAAP measure, “adjusted consolidated segment operating income.” The biggest difference from GAAP earnings was online marketing expenses. Those costs amounted to $179.9 million in the first quarter of 2011. Backing them out helped to turn a $117.1 million operating loss into an $81.6 million gain. Another example is when the SEC imposed a $1.5 million penalty on MCD Partners on January 18, 2017, for its improper adjustment to meet or exceed quarterly earnings target by coming up with a unique measure to do so – “organic revenue growth.” In addition, they did not give GAAP metrics equal or greater prominence to non-GAAP metrics in its earnings release. Another cost may be that management uses non-GAAP measures to put the best face on the earnings numbers. This is a way for management to show its side of the earnings story. The problem is it may include some items in some years, when it benefits management, and then not use that same amount in subsequent years because it negatively affects earnings. The result is the numbers are not comparable from period to period. The companies referred to in this chapter may be using an ‘ends justify the means’ approach to decision making in selecting the desirable adjustments to GAAP earnings. The problem is that the way management gets from GAAP earnings to non-GAAP amounts is very important, even more important than the non-GAAP amounts they use. This is why relevancy, consistency, comparability, and transparency are core values that underly financial reporting whether for GAAP or non-GAAP measures. These core values are linked to integrity so that differences of opinion within an organization about which non-GAAP earnings amounts to use are

82  Research handbook on financial accounting based on what is right and useful to investors, analysts, and the general public, and not based on the perceived needs of the firm to adjust GAAP earnings to an inflated non-GAAP amount. In the past, the non-GAAP financials were used to isolate the impact of significant one-time events. Ryan (2019) points out that over the past two decades, the number of non-GAAP filings rose from 2.35 to 7.45. The result is a “growing divergence” between the earnings calculated using GAAP and the “earnings” publicized in press releases and analyst research reports. This raises additional ethical questions about the appropriateness of non-GAAP measures and how they reconcile to comparable GAAP amounts. Francine McKenna, an investigative reporter and faculty member at The Wharton School at The University of Pennsylvania, said the following about non-GAAP reporting: How can anyone say with a straight face that non-GAAP numbers more accurately represent public company earnings? They’re now more than double the numbers, according to GAAP accounting standards. They often change losses to fake profits. No wonder the stock market is barely aligned with fundamentals. (Linnane, 2021)

She believes that the SEC “has a big job ahead trying to bring financial reporting back to reality.”

CONCLUSIONS AND SUGGESTIONS FOR FUTURE RESEARCH The use of non-GAAP measures by organizations is common practice and has value if the use of a GAAP measure does not accurately reflect economic reality. Unfortunately, the use of non-GAAP measures provide an easy opportunity for management to manipulate GAAP earnings (or eliminate a loss) to show that their uniquely created non-GAAP metrics exceeded the GAAP amount. The SEC has implemented a strong set of regulations and processes to help mitigate the risk that management will take advantage of this opportunity and that financial analysts and the investing public will be harmed. Yet, misreporting, by some companies, continues to occur. Strong corporate governance systems have been shown to reduce the risk of abuse even further, supported by meaningful ethical standards within the organization. The PCAOB needs to address the GAAP--non-GAAP issue and promulgate audit standards on the form, content and disclosures of non-GAAP measures in relation to the GAAP amounts. As noted, the role of the external auditor in relation to the use of non-GAAP measures is limited. We believe that it is time for the PCAOB to require external auditors to audit non-GAAP measures. People don’t respect what you don’t inspect. While we appreciate Anderson et al.’s (2022) concern that investors might place more emphasis on audited non-GAAP numbers then they should, we feel the risk to the investing public of relying on these numbers far outweighs this concern, assuming those numbers are audited. Researchers could explore how corporate culture affects the opportunistic use of non-GAAP disclosures. Another research opportunity is to explore how external auditors could contribute to increasing stakeholders’ confidence in non-GAAP reporting. Investors would benefit from consistent calculation, presentation, and audit disclosures of non-GAAP performance measures. Finally, future research might focus on the common ways in which non-GAAP measures are manipulated perhaps by having inter-company comparisons. We recommend that accounting educators, especially those who research corporate control and ethics issues, extend the

Non-GAAP financial reporting: an ethical analysis  83 boundary of their work and examine the corporate culture in companies that use non-GAAP measures to see if the intent is to provide useful non-GAAP information, not to pull the wool over the eyes of the investing public, many of whom may not be familiar with or are misinformed about the usefulness of non-GAAP metrics.

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5. Comprehensive red flag model for accounting fraud detection using qualitative and quantitative variables Pilar Lloret Millán, Núria Arimany Serrat and Oriol Amat

INTRODUCTION Accounting information is essential to know the situation and prospects of a company; it is also essential to be able to make decisions to achieve the objectives pursued (Cañibano, 1987). However, very often scandals reveal situations in which accounting deceptions have occurred (Lev, 2013). Accounting deception is a consequence of the so-called creative accounting, or accounting manipulation, which consists of preparing and providing accounting information that does not correspond to the reality of a company (Gisbert et al., 2005). Accounting manipulation consists of intervening in the process of preparing financial information in order to ensure that the accounts present a different picture from reality. This is a major problem as it affects the reliability of the accounts. The manipulations are carried out to ensure that the accounts reflect what is in the interests of the managers and directors. In this way, reality is not reported and the users of the accounts are misled. Accounting deception can be carried out either through accounting manipulations or through real transactions, since both can modify the figures of the companies. In the first case, the deception is done through changes in valuation criteria or by altering the accounts, raising or lowering revenues, expenses, assets or liabilities. One practice, for example, may be the discretionary use of accruals to increase or decrease the company’s earnings. In the second case, they are actual transactions that change the figures by anticipating or delaying transactions or by carrying out transactions that have no reasonable economic justification but alter the earnings; for example, when deciding to sell to a customer of poor credit quality. In this case, the company may increase sales and profits for a few months, although this will have to be corrected some time later. Accounting deception is a problem as old as mankind; as an example, we can recall that there are documented episodes of accounting deception that occurred more than 3,000 years ago in Ancient Mesopotamia (Jones, 2012). And, since then, there have been multiple cases that have alarmed the population. Accounting deception is a topic of great interest because of the negative impact it has on the confidence of investors, creditors, employees and any party interested in the accounting information of an organization. When an accounting deception is made public, there are important consequences that are very negative: economic or image losses for the company, shareholders, employees, auditors, creditors and public administration, among other interested parties (Amat et al., 1995). According to the Association of Certified Fraud Examiners, ACFE (2020a), the losses of companies due to fraud in their organizations are equivalent to 5 percent of their annual revenues. In many cases, it also leads to the bankruptcy of the company, the loss of 87

88  Research handbook on financial accounting jobs and significant criminal consequences for the persons responsible for the offenses, which may entail fines or even imprisonment. Another negative consequence is often the imposition of significant penalties on the auditors when it is considered that they have not done their job properly. Other negative consequences of accounting scandals are the loss of confidence of users in relation to accounting information and all the actors involved in its preparation, such as company management, regulatory and supervisory bodies, and statutory auditors. All this causes very negative impacts on financial markets and the economy (Karpoff et al., 2008; Hernández-Gil et al., 2019; Cornejo and Guíñez, 2016). In some cases, the seriousness of the situation has led to major changes in legislation in an attempt to prevent the recurrence of negative episodes (Camfferman and Wielhouwer, 2019), as in the Enron case in 2000, which led to very profound changes in commercial and accounting legislation in the United States and Europe (Akhigbe et al., 2005). The scandals also highlight the need to strengthen the ethical foundations of education and corporate governance (Gargouri et al., 2010; Kreismann and Talaulicar, 2020). Another consequence of this type of scandal is that it makes the fight against accounting fraud gain importance since it is essential to achieve compliance with the United Nations Sustainable Development Goals, set out in the 2030 Agenda, and thus achieve the desired transparency of financial information (Lashitew, 2021). For reasons such as those mentioned above, accounting deception is a subject of great scientific interest at present (Akpanuko and Umoren, 2018). Given the negative consequences of accounting frauds, it is important to reinforce preventive measures to prevent frauds from occurring and to detect frauds as soon as possible after they have already occurred. Among the preventive measures is the identification of warning signs that a company may commit deception and warning signs that deception has already occurred. The objective of this chapter is to review the state of the art in relation to warning signs based on quantitative and qualitative variables that can help to foresee in advance that a company is a strong candidate to commit accounting fraud or that it has already committed it. In this way, a comprehensive model of warning signs is proposed to detect accounting fraud before it is too late.

CONCEPT OF ACCOUNTING MANIPULATION The literature review refers to the concept of accounting manipulation and, in the following section, we will continue with the relationship between accounting manipulation and accounting fraud. In relation to accounting manipulation, Breton and Stolowy (2001) explain that the literature in the USA uses the term earnings management, while in the UK, the term used is creative accounting. Gisbert et al. (2005) define earnings management as “any practice intentionally carried out by management, for opportunistic and/or informative purposes, to report desired accounting figures, different from the actual ones”. It is a process by which accountants, using their knowledge of accounting standards, manipulate the accounts of a company. In this process there is “intentionality” on the part of those responsible for preparing the financial information (Breton and Stolowy, 2001). In order to carry out the interested modification of accounting information, the company’s management can make accounting entries and/or real transactions (Amat, 2017). In both cases they can be legal or illegal and are aimed at modifying the accounts. In the first case, these

Comprehensive red flag model for accounting fraud detection  89 are techniques that take advantage of the different interpretations of the current regulations using their flexibility or the subjectivity of some of the valuation methods when accounting for the different elements of the balance sheet and income statement. It would also be the case of using possible legal loopholes in the accounting regulations. In the second case, we would be dealing with real transactions or accounting entries that are not allowed by law and that constitute an accounting crime (Elvira and Amat, 2008).

ACCOUNTING MANIPULATION AND FRAUD International Standard on Auditing 240 (ICJCE, 2015) defines fraud as “an intentional act by one or more persons in management, those charged with governance of the entity, employees or others, involving the use of deception for the purpose of obtaining an unfair or unlawful advantage.” It also indicates as fraud risk factors, “facts or circumstances that indicate the existence of an incentive or element of pressure to commit fraud or that provide an opportunity to commit fraud”. The Association of Certified Fraud Examiners (a non-profit organization with the objective “to serve the community through the expansion of knowledge and continuing education on issues related to fraud prevention, detection, investigation and deterrence and combating corruption”, is the world’s leading anti-fraud organization, with more than 75,000 members in more than 150 countries), hereinafter ACFE. This association considers that fraud “can reach any crime for profit that uses deception as its main modus operandi” (ACFE, 2020b). With regard to the different types of fraud that can occur in a company, according to ACFE (2020a) it can be separated into three blocks: theft of assets, corruption, and accounting fraud. In most cases, two or more of these types of fraud are present. Asset theft represents the most common fraud in companies. Accounting fraud is defined by ACFE (2020a) as “a scheme in which an employee intentionally causes a material misstatement or omission of information in the organization’s financial reports”. Regarding the different ways of accounting fraud, ISA 240 (ICJCE, 2015) identifies the following modalities: ● Manipulation, falsification or alteration of accounting records. ● The intentional misrepresentation or omission of material facts, transactions or other significant information in the financial statements. ● The intentional misapplication of accounting principles. One aspect of interest is the study of the circumstances that explain why individuals and companies engage in these practices. Works such as those of Cressey (1980, 1986) show that when there is the motivation and simultaneously the opportunity, these deceptions are more likely to be carried out. There is no single typology of company in which fraud occurs, but rather it can appear in any company regardless of size or industry (Zayas, 2016). The same conclusion is reached by ACFE (2020a) when it points out that all industries are prone to corporate fraud, and it can also occur in any country. As for the average duration of corporate fraud, ACFE (2020a) quantifies the average time from the start of the fraud to its discovery at 14 months. This period increases to 24 months in the case of accounting fraud.

90  Research handbook on financial accounting

THEORETICAL FRAMEWORK OF ACCOUNTING MANIPULATION Having introduced the subject under study, this section presents the concepts used. The main concept used is that the misleading information does not represent reality. Accounting manipulation is also called by other names, as mentioned above, and the most commonly used terms according to the literature review are creative accounting and earnings management. However, other expressions are also used, such as window dressing (used when a store arranges the window to make it more attractive and used in accounting to imply that the accounting manipulation is intended to improve the company’s image), cooking the books or enronomics (referring to what is possibly the best known accounting scandal at the international level). As has been indicated, accounting manipulation is done with the aim of making the accounts give an image that interests those who prepare the accounts, instead of reporting the reality. Therefore, these are practices that reveal ethical problems. Manipulations of the accounts can be made with accounting entries (which modify the company’s assets, liabilities, income or expenses) or with actual transactions that are made to change the accounts (for example, by anticipating or delaying a transaction). A subject of debate is that there is no unanimity on whether accounting manipulation is a legal practice or not. Specifically, accounting manipulation can be done without violating current regulations but by taking advantage of the flexibility and loopholes in the regulations and, for this reason, it can be thought that there are cases of accounting manipulations that could be legal. In other cases, when the regulations are violated, these would clearly be illegal practices. It is possible that in many cases, the manipulations are in a gray area where it is not clear whether or not the regulations are being violated. Continuing with the theoretical framework, accounting manipulation is done because the people who prepare the accounts (or the managers who order them) may have motivations for doing so. For example, if the company has high indebtedness and wants banks to renew or extend financing, it may be interested in showing accounts with less indebtedness. The same would be true if the level of profitability is low. These types of motives will be aggravated when it comes to companies that have a very aggressive management incentive system or when managers are unethical. On the other hand, when there is the motivation and simultaneously the opportunity is given, it is more likely that these practices are carried out. There are factors internal to the company that can contribute to more accounting manipulation (poor corporate governance, a deficient internal control system, lack of auditing or unqualified auditors, and so on). There are also factors external to the company that can create opportunities for manipulation. An example would be poor accounting regulation when it allows an excess of alternatives or has loopholes in the regulation. Another aspect to consider is that there are particular moments when the probability of accounting manipulations by the company increases. For example, when an IPO (Initial Public Offering) is being prepared (or the company is in the process of being sold) there may be more interest in improving the image offered by the accounts. Another situation that may generate more interest in manipulating the accounts is when there are important changes in the company’s management, since the new management may be tempted to communicate that the previous management has not done a good job (see Figure 5.1). Once the deception occurs, users of financial information make different decisions from those they would make if the information was correct. Thus, we can find, for example, banks that grant loans to companies that do not deserve them, investors who buy shares in a company

Comprehensive red flag model for accounting fraud detection  91 thinking that the company is a better investment than they would think with truthful information, or managers who receive higher incentives than they would have received if they had not manipulated the accounts. These erroneous decisions generate negative consequences (financial losses, company bankruptcy, loss of company image, etc.) that end up being reported in the media and cause a scandal (see Figure 5.1). In fact, the media tend to give a lot of coverage to these issues. Once a scandal occurs, a whole series of actions are taken to punish the culprits on the one hand, and to prevent a repetition of bad practices on the other (see Figure 5.1). Sanctions by regulators or supervisors, or other authorities, against the companies and managers involved in the schemes can be significant, especially in Anglo-Saxon countries. On the other hand, in some cases, such as that of Enron in 2000, the magnitude of the scandal led to major changes in the regulation of commercial legislation, especially in accounting and auditing. These changes substantially modified commercial and accounting regulation in the United States and also in Europe. In the case of Europe, the International Financial Reporting Standards for the consolidated accounts of listed companies were adopted in 2004. These changes, especially those related to corporate governance and sanctions, if effective, can reduce the opportunities and motivation for accounting fraud. From the topics presented so far in this theoretical framework, we have concluded that, in most of them, the research done so far already allows us to have sufficient knowledge on the subject under study. This is the case for aspects such as the following, included in this theoretical framework: ● How the accounting manipulation is done (type of accounting entries, choice of alternatives among the different ones allowed by the legislation, type of actual transactions, etc.). ● Why the accounting manipulation occurs (motivations, opportunities, particular moments, etc.). ● Consequences of misleading financial information: economic consequences (fall in share price and loss of company value, dismissal of employees, etc.). ● Measures taken to punish offenders: dismissal, fines and other financial penalties, imprisonment, etc. ● Other measures to prevent the recurrence of bad practices: improvement of commercial, accounting and auditing legislation; strengthening of the sanctioning system, etc. On the one hand, we have identified an aspect that is of great scientific and social interest but which, on the other hand, still requires a great deal of research to deepen the knowledge about it, i.e., the identification of signs that warn before deception occurs or that, even if deception has already occurred, the signs warn before it is too late. This is a highly relevant issue since, as has been shown, accounting frauds cause very significant losses and can have very negative impacts on the users of accounting information. As can be seen in Figure 5.1, red flags can indicate that a company has a high probability of committing an accounting fraud and, therefore, can warn before any accounting manipulation occurs. However, since the deceptions will continue to occur, warning signals are also needed to indicate that a company has a high probability that it has already manipulated its accounts. The questions that this research seeks to answer are as follows: ● What are the qualitative warning signs (personal, organizational, operational, etc.) that can indicate that a company may commit or has committed accounting fraud?

92  Research handbook on financial accounting ● What are the quantitative warning signs (inventories, customers, debt, working capital, profit-to-cash ratio, profitability, etc.) that can indicate that a company can commit or has committed accounting fraud? ● Can accounting policy indicators (depreciation, impairment, intangible assets, etc.) give a warning that a company may be committing or has committed accounting fraud? Can they warn that a company can commit or has committed accounting deceptions? In the following section we will review the research that has been done in relation to the previous questions.

Source:

Own elaboration.

Figure 5.1

Misleading financial reporting process, scandal, corrective actions and warning signs

STATE OF THE ART ON WARNING SIGNS TO DETECT COMPANIES THAT CAN MAKE OR HAVE MADE ACCOUNTING DECEPTIONS This section reviews the state of the art on warning signs to detect companies that can make or have made accounting deceptions. According to Rocco and Plakhoknik (2009), the review of the state of the art will allow us to go deeper into the subject under study and also to know the research that has been done on this topic by identifying the main authors who have worked on it. It will also demonstrate the need for research and will help to find specific aspects where further research is needed. In this section we study the state of the art of qualitative and quantitative signals that allow us to detect whether a company has a high risk of making accounting misrepresentations or whether there are indications that it may have already made accounting misrepresentations.

Comprehensive red flag model for accounting fraud detection  93 The authors who have worked on these issues study whether there are patterns or characteristics that occur more frequently in companies that engage in accounting misrepresentations. For the purposes of the literature review, we will distinguish between signals based on qualitative information and quantitative signals (accounting data). One aspect to be clarified is that the existence of warning signals does not mean that accounting manipulations exists or are bound to occur, but rather that there is a high probability that accounting manipulations exists (PWC, 2020) or have occurred. Therefore, when we say high probability, we do not say for certain that there is accounting manipulation. Research on warning signs for detecting fraud has been of great interest since the 1980s (Albrecht et al., 1985). As a sample of this type of research, we can mention Albrecht and Romney (1986) who found 30 warning signs that are good predictors of fraud, and most of them were characteristics of individuals. Heiman-Hoffman and Morgan (1996) identified 36 warning signs that can be very useful for external auditors to detect fraud. Apostolou et al. (2001) and Moyes (2007) did the same with internal auditors. Other researchers, such as Coram et al. (2008) and Liou (2008), did similar work but with fraud investigators. In the auditing world these signs are called ‘red flags’ and are regulated by the International Standard on Auditing: The Auditor’s Responsibilities for the Audit of Financial Statements with respect to Fraud (ISA-ES 240). This standard includes warning signs that auditors have to evaluate in the audited company. They are warning signs related to behaviors and facts, fraudulent financial information, possible misappropriation of assets, sales, estimates, discrepancies in accounting records, contradictory evidence or lack of evidence; and relations with management and management’s relations with the previous audit (ICJCE, 2015). The ISA 240, The Auditor’s Responsibility to Consider Fraud and Error in an Audit of Financial Statements, was issued by the International Auditing and Assurance Standards Board (IAASB) and published by the International Federation of Accountants (IFAC, 2009). This auditing standard has its equivalent in the United States in US SAS (Statement of Auditing Standards) 99, Consideration of Fraud in a Financial Statement Audit issued by the AICPA (American Institute of Certified Public Accountants). US SAS 19 requires auditors to evaluate 42 red flags before performing the audit (AICPA, 2002). Below, we list the main warning signs identified in the literature. These signals include those mentioned above plus those that have been proposed in other relevant research articles. Works that Identify Warning Signs Based on Qualitative Information Table 5.1 shows the most relevant studies that have proposed warning signals based on qualitative information. Works that Identify Warning Signals Based on Quantitative Information (Accounting Data) Table 5.2 lists articles that have identified warning signals based on quantitative information. These signals that we have identified in the literature as relevant (Tables 5.1 and 5.2) are very useful for detecting accounting frauds before it is too late. On the other hand, it is also worth noting that, according to Du Toit (2008), there are variables in which the relationship with the accounting frauds is contradictory. This would be, for example, the size of the company, since it is not clear whether the fact that the company is small or large influences if

A company that is experiencing particularly stressful times: it has to go public or has

Schilit (1993), Amat (2017)

Warning sign after manipulations

board of directors

Aggressive management style (results must be achieved at all costs) and with a lot

of arrogance. Managers with very aggressive verbal and non-verbal language, very

(2010), Amat (2017)

Singleton and Singleton (2010), Akpanuko

and Umoren (2018).

Poor corporate governance

Loans between the company and members of the board of directors or executive

Sahiti and Bektashi (2015)

Mills (2003)

officers

Secret agreements between executives and third parties

Singleton and Singleton (2010)

goodness of the company.

optimistic without any basis to support it or not very concrete when talking about the

Conflictivity: high turnover of employees, managers or advisors, conflicts with the

Singleton and Singleton (2010), DiNapoli

 

 

 

 

 

explanation.

not take all vacations, inexperienced managers in key locations, owners/managers do

(2007), Amat (2017), ICJCE (2015)

not distinguish between personal and business transactions

of managers or employees, selling shares without logical

unauthorized activities, heavily indebted, overspending or very luxurious lifestyle, do

Managers who generate mistrust: changes in life habits

 

authorities

Company that has been delisted or sanctioned by the

 

 

 

(1986), Yücel (2013), Fich and Shivdasani

Albrecht et al (1985). Albrecht and Romney Managers who generate distrust: bad reputation, have been sanctioned, do other

renegotiated.

company, major investments that require financing, times when financing is being

recently gone public, has a takeover bid or has to be sold, changes at the top of the

 

Companies with a history of legal non-compliance and sanctions.

variables such as revenues, costs or profits.

These are companies that may experience a lot of pressure to achieve certain values in

Companies that carry out regulated activities, concessionaires or receive subsidies.

for financing.

in order to attract investors who bet on the company in years when there is a great need

more difficulties in obtaining financing. It is also more difficult to achieve profitability

A company that has been in existence for only a few years. Young companies have

it more difficult for companies to achieve profit and profitability targets.

Singleton and Singleton (2010)

Amat (2017)

Beneish (1997)

High competition in the sector (motivation for fraud). In sectors where there is a lot of

competition, it costs more to generate revenues and margins are very tight. This makes

Warning sign before manipulations

Wilks and Zimbelman (2002)

Works that have identified qualitative warning signs

Author

Table 5.1

94  Research handbook on financial accounting

Lack of independence: company dominated by one person. For example, the president

Dechow et al. (1996), Beasley (1996)

members, for example) or inexperienced, people.

(2017)

internal auditor’s reports

Negative or qualified external audit reports, negative

 

 

 

Managers hold a significant portion of the company’s shares.

Complex corporate and organizational structure with many subsidiaries abroad

(opportunity for fraud), complex operations that are difficult to understand.

Unusual significant transactions. Unusual transactions with foreign subsidiaries.

High expectation of profitability and obsession with profits and share price by

shareholders, managers and creditors. Very aggressive incentives for short-term results

Calderon and Green (1994)

Lendez and Korevec (1999), Wilks and

Zimbelman (2002), Robertson (2002),

DiNapoli (2010), Pai et al. (2011)

Lee et al. (1999), Wilks and Zimbelman

(2002), Singleton and Singleton (2010)

(rationalization of fraud), unreported conflicts of interest of managers or employees.

and Singleton (2010)

Frequent claims to insurance companies.

Ethical problems: companies or managers and employees with low ethical standards

Wilks and Zimbelman (2002), Singleton

Potential non-compliance may be an incentive to commit deception.

Difficulties in meeting covenant targets that may lead to early loan termination.

(motivation for fraud). Company not meeting shareholders’ or analysts’ expectations.

 

Frequent bank account changes

Singleton and Singleton (2010)

 

 

 

auditor also responsible for internal audit (illegal in principle).

 

Undesirable auditor: poorly qualified external auditor, very low audit cost, external

(2003)

company does not want the auditor to have complete information on the group).

Subsidiaries not audited or audited by other auditors (this may be an indication that the  

Unusual relationships between auditors and management.

external auditor’s criteria or making difficulties for the external auditor.

Warning sign after manipulations  

Albrecht et al. (2011), Amat (2017), Mills

Yücel (2013)

contract, conflicts with the auditors, auditors questioning the going concern principle

Sahiti and Bektashi (2015), Yücel (2013)

(the continuity of the company is in question), management trying to change the

Problems with the auditors: changes of external auditor before the deadline set in the

Robertson (2002),

anonymous reporting channel

Lack of a code of ethics or code of conduct, lack of fraud prevention regulations, no

Inadequate control of executive expenses.

There is no audit committee or it has inadequate, not very independent (family

Zimbelman (2002), AICPA (2002), Amat

Amat (2017)

Weak control system (opportunity for fraud), absence of internal or external audit.

Singleton and Singleton (2010), Wilks and

of time.

board of directors. Independent directors who are on the board for a very short period

of directors. Shareholders who are not part of the controlling group but are on the

of the company is the founder and CEO. Lack of independent directors on the board

Warning sign before manipulations

Author

Comprehensive red flag model for accounting fraud detection  95

Warning sign after manipulations  

Source:

Own elaboration.

are worsening.

which the opinions of analysts and credit rating agencies

irregularities in the company’s management, companies in

Negative news in the media: News in the press warning of

Amat (2017).

Changes in accounting criteria or adjustments for errors

Miller (2006), Sahiti and Bektashi (2015),

 

Akpnuko and Umoren (2018), Amat (2017).  

inflate profits.

and which are not consolidated. One motivation would be to hide indebtedness or

Subsidiaries with shareholdings exceeding 50% (or close to this percentage of control)

interest in hiding information, perhaps in connection with illegal practices).

Subsidiaries in tax havens (apart from the interest in paying less taxes, there may be an  

or customers

Unprofessional or self-serving relationships of managers or employees with suppliers

Singleton and Singleton (2010)

Yücel (2013) Akpnuko and Umoren (2018)

Warning sign before manipulations

Author

96  Research handbook on financial accounting

Comprehensive red flag model for accounting fraud detection  97 Table 5.2

Works that have identified quantitative warning signals

Author

Warning sign before manipulations

Warning sign after manipulations

Yücel (2013), Albrecht  

Very surprising positive data considering the history of the

and Romney (1986)

company and the situation of the industry.

Amat (2017)

 

Akpnuko and Umoren

 

Inconsistency between sales and store and employee performance. Many returns shortly after year-end.

(2018), Amat (2017)

Increases in capitalized expenses, intangible assets, deferred tax assets, work performed by fixed assets, etc.

Amat (2017)

 

Turnover ratios very different from those of the sector

Albrecht et al. (2011)

 

Longer collection period

Akpnuko and Umoren

 

Stock lead time grows

(2018) Amat (2017)

Low liquidity or insufficient working capital.   This could motivate the company to be more interested in cheating on its accounts.

Yücel (2013)

 

Suppliers discount very frequently

Amat (2017)

Very high debt. This could motivate the

Increase in off-balance sheet financing (project finance,

company to have more interest in cheating

for example). May be an indication that the company is

on its accounts.

trying to hide debt.

 

Unusual movements in provisions (pensions, etc.)

Negative or insufficient results, gross

Relevant discrepancies between profit and cash generated.

Akpnuko and Umoren (2018) Yücel (2013)

margin or cash flow. This could motivate the Profit higher than cash generated. This is a sign that it is company to have more interest in cheating in easier to manipulate profit than cash. its accounts. Albrecht and Romney

 

sense, growth in sales with repurchase agreements, etc.

Umoren (2018) Schilit (1993)

Suspicious sales: growth in the portion of revenues based on estimates, sales to customers that do not make much

(1986), Akpnuko and

Company that has grown a lot in the past and   now grows less

Beneish (1999)

 

Significant change in gross margin on sales

Beneish (1999)

 

Depreciation, provisions, impairments very different from

Beneish (1999)

 

Yücel (2013)

 

those of the industry or previous years Increase in general and administrative expenses in relation to sales Very large profits are made on unusual transactions near the end of the year

Source:

Own elaboration.

there is more or less accounting deception. Nor is there clear evidence regarding the influence of the industry in which it operates. The fact that the share price is doing well or poorly is not have sufficient evidence that it influences whether there is more or less deception, since if things are going well there is an interest in maintaining it; and if they are going badly there is an interest in improving it.

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COMPREHENSIVE MODEL OF WARNING SIGNS OF ACCOUNTING DECEPTION Based on the works included in Tables 5.1 and 5.2, we propose a comprehensive model of warning signs. We say comprehensive model because it includes an exhaustive list of aspects ranging from the characteristics of the company, the particular moments in which more frauds can be committed, profiles and performance of people, corporate governance, control systems, incentive systems, objectives, financial and accounting practices, results, and accounting data, among others. The comprehensive model is composed of a total of 105 red flags that indicate that there is a high probability of accounting deception in a company or a high probability of deception in the future (see Tables 5.3, 5.4, 5.5 and 5.6). Table 5.3

Qualitative warning signs that indicate a high probability of accounting fraud in a company

Subject Characteristics of the company

Warning signs 1. Industries where there is a lot of competition 2. Regulated companies, concessionaires or companies receiving subsidies 3. Young company 4. Complex corporate and organizational structure 5. Many foreign subsidiaries 6. Subsidiaries in tax havens 7. History of legal non-compliance and sanctions

Particular times when there are

8. Initial Public Offering

more motivations for cheating

9. Takeover bid 10. Changes in the top management of the company 11. Major investments requiring financing 12. Times when financing is being renegotiated

Owners, officers or employees

13. Troubled history (legal issues, conflicting dismissals) 14. Bad financial habits (very indebted, overspending or very luxurious lifestyle) 15. They do not distinguish between personal and business transactions 16. Low ethical standards 17. Managers or employees who do not take all vacations 18. Inexperienced managers in key positions 19. High turnover of managers, employees or consultants 20. Aggressive managing style 21. Excessive optimism without any basis for optimism 22. Secret agreements with third parties 23. Unprofessional or self-serving relationships of managers or employees with suppliers or customers 24. Managers hold a significant portion of the company’s shares

Comprehensive red flag model for accounting fraud detection  99 Subject

Warning signs

Corporate governance

25. Disagreements and conflicts among members of the board of directors 26. Deficiencies in corporate governance 27. Company dominated by one person 28. Lack of independent directors 29. Officers or employees to the board of directors 30. Lack of directors who are shareholders and are not part of the controlling group 31. High turnover of independent directors 32. Lack of a code of ethics or code of conduct 33. Lack of fraud prevention regulations 34. Lack of a channel for anonymous complaints 35. Undisclosed conflicts of interest

Control and audit systems

36. Absence of internal or external audit 37. The external auditor also performs the internal audit 38. No Audit Committee 39. Inadequate auditors: not independent or inexperienced 40. Unusual relationships between auditors and management 41. Very low audit cost 42. Changes of auditors 43. Unsubstantiated request for changes in the audit team 44. Conflicts with auditors 45. Auditors question going concern principle 46. Subsidiaries not audited or audited by other auditors 47. Inadequate control of executives’ expenses

Financial objectives

48. High expectation of profitability and obsession with earnings and share price by share-

Financial practices

49. Frequent bank account changes

holders and managers 50. Complex operations that are difficult to understand 51. Unusual major transactions 52. Unusual transactions with foreign subsidiaries 53. Difficulties in meeting covenant targets that may result in early loan termination 54. Frequent claims to insurance companies Accounting practices

55. Subsidiaries with shareholdings exceeding 50% (or close to this percentage of control)

Incentive systems

56. Very aggressive incentives for short-term results (motivation for fraud)

Results

57. Company that does not meet performance expectations

and which are not consolidated

Source:

Own elaboration.

Table 5.4

Qualitative warning signs indicating a high probability of accounting fraud in a company

Subject Characteristics of the company

Warning signs 58. It has been delisted 59. Sanctioned by the authorities

Owners, officers or employees

60. Changes in lifestyle habits 61. Selling shares without logical explanation

Control and audit systems

62. Negative external audit reports or with exceptions 63. Negative reports from internal auditors

100  Research handbook on financial accounting Subject

Warning signs

Reports from analysts and credit

64. Negative or worsening reports

rating agencies Accounting practices

65. Changes in accounting criteria 66. Adjustments for errors

Media and communications

Source:

67. Negative news alerting of irregularities or conflicts

Own elaboration.

Table 5.5

Quantitative warning signs that indicate a high probability of accounting fraud in a company

Subject

Warning signs

Balance sheet

68. Low liquidity ratio 69. Insufficient working capital 70. High debt

Income statement

71. Company that has grown a lot in the past and now grows less 72. Negative or insufficient result 73. Negative or insufficient gross margin 74. Negative or insufficient cash flow

Source:

Own elaboration

Table 5.6

Quantitative warning signs indicating a high probability of accounting fraud in a company

Subject

Warning signs

Accounting policies

75. Increase in the capitalization of expenses 76. Increase in intangible assets 77. Increases in deferred tax assets 78. Increases in internal works added to fixed assets 79. Unusual movements in provisions 80. Depreciation, amortization, provisions or impairment very different from those of the industry or of previous years 81. Not very credible estimates

Balance

82. Very surprising positive data considering the history of the company and the situation of the industry 83. Unusual changes in the balance sheet 84. Insufficient working capital 85. Turnover ratios very different from those of the industry 86. Longer collection period 87. Inventory lead time is growing 88. High debt

Comprehensive red flag model for accounting fraud detection  101 Subject

Warning signs

Income statement

89. Very surprising positive data considering the history of the company and the situation of the sector 90. Unusual changes in income statement items 91. Suspicious sales 92. Growth in the portion of revenues based on estimates 93. Sales to customers who do not have much logic 94. Growth in repurchase agreement sales 95. Unusual evolution of expenses in relation to sales 96. Negative or insufficient result 97. Significant benefits in operations near year-end 98. Negative or insufficient cash flow

Cash flow statement

99. Relevant discrepancies between profit and cash generated 100. Profit grows but cash generated declines

Operational data

101. Inconsistency between sales and evolution of stores and employees

Financial practices

102. Suppliers discount very frequently 103. Unusual significant transactions 104. Significant transactions near the end of the fiscal year 105. Many returns shortly after the end of the fiscal year

Source:

Own elaboration.

The proposed model can be applied to a company and as more red flags are raised it can be interpreted as more indications of accounting deception and, therefore, increased caution is required.

CONCLUSIONS Accounting deceptions have very negative consequences for the people who suffer them, but also for the companies themselves, society in general and for the credibility of a country’s economic system. For this reason, it is in the interest of the company to strengthen preventive measures to avoid deception and to detect deception before it is too late. The objective of this chapter is to propose a comprehensive model of warning signals based on qualitative and quantitative variables that have been identified from international research. The proposed list of signals can help to foresee that a company is a strong candidate to commit accounting fraud or has already committed it. The comprehensive model includes an exhaustive list of topics, such as the characteristics of the company, the particular moments in which more frauds can be committed, profiles and performance of people, corporate governance, control systems, incentive systems, objectives, financial and accounting practices, results and accounting data, among others. The comprehensive model is composed of a total of 105 warning signs. This set of warning signs can be useful for the work programs of internal auditors and also of external auditors since they can use them when reviewing a company. They are signals that can also be useful for analysts and supervisory bodies. The work carried out has several limitations and, among them, we can highlight that the relationship of signals does not contain a prioritization, so that it has not been identified which signals are more important and which signals are less important, differentiating between properly financial and non-financial signals and the implications at the level of the Sustainable Development Goals (ODS).

102  Research handbook on financial accounting With a view to future work, this line of research will be worked on to analyze which signals are more powerful while identifying situations related to accounting fraud and their relationship with integrated information and the ODS, to identify which signals identify companies that make accounting mistakes compared with companies that do not.

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PART III SUSTAINABLE ACCOUNTING

6. Financial accounting and the natural environment: the case of climate change Elena Carrión, Carlos Larrinaga and Antonio Mateo

INTRODUCTION The Earth has transitioned into the Anthropocene, a new geological epoch (Crutzen, 2002), characterized by human impact at the geological level, which is materialized in climate change and the use of natural resources to a degree that will leave a geological imprint even after the disappearance of humanity (Steffen et al., 2015). Although the state of the Planet in, say, two million years could be irrelevant to the human genre, the Anthropocene is likely to involve unsustainable regime shifts and irreversible changes in the Earth-system processes (Griggs et al., 2013). Rockström et al. (2009) have translated the challenges of the Anthropocene into nine critical system-wide Earth processes, such as global climate change and biodiversity loss (Bebbington et al., 2020a). Rockström et al. (2009) posit that transgressing any of those planetary boundaries could jeopardize a safe operating space for humanity. To explore the relationship between financial accounting and the environment, this chapter focuses on one critical environmental process: climate change. The stability and resilience of the planet largely depend on limiting the volume of greenhouse gases (GHG hereafter) that are present in the atmosphere and, therefore, a substantial reduction of emissions (Rockström et al., 2009; Steffen et al., 2015). The latest report of the United Nations Intergovernmental Panel on Climate Change (IPCC, 2022) reiterates that human activity is the main driver of climate change. The energy sector accounts for around 73 percent of global GHG emissions; agriculture, forestry, land & use for 18 percent; waste 3 percent; and chemicals and cement 5 percent of total emissions (Our World in Data, 2022). Companies, particularly transnational companies, play a crucial role in these industries and in the economic system in general and, therefore, it has been suggested that they have a key role to play and responsibility in abating GHG emissions. Reducing corporate GHG emissions requires thinking bidirectionally. On the one hand, companies influence critical Earth-system processes, something that is especially true for transnational corporations that have extended supply chains and concentrate the production of goods and services within their sector (Virdin et al., 2021). For example, the four largest companies in the cruise tourism sector account for 93 percent of revenues ($47 billion) in this industry (Virdin et al., 2021). The activities in this sector increase climate change and ocean acidification, for which measuring and reducing their impact is crucial for sustainability. On the other hand, the effects of climate change may significantly impact companies’ operations, cash flows, financial position, and financial performance. As we compromise the equilibrium of the Earth (Rockström et al., 2009; Steffen et al., 2015) and move forward in the Anthropocene (Folke et al., 2021), the interplay between companies’ economic activities and the natural environment is likely to produce non-negligible financial implications for com106

Financial accounting and the natural environment: the case of climate change  107 panies that need to comply with stringent regulation or whose assets and activities crucially depend on natural resources/services. The International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB), the dominant standard-setters for corporate financial accounting and reporting, have affirmed that material climate-related issues need to be considered in the elaboration of financial statements. However, companies’ financial statements are still, and to a large extent, silent on the financial implications of material climate-related issues. These are the findings of a recent study of more than 130 carbon-intensive firms, carried out by Carbon Tracker (2022). This study showed that companies generally fail to include such information both in their narratives and financial accounts. Along the same lines, for the oil and gas industry, Bebbington et al. (2020b) found that investors relying on corporate reports lack an accurate company valuation of fossil fuel reserves and contingent resources, as well as a full picture of their contribution to climate change. The findings of Bebbington et al. (2020b) reflect the difficulties in capturing environmental impacts in conventional financial accounting, as the impossibility of burning fossil fuel reserves in a constrained climate change scenario does not appear to permeate in market and accounting values. Environmental impacts remain externalities, or “issues without internal consequence” for the company (Unerman et al., 2018, p. 497). Full cost accounting (FCA hereafter) is a practice emerging from sustainability accounting that seeks to call the attention and incorporate into financial reports those environmental costs that appear as externalities in accounting. Sustainability accounting scholars claim that, despite the difficulty of translating Earth-system processes into the corporate level (Gray & Milne, 2004), we need to bear in mind that accounting has a constitutive role (Miller & Power, 2013) and, therefore, accounting or not accounting for environmental externalities creates specific visibilities about the organization and its environmental impacts (Hopwood, 2009). In such a way, FCA constitutes a tool to increase corporate responsibility by representing, if not internalizing, the external costs of environmental impacts (Unerman et al., 2018). This chapter explores the relationship between financial accounting and the natural environment, to ascertain to what extent accounting numbers provide the appropriate information about required substantive ecological transitions. To that aim, the chapter focuses on climate change and draws on a bidirectional approach. First, we problematize the limitations of financial accounting to measure and reduce climate change externalities. In addition, we build into the process of FCA a mechanism to provide visibility of corporate impacts on the natural environment. Second, we present a business landscape to reduce GHG emissions, and we analyze their financial implications in corporate statements. Eventually, we conclude that FCA provides a tool to connect the external and internal costs of climate change in companies.

MAPPING THE BIDIRECTIONAL IMPACTS OF CLIMATE CHANGE Climate change can be recognized in companies’ financial statements through the internalization of climate risks. This could be the case, for example, when the rise of sea levels caused by climate change or the obsolescence of GHG emitting products impair the value of assets. However, climate-related assets impairments and provisions are exclusively recognized through an outside-in direction, withholding a complete picture of companies’ climate-related

108  Research handbook on financial accounting benefits and costs that are imposed on others. The company may participate in climate change through its GHG emissions, giving rise to an external cost (negative externality), since its emissions are contributing to climate change and, therefore, contributing to its negative effects, which will be borne by stakeholders that do not participate in the gains of the corporation’s activities. In sum, the company may not only suffer the costs of climate change, but also contribute its share by imposing an externality on third parties. This is the bidirectional approach to which we refer in this chapter. Externalities are generated by inside-out impacts, i.e., business operations causing costs or benefits to the natural environment and/or society. Externalities arise from a market failure and go unaccounted for (Mildenberger, 2018), and unrecognized by the reporting entity (Unerman et al., 2018). Accounting for externalities can help overcome the market failure, informing about the broader social corporate financial position and performance and increasing corporate responsibility and accountability (Mildenberger, 2018), by reporting the social and ecological value of production. The social and environmental accounting literature has coined the term “full cost accounting” (FCA) for a modified profit and loss account, where externalities are accounted for (Unerman et al., 2018). FCA allows corporations to: (i) account for the use of social and environmental resources lent to them by society (Gray et al., 1996); (ii) show the un/sustainability of business behavior; (iii) report more accurate prices (from an environmental point of view) for services and goods; and (iv) identify more environmentally-efficient procedures for obtaining goods and services (Unerman et al., 2018). FCA was already considered more than five decades ago (e.g., Estes, 1972). Its main potential lies in the possibility to translate sustainability into the language of business through the monetization of environmental benefits and costs, including those that are external (Antheaume, 2004; Bebbington et al., 2001; CICA, 1997). However, FCA faces some limitations. It represents a compromise with weak sustainability because it assumes some degree of substitutability between different forms of capital (Magness, 2003). In addition, the figures produced through FCA are difficult to interpret due to uncertainty over the definition of its scope, the fact that external costs are never turned into cash and the consideration that it should not include opportunity cost (Magness, 2003). Despite its limitations, FCA can help incorporate external social and environmental costs into corporate accounting. This chapter builds on FCA to analyze the financial implications of climate change on corporate financial statements through a bidirectional approach. Outside-in impacts, which capture the effects of climate change on companies, are embedded in financial accounting through the internalization of climate change costs. Internal environmental costs are those borne by the organization and are frequently linked to compliance with environmental norms (Boone & Rubenstein, 1997) that relate to the prevention, mitigation and remediation of environmental impacts as well as to fines for failing to comply with norms and standards (Boone & Rubenstein, 1997; CICA, 1997). In this regard, different mechanisms have arisen in the last few decades that produce outside-in impacts. Examples include carbon taxes, emissions trading schemes, or climate-specific regulations, which require target companies to identify, measure, manage and report the financial cost arising from emissions. The EU-ETS (European Union Emissions Trading System) obliges regulated companies to surrender one emission allowance for each ton of CO2 emitted, or otherwise pay a penalty (Garcia-Torea et al., 2022). Stakeholders most interested in information on climate

Financial accounting and the natural environment: the case of climate change  109 change outside-in impacts are investors and creditors, as these impacts may significantly affect corporate value. In contrast with outside-in impacts, which are potentially or de facto internal costs, inside-out impacts produce externalities. Inside-out impacts have their roots in business activities and their effects on the natural environment and society. In the case of climate change, through the GHG footprint of the energy, products and services used, the company is contributing to climate change and, therefore, to the generation of climate change costs that are borne by the whole society. Although climate change costs are subject to uncertainty, they are substantial (Antheaume, 2004; Bebbington & Larrinaga, 2008). To address inside-out impacts it is necessary to identify how externalities can be internalized (Unerman et al., 2018). Different mechanisms, such as voluntary initiatives and environmental standards, as well as global campaigns, lie at this juncture between regulation (which leads to internal costs) and externalities. Those mechanisms have weak financial implications because they are not enforced by a regulatory agency, but they represent the process, mediated by reputation, responsibility and legitimacy concerns, by which externalities are progressively internalized. As stated by Unerman et al. (2018), “with progressively greater financial internalization, the former externalities should come clearly into the domain of financial accounting and reporting” (p. 513). For instance, failing to keep to a voluntary science-based

Figure 6.1

Bidirectional approach of climate change impacts

110  Research handbook on financial accounting commitment may not directly affect a company’s financial statements as there are no penalties for non-compliance, but may indirectly affect the value of its assets by impairing its reputation. In conclusion, inside-out climate change impacts create externalities that are not innocuous from a financial perspective, since, like a boomerang, different mechanisms have the potential to return external costs into outside-in impacts (CICA, 1997; Unerman et al., 2018). This is critical since business transformations to reduce emissions can only occur if environmental externalities are captured and internalized as a responsibility of the company, leading to strong financial implications. As shown in Figure 6.1, FCA values internal costs (i.e., impacts covered within financial statements) but also externalities (i.e., unintended impacts resulting from the activity of the company that are not incorporated in its financial statements). FCA is a dynamic process which aims to internalize externalities as these may eventually have financial consequences for the company (Unerman et al., 2018). Because it is a dynamic process, it is worth exploring the financial accounting implications of the current landscape of mechanisms addressing climate change.

STRONG FINANCIAL IMPLICATIONS OF CLIMATE CHANGE Climate change has direct implications in the financial statements when climate costs are internalized. On the one hand, for the internalization of climate costs, it is critical to expand the boundaries of the mechanisms to mitigate carbon emissions so that weak financial implications turn into strong financial implications. Carbon pricing mechanisms produce internal climate costs that have a direct impact on companies’ financial bottom line. More generally, reporting standards can potentially make further climate costs with strong financial implications visible. On the other hand, voluntary climate initiatives and accounting standards, as well as global campaigns have weak financial implications, i.e., can potentially and indirectly impact the financial value of assets. In the rest of the chapter, we discuss, first, mechanisms with strong financial implications, and then, mechanisms with weak financial implications. Carbon Pricing Mechanisms: Carbon Taxes and ETS Governments play a critical role in incentivizing companies to reduce their carbon emissions, given their capacity to implement specific rules and laws to tackle climate change (Stoddart et al., 2012). National climate-related laws are crucial to implementing international agreements such as the Kyoto Protocol and the Paris Agreement, as well as to increase confidence to reach future ambitious commitments. To address climate change and to internalize climate costs, many governments use carbon pricing mechanisms (Lodhia, 2011; Metcalf & Weisbach, 2009) to put an explicit price on GHG emissions. Along with carbon offsetting, carbon pricing is a market mechanism by which governments can reduce GHG emissions by making carbon-intensive products and processes inefficient. It has been argued that carbon pricing not only is an effective method to mitigate climate change, but also an important source of revenue for national governments (World Bank, 2022). Among the different carbon pricing mechanisms carbon markets and carbon taxes are the most common.

Financial accounting and the natural environment: the case of climate change  111 In carbon markets, regulated companies must surrender at the end of the compliance period a number of emission allowances that offset their total emissions. Carbon markets introduce a flexibility mechanism by which regulated entities can buy and sell emission allowances; they can choose between reducing their GHG emissions (e.g., through technological changes) and obtaining emission allowances (World Bank, 2022). Thus, while the price of emission allowances is determined by supply and demand in the market, the level of reduction in carbon emissions is the decision of regulated entities. Carbon markets based on cap-and-trade systems set a limit, or cap, to the GHG emissions target and distribute allowances in quantities roughly equal to the cap (World Bank, 2022). For example, the European Union implemented in 2005 a cap-and-trade mechanism to address the objectives of the Kyoto Protocol (Lodhia, 2011; Metcalf & Weisbach, 2009). A carbon tax puts an explicit price on GHG emissions, for example, a price per ton of CO2 emitted to the atmosphere. This instrument differs from carbon markets in that the price of carbon emission is predefined, but the emissions reduction is not. It has been suggested that a carbon tax is a more direct and effective means to control and reduce carbon emissions (Lodhia, 2011). For instance, with the aim of reducing carbon emissions, the UK government implemented in 2001 the Climate Change Levy, which is a climate tax to non-domestic consumers of electricity and gas (Metcalf & Weisbach, 2009). Companies will identify, measure, manage and report the financial cost arising from the outside-in impacts, which capture the effects of climate change on companies. The internal costs of GHG emissions are embedded in the financial accounting in the form of environmental assets, liabilities, and costs, as well as impairments of assets. Although some externalities are difficult to measure, carbon pricing mechanisms produce an economic cost for GHG emissions, make them an internal cost and make them worthy of consideration for financial reports. Once these costs are included in companies’ financial statements, they will cease to be considered as externalities (Unerman et al., 2018). Different institutions, such as the European Union, have mobilized carbon pricing mechanisms as an efficient means to tackle climate change (Lodhia, 2011). However, to effectively internalize the costs of climate change to society, carbon pricing instruments need to price carbon emissions according to the damage they cause to the natural environment (Hopwood, 2009). This is important, because the internal cost might not compensate the total climate cost and so the climate cost of GHG emissions could only be internalized in part. In that regard, financial accounting plays a crucial role in carbon pricing by identifying, measuring, assessing and reporting organizations’ footprints regarding their impact on the natural environment (Bebbington & Larrinaga, 2008). There has been a long debate in the social and environmental accounting literature about the relevance of carbon pricing, given the potential mismatch between internal costs and total environmental costs. However, as far as financial accounting is the language of business, accounting for mandatory carbon pricing instruments allows entities to effectively manage risks and uncertainties resulting from climatic change, as well as to discharge to their interested parties their accountability regarding carbon emissions (Bebbington & Larrinaga, 2008). Omitting this information would have the effect of discouraging investors who are keen on understanding the external impact of climate-related factors, as it creates a gap in the information available to them (Giordano-Spring et al., 2022). This leads to the discussion of reporting standards, which can potentially make further climate costs visible.

112  Research handbook on financial accounting International Financial Reporting Standards (IFRS) The IFRS Foundation seeks to develop globally accepted standards on accounting. It is structured in two main standard-setting bodies: the International Accounting Standards Board (IASB), which develops financial accounting and reporting standards, and the International Sustainability Standards Board (ISSB), which works on sustainability reporting standards. IFRS accounting standards, which are endorsed in more than 140 countries worldwide, do not explicitly refer to climate change risks, although companies need to account for the impacts when these have a material effect in their financial position. Accounting for climate change leads companies to make the consequences of global warming visible in their corporate financial accounts. Although there is no explicit IFRS accounting standard concerning climate change-related issues, climate risks may significantly affect different areas in financial accounting. For example, IAS (International Accounting Standard) 1 requires companies to report judgements, estimations and uncertainties related to going concern, which refers to the analysis of the business’s continued operation. Thus, a firm’s going concern evaluation may be significantly influenced by climate-related issues, with assumptions concerning the nature of future business operations and constraints on financial support likely to be included into the evaluation (Lombardi, 2021). Furthermore, the reporting entity should consider other external factors such as water shortages, energy access, and waste management that are important to the going concern principle. Given the growing preoccupation with climate change, companies that prepare their financial statements under IFRS standards are more likely to include an assessment on the climate-related risks by, for example, disclosing sensitivity analyses considering different scenarios. Significant judgement is necessary when identifying how climate-related risks impact on financial statements in accordance with IFRS standards. Climate change may also affect other significant areas of accounting, such as property, plant, and equipment (hereinafter PP&E), financial instruments or fair value measurement. For example, IAS 16 requires companies to recognize a certain item as PP&E if its costs can be reliably identified as well as if it is likely that the company will receive future economic gains related to the item. Climate change is likely to cause a significant impact on PP&E’s residual value, useful life, and decommissioning costs. In addition, growing regulatory pressure at the national and international level may increase the likelihood that certain PP&E items turn into “stranded assets”, especially for companies in carbon-intensive sectors. In this regard, a recent study has shown that to meet the Paris Agreement 1.5ºC target, 60 percent of oil and gas (and 90 percent of coal) reserves should remain unextracted (Welsby et al., 2021). Thus, in the Paris Agreement scenario, many companies extracting carbon-intensive resources may lose the value of their assets as, in this scenario, they will not be able to exploit and recover the value of these stranded assets through continued use in the entity’s operating activities. From a climate outside-in perspective, to keep the users of financial reports informed about the future internal economic costs and benefits associated with their PP&E, companies should consider the impact of risks related to climate change when evaluating and making judgements related to their PP&E items. Moreover, climate-related information included in companies’ IFRS financial statements should be consistent with the information reported to their stakeholders through other channels such as standalone sustainability reports.

Financial accounting and the natural environment: the case of climate change  113 Sustainability Reporting Standards There are currently three main actors involved in sustainability reporting standard-setting from an outside-in perspective: the European Financial Reporting Advisory Group (EFRAG), the International Sustainability Standards Board (ISSB), and the Securities Exchange Commission (SEC) of the United States. These institutions seek to elaborate standards for companies that voluntarily or mandatorily report sustainability-related issues that have a financial impact. Proposals developed by these international bodies differ on, among other issues, their structure, main intended audience, scale of mandatory disclosures, materiality, and reporting boundary, as presented in Table 6.1. EFRAG is a private body created in 2001 under the auspices of the European Commission (EC) to serve the European public interest and support the adoption of the international financial reporting standards (Giner & Luque-Vílchez, 2022). More recently, it actively participated in the development of the Corporate Sustainability Reporting Directive (Directive 2022/2464/EU-CSRD), amending the Non-Financial Reporting Directive (Directive 2014/95/ EU-NFRD). CSRD entered into force in January 2023, increasing the number of companies covered by the reporting obligation and extending disclosure requirements, including a double materiality assessment, assurance, forward-looking qualitative and quantitative disclosures, and information on targets and progress. In addition, companies reporting under the CSRD must follow the European Sustainability Reporting Standards (ESRS), which include cross-cutting (ESRS 1, ESRS 2), environmental (ESRS E1-E5), social (ESRS S1-S4), and governance (ESRS G1) standards. EFRAG’s sustainability reporting standards have a wider scope than ISSB’s standards concerning key disclosure topics, including materiality, intended audience, and reporting boundary (Giner & Luque-Vílchez, 2022). For example, regarding the intended audience, EFRAG took a wider approach than ISSB when developing its standards, in alignment with GRI, considering the demands of a broad range of stakeholders, beyond investors and shareholders. Table 6.1 Characteristics/

Landscape of proposed sustainability standards by the main international bodies EFRAG

ISSB

SEC

Number of proposals 12

Two (IFRS-S1, IFRS-S2)

One (SEC Climate Disclosure Rule)

Main audience

Multi-stakeholder focus

Investor and creditors

Investor and creditors

Topic

Environmental, social, and

To date, detailed guidance on

Detailed requirements to report on

governance

climate only

climate only

Double materiality: financial and

Financial materiality

Financial materiality

Standard-setter

Materiality

impact perspective

Source:

The authors.

Since its creation, the IFRS Foundation has primarily focused on elaborating financial reporting standards. However, in 2021 it launched a new body, the International Sustainability Standards Board (ISSB), to focus specifically on sustainability matters and develop sustainability-related standards. This organization has issued in 2023 two disclosure standards concerning sustainability matters: IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosure, which

114  Research handbook on financial accounting will enter into force in January 2024. IFRS S2 requires corporations to disclose information concerning climate-related risks and opportunities that could affect the entity’s cash flows, its access to finance or cost of capital. Unlike EFRAG’s sustainability reporting standards, ISSB’s requirements are primarily focused on the demands and needs of creditors and investors (Giner & Luque-Vílchez, 2022). In fact, its proposed standards are based on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) and institutions that focus on investors’ protection such as the Climate Disclosure Standard Board (CDSB), the Value Reporting Foundation (VRF), and the World Economic Forum (WEF) (Giner & Luque-Vílchez, 2022). Moreover, the ISSB sustainability standards borrow the definition of materiality from the IFRS financial reporting standards. The SEC (Securities and Exchange Commission of the United States) is an independent organization that regulates the US capital markets and facilitates information transparency. In March 2022, it issued a proposal on climate-related disclosures that would require companies within its scope to include climate-related information in their registration files (SEC, 2022). The proposal, which is due by November 2023, focuses on how climate risks will pose a material impact on companies’ business operations, and requires companies to report certain emission metrics in their financial statements. As in the case of ISSB standards, the SEC proposal is primarily driven by the information needs of creditors and investors (SEC, 2022). In fact, the objectives of the SEC proposal are very similar to those of the ISSB sustainability reporting standards. The implementation of the SEC proposal would make mandatory for listed companies in the United States climate disclosures that are largely voluntary as of now. Despite the differences between the primary sustainability reporting standards, standard setters assert they seek a global convergence of sustainability reporting. EFRAG is particularly interested in making ESRS interoperable with the IFRS and GRI frameworks. For example, the definition of outside-in impacts conceived in ESRS is like that of IFRS S2, which is also convergent with investor frameworks, such as the TCFD. Additionally, the ESRS concept of “impact” is drawn from GRI to frame inside-out impacts.

WEAK FINANCIAL IMPLICATIONS OF CLIMATE CHANGE Costanza et al. (1997) argue that economic valuations of ecosystems are carried out every day when making decisions, although they are not always expressed in monetary terms. Therefore, the fact that GHG emissions may not have strong financial implications mean that they are attributed a negligible value and decisions are made accordingly. In this case, if GHG emissions have weak financial implications, from an inside-out perspective, it is still important to report the effect of companies’ activities on climate change to a broad range of stakeholders. Indeed, companies generally freely engage in mechanisms to address climate change issues, such as voluntary initiatives and standards, or global campaigns, to progress in sustainability and show stakeholders their commitment with a degree of flexibility that leaves space for innovation.

Financial accounting and the natural environment: the case of climate change  115 Voluntary Climate Initiatives and Accounting Standards Building on the current state of guidance for emissions abatement, we point out some of the mechanisms that are more widely used by companies to limit global warming and explore some of the accounting implications of those mechanisms. The Science-Based Target initiative (SBTi) is a partnership between the Carbon Disclosure Project (CDP), the United Nations Global Compact (UNGC), the World Resources Institute (WRI), and the World Wide Fund for Nature (WWF). It was launched in 2015 to provide the private sector with the tools to align corporate performance with climate science requirements (SBTi, 2023). Under the SBTi, companies voluntarily commit to limit global warming to 1.5ºC by setting science-based targets, which include a target boundary (i.e., the inventory to decarbonize), a timeframe (i.e., the roadmap to decarbonization), and the permitted methods for decarbonization. The SBTi is currently the main initiative to reduce emissions based on a global carbon budget. Indeed, by November 2023, 6,380 companies from more than 75 countries worldwide, and operating in different sectors, were committed to the initiative (SBTi, 2023). As part of their commitments, companies in the SBTi are held accountable to an external audience by developing, validating, and publishing their approved targets. However, there are no financial penalties for companies that fail to comply with their science-based targets. Thus, the SBTi has weak financial implications because the emissions reduction, or otherwise the failure to comply with targets, do not have material implications in companies’ financial position. The Global Reporting Initiative (GRI) is the global standard setter for sustainability reporting. The objective of this not-for-profit organization was to create a common accountability mechanism for triple bottom line reporting. In 2022, more than ten thousand organizations published a GRI report, including 70 percent of the Global Fortune 500 according to GRI.1 Since the first version of the guidelines in 2000, GRI has expanded its boundaries to include new sustainability-related questions. In 2016, GRI launched the first global standards for sustainability reporting – the GRI Standards. The GRI Emissions 2016 Standard (GRI 305) is part of the set of GRI Sustainability Reporting Standards and specifically reports emissions reduction across companies’ scopes 1, 2, and 3. GRI standards are developed in the public interest through a stakeholder consultation process. Although GRI has become the de facto sustainability reporting standard setter (Larrinaga & Bebbington, 2021), it is still a voluntary initiative. In this scenario, companies may use GRI standards to report on their GHG emissions, but their environmental performance is not necessarily linked to financial consequences. The GHG Protocol is the generally accepted standard for carbon accounting. For instance, GRI, EFRAG, ISSB and SEC leverage the GHG protocol in their sustainability standards to identify and measure corporate carbon emissions. However, the GHG Protocol has been subject to criticism, especially for its guidance on indirect emissions (scopes 2 and 3) (Bjørn et al., 2022). For example, the protocol allows firms to use renewable energy certificates (also known as RECs) to offset significant amounts of scope 2 emissions (purchased energy) from their carbon ledgers. Companies are allowed to drastically reduce their scope 2 emissions by buying RECs from clean power providers. This could be a way to internalize those emissions. However, recent evidence has shown that it does very little to lower carbon emissions as well



1

https://​www​.globalreporting​.org/​about​-gri/​.

116  Research handbook on financial accounting as to contribute to expanding renewable energies. It is just a low-cost accounting mechanism that companies use to remove huge amounts of scope 2 emissions from their environmental ledgers. Thus, this practice just contributes to overestimating carbon emissions reductions and consequently does not pave the way to limiting global warming and, eventually, to equilibrium in the Earth-system processes. Despite its limitations, the GHG protocol is currently the generally accepted framework to account for GHG emissions with the GRI 305 building its reporting requirements on carbon emissions on the guidelines provided by the GHG Protocol. Voluntary Investor Frameworks: CDP and TCFD Climate change can have serious consequences for business operations. Investors and creditors concerned by the value of their investments need information about the effects that climate change may have them (Stanny & Ely, 2008). To obtain the appropriate information, groups of investors and creditors and concerned institutions have developed different frameworks, such as the CDP questionnaire and the TCFD, to better understand how climate change can affect companies’ operations, since the wealth of the investors and creditors may be in jeopardy if climate change seriously impacts the operations of companies in which they invest. CDP (formerly known as Carbon Disclosure Project) is a voluntary initiative developed in 2000 by a group of institutional investors who were concerned about the impacts of climate change on companies in which they invest.2 CDP collects environmental data from companies through an annual questionnaire sent to companies around the world. Companies can voluntarily decide to respond or not. Initially, the CDP was more focused on carbon emissions of corporations and cities. However, in the last decades it has expanded its focus to include specific questionnaires on forests and water. In its general climate change questionnaire, CDP includes several modules of information regarding carbon emissions (e.g., governance, risks and opportunities, business strategy, targets and performance, emissions methodology, emissions data, energy, additional metrics, verification, carbon pricing, and engagement). Once the companies answer the questionnaire, CDP evaluates the transparency, as well as the quality of the information reported and accordingly awards an alphabetical score (A–E, with A being given to the companies with the best performance and transparency) to reflect a standardized benchmark on a company’s progress in environmental stewardship. In the last decades, CDP has gained relevance among investors and creditors. For example, some loan contracts include a covenant linked to the CDP score (FreightWaves, 2019). Thus, companies’ climate disclosures through the CDP questionnaire may have an indirect impact on their financial costs, which in turn may affect their financial position and performance. The Task Force on Climate-related Financial Disclosures (TCFD) is an investor reporting framework that provides climate-related financial recommendations on the areas of governance, strategy, risk management and targets.3 The TCFD offers guidelines to include climate information within the financial statements to provide investors with useful information on how climate change and the transition to a lower-carbon economy may affect companies’ financial position and performance. TCFD’s reporting framework is aligned with other reporting initiatives such as the CDP climate change questionnaire. In fact, the CDP climate change questionnaire was redesigned in 2018 to incorporate the recommendations of the TCFD.

2



3

www​.cdp​.net. https://​www​.fsb​-tcfd​.org/​about/​.

Financial accounting and the natural environment: the case of climate change  117 TCFD’s recommendations are also acknowledged in the Corporate Sustainability Reporting Directive (Directive 2022/2464/EU). Global Campaigns Global campaigns are multi-stakeholder alliances and networks that co-create, coordinate, and consolidate business practices. Global campaigns provide a space to experiment before scaling to make the practice binding. The most prominent climate change campaign is the Race to Zero Campaign, developed by the United Nations Framework Convention on Climate Change. The Race to Zero Campaign mobilizes more than 8,000 companies and 3,000 other non-state actors, such as educational institutions or cities, to establish business practices that decrease emissions through a carbon budget.4 Participating organizations need to meet minimum criteria built under “Five Ps” (Pledge, Plan, Proceed, Publish, Persuade). Over these five pillars, a stakeholder consultation process is created to develop further guidance on leadership practices. The independent experts developing this guidance include scientists, academics, practitioners, and companies. The Race to Zero promotes building responsible claims that increase the credibility of climate action. Thus, there are no compliance mechanisms for the Race to Zero Campaign. In addition, companies need to include the “Five Ps” in their corporate strategy, but these may not internalize the environmental costs in their financial statements that arise from their (un)sustainable business practices.

CONCLUSION This chapter has explored the relationship between financial accounting and the natural environment by addressing climate change, the most urgent environmental concern of our days. However, further planetary processes, such as biodiversity, are equally important for ensuring a safe operating space for humanity. This chapter has mobilized FCA as a method to approach the bidirectional relationship between financial accounting and the natural environment and present some of the most important developments emerging at that intersection. There are two main assumptions in FCA (Bebbington et al., 2001). On the one hand, that current prices underestimate the value of the environmental – and social – damage caused by products, processes, and services. On the other hand, by identifying and valuing externalities, FCA allows stakeholders to identify and communicate costs and profits that are more correct from a sustainable development perspective (Antheaume, 2004; Boone & Rubenstein, 1997; CICA, 1997; Estes, 1972), which in turn would allow them to make more sustainable decisions. Financial accounting focuses on the outside-in approach, climate costs that are internalized by mechanisms such as the carbon markets and accounted for following accounting standards issued by IFRS and other bodies. However, total climate costs are not always accounted for in financial statements, they are underestimated. In this case, a gray area emerges, where costs are external but can potentially become internal. This is the reason why the inside-out perspective should concern not only the broader society, but also investors and creditors, who



4

https://​unfccc​.int/​climate​-action/​race​-to​-zero​-campaign​#eq​-3.

118  Research handbook on financial accounting may be interested in the possibility that externalities are internalized. We have referred in this chapter to the weak financial implications of climate change when voluntary initiatives, global campaigns and intergovernmental agreements may, over time, develop into strong financial implications and directly affect financial statements. This dynamic process is leading to different voluntary initiatives that call for the disclosure of information about climate risks, risks that not only concern the environment and humanity, but risks that primarily affect the financial position, performance and value of firms. In conclusion, financial accounting has been conventionally equipped to deal with internal costs. However, climate change and further environmental challenges are driving accounting to consider risk and non-financial information to better represent the position of companies in global ecological changes that are intrinsically dynamic and where companies share a responsibility for the natural environment.

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7. Sustainability reporting regulation: current situation and future developments Soledad Moya

INTRODUCTION Sustainability reporting (SR) is going through crucial times with an increasing demand from stakeholders to know and assess sustainability practices and outcomes of organizations. The amount of information provided by companies has increased as evidenced by the KPMG Survey of Sustainability reporting 2020 (KPMG, 2020) which has observed substantial changes since the survey was first published in 1993 when only 12 percent of companies published sustainability reports as compared with the current 80 percent (over 90 percent among the largest of the world). However, one must avoid the assumption that increased SR necessarily means improved accountability (Adams, 2004). And, in fact, this positive evolution in terms of SR quantity has not meant a similar evolution in its quality as sustainability reports are still found to be sometimes unclear, lacking meaningful content (in particular for some dimensions such as the social one) and with a low level of comparability (Chatelain-Ponroy and Morin-Delerm, 2016; Vila and Moya, 2023). In this sense, the lack of specific and harmonized frameworks that facilitate the tasks of entities has been found to be determinant. One of the key players of SR evolution is regulation. Several guidelines have been available for companies to help them develop their SR over time and special mention should be made of the Global Reporting Initiative (GRI), which is today the most commonly used by European companies (Alonso-Almeida et al., 2015; KPMG, 2020). However, there is another player who also wants to act in a predominant role (Abad et al., 2022) and that is the European Union (EU). And a key year in the EU progress to becoming a front-runner in the SR challenge is 2021, when the Corporate Sustainability Reporting Directive (CSRD) proposal was issued (European Commission, 2021). The new Directive expands the scope, the content and the verification of SR for large and SME companies, trying to foster sustainability practices and development and with the aim of correcting the deficiencies of the Non-Financial Reporting Directive (NFRD) issued in 2014. The new CSRD should foster an increase in the accountability of companies regarding their impact on the planet and society, and promote the change in the direction of their activities towards activities that are respectful of the environment and people. The EU is trying to harmonize SR, providing a new mandatory framework that facilitates the issuance of comparable and reliable information that enhances the transition towards a more sustainable economy. In addition, building on the steps given by the CSRD, the EU has asked the European Financial Reporting Advisory Group (EFRAG) to develop new mandatory sustainability standards, the European Sustainability Reporting Standards (ESRS), which are still in progress, with some drafts having already been published and being under discussion. These new standards will set the path for European companies in the incoming future regarding SR. And, additionally to these steps, the IFRS Foundation, by means of the recently launched 121

122  Research handbook on financial accounting International Sustainability Standards Board (ISSB), is also willing to have an input into SR in Europe. In this sense, and as stated by Giner and Luque-Vílchez (2022), no one would deny the legitimacy of the EU in the definition and issuance of these rules at the European level, while the position of the IFRS Foundation is not that clear as it is not a public institution, although it has made important efforts to be considered legitimate, due to its strong tradition in the issuance of successful financial reporting standards, and also through changes in its accountability and governance (Botzem, 2014). Academic research has evidenced the advantages of harmonization in sustainability reporting. Fortanier et al. (2011) show that global standards do not only increase the level of SR reporting but are also associated with a harmonization of sustainability practices of firms, reducing the role that local institutions may play in the definition of sustainability activities. Tschopp and Nastanski (2014) assessed the evolution and possible harmonization of sustainability standards with those of the financial reporting ones and concluded that, at that moment, GRI was the best option for companies to follow, as this would lead to the provision of useful sustainability information and would facilitate comparison and homogenization. With all this in mind, the objective of this chapter is, first, to describe the current situation of sustainability reporting regulation in Europe, comparing the new European drafts proposed with the most frequently used guidelines (GRI) and adding the contribution from the IFRS Foundation, and, second, to determine what are the main challenges ahead and possible future developments. The reminder of the paper is as follows: the next section deals with the main changes in European SR after the issuance of the CSRD proposal with special reference to materiality and assurance. The third section introduces the drafts issued by the EC/EFRAG and compares some of the social standards proposals with the GRI framework. The fourth section describes the main steps taken by the IFRS foundation and the ISSB and compares their proposal with the one from EC/EFRAG. Finally, the fifth section includes the conclusions and discussion regarding the current situation, the main challenges and possible future developments.

THE CSRD AS A MILESTONE IN EUROPEAN SUSTAINABILITY REPORTING REGULATION DEVELOPMENT It can be said that the year 2021 defined an important moment in SR; there was a before and an after. The constant increase in the interests of stakeholders regarding sustainability disclosures together with the issuance in April 2021 of the new Directive proposal on Sustainability reporting set a new scenario for companies and institutions in relation to the disclosures of sustainability performance and achievements. This new Directive asks for the development of mandatory sustainability standards that will determine what and how European companies will disclose sustainability in the following years. The main objective is that transparency regarding environmental, social and governance affairs becomes the rule for large European companies. The CSRD proposal was issued1 motivated by the fact that the legislation issued until that moment in Europe, more specifically the 2014 Non-Financial Reporting Directive (NFRD, 1 The CSRD has been adopted by the European Parliament on 10 November 2022, with 525 votes in favor, 60 votes against and 28 abstentions.

Sustainability reporting regulation: current situation and future developments  123 European Parliament and Council of the EU, 2014), could not guarantee that the needs of the different stakeholders regarding sustainability information were met. Some of the issues that had arisen regarding the insufficiencies of the NFRD were related to the scope of the law (considered to be too narrow), the lack of homogenization and comparability achieved, and the low level of accessibility of the information. In that sense, Breijer and Orij (2022) found that this lack of comparability was more exacerbated in those companies that resisted SR adoption as compared with those that voluntarily adopted it. The CSRD proposal tries to address those deficiencies by introducing some relevant changes referent to the scope (with a substantial increase in the number of companies affected), the double materiality concept, an increase in the prospective information including objectives and progresses, disclosure of information about intangibles (social, human and intellectual capital), assurance requirements and the alignment with the Sustainable Finance Disclosure Regulation (SFDR) and the UE Taxonomy Regulation. In Table 7.1, we have included a summary of the main facts included in the new Directive as compared with those of the NFRD. Table 7.1

Comparison NFRD 2014 and Proposal CSRD 2021

 

EU Directive 2014/95/EU

CSRD proposal

When?

FY 2018

FY 2023 ● FY 2023: first set of SR Standards (draft standards available mid-2022) ● FY 2024: second set of SR Standards ● Adoption EU-Directive member states: 1 December 2022

Which companies?

Large public interest entities with > 500 All large companies: > 250 employees and/or > €40 million employees.

turnover and/or > €20 million total assets

Public interest entities are: listed

Listed companies

companies, banks and insurance

Note: Listed SMEs extra 3 years to comply.

companies Number of

11,600

49,000

Reporting

Companies are to report on:

Adding additional requirements on:

requirements

● Environmental protection

● Double materiality: sustainability risk (including climate change)

companies

● Social responsibility and treatment of employees

affecting the company + companies’ impact on society and environment

● Respect for human rights

● Process to select material topics for stakeholders

● Anti-corruption and bribery

● More forward-looking information, including targets and progress

● Diversity on company boards (age, gender, educational and professional

thereon ● Intangibles information (social, human, and intellectual capital) ● Reporting in line with SFDR and the EU Taxonomy Regulation

Independent third

background) Non-mandatory (for most countries).

Mandatory – limited level of assurance

party assurance

In some countries part of legal audit

● Integration in Auditor’s Report

requirements.

● Involvement of key audit partner ● Scope to include EU Taxonomy and process to identify key relevant information

Where?

Included in the Annual Report

Inclusion in the Management Report

Format

Online or PDF version

To be submitted in electronic format (XTML in accordance with ESEF regulation)

Source:

Adapted from KPMG (2021).

124  Research handbook on financial accounting Regarding the scope, it will be mandatory to all companies listed in any regulated market of the UE, except for the micro-companies. As for listed SME, although they are also included in the scope of the Directive, they will have a longer period (until 1 January 2026) to comply with its information requirements. In order to maintain the proportionality, the UE will adopt new sustainability standards for large companies and separate and proportional standards for the SMEs. It will also be mandatory for large entities in the UE, defined as entities that comply with the criteria detailed in Table 7.1. It is worth noting here that subsidiaries where the parent already includes this information will be exempted. Finally, micro-companies and non-listed SME are also exempted from this obligation although they can apply the regulations voluntarily. It can be observed, therefore, that there is an increase in the scope of the CSRD proposal in comparison with the criteria initially established in the NFRD. With the new scope criteria, the number of companies affected will be close to 50,000 which covers more than 75 percent of the total EU companies’ turnover and represents an approximate increase of 300 percent in relation to the NFRD (KPMG, 2021). When we compare the content required by the two Directives, we observe how there is also a significant increase in the CSRD proposal as compared with the NFRD with special reference to the double materiality concept and the process followed to determine the materiality levels. It also adds requirements regarding disclosure of forward-looking information and specifies that companies should report qualitative and quantitative information, both forward looking and retrospective, covering short, medium and long-term time horizons as appropriate. The proposal also refers to the frequent under-development of intangibles reporting, including internally generated ones, even though these intangibles represent the majority of private sector investments in advanced economies. The CSRD proposal states that, in order to enable investors to better understand the increasing gap between the accounting book value of many undertakings and their market value, it is necessary to require disclosures on intangibles other than intangible assets recognized in the balance sheet, including intellectual capital, human capital, skills development and social and relationship capital, including reputation capital. Double Materiality in SR The European Commission was the first to formally describe, in 2019, the concept of double materiality in the context of SR as it was included in the Guidelines of Non-Financial Reporting: Supplement on Reporting Climate-related information (European Commission, 2019). The materiality is, in this proposal, encouraged to be analyzed from a double perspective (Adams et al., 2021), first perspective allows an understanding of the impact of sustainability matters on the performance, development and position of the company, that is, on the value of the company; and the second measures the environmental and social impact of the company’s activities on a variety of stakeholders. It is also required to explore the interconnectivity between the two dimensions mentioned. The second component of double-materiality had already been taken into consideration before the concept of double-materiality was introduced by the EC (Adams et al., 2021). GRI for example revised its definition of materiality in an exposure draft (2020, p. 9) stating that The GRI Standards focus on an organization’s most significant impacts outward: on the economy, environment and people, including impact on human rights. These impacts can have negative or

Sustainability reporting regulation: current situation and future developments  125 positive impacts for the organization itself (operational, reputational and, therefore in many cases, financial). Understanding an organization’s impacts outward is necessary in order to identify financially material risks, opportunities and impacts.

The European Financial Reporting Advisory Group, EFRAG (2022), in its European Sustainability Reporting Guidelines working paper, defines double materiality as a concept which provides criteria for determination of whether a sustainability topic or information has to be included in the undertaking’s sustainability report. Double materiality is the union of impact materiality and financial materiality. A sustainability topic or information meets therefore the criteria for double materiality if it is material from the impact perspective or from the financial perspective or from both of these two perspectives.

EFRAG states that a sustainability topic is material from an impact perspective if the undertaking is connected to actual or potential significant impacts on people or the environment and is related to the sustainability topic over the short, medium or long term. As for financial materiality, EFRAG considers a sustainability topic to be material if it triggers financial effects on undertakings, that is, if it generates risks or opportunities that may influence the future cash flows and enterprise value in the short, medium or long term but are not captured by the financial reporting at the reporting date. Academic research has also devoted relevant efforts to gain understanding on the concept of double materiality and the tensions originated by the different approaches. From a historical perspective, Baumüller and Sopp (2022) analyze the different sustainability regulations in Europe and highlight the relevance of materiality as a principle set forth in the 2014 Directive, which has shifted to the double materiality concept in the CSRD proposal and the challenges and costs in practice of this shift. Jørgensen et al. (2022) explore the tension between the approach based on the GRI definition, which emphasizes sustainability issues that are important to stakeholders, and the one by the Sustainability Accounting Standards Board, which highlights sustainability issues that are financially material and likely to determine the financial performance of the company. Cooper and Michelon (2022) provide an overview of the most influential SR frameworks and analyze how each of them conceptualize materiality, concluding that the concept tis complex and arguing how the stakeholder’s purpose, instead of the valuation role, should determine materiality processes. From a more empirical perspective, authors such as Farooq et al. (2021) have examined the drivers for materiality assessment disclosure and their findings reveal that while reporters provide more information, the number of sustainability reports that offer information on how the reporter identifies material issues has decreased. They find a positive influence of higher financial performance, lower leverage and better corporate governance on materiality assessment disclosure scores. Ruiz-Lozano et al. (2022) assess the disclosure of the materiality process and motivations, showing that, although the number of companies disclosing is still low, the ones that do so show some recognition by including a specific section on the topic, although they are still at the early ages of maturity and formalization. Finally, Guix et al. (2018) examine the materiality disclosures in a study devoted to the hospitality sector and conclude that the low transparency and imprecision of decision-making criteria suggest that this process may be more of a legitimization exercise than one of accountability. Other approaches to the materiality analysis have been developed trying to determine the type of information considered material and whether this information responds to the needs of

126  Research handbook on financial accounting stakeholders. An interesting study by Sepúlveda-Alzate et al. (2021), develops an index which examines the materiality in the sustainability reports of companies belonging to different sectors. Their results show medium–high materiality indices and particular interest for issues such as water management, climate change and occupational health and safety. They also wonder if this materiality analysis answers the needs of stakeholders or if it emerges more from the interests of the company. We observe therefore, how academic research discusses the importance of proper definition and interpretation of materiality (Jørgensen et al., 2022; Farooq et al, 2021; Ruiz-Lozano et al., 2022). Clarity about materiality in non-financial reporting is relevant both for investors that pursue financial return on green investments and for society at large and this should rely on information about real sustainability impacts. These authors also conclude that managers responsible for the preparation of sustainability reports would benefit from examples of materiality assessment disclosures and that practitioners could use the examples of best practice when evaluating reports. The absence of information on the materiality process may not allow a report’s recipients to know how the contents have been selected, leaving open the possibility that preparers chose the contents without considering the needs of interested parties. Assurance of Sustainability Disclosures As discussed in previous sections and observed in Table 7.1, the CSRD includes, for the first time, a general requirement for the assurance of sustainability information all over Europe. This requirement will try to guarantee that the information published is precise and reliable and should also meet the expectations of stakeholders regarding their interest on the sustainability practices and results of companies. In this sense, the mostly voluntary sustainability reporting that has been happening in many countries in past few years, has generated concerns about the reliability and credibility of the information provided (Boiral, 2018) and, in order to address this problem, external independent verifications have grown considerable in the past decade, trying to answer to investors’ and other interested parties’ distress. As shown in the study by KPMG (2020), assurance of sustainability information has become a majority practice in top companies all over the world and the number of companies investing in independent third-party assurance has exceeded 50 percent for the first time since this survey started in 1993. These findings show that assurance of sustainability information has now become a standard practice in worldwide companies, which can be classified as medium or large capitalization. The study also shows that 71 percent of the world’s 250 largest companies has gone through an assurance process. This rate suffered a small decline in 2020 due to the incorporation of many Chinese companies into this group, as many of them are pretty new to sustainability reporting and, therefore, are not yet into the assurance processes. Academic research has also shown interest in the assurance processes of SR. Some studies, such as Alsahali and Malagueño (2021) have analyzed the evolution and trend of global assurance practices and show how the assurance growth was slower than that of SR. The study also shows that, in relation to assurance providers, top accounting firms mostly control the market although engineering firms are also increasing their presence while consulting firms are decreasing theirs. Simnett et al. (2022) assess the current fragmentation of SR frameworks and examine the need to rebuild trust. They analyze the evolution of sustainability assurance from past, present and future perspectives and outline the need for further research that helps determine whether the intended result is achieved.

Sustainability reporting regulation: current situation and future developments  127 We have no doubt here that the assurance implementation will require of deeper analysis, both theoretical and empirical, in order to validate procedures, disclosures and practices while helping to ensure the appropriateness of the Directive approach in Europe.

EC/EFRAG DEVELOPMENTS The European Commission’s Directive envisages the adoption of EU sustainability reporting standards, and the working drafts published by EFRAG are listed in Table 7.2.2 The EFRAG has launched a public consultation by which it aims to receive opinion regarding some of the fundamental facts such as the adequacy of the structure, the general content, the alignment with the CSRD, the possible options to prioritize the implementation of the ESRS and the appropriateness of each disclosure requirement included. Table 7.2

ESRS drafts issued until 3 August 2022

Num

Code

Category

Topic

Date issuance draft

1

1

General

General provision*

16/3/2022

2

P1

General

Sustainability standards

3/3/2022

3

E2

Environmental

Pollution

18/2/2022

4

E3

Environmental

Water and Marine

18/2/2022

5

E4

Environmental

Biodiversity

3/3/2022

6

E5

Environmental

Resources use and circular economy

18/2/2022

7

S1

Social

Own workforce general

3/3/2022

8

S2

Social

Own workforce – working conditions

10/3/2022

9

S3

Social

Own workforce – equal opportunities

10/3/2022

10

S4

Social

Own workforce and other work-related rights

3/3/2022

11

S5

Social

Workers in the value chain

3/3/2022

12

S6

Social

Affected communities

3/3/2022

13

S7

Social

End-users and consumers

3/3/2022

14

G1

Governance

Governance, risk management and internal control

10/3/2022

15

G2

Governance

Products and services, management and quality of relationships 25/3/2022

16

G3

Governance

Business conduct

10/3/2022

17

SEC1

Sector

Sector classification standard

25/2/2022

with business partners

Note: Source:

* Includes Cover note. Own elaboration.

The working drafts can be classified into transversal or general and thematic standards. The transversal ones describe general dispositions applied to the presentation of sustainability reports included in the framework of the CSRD, along with the principles to be followed by the thematic ones as they indicate the disclosure requirements (DR) related to policies, objectives, action plans and resources in all topics of sustainability, with the aim of guaranteeing coherence across ESRS. They also consider how the companies comply with ESRS and how sustainability is integrated in the commercial strategy of the company, its business model At the time of writing this chapter, 17 drafts have been issued by EFRAG. However, it is a regulation in progress and, as such, modified versions and new drafts are expected to be issued in the near future. 2

128  Research handbook on financial accounting and its governance, as well as the way that the company identifies its main impacts, risks and opportunities regarding sustainability. As for the thematic standards, they refer to a specific topic approached from a perspective independent of the industry. The three main topics considered are environment, society and corporate government. Environment refers to climate change, pollution, water, marine, biodiversity, resources use and circular economy. Society includes standards focused on own workforce, workforce in the value chain, affected communities, consumers and end-users and corporate governance refers to risk management, internal control, management and quality of relationships with business partners and business conduct. These three categories allow for a better organization and presentation of the information in a way that fosters comparability and appropriateness (in each industry and across them) while they pretend to be easily readable and used. DR in the thematic standards complement those described for the general or transversal ones and also relate the information that needs to be communicated regarding the policies, objectives and action plans, resources and the metrics that allow for the performance measurement in each of the topics approached. The ESRS Project also plans to issue sector standards. These standards will determine the disclosure requirements to inform about risks, impacts and opportunities considered to be relevant for a specific sector. ESRS SEC 1 draft is available and follows the classification based on the European Classification of Economic Activities (NACE) and the classifications made in the EU Taxonomy. Fourteen sector groups are subdivided in 40 sectors, for which sector-specific aspects are provided in the appendix to ESRS SEC1. A Closer Look at the Social ESRS Drafts As we can see in Table 7.2, the dimension that has been most developed up to now has been the social one, with seven drafts issued.3 All social ESRS have a similar structure including the objective, the interaction with other ESRS and the disclosure requirements. They may also include a list of terms, guidelines for application and a basis for conclusions. Table 7.3 shows the summarized structure of the four ESRS we are going to analyze in more detail. Table 7.3

ESRS drafts’ structure and available information issued up to 3 August 2022

 

S1 General

S2 Working

S3 Equal

S4 Other

conditions

opportunities

work-related rights

Objective

Yes

Yes

Yes

Yes

Interaction with other ESRS

Yes

Yes

Yes

Yes

Disclosure Requirements

12

9

6

8

Appendix A: Defined terms

12

29

12

13

Appendix B: Application guidance

12

9

6

8

Basis for conclusion

Pending

Pending

Pending

Pending

Number of pages

31

20

13

15

Source:



3

Own elaboration.

www​.efrag​.org (accessed 3 August 2022).

Sustainability reporting regulation: current situation and future developments  129 ESRS S1 The Objective of ESRS S1 is to set out the DR for undertakings to report on how they affect their own workforce (both positively and negatively) with regard to (i) working conditions, (ii) equal opportunities and (iii) other work-related rights. In doing so, it complements ESRS S2, S3 and S4, which include disclosures related to performance measures on these issues. The first DR focuses on the impact originating from business model and strategy, and how the highest governance bodies are informed about them. The second DR requires the undertaking to look at the material impact on the workforce and describes the main types of workers that are affected. DRs 3 and 4 focus on the management of risks and opportunities related to the undertaking’s workforce. The following two DRs (5 and 6) deal with the way the undertaking engages with own workers, trade union and workers’ representatives, and other stakeholders. Under DR 5, the undertaking shall explain its general processes for engaging with them while DR 6, requires a description of the channels available for those subjects to raise their concerns and how issues raised are being monitored and addressed. In a similar vein, Disclosure Requirements 7 to 10 relate to the targets, actions, and initiatives to mitigate risks and pursue opportunities. Under DR 7 the undertaking shall describe any outcome-oriented targets aimed at reducing negative impacts and/or advancing positive impacts as they relate to any of the specific material issues, and/or managing material risks and opportunities. Under DR 8, it shall explain its approaches to taking action on material impacts and how it assesses the effectiveness of the actions. Third, (DR 9), it shall list the existing programs to positively contribute to improved outcomes and whether these also play a role in mitigating related material impacts. Finally, the last two DRs compel the undertaking to list key characteristics of employees. ESRS S2 ESRS S2 is complementary to S1, and its disclosure scope is a specific set of working condition issues, including (a) training and skills development, (b) health and safety, (c) working hours, (d) work–life balance, (e) fair remuneration and (f) social security. In the first place, DRs 1 and 3 cover what the undertaking shall explain regarding skills and training. Under DR 1, the undertaking shall disclose the process for determining the skills gaps and training needs to fulfil its strategic objectives on an ongoing basics. In addition, under DR 3, it shall describe the extent to which training and development is provided to the workforce within the context of continuous professional growth. In second place, health and safety disclosure is covered under DRs 2, 4 and 5. Following DR 2, the undertaking shall describe the governance and management responsibilities regarding health and safety, to provide an understanding of which management and governance bodies oversee and are ultimately responsible for health and safety management. Next, DR 4 compels the undertaking to disclose information on the extent to which its workforce is covered by the health and safety management system, in order to prevent harm and promote health. Finally, under DR 5, it shall lay out the number of incidents associated with work-related injuries, ill health, and fatalities of its own workers. In third place, DR 6 relates to working hours and obliges the undertaking to disclose the percentage of its workers that exceed 48 hours per week over the applicable reference period (thresholds established by the EU and ILO standards).

130  Research handbook on financial accounting In fourth place, DR 7 covers work–life balance indicators by establishing the obligation to disclose to which extent the employees are entitled to, and make use of, family-related leave and flexible working arrangements in a gender equitable manner. In the fifth place, DR 8 deals with the issue of fair remuneration. Under it, the undertaking shall lay out information on the remuneration of its lowest-paid workers. In particular, it shall disclose what percentage of workers are earning less than a fair wage. Finally, under DR 9, the undertaking shall make public the percentage of its workers eligible for social security and those who are not and, as a result, become potentially especially vulnerable. ESRS S3 The objective of ESRS S3 is to specify additional Disclosure Requirements regarding the issues of equal opportunities, discrimination, and inequalities, including performance measures on (a) pay inequalities, (b) discrimination incidents and opportunities for persons with disabilities, and (c) benefits regardless of type of employment contract. Similar to ESRS S2, S3 is complementary to ESRS S1. Pay inequalities are addressed through the use of ratios in Disclosure Requirements 1 and 2. Under DR 1, the undertaking shall disclose the ratio of basic salary and remuneration of women to men, to provide the extent of any pay gap between them. Moreover, under DR 2, the undertaking shall disclose the ratio between the remuneration of its highest paid individual and the median compensation for its employees, to assess any wide pay disparities and their evolution. Second, DRs 3 and 4 look at discrimination incidents and opportunities to persons with disabilities. ESRS DR 3 obliges the undertaking to reveal the number of work-related discrimination incidents and any corrective actions taken including, but not limited to, incidents on the grounds of gender, gender, racial or ethnic origin, nationality, religion or belief, disability, age, and sexual orientation. Under DR 4, the undertaking has to disclose the percentage of persons with disabilities amongst the workforce, broken down by gender. DR 5 obliges the undertaking to bring forward information on benefits that are standard for full-time employees but are not provided to employees with temporary, part-time and zero-hour contracts. Finally, DR 6, refers to the report on the violations of its own workers’ equal opportunities rights where it is financially material. ESRS S4 Like ESRS S2 and S3, ESRS S4 is complementary to S1, and its objective is to specify additional DR regarding work-related rights, including (a) collective bargaining and freedom of association; (b) social dialogue; (c) freedom from child labor; (d) freedom from forced labor; and (e) privacy at work. First, a general requirement is set under DR 1, which obliges the undertaking to report the number of grievances and complaints received and resolved relating to workers’ other work-related rights. Subsequently, DRs 2 and 3 cover collective bargaining and freedom of association. Under DR 2, the undertaking must describe the extent to which the working conditions and terms of employment are determined or influenced by collective bargaining agreements, while DR 3 addresses work stoppages because of disputes between the undertaking and its own workforce.

Sustainability reporting regulation: current situation and future developments  131 Under DR 4, the undertaking is obliged to report the extent and functioning of social dialogue with trade-union and worker representatives, in order to understand the extent to which the institutional prerequisites for social dialogue exist and whether rights to social dialogue are respected in its EU/EEA operations. Furthermore, forced and child labor are addressed through DRs 5 and 6. First, under DR 5, the undertaking shall state the number of incidents of forced labor and/or, the trafficking of persons for the purposes of forced or compulsory labor. Second, DR 6 obliges the undertaking to report the number of incidents of child labor identified in its workforce. In all cases, if there have been no such instances, that shall be stated as well. Privacy at work is covered under DR 7, which compels the undertaking to disclose the right to privacy at work in order to understand its measures on personal data protection and the nature and extent of worker surveillance conducted. Finally, DR 8 includes an obligation to report on the violation of workers’ other work-related rights in cases where it is financially material. Comparing ESRS and GRI Proposals Regarding Social Standards Different laws, initiatives and standards have been developed for the enhancement and reporting of sustainability practices. Some of them are mandatory while the majority have been voluntary (Larrinaga et al., 2019; Vila and Moya, 2023). Organizations around the world have relied on them to address SR and one of the trends observed is the use of a combination of voluntary and mandatory frameworks (V.A. 2010; Chatelain-Ponroy and Morin-Delerm, 2016) that allow them to report in a more comprehensive and understandable manner. It is worth noting here that the use of different reporting frameworks is consistent with sustainable development as an emergent paradigm (Lozano, 2011) because in the early stages of a paradigm’s diffusion, a unique reporting framework may not exist. International SR frameworks issued up to now are mostly voluntary but have exerted a dominant influence on the development of sustainability reports. And our focus here relies on the Global Reporting Initiative (GRI) founded in 1997 in the US after calls for corporate transparency derived from the Exxon scandal.4 The GRI has issued different sets of guidelines and standards aimed at providing corporations and institutions in general with support regarding communication, measurement and reporting of sustainability practices. The GRI reporting standards are the most widely used and best available standards for SR worldwide because they consider economic, environmental and social dimensions and have also developed some specific sector-related guidelines (Alonso-Almeida et al., 2015; Larrán et al., 2019). They are considered to be multi-stakeholder oriented and do not include many metrics as compared with other frameworks. The use of SR guidelines is increasingly widespread (KPMG, 2020). In 2020, 84 percent of the G250 reporting groups used some kind of framework to support their sustainability reporting. GRI remains the most commonly used with around three-quarters of G250 reporters. The application of the GRI has significantly increased compared with 2017. Adams et al. (2022) discuss GRI standards and analyze applicability, nature of adoption by preparers, materiality assessment, level of understanding, voluntary status and quality of



4

www​.globalreporting​.org (accessed July 2022).

132  Research handbook on financial accounting assurance. Findings show that GRI standards enhance comparability, the identification of material issues and the context relevance. However, the fact that GRIs are voluntary implies that companies tend to disclose sustainability issues in a strategic way, induced by corporate reputation and, from this point of view, some companies may not be informing about material negative impacts. When we compare the new social ESRS drafts with the GRI proposals, we observe that they differ in terms of structure as the GRI follows a four-part internal structure, including two subsections which cover the disclosure requirements while the ESRS have a six-part structure, including the objective, the interaction with other ESRS and the disclosure requirements. Regarding the number of overall disclosure requirements, GRI social standards cover between them 37 disclosure requirements. It is significant that many of the GRI standards contain only one or two disclosure requirements, i.e., there are many different categories. ESRS standards, on the other hand, are much more complex and the categories wider. As explained above, as of August 2020 there were only seven categories of social standards, the first four containing a sum of 35 disclosure requirements. The overall content of many of the DRs in the draft ESRS is strongly aligned with GRI. This could be partially explained by the agreement signed between EFRAG and GRI in July 2021 by which the two organizations joined each other’s technical expert groups and committed to sharing information. However, the ESRS standards are far more detailed than the GRI. In fact, many of the optional disclosure requirements covered in the latter have been made mandatory in the former. Not only that, but the ESRS drafts also have a wider scope than many of those of the GRI. While the intention behind this is undoubtedly good, the reality is that complying with such sophisticated standards seems utterly complicated even for the most experienced reporters and could eventually lead to focused reporting and less useful information for stakeholders, which should ultimately be one of its goals. In addition, it will also increase considerably the burden of reporting, and therefore its cost, as well as potentially giving rise to obstruction of information. In conclusion, while the ESRS are already strongly aligned with the GRI Standards, there could, and perhaps should, be greater convergence between them. Given that the GRI Standards are the most widely applied standards in Europe, a closer alignment will certainly help companies transitioning from using one standard to the other, as well as reducing confusion and achieving consistency in reporting material impacts globally.

AN INTERNATIONAL PROPOSAL: THE NEW INTERNATIONAL SUSTAINABILITY STANDARDS BOARD AND ITS CONTRIBUTION TO SR REGULATION On 3 November 2021, the IFRS Board of trustees announced, during the COP26 Conference (UN Conference on Climate Change, Glasgow), the establishment of the new International Sustainability Standards Board (hereinafter ISSB) with the aim of developing a global regulation sustainability reference for the financial markets. During the same announcement, they also committed to publishing the first set of standards, and they did meet their deadline. During March 2022, the ISSB published the first two drafts, IFRS S1 General requirements for disclosure of sustainability-related financial information, and IFRS S2 Climate-related disclosures.

Sustainability reporting regulation: current situation and future developments  133 The IFRS S1 requires entities to disclose any information that is relevant about their exposition to the risks and opportunities regarding sustainability so that users of this information may make investment decisions or facilitate resources to the entities. This information needs to be comprehensive and neutral, that is, a precise picture of the risks and opportunities of entities regarding sustainability. Additionally, it needs to be related to the governance, strategy and risk management of those entities and has to be backed up by metrics and objectives. The draft also includes a definition of materiality aligned with the conceptual framework of some of the International Financial Reporting Standards (IFRS) and some of their specific standards. The IFRS S2 includes disclosure requirements on the identification and assessment of climate issues regarding governance, strategy, risk management and metrics and targets. Governance will refer to the procedures and controls employed by the company in order to evaluate climate risks and opportunities. The strategy must include those risks and opportunities that may improve, threaten or change the entity’s business model in the short, medium or long term, including decisions processes, resilience, cash flows expectations and/or access to funding. As for the metrics and objectives, general and industry-specific ones are required and, if there is any relationship with the financial information, it should be noted. Once those drafts are issued, the process to be followed for their final emission will be similar to those of IFRS. The drafts have been open for consultation and the feedback obtained will be discussed. The drafts do not include implementation dates although they do consider early implementation. The application of the ISSB standards is not linked to that of the IFRS or vice versa, and only the jurisdictions will be able to determine if ISSB standards are mandatory or not. Giner and Luque-Vilchez (2022) conduct a reflexive analysis by comparing the CSRD with the Consultation Paper on Sustainability Reporting (CPSR) issued by the Foundation in 2020 (IFRS Foundation, 2020). The comparison is structured in terms of scope, target audience, materiality and reporting boundary, this categorization having been inspired by previous debates (Adams, 2021; Christensen et al., 2021). The findings show that, at least for the moment, the EU option is taking a wider approach, starting with the target audience as the CSRD addresses investors, non-governmental associations, social partners and other stakeholders while the IFRS Foundation seems to address mainly investors. Regarding scope, the CSRD approaches sustainability development issues in a broad sense including the economic, social and environmental dimensions, in addition to human rights, anti-bribery measures and specific reference to intangibles approached from a comprehensive perspective (intellectual, human, social and relational) while the scope of the IFRS Foundation is again more restrictive, although with the intention to broaden it. Regarding materiality, the CSRD introduces the double materiality concept while the IFRS Foundation focuses on the “outside-in” perspective because, as stated in the CPSR, a “double materiality approach would substantially increase the complexity of the task and could potentially impact or delay the adoption of the standards” (IFRS Foundation, 2020, 14). And finally, regarding the reporting boundary, again the proposal of the EC/EFRAG is shown to be wider considering that they could be specific to each sustainability indicator while the IFRS foundation proposal does not refer to this topic, although it seems to be moving towards this wider approach.

134  Research handbook on financial accounting

DISCUSSION AND CONCLUSIONS In this chapter we have described and discussed the most recent developments on SR regulation in Europe, starting from the CSRD proposal in April 2021, followed by the ESRS development, its comparison with GRI for the particular case of social standards and the analysis of the ISSB progress. We have seen how the EU pretends to be the front-runner in global sustainability reporting standards with the issuance of mandatory ESRS to be implemented starting in 2024. As stated by the EU and the same EFRAG, the new standards will try to address the shortcomings that have been found in the previous NFRD, which has been described as insufficient and unreliable. The CSRD incorporates relevant changes that can be explained in different areas such as scope, disclosure requirements, assurance and presentation/format. From the detailed analysis of these areas, we can conclude that the aim of the EU is to expand and, at the same time, increase, the quality and transparency of sustainability disclosures in the region. There is a substantial increase in the companies affected by the new regulation, which runs parallel to the increase in the demand for information and the new assurance requirements. Regarding assurance, companies will be subject to independent auditing and certification, which will certainly increase the demand of audit work in the three dimensions of sustainability, and auditors will need a certain and rigorous framework on audit proceedings that allows them to pursue this new aim. All of this shows how the EU wants to be the first to mandatorily regulate SR with quality and rigor. For those of us who were witnesses to the IFRS adoption in Europe in 2005, it somehow resembles that moment, although the success of the project is still pending to be determined. The double materiality concept and assurance requirements are relevant changes to address in the following years. The EU is not walking this path alone and it is worth mentioning here the agreement signed between EFRAG and GRI in 2021, in which both organizations commit to share knowledge and expertise. This first statement of cooperation was signed in July 2021 and enhances a co-construction spirit between the parties. The GRI standards are currently the most commonly used sustainability reporting standards amongst EU companies and their contribution to the development of the ESRS is of interest for all stakeholders of sustainability information and disclosures. And, of course, we cannot disregard the role of ISSB in this SR standard setting. There seems to be already some speculation (Abela, 2022) about the status of the SR standards issued by the IFRS Foundation as compared with the ESRS although these concerns may have been reduced by a levelling of power relationships supported by cooperation with the aim of the reconciliation of both approaches. For the moment, the EU proposal seems to be wider in all aspects considered and the different approach in materiality is shown to be one of the most challenging ones, together with the scope and target audience ones (Giner and Luque-Vilchez, 2022). The dimension which has been more abundantly approached by the EU has been the social one and this, together with the lack of depth found by academic research (Belal and Owen, 2007; Chatelain-Ponroy and Morin-Delerm, 2016; Vila and Moya, 2023) has led us to proceed with a deeper analysis of the new social ESRS drafts while comparing them with the GRI proposal. Our findings show that ESRS and GRI are strongly aligned, although more detail and a wider scope is found in the ESRS while many optional disclosure requirements that are optional in GRI are considered mandatory under ESRS. The first social standards’ drafts under ESRS are sophisticated and can seem complicated, which could increase the burden on

Sustainability reporting regulation: current situation and future developments  135 companies, leading to less focused reporting and, eventually, less usefulness. However, it is still too early to assess the quality and usefulness achieved and only their use and outcomes will let us know about their success. The next relevant steps regarding new ESRS standards and implementation in Europe will take place in year 2024 for large public companies already subject to the NFRD with reports due in 2025, year 2025 for large companies not subject to NFRD with reports due in 2026, and year 2026 for listed SMEs with reports due in 2027. Questions remain open regarding the success achieved both in the quality objective but also in the comparability one. Amongst the problems in SR in recent years found by academic research is the lack of comparability together with comprehensiveness and clarity (Vila and Moya, 2023), and the reasons for this have been attributed, among other things, to the lack of a proper framework that would help organizations to address this challenge accurately. We remain interested to see if the new ESRS will become a key element in this path and will help European entities to provide quality, reliable and comparable sustainability information that allows stakeholders to make informed decisions.

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8. EFRAG roadmap for new developments in ERS reporting Luz Parrondo

INTRODUCTION In recent years, there has been an increasing focus on Environmental, Social, and Governance (ESG) factors in the business world. This has been driven by a growing recognition of the significant impact that companies can have on the environment and society, as well as the importance of good governance in ensuring long-term sustainability and success. In response to this, the European Union (EU) has introduced new standards for ESG reporting that will apply to companies operating within its member states. In this chapter, we will explore these new standards and their implications for businesses. The new EU standards require companies to provide a comprehensive and transparent account of their ESG performance, including their environmental impact, social responsibility, and governance practices. This includes disclosing their policies, processes, and performance in relation to issues such as climate change, human rights, labour practices, and anti-corruption measures. The aim of these standards is to provide investors, stakeholders, and the wider public with a clear picture of a company’s ESG performance, and to enable them to make informed decisions about the companies they choose to invest in or do business with. One of the key features of the new EU standards is the requirement for companies to report on their alignment with international sustainability frameworks and standards, such as the United Nations Sustainable Development Goals (SDGs) and the Paris Agreement on climate change. This means that companies will need to demonstrate how their ESG performance is contributing to the achievement of these global goals, and how they are addressing the environmental and social challenges that they face. Another important aspect of the new EU standards is the emphasis on stakeholder engagement and consultation. Companies will be required to engage with their stakeholders, including employees, customers, suppliers, and communities, to understand their views and concerns about the company’s ESG performance. This will enable companies to better understand the impact of their operations on the wider community and to identify opportunities to improve their ESG performance. In terms of reporting requirements, the new EU standards call for a more integrated and comprehensive approach to ESG reporting. Companies will be required to provide a single, consolidated report that covers all aspects of their ESG performance, rather than separate reports on individual issues. This will enable investors and stakeholders to gain a more complete understanding of a company’s ESG performance and its impact on society and the environment. The new EU standards also require companies to use consistent and comparable ESG metrics and indicators, to enable benchmarking and comparison between companies. This will help investors and stakeholders to identify companies that are performing well in terms of their ESG performance, and to encourage others to improve their performance. 138

EFRAG roadmap for new developments in ERS reporting  139 There are several benefits to the new EU standards for companies. First, by improving their ESG performance and reporting, companies can enhance their reputation and credibility with investors, customers, and other stakeholders. This can help to attract investment, improve customer loyalty, and build stronger relationships with suppliers and communities. Second, the new EU standards can help companies to identify new opportunities for sustainable growth and innovation. By engaging with stakeholders and understanding their concerns, companies can identify areas where they can improve their ESG performance and create new products or services that address these concerns. This can help to drive innovation and create new business opportunities. Finally, the new EU standards can help to promote long-term sustainability and success for companies. By improving their ESG performance and reporting, companies can mitigate risks, improve their resilience, and enhance their ability to adapt to changing environmental and social conditions. This can help to ensure their long-term viability and success. In summary, the new EU standards for ESG reporting represent an important step forward in promoting sustainability and responsible business practices. By requiring companies to provide comprehensive and transparent reporting on their ESG performance, and by promoting stakeholder engagement and the use of consistent and comparable metrics, the standards will help.

A ROADMAP TO ESG REPORTING The European Financial Reporting Advisory Group (EFRAG) has provided guidance on the main requirements for ESG reporting in line with the European Union’s Non-Financial Reporting Directive. The main requirements for ESG reporting according to EFRAG are: ● Disclosure of the company’s business model, including its value creation processes and how it integrates sustainability considerations into its operations. ● Description of the policies and due diligence processes in place to identify, prevent and mitigate ESG risks and impacts, including those of the supply chain. ● Identification and prioritization of the ESG topics relevant to the company and its stakeholders, including environmental issues, social impacts and governance practices. ● Disclosure of the company’s targets and performance indicators in relation to the relevant ESG topics, including how these align with international frameworks and standards, such as the UN Sustainable Development Goals (SDGs). ● Reporting on the company’s environmental impact, including its use of natural resources, emissions, waste and the impact on biodiversity. ● Reporting on the company’s social impact, including its labour practices, human rights due diligence, health and safety, diversity and inclusion, and community engagement. ● Reporting on the company’s governance practices, including the composition and independence of the board, risk management processes, and anti-corruption measures. ● Providing a description of the company’s stakeholder engagement processes, including how it identifies and responds to stakeholder concerns, and how it integrates stakeholder feedback into its decision-making processes. ● Providing a statement on the company’s approach to tax, including how it manages tax risks, and how it supports the public interest through tax compliance.

140  Research handbook on financial accounting ● Providing information on the company’s contribution to the economy and society, including its impact on employment, innovation and the achievement of sustainable development goals. These requirements aim to provide a comprehensive and transparent account of a company’s ESG performance and to enable stakeholders to make informed decisions about the company’s sustainability practices. Companies are encouraged to report in a clear and concise manner, using measurable and comparable metrics, and to provide context and explanations where necessary to ensure that stakeholders understand the company’s ESG performance and its impact on society and the environment. ESG Reporting Guidelines Non-financial reporting refers to the disclosure of a company’s performance information beyond the typical assessment of financial performance. This can include outcomes related to social impacts, environmental accounting, community outreach activities, philanthropic gifts, and corporate social responsibility. ESG reporting is a formal communication of a firm’s sustainability goals, including its environmental, social, and governance goals, as well as its progress toward achieving them. By providing greater information, ESG reporting can help external stakeholders assess a company’s overall performance and make more informed purchasing and investment decisions, while also influencing stakeholder confidence and improving corporate reputation. This can ultimately lead to increased profitability for the firm. Currently, several European countries and stock exchanges require ESG reporting, but the exact content and procedures for information disclosure are not defined, leaving significant leeway for firms to determine what and how they report. In most other instances, governments encourage ESG reporting and suggest firms use guidelines to assist them. These guidelines are normative and non-binding governance tools that define societal objectives or goals and specify substantive standards or rules for firms to follow in achieving them (López-Santana, 2006). Over a dozen major international frameworks exist that offer guidance on ESG reporting, but most firms rely on one of five international ESG reporting guidelines, including: 1. 2. 3. 4. 5.

Global Reporting Initiative (GRI).1 Sustainability Accounting Standards Board. Carbon Disclosure Project. International Integrated Reporting Council. Carbon Disclosure Standards Board.

Although there are differences between these frameworks, they overlap significantly, creating confusion for firms and investors. In 2020, standard-setting organizations pledged to collaborate and create a unified reporting standard that integrates financial and sustainability disclosure, representing a significant shift toward consolidation globally and enhancing the robustness of existing ESG reporting. However, GRI has announced that it will remain independent.

1 GRI dominates the field, with 67 percent of firms that use ESG reporting guidelines following the GRI reporting standard (Threlfall et al., 2020).

EFRAG roadmap for new developments in ERS reporting  141 The institutional theory provides an important lens for assessing the extent to which ESG reporting guidelines influence firms’ information disclosure. ESG Reporting on the Firm’s Information Quantity and Quality Firms that provide ESG (Environmental, Social, and Governance) information to external stakeholders can enhance transparency and accountability. This is because it allows stakeholders to compare a firm’s claimed sustainability practices and performance with their actual practices. However, it is crucial for firms to disclose a reasonable quantity of information as well as quality and therefore enhance credibility. Information quantity Information quantity refers to the amount of relevant information that firms publicly disclose, and it is not necessarily a measure of quality, any quantifiable measure of quality requires a measure of information (Hilbert, 2012). There is significant variation in the quantity of information that firms disclose in their ESG reporting. Some firms include little actual text explaining their sustainability activities and instead fill their reports with images and diagrams (Kassinis & Panayiotou, 2018). For example, in 2010, following the Deepwater Horizon disaster, BP received significant public criticism for the environmental damage caused. To avoid further attention, BP reduced the amount of textual information on its website about its environmental practices and instead included many attractive sustainability images (Kassinis & Panayiotou, 2018). The use of these images helped BP to avoid any perceived contradiction between its stated corporate practices and its actual practices. This example illustrates why previous studies analysing firms’ sustainability claims and symbolic actions have focused mainly on evaluating the language and narratives used by firms. Darnall et al. (2022) suggest that the institutional rules of ESG reporting guidelines encourage firms to disclose greater quantities of sustainability information than firms that publish sustainability reports but do not follow ESG guidelines. The rationale is that firms which follow ESG reporting guidelines encourage firms to disclose greater quantities of sustainability information than firms that publish sustainability reports but do not follow ESG guidelines. These guidelines provide direction to firms on what they should disclose and dictate a set of sustainability objectives, courses of action, and approaches to achieve them. However, firms that follow these guidelines are free to adapt their reporting content and procedures and disclose more or less information. While this flexibility allows firms to customize their sustainability reporting to their specific circumstances, ESG guidelines are expected to encourage greater information disclosure around key sustainability metrics. Nevertheless, there is a lack of assessments of ESG reporting guidelines, especially regarding the quantity and quality (credibility) of the information that firms report. Information quality/credibility Joshi & Li (2016) define information credibility as the degree to which external stakeholders perceive a company’s sustainability information to be trustworthy and reputable. Third-party verification is the process by which an independent body assesses whether the information in a firm’s sustainability report meets the expectations of guidelines (Dando & Swift, 2003; KPMG, 2013). The existence of these guidelines encourages firms to develop routines and

142  Research handbook on financial accounting systems that enhance verification, which imposes costs on firms in the form of preparing for the audit and hiring an external verifier. However, these costs may increase firms’ commitment to developing a more credible sustainability report that external stakeholders view as trustworthy and reputable. Over the years, there has been an increase in ESG standards, resulting in an increase in verified reports. In 2013, only 38 percent of published sustainable reports were third-party verified, whereas, in 2020, more than 50 percent were verified (Threlfall et al., 2020). There are two main types of third-party verifications: ● Process-focused ● Content-focused Process-focused verification involves a professional auditing company that certifies whether the information contained in a firm’s sustainability report follows the expected reporting procedures. This type of verification often results in an objective assurance about a firm’s compliance with a set of neutral parameters and criteria rather than assessing the quality or substance of the firm’s sustainability information. Process-focused verification tends to encourage firms to adapt their current reporting practices to comply with the standard rather than encouraging systematic change. This is the verification required by the top five ESG reporting guidelines. On the other hand, content-focused verification generally involves a panel of expert stakeholders that assure the information quality and reliability of a firm’s sustainability report. This verification requires that auditors have significant knowledge about sustainability and apply this in the intensive reviews and validations of firms’ sustainability information quality, accuracy, and comprehensiveness. This type of verification is more likely to expose firms’ attempts at greenwashing. Although both types of verification assess whether a firm conforms to a guideline’s established rules and standards, content-focused verification involves a more intense review process compared with process-focused verification. Compared with firms that do not follow ESG guidelines, firms that follow ESG reporting guidelines are more likely to pursue content-focused verification over process-focused verification (Darnall et al., 2022). However, stakeholders generally lack the information needed to differentiate between the different forms of third-party verification, making content-focused verification less appealing to firms

IMPACT OF ESG REPORTING ON COMPANIES ESG disclosure or reporting has been found to have significant impacts on various areas of a company and its stakeholders. A review of the relevant literature suggests that ESG disclosure can influence how a company is perceived by its customers, investors, and other stakeholders, and can affect its reputation and brand image (Brammer et al., 2012); can impact a company’s financial performance, particularly in the long term, by influencing its cost of capital, access to capital, and overall risk profile (Eccles et al., 2014); can help a company engage with its stakeholders, including customers, employees, suppliers, and local communities, by providing information on its sustainability practices and initiatives (Berthelot et al., 2012); helps companies to comply with various regulations and reporting requirements related to sustainability, particularly in industries that are heavily regulated and to identify and manage various environmental, social, and governance risks that may impact their operations,

EFRAG roadmap for new developments in ERS reporting  143 including climate change, labour practices, and supply chain management (Clark et al., 2015); encourages companies to innovate and develop new products, services, and business models that address environmental and social challenges and create value for stakeholders (Hahn & Kühnen, 2013); and impacts a company’s ability to attract and retain talent, particularly among employees who value sustainability and social responsibility in the workplace (Kaptein, 2017). In other areas, such as company valuation, research has shown mixed results. Some studies suggest that ESG disclosure has a positive impact on company valuation, as it can signal to investors that a company is committed to sustainable practices and reducing risk (Eccles et al., 2014; Khan et al., 2021; Clark et al., 2015; Kotsantonis & Serafeim, 2018). These studies suggest that ESG disclosure can lead to a positive impact on company valuation, as investors value sustainability and view it as an indicator of long-term performance and risk management. First, ESG reporting can provide investors with more information about a company’s sustainability performance, which can enable them to make more informed investment decisions. This can increase the demand for stocks in companies with strong ESG performance, leading to higher valuations. Second, companies with strong ESG performance may be perceived as having lower risk profiles, which can lead to lower cost of capital and higher valuations. This is because investors may be willing to pay more for companies that are better able to manage ESG risks and are less likely to face reputational or regulatory risks in the future. Third, ESG reporting can help companies identify areas where they can improve their sustainability performance and take action to reduce ESG risks and improve their reputation. This can lead to improved financial performance and higher valuations over the long-term. On the other hand, other studies suggest that there is no significant impact on company valuation, or that the impact is contingent on a variety of factors, such as industry, geographic location, and investor preferences (Brammer et al., 2006; Barnett, 2007; Landi and Sciarelli, 2019; Folger-Laronde et al., 2020). Although this research highlights the importance of transparent ESG reporting, the impact on company valuation may vary depending on a range of contextual and formal factors. We need to be aware that these analyses depend on the quality and comparability of ESG data and the regulatory environment. Therefore, implementing a strong, homogeneous, and structured set of guidelines may improve future research on ESG reporting and company performance. Developing a regulation for reporting on Environmental, Social and Governance (ESG) may offer advantages for a company’s performance, yet it requires significant investments. EU companies must allocate resources to prepare, update and abide by ESG reporting standards, and may not be certain if the benefits outweigh the expenses. The Cost of ESG Reporting The cost of ESG reporting for companies can vary widely depending on the size of the company, the scope of the reporting, and the level of sophistication of the reporting system. However, there is evidence to suggest that ESG reporting can impose significant costs on companies, particularly in the short term. A report by the European Securities and Markets Authority (ESMA) in 2019 found that “the costs of ESG reporting and disclosure for issuers could be significant, particularly in the short-term, as additional systems, procedures and controls may need to be developed” (ESMA, 2019). In addition, a study by the Global Reporting Initiative (GRI) in 2018 found that “ESG reporting can be time-consuming and expensive for companies, particularly in the early stages of implementation” (GRI, 2018) and a survey by

144  Research handbook on financial accounting EY in 2018 found that “almost half of the companies surveyed (46%) expected the cost of ESG reporting to increase significantly over the next two years” (EY, 2018). Finally, a report by the Harvard Law School Forum on Corporate Governance in 2020 found that “the costs of ESG disclosure can be significant, both in terms of time and money” (Harvard Law School Forum on Corporate Governance, 2020). These sources suggest that ESG reporting can impose significant costs on companies, particularly in the short term, due to the need to develop new systems and procedures, and allocate additional resources related to data collection, software and IT infrastructure, personnel training and development, and external consulting and advisory services. However, a report by the Principles for Responsible Investment (PRI) in 2016 found that “the costs of ESG reporting tend to decline over time, as companies become more experienced and efficient in collecting and reporting on ESG data.” The report also found that “companies that adopt ESG reporting tend to experience long-term benefits in the form of improved reputation, stakeholder engagement, and financial performance” (PRI, 2016). The report cites several case studies and examples of companies that have experienced benefits from ESG reporting, including increased investor interest, improved risk management, and enhanced brand reputation. The report also notes that while the costs of ESG reporting may be significant in the short term, the benefits are likely to outweigh the costs over the long term. Another study, published in the Journal of Corporate Finance, found that the costs of ESG reporting may depend on the level of standardization and regulation of the reporting system. The study found that companies operating in countries with mandatory ESG reporting requirements tend to experience higher costs in the short term, as they adapt to new reporting standards and requirements. However, the study also found that mandatory ESG reporting can lead to greater transparency and comparability of ESG data, which can reduce costs and improve efficiency in the long term. Overall, while ESG reporting can impose significant costs on companies in the short term, the evidence suggests that these costs tend to decline over time, and may be outweighed by the long-term benefits of improved sustainability performance and stakeholder engagement. However, the costs of ESG reporting may depend on a range of factors, including the size and complexity of the company, the level of standardization and regulation of the reporting system, and the level of sophistication of the reporting infrastructure.

BUILDING AN ESG REGULATORY FRAMEWORK The EU is at the forefront of sustainable development and sustainable finance policies, taking a leading role in this area. Other global entities such as the G20, the Financial Stability Board, and the International Platform on Sustainable Finance, as well as key regions such as the United States, are also becoming more interested in these policies, particularly in relation to sustainability disclosures and reporting. The European Financial Reporting Advisory Group (EFRAG) is an organization established by the European Commission to provide technical expertise and advice on financial reporting issues to the Commission and other European Union (EU) institutions. EFRAG’s main task is to develop and promote the use of high-quality financial reporting standards for companies operating in the EU. The EFRAG recommends building on two overarching principles and

EFRAG roadmap for new developments in ERS reporting  145 a combination of building blocks that provide strong foundations for possible standard-setting. The first principle is an inclusive range of stakeholders. The EU sees businesses as contributors of value creation in both economic and financial dimensions affecting the providers of capital, and environmental and social dimensions affecting a broader range of stakeholders. Therefore, the sustainability reporting framework must meet the needs of an inclusive range of stakeholders. The second principle is a principle-based legal and regulatory environment. The EU prefers a principle-based environment combined with a civil law framework, but detailed and practical regulatory rules are necessary when translating principles into practice. Sustainability reporting standards must strike the right balance between a general principle-based approach consistent with the EU legal environment and the need for more detailed and prescriptive disclosure requirements to ensure the relevance and comparability of reported information. The building blocks for sustainable development and sustainability reporting momentum in the EU include reflecting the needs of evolving sustainable development and sustainable finance policies and legislation, establishing a robust basis for convergence and increased harmonization within the EU sustainability reporting landscape, building on and contributing to the global convergence of sustainability reporting through public and private international initiatives, addressing specific challenges faced by financial institutions, including SMEs in the reporting landscape in a proportionate manner, fostering sector-specific sustainability reporting, and acknowledging the importance of intangibles in sustainability reporting. Financial institutions must be considered as both preparers and users of sustainability reporting, as investment and financing activities must support the transition to a sustainable economy. Financial institutions face specific challenges in reporting their sustainability impacts, which are mostly indirect. Standard-setting should foster the coherence and relevance of data flows corresponding to the needs of each of the three categories of financial institutions (asset management, banking, and insurance). SMEs must be involved in a proportionate manner since they are a major part of the economy and are confronted with sustainability-related risks and opportunities that impact society and the environment. The standard-setter should adopt a proportionate approach tailored to EU SMEs by balancing the specific governance, organization, and resources of SMEs and the need for sustainability information produced by SMEs to be relevant for their stakeholders (value chain and financial institutions in particular). Sector-agnostic sustainability reporting requirements are essential to allow comparability across sectors. However, sector-agnostic disclosures are not sufficient to address the specific information needs related to the many challenges a reporting entity is confronted with. At the same time, entity-specific disclosures are not sufficient to complement mandatory sector-agnostic disclosures. Therefore, the standard-setter should recognize sector-specific sustainability reporting as a natural and necessary complement to sector-agnostic and entity-specific disclosures in order to promote an appropriate layer of sectoral relevance and comparability. In this pursuit, regulators face several challenges in creating and enforcing new ESG reporting requirements: ● Lack of standardization: ESG reporting frameworks and standards are not yet fully standardized, and there is a lack of consensus on which metrics and indicators to use. This makes it difficult for regulators to create consistent and comparable reporting requirements across different industries and regions.

146  Research handbook on financial accounting ● Data quality and availability: Companies may not have access to reliable and consistent data on their ESG performance, and may struggle to measure and report on their impact in a standardized way. Regulators may need to invest in improving data collection and analysis systems, and provide guidance and support to companies to improve data quality. ● Resource constraints: Companies may face resource constraints in implementing ESG reporting requirements, particularly small and medium-sized enterprises. Regulators may need to provide support and incentives for companies to adopt ESG reporting practices, and ensure that reporting requirements are proportionate to the size and complexity of the company. ● Compliance and enforcement: Regulators may face challenges in enforcing ESG reporting requirements, particularly if companies are not motivated to comply or if penalties for non-compliance are insufficient. Regulators may need to develop effective enforcement mechanisms and penalties and provide guidance and support to companies to ensure compliance. ● Stakeholder engagement: ESG reporting aims to provide transparency and accountability to stakeholders, but regulators may face challenges in engaging with diverse stakeholder groups and ensuring that their feedback is integrated into reporting requirements. Regulators may need to invest in stakeholder engagement processes, and ensure that reporting requirements are relevant and useful to stakeholders. ● Global coordination: ESG reporting requirements are increasingly being adopted by regulators around the world, but there is a need for greater coordination and alignment across different jurisdictions to ensure consistency and comparability. Regulators may need to work together to develop common standards and frameworks, and ensure that reporting requirements are compatible with international norms and standards. The EFRAG Roadmap for EU Sustainability Reporting Standard Setting On 25 June 2020, the European Commission requested that EFRAG prepare for the creation of potential EU non-financial reporting standards in a revised EU Non-Financial Reporting Directive. The work was carried out by a group called the Task Force, which was established by EFRAG to fulfil the Commission’s mandate. The Task Force operated within the European Corporate Reporting Lab and produced a final report proposing a roadmap for developing a comprehensive set of EU sustainability reporting standards. The report is the result of the collective work of the Task Force, which considered input from global initiatives and feedback from outreach events organized by EFRAG. The Task Force’s report and its appendices were published as seven separate documents, including the main report and six assessment reports from six streams operated within the Task Force to review the status of non-financial information and sustainability reporting in detail.2 Overview of the “Proposals for a Relevant and Dynamic EU Sustainability Reporting Standard-setting” report The process of standard-setting for sustainability reporting needs to achieve a significant change within a limited time frame, unlike financial standard-setting which has taken decades



2

See https://​www​.efrag​.org/​Lab2.

EFRAG roadmap for new developments in ERS reporting  147 to mature. This requires careful prioritization and a step-by-step approach to create a stable reporting platform that aligns with the provisions of the revised NFRD. The EU needs to establish a pragmatic roadmap that combines the need for game-changing initial sets of standards with an ongoing longer-term enhancement process. This requires a clear and robust due process, swift action, and adequate resources under the appropriate EU standard-setting governance to meet the deadlines assigned for the first-time application of the revised NFRD. The development of the initial sets of standards for reporting years 2023 and 2024 should be guided by four priorities: consolidating appropriate core disclosures, prioritizing more mature topics, meeting the needs of sustainable finance legislation, and helping preparers, especially SMEs. The first set of standards tentatively includes double materiality and quality of information conceptual guidelines, core standards for reporting areas and entity-specific materiality assessment, and core and advanced standards for sub-topics, including climate change. The second set of standards should start enhancing content and cover the remaining four conceptual guidelines, advanced cross-cutting standards, and advanced standards for other priority sub-topics. Alongside the first two sets of sector-agnostic standards, sector-specific disclosures should be considered prioritizing impactful and impacted sectors or under an all-sector coverage based on an initial limited approach. SME-specific standards should focus on business models, summarized sustainability challenges, and retrospective KPIs that meet the expectations of SME management teams, value chain counterparts, and financial institutions. The following are the steps to build an ESG reporting guideline: ● Developing standard-setting methodologies to align standards with EU and global sustainability policy priorities. ● Developing criteria supporting a standard-setting process aligned with the expected characteristics of information quality. ● Defining detailed retrospective and forward-looking sustainability information components. ● Developing standard-setting methodologies to define levels of reporting based on clear boundaries. ● Developing standard-setting assessment guidelines to operationalize the double materiality concept. ● Defining methodologies and processes enabling connectivity between sustainability reporting and financial reporting. ● Promoting proportionality, comparability, and relevance through a three-layer reporting approach: sector-agnostic, sector-specific, and entity-specific disclosures (see Figure 8.1). ● Designing a comprehensive scope for EU standard-setting. ● Proposing a unified sustainability reporting format and the related data taxonomy mechanism allowing easy digitization. Establishing standard-setting as an ongoing process means that sustainability reporting will not have reached the target architecture defined by the first two sets of standards. Progressive enhancement of content will be required to achieve comprehensive and stable reporting platforms, which will continue to evolve over time.

148  Research handbook on financial accounting

Note: The Governance+ category (G+) would be broader than traditionally considered under the concept of ‘governance.’ This category would include a full spectrum of relevant matters in order to report on sustainability aspects relating to the reporting entity itself: governance, business & ethics, management of the quality of relationships with stakeholders, organization and innovation, and reputation and brand management.

Figure 8.1

Target architecture

Roadmap The development of standards for sustainability reporting needs to prioritize certain areas and follow a pragmatic roadmap to meet the deadlines set for the revised NFRD. This requires a clear due process, adequate resources, and appropriate EU standard-setting governance: The initial sets of standards (reporting years 2023–2024) should focus on four priorities: ● an appropriate ‘core’ of disclosures consolidating and complementing best achievements based on existing standards and frameworks where these sufficiently meet the quality of information and standards guidelines; ● climate-related disclosures; ● compliance with recently adopted EU legislation in the field of sustainable finance, in particular the SFDR. Failing to do so would create major inconsistencies; ● helping preparers, in particular SMEs and small- and medium-size accountancy practices (SMPs), to respond to the demand for sustainability information. Therefore, the first set of standards for the reporting year 2023 (reports published 2024) should include: a. two priority conceptual guidelines: double materiality and quality of information; b. cross-cutting ‘core’ standards covering reporting areas, reporting structure and entity-specific materiality assessment; c. ‘core’ standards for most sub-topics (reasonably mature) and ‘advanced’ standards for some priority sub-topics such as climate change. The second set of standards for reporting the year 2024 (reports published in 2025) should start enhancing content and tentatively cover (see Figure 8.2): a. the remaining four conceptual guidelines; b. ‘advanced’ cross-cutting standards (if need be);

EFRAG roadmap for new developments in ERS reporting  149 c. ‘advanced’ standards for other priority sub-topics.

Figure 8.2

Standard-setting roadmap

Alongside the first two sets of sector-agnostic standards, sector-specific disclosures and small and medium-sized enterprises (SMEs) should include sustainability reporting as part of their initial two sets of standards. Additionally, SME-specific standards should be developed with a focus on their business model, outlining sustainability challenges, and using retrospective key performance indicators (KPIs). These standards should align with the expectations of SME management teams, value chain partners, and financial institutions. Introduction of Materiality Materiality refers to information that is relevant and significant to a company’s stakeholders and should be included in its reporting. Research has extensively explored the importance of materiality in ESG reporting. One area of focus has been on improving the consistency and comparability of materiality assessments across companies and sectors. Ho (2022) found that while there is a general consensus on the importance of materiality in ESG reporting, there is still a lack of consistency in how companies define and assess materiality. The study suggests that standardization and harmonization of materiality assessments could help to improve the comparability and reliability of ESG reporting. Including a consensual definition of materiality in the regulatory guidelines for ESG reporting may contribute to a better understanding of the concept and its implications.

150  Research handbook on financial accounting Another area of research has been on the integration of ESG factors into financial reporting. The International Federation of Accountants (IFAC) published a report in 2020 highlighting the need for a more comprehensive and integrated approach to corporate reporting, which includes both financial and non-financial information (IFAC, 2020). The report emphasizes the importance of materiality in this context, stating that companies need to identify and report on the ESG factors that are most material to their business and stakeholders. Research has also explored the role of stakeholders in materiality assessments. Calabrese et al. (2016) found that stakeholder engagement is critical in identifying and prioritizing ESG factors that are most material to a company. The study suggests that companies should involve a broad range of stakeholders in their materiality assessments, including employees, customers, suppliers, investors, and civil society organizations. Finally, research has examined the link between materiality and the financial performance of companies. A study published in the Journal of Sustainable Finance & Investment in 2021 found that companies with strong materiality assessments tended to outperform their peers in terms of financial performance (Garst et al., 2022). The study suggests that this may be due to the fact that companies with strong materiality assessments are better able to identify and manage ESG risks and opportunities, which can ultimately have a positive impact on their financial performance. EFRAG addresses most of these concerns Probably one of the main contributions of the EFRAG’s set of standards has been to adopt a more dynamic approach to materiality in sustainability reporting. The EFRAG suggests that materiality should be viewed as a continuous process, rather than a one-time assessment and that it should take into account a range of factors such as stakeholder feedback, emerging risks, and changing business models. EFRAG also highlights the importance of having a clear and consistent definition of sustainability reporting. It suggests that the EU should adopt a broad definition that encompasses environmental, social and governance (ESG) factors, and that it should be aligned with international standards (EFRAG, 2021, p. 19). In terms of implementation, the report recommends that the EU establish a central oversight body to ensure consistency and quality in sustainability reporting. The report also suggests that companies should have the flexibility to report on ESG issues in a way that is relevant to their business and stakeholders, while still adhering to the overall reporting framework. And to ensure its usefulness for stakeholders, the reporting should be linked to business strategy and decision-making and it should provide meaningful information to investors, regulators, and other stakeholders. The focus is placed on the stakeholders’ utility, and the report highlights the importance of stakeholder engagement in the development and implementation of sustainability reporting (EFRAG, 2021, pp. 25, 28, 34, 41). The report suggests that companies should engage with a broad range of stakeholders, including customers, employees, investors, and civil society organizations, to identify and prioritize ESG issues that are most relevant and significant to them. Additionally, the report emphasizes the importance of transparency and accountability in stakeholder engagement, suggesting that companies should provide clear and accessible information on their engagement activities and outcomes. Regarding the role of materiality in improving ESG reporting and financial performance, the EFRAG report notes that

EFRAG roadmap for new developments in ERS reporting  151 a sound understanding of what is material for a company and its stakeholders can help companies to better identify, manage and report on ESG risks and opportunities, which can ultimately have a positive impact on financial performance. (EFRAG, 2021, p. 16)

Overall, the EFRAG’s approach to ESG reporting addresses most of the concerns raised by scholars in the related literature and proposes a comprehensive and forward-looking approach to sustainability reporting in the EU, with a focus on materiality, definition and stakeholder alignment. Although significant efforts have been made, the issue of whether ESG disclosure aligns with ESG performance remains a concern. It is important not to overlook how EFRAG addresses this question and whether companies are actually performing as they claim.

BEYOND ESG DISCLOSURE: ESG PERFORMANCE Research on the relationship between ESG disclosure and actual ESG performance has yielded a growing body of evidence suggesting that companies that disclose ESG information tend to perform better on ESG measures than those that do not. A study by Khan and Serafeim (2016) found that companies that disclosed more ESG information tended to have higher ESG performance scores. The study analysed a sample of over 2,000 companies across 23 countries and found a positive correlation between the extent of ESG disclosure and ESG performance. Fatemi et al. (2018) found that ESG disclosure positively affects ESG performance, but only when the disclosure is of high quality. The study analysed a sample of European companies and found that those with higher-quality ESG disclosures tended to perform better on ESG measures. Additionally, Hoepner et al. (2018) found that companies that adopt a more comprehensive approach to ESG disclosure tend to perform better on ESG measures than companies with a more limited approach. The study analysed a sample of over 4,000 companies across 26 countries and found that those with more comprehensive ESG disclosures tended to have higher ESG performance scores. Finally, a study by Khan et al. (2016) found that ESG disclosure can have a positive effect on firm value, particularly when the disclosure is related to material issues that are relevant to the company’s business. The study analysed a sample of US companies and found that those that disclosed more material ESG information tended to have higher market valuations. These studies suggest that ESG disclosure is positively associated with ESG performance and that the relationship may be strengthened when the disclosure is of high quality and is related to material issues. On the other hand, Arvidsson and Dumay (2022) suggest that addressing issues such as the effects of climate change and the COVID-19 pandemic requires better ESG (Environmental, Social, and Governance) performance, but this did not lead to an enhancement in the quantity or quality of ESG reporting. Thus, rather than focusing on improving ESG reporting regulations, we need to redirect our focus towards creating better ESG outcomes. The authors propose that companies must be asked to provide more timely, relevant, credible, and comparable data that demonstrate improved ESG performance. With this information, financial analysts and investors can redirect and accelerate capital flows towards corporate investments that help tackle important problems related to climate crises and the reaching of sustainable development.

152  Research handbook on financial accounting How EFRAG Plans to Avoid the Greenwashing ESG disclosure that does not correlate with ESG performance has been addressed as the ‘Greenwashing effect’. Greenwashing is a practice whereby companies overstate or exaggerate their environmental or social credentials in order to attract customers or investors, without actually making significant improvements to their sustainability performance. This can mislead stakeholders and undermine the credibility of ESG reporting. The EFRAG has outlined several ways to avoid greenwashing and ensure that ESG reporting is credible and transparent: ● Companies should use standard and recognized frameworks for ESG reporting, such as the Global Reporting Initiative (GRI) or the Sustainability Accounting Standards Board (SASB) standards. This can help to ensure that reporting is consistent, comparable and credible and that it meets the needs of stakeholders. ● Companies should provide context and explanations to help stakeholders understand the data and metrics being reported, and how they relate to the company’s sustainability performance. This can help to avoid misinterpretation and ensure that stakeholders have a clear and accurate picture of the company’s sustainability performance. ● Companies should consider using independent third-party verification to provide assurance that their ESG reporting is accurate and reliable. This can help to build trust and credibility with stakeholders and provide a signal that the company is committed to transparency and accountability. ● Companies should be transparent about the limitations and challenges of their ESG reporting, including any data gaps or uncertainties. This can help to manage stakeholder expectations and avoid unrealistic or exaggerated claims about the company’s sustainability performance. ● Companies should demonstrate ongoing improvement in their sustainability performance, rather than simply reporting on their current performance. This can help to show that the company is committed to making real and meaningful progress and is not simply engaging in greenwashing. By following these guidelines, companies can ensure that their ESG reporting is credible, transparent and trustworthy, and avoid the risk of greenwashing. This can help to build trust and credibility with stakeholders, and support the company’s long-term sustainability goals. Additionally, the EFRAG addresses the issue of oversight and enforcement. The Group recognizes the current lack of regulatory oversight and enforcement, which can lead to a lack of trust and credibility in the information provided by companies and suggests the development of a European-level oversight body for ESG reporting, which would be responsible for monitoring compliance with the reporting standard and enforcing penalties for non-compliance. This oversight body could also play a role in promoting consistency and comparability in ESG reporting across companies and sectors (EFRAG, 2021, p. 49).

CONCLUSIONS The European Financial Reporting Advisory Group (EFRAG) has been actively contributing to the development of improved Environmental, Social, and Governance (ESG) reporting

EFRAG roadmap for new developments in ERS reporting  153 standards in Europe. With sustainability becoming an increasingly important issue for investors, regulators, and companies alike, EFRAG has been working to improve the quality, comparability, and relevance of ESG reporting. EFRAG has been working on the development of a comprehensive ESG reporting framework that is aligned with the EU’s Sustainable Finance Action Plan. The framework will provide a set of guidelines for companies to report on their ESG performance in a standardized and comparable manner. The aim is to improve the quality and relevance of ESG reporting and to facilitate the integration of sustainability considerations into investment decision-making. As a main contribution, the EFRAG has recognized the importance of materiality in ESG reporting. Materiality refers to the relevance and significance of ESG factors to a company’s business and its stakeholders. EFRAG has been working to develop a materiality assessment framework that will help companies identify the ESG issues that are most relevant to their business and stakeholders. This will enable companies to report on the most important ESG issues in a more focused and relevant way. Additionally, the EFRAG recognizes the need to integrate ESG reporting with financial reporting. This means that companies should report on ESG issues in the same way that they report on financial performance. This will make it easier for investors and other stakeholders to understand the impact of ESG issues on a company’s financial performance, and to make informed investment decisions. EFRAG has been working to enhance the credibility of ESG reporting by improving the quality and reliability of the data reported. This includes developing guidance on data quality and an adequate quantity of ESG information. The aim is to improve the accuracy and reliability of ESG data, and to increase the trust and confidence that investors and other stakeholders have in ESG reporting. Additionally, EFRAG provides guidelines for ESG performance and disclosure consistency, ensuring that companies follow best practices in reporting their environmental, social, and governance activities. In summary, EFRAG’s efforts to improve ESG reporting are aimed at promoting more sustainable business practices and investment decisions. By providing a comprehensive and standardized framework for ESG reporting, EFRAG is helping to improve the quality, comparability, and relevance of ESG reporting. This will enable investors and other stakeholders to make more informed investment decisions and encourage companies to adopt more sustainable business practices.

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EFRAG roadmap for new developments in ERS reporting  155 Khan, M., & Serafeim, G. (2016). Corporate sustainability: First evidence on materiality. The Accounting Review, 91(6), 1697–1724. Khan, M., Serafeim, G., & Yoon, A. (2016). Corporate sustainability: First evidence on materiality. The Accounting Review, 91(6), 1697–1724. Khan, M. M., Qadeer, F., Shahzad, F., & Nadeem, M. (2021). Relevance of ESG factors on financial performance of firms: A review of the literature. Sustainability, 13(3), 1443. Kotsantonis, S., & Serafeim, G. (2018). Four things no one will tell you about ESG data. Harvard Business Review, 23. KPMG (2013). The KPMG Survey of Corporate Responsibility Reporting 2013 kpmg​.com/​sustainability. Available at: https://​assets​.kpmg​.com/​content/​dam/​kpmg/​pdf/​2013/​12/​corporate​-responsibility​ -reporting​-survey​-2013​.pdf Landi, A., & Sciarelli, M. (2019). ESG score and financial performance of Italian listed companies. Sustainability, 11(5), 1467. López-Santana, M. (2006). The domestic implications of European soft law: framing and transmitting change in employment policy. Journal of European Public Policy, 13(4), 481–499. Principles for Responsible Investment (PRI) (2016). Evaluating ESG impact on project costs. Available at: https://​www​.unpri​.org/​listed​-equity/​evaluating​-esg​-impact​-on​-project​-costs/​157​.article Threlfall, R., King, A., Shulman, J., & Bartels, W. (2020). The Time has Come: The KPMG Survey of Sustainability Reporting 2020. The Netherlands: Amstelveen.

9. Materiality in sustainability and integrated reporting contexts: an application of logics Dannielle Cerbone and Warren Maroun

INTRODUCTION1 Driven by changing socio-economic factors, environmental challenges and stakeholder awareness, corporate reporting has expanded beyond the one-dimensional focus of financial statements. The last three decades, in particular, have seen the emergence of “triple-bottom-line”, “corporate social responsibility”, “environmental” and “sustainability” reports. Each is an example of how an expanded reporting model, incorporating financial and extra-financial elements, is intended to lower information asymmetry, promote sustainable development (Lai et al., 2016) and advance accountability for economic, social and environmental factors (IIRC, 2021). More recently, “integrated reporting” has emerged. This type of reporting focuses on different “capitals” and how trade-offs among the capitals either create or destroy value for the organisation and its stakeholders (International Integrated Reporting Council [IIRC], 2021; Eccles & Krzus, 2010; Lai et al., 2016; Maroun & Cerbone, 2020). While integrated and, more generally, sustainability reporting has grown in popularity (Landau et al., 2020) the reports are often criticised for poor quality and limited credibility (Farooq & de Villiers, 2018; Maroun, 2019). Under-developed regulatory environments, the absence of minimum industry-level reporting requirements (Lai et al., 2018), the difficulty of defining and gauging “sustainable development” (Rupley et al., 2017; Braam & Peeters, 2018) and the susceptibility of inherently subjective reports to manipulation, further limit sustainability reporting’s potential to advance positive change (Kitsikopoulos et al., 2018). In this context, there is considerable variation in how the concept of materiality is being interpreted and applied by preparers (de Villiers et al., 2014; Jørgensen et al., 2022). For example, the focus and extent of environmental, social and governance (ESG) disclosures included in integrated reports vary significantly among organisations, even when these are in the same industry (Solomon & Maroun, 2012). How companies determine if information is material offers a possible explanation for the criticisms and may explain divergent reporting practices (Edgley et al., 2015; Lai et al., 2017). Despite the importance and inherent complexity of materiality determination, there is little guidance in either the professional (Torelli et al., 2019) or academic literature (Gerwanski et al., 2019; Mio et al., 2019). Most of the prior research on integrated or sustainability reporting tends to focus on theory development (e.g. Gray, 2001), the type of information being included in the reports (O’Donovan, 2002) and the drivers and consequences of adopting integrated or sustainability reporting principles (Alrazi et al., 2015; de Villiers et al., 2017). As a result, 1 Abbreviations used in this report include International Financial Reporting Standards (IFRS); Institute of Directors in Southern Africa (IOD); International Integrated Reporting Council (IIRC).

156

Materiality in sustainability and integrated reporting contexts  157 there is significant variation in how companies determine if extra-financial issues are material (Chewning & Higgs, 2002; IFAC, 2015; Puroila & Mäkelä, 2019; GRI, 2020; IIRC, 2021) with implications for the nature and extent of information being communicated to users (Chewning & Higgs, 2002; McNally et al., 2017; Lai et al., 2018; Adams et al., 2020). Considering the above, the current chapter is concerned with how companies determine and operationalise materiality in a non-financial reporting context.2 This is done by examining how different institutional logics interact to inform the understanding and application of materiality by organisations. Doing so makes an important practical contribution by complementing guidance provided by, for example, the EFRAG (2022), GRI (2020), IFAC (2015) and AccountAbility (2008). The considerations by preparers regarding material information should be relevant for practitioners when developing a framework for identifying material considerations for inclusion in an integrated report (see de Villiers et al., 2014; IIRC, 2014) and for academics interested in understanding better how companies decide on the scope and extent of their financial and non-financial disclosures. At the theoretical level, institutional logics are mobilised to explain the interconnection between preparers’ understanding of non-financial reporting, stakeholder engagement and materiality determination. The research identifies three groups of preparers (compliance, stakeholder-aware and interpretive), each of which is influenced, to a different extent, by market, professional and stakeholder logics yielding different views on sustainability and integrated reporting, stakeholder engagement and materiality. This chapter is structured as follows. The concept of materiality is first introduced, followed by a short description of the logics relevant to corporate reporting. How the logics interact and affect the operationalisation of materiality is then explained. Findings from interviews are presented and summarised followed by the conclusion.

MATERIALITY “Materiality” can be simply defined as the relative, importance of a piece of information, to a user, in the context of a decision to be made (Frishkoff, 1970). The concept of materiality is, traditionally, a financial one (Chewning & Higgs, 2002) and in an accounting setting is often framed according to a market and professional logic. In a financial reporting context, the International Accounting Standards Board (IASB) defines “materiality” as follows: Information is material if omitting or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. (IASB, 2018, p. 6)

In a non-financial reporting context, preparers may use the EFRAG’s, GRI’s, AccountAbility’s or the IIRC’s materiality guidance to assist in determining whether non-financial information is material (McNally et al., 2017; EFRAG, 2022). The GRI (2020, p. 10) evaluates materiality according to an organisation’s economic, environmental or social impact or its influence on stakeholders’ assessments and decisions. AccountAbility (2008) follows a similar approach which avoids a finance-centric conceptualisation of materiality. Instead, materiality is assessed 2 Non-financial reporting context refers to materiality in a sustainability or integrated reporting context throughout this chapter.

158  Research handbook on financial accounting qualitatively, taking into consideration an organisation’s context, sustainability drivers and the impact on and expectation of a broad group of stakeholders (AccountAbility, 2008; Edgley et al., 2015; GRI, 2020). Like the GRI and Accountability guidance, EFRAG (2022, p. 4) also define materiality using a stakeholder framing but includes the ‘double materiality’ concept. Double materiality is the union of impact materiality and financial materiality3 which is used to assist in the determination of material items (EFRAG, 2022). The IIRC’s guidance considers information material “if it could substantively affect the organisation’s ability to create value in the short-, medium- or long-term” (IFAC, 2015, p. 8). The concept of materiality is still regarded as inherently difficult to operationalise in a non-financial reporting context (McNally et al., 2017; Raith, 2022). This may be a result of the difference in the definition of materiality in a financial context when compared with materiality in a non-financial context (Kitsikopoulos et al., 2018), how organisations manage various stakeholder demands (Adams et al., 2020) and the guiding standards they use to determine materiality (Raith, 2022). Without a definitive rule separating material and non-material matters, the determination of materiality has become a complex task. Adding to this complexity is the principles-based nature of materiality guidance which allows flexibility in the construction of non-financial accounts (IFAC, 2015; GRI, 2020). This flexibility allows companies to engage in expectation management and favourable self-display (Edgley, 2014; Stubbs & Higgins, 2018).

LOGIC INTERACTIONS AND THEIR RELEVANCE FOR MATERIALITY DETERMINATION It is possible to draw on the multiple logics identified in business management and organisational change literature (see, for example, Besharov & Smith, 2014; Ocasio et al., 2015). As this chapter focuses specifically on the corporate reporting process (rather than strategic, operational or systems issues) materiality is explained using the logics which have emerged in the technical accounting and sustainability reporting literature as outlined primarily by Edgley (Edgley, 2014; Edgley et al. 2015), a market, professional and stakeholder logic. A market logic is the core logic which underpins the traditional accumulation and maintenance of financial wealth (Friedland & Alford, 1991). The focus is on the providers of financial capital, mainly the shareholders. As a result, materiality is framed as a concept designed to protect shareholders from misleading information. The logic is central to conventional views on financial reporting which see accounting as a rational technical development designed to aid efficient capital allocations and to mitigate agency costs (Edgley, 2014). A professional logic bridges the gap between government regulation and capital market expectations (Edgley et al., 2015). The logic is based on commercial concerns and public interest, however it is independent of both (Edgley, 2014). This logic frames professional guidance about financial audit and materiality practices for practitioners. Preparers espousing a professional logic are characterised by adherence to the various codes of best practice,

Impact materiality refers to the potential significant impacts on people or the environment where as financial materiality refers to the financial effects of the extra-financial item in the short-, medium- or long-term (EFRAG, 2022). 3

Materiality in sustainability and integrated reporting contexts  159 reporting guidelines and applicable regulatory requirements (see DiMaggio and Powell, 1983; Fogarty, 1992). A stakeholder logic (Edgley et al., 2015) or sustainability logic (Schneider, 2015) is community orientated. Both challenge the ethics of capitalism. From a stakeholder logic perspective, organisational legitimacy is not only the result of generating financial returns but also of demonstrating how a company is aligning its processes and outcomes with broader societal concerns (O’Donovan, 2002). This includes reframing value creation as a broader assessment of how multiple types of financial and non-financial capitals are managed in order to generate responsible returns for investors and positive outcomes for society (Eccles & Krzus, 2010; Alrazi et al., 2015; Atkins & Maroun, 2015; IOD, 2016). In other words, a stakeholder or sustainability-centric approach to business does not mean that financial performance is unimportant but that economic objectives must be balanced with environmental and social considerations (Schneider, 2015), something which Lok (2010) names an ‘enlightened shareholder value logic’.

MATERIALITY LOGICS AND REPORTING Sustainability and integrated reporting involve collaboration among members of a multi-disciplinary team (Stubbs & Higgins, 2014). Conflict between accounting functions (subscribing to a market logic) and other experts (relying on environmental or social responsibility discourses) often limits the change potential of sustainability or integrated reporting (Larrinaga-Gonzalez & Bebbington, 2001; Brown & Dillard, 2014). Differences can also emerge between a risk-management or compliance philosophy which seeks to limit the extent to which an organisation is held accountable for its sustainability performance and the desire for significant reforms by some of an organisation’s agents (consider Stubbs & Higgins, 2014; Tregidga et al., 2014; Cho et al., 2015; McNally et al., 2017). Related closely to this is the emphasis which is placed on either financial or non-financial performance measures and how materiality is framed and applied when deciding on the content of an integrated or sustainability report (Edgley et al., 2015). To illustrate the interaction between the different logics, Figure 9.1 highlights how an understanding of the purpose of preparing an integrated or sustainability report (R1), the relevance of stakeholder engagement (R2) and factors which contribute to information being seen as material (R3) are closely connected (IIRC, 2021). These are related to corresponding conceptual approaches to preparing a sustainability or integrated report and are also influenced by the extent to which preparers’ epistemic commitment or technical cognition is informed by a market, professional and stakeholder logic (Edgley et al., 2015). At one extreme, a preparer adhering to a market logic would consider non-financial reporting to be an extension of the financial reporting system. Reporting on other capitals would be understood as necessary for the purpose of addressing stakeholder expectations for some level of ESG disclosures and only a secondary consideration (C1). In keeping with the view that the shareholder is the primary provider of financial capital (Flower, 2015), there is no need for formal and extensive stakeholder engagement (R2; C2) and integrated reporting is limited to explaining managements’ interpretation of the business to these capital providers (see Cummings, 2001; Belal, 2002; Kaur & Lodhia, 2014).

160  Research handbook on financial accounting

Figure 9.1

Modified materiality model

The information needs of investors and creditors are prescribed by IFRS and those of other stakeholders are addressed automatically by providing information which financial capital providers find useful (see IASB, 2010; IIRC, 2021). In turn, a finance-centric framing of integrated reporting, according to a market and professional logic, means that information is material if it affects financial accounting – or market-based performance measures (R3; C3). In particular, ESG disclosures are material if they can be quantified and/or linked directly to financial indicators (Edgley et al., 2015). In contrast, when a stakeholder logic is the dominant perspective for framing corporate reporting, the integrated report is seen as a means of giving a holistic account of a firm’s value creation process (R1; C1). Reporting on the connections between multiple types of capital, strategy, risk and operations improves transparency and accountability. High quality integrated reporting can also be reflexive, highlighting new areas for management review and control in order to drive positive change, including improved sustainability performance (Guthrie et al., 2017; McNally & Maroun, 2018). To prepare a high quality integrated report, the preparer relies on formal and detailed engagements with multiple stakeholders (R2; C2) to understand their legitimate expectations and identify details that need to be included in an integrated report in order to meet their information needs (see Cummings, 2001; Belal, 2002; Kaur & Lodhia, 2014). In this stakeholder-focused and multi-capital reporting environment, the materiality determination is described as interpretive (R3; C3) because the preparer needs to take various perspectives into account when deciding whether or not information is relevant for the users of the integrated report. Finally, Figure 9.1 shows that there is a continuum with the market and professional logic on the one side and broader stakeholder logic at the opposite end. Professional judgement, influenced by the extent to which the different logics are internalised, shapes individual preparers’ understanding of materiality at any point along the continuum. This is in keeping

Materiality in sustainability and integrated reporting contexts  161 with the fact that, in an evolving reporting environment, institutional logics are interpreted and applied differently by preparers, leading to conflicting perspectives and overlapping of logic boundaries (see Llewellyn, 1994; Reay & Hinings, 2009; Tremblay & Gendron, 2011). Until a dominant logic emerges for conceptualising the integrated report and informing reporting practice, variations of a purely market and stakeholder logic are possible (de Villiers et al, 2014; Edgely et al, 2015). As the magnitude of social and environmental challenges increases and integrated reporting becomes better understood, a stakeholder logic may emerge as the primary logic. Conversely, the continued dominance of financial and economic paradigms may contribute to a market logic which stifles a multi-dimensional approach to reporting (Stubbs & Higgins, 2014; Tregidga et al., 2014).

PREPARER VIEWS Interviews with 20 respondents from 12 organisations were used to collect data on how companies are interpreting the concept of materiality in a non-financial reporting context and how this is linked with their understanding of non-financial reporting and the need for stakeholder engagement (Alvesson, 2003). The detailed interviews revealed preparers with different views on materiality, reflecting a continuum from a market/professional logic to a stakeholder logic as depicted in Figure 9.1 (see Edgley et. Al., 2015). Type 1 – Compliance Preparers For compliance preparers, non-financial reporting is seen as ‘costly’ and ‘time-consuming’. It provides little direct benefit and is primarily a compliance-driven exercise. Interviewees point to a professional logic at work in the sense that the emphasis is on providing comprehensive disclosure and demonstrating that non-financial reports are aligned with dominant non-financial reporting discourse. This involves strict adherence to codes of corporate governance4 and reporting guidelines such as the GRI. The aim is to demonstrate that technical standards, intended to serve the public interest, have been complied with and that the reports meet certain ‘minimum standards’ to ‘prove’ that there has been a reasonable effort to compile the non-financial report (Preparer 8). Replicating the disclosure practices of perceived non-financial reporting leaders forms part of this process. To ensure that stakeholders’ information needs are satisfied, compliance preparers default to using reporting guidelines as a set of rules and to demonstrate that they provide, at least, the minimum recommended disclosures. Stakeholder-aware preparers think that compliance with reporting guidelines is important but not a primary issue. They attempt to interpret these as frameworks, apply the principles to their business and, as their reporting matures, focus on more than just the minimum reporting requirements.



4

King-III at the time of data collection.

162  Research handbook on financial accounting Type 2 – Stakeholder-aware Preparers In contrast, stakeholder-aware preparers recognise that compliance with applicable laws and regulations is still a relevant driver for preparing a non-financial report but that the document can also be relevant for providers of financial capital and other stakeholders. In keeping with a market logic, stakeholder-aware preparers confirmed that conventional accounting measures play a critical part in ensuring that a non-financial report provides useful information to users. In addition, this group of respondents recognise the importance of providing disclosures on a range of metrics (including ESG issues) which stakeholders require to understand the ‘business model’, as opposed to just ‘the final bottom line’ (Preparer 4). In this way, the professional logic is concerned with more than just strict compliance with recommended practices. Stakeholder-aware preparers understand that a non-financial report is about providing information which is useful to a broad group of users. In a stakeholder-aware context, application of reporting guidelines or codes of best practice rest with management. The sustainability and integrated report are normally the responsibility of a team of preparers representing different divisions of the organisation and led by the CFO, company secretary or investor relations. Interpretive preparers are similar but are also more likely to rely on a multi-disciplinary team to prepare and assume responsibility for the non-financial reports. Stakeholder-aware organisations rely on staff with backgrounds in financial and ESG reporting. Interpretive preparers complement these teams with specialists in areas such as biodiversity, human capital and intellectual capital management, as opposed to reporting experts only. For both types of preparers, consultants play a limited advisory role, unlike the situation with compliance-focused preparers. These individuals are more likely to engage external consultants to develop comprehensive disclosure checklists which address each major issue or theme found in the relevant reporting guidelines. The CFO and company secretary assume responsibility for the integrated report and consultants are tasked with planning and preparing the integrated report. This is justified on the grounds that the integrated report is not part of the ‘real management’ of the company or is beyond managers’ area of expertise (Preparer 11). Consequently, while non-financial reporting should promote reflection and a more comprehensive approach to managing financial and non-financial metrics (Eccles & Krzus, 2010; Atkins & Maroun, 2015) any change is limited to an increase in the extent of reporting aimed at signalling compliance with reporting guidelines or codes on corporate governance. Stakeholder-aware preparers recognise the importance of reporting on a broad range of issues in order to provide stakeholders with a more complete account of their organisations’ performance, in addition to conforming to reporting and governance conventions. Non-financial reporting is subject to an underlying market logic which results in stakeholders’ information needs being subordinate to the cost of reporting. Concerns about the cost of system development may be valid but there was no indication that any formal costing exercise had been performed. In many cases, the prohibitively high cost of refined ESG reporting was assumed. Related to this, none of the stakeholder-aware respondents could explain precisely how the benefits of enhanced ESG reporting can be quantified and compared with the costs. On one hand, this is because of the difficulty of defining and measuring the value of non-financial information; on the other hand, the limited responses imply that organisations are yet to realise additional value in integrated reporting, besides the

Materiality in sustainability and integrated reporting contexts  163 use of the IR to address the information needs of shareholders, satisfy regulatory requirements and meet stakeholders’ general expectations. Type 3 – Interpretive Preparers Interpretive preparers take a similar position but emphasise that, in addition to acting as a reporting mechanism, non-financial reporting is about the organisation being accountable to stakeholders for its strategy, risk management and both financial and non-financial performance. In this context, interviewees are aware of laws and regulations but they believe that, if a company prepares a good integrated or sustainability report, it automatically addresses the majority of the compliance issues, with the remaining requirements seen as residual ones. Unlike compliance and stakeholder-aware preparers, interpretive ones are more inclined to depart from recommended practices or develop their own approach to reporting on a particular issue on the grounds that this explains the organisation’s context more accurately and is, therefore, more useful for stakeholders. The compliance preparer applies a professional logic by ensuring that codes of best practice are strictly followed. For the interpretive preparer, exercising judgement when interpreting and applying reporting guidelines is not inconsistent with the professional duty to prepare a prepare a relevant and reliable report or with discharging accountability to stakeholders. The interpretive preparer, like the stakeholder-aware preparer, understands that reporting on transformations of financial capital is necessary but that this needs to be explained in the context of the firm’s business model, risks and the other ESG information under review. In addition, the sustainability and integrated report have a type of feedback loop in the sense that it highlights weaknesses in strategies, management systems and operations and, in turn, contributes to positive change. For example, a respondent explained that, once the risk areas are identified, the company proceeds to measure the risk, implement mitigation plans, track risk management performance and improve efficiencies (Preparer 2). To facilitate this, new internal systems have been established to collect data and identify whether issues have a significant impact on the business. Information included in a sustainability and/or integrated report has also heightened awareness about the importance of so-called ‘non-financial information’ for organisational management. In other words, integrated reporting by interpretive preparers is no longer a compliance or neutral reporting exercise (Guthrie et al., 2017). It is associated with changes to the accounting infrastructure and performance management systems and is being used to report on and inform changes in an organisation’s business processes, risk management and strategy (cf. Stubbs & Higgins, 2014). At the heart of this is a sophisticated process of stakeholder engagement.

COMPANY ANALYSIS As illustrated in Figure 9.1, variations in the interpretation of and adherence to a market, professional and stakeholder logic will occur, leading to conflict and overlapping perspectives (see Llewellyn, 1994; Reay & Hinings, 2009; Tremblay & Gendron, 2011). As a result, rather than highlight only the dominant approach being followed to prepare an integrated report, a secondary approach is also included in Table 9.1. For example, at four companies, preparers are compliance-driven but two of these organisations are also starting to adopt

164  Research handbook on financial accounting a more stakeholder-aware approach to reporting. Likewise, at all the organisations in which stakeholder-aware preparers hold sway, there are some indications of them behaving like interpretive preparers to, at least, some extent. Based on interviewees’ responses, Table 9.1 shows that FS2 and M4 see integrated reporting primarily as a compliance exercise. At both organisations, the detailed interviews revealed stakeholder engagement limited to financial capital providers and the absence of formal processes for determining or reporting on materiality. Materiality is defined in financial terms and there are no formal processes in place for setting and revising materiality levels. A strong market and professional logic negate the need for detailed stakeholder engagement. The emphasis is firmly on providers of financial capital. With materiality for financial reporting defined by professional standards, a detailed materiality assessment for the integrated report is unnecessary. In contrast, EC2, M2, M3 and FS3 rely predominantly on stakeholder-aware and interpretive preparers. In keeping with a professional logic, the need to adhere to codes of best practice and technical standards is still essential but integrated reporting is also seen as a legitimate means of servicing the information needs of a broad group of stakeholders. The result is an increasingly sophisticated approach to stakeholder engagement and materiality determination. For GS1, GS2, GS3 and M1, the shareholder is still the primary stakeholder although the legitimate information needs of other parties are acknowledged. As a result, all these organisations frame materiality in terms of financial performance but also refer explicitly to other stakeholders as part of their materiality assessment. Barring GS2, the companies rely on internal and external sources to inform their definition of materiality. GS3 and M1 also refer to strategy, risk and long-term value creation when explaining materiality. It is possible that more frequent stakeholder engagement may be revealing competing expectations which have to be managed by the teams preparing the integrated reports (Cho et al., 2015; de Villiers et al., 2017). One approach to resolving these tensions is relying on internally-determined assessments of materiality to a greater extent than feedback received from different stakeholders. Preparers grounded in a market logic are also likely to adopt the position that, while it is important to recognise the information needs of a broad group of stakeholders, the shareholder remains the primary user of an integrated report (Flower, 2015). An alternative position accepts economic, environmental and social dimensions of performance as equally relevant (Schneider, 2015). In this context, respondents from M2 and M3 explained that materiality must be gauged for each ‘element’, cognisant of the fact that different stakeholders may be the primary users of different parts of an integrated or sustainability report. Both organisations incorporate a formal stakeholder identification process to define stakeholders, ascertaining their specific information needs and determining whether or not disclosures are relevant according to the applicable context and the stakeholders’ relative influence. The interests of a broad group of stakeholders are accepted as legitimate and the shareholder is not automatically the sole focal point. In turn, the focus of reporting shifts and the information provided to different stakeholders is being used to identify weaknesses in business models and drive positive change (see also McNally & Maroun, 2018). The final observation from the classifications in Table 9.1 is that preparers and their respective organisations do not fit into mutually exclusive categories. Similarly, interpretive preparers dealt with issues which were similar to those of their stakeholder-focused counterparts such as the central role played by providers of financial capital. Ultimately, these results

Compliance

Compliance

Compliance

Compliance

Stakeholder Stakeholder

Stakeholder

Stakeholder

Interpretive

Interpretive

Interpretive

Interpretive

FS2

M4

EC1

FS1

M1 GS1*

GS2

GS310

EC2

M2

M3

FS3

P

P

P

–

P

P

P

–

–

–

–

P

P

P

P

–

–

– –

P

P

–

–

–

–

–

P

–

P

–

–

–

–

–

perspective?

perspective?

perspective? –

an interpretive

stakeholder-aware

a compliance

–

Evidence of

Evidence of

Evidence of

Secondary approaches to reporting

Semi-formal assessments

internal assessments least some extent, by

increasingly ancillary concern

information relevant for understanding the business

emphasis they place on different elements of the report

and external) to identify

multiple sources (internal perspective with different a complete account of the

organisation with compliance an stakeholders varying the

A formal assessment of Multi-stakeholder

stakeholders

still the primary stakeholder direct engagement with

although the shareholder is

A means of providing

a compliance-driven process

multiple stakeholders as well as groups of stakeholders

complemented, to at

Increasingly formal

A mechanism for servicing the

The firm recognises the

are secondary stakeholders

may value reporting

legitimate information needs of importance of different

acknowledgment that there reporting team

recognition that stakeholders

performed by the

disclosed

Focus on financial capital

Not formally assessed or

capital providers

Exclusively on financial

reporting prescriptions but some providers but with the

Ensuring compliance with

reporting prescriptions

Ensuring compliance with

 

 

materiality determination

 

Basis for firm’s

reporting

engagement

Understanding of non-financial Level of stakeholder

Note: * There were two respondents from GS1 and GS3. At each company, one interviewee did not align with an interpretive logic, while the other did. The views of the more senior respondent are used to categorise the respective companies’ alternative logic.

 

reporting

approach to

Dominant

Logic versus materiality matrix

 

Organisation

Table 9.1

Materiality in sustainability and integrated reporting contexts  165

166  Research handbook on financial accounting shows that underlying market, professional or stakeholder logics work to differing degrees on practitioners and their firms.

CONCLUSION This research highlights the connection between different perspectives on the role of non-financial reporting and the relevance of stakeholder engagement for defining materiality. The interplay between the logics has resulted in three categorisations of preparers. These include: compliance, stakeholder-aware and interpretive preparers. With compliance preparers the understanding of the reporting process is dominated by a market logic and non-financial reporting is seen only as a means of disclosing information to shareholders to demonstrate compliance with codes of best practice and reporting guidelines. A finance-centric approach to reporting takes hold, leading to the marginalisation of different stakeholders and the relevance of ESG disclosures as espoused under a stakeholder logic (Edgley et al., 2015). In this environment, there is a tension between reporting designed to satisfy shareholders and maximise share prices and the need to comply with codes of best practice to demonstrate that the integrated report is balanced, even if additional disclosures are to the short-term economic disadvantage of the firm, its managers or shareholders. For stakeholder-aware preparers, the role of non-financial reporting is expanded. Compliance is still relevant but the integrated report becomes a means of addressing stakeholders’ legitimate information needs in line with a stakeholder logic. An underlying professional logic is also at work with preparers wanting to ensure that codes of best practice are applied to serve stakeholders’ interests. These two logics are, however, in conflict with underlying capitalistic pressures associated with a market logic. Where this is the case, some organisations limit the extent of stakeholder engagement and continue to rely on internally driven assessments of materiality. Tensions between logics are managed by defaulting to the view that, while it is important to manage the information needs of different stakeholders, the provider of financial capital remains the primary focus and ESG disclosures are of secondary importance (see Flower, 2015). In this way, a broader understanding of integrated reporting does not guarantee that a stakeholder-aware organisation will refrain from using its integrated report as a tool for impression management. Where this is the case, there is a tension between the stakeholder and professional logic (on the one hand) and the market logic (on the other). For the interpretive preparer, the importance of adhering to codes of best practice is not disputed but is about more than just compliance. The preparer understands that there is a duty to ensure a holistic approach to managing and reporting on the business’s activities. This recognises the relevance of financial and non-financial indicators for understanding the business model and strategy: addressing stakeholders’ reasonable expectations and securing organisational legitimacy. The findings support Adams et al. (2021) and Beske et al. (2019) as interpretive preparers emphasize the importance of stakeholder participation in the materiality assessment. The result is a pluralistic perspective of the business grounded in different but complementary logics which inform the scope and content of an integrated report. These findings have several important implications. First, variations in logic underlying the materiality determination process confirm the inherent subjectivity and still evolving nature of the non-financial reporting process. No single or dominant logic has taken hold. In this dynamic reporting space, competing market, professional and stakeholder logics explain

Materiality in sustainability and integrated reporting contexts  167 variations in reporting practices and can be represented as a continuum between a purely compliance and interpretive-driven approach to integrated reporting. Second, the study shows that materiality and stakeholder engagement cannot be understood only in terms of the guidance issued by the EFRAG (2022), GRI (2020), AccountAbility (2008) and the IIRC (2021). The interpretation and application of these frameworks is subject to adherence with prevailing logics. In addition, materiality cannot be defined separately from the preparers’ understanding of the purpose of an integrated report (which is also significantly influenced by the level of commitment to prevailing logics). The perceived value and purpose of an integrated report is linked to the emphasis placed on stakeholder engagement and, in turn, the extent to which materiality is articulated according to prevailing reporting discourses. Finally, the operationalisation of logics should inform normative recommendations for improving integrated reporting. For example, professional guidelines can include details on how to perform an interpretive analysis of stakeholder needs and materiality assessments. Possible points include the methods for interacting with stakeholders, how to analyse and reduce their feedback and how existing corporate governance systems can be used to ensure the validity and reliability of this part of the reporting process. Definitions of materiality can also be revised to take this paper’s more detailed findings into account. At a broader level, regulators and standard-setters interested in encouraging more integrated forms of reporting will need to realise that this cannot be achieved only by issuing reporting prescriptions. To avoid a compliance-approach to reporting, the benefits of integrated reporting need to be made clear, as well as the methods that can be used to engage meaningfully with stakeholders and develop an informed definition of materiality. Future research is needed on how to report on multiple types of capital in a way that improves stakeholders’ understanding of the organisation’s business model. This chapter has only provided preliminary views on how stakeholder engagement can be used to enhance the reporting process.

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PART IV FAIR VALUE AND INTANGIBLES IN ACCOUNTING

10. Outlining commitment and resistance to dominant accounting paradigms Wayne van Zijl and Warren Maroun

INTRODUCTION Stewardship has a long history and is frequently used to explain the emergence and development of accounting as a management control tool and the technology of accountability (Hopwood, 1987; Hoskin and Macve, 1988; Murphy et al., 2013; Macve, 2015). As a result, it comes as no surprise that fair value accounting, which places neoliberal economics above accountability, has been met with considerable criticism (Whittington, 2008a, b). Fair value accounting was a ‘timely and modern’ response to the limitations of historic cost accounting, which could not capture the economic substance of the booming trade in financial instruments in the 1990s and early 2000s (Haswell and Evans, 2018, p. 43). But fair value is also open to manipulation, playing at least some part in well-known financial failures of the early twenty-first century. Standard setters may not have had a complete understanding of the policy and practice implications of the ‘mark-to-market’ measurement basis (see, for example, Benston, 2006; Plantin et al., 2008; Haswell and Evans, 2018). Bengtsson (2011) and Zhang and Andrew (2014, 2016) argue that the ascendance of fair value accounting is the result of power struggles between standard-setters and established institutions focused on enforcing a dominant political economy rather than the technical superiority of fair value over cost accounting. The quasi-mathematical elegance of financial economics used to support neoliberal accounting practice is mobilised as part of a legitimisation process designed to obscure the inherently subjective nature of fair value accounting and reframe it as a ‘science’ (Ravenscroft and Williams, 2009). As a result, despite the apparent preference for fair value accounting by the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) (Zhang and Andrew, 2014), elements of historic cost accounting are retained (Ijiri, 2005; Ravenscroft and Williams, 2009; Macve, 2015). The accounting standards have become a ‘hodgepodge’ of rules, principles and techniques based to varying extents on either fair value or historic cost paradigms (Ravenscroft and Williams, 2009, p. 774). Some practitioners understand, appreciate and apply fair value measurement bases with little issue. Fair value accounting resonates with their own beliefs about financial reporting and they become active proponents of what Zhang and Andrew (2014) refer to as the ‘financialisation’ process. In contrast, individuals who identify with the logic of cost accounting reject fair value accounting as a credible part of the financial reporting system and resist its adoption. Between these extremes are the ‘flexible adherents’ who simply subscribe to the dominant discourse at the time. This chapter focuses on financial reporting practices in South Africa where compliance with International Financial Reporting Standards (IFRS) has been mandatory since the mid-2000s. Results from South African studies are used to demonstrate that individuals subscribing to 172

Outlining commitment and resistance to dominant accounting paradigms  173 a neoliberal philosophy prefer fair value accounting. Those who identify with accounting as a stewardship function align with cost accounting. Their resistance to fair value accounting takes the form of ideological opposition focused on how fair value undermines the usefulness of financial statements and the broader stewardship objective. Flexible adherents also resist fair value accounting but for different reasons. They are unconcerned with the conceptual rigour of either the stewardship or neoliberal framework. Resistance is context-specific and driven by the perception that fair value accounting is more complex and time-consuming to apply than the alternative. In turn, this suggests that differences in ontological views on accounting (Durocher and Gendron, 2014) and resistance to change (Tremblay and Gendron, 2011) are not separate issues but complementary parts of a unified theoretical perspective on how accounting is applied in real-world settings.

THE FAIR VALUE AND COST ACCOUNTING PARADIGMS In a financial reporting context, stewardship and neoliberalism are often presented as two opposing perspectives (Hoogervorst, 2015). The stewardship objective aims to provide information which facilitates holding management accountable. Neoliberalism prioritises information used to predict an entity’s future cash flows and make investment decisions (Bryer, 2000; Whittington, 2008a; Bengtsson, 2011; Zhang and Andrew, 2014). The stewardship objective can be traced back to accounting’s early history. Accounting served as an immutable and permanent record of assets and transactions (Basu and Waymire, 2006; Basu et al., 2009; Ravenscroft and Williams, 2009). Accounting was used to report on agents’ actions as custodians of their principals’ assets. Accounting, aligned with a stewardship agenda, favours the use of reliable, verifiable and entity-specific information (Whittington, 2008a; Ravenscroft and Williams, 2009). This is because the primary objective of financial statements is not to forecast future cash flows or compare entities’ values but to provide an account of management’s deployment and stewardship over resources entrusted to it (Bryer, 2000; Whittington, 2008a; Murphy et al., 2013). Some researchers argue reporting should prioritise users already invested in the entity over potential users if there is a conflict in the required information (Watts and Zimmerman, 1979; Whittington, 2008a; Barker and McGeachin, 2015; Macve, 2015). The years post World War II saw significant advancements in finance, economics, computing, and telecommunications (Barlev and Haddad, 2003; Ravenscroft and Williams, 2009; Zhang and Andrew, 2014). A neoliberal-inspired agenda developed, largely described as an ideology calling for the deregulation of financial markets, privatisation, weakening of institutions of social protection, weakening of labour unions, … shrinking of government, … [and] opening up of international goods and capital markets. (Zhang, 2011, p. 4)

Access to capital markets had grown since the early 1900s, leading to high proportions of investors primarily interested in maximising returns (Bryer, 2000; Walker, 2006). Together with finance- and economic-centric research originating in the United States, accounting shifted from a stewardship objective to providing ‘decision-useful’ information necessary for

174  Research handbook on financial accounting ensuring efficient capital allocations1 (Whittington, 2008a; Ravenscroft and Williams, 2009). Information is only useful if it provides relevant and timely information about the amount, timing and uncertainty of future cash flows (Ravenscroft and Williams, 2009; IASB, 2018). Historical cost information is relegated because it is considered out-of-date2 (Barlev and Haddad, 2003; Whittington, 2008a). While historical costs may not be current, they are considered more verifiable than fair values. This is especially the case when active market prices for the respective assets and liabilities are not available and a Level 1 fair value cannot be determined (see Haswell and Evans, 2018). In these cases, the fair value needs to be determined using ‘inputs other than quoted market prices included within Level 1 that are observable for the asset or liability, either directly or indirectly’. The result is a Level 2 fair value measure (IFRS 13, para 81–82). When Level 1 and 2 measures cannot be determined, financial valuation techniques using a combination of observable and unobservable inputs are employed to calculate an asset or liability’s fair value (IFRS 13, para 86–89). This is often referred to as a marked-to-model fair value (Level 3) as opposed to a marked-to-market value (Level 1) (see Haswell and Evans, 2018). From a neoliberal standpoint, the fact that an asset is measured at a less reliable3 amount is offset by the marginal benefit of providing more relevant information about future cash flows (Whittington, 2008a). In other words, measurement or estimation uncertainty does not necessarily undermine the usefulness of an entity’s financial statements. This is because the primary objective of financial statements is seen as providing information which can be used by current and prospective investors and creditors to estimate future cash flows and value the entity. In the context of an efficient market, any uncertainty about the quantum of future cash flows inherent in an asset or liability is considered when evaluating risk. Rather than preclude the recognition of the asset or liability in the statement of financial position the element is accounted for but the value assigned is adjusted for any uncertainty (Barth, 2006). By using current measures of value, comparability is enhanced and more efficient capital allocations are possible (see Bryer, 2000). In contrast, a stewardship paradigm requires exogenous changes in net asset values to be excluded from measures of financial position and performance because these distort measures of management’s performance (see Whittington, 2008a; Zhang and Andrew, 2014). Accounting can only reduce information asymmetry and agency costs if assets and liabilities are measured reliably. As a result, past transactions should be the focal point of the accounting system rather than subjective projections of future cash flows. The statement of financial position can provide important information to users but only if a prudent approach is adopted, which refrains from recognising assets or liabilities unless it is probable that an inflow or outflow of resources will take place (Basu and Waymire, 2006; Whittington, 2008b; Barker and McGeachin, 2015). This needs to be complemented with measures of earnings (including

1 A general discussion of neoliberalism is beyond the scope of this chapter. Only aspects crucial to following the chapter’s objective are discussed. 2 While many IFRS standards still permit or require historical cost-based measurements, this is often attributed to the entrenchment of stewardship principles (see Whittington, 2008a; Ravenscroft and Williams, 2009; Georgiou and Jack, 2011; Durocher and Gendron, 2014). 3 Marked-to-model fair values are argued to be less reliable because of the inherent subjectivity and complexity when fair values must be estimated using valuation techniques (see Haswell and Evans, 2018).

Outlining commitment and resistance to dominant accounting paradigms  175 the attribution of asset costs) which, in conjunction with the statement of financial position, can be used to assess the return on capital employed. A summary of the accounting features aligned with a neoliberal and stewardship logic is provided in Table 10.1. Table 10.1

Summary of accounting features associated with each paradigm

Feature

Neoliberalism

Stewardship/accountability

Primary decision/s users seek

● Whether to buy, hold or sell shares and other

● Whether management has performed dutifully

to make

securities in the reporting entity

Objective of financial statements

in their stewardship of company resources

● To facilitate the determination of the future net ● To facilitate the judgement of management’s cash flow potential of the reporting entity and

actions and inactions with regards to its custo-

dianship over company resources ● Relevance to current market conditions affect- ● Reliability and verifiability of figures to estimate its value

Key attributes and trade-offs of included information

ing asset/liability valuations ● Relevance is prioritised over reliability

facilitate accurate judgement of management’s actions and inactions

● Faithful representation (no prudence exercised) ● Reliability is prioritised over relevance/current ● Early recognition of assets and liabilities; uncertainty incorporated into measurement ● Correctly determine asset and liability values (balance sheet focus) ● Income is the change in asset and liability values

information ● De-emphasises recognition of changes in value not under management’s control ● Prudence is emphasised to address agency costs ● Correctly determine income and expenses using matching concept (income statement focus)

How estimation/measurement uncertainty is dealt with

● Recognise assets/liabilities when there is the potential to generate inflows/require outflows

● Recognise assets/liabilities when the inflow/ outflow is probable ● Apply prudence

Preferred measurement basis

● Fair value

● Historical cost

● Movements in net assets measured at fair value ● Match income and expenses provides income View on past transactions versus future cash flow

● Cost represents sunk costs with little relevance ● Historical cost is vital for ensuring reliability to current information needs ● Readily forecast future expectations from

● Minimise subjectivity, including forecasting future cash flows

a market perspective

Source:

Adapted from Maroun et al. (2022).

EPISTEMIC COMMITMENT AND RESISTANCE Despite the IASB’s efforts to advance a finance-centric position favouring the use of fair value measurements (Whittington, 2008a; Zhang and Andrew, 2014), cost accounting remains firmly rooted in professional discourse. Ravenscroft and Williams (2009) attribute this to the fact that ‘information usefulness’ (at the heart of the neoliberal accounting movement) lacks internal consistency and coherence. Changes to accounting principles are not based on scientific or technological developments but changing social and political trends which favour neo-classical economics over accounting’s conventional stewardship function (see also Bengtsson, 2011).

176  Research handbook on financial accounting In the absence of an unambiguous referent (beyond compliance with a dominant set of rules), ‘the structure of accounting systems remains rooted in accountability’ (Ravenscroft and Williams, 2009, p. 777). The long history of accounting’s stewardship function is grounded in a deeply held set of beliefs in or traditions of stewardship which are sufficient to justify retaining at least some cost-based accounting principles when developing and applying accounting policies (Ijiri, 2005; Murphy et al., 2013; Macve, 2015). Consequently, a complete shift from the stewardship to neoliberal knowledge template is not achieved and accounting practices become a mix ‘of rules and valuations justified on the dubious argument that the resulting statements are useful because they are being produced in accordance with principles of financial economics’ (Ravenscroft and Williams, 2009, p. 784). Variations in the level of acceptance of neoliberal/fair value paradigms are also apparent in how fair value is interpreted and the requirement to measure an asset at fair value is applied by individual accountants and auditors (Durocher and Gendron, 2014). Some practitioners are strong proponents of the fair value knowledge template. They react positively to the proliferation of fair value accounting and revisions to the Conceptual Framework (see Whittington, 2008a; Murphy et al., 2013) which favour a neoliberal paradigm (see Ravenscroft and Williams, 2009). For these individuals, fair value resonates with their own views on the role of financial reporting and how to produce high quality financial statements. Consequently, they have no difficulty understanding fair value and can easily incorporate fair value requirements into their daily professional activities (Durocher and Gendron, 2014). In contrast, “others, who are more substantively committed to the historical cost template, may find it difficult to implement fair-value standards, given the gap over what these practitioners fundamentally believe accounting should be” (Durocher and Gendron, 2014, p. 634). This makes resistance to fair value accounting possible. Resistance While resistance in different settings is well documented, the mechanisms by which opposition to new rules and regulations operate are not explicitly addressed; but different resistance strategies can be teased out of the prior research. In a management context, the functionality of new systems and processes can be questioned on technical or operational grounds and used to trivialise certain policies or to justify circumventing normal protocols to deal with ‘exceptions’ (Cowton and Dopson, 2002). Monitoring processes takes advantage of technological developments to provide an expanded sense of hierarchical surveillance (Hopper and Macintosh, 1993) complemented by a broader peer-review surveillance network (Brivot and Gendron, 2011). Unintended consequences can, however, result. Individuals working in a professional environment and subject to additional scrutiny take steps to conceal their activities, refrain from sharing information or engage in symbolic displays of compliance while underlying actions and behaviours remain largely unaltered (see also Roberts and Scapens, 1985). Roberts (1991, 2001) concentrates on the individualising effect of corrective monitoring and review. Subjects of surveillance are not docile. Their need for self-preservation drives them to exploit gaps in the field of visibility. Tremblay and Gendron (2011) provide a different account. New rules and regulations are subject to informal ‘trials of strength’ as they are reviewed, interpreted and applied by different individuals in different contexts (see also Rodrigues and Craig, 2007). When prescriptions are accepted, they are described in a rational

Outlining commitment and resistance to dominant accounting paradigms  177 positive discourse and give rise to substantive change. When this is not the case, they are framed in a manner which negates the need for material reform. Possible mechanisms of resistance include: distancing the respective organisation from the need for change, disputing the effectiveness of proposed reforms or rationalising an adverse event which results in calls for change as an isolated occurrence. A similar approach is followed in a financial reporting context where the decision-usefulness of fair value accounting is challenged on the grounds that it is difficult to understand, is inherently unreliable or poses a number of implementation challenges/costs (Durocher and Gendron, 2014). The prior literature usually points to resistance as a logical result of a tension between knowledge templates. The outcome is binary. Dissidents resist new prescriptions while other constituents dutifully comply. A more nuanced perspective is provided if the manner and extent of resistance to fair value accounting is used to gauge the underling commitment to an alternative cost paradigm. Individuals who identify accountability or stewardship as a defining feature of the accounting system challenge the appropriateness of fair value accounting on a conceptual basis. The thesis that fair value accounting is appropriate because it is grounded in economic and finance theory is associated with a counter-thesis challenging the appropriateness of quasi-scientific assumptions at the heart of these paradigms and advancing an alternate theoretical perspective on accounting (see Rodrigues and Craig, 2007; Ravenscroft and Williams, 2009). This means that arguments against the use of fair value accounting are technical, rather than procedural, and supported by a clear view on the fundamental role of financial statements and the adverse implications of fair value accounting for the users of the financial statements. Conversely, practitioners subscribing to the fair value knowledge template can give clear examples of precisely how fair value accounting generates useful information and evidence that they are actively implementing fair value accounting as prescribed by the applicable financial reporting standards. Between these two extremes are the “flexible adherents” whom Durocher and Gendron (2014, p. 649) describe as acknowledging the role of fair value measures in contemporary accounting and exhibiting a ‘high degree of obedience to formal standard-setting authorities’. They may not, however, “be substantively inclined toward fair value or historical cost, having a kind of generically malleable epistemic commitment which translates into flexible adherence toward knowledge templates in vogue” (Durocher and Gendron, 2014, p. 634). As a result, if there is any resistance to fair value accounting, it tends to be procedural or operational in nature, rather than conceptual. It is unlikely that a flexible adherent will raise concerns about the underlying principles of neoliberal accounting or the implications of fair value accounting for users of financial statements. Drawing on Tremblay and Gendron (2011), flexible adherents may also include those individuals who dispute the relevance of fair value accounting at the conceptual level but, because of coercive pressures to demonstrate compliance with accounting standards, adopt fair value measures ceremonially. These accountants are unlikely to have an appreciation of the technical detail of fair value accounting. Instead, they rely on market prices, reports from valuation experts or the guidance of external auditors to conclude that fair value measures are appropriate. Without a true commitment to an underlying neoliberal paradigm, fair value is only used when required and the argument that the cost of determining fair values exceed the benefits is often raised.

178  Research handbook on financial accounting The relationship between the commitment to one accounting paradigm and resistance to the other is summarised in Figure 10.1.

Source:

Adapted from Maroun and van Zijl (2022).

Figure 10.1

Degrees of commitment to fair value or cost accounting

EVIDENCE FROM SOUTH AFRICA To provide empirical details on the extent to which fair value is applied and how resistance to fair value is operationalised by its opponents, the remainder of this chapter summarises earlier research on the experiences of the South African accounting community. The Use of Fair Value Accounting and Related Challenges The first-time adoption of IFRS provides a useful setting to gauge support for fair value accounting because IFRS allows measurement bases for assets and liabilities to be easily changed. Christensen and Nikolaev (2009) found that of 1,539 German and UK companies, 44 percent switched from fair value to cost accounting on transition. In comparison, only 1 percent switched from cost to fair value accounting. Where fair value was adopted, it was primarily for property and never for intangible assets. Companies are equally likely to adopt cost and fair value accounting for investment property, except where their core business is real estate. In these cases, fair value accounting was more common.

Outlining commitment and resistance to dominant accounting paradigms  179 The results from a developing country align with those of Christensen and Nikolaev (2009). Covering 2013–2017, van Zijl and Hewlett (2022) found that companies listed on South Africa’s Johannesburg Stock Exchange (JSE) made limited use of fair value accounting. Of all elements carried at fair value, JSE-listed firms adopted fair value accounting for financial instrument (84 percent) and investment property (8 percent). Only 13 percent of assets and liabilities adopting fair value were classified as Level 1 valuations, supporting claims by Barker and Schulte (2017, p. 55) that fair value accounting for non-financial operating assets is often ‘unknowable’. JSE-listed firms report fewer Level 1 and 2 fair values and more Level 3 fair values over time (van Zijl and Hewlett, 2022). This may not reflect issues with underlying market and valuation fundamentals, but rather the fact that proactive monitoring by the JSE revealed that companies were misclassifying Level 3 measures as either being Level 1 or Level 2. The exchange required firms to correct this error, leading to an increase in Level 3 measures being reported (JSE, 2018). A misunderstanding of the requirements of IFRS is possible. Equally possible is that companies sought to avoid onerous disclosure requirements for Level 3 valuations by misclassifying them (van Zijl and Hewlett, 2022). A positive relationship between the level of uncertainty inherent in a fair value measure and audit fees may also encourage companies to misclassify fair value levels to reduce audit scrutiny and associated costs (Ettredge et al., 2014; Alexeyeva and Mejia-Likosova, 2016). Drawing on the limited extent of Level 1 fair values, Christensen and Nikolaev (2009) and van Zijl and Hewlett (2022) call the relevevance and reliability of the fair value paradigm into question. As explained by Barker and Schulte (2017), fair value is conceptually valid when Level 1 valuations are used because these are the only market-based estimates which are directly observable. The more management estimates are incorporated into ‘fair values’, the less likely it is that the valuation captures market assumptions. Paradoxically, the increased use of Level 2 and Level 3 ‘fair values’ points to the fact that ‘fair value’ is actually ‘unknowable’. What appears to be a fair value is “expedient, unstable and ultimately in direct contradiction of the marker participant’s perspective” (Barker and Schulte, 2017, p. 56). Unsurprisingly, fair value accounting is more widely adopted and accepted for financial than non-financial assets and liabilities and, as a result, is more prevalent in the financial services sector (Christensen and Nikolaev, 2009; Barker and Schulte, 2017; van Zijl and Hewlett, 2022). In this industry, fair value accounting aligns closely with organisations’ business models (Christensen and Nikolaev, 2009; Barker and Schulte, 2017; van Zijl and Hewlett, 2022). While it may be expected that active market prices are available for most financial instruments, van Zijl and Hewlett (2022) found that the South African financial services sector had the highest proportion of Level 3 fair values (67 percent) of all South African industries. This may be because the industry holds many non-listed instruments, such as loans to and from customers and the fact that South Africa’s capital market is not as deep and active as those of developed economies. Pandya et al. (2021) interviewed 20 South African accounting experts including preparers of financials statements, regulators, auditors and academics. Impediments to the adoption of fair value accounting included: ● a reluctance to invest in training; ● the cost of developing new systems and updating current practices;

180  Research handbook on financial accounting ● the absence of Level 1 input data requiring the use of more complex and costly Level 2 and 3 measures; and ● increases in audit fees associated with more extensive use of fair value measurements. The additional disclosures required by IFRS when fair values are used is a related concern. On the one hand, transparency is enhanced. On the other, the time expended to prepare financial statements increases and there is no guarantee that investors and creditors respond favourably to the added disclosure (Pandya et al., 2021, p. 229). Paradoxically, so much information is disclosed to support fair value that users are overwhelmed and either do not read the additional information or only review it at a high level (Pandya et al., 2021; Maroun and van Zijl, 2022). Evidence of Resistance to Fair Value Accounting Preparers’ responses to the challenges of fair value accounting included (1) where possible, selecting accounting policies that did not use fair value; (2) adopting a compliance approach to reporting; and (3) relying on auditors to correct shortcomings in their fair value application (Pandya et al., 2021). Each can be viewed as a type of resistance to fair value accounting (discussed in more detail below). Resistance by the proponents of historical cost accounting Objections to the use of fair values to measure assets and liabilities by proponents of historical cost accounting include (Baudot, 2018; Maroun and van Zijl, 2022): ● There is a disconnect between the manner in which an asset is used and the requirement to measure it at an exit price. ● The volatility of certain fair value measures suggests that there has been a significant change in how an asset is being deployed when this is not the case. ● Historical costs are not irrelevant because they are used as the starting point in most analysts’ valuations. Conversely, many marked-to-market or -model adjustments are reversed by analysts. ● Fair values are based on assumptions by ‘hypothetical market participants’. These are largely theoretical, difficult to implement in practice and subject to manipulation. As a result, fair values may appear more objective and useful than they actually are. The criticisms of fair value are conceptual. Some accountants are concerned that fair values are unreliable and do not provide a faithful representation of how the organisation is being managed, something which is essential if accounting is to enable better stewardship and accountability. Resistance to fair value accounting by advocates of historic cost accounting is, however, passive. These accountants have no objection to additional presentation and disclosure of fair values. The concerns listed above are only applicable when fair values are used to measure assets and liabilities and are incorporated into the determination of profit and loss. When this is the case, Even when confronted with a conflicting knowledge template, proponents of historical cost accounting [default] to the importance of professionalism and ensuring transparent reporting … [Any] reservations about using fair value accounting are addressed in consultation with clients, the professional accounting bodies and the standard-setter and not by deliberately departing from IFRS. (Maroun and van Zijl, 2022, p. 228)

Outlining commitment and resistance to dominant accounting paradigms  181 Resistance by flexible adherents Some accountants are flexible adherents with an affinity for neither historical cost nor fair value accounting. They tend to resist any accounting requirements which are perceived as more difficult, time consuming or costly to implement. This is often the case with fair value accounting, especially when Level 2 and 3 valuations must be determined. Like proponents of historical cost accounting, flexible adherents do not depart explicitly from IFRS. As is the case with many jurisdictions, South Africa mandates the use of IFRS by listed companies. Nevertheless, subtle forms of resistance are used to de-couple statements of compliance with IFRS from messier technical applications which may not be entirely consistent with the relevant accounting prescriptions: ● Company-level policies detailing how fair values are calculated are set. The policies are strictly adhered to but are not tailored for additional facts and circumstances arising in different parts of the organisation even if this would lead to a more appropriate measure of fair value. Post-implementation reviews, calibration checks and formal reconciliations of policy requirements to the provisions of IFRS 13 are performed either at a high level or not at all. ● Even if policies to calculate fair value are technically sound, they are only loosely applied. There is no guarantee that fair values are being consistently and accurately determined by different parts of the organisation even when dealing with the same or similar assets. Operational complexity and the fact that not every judgement is documented and reviewed allows subtle departures from IFRS to go undetected by managers and auditors. ● In other cases, accountants understand that fair value must be determined but, because there is no appreciation for how fair value provides useful information, the relevant systems were not put in place. Access to Level 1 values may be limited and the data needed for computing Level 2 and 3 measures may be unavailable. What appears to be a sound estimate of future cash flows is actually management’s best guess. Alternatively, the responsibility for determining fair value is outsourced to a third party, including auditors. Rather than forming an integral part of the core accounting function, fair value becomes an ancillary issue and the results reported by an external service provider are accepted without question. ● Flexible adherents are also quick to argue that the cost of accurately determining fair value exceed the benefits and that variations in estimates because of poor valuation methodologies are immaterial. Rather than being seen as loose applications, at best, or non-compliance with IFRS, at worst, inappropriate fair value determination is legitimised on the grounds of efficiency and a sound understanding of users’ needs.

DISCUSSION AND CONCLUSIONS Consistent with Durocher and Gendron’s (2014) findings, in the absence of cognitive unity in financial reporting, epistemic commitment to fair value accounting is uncertain and resistance to it becomes inevitable. There are, however, degrees of resistance. Proponents of a stewardship knowledge template do not completely reject the use of fair value. It is only when exogenous gains and losses are recognised in the financial statements that stewardship is undermined and resistance results. This takes place at the ideological/

182  Research handbook on financial accounting conceptual level and is primarily focused on whether or not fair value provides a faithful representation of how the organisation is being managed necessary for enabling stewardship and accountability. Some practitioners are flexible adherents. They do not fully subscribe to a stewardship or neoliberal framework but continue to resist the implementation of fair value accounting. This is not on the grounds of a conceptual flaw in fair value accounting, but context-specific operational challenges which make the use of fair value accounting cumbersome, costly or time consuming. Put simply, flexible adherence leads to resistance out of self-interest rather than due to ontological challenges, as in the case of accountants supporting historic cost accounting. As a result, flexible adherents are more likely to adopt fair value accounting symbolically. They do not necessarily adhere to all of the accounting prescriptions. Financial statements are presented on the basis that they comply with IFRS but preparers depart from strict application of fair value methods on the grounds that costs exceed benefits and any differences are immaterial (Maroun and van Zijl, 2022). Degrees of resistance to fair value accounting have important implications for standard setters and regulators. If the IASB and FASB are moving to a neoliberal accounting model (Ravenscroft and Williams, 2009; Zhang and Andrew, 2014), the focus should not be on proponents of accountability to ensure consistent application of accounting standards. These accountants are unlikely to comply with IFRS only superficially. Even if they disagree with fair value accounting, they rely on engagement with clients, professional bodies and the standard-setters to resolve their concerns and lobby for changes. In contrast, flexible adherents are not grounded in a principles-based approach to accounting. Their decision to comply with IFRS is informed by self-serving assessments of the cost and effort of doing so. Without a sound ontological grounding, it is easy for flexible adherents to decouple accounting policy from practice. This means that prescriptions designed to reduce non-compliance with IFRS need to be tailored to address the mechanisms used by flexible adherents to depart from accounting standards. Similarly, external auditors and regulators should be aware of the fact that cost versus benefit or materiality assessments may be indicators of an elevated risk of misstated accounting measures. Finally, a number of questions are raised which may be the subject of future research. For example, how does an accountant’s formal and informal training and working environment influence commitment to accounting standards? The prior research assumes that the professional accounting community is homogeneous. It is possible that cultural or social variables (and changes in these factors over time) influence how IFRS developed by the IASB and FASB are operationalised in different regions. The research community has dedicated significant attention to understanding the professionalisation project at the institutional level (see, for example, Power, 1996; Cooper and Robson, 2006; Malsch and Gendron, 2011). Exactly how individuals internalise and contribute to the social and political pressures which shape the accounting discourse needs more attention.

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11. Value-relevance of intangibles – a structured literature review Olga Grzybek and Elena-Mirela Nichita

INTRODUCTION This chapter reviews the literature on value-relevance of intangibles to achieve several goals. First, we present a systematic and structured overview of this important field of accounting research. Second, by critical assessment of extant studies, we point out gaps and avenues for further research to produce new and deeper insights. By analysing the value-relevance of intangibles, we inform the discussion on the importance of intangibles for equity valuation. In the knowledge economy many parties have an interest in intangibles: researchers, practitioners and regulatory bodies (Garanina et al., 2021). Intangible resources such as corporate reputation, employee motivation or innovativeness are considered key to achieving business success (Castilla-Polo & Ruiz-Rodríguez, 2017). Researchers argue that intangibles are the most important value-creating resources of modern enterprises, not only in the high tech and science-based industries (Ferdaous & Rahman, 2019; Lev, 2018). Not all intangible resources are recognized in the statement of financial position of a company because of the strict requirements of International Accounting Standard 38 Intangible Assets (IAS 38). Intangible assets – identified and recognized in the balance sheet – constitute only a small part of all intangible resources used by companies in their activities. The other part, broadly called intellectual capital, remains beyond financial statements. For that reason, it is argued that the usefulness of financial information is declining (Lev & Gu, 2016). Is it really the case? The academic literature related to intangibles is extremely extensive (see Appendix 1 in Zambon et al., 2020) with a great deal of literature reviews concerning intangible assets and/ or intellectual capital – issues of reporting, managing, measuring, valuation and finally disclosing information on those resources. Recent literature reviews include the ones by Pastor et al. (2017), Castilla-Polo and Ruiz-Rodríguez (2017), Nichita (2019), Vanini and Rieg (2019), Zambon et al. (2020), Garanina et al. (2021), to name only a few. One of the most challenging questions in accounting research on intangibles is what kind of information on intangibles is relevant to the information users, especially investors as the primary stakeholders group? How well accounting amounts reflect information used by equity investors is in the scope of so-called value-relevance research. This is a broad stream of research conducted in a variety of accounting issues, beginning with the general accounting information, and ending up on corporate social responsibility and integrated reporting (Dunham & Grandstaff, 2022; Veltri & Silvestri, 2020; Wulan, 2022). An accounting amount is value-relevant if it has a predicted association with equity market value (Barth et al., 2001). According to Holthausen and Watts (2001), value-relevance studies typically compare the association between stock market values and alternative bottom-line measures (relative association studies), investigate whether the accounting number of interest is helpful in explaining value or returns in the long-term given other specified variables (incremental association studies), or investigate whether a particular 185

186  Research handbook on financial accounting accounting number adds to the information set already available to investors (marginal information content studies based on event studies). Although the value-relevance of intangibles is the main object of many studies, they are not sufficiently reviewed and summarized in the literature. The only literature review devoted entirely to this topic is the one by Güleç (2021). Our chapter complements and deepens his work substantially by conducting a more systematic and structured literature review with bibliometric analysis. Therefore, in this set-up, our research questions are: RQ1: How is the research on the value-relevance of intangibles developing? RQ2: What are the main trends and future directions for the research on the value-relevance of intangibles? The remainder of the chapter is as follows. The next section describes a structured literature review method employed to investigate the value-relevance of intangibles. The third section provides insights and a critique of the value-relevance of intangibles literature. The fourth section offers avenues for further research.

RESEARCH METHODOLOGY To select relevant academic papers, this literature review covers papers indexed in Scopus database. The search was limited to papers written in English and based on a keyword search within titles, abstracts and keywords of the articles. The following keywords were used: intangible*, r&d, intellectual-capital in connection with value-relevan*, in order to provide results focused on the topic under investigation.1 This search strategy returned 216 potentially relevant records which were migrated into an Excel database. The corpus was then reviewed for relevance by two researchers independently; the researchers reading the abstracts, and the full text if needed. Afterwards, researchers compared their assignments and discussed all cases where inconsistencies occurred until reaching agreement. All literature reviews, discussion articles without original empirical findings and records doubled in Scopus were excluded. This procedure resulted in 140 articles to review. However, due to the access restrictions, the final sample consisted of 118 papers with the full text available, which constitutes 84 percent of relevant papers. Table 11.1 presents the analytical framework employed in this study. At this step, an initial framework was developed based on the categories used in previous structured literature reviews that are relevant to our context. The content analysis was used to manually code all 118 articles by one author. Afterwards, the analytical framework was discussed and amended together by two co-authors. Every paper was finally coded according to the revised analytical framework. We decided that one author would code all papers within a single category, which ensures consistency of coding. To ensure reliability of this literature review, when coding a paper within the selected categories, each author scrutinized the coding results of the co-author within remaining categories. Ambiguities were resolved by consulting the co-author, and discussion. The exact string for advanced search: (TITLE-ABS-KEY (intangible*) OR TITLE-ABS-KEY (r&d) OR TITLE-ABS-KEY (intellectual-capital) AND TITLE-ABS-KEY (value-relevan*)) AND (LIMIT-TO (LANGUAGE, “English”)). 1

Value-relevance of intangibles – a structured literature review  187 Table 11.1

Analytical framework

Category

Attributes

Results

Article

Title

118 unique titles

Journal

71 unique journals

Year

1996 to 2022

Author(s)

240 unique names

Number of Scopus citations

0 to 989 citations

Archival research:

115

97%

a. Ohlson model (1995)

3

3%

Archival data (research unit)

1

 

a. annual reports

27

Research methods

b. Barth model (1994) c. Barth and Clinch (1998) model d. Other type of regression e. Event study f. Portfolio analysis g. Mixed methods Perception study (survey, interview) Type of data used

b. firms c. firm-year observations d. brands Interviews

86 1 1 2

Surveys Country of research Research period

Industry focus

Single-country

102

Multi-countries

16

14%

Single year

10

8%

Two non-consecutive years

5

4%

Multi-period analysis

96

81%

Comparative analysis (pre-post regulation) Specific industry:

7 28

6% 24%

a. biotech, pharma

7

6%

7

6%

2

2%

5

4%

7

6%

48

41%

39

33%

3

3%

b. electronics, IT c. financial d. hi-tech in general e. other specified (restaurants, tourism, semiconductors, metals) Non-financial companies only Without limitation Main research focus

Not applicable (survey) R&D

86%

36

31%

Intangible assets recognized in financial statements

25

21%

Intellectual capital

23

19%

Other

34

29%

RESEARCH RESULTS RQ1: How is the research on the value-relevance of intangibles developing? Figure 11.1 shows that the annual volume of papers focused on the value-relevance of intangi-

188  Research handbook on financial accounting bles tends to increase over time. This stream of research has been developing since the seminal paper by Lev and Sougiannis (1996), which remains the most influential paper in the field (see also Table 11.2).

Figure 11.1

Number of papers per year

The sample articles were published in 71 unique journals. The journal that published the most papers on the value-relevance of intangibles is the Journal of Intellectual Capital with nine papers being published. Twenty-six papers (22 percent of selected articles) were published in the top 10 percent of journals in the “business, management and accounting” area

Figure 11.2

Number of citations (individual and cumulative)

Value-relevance of intangibles – a structured literature review  189 according to the Scopus ranking of journals. It proves the interest in the market consequences of information on intangibles. The total annual number of citations of all papers reviewed as well as the average number of citations per paper (cumulative) have increased almost constantly since 1996 (see Figure 11.2). That confirms the development of the research on the value-relevance of intangibles. Thirty-one documents have been cited at least 30 times. Interestingly, the top 25 percent of articles contribute to 80 percent of citations, which may suggest that Pareto’s 80/20 rule applies to citation patterns (Abramo et al., 2016; Pak et al., 2018). In line with previous research (Garanina et al., 2021; Tsalavoutas et al., 2020; Vanini & Rieg, 2019), we measure the impact of an article by the number of total citations and the number of citations per year. Much research uses Harzing’s software Publish or Perish and Google Scholar citations to measure article impact. However, Google Scholar citations count citations from both peer-reviewed and non-peer-reviewed works, i.e. newspapers and magazines (Dumay, 2014). Although such broad citation sources offer insight on an article’s general reach, we believe citations from high-quality journals better capture the article’s impact on knowledge development. Therefore, we identify the most influential papers using only citations from Scopus, which is one of the largest abstract and citation databases of peer-reviewed literature (Massaro et al., 2016). Table 11.2 presents the results. As already mentioned, the most influential paper by Lev and Sougiannis (1996) has the highest number of citations and citations per year (CpY). Articles that deserve special attention are those by Raithel and Schwaiger (2015) and Lourenço et al. (2014). Although both of them were published relatively recently, they already have high citation measures. Additionally, the very recent paper by Wong and Zhang (2022) is rapidly gaining new citations. All these articles relate to corporate reputation, especially in the context of sustainability. Research Methods This chapter analysed the research methods preferred by authors when they investigated the value relevance of information provided by intangibles. The vast majority of selected papers (97 percent) are archival research, which is not surprising given the topic of value-relevance. Only three papers present a direct information user’s perspective by a survey or interview. Commonly, researchers adapt the Ohlson model (1995) that develops theoretical underpinning for the relationship between the market value of equity and accounting numbers and enables including additional variables as “other information” in the model. The academic literature recognizes the status of this model as the best known model of value relevance, aimed at formalizing the relationship between accounting values and firm value. The Ohlson model (Ohlson, 1995) is adopted by about one quarter of papers (23 percent). The papers which analyse intangible assets recognized in the financial statements apply quantitative methods with regression analysis: derivatives of Ohlson model (25 percent), Barth model (1994); Barth and Clinch model (1998) or another regression which regresses some kind of market value on a variety of independent and control variables. Papers investigating intangibles not recognized in the financial statements (e.g. intellectual capital; marketing capabilities) use mixed methods, mainly content analysis complemented by a regression model. A single paper applies an event research design (Gu & Li, 2010). In case of perception studies (three papers), authors conducted surveys (two papers) or interviews (one paper).

The most influential papers on value-relevance of intangibles

Lev and Sougiannis (1996)

Aboody and Lev (1998)

Raithel and Schwaiger (2015)

Black et al. (2000)

Lourenço et al. (2014)

Hirschey et al. (2001)

Kallapur and Kwan (2004)

Aharony et al. (2010)

Amir et al. (2003)

Rajgopal et al. (2003)

1

2

3

4

5

6

7

8

9

10

Title

firms

The value relevance of network advantages: The case of e-commerce

Do financial analysts get intangibles?

accounting numbers for security investors in the EU

The impact of mandatory IFRS adoption on equity valuation of

firms

The value relevance and reliability of brand assets recognized by UK

Value relevance of nonfinancial information: The case of patent data

The value relevance of reputation for sustainability leadership

The market valuation of corporate reputation

shareholder value

The effects of corporate reputation perceptions of the general public on

The value relevance of intangibles: The case of software capitalization

The capitalization, amortization, and value-relevance of R&D

Authors

Lev and Sougiannis (1996)

Wong and Zhang (2022)

Raithel and Schwaiger (2015)

Aboody and Lev (1998)

Lourenço et al. (2014)

Aharony et al. (2010)

Garanina and Dumay (2017)

Oliveira et al. (2010)

Vafaei et al. (2011)

Kallapur and Kwan (2004)

No.

1

2

3

4

5

6

7

8

9

10

101

7.62

firms

The value relevance and reliability of brand assets recognized by UK

The value relevance of intellectual capital disclosures

stock exchange

Intangible assets and value relevance: Evidence from the Portuguese

intellectual capital and integrated reporting

6.00 5.32

The Accounting Review

6.31 Journal of Intellectual Capital

The British Accounting Review

6.50

12.33 European Accounting Review

14.50 13.16

16.00 Strategic Management Journal

Journal of Business Ethics

36.63

The British Accounting Review

Journal of Accounting Research

CpY

Journal of Accounting and Economics

92

Journal of Accounting Research

Source

95

European Accounting Review

99

102

The Accounting Review European Accounting Review

111

Review of Quantitative Finance and Accounting

116

Strategic Management Journal

114

329

Journal of Accounting Research

Journal of Business Ethics

989

Journal of Accounting and Economics

Corporate Reputation Review

Citations

Source

Forward-looking intellectual capital disclosure in IPOs: Implications for Journal of Intellectual Capital

accounting numbers for security investors in the EU

The impact of mandatory IFRS adoption on equity valuation of

The value relevance of reputation for sustainability leadership

The value relevance of intangibles: The case of software capitalization

shareholder value

The effects of corporate reputation perceptions of the general public on

Stock market reactions to adverse ESG disclosure via media channels

The capitalization, amortization, and value-relevance of R&D

Title

Panel B: The top 10 papers by citations per year (CpY)

Authors

No.

Panel A: The top 10 papers by total number of citations (NoC)

Table 11.2

190  Research handbook on financial accounting

Value-relevance of intangibles – a structured literature review  191 However, researchers employ very different research designs with both dependent and independent variables defined in a different way, e.g. a dependent variable may be the equity market value (Dinh & Schultze, 2022; Kumari & Mishra, 2019), share price (variables deflated by the number of shares outstanding; Ciftci & Zhou, 2016; Ferguson et al., 2021) or returns (Callimaci & Landry, 2004; Cazavan-Jeny & Jeanjean, 2006). Next to those commonly used dependent variables, other market-based variables are used less frequently, such as like Tobin’s q or market to book value. Additionally, one paper uses the value of growth options as a percentage of total equity value (Makrominas, 2017) and one paper uses unsigned forecast error (Cheong et al., 2010) as a dependent variable. The dichotomic model is applied by Tutticci et al. (2007) for the dependent variable, which takes the value of 1 when firms capitalize some R&D expenditure in a given year, and a value of 0 when firms expense all R&D costs. The reputation is considered the appropriate dependent variable by Raithel and Schwaiger (2015). When adapting their models, some researchers adjust equity book value and/or earnings for the amounts of intangibles investigated (e.g. Ariff et al., 2014; Chalmers et al., 2008) and some others do not make any adjustments to book values (e.g. Al-Ani & Tawfik, 2021; Kimouche & Rouabhi, 2016). In the latter case the amounts of intangible assets are included in the model twice: in the book value of net assets and as a separate variable. Type of Data Used In our analysis we investigated sources and the data set used by authors to conduct their research. As expected, the data are mainly extracted from databases (95 percent of papers). A single paper is prepared based on the brand values, information provided by brand valuation consulting firms (Bagna et al., 2017). Ellis and Seng (2015) investigated the voluntary disclosure of intellectual capital in 284 annual reports covering three years (2008, 2009, 2010). The perception studies (two papers in our sample) conducted by Petty et al. (2008) and Sakakibara et al. (2010) are relying on data collected through surveys administered to a group of financial professionals in Hong Kong or a large sample of Japanese financial analysts. Country of Research With regard to the region being investigated, most papers are single-country research, with the US being investigated the most extensively (39 papers and an additional three papers with a multi-country approach), Australia is in the second place (13 single-country + four multi-country papers) and the UK third (7+10 papers, respectively). These are three common-low countries with Anglo-Saxon accounting. However, the accounting for intangible assets differs substantially in these countries. ASC 730 in the US generally does not allow capitalization of research and development costs, UK SSAP 13 gives the discretion to capitalize or expense development costs, while Australian GAAPs prior to IFRS allowed a broad recognition of internally generated intangible assets. Differences in local GAAP may impact substantially the research findings. The map in Figure 11.3 presents the countries investigated in papers included in our review.

192  Research handbook on financial accounting

Figure 11.3

Geographical distribution of sample used in investigated papers

Research Period Papers included in this literature review use data from a single period (1 year; 10 papers), two non-consecutive years (five papers), and 81 percent of papers are constructed based on large observations covering 3 to more than 20 years. An analytical investigation shows that more than 50 percent of papers cover 5 to 10 years, about 30 percent of papers use data for a period between 11 to 20 years and approximately 15 percent covers more than 20 years. Our sample includes seven papers which perform a comparative analysis of intangibles, before and after IAS 38 implementation. The results obtained are mixed: some papers highlight that the value relevance of intangibles increased after IAS adoption (Aharony et al., 2010; Shah et al., 2013), and others inform that intangible assets are value relevant in the pre IFRS period, but are not value relevant in the post adoption period (Azin & Alias, 2019). Gong and Wang (2016) disclosed that there is no change in the value relevance of R&D expenses for countries that switched from the mandatory capitalization rule to IFRS. For Italian companies, the implementation of IFRS led to particular results: goodwill, intellectual property and other rights, start-up costs and other intangible assets are value relevant in the pre-IFRS adoption period, except for R&D. In respect of intellectual capital, the paper of Kulshrestha and Patro (2021) concluded that, even if the quantity disclosed increased, the quality of intellectual capital reporting decreased; therefore, the value relevance is lost. By contrast, Ariff et al. (2014) show that voluntary disclosure of intangibles is value relevant, over and above the numbers in the balance sheet and income statement. The analysis is performed for eight companies located

Value-relevance of intangibles – a structured literature review  193 in East Asian countries, and the data refer to 2007 when firms in the sampled countries either adopted IAS 38 on intangible assets or had accounting standards similar to IAS 38. The current chapter puts a spotlight on the period of analysis regarding intangibles. Research and development is a highly scrutinised topic, and intellectual capital is the newest stream of interest for academics, available in the research papers starting with 1990 to nowadays (see Table 11.3). Table 11.3

Period of analysis

Category

Starting year

Ending year

Research and development

1962

2017

Intangible assets

1979

2016

Other intangible (recognized in the balance sheet)

1974

2018

Intellectual capital

1990

2019

Industry Focus Regarding sample composition, most research is not focused on a particular industry (74 percent), but commonly researchers exclude financial companies from the sample because of differences in financial statement items. However, financial companies are generally large and important for the economy (Tsalavoutas et al., 2020). We find that 33 percent of studies include financial firms in the research sample while only two studies focus exclusively on financial institutions. RQ2: What are the main trends and future directions for the research on the value-relevance of intangibles? To answer the second research question, each paper was coded to the specific issue that was in the core of the article. We used the text mining feature of VOSviewer software, which constructs co-occurrence networks of important terms extracted from the body of the literature to visualize the scientific landscape in this area (see Figure 11.4 which depicts terms used in at least 10 percent of the papers with a minimum link strength of 5). Three primary categories of intangibles that had been researched are intangible assets, research and development costs, and intellectual capital. When developing our analytical framework, we also added the category “other”, because not all articles might be unambiguously assigned to one out of the three main categories. Consequently, we inductively developed secondary categories that especially relate to the value-relevance of the amounts of intangibles or to the value-relevance of disclosure of information. Research and Development Costs (R&D) The earliest and, at the same time, the most extensively explored research stream is the value-relevance of R&D, which is the core issue of 31 percent of papers. The vast majority of these papers investigate whether the amounts of expensed or capitalized R&D is related to the market value of a company and what is the market participants’ view on these amounts. In general, the broad evidence suggests that both the expensed and the capitalized portion of R&D costs are positively related to the market value of a firm.

194  Research handbook on financial accounting

Figure 11.4

Co-occurrence network

However, Cazavan-Jeny and Jeanjean (2006) indicate that investors in France are concerned with and react negatively to capitalization of R&D. Firms choosing to capitalize R&D are smaller, more highly leveraged, less profitable and have less growth opportunities than firms choosing to expense R&D costs. Other research suggests that the R&D treatment regulated by the IAS 38 contains value-relevant information with the expensed (capitalized) R&D negatively (positively) related to the market value (Napoli, 2015; Tsoligkas & Tsalavoutas, 2011). Wang and Fan (2014) support this evidence on the sample of Chinese firms, which apply similar accounting solutions for R&D. The authors document that firms capitalizing R&D investments have higher stock price and return. Investigating value-relevance of R&D separately for profit and loss firms gives deeper insight. Franzen and Radhakrishnan (2009) state that the valuation multiplier on R&D expenditures is likely to be positive for loss firms while negative for profit firms. Jones (2018) using the real options theory adds that the negative coefficient on the R&D expenditures only exists for low growth profitable firms while it remains positive for loss firms and profitable firms with high sales growth. Additionally, investors may consider capitalized R&D cost as a signal of earning management in non-intangible intensive firms (Kumari & Mishra, 2021). Only a few papers investigate other issues related to the value-relevance of R&D, i.e. R&D intensity (Liu, 2006; Oswald, 2008), accrual component of R&D (Dinh & Schultze, 2011) and R&D spending by rivals (Asdemir et al., 2013). However, the most recent papers in this field relate not to the value of R&D but to disclosure of information. Research suggests that descriptive information has a more significant explanatory power of firm value than a numerical one

Value-relevance of intangibles – a structured literature review  195 (Feng et al., 2022) and that voluntary disclosure of forward−looking information on product pipeline development is value-relevant over and above the mandated financial information (Chen et al., 2017). Intangible Assets Recognized in the Balance Sheet The second research stream investigates the value-relevance of intangible assets recognized in the balance sheet. With few exceptions, research results indicate that intangible assets are value-relevant and positively valued by the market. Interestingly, much research suggests a decline in the value-relevance of intangible assets under IFRS in comparison with pre-IFRS periods, at least for some classes of intangible assets recorded by firms in Australia, Italy and Malaysia (Azin & Alias, 2019; Chalmers et al., 2008; Cordazzo & Rossi, 2020; Ji & Lu, 2014). On the other hand, intangibles capitalized in the post-IFRS periods by Australian firms are negatively associated with earnings forecast error (Cheong et al., 2010), suggesting that the adoption of IFRS may indeed provide more value-relevant information for the users of financial reports. Because many intangible assets may be recognized as a part of the acquisition cost allocation according to IFRS 3 Business combinations, mergers and acquisition are worth consideration when determining the value-relevance of intangible assets. In their pre-IFRS event study, Kallapur and Kwan (2004) found that the stock price reaction during the 21 days surrounding the first announcement of brand recognition is significantly positively associated with the recognized brand amount. Bauman and Shaw (2018) stated that customer-related intangible assets are positively associated with equity prices, although valued at a discount relative to goodwill. Hence, value-relevant information is lost if customer-related intangible assets are subsumed into goodwill rather than being reported separately. There is also evidence (Kwon & Wang, 2020) on the increasing value relevance of goodwill and other intangible assets after SFAS 141(R). Tunyi et al. (2020) report similar results for IFRS 3 amendment in 2008. Finally, we found only one paper, which was by André et al. (2018), that investigated the value-relevance of disclosure of mandatory information on intangible assets. The positive relationship between average disclosure levels and market values was found. However, results for IAS 38 mandatory disclosure level are not statistically significant. Intellectual Capital (IC) Studies on the value-relevance of intellectual capital are far more diversified than those on R&D and on intangible assets in general. Moreover, research interest in the value-relevance of intellectual capital has been developed relatively recently with only one paper published in 2005 and a substantial part of research published from 2008. Two distinct research streams deal with the value-relevance of intellectual capital proxied by different measures or with the value-relevance of IC information disclosure. The first research stream uses different measures of intellectual capital and its components to test their association with the market values, returns, or other firm performance measure. Research on the value-relevance of intellectual capital provides evidence that the total value of intellectual capital is positively related to the firm value (Wang, 2013, 2015; Yang et al., 2015). The productivity of intellectual capital is significantly positively related to share price as well (Kim & Taylor, 2014).

196  Research handbook on financial accounting When intellectual capital components are investigated separately, human capital gains the most extensive research interest with results supporting a positive relationship between human capital and firm performance. Gavious and Russ (2009) suggest that the market values compensation expenses not as expenses but as a human asset omitted from the balance sheets. These results are confirmed by Schiemann and Guenther (2013), who state that employee expenses contribute incremental information content over and above that of earnings alone. On the contrary, a negative relationship was found in the sample of Italian firms (Ferraro & Veltri, 2011). According to Elbannan and Farooq (2016), market participants incorporate changes in labour cost information into their pricing decisions when such cost is reported as a separate line item in the income statement. Finally, García-Zambrano et al. (2018) indicate that investing in training has a positive relationship with the market-to-book ratio a year ahead. Findings associated with other components of intellectual capital are inconsistent and depend heavily on the proxy measure used. Moreover, the value-relevance of intellectual capital components varies during the business cycle (Liang & Lin, 2008; Liang & Yao, 2005). Presumably due to the measurement issues, research on the value-relevance of intellectual capital components other than human capital is scarce. Consequently, a new research trend has been emerging since 2011, using the amount of information on – and not the value of – intellectual capital and its components. With regard to the disclosure of information on intellectual capital, research generally confirms that the higher disclosure level is associated with the higher market value (Alfraih, 2017; Anifowose et al., 2017; Ariff et al., 2014; Dharni & Jameel, 2022; Vafaei et al., 2011). Garanina and Dumay (2017) argue that IPO prospectuses contain significant amounts of IC disclosure and this disclosure influence on post-issue stock performance is positive in both the short and long term. Most recently, Kulshrestha and Patro (2021) found that the quantity of intellectual capital reporting has increased post-IFRS adoption. However, the quality of reporting had fallen significantly, which resulted in the loss of value relevance of intellectual capital reporting. Hence, firms making higher disclosures but of inferior quality experienced suboptimal market returns. Last but not least, all three papers that use surveys as a research method in our literature review, investigate the value-relevance of intellectual capital and its disclosure, giving direct evidence on the usage of information by its users. IC is used in setting price targets by analysts, whereby human capital is viewed as the most important category of IC (Abhayawansa et al., 2015). Moreover, respondents believe that greater disclosure would be rewarded with an increase in the company’s share price (Petty et al., 2008). The lack of access to information hampers analysts’ use of IC in their evaluation of companies, particularly in their use of human capital measures (Sakakibara et al., 2010). However, information users generally are not willing to pay for enhanced disclosure (Petty et al., 2008). Other Research Topics A few papers included in this literature review investigate whether the advertising cost is viewed by the market participants as an unrecognized intangible asset or expense. Except for the early study by Han and Manry (2004), studies document positive association between advertising and the market values of firms (Gu & Li, 2010; Shah & Akbar, 2010), although the relationship is often insignificant (García-Zambrano et al., 2018; Shah et al., 2009).

Value-relevance of intangibles – a structured literature review  197 Another interesting research stream deals with different customer-related intangibles not recognized as an asset. Although strictly related to the relational component of intellectual capital, these papers do not integrate these two concepts. It is confirmed that corporate reputation and brand value affect positively firm value (Bagna et al., 2017; Black et al., 2000; Raithel & Schwaiger, 2015). Some recent papers connect corporate reputation with sustainability issues (Lourenço et al., 2014; Wong & Zhang, 2022). Seven papers focus on the value-relevance of knowledge-related intangibles proxied by other than R&D measures, mostly patent counts and citations. Not surprisingly, the number of patents granted, patent applications, patent quality, patent citations and other non-financial measures are significantly associated with abnormal returns (Anandarajan et al., 2008; Callen et al., 2010; Russell, 2016). Six articles deal with the value-relevance of general accounting numbers for high- and low-intangible firms or industries. According to Dugar and Pozharny (2021), the value relevance of book value and earnings has declined for high-intangible-intensity companies in the United States and abroad, but for the low-intangible-intensity group, it has remained stable in the United States while increasing internationally. That confirms findings by Ciftci et al. (2014) who state that the value relevance of accounting numbers for intangible-intensive industries is substantially lower than that for non-intangible-intensive industries. Moreover, a temporal decline in value relevance is observed only for intangible-intensive industries. Most recently, Kumari and Mishra (2020) found that the earnings disaggregated into accrual and cash flow components better explain the market value of companies than aggregated earnings, especially in intangible intensive firms. Finally, a few articles cover miscellaneous topics such as blog and media visibility (Hu et al., 2011), capitalized exploration expenditure (Ferguson et al., 2021), extensive voluntary disclosure of information (Saha & Kabra, 2021) and organizational strategy profiles of firms (Ballas & Demirakos, 2018) among others.

GENERAL OBSERVATIONS AND RESEARCH AVENUES This literature review reveals that, with a few exceptions, research findings indicate value-relevance of different intangible items. This is not surprising, given the well-known publication bias (the so-called “file drawer problem”) towards publishing results that are statistically significant, confirming prior beliefs (Andrews & Kasy, 2019; DeVito & Goldacre, 2019). Our recommendations for future research are as follows. First, most research uses data from the US, UK and Australia with Anglo-Saxon, capital market-driven accounting. Some papers use data from the previous century, and their results may not be valid anymore. Given rapid changes in intangible investments and their continuously growing role in economies, there is scope for future research to draw on data from more recent periods and from countries that have not been examined previously. Research on CEE countries is especially scarce. Second, the overwhelming majority of studies is archival research using a variety of Ohlson model adoption. While the Ohlson model gives theoretical background for the relationship between market and book values, it is often liberally modified without clear explanation of adjustments undertaken. Future research may employ more diversified methods to give deeper insight and direct evidence on the relationship between intangibles and the market value

198  Research handbook on financial accounting (interviews, experimental design). Archival research should follow a more rigorous approach and adapt more event-studies besides association studies. As intangible assets are identified broadly during business combinations, therefore studies on M&A transactions may offer a significant contribution. To close, observing research topics published over time in the top-quality journals (top 10 percent on Scopus list for Business, Management and Accounting; 26 papers in total), we conclude that there is little interest in studies on intangible assets recognized in the financial statement and R&D. Out of the total of seven papers published in the top-quality journals on these items, only two were published after 2010. On the contrary, research on intellectual capital and other topics, especially customer-related issues, was published 19 times, with 16 papers published after 2010. The most recent articles deal with the value-relevance of information disclosure, not the amounts of intangibles.

CONCLUSION The value relevance of intangible assets creates a favourable field for debates and research. This literature review addresses the topic of intangibles investigated in papers published in the last 26 years (1996–2022). To assess the meaningfulness of intangible assets academics, we observed that authors employed quantitative and qualitative models. Their results advocate the need for a more comprehensive accounting model for reporting and recognition of intangibles. To make available a pertinent assessment of intangibles, this analysis is based on 118 papers; beside the paper characteristics – namely: number of citations (NoC) and citation per year (CpY) – the categories scrutinized in this literature review refer to research method, type of data used, research period, country of research, industry focus and type of intangibles (as presented in the analytical framework – Table 11.1). The findings bring upfront the authors’ preference for archival research methodology (97 percent) applying the Ohlson model (1995), Barth model (1994), Barth and Clinch (1998) model or other regression models. Only 3 percent of our papers are designed using data obtain via surveys or interviews. The content analysis which “obtains data by observing and analysing the content of written text” (Hair et al., 2007) is useful in the construction of disclosure scores/ indexes; the scores/indexes are complemented by quantitative models in papers which investigate intangibles non-recognized in the financial statements (intellectual capital, mainly). The content analysis is practical in the measurement of independent variables in a determinants studies (3 percent of our sample): Alfraih (2017), Garanina and Dumay (2017), Vafaei et al. (2011), Wang (2005). The analysis by methodology is useful to identify the over/under-used methodologies emphasizing the gaps that are valuable in future opportunities for research. In respect to country of research, our investigation shows that 86 percent of papers are constructed based on data from a single country. We observed that 34 percent of papers discuss intangibles using data from US and 14 percent of papers are based on data form Australia. Similar literature reviews highlight the predominance of papers built on data from US (Erkens et al., 2015; Garanina et al., 2021). European countries are represented by the UK (8 percent of papers), Germany (4 percent of papers), France (3 percent of papers), Italy (3 percent of papers), Austria, Belgium, Sweden, Portugal, Spain, Greece (one paper for each country).

Value-relevance of intangibles – a structured literature review  199 The literature review allows us to state the preference of authors towards non-financial companies (41 percent) regardless of the industry; in the case of single industry analysis (24 percent), our research underlines the predilection for biotech/pharma and electronics. Indisputably, the research and development topic creates the main corpus of papers included in our investigation. The relationship with financial markets is intensively investigated; share (stock) price, stock return, market value of equity and Tobin’s q are set as dependent variables. Research and development, either capitalized or expensed, are positively related to financial market variables, which should lead to a request for changes in IAS 38 regarding the accounting treatment, as some authors demand (Aharony et al., 2010; Abubakar, 2015; Dinh and Schultze, 2022; Wang and Fan, 2014). Dichotomist analysis – pre–post IFRS implementation or intangibles under US GAAP– IFRS – was conducted to contradictory results: positive correlation (Aharony et al., 2010); negative correlation (Cheong et al., 2010; Kulshrestha and Patro, 2021); inconclusive results (Gong and Wang, 2016; Oliveira et al., 2010). As a remark, a plethora of theories, research designs and methodologies are applied in papers dealing with intangibles included in non-financial reports: from signalling theory (Anifowose et al., 2017) to valuation model (Black et al., 2000) to content analysis and citation of patents (Dharni & Jameel, 2022). We acknowledge a few limitations of our study: the corpus of papers is extracted WOS and the book chapters, monographs, textbooks are excluded. The theories used by researchers are not explored. The restriction of our literature review to value-relevance of intangibles eliminated pertinent papers regarding recognition concern, measurement issues or disclosure practices. Future studies may consider the above-mentioned matters and to develop meta-analysis. We are witnessing one of the most critical moments in the history of accounting: based on knowledge and technology – an intensive economy imposes new guidelines for recognition, measurement, disclosure and reporting of intangibles to ensure the reliability of accounting for decision-making processes. This research opens up opportunities for further development into a multidisciplinary analysis to understand the role of intangible assets in contemporary economies and to articulate policies to foster their expansion and use in business.

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Value-relevance of intangibles – a structured literature review  205 Wulan, D. F. (2022). Value relevance and corporate social responsibility disclosure: A literature review. Asian Journal of Economics and Business Management, 1(1), 1–7. Yang, J., Brashear, T. G., & Asare, A. (2015). The value relevance of brand equity, intellectual capital and intellectual capital management capability. Journal of Strategic Marketing, 23(6), 543–559. https://​doi​.org/​10​.1080/​0965254X​.2014​.1001863 Zambon, S., Marzo, G., Girella, L., Abela, M., & D’Albore, N. (2020). An academic literature review on reporting on intangible assets, EFRAG. Retrieved from: https://​www​.efrag​.org/​News/​Project​-403/​ Literature​-review​-on​-intangibles (30 November 2022).

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APPENDIX – PAPERS INCLUDED IN THE STRUCTURED LITERATURE REVIEW 1. Abhayawansa, S., Aleksanyan, M., & Bahtsevanoglou, J. (2015). The use of intellectual capital information by sell-side analysts in company valuation. Accounting and Business Research, 45(3), 279–306. https://​doi​.org/​10​.1080/​00014788​.2014​.1002445 2. Aboody, D., & Lev, B. (1998). The value relevance of intangibles: The case of software capitalization. Journal of Accounting Research, 36(Supplement), 161. https://​doi​.org/​10​.2307/​2491312 3. Abrahams, T., & Sidhu, B. K. (1998). The role of R&D capitalisations in firm valuation and performance measurement. Australian Journal of Management, 23(2), 169–183. https://​doi​.org/​10​.1177/​ 031289629802300203 4. Aharony, J., Barniv, R., & Falk, H. (2010). The impact of mandatory IFRS adoption on equity valuation of accounting numbers for security investors in the EU. European Accounting Review, 19(3), 535–578. https://​doi​.org/​10​.1080/​09638180​.2010​.506285 5. Ahmed, K., & Falk, H. (2006). The value relevance of management’s research and development reporting choice: Evidence from Australia. Journal of Accounting and Public Policy, 25, 231–264. https://​doi​.org/​10​.1016/​j​.jaccpubpol​.2006​.03​.002 6. Al-Ani, M. K., & Tawfik, O. I. (2021). Effect of intangible assets on the value relevance of accounting information: evidence from emerging markets. Journal of Asian Finance, Economics and Business, 8(2), 387–399. https://​doi​.org/​10​.13106/​jafeb​.2021​.vol8​.no2​.0387 7. Alfraih, M. M. (2017). The value relevance of intellectual capital disclosure: empirical evidence from Kuwait. Journal of Financial Regulation and Compliance, 25(1), 22–38. https://​doi​.org/​10​.1108/​ JFRC​-06​-2016​-0053 8. Amir, E., Lev, B., & Sougiannis, T. (2003). Do financial analysts get intangibles? European Accounting Review, 12(4), 635–659. https://​doi​.org/​10​.1080/​0963818032000141879 9. Anandarajan, A., Chin, C.-L., Chi, H.-Y., & Lee, P. (2008). The effect of innovative activity on firm performance: The experience of Taiwan. Advances in Accounting, 23, 1–30. https://​doi​.org/​10​.1016/​ S0882​-6110(07)23001​-9 10. André, P., Dionysiou, D., & Tsalavoutas, I. (2018). Mandated disclosures under IAS 36 Impairment of Assets and IAS 38 Intangible Assets: value relevance and impact on analysts’ forecasts. Applied Economics, 50(7), 707–725. https://​doi​.org/​10​.1080/​00036846​.2017​.1340570 11. Angulo-Ruiz, F., Donthu, N., Prior, D., & Rialp, J. (2018). How does marketing capability impact abnormal stock returns? The mediating role of growth. Journal of Business Research, 82, 19–30. https://​doi​.org/​10​.1016/​j​.jbusres​.2017​.08​.020 12. Anifowose, M., Abdul Rashid, H. M., & Annuar, H. A. (2017). Intellectual capital disclosure and corporate market value: does board diversity matter? Journal of Accounting in Emerging Economies, 7(3), 369–398. https://​doi​.org/​10​.1108/​JAEE​-06​-2015​-0048 13. Ariff, A. M., Cahan, S. F., & Emanuel, D.M. (2014). Institutional Environment, Ownership, and Disclosure of Intangibles: Evidence from East Asia. Journal of International Accounting Research, 13(1), 33–59. https://​doi​.org/​10​.2308/​jiar​-50655 14. Asdemir, O., Baowaidan, M., & Bugshan, T. (2013). Value relevance of R&D spending by rivals. Academy of Accounting and Financial Studies Journal, 17(1), 103–118. 15. Azin, N. A. B. N., & Alias, N. B. (2019). Value relevance of intangible assets before and after FRS 138 adoptions: Evidence from Malaysia. International Journal of Financial Research, 10(3), 267–279. https://​doi​.org/​10​.5430/​ijfr​.v10n3p267 16. Bagna, E., Dicuonzo, G., Perrone, A., & Dell’Atti, V. (2017). The value relevance of brand valuation. Applied Economics, 49(58), 5865–5876. https://​doi​.org/​10​.1080/​00036846​.2017​.1352078 17. Ballas, A., & Demirakos, E. (2018). The valuation implications of strategy in R&D-intensive industries. Journal of Applied Accounting Research, 19(3), 365–382. https://​doi​.org/​10​.1108/​JAAR​-11​ -2015​-0096 18. Bauman, M. P., & Francis, R. (2008). An examination of supplemental disclosure requirements for development stage enterprises. Research in Accounting Regulation, 20, 155–174. https://​doi​.org/​10​ .1016/​S1052​-0457(07)00208​-1 19. Bauman, M. P., & Shaw, K. W. (2018). Value relevance of customer-related intangible assets. Research in Accounting Regulation, 30, 95–102. https://​doi​.org/​10​.1016/​j​.racreg​.2018​.09​.010

Value-relevance of intangibles – a structured literature review  207 20. Behname, M., Pajoohi, M. R., & Ghahramanizady, M. (2012). The relationship between intangible assets and the market value; metals industry of Tehran stock exchange case study. Australian Journal of Basic and Applied Sciences, 6(12), 115–122. 21. Beisland, L. A., & Hamberg, M. (2013). Earnings sustainability, economic conditions and the value relevance of accounting information. Scandinavian Journal of Management, 29, 314–324. https://​doi​ .org/​10​.1016/​j​.scaman​.2013​.02​.001 22. Black, E. L., Carnes, T. A., & Richardson, V. J. (2000). The market valuation of corporate reputation. Corporate Reputation Review, 3(1), 31–42. https://​doi​.org/​10​.1057/​palgrave​.crr​.1540097 23. Callen, J. L., Gavious, I., & Segal, D. (2010). The complementary relationship between financial and non-financial information in the biotechnology industry and the degree of investor sophistication. Journal of Contemporary Accounting and Economics, 6, 61–76. https://​doi​.org/​10​.1016/​j​.jcae​.2010​ .09​.001 24. Callen, J. L., & Morel, M. (2005). The valuation relevance of R&D expenditures: Time series evidence. International Review of Financial Analysis, 14, 304–325. https://​doi​.org/​10​.1016/​j​.irfa​.2004​ .10​.007 25. Callimaci, A., & Landry, S. (2004). Market valuation of research and development spending under Canadian GAAP. Canadian Accounting Perspectives, 3(1), 33–53. https://​doi​.org/​10​.1506/​V5LY​ -4CNE​-3J0Q​-00HN 26. Cazavan-Jeny, A., & Jeanjean, T. (2006). The negative impact of R&D capitalization: A value relevance approach. European Accounting Review, 15(1), 37–61. https://​doi​.org/​10​.1080/​09638180500510384 27. Chalmers, K., Clinch, G., & Godfrey, J. (2008). Adoption of international financial reporting standards: Impact on the value relevance of intangible assets. Australian Accounting Review, 18(3), 237–247. https://​doi​.org/​10​.1111/​j​.1835​-2561​.2008​.0028​.x 28. Chen, E., Gavious, I., & Lev, B. (2017). The positive externalities of IFRS R&D capitalization: enhanced voluntary disclosure. Review of Accounting Studies, 22, 677–714. https://​doi​.org/​10​.1007/​ s11142​-017​-9399​-x 29. Cheong, C. S., Kim, S., & Zurbruegg, R. (2010). The impact of IFRS on financial analysts’ forecast accuracy in the Asia-Pacific region: The case of Australia, Hong Kong and New Zealand. Pacific Accounting Review, 22(2), 124–146. https://​doi​.org/​10​.1108/​01140581011074511 30. Ciftci, M., Darrough, M., & Mashruwala, R. (2014). Value relevance of accounting information for intangible-intensive industries and the impact of scale: The US evidence. European Accounting Review, 23(2), 199–226. https://​doi​.org/​10​.1080/​09638180​.2013​.815124 31. Ciftci, M., & Zhou, N. (2016). Capitalizing R&D expenses versus disclosing intangible information. Review of Quantitative Finance and Accounting, 46, 661–689. https://​doi​.org/​10​.1007/​s11156​-014​ -0482​-0 32. Cordazzo, M., & Rossi, P. (2020). The influence of IFRS mandatory adoption on value relevance of intangible assets in Italy. Journal of Applied Accounting Research, 21(3), 415–436. https://​doi​.org/​10​ .1108/​JAAR​-05​-2018​-0069 33. Dahmash, F. N., Durand, R. B., & Watson, J. (2009). The value relevance and reliability of reported goodwill and identifiable intangible assets. The British Accounting Review, 41, 120–137. https://​doi​ .org/​10​.1016/​j​.bar​.2009​.03​.002 34. Dharni, K., & Jameel, S. (2022). Trends and relationship among intellectual capital disclosures, patent statistics and firm performance in Indian manufacturing sector. Journal of Intellectual Capital, 23(4), 936–956. https://​doi​.org/​10​.1108/​JIC​-05​-2020​-0148 35. Dinh, T., & Schultze, W. (2011). Capitalizing research & development and ‘other information’: The incremental information content of accruals versus cash flows. Journal of Management Control, 22, 241–278. https://​doi​.org/​10​.1007/​s00187​-011​-0137​-4 36. Dinh, T., & Schultze, W. (2022). Accounting for R&D on the income statement? Evidence on non-discretionary vs. discretionary R&D capitalization under IFRS in Germany. Journal of International Accounting, Auditing and Taxation, 46, 100446. https://​doi​.org/​10​.1016/​j​.intaccaudtax​ .2022​.100446 37. Dugar, A., & Pozharny, J. (2021). Equity investing in the age of intangibles. Financial Analysts Journal, 77(2), 21–42. https://​doi​.org/​10​.1080/​0015198X​.2021​.1874726

208  Research handbook on financial accounting 38. Elbannan, M. A., & Farooq, O. (2016). Value relevance of voluntary human capital disclosure: European evidence. Journal of Applied Business Research, 32(6), 1555–1560. https://​doi​.org/​10​ .19030/​jabr​.v32i6​.9807 39. Ellis, H., & Seng, D. (2015). The value relevance of voluntary intellectual capital disclosure: New Zealand evidence. Corporate Ownership and Control, 13(1), 1071–1087. https://​doi​.org/​10​.22495/​ cocv13i1c9p9 40. Feng, C., Fay, S., & Kashmiri, S. (2022). The value relevance of descriptive R&D intensity. Journal of Business Research, 139, 1394–1407. https://​doi​.org/​10​.1016/​j​.jbusres​.2021​.10​.033 41. Ferguson, A., Kean, S., & Pündrich, G. (2021). Factors affecting the value-relevance of capitalized exploration and evaluation expenditures under IFRS 6. Journal of Accounting, Auditing and Finance, 36(4), 802–825. https://​doi​.org/​10​.1177/​0148558X20916337 42. Ferraro, O., & Veltri, S. (2011). The value relevance of intellectual capital on the firm’s market value: An empirical survey on the Italian listed firms. International Journal of Knowledge-Based Development, 2(1), 66–84. https://​doi​.org/​10​.1504/​IJKBD​.2011​.040626 43. Franzen, L., & Radhakrishnan, S. (2009). The value relevance of R&D across profit and loss firms. Journal of Accounting and Public Policy, 28, 16–32. https://​doi​.org/​10​.1016/​j​.jaccpubpol​.2008​.11​ .006 44. Fung, M. K. (2005). Value-relevance of knowledge spillovers: Evidence from three high-tech industries. In C.-F. Lee (Ed.), Advances in Quantitative Analysis of Finance and Accounting (New Series) Volume 2 (Vol. 2, pp. 17–31). World Scientific. https://​doi​.org/​10​.1142/​5756 45. Garanina, T., & Dumay, J. (2017). Forward-looking intellectual capital disclosure in IPOs: Implications for intellectual capital and integrated reporting. Journal of Intellectual Capital, 18(1), 128–148. https://​doi​.org/​10​.1108/​JIC​-05​-2016​-0054 46. García-Zambrano, L., Rodríguez-Castellanos, A., & García-Merino, J. D. (2018). Impact of investments in training and advertising on the market value relevance of a company’s intangibles: The effect of the economic crisis in Spain. European Research on Management and Business Economics, 24, 27–32. https://​doi​.org/​10​.1016/​j​.iedeen​.2017​.06​.001 47. Gavious, I., & Russ, M. (2009). The valuation implications of human capital in transactions on and outside the exchange. Advances in Accounting, 25, 165–173. https://​doi​.org/​10​.1016/​j​.adiac​.2009​.09​ .004 48. Glova, J., & Mrázková, S. (2018). Impact of intangibles on firm value: An empirical evidence from European public companies. Ekonomický Časopis, 66(7), 665–680. 49. Godfrey, J., & Koh, P. S. (2001). The relevance to firm valuation of capitalising intangible assets in total and by category. Australian Accounting Review, 11(2), 39–48. https://​doi​.org/​10​.1111/​j​.1835​ -2561​.2001​.tb00186​.x 50. Gong, J. J., & Wang, S. I.-L. (2016). Changes in the value relevance of research and development expenses after IFRS adoption. Advances in Accounting, 35, 49–61. https://​doi​.org/​10​.1016/​j​.adiac​ .2016​.05​.002 51. Goodwin, J., & Ahmed, K. (2006). Longitudinal value relevance of earnings and intangible assets: Evidence from Australian firms. Journal of International Accounting, Auditing and Taxation, 15, 72–91. https://​doi​.org/​10​.1016/​j​.intaccaudtax​.2006​.01​.005 52. Gu, F., & Li, J. Q. (2010). The value-relevance of advertising: Evidence from pharmaceutical industry. Journal of Accounting, Auditing and Finance, 25, 85–120. https://​doi​.org/​10​.1177/​ 0148558X1002500104 53. Han, B. H., & Manry, D. (2004). The value-relevance of R&D and advertising expenditures: Evidence from Korea. The International Journal of Accounting, 39, 155–173. https://​doi​.org/​10​.1016/​ j​.intacc​.2004​.02​.002 54. Hevas, D. L. (2005). The value relevance of start-up costs and other balance sheet items: some Greek evidence. Managerial Finance, 31(2), 55–65. https://​doi​.org/​10​.1108/​03074350510769497 55. Hirschey, M., Richardson, V. J., & Scholz, S. (2001). Value relevance of nonfinancial information: The case of patent data. Review of Quantitative Finance and Accounting, 17, 223–235. https://​doi​.org/​ 10​.1023/​A:​1012223625399 56. Hodgson, A., Lhaopadchan, S., & Ratiu, R. (2018). Is advertising under-resourced in a growth market? Intangible endogeneity and informed trading issues. Accounting & Finance, 58, 343–373. https://​doi​.org/​10​.1111/​acfi​.12276

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PART V NEW TRENDS IN FINANCIAL ACCOUNTING

12. The use of non-financial information in financial reporting Jordi Martí Pidelaserra

INTRODUCTION The Wealth of Nations From Adam Smith’s (Adam Smith, 1776) most fruitful work, everyone has accepted that the wealth of nations is basically generated from three factors: land, labor, and capital. Now everyone understands that this wealth results from the added value that a large number of entities, many of them mercantile companies, contribute to the whole of humanity. Therefore, historically, it has been thought that the good management of these entities should be measured by their creation of added value. Economic theory and, especially, economic policy have concentrated on diagnosing the best ways to achieve increases in that added value, in that wealth of nations. The production of wealth has attracted the attention of societies throughout the twentieth century. But it should be remembered that already in 1848 (Garnier, 1848) the production and the distribution of this added value were being discussed simultaneously. If production depended on three factors, distribution also had to cater to those three factors. In 1935, the first book with the title ‘Econometrics’ was published; the author was the Frenchman Paul Razous (Razous, 1935). The subtitle, in French, obviously, is very long, but introduces the concept of production and distribution: Caractéristiques principales des agents de la production, des éléments de la circulation des biens, des facteurs de la distribution, de l’évolution des consommations et de l’ajustement économique national et international.

The translation to English is: Main characteristics of the agents of production, of the elements of the movement of goods, of the factors of distribution, of the evolution of consumption, and of national and international economic adjustment.

Razous, in the chapter dedicated to distribution, makes special reference to agricultural industries, according to the conception of this topic in Europe between the world wars. From the second industrial revolution, economics scholars were concentrating, more and more, on production, and the study of distribution was marginal. The distribution of wealth was explained between labor income and capital income. The distribution towards the earth factor disappeared from academic texts (Figure 12.1). Currently, the need to study the distribution of the wealth of nations towards the land factor has been recovered, under the environmental concept. And this introduces the need to 214

The use of non-financial information in financial reporting  215

Source:

Created by the authors.

Figure 12.1

Added value, production and distribution

study the distribution under a triple perspective: Environment, Social, and Governance (ESG) (Figure 12.2).

Source:

Created by the authors.

Figure 12.2

ESG, new variables for wealth distribution

216  Research handbook on financial accounting It has not been an easy task to ensure that the environment plays a central role in the development objectives of countries and commercial entities. Hence, it is vital that the managers of investment and pension funds, such as Larry Fink (2020), have understood the importance of considering the sustainability of the environment as a strategic management variable. Therefore, information for business decision-making and also in public administration must consider the distribution of value-added between wage and capital income, as has traditionally been done, but now with the introduction of the environment. A much broader vision of environmental conservation is now being developed, which is called Natural Capital. The Natural Capital, a Historical Perspective In the mid-1970s, different events began to take place that entailed great public concern. Collective memory still considered the impact of atomic bombs on the civilian populations of Hiroshima and Nagasaki, and the Cold War between the capitalist and communist fronts threatened global destruction with a nuclear arsenal capable of destroying all planetary life several times over. The same people who accumulated these weapons kept on running the race to conquer space with all kinds of satellites. And they built thermo-nuclear power plants, and exported this technology to developing countries, keeping the waste that allowed them to obtain plutonium for more atomic bombs. In addition, they were flaunting “controlled” explosions in deserts or islands in the Pacific Ocean. For more than 40 years, these places had levels of radiation that affected the land but also the flora and fauna. The explosions made by the French administration in the “atolls” of Mururoa also affected the waters of the Pacific Ocean and the closest human populations received the winds with the air contaminated with uranium and plutonium. There are no political or natural boundaries that prevent the circulation of polluted air. In Denmark, protests began when Sweden installed one of these nuclear power plants closer to Copenhagen than to Stockholm. The European population began to see that certain actions in one country could cause damage in another. At the same time, episodes of air pollution from coal combustion had caused damage to the health of many British people. And in Germany, they were seeing how forests were slowly dying from acid rain. In the Appalachian Mountains in the USA, there was a similar situation. Scientists began to explain that air pollution from the combustion of coal with a high sulfur content caused acid rain which could fall on populations that had not used this type of fuel. Meanwhile, CO2 emissions caused by atmospheric-powered vehicles in large North-American cities were creating a haze called “smog” that colored the sky reddish. All these facts create visions of what is coming. So, in 1987, an OECD report was presented to the United Nations with the title, Our Common Future, which has become better known by the name of the person who served as its director, the former Norwegian Prime Minister, Gro Harlem Brundtland (World Commission on Environment and Development, 1987). This ‘Brundtland Report’ began to talk about sustainable growth. This whole international movement had an academic base that has been silenced but was very powerful. For example, Xavier Garcia i Pujades (Garcia i Pujades, 1988) published the first book on ecological ethics in the Catalan language under the title, Devourers of Nature

The use of non-financial information in financial reporting  217 Devoured by Artifice, after having studied the theses of Joan Martínez Alier (Martínez Alier, 1999) – one of the first researchers in ecological economics – and Nicholas Georgescu-Roegen (Georgescu-Roegen, 1970) – who is considered the father of bioeconomy. Georgescu-Roegen gave a speech at the University of Geneva in June 1974 in which he defined the bioeconomic program. It was, he said, necessary to redefine the economic model by limiting four variables: 1. 2. 3. 4.

Weapons production Human population Energy embezzlement Short-lived products

All these proposals were not considered by the academic community for years. Simultaneously the mass media devoted great attention to Milton Friedman’s (1970) thesis that defended the maximization of shareholder profit as the best way to organize the world economic system. It was not until 1983 that the approach of Edward Freeman and David L. Lee began to find a path (Freeman and Reed, 1983). They argued that the company does not only have shareholders or stockholders as its interlocutors. Entities relate to many more human beings than equity funders. Entities must serve their consumers, but also their workers and must fulfill their obligations to the State as a representative of all citizens. It is from this publication that Freeman generated a school of thinkers who developed the concept of stakeholders. The introduction of this concept in Spanish universities is due to a University of Barcelona professor, Isabel Vidal who organized, in 1987, the first master’s in Corporate Social Responsibility (CSR), where the professor of accounting Jordi Morrós Ribeira intervened directly (Morrós Ribeira and Vidal Martínez, 2006). This silence from scientists not only occurred in the field of economics, but also in the field of climatology, it was also broken by those who demonstrated the limitations of atmospheric resources. In 2021, Syuhuro Manabe was recognized with the 90-year-old Nobel Prize in Physics; in 1960 he had already formulated that doubling CO2 emissions into the atmosphere would cause a 2°C increase in temperature on the Earth’s surface. Also sharing the award was 89-year-old Klaus Hasselmann, who, in the 1970s, demonstrated that climate models can be reliable, even though atmospheric weather seems to behave chaotically, and that all the data observed until then, 40 years ago, were already conclusive regarding climate warming. Now, at the beginning the third decade of the twenty-first century, the realization that the natural environment can be affected from thousands of kilometers away, by human beings who may never cover that distance, entails the configuration of a single environmental entity – planet Earth itself. For this reason, the concept of Natural Capital has been developed as an economic approach to a world heritage that must be cared for in the same way as any human entity, whether individual or social, is cared for. Nature’s Law We do not yet have a well-structured legal body that allows us to explain the rights of nature or, in other words, how the human species must interact with natural resources. Since a human group can pollute the air in one area of the planet, and this polluted air can affect another

218  Research handbook on financial accounting geographical area with another human population, universal justice will be needed to defend nature. International courts and international legislation are urgently needed to protect air, water, and land from irresponsible conduct. Although, for centuries, Natural Law was developed, nowadays we are not talking about the same thing, we are talking about the Law of Nature. Whereas Natural Law has been a discipline that studied the foundations of legal bodies, the Law of Nature requires a new legal body that applies to citizens, companies, and other social organizations, such as public administrations, whether state-run or state-owned. It is necessary that current managers of companies introduce restrictions on emissions so that nature cannot be defended by itself. Financial partners and shareholders must understand that they can be challenged by Nature, as they can be by consumers, workers or the public Treasury. An Environment with Personhood Status In 2017, New Zealand’s authorities granted personhood status to a river (New Zealand River’s Personhood Status Offers Hope to Māori | AP News, n.d.). The Whanganui River is more than a geographical element for the Maori population, it has a spiritual status for them. The government recognizes that the better way to protect all of these special characteristics is to consider the natural environment as a person. In 2022, the Spanish authorities followed New Zealand and granted personhood status to a little marine bay called “Mar Menor” (Spain makes history by giving personhood status to salt-water lagoon, thanks to 600,000 citizens | Euronews, n.d.). These two examples show the beginning of a recognition of the environment that goes beyond the conservationist positions that had developed in the last 200 years. Now, public administrations recognizes that it is not enough to declare natural areas have special protection or to declare natural parks. It must be understood that the environment is as important as human beings. For this reason, it is essential that the expanded balance sheet of a company highlights to the “shareholders”, that they must incorporate in their decision-making a series of rules for the preservation of ecosystems. This means respecting and conserving those ecosystems that already exist. It also means ensuring their continuity and – what is more difficult – making decisions to ensure the correct evolution of these ecosystems.

THE NON-FINANCIAL INFORMATION BALANCE SHEET Since the first written report of the double entry system appeared in a chapter of Luca Pacioli’s Summa Arithmetic (Pacioli, 1494), the balance sheet has been a tool for analyzing business management. The traditional balance sheet presents the financial perspective of a company. The investments are compared with the financing necessity for the company’s operation (Table 12.1), to verify that their weight coincides, and that the balance sheet is balanced.

The use of non-financial information in financial reporting  219    

Table 12.1

Traditional financial balance sheet

 

FINANCIAL BALANCE SHEET

 

 

 

 

 

 

 

 

 

 

 

 

 

ASSETS

FINANCIAL CAPITAL

 

 

 

 

 

 

 

 

Source:

Created by the authors.

Focusing attention on financial capital, it can be seen that the savings of the shareholders, who will make up the equities, can be combined with the savings of a great many citizens through commercial banks, as they provide loans, which will make up the liabilities (Table 12.2). Table 12.2

Equities and liabilities from savings

 

FINANCIAL BALANCE SHEET

 

 

 

 

 

 

 

 

 

 

 

ASSETS

FINANCIAL CAPITAL

 

 

 

SHAREHOLDERS SAVINGS

 

 

 

 

SAVINGS FROM LENDERS

 

 

 

 

 

 

 

 

 

 

 

 

Source:

Created by the authors.

When it is necessary to enter ESG (Environment, Social, and Governance) information, it seems that the Balance Sheet is not an adequate element and that it is necessary to design other analysis and reporting tools. However, the view of the Balance Sheet can be expanded by incorporating the non-financial information required by ESG. It is possible to build an Extended Balance Sheet that incorporates more records than strictly financial ones (Table 12.3). Table 12.3

Extended balance sheet

 

 

EXTENDED BALANCE SHEET

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

FINANCIAL CAPITAL

 

 

 

 

 

 

 

 

 

NON-FINANCIAL ASSETS  

Source:

 

 

NON-FINANCIAL CAPITAL  

 

 

 

Created by the authors.

The particularity of this extended balance sheet lies in observing that entities must finance investments that will not fit with any of the characteristics that the financial framework assigns to assets.

220  Research handbook on financial accounting If we look at the definition of Assets, we see that those assets or rights should generate cash flows in the future. This is a characteristic of finance. In other words, the definition of Asset in the conceptual framework is conceived from a financial perspective although not all assets are financial instruments. When the entity must formulate its objectives beyond finance, when shareholders are not the only human beings to whom the entity must be accountable, then the need arises to contemplate investments, assets, that will not directly generate future cash flows (Figure 12.3).

Source:

Created by the authors.

Figure 12.3

Disaggregation of non-financial assets and non-financial liabilities

As it cannot be otherwise, if there are investments in environmental, social or governance issues, specific sources of financing will be necessary. Entities should identify assets and liabilities, investments and financings that refer to ESG. The rigor and precision that, during the last seven centuries, have been used in configuring a Financial Balance Sheet that is increasingly full of information, cannot be achieved with ESG information. Important steps have been taken in non-financial reporting and very important convergence processes are being generated to achieve a standardization of non-financial information. But a consensus – such as the one that led to the publication of the IAS, or the current IFRS – is not yet available. It should be remembered that the last decade of the twentieth century was when the initiatives were generated that, in these first 20 years of the twenty-first century, are bearing the first fruits. We are talking about 30 years of non-financial reporting versus 700 years of double accounting. In this environment, it is essential to expose the expectations generated by the European Union Commission, led by Ursula von der Leyen, when commissioning EFRAG (EFRAG, 2020) to publish a reporting standard for ESG.

ENVIRONMENTAL ASSETS AND NATURAL CAPITAL The relationships that entities maintain with natural capital are very varied. All natural capital is available to become an asset, a good under the control of the most diverse entities.

The use of non-financial information in financial reporting  221 The conceptual framework of accounting achieves a consensus in the definition of asset, avoiding the use of the concept of property. The concept of “economic control” makes it possible to open the identification of assets to a series of resources for which a specific owner cannot be assigned (Figure 12.4).

Source:

Created by the authors.

Figure 12.4

Disaggregation of non-financial assets and non-financial liabilities by environmental assets

The founders of entities must know the relationship that their funds will have with the assets coming from nature. This requires the identification and registration of the elements linked to the use of land, water, and air. It is not a question of recording consumption, it is a question of registering the right to use land, water, and air. Consumption must appear in other accounting documents. The balance sheet is where those rights and the financial obligations that sustain them should be recorded. When someone constructs a building, they are using a right to the ground, but they are also exercising a right to overfly. Therefore, the space above ground is a public right. If anybody builds a new construction, he is using a public right and, therefore, the corresponding liability must also be registered. When someone is using water, even if they return it to the channel, which they leave under identical conditions to when they received the water, they are reducing the usual flow of that river or that source during a specific period of time. It should be ensured that the entity making such use has the right and the necessary funding to ensure the proper functioning of the facilities. In the same way, rainwater retention must be carried out. Although it is water that does not come from a riverbed, rain is part of natural law rights. Whoever is able to retain rainwater must also have a right to that activity, which must be properly financed.

222  Research handbook on financial accounting When the use of water involves an alteration of its quality or a loss of the volume received, the right and liabilities that this change in the properties of the water will entail must be correctly recorded. If an entity needs oxygen, hydrogen or any of the gases that make up the air contained in our atmosphere, it will be necessary to wield the right to its use and the financing that supports it.

SOCIAL ASSETS AND SOCIAL CAPITAL With the perspective of recognizing assets from the right-of-use, it will be necessary to identify and record the relationships that entities maintain with human beings. Some of these relationships are maintained on an individual basis, for example, employment contracts. But other relationships are maintained with social organizations, such as tax payments or contributions to pension funds. To correctly classify these social assets, one can begin by identifying all the boundaries that entities must establish to protect the human rights recognized by the United Nations (United Nations, n.d.). The set of human rights standards is known as the International Bill of Human Rights. These are three provisions generated within the UN: 1. Universal Declaration of Human Rights 2. International Covenant on Civil and Political Rights 3. International Covenant on Economic, Social, and Cultural Rights When a country signs these agreements, it undertakes to translate the content of the declaration and the covenants into its own law. To this end, states must establish organizations to monitor compliance. The optional protocols that usually accompany human rights treaties establish voluntary procedures (inquiry, complaint, or communication procedures) to be adopted by states in relation to the main treaty, or develop particular aspects of it. The optional protocols have the status of international treaties and are open for signature and ratification by the states that are party to the treaty. Although it seems that these declarations affect only governments, today the world population expects the co-responsibility of commercial entities in their fulfillment. The letter S, of the ESG obliges entities to show their alignment with individual and social human rights. These are rights that refer mainly to individual freedoms. But in them there are some very direct references to economic issues. In particular, the right to work should be highlighted. To defend labor rights, the United Nations has developed a specific organization, the International Labor Organization (ILO) (International Labor Organization, n.d.). Its objectives are the following. 1. 2. 3. 4. 5. 6.

Promote respect for basic labor principles. The eradication of child labor. Supervision of labor regulations and compliance with Conventions. The development of technical cooperation programs. Migration of workers. Analyze the social dimension of globalization.

The use of non-financial information in financial reporting  223 These objectives of the ILO are enshrined in the International Bill of Human Rights, and its mission is to implement activities that lead to greater compliance. To this end, it has a “Decent Work Agenda” based on the ILO Declaration on Social Justice for a Fair Globalization (2008), heir to the Declaration of Philadelphia (1944) and the ILO Declaration on Fundamental Principles and Rights at Work and its Follow-up (1998). The ILO is the only surviving entity of the Treaty of Versailles (1919) that ended the First World War, giving rise to the League of Nations, which would later become the United Nations. Complying with the Universal Declaration of Human Rights and reporting on it in non-financial information documents means meeting the ILO’s requirements in labor matters. But ESG’s S information goes beyond the workplace. For this reason, it is necessary to reflect the assets which the entity has invested in order to protect those rights. It will be necessary to identify all the measures that have been activated to protect the privacy and safety of workers, to guarantee their right to assembly and association, and especially to achieve equal pay without discrimination. Expanding the field of vision of discrimination, beyond gender, ethnicity, and belief, it should be noted that, in 2006, the Convention on the Rights of Persons with Disabilities and its optional protocol were published (Convention on the Rights of Persons with Disabilities (CRPD) | United Nations Enable, n.d.). Never before had a United Nations convention brought together such a large number of signatories on the day of its opening for signature. It is the first comprehensive human rights instrument of the twenty-first century and the first human rights convention to be open for signature by regional integration organizations. It points to a “paradigm shift” in attitudes and approaches towards persons with disabilities. The Convention was conceived as a human rights instrument with an explicit social development dimension. It adopts a broad classification of persons with disabilities: Article 1 Persons with disabilities include those who have long-term physical, mental, intellectual, or sensory impairments that, when interacting with various barriers, may impede their full and effective participation in society, on an equal basis with others.

The document reaffirms that persons with any kind of disabilities should be able to enjoy all human rights and fundamental freedoms. It clarifies how all categories of rights apply to persons with disabilities and identifies areas where adaptations are needed to enable persons with disabilities to effectively exercise their rights and areas where these rights have been violated and protection needs to be strengthened. The entities have to identify and register all the investments that demonstrate their pro-activity to avoid discrimination and guarantee the equality of all human beings. It seems relatively easy to find these investments in the field of industrial relations, but the S, of ESG, goes also beyond industrial sites. Entities must protect the individual and social human rights of consumers, and the suppliers with whom they do business. This already entails several actions that must be recognized in the balance sheet, but the entity must be considered to affect human populations that may not intervene in the supply chain or in the distribution chain.

224  Research handbook on financial accounting People who live near production facilities can receive positive and negative effects from their neighborhood, without having anything to do with production or marketing activities. The company must identify and register the assets and liabilities that all this entails. But there are other assets that the company must show, not for compliance with labor standards or international agreements, but to reflect a faithful image of its activity. It’s about intellectual assets. Financial reporting records the cost of wages and other benefits arising from employment contracts but does not reflect the education of workers. A company with illiterate workers would have the same accounting entries as a company with university-educated workers if labor costs were the same. Taking advantage of the consensus generated by the International Financial Reporting Standards, it can be understood that workers are not an asset. The entity has no control over its people and therefore does not meet the definition contained in the Conceptual Framework. Workers are free beings who decide where and when they go to work. Human rights conventions enshrined the eradication of slavery, and financial reporting should be based on those principles. However, in the entities, the workers constitute a network of social relations between them. A network that intertwines their intellectual capacities. This social collaboration generates advantages for the entity that are not reflected in traditional financial reports. Not having economic control of intellectual capital does not mean that it does not exist or that it is not a differentiating element of one entity with respect to another. This intellectual capital creates possibilities for future returns that well-managed entities take in their favor. Considering the payment of salaries as an expense is something accepted worldwide, but the training of these workers, which they have already obtained before entering work in an entity, such as the training they obtain within the entity, should be considered a social asset. Payments made by institutions to improve the training of their workers should not only have an impact on the profit and loss account but should be identified and recorded as an asset that must be maintained to comply with the going concern principle. However, the value of the company would not be the same. A company with highly trained workers generates the capacity to adapt to risk and to new business opportunities that do not occur when these workers have not had access to quality education. Similarly, a staff of well-educated workers can better manage accident prevention and their own health than a company with workers who cannot understand certain tips to avoid accidents or diseases. In some parts of the world, access to education is guaranteed by public authorities, but in others, the companies themselves must equip themselves with the necessary educational equipment so that their employees can ensure a risk-free activity. This means that the investments that a company must develop in training can be explicit, the entity organizes its own educational centers, or they can be implicit because the workers have already obtained training from the welfare state. In any case, it is about correctly identifying and registering the intellectual capital available to the company (Figure 12.5).

The use of non-financial information in financial reporting  225

Source:

Created by the authors.

Figure 12.5

Disaggregation of non-financial assets and non-financial liabilities between environmental and social resources

GOVERNANCE ASSETS AND GOVERNANCE CAPITAL To properly manage the G of ESG, it should be understood that entities have governance bodies. In each country, in each cultural environment, these bodies may be different, but there are common minimums that are required of all of them. Studying the governance of an entity is to identify and register the assets and liabilities that must guarantee the correct fulfillment of three major duties: a. Duty of information: Here, double materiality comes into play. It is necessary to pass information from the entity to the stakeholders and shareholders, but also the entity must provide quality information to the internal managers so that they can make the appropriate decisions. b. Duty of fidelity: The members of governance bodies must fulfill the duties imposed by the laws and the statutes with fidelity to the social interest, understood as the interest of the entity. This implies setting a standard of diligence and configuring an area of business discretion for strategic and business decision-making. c. Duty of loyalty: The entity must establish the requirements to select the members of the governance bodies who have to serve with the loyalty of a faithful representative, acting in good faith and in the best interest of society.

226  Research handbook on financial accounting The duty to inform shall entail investments to ensure the transparency of the institution. The duty of fidelity will involve investments to show the ethical behavior of the entity. The duty of loyalty will involve investments to avoid corrupt practices from the highest responsible to the lowest qualified worker of the entity. Good governance of an entity can only be demonstrated if the entity has developed sufficient investments to ensure transparency, ethical behavior, and the prevention of bribery and corruption practices. The assets that guarantee the professional administration of the G in ESG can be of an intangible nature. New technologies allow the implementation of computer applications that reduce the risks of non-compliance with the three duties, generating alerts to redirect those activities that may lead to infractions. Infringements and breaches of duties introduce a risk that until a few years ago was not considered relevant: reputational risk. The reputational risk appears when the good name of the company is attacked. The impact such an attack can have on the future of the company can be diverse.

Source:

Created by the authors.

Figure 12.6

Disaggregation of non-financial assets. Governance assets

The use of non-financial information in financial reporting  227 Reputational risk can be generated: ● Directly, as a result of the actions of the company itself. ● Indirectly, due to the actions of an employee or employees. ● Tangentially, through other peripheral parties, such as joint venture partners or providers. Good governance should avoid, as much as possible, reputational risk. But since this objective is not always easy to achieve, good governance is relied upon to limit it to levels that do not cause a serious crisis in the entity. Good governance must involve investments that prevent reputational damage, especially those that may appear due to the actions of the entity itself, the direct reputational risk. But it cannot be forgotten that the activity of employees, inside and outside the environment of the entity, will generate an indirect reputational risk. Investments in good governance should prevent and mitigate these effects. The tangential reputational risk is the most difficult to prevent. But investments for its mitigation must be prepared. The assets that can help communicate the correct reactions against malpractice of external collaborators or competitors must exist, and their adequacy must be checked periodically (Figure 12.6).

CONCLUSIONS Entities are now evaluated from broader perspectives than just the financial ones. For centuries a company’s profit has been measured by increases in the equities account. Today, with a climate crisis due to global warming, a social crisis due to the increase of inequality in the distribution of economic incomes, and a reputational crisis due to bad practices in corporate governance, the evaluation of companies must be measured with the ESG (Environment, Social, Governance) perspective. Public administrations have been establishing a Welfare State that distributes security, health and education with more or less efficiency, but that uses very outdated bureaucratic structures. Politicians have focused their objectives over the past two centuries on the growth of production and on how to generate tax revenues from production increases. They have been much less concerned with the correct distribution of that wealth. Although there is a consensus that the generation of wealth is achieved with the added value generated by the factors of production, land, labor, and capital. The concern of public authorities and also of senior managers of companies, has been the distribution of value-added between labor income and capital income. The distribution of wealth toward one of the factors that generated it, the land, has been forgotten. To remember that planet Earth needs to be managed carefully, the United Nations has developed the Sustainable Development Goals (SDGs). These objectives are translated from public policies to the administration of productive entities. The translation has identified three evaluation perspectives for the distribution of added value. It is about distributing wealth according to ESG: Environment, Social, and Governance. The E, of the ESG, the environment, is the current name for the land factor. When companies report on their results, stakeholders also ask about the environmental impact of their activities. Answering these questions correctly involves preparing environmental accounts.

228  Research handbook on financial accounting If all the knowledge developed by double-entry accounting is used, an environmental balance can be generated (Figure 12.7).

Source:

Created by the authors.

Figure 12.7

Environmental balance sheet

Here it is necessary to emphasize that, after a long process of social consciousness generated from the 1970s, today we have the concept of Natural Capital. It is about understanding that natural resources form a unit of land, water, or air that cannot be managed independently. Natural resources have interdependent relationships that require their own legal regulation. In the last five years, New Zealand and Spain granted personhood status to a river and to a marine bay, respectively. This means that we have a new legislative body, which is that of the rights of nature. It must be understood that the impacts of an oil spill or nuclear pollution, to give two examples, are not restricted to a specific territory, they can affect populations very distant from the place where the accident or abuse occurred. Therefore, a new legal dimension on the rights of nature is being entered. In the same way that international tribunals have been created to defend, outside their country, the beings who have suffered a violation of their human rights, courts will be created to judge environmental attacks outside the geographical places where the accident or abuse has occurred, and those who may be the ones that suffer the most from its harmful effects. An Environmental Balance Sheet must be prepared understanding that the requirement of control to be able to recognize an asset, according to the definition of asset in the conceptual framework, allows us to recognize the environmental assets, without the need for a title deed. These are natural resources over which a right of use can be obtained, never the property.

Source:

Created by the authors.

Figure 12.8

Social balance sheet

The use of non-financial information in financial reporting  229 The environmental balance sheet identifies and records usage rights over natural resources, land, water, and air. Liabilities with natural capital must also be identified and registered. The stakeholders and the shareholders can use this report to organize the management of their entities. In the same sense, using the definitions of the conceptual framework, entities can prepare a social balance sheet (Figure 12.8). a report concerning the S of the ESG. This report should allow responsible decision-making. Social factors are more than workers and employees. Traditionally, financial reporting has considered earned income as an expense in the profit and loss account. But, today, social factors encompass much more than labor rights. Entities must report on their work to protect the human rights of all stakeholders affected by productive activity. Individual freedom is a good that must be protected from all areas, including from the business point of view. But individual rights must be combined with collective rights, the social rights. This requires investments by the entities. Many of these social assets will be intangible assets, but they must be identified and registered correctly, together with the liabilities that they entail. Avoiding discrimination is an objective that social assets must guarantee. The International Labor Organization (ILO) helps to secure these assurances. But, in addition to not discriminating, entities must be initiative-taking in the process of insertion of vulnerable people. Social assets, in addition to avoiding violations of individual and collective rights, must help those less favored to get access to the labor market. It should not be forgotten that intellectual assets must appear in the accounting of social assets. As has already been said, traditionally the labor factor has been counted as an expense. Since the worker cannot be controlled, he or she is not an asset. However, the intellectual capacities of each individual worker are intertwined in the entities that form a collaborative network that constitutes intellectual capital. Companies with more trained workers have the advantage in coping with critical situations. When a company offers training to its workers, this should also be seen as an investment. Companies with the highest market capitalization are those with teams of people with better training. Therefore, the social balance sheet must show this reality. Following these intangible assets that do not always emerge when a financial report is made, the protection that entities have been creating to improve their reputation, must be analyzed. In a global world, the reputation of entities can be questioned directly (when an action of the company causes damage), indirectly (when an employee causes an accident) or tangentially (when an external stakeholder or a competitor launches an accusation). To prevent and respond to these critical situations, the entity must have investments that favor good governance, the G of the ESG. Governance assets must enable decision-making that protects and guides the entity on the right path. To achieve this objective, entities must recognize their duty of information (transparency), their duty of fidelity (ethics) and their duty of loyalty (anti-corruption) (Figure 12.9). The governance bodies of entities can differ depending on the geographical location and cultural environment where they were founded or where they operate. But the common denominator contemplated by the most advanced legislations refers to the three duties mentioned: transparency, ethics, and loyalty. Through intangible assets, entities must guarantee their ability to generate adequate and transparent information for their stakeholders and shareholders. Similarly, a code of conduct

230  Research handbook on financial accounting

Source:

Created by the authors.

Figure 12.9

Governance balance sheet

must be established for senior managers and for all workers that guarantees the fidelity of the entity to the social objectives that have led it to be constituted. This code of conduct must be translated into computer applications that facilitate the correct behavior of all members of the entity, from the highest responsibility to the simplest activity. These applications should make it possible to bring that code of conduct into the supply chain and distribution chain. The suppliers and distributors of the goods or services produced by the entity must be selected with this principle of fidelity that conditions business ethics. This helps to minimize the reputational attacks of tangential origin. With other intangible assets, bribery and corruption practices must be made impossible in the entity. There must be no direct reputational risk from these bad practices. It should be avoided as much as possible that this risk has an indirect origin, that is, that some worker executes these incorrect behaviors. Regarding the tangential reputational risk caused by the corruption of people outside the organization, the necessary mitigating mechanisms must be activated. This activation requires investment placed at the right time and periodic verification. With governance assets and governance liabilities, the balance sheet that must guarantee the reputation of the entity can be closed. This is an increasingly important activity in a global world. At this point, the entity has a Financial Report that must be extended to a Report that includes investments and liabilities in ESG. This means consolidating the four balance sheets. The financial balance sheet with non-current assets, current assets and equities and liabilities according to the conceptual financial framework must be consolidated with non-financial assets and non-financial liabilities. This means that a process of preparing an extended balance sheet should be initiated when environmental, social and governance balance sheets are recognized (Figure 12.10). The Consolidated Extended Balance Sheet shows the information that managers, shareholders, and stakeholders must use. Managers have to use it to make the best tactical decisions. The shareholders will have in this balance a reflection of the strategy followed and a guide to define the next steps to take. Finally, stakeholders can check the company’s responsibility for ESG.

The use of non-financial information in financial reporting  231

Source:

Created by the authors.

Figure 12.10 Extended BALANCE SHEET after consolidation of non-financial assets and liabilities

REFERENCES Convention on the Rights of Persons with Disabilities (CRPD) | United Nations Enable. (n.d.). Retrieved November 23, 2022, from https://​www​.un​.org/​development/​desa/​disabilities/​convention​-on​-the​ -rights​-of​-persons​-with​-disabilities​.html EFRAG. (2020). Progress Report Published for Project on Preparatory Work for the Elaboration of Possible EU Non-financial Reporting Standards. EFRAG. Fink, L. (2020). Larry Fink’s letter to CEOs. https://​www​.blackrock​.com/​corporate/​investor​-relations/​ 2020​-larry​-fink​-ceo​-letter Freeman, R.E. and Reed, D.L. (1983). Stockholders and stakeholders: A new perspective on corporate governance. California Management Review, 25(3). Friedman, M. (1970). The social responsibility of business is to increase its profits. New York Times Magazine, September 13. Garcia i Pujades, X. (1988). Devoradors de natura devorats per l’artifici. El Llamp. Garnier, J. (1848). Elementos de Política Económica (4th ed. 1864). M. Rivadeneyra. Georgescu-Roegen, N. (1970). La Science économique: ses problémes et ses difficultés. Dunod.

232  Research handbook on financial accounting International Labor Organization. (n.d.). Retrieved November 23, 2022, from https://​www​.ilo​.org/​ global/​lang​-​-en/​index​.htm Martínez Alier, J. (1999). Introducción a la economía ecológica. Rubes. Morrós Ribeira, J. and Vidal Martínez, I. (2006). Responsabilidad Social Corporativa. FC editorial. New Zealand river’s personhood status offers hope to Māori | AP News. (n.d.). Retrieved November 23, 2022, from https://​apnews​.com/​article/​religion​-sacred​-rivers​-new​-zealand​-86​d34a78f5fc​662ccd554d​ d7f578d217 Pacioli, L. (1494). Summa de arithmetica, geometría, proportioni et proportionalita. Razous, P. (1935). Principes et Applications de l’Econometrie. Dunod. Smith, A. (1776). An Inquiry into the Nature and Causes of the Wealth of Nations. Strahan and Cadell. Spain makes history by giving personhood status to salt-water lagoon, thanks to 600,000 citizens | Euronews. (n.d.). Retrieved November 23, 2022, from https://​www​.euronews​.com/​green/​2022/​09/​22/​ spain​-gives​-personhood​-status​-to​-mar​-menor​-salt​-water​-lagoon​-in​-european​-first United Nations (n.d.). Universal Declaration of Human Rights | United Nations. Retrieved November 23, 2022, from https://​www​.un​.org/​en/​about​-us/​universal​-declaration​-of​-human​-rights World Commission on Environment and Development (1987). Our Common Future. Oxford: Oxford University Press.

13. The role of the public interest in shaping corporate reporting: challenges for accounting research Begoña Giner and Araceli Mora

INTRODUCTION What does “public interest” mean in the accounting field? How has the notion changed or evolved in the last years? What are the intended or unintended consequences of changes in the use and understanding of this term? And more concretely, do these changes pose challenges for accounting research? The terms “public interest”, “public value”, “common good”, and “publicness” have multiple definitions that have been evolving over time and have been mostly used in the field of public affairs or public administration. Accounting has always been related to the public interest, at least implicitly, but the use of public interest arguments in the development of corporate reporting, at the international level, and more in particular in the European landscape, has increased significantly during last decade. The idea that the “public interest” or “public good” can be identified has been always problematic (Box, 2007). This notion has always been open to interpretations, it is contingent on the ideological perspective, differs among stakeholders and jurisdictions, and varies over time depending on the circumstances (Baker, 2005; Abela and Mora, 2012; Hossfeld and Muller-Lagarde, 2018). All these aspects acquire special relevance in an international context. Traditionally, accounting information has played two main roles in the economy: to provide information for investment decisions (valuation role) and to facilitate a measurement for accountability and governance purposes, including its use in contracts (stewardship role) (Beyer et al., 2010). The “public interest” concept might be implicit in the assumption that the reduction of information asymmetry problems is in the interest of market participants. Accounting information facilitates better and more efficient allocation of resources, which a priori should be considered an economic benefit not just for investors, but for society as a whole. For accounting information to play its function well, it must be of high quality and reliable, which can be achieved through two main means. On the one hand, it needs the good practice of preparers and gatekeepers (auditors and other enforcement mechanisms). In this context, the accounting profession has asserted that it serves the “public interest” and the main implication of this has been mostly focused on governance, accountability and ethical aspects of the professionals’ behaviour (IFAC, 2012). On the other hand, high quality accounting standards are required. Despite there being many stakeholders, the Constitution of the International Financial Reporting Standards (IFRS) Foundation states that the standards are developed “to help investors, other participants in the world’s capital markets and other users of financial information make economic decisions” (IFRS Foundation 2018, para 2a); so, investors are the 233

234  Research handbook on financial accounting main target users for the International Accounting Standards Board (IASB). Consequently, when these two roles, valuation and stewardship, have been in conflict, the valuation role has had in general a prevalence in the standard-setting process (Gebhardt et al., 2014). Under the contracting role of accounting information, the existence of consequences recently called “real effects”, was highlighted by Zeff (1978). They have been traditionally considered “unintended consequences” and have been mostly based on economic consequences. These have been widely discussed at the theoretical and empirical level in accounting research, mostly from the agency theory perspective (Kanodia and Sapra, 2016; Napier and Stadler, 2020; Shakespeare, 2020). Although in academia it has been generally argued that unintended consequences are not a cost of the standards because contracts can be adjusted, its knowledge is relevant to predict how the application of the standards might achieve the intended objective under the valuation role (Abela and Mora, 2012). As highlighted by Young (1995), financial scandals and economic crises are drivers for an increased interest of politicians in affecting the standard-setting process and auditing oversight. The financial scandals that happened at the beginning of the century, and more recently the financial crisis, have been main triggers of the further explicit emphasis on the concept of public interest; in the European Union (EU) this concept has been associated with financial stability, and has been included in the endorsement process of IFRS. In addition, after the issuance of the Non-financial Reporting Directive (NFRD) in 2014, and following the European Green Deal objectives (European Commission, 2019), there have been enormous changes towards mandatory sustainability reporting (SR) with the aim, among others, of encouraging a change in corporate behaviour towards the achievement of sustainable development (Giner and Luque-Vílchez, 2022). In April 2021 the Corporate Sustainability Reporting Directive (CSRD) proposal was published emphasizing the social and environmental public interest of corporate reporting. The inclusion of new goals for corporate reporting and the increasing importance of stakeholders, other than investors, suggests an enlargement of the “public interest” notion, and shows that we are dealing increasingly with what Lambert (2010) calls the use of information to “influence” rather than to “predict”; which in our view might be seen as a new “paradigm” (Giner and Mora, 2019b). The analysis of intended and unintended effects under this paradigm is a matter of study, in which accounting researchers can play an important role. However, in spite of the aforementioned changes and the growing importance of considering the public interest in the field of accounting, researchers have not shown much interest in the interaction of the public interest notion with accounting (Bracci et al., 2019). And public interest-related theories have not been used when establishing hypothesis regarding to the development of corporate reporting. The objective of this chapter is to present an overview of the theories related to public interest that might facilitate a better understanding of the relationship between public interest and accounting and the recent evolution of that notion. To that end, we extend some previous literature that shows how theoretical frameworks related to the public interest may be used to explain recent development in corporate reporting, mainly in Europe (Di Fabio, 2020; Giner and Mora, 2021). We link those theories to current developments in the oversight of the profession and the regulation of corporate reporting in both financial reporting (FR) and Sustainability Reporting (SR). Our main contribution is to put into place the different existing theories that might help to build a theoretical framework adapted to these new developments

The role of the public interest in shaping corporate reporting  235 in corporate reporting in which the public interest notion seems to prevail as a new paradigm and to pose new challenges for future research. The structure of this paper is the following. We show different theories and perspectives on the public interest notion under an interdisciplinary perspective in the next section. Then we discuss the link between the public interest and the accounting profession in the third section. In the fourth section we analyse how the two pillars of the current corporate reporting scenario, FR and SR, have evolved in connection with the public interest notion. Finally, in the fifth section we provide the discussion and derive some research implications, and in the sixth section we conclude.

THEORETICAL BACKGROUND The theories and arguments discussed in this section have been developed in the field of political science but may be used to establish a theoretical framework for corporate reporting. They are used to analyse public interest in the context of the accounting profession and in the standard-setting process; they are especially useful to find arguments to explain the debate on the existence of a public interest in traditional accounting regulation (Bischof and Daske, 2016; Neu and Graham, 2005; Killian and O’Regan, 2020; Dellaportas and Davenport, 2008), but also to comprehend the recent developments in SR. We start by considering the notion of public interest in the field of public administration, followed by an analysis of the traditional theories on accounting regulation, as well as other theoretical developments. Different Perspectives of the Public Interest Notion As pointed out by Box (2007), people in public life, politicians, and even scholars, use the terms public interest and public good despite its lack of identifiable substance, under the assumption that authors and readers share a common understanding of their meaning. However, the idea that a “public interest” or “public good” can be identified has been problematic. Based on the theories developed by Cochran (1974),1 Box (2007) considers three perspectives of the public interest: substantive, aggregative, and process. From the substantive perspective, there is a “common good” that in an “ideal” model might be relatively stable. Under this perspective, the concept would be agreed upon by most, if not all citizens; people well informed about the current situation and alternatives for the future, and capable of rationally choosing the “best” alternative. This is a pure normative perspective which seems to be unsupportable by evidence (Box, 2007). The aggregative perspective would be the opposite of the substantive one, the public interest is the result of aggregated individual preferences. This perspective does not require the definition of abstract concepts such as public interest; by considering that the public is a collection of individuals (or groups) with different preferences, the public interest consists of whatever the majority wants at a given time. As pointed out by Box (2007) this perspective can be attractive from a democratic point of view because it valorizes the majority view. However, the pure 1 Cochran (1974) considers a wider range of theories and sub-theories, but for the aim of this paper we consider Box’s (2007) simplification is essentially valid.

236  Research handbook on financial accounting aggregative perspective has the classical objection that some criterium should be applied to rank the interests, unless all interests are equivalent (Cochran, 1974); and this perspective fails to explain the perception of collective goals in public affairs (Box, 2007). Between these two approaches, the process perspective contemplates individuals as participants in a dialogue about what is in the public interest. Individuals (or groups) are perceived as people with interests who can learn from social interactions in which they become aware of others’ perceptions. They might even change or be willing to compromise for the good of the larger community and arrive at a “consensus”. This perspective emerged as an ideal alternative to the notion of public interest. This alternative has its own weaknesses in practice. The “common good” is still a vague and debatable concept. Some theorists have tried to avoid the difficulties involved in identifying the public interest with the outcome of the political process by declaring that the process itself is the public interest, provided that certain standards of “due process” are followed (Cochran, 1974). However, this is not generally accepted since following due process does not necessarily guarantee that public interest is achieved. Besides, in most cases a relatively small percentage of the affected individuals (groups) participate in the policy dialogue, and the power attributed to those who participate might be unbalanced. We will return to these weaknesses when applying these theories to the accounting field. But we want to highlight that the central principle of the public interest is the “principle of consequences” that exhorts the decision-maker to examine the consequences of alternative courses (Cochran, 1974). This is where academic research has a significant role to play. Market-driven Theories of Regulation The literature has produced three major theories of regulation (Peltzman, 1976; Kalt and Mark, 1984) specifically linked to the public interest notion: the so-called “public interest”, the “capture” and the “ideology”. 2 Some authors have applied these theories to the behaviour of capital market regulators (Kothari et al., 2011; Abela and Mora, 2012). The pure form of the public interest theory describes regulation as a ¨benevolent and socially efficient” response to market failures. It shows the regulator as an infallible entity that is not susceptible to political influence and draws its judgements on purely technical grounds. This theory relies heavily on the belief that lobbying has a negligible impact on regulatory outcomes. According to Kothari et al. (2011), this assumption could be interpreted as consistent with how some standard setters view their own work, although it does not fit with what is observable in practice. On the opposite side of the purest form of the public interest theory is the capture theory, which considers regulators as economic agents seeking to maximize their own utility. These regulators are usually politicians, whose interest lies in retaining their power. Consequently, they will supply regulation in accordance with those constituents that they believe will be most effective in helping to maintain their power. The implication of this theory to the accounting domain would be that accounting regulators, who are assimilated with the self-interested politicians, are captured by specific and powerful lobbyists; in addition, as a result of these The public interest and the capture theory were seen as alternative theories of regulation in the late 1970s (see Pelzman, 1976). The ideology theory arose later as a consequence of the observed behaviour (see, for example, Kalt and Mark, 1984). 2

The role of the public interest in shaping corporate reporting  237 political pressures, the market would no longer trust the output that results from the standards (Abela and Mora, 2012). The empirical evidence does not appear to support the arguments put forward under this theory either (Dal Bo, 2006) and, with some exceptions (Kothari et al., 2022), it is also difficult to reconcile with what is mostly observed in practice. Lastly, the ideology theory is premised on a behavioural model of regulators that assumes neither the naïve view under public interest theory nor the prominence of self-interest under capture theory. It argues that the regulatory outcomes result from the combination of the political ideologies of regulators and the effect of interest-groups lobbying regulators. Lobbying activities might be self-interested, but they could also be seen as a mechanism through which regulators become aware of policy issues that they need to respond to, and this is precisely the reason why consultation periods are key in the due process of accounting standard-setting (Esty, 2006). The ideology theory does not attempt to assess the “optimality” of the regulatory outcome. This is the theory that seems to better explain the behaviour of standard setters observed in practice (Abela and Mora, 2012). These theories of regulation can be linked with the aforementioned perspectives of the notion of public interest. The ideology theory of regulation is associated with a notion of public interest based on the process perspective, which could be a priori the theoretical framework that better fits with the accounting regulation process. However, as mentioned, these theoretical assumptions have weaknesses in practice. Focusing on a scenario in which different stakeholder are involved in the regulation process, and there are interests in conflict, the problem of making decisions emerges. Indeed, there will likely be an imbalance of power between groups of stakeholders, and how to weight the different interests. As discussed below, the “balancing approach” provides an solution to this imbalance, although it is not free from criticism. Other Theories Based on Public Interest: the Balancing Approach Politicians are normally in a privileged position to influence regulation in general, and accounting or auditing regulation in particular. There are several channels through which political forces can affect different stages of the standard-setting process, including the governance structure of institutions, lobbying and direct political channels. It has been argued and empirically tested that politicians have a strong interest in accounting information, and the use of accounting as a tool to achieve their own objectives is not free from self-interested motivations (García Osma et al., 2019; Bischof et al, 2020; Giner and Mora, 2021). Based on the traditional agency framework, some studies provide empirical evidence that politicians might use accounting to gain political goals for their own benefit, which confirms the view that politicians often value short-run economic effects while discounting longer-run consequences (Walsh, 2005). But this framework has limitations on explaining how they behave in particular circumstances, such as for example a severe financial crisis (Giner and Mora, 2021). Giner and Mora (2021) adopt a broader and more interdisciplinary view that helps to understand how and why, in extreme circumstances, particularly in a financial crisis emergency, politicians might use accounting to obtain desirable short-term outcomes with the consent of institutions and the inaction of gatekeepers on behalf of the “public interest”. In the fields of law and politics, the “balancing approach”3 helps to explain the use of the “public interest” 3 This theory is based on the use of public interest argument to break legal rights (Aleinikoff, 1987; Meyerson, 2007).

238  Research handbook on financial accounting as an argument to “overrule” standards (Aleinikoff, 1987). Thus when two policies come into conflict, the satisfaction of one must be at the expense of the other, and the “correct” decision is the one that produces the “greatest net benefit”, which would be conducive to the “common good” (Meyerson, 2007). However, this apparently “correct” decision requires giving weights to the variables in conflict to balance the competing interests, and then self-interest and ideology might influence the weights given to the alternatives. Furthermore, when determining which of them has more weight, it is (wrongly) assumed that there is a homogeneous measurement criterion to consider the consequences, which makes alternative courses of action comparable. Giner and Mora (2021) argue that when there is a conflict between accounting rules and governmental goals, specifically with public policy objectives (such as providing for economic well-being, which is commonly understood as a matter of public interest), the benefits of breaking those rules could be seen by politicians as greater than the possible costs. Although these authors are adapting this framework to the case of overruling accounting rules, so to accounting practice and its oversight, it could be also adapted to the decision to change or adopt an accounting rule, consequently to the standard-setting process.

THE INSTITUTIONAL CONTEXT OF THE ACCOUNTING PROFESSION In this section we first discuss how the accounting profession has been presumed to work in the public interest, and then, based on the public interest arguments, we look at how its oversight has evolved. As stated by Huber (2015), for decades it has been considered that the public interest is inherent to the accounting profession, since its mission is to serve and protect the public interest. According to the International Federation of Accountants (IFAC), accountants and accounting play a significant role in the creation and maintenance of the public interest, most obviously through the fundamental obligation for professional accountants to serve the public interest (IFAC, 2012). To achieve good audit quality, high quality standards on auditing are needed, which at the international level have been issued by the International Accounting and Assurance Standards Board (IAASB); otherwise the public will not trust in the auditor’s opinion. A logical complement of having quality standards is having a trustable profession that behaves ethically, and this is precisely what the standards issued by the International Ethics Standards Board for Accountants (IESBA) aim at too. Until very recently, these two boards were IFAC committees. Hope and Langli (2010) define “acting in the public interest” as compliance with the code of ethics of the profession, and consider that the purpose of the code is to enhance the reliability and credibility of audited financial statements. Similarly, McGuire et al. (2012) and Schmidt (2012) define the public interest from the auditing perspective as the validation of the accuracy, reliability, and credibility of the financial statements in order to help investors’ decision-making. There is the belief that the provision of accounting information aims to help the efficient functioning of the capital market, and that itself might be seen as contributing to the public interest. But for this to work, the auditor’s independent judgement is an essential component in reducing agency problems as companies produce the information.

The role of the public interest in shaping corporate reporting  239 After several major corporate collapses that took place at the beginning of this century, which not only affected the economy as a whole but impacted the credibility of the profession significantly, regulatory arrangements were put in place by certain institutions creating what was known as the Monitoring Group (MG).4 These arrangements affected the oversight of the process of developing standards on auditing and assurance as well as on ethics. They were based on the premise that unless there was appropriate structure and process for governance and oversight of the accounting profession, the public interest would not be protected.5 Central to these arrangements is the Public Interest Oversight Board (PIOB). The PIOB was established in 2005, and is the intermediate level in the three-tier structure formed by the Monitoring Group (MG), which exercises an overall monitoring role as guarantor of the public interest in the financial institution domain, the PIOB a multistakeholder body representing the interests of investors, markets and users of the corporate information, and the standard setters: the IAASB and the IESBA. The main goal of the new structure is to establish some control over the accounting and auditing profession, by means of a strong supervision of their standards and the composition of the standard-setting bodies.6 As explained by Wymeersch (2015, p.1), a former PIOB Chair, the need was felt to upgrade the status of the previously existing professional standards from purely self-regulatory instruments implemented by the IFAC member bodies, to widely recognized and used professional standards with a higher public interest status due to external public oversight.

Since its establishment, the PIOB has been overseeing the due process leading to the establishment of auditing and ethics standards (understood in a broad way, since the boards establish their agendas until the standards are approved). In order to guarantee that the standards are designed having the users’ interests in mind, the process has to be independent, and free of undue pressures that might go against the users. It is important to consider some characteristics of the oversight procedure followed by the PIOB that are relevant for the further analysis (Wymeersch, 2015). When the PIOB refers to the protection of the public interest, it does not assume that it depends on the remarks made during the consultation process; on the contrary, PIOB has a duty to pursue the interest of the public, the users, regardless of whether they actively participate in due process or not. The financial crisis was a trigger for further interest and changes in the oversight of the profession’s landscape in the EU. Thus, in 2011 the European Parliament (EP) stated:

4 The Monitoring Group is a group of international financial institutions and regulatory bodies committed to advancing the public interest in areas related to international audit standard setting and audit quality. The members of the Monitoring Group are the Basel Committee on Banking Supervision, European Commission, Financial Stability Board, International Association of Insurance Supervisors, International Forum of Independent Audit Regulators, International Organization of Securities Commissions, and the World Bank. 5 Directive 2014/56/EU states in the revised article 26 of Directive 2006/43/EC allows that the Commission is allowed to adopt the international auditing standards (ISAs) issued by the IAASB, only if they “have been adopted with proper due process, public oversight and transparency, and are generally accepted internationally”, and “are conducive to the Union public good”. 6 See the report “Standard setting in the public interest: A description of the model”, PIOB, 15 September 2015. Available at: https://​ipiob​.org/​how/​.

240  Research handbook on financial accounting The public-interest function of statutory audit means that a broad community of people and institutions rely on the quality of a statutory auditor’s or an audit firm’ s work. Good audit quality contributes to the orderly functioning of markets by enhancing the integrity and efficiency of financial statements. Thus, statutory auditors fulfil a particularly important societal role.7

That said, it is relevant for the further discussion to consider the 2020 Recommendations issued by the MG regarding how the different actors should perform in pursuing the public interest. The MG emphasizes that the standards should consider the different stakeholders, balancing and weighting of evidence and diverse stakeholder’s viewpoints. However, since their needs might differ, it is important to highlight that the MG points out that they should be focused “primarily on the interests of users, and more specifically the longer-term interests of creditors and investors and the protection of those interests” (MG, 2020, p. 20). As a consequence of the 2020 Recommendations, some changes have been recently implemented. In 2021, a PIOB Nominating Committee was established to replace the IFAC in the selection and nominating process of the members of both the IAASB and the IESBA. The objective is not only to separate the boards from IFAC’s sphere of influence, but to have multi-stakeholder boards in which accountants do not dominate. And, in November 2022, a new International Foundation of Ethics and Audit (IFEA) has been established to house the two boards, thus they are not IFAC committees anymore.8

THE CORPORATE REPORTING STANDARD-SETTING PROCESS: THE EU INSTITUTIONAL CONTEXT Next, we expose the current developments undertaken in corporate reporting in the EU focusing on the evolution of the notion of public interest linked to the standard setting process distinguishing developments in FR from those more recent developments in SR. Financial Reporting Standards As already mentioned, FR of companies (more concretely listed entities) has been considered under the financial market perspective. Consequently the “common good” notion has been linked to efficiency and better allocation of resources in the capital market, which in the market-based accounting research fits with the paradigm of usefulness to make investment decisions. IFRS are designed with a specific interpretation of the economic public interest in mind, based on the belief that the IASB should act to respond to capital market failures. Under this view, investors are the primary users, and usefulness for their decision-making process

7 See Recital 2 in the Proposal for a Regulation of the European Parliament and of the Council on specific requirements regarding statutory audit of public interest. Brussels, COM (2011) 779 final, 2011/0359 (COD). Available at: http://​www​.europarl​.europa​.eu/​sides/​getDoc​.do​?pubRef​=​-//​EP//​ TEXT+​TA+​P7​-TA​-2014​-0283+​0+​DOC+​XML+​V0//​EN. 8 The IFEA Trustees will be nominated by the PIOB and the IFAC, but with a majority of seats for the PIOB. This new formula agreed by the three parties (MG, IFAC and PIOB), aims at reducing the direct control of the standard-setting bodies from IFAC to make them more independent from the profession.

The role of the public interest in shaping corporate reporting  241 is the main objective of information. This approach to the public interest also underlies the interpretation of the European Commission (EC) as stated in Regulation 1606/2002 on the adoption of IFRS, which aims “to contribute to a better functioning of the internal market”, and “the efficient and cost-effective functioning of the capital market” (European Parliament and Council of the EU, 2002, p. 1). A few years after IFRS were implemented in the EU in 2005, the global financial crisis served as an important catalyst and power struggles between the EU and the IFRS Foundation emerged (Bengtsson, 2011; Burlaud and Colasse, 2011; Botzem, 2014; Palea, 2015), which affected the initial common view of the public interest notion.9 Therefore, at the EU, the so-called “European public good or public interest” has been adapting to changing economic and political concerns that could conflict with the initial notion (Warren et al., 2020). Referring to the EP’s attitude towards endorsement, some argued that IFRS should not be simply endorsed by the EC, but “had to be justified not just economically, but also politically and socially” (Crawford et al., 2014). Some voices have been arguing that their interests were not adequately considered by the IASB; the issuance of the Maystadt Report can be seen as a turning point in the attitude of the EC towards IFRS (Maystadt, 2013). The 2013 Maystadt Report stresses the need to enhance the criteria of the “European public good” in the endorsement process (Alexander and Fasiello, 2021). Along those lines, ten years after the introduction of IFRS, the EC concluded that the term public good “may be understood to encompass broad financial stability and economic considerations” (EC, 2015, p. 7), which is a major change compared with the prior economic interpretation in the Regulation.10 As a consequence, nowadays, the criterion to endorse IFRS encompasses the financial stability goal and, more generally, the protection of the European economy which is the implied interpretation of the “public interest”. The increase of political influence in the process of adopting IFRS has to be considered when analysing the relationship between the public interest and the accounting standard-setting process, as several authors have stated (Alexander and Eberhartinger, 2010; Burlaud and Colasse, 2011; Camfferman and Zeff, 2018). The IFRS Foundation reacted in 2015 by publishing a mission statement stating that it was contributing to the public interest by fostering trust and growth and introducing a reference to “long-term financial stability in the global economy” (Hoogervorst and Prada, 2015, p. 3). This statement is still aligned with the initial economic notion of public interest. But the European changes have involved a broadening of the “public” toward other stakeholders beyond investors, resulting in a greater prevalence of the financial stability objective that continues to gain some importance over utility (Pelger, 2016; Mora, 2022), and has led to greater political influence in the regulatory process. The financial crisis also affected the final output of the standard-setting process, as happened with financial instruments, resulting in IAS 39 being replaced by IFRS 9. In particular, the change in the impairment loss model was due to the pressure from banking regulators, supervisors and politicians, who considered the IFRS 9 model to be more in line with financial

Another consequence of the crisis was the establishment in 2009 of a Monitoring Board located above the IFRS Foundation as a reinforcement mechanism to enhance public accountability (IASCF, 2009). 10 The changes in the EFRAG governance structure following the Maystadt Report are another example of the politization of the European regulatory process (Walton, 2015). 9

242  Research handbook on financial accounting stability objectives. Paradoxically, these same banking regulators called in 2020 for more flexibility in the application of the IFRS 9 model, arguing that, due to the COVID-19 pandemic crisis, the model had a negative effect on financial stability. Although the IASB was rather reluctant to follow the demands of financial supervisors when it issued IFRS 9, it now seems much more willing to accept their demands by allowing the prudential supervisor to issue guidance for interpreting the IFRS 9 model (Mora, 2022). Sustainability Reporting Standards Since the 1980s, there has been a line of thinking pointing to the need to rethink accounting considering wider values and concepts than the traditional focus on usefulness to predict cash flows and on measuring economic impacts on entities. This line opens up the scope to account for ecological and other social responsibilities, as well as the so-called sustainable business. Several institutions have been strongly working toward the establishment of guidelines to help entities to produce NFR, also known as environmental, social and governance (ESG) information, and more recently SR. We refer to the Global Reporting Initiative (GRI), as well as the International Integrated Reporting Committee (IIRC) and the Sustainability Accounting Standards Board (SASB), these last two institutions focus on investors, and merged in 2021 to create the Value Reporting Foundation (VRF), which in August 2022 completed the consolidation with the IFRS Foundation. As mentioned above, after the adaptation of national laws to Directive 2014/95/EU on NFR, the CSRD proposal represents a huge change in the field of SR, and there are some aspects that deserve attention in this study. The first is that, contrary to what happened with FR, the EU has opted for a European standard setter, EFRAG, and this is being materialized in the draft European sustainability reporting standards (ESRS) sent to the EC at the end of November 2022, although the authority to issue the final standards by means of delegated acts is the EC. To accommodate this new task, and following a consultation that took place in 2021, EFRAG has substantially modified its structure and, since the beginning of 2022, a new SR pillar, in parallel with the FR one, has been established. The new board in that pillar also includes the civil society. Additionally, the CSRD has introduced some aspects that will characterize the future ESRS, we refer to double materiality, target audience and scope. The concept of “double materiality”, which was implicit in previous position papers issued by the EC but not in the NFRD (Baümuller and Sopp, 2022), has been clearly stated. This means that in addition to considering how sustainability topics are sources of risk and opportunities on entities, the so-called “financial materiality”, it should be considered how entities affect or impact the environment and society, referred as “impact materiality”. This constitutes a big challenge in terms of reporting at the EU (Giner, 2023). Regarding target audience, consistent with the Maastricht Treaty, the CSRD proposal considers investors and non-governmental associations, social partners, and other stakeholders to be primary users, which means adopting a multi-stakeholder approach in which there is no prevalence of investors. Regarding the scope, following the mandate of the CSRD proposal, draft ESRS cover environmental (climate, pollution, biodiversity, water, and circular economy), social (own workforce, other workers, affected communities, consumers and users), and governance.

The role of the public interest in shaping corporate reporting  243 Simultaneously, at the international level, the IFRS Foundation created a new board in parallel to the IASB, the International Standard Sustainability Board (ISSB) to develop IFRS sustainability standards. However, the ISSB only considers “financial materiality” since it is oriented to investors, and at the moment is focused on climate, although it has already indicated that other topics will come later (IFRS Foundation, 2020). Regarding how the two institutions have adapted their previous concepts of “public interest” to the new SR domain, the fact that the ISSB maintains investors as the main users and narrows the provision of information to that related to the financial position of the entity does not suggest a change compared with the IASB. However, the introduction of the “impact materiality” and the consideration of all stakeholders, of which some might be only affected stakeholders (and not users), suggest a significant change in the definition of public interest of the ESRS issued by the EFRAG compared with the focus on investors and financial stability in the field of FR.

DISCUSSION AND RESEARCH IMPLICATIONS In this section we link the theoretical frameworks shown in the second section with the institutional context and infer research implications in the accounting field. The Role of the Accountants and their Incentives The incentives of the profession to act or not in the public interest have been, at least indirectly, a matter of research for years. Regarding independence and audit quality, Tepalagul and Lin (2015) provide a comprehensive summary of the literature on the relationship between both aspects. Also, recent literature reviews highlight the link between whistleblowing and accounting-related misconduct (Gao and Brink, 2017). However, little attention has been paid to the theoretical assumptions connecting professionals’ behaviour to the public interest (Dellaportas and Davenport, 2008; Neu and Graham, 2005), which might allow us to analyse the consequences of changes in this notion. Economic-based accounting research is mainly based on economic theories of the audit market, or, grounded on agency theory, it has been traditionally considered in the development of hypotheses on professionals’ actions (Parker, 1987). However, traditional agency theory might not fully explain professionals’ behaviour. To solve the insufficiency of traditional research, other approaches have been considered, of which some have a psychological and sociological background (Baker, 2014), others are based on the theory of moral action (Lokanan, 2018), and on other non-conventional approaches and critical perspectives (Baker, 2014). However, the notions of “public task” or “serving the public interest” are not used in those approaches and research that establishes the link of public interest theories with professionals’ behaviour is, to the best of our knowledge, scarce. An exception is Giner and Mora (2021), who extend the implications of the balancing approach to explain why, in a case of extreme political interference in accounting, considered in the “public interest”, auditors and enforcers (particularly the less independent ones) instead of following their professional rules, might act in the interest of politicians. The previous analysis of the last developments in the oversight of the accounting profession shows some similarities with the evolution of the public interest notion in the standard-setting

244  Research handbook on financial accounting process of corporate reporting. However, some significant differences prevail. Since the public interest notion applied in this context is focused on the behaviour of the profession, any institutional or standard changes that occur will be aimed at affecting their behaviour. Will the increasing independence of the boards from the profession and the multi-stakeholder approach pursued by the oversight institutions affect the behaviour of auditors? In our view, more attention should be given to theories that explain the link between public interest and how the profession is adapting to the new context when developing hypothesis and empirically testing them. The Standard Setting Process: Further Effects Analysis Traditionally, mainstream FR research has been mostly grounded on the pure public interest view of regulation. Thus, the role of accounting information should be to enhance efficiency and equity in financial markets (Lev, 1988). Following the US tradition, empirical research on FR that preceded and followed the IFRS implementation, has been principally considered under the financial markets research domain, while publicness has not played a significant role. Additionally, research on the standard-setting process has been mainly focused on the analysis of lobbying activities, mostly under the agency theory and self-interest perspective. The focus on due process and the prominence of some stakeholders in the EU landscape after the financial crisis, including the higher interference of politicians, as well as the introduction of the financial stability goal should be a matter of theoretical development and empirical analysis. According to a large body of accounting researchers, the main problem with the growing importance of considering financial stability a goal of FR is that the two different objectives, usefulness for investors and financial stability, are usually in conflict (Zeff, 2012; Giner and Mora, 2019a). From the perspective of accounting researchers when this happens, the prevalence of the second objective might have negative consequences in transparency and credibility (Barth and Landsman, 2010; Acharya and Ryan, 2016; Novotny-Farkas, 2016; Giner and Mora, 2019a; Mora, 2022). There are some key questions for debate related with the goal of financial stability on behalf of the public interest which will require further theoretical and empirical research. Is there a unique view of financial stability? Should accounting standard setters meet the needs of one set of users at the expense of others? Could the IASB be captured by the self-interest view of dominant or powerful stakeholders (as politicians or prudential regulators)? Will recent developments in the standard-setting process have unintended consequences on transparency and market allocation of resources? The current EU process can be explained through the ideology theory of regulation with a public interest notion based on the process perspective, although inevitably the weaknesses of those perspectives emerge. The IASB legitimacy derives from the ability to develop rules acceptable to the different stakeholders, rather than to obtain “optimal” rules (De Luca and Prather-Kinsey, 2018), which is consistent with the ideology theory. It can be argued that the public interest notion in this context is mostly focused on the process perspective because of the existence of a due process in which stakeholders can influence and provide their own views. However, it can also be argued when there is a conflict of interests that the final output

The role of the public interest in shaping corporate reporting  245 might be driven by unbalanced power of stakeholders, and the capture theory of regulation might have a role.11 Di Fabio (2020) does an interesting analysis trying to link public interest theories with the IASB standard-setting process. Aligned with this view, she highlights that the IASB has the risk of being captured by the most powerful stakeholders, pointing out to its major constituency: the EU (which might be viewed as a “political” constituent) and the financial industry, and argues that financial stability might be interpreted as a tool to favour the financial industry’s interests rather than as a means to safeguard the real economy’s health. Some complexity can be added to the European scenario when considering that the EU is a political constituent whose view is an aggregation of interests, since all jurisdictions have a vote and different self-interests (Di Fabio, 2020). From a related but different angle, Giner and Mora (2021) use the balancing approach to highlight the potentially dangerous consequences of politicians using accounting as a tool, on behalf of the public interest. In summary, the current IFRS context and the circumstances surrounding its implementation in different jurisdictions offer an interesting field of research. The interaction between achieving the public interest, with its various interpretations for the different stakeholders with different interests, together with the use of accounting to get political goals, results in a complex scenario in which the potential number and typology of unintended effects is difficult to predict. Researchers play an essential role in evidence-based accounting regulation (Buijink, 2006; Abela and Mora, 2012) and current developments do provide material for empirical evidence. When dealing with SR, the scenario becomes even more complex, and poses even more challenges for researchers particularly in the EU context. Since the 1990s, the critical perspective approach to accounting research has been evolving out, and there is a strong body of literature focusing on corporate social responsibility (CSR) stating that accounting should focus more on provoking changes in organizations rather than merely describing them (Gray, 1992; Larrinaga and Bebbington, 2001; Larrinaga-Gonzalez et al., 2001; Adams, 2002; O’Dwyer, 2002; Castelo Branco & Lima Rodrigues, 2006). This field of corporate reporting which started as a critical approach has recently become mainstream, but a line of research similar to the traditional marked-based one that considers economic consequences is needed. The multi-stakeholder perspective increases the likelihood of conflicts of interests, not just the economic interests of the different stakeholders but the economic versus the societal interests. It should be noted that despite ESRS being mandatory, they will not oblige companies to behave in one way or another, although they might change their behaviour, and this is an interesting matter of research (García and Mora, 2021). It has been argued that the EU requirements might create a competitive disadvantage, or even advantage, for EU companies; in fact, there might be a conflict between maximizing corporate economic value and some socially responsible behaviour, but also some beneficial aspects in terms of improved reputation. These assertions are not obvious and also need empirical testing. Many of the early studies that analysed the relationship between CSR and company wealth obtained inconclusive results and some subsequent studies have found a positive but non-linear relationship (Flammer, 2015); and, the most current ones show positive market reactions, but only from certain long-term (such as Durand et al., 2019) or institutional investors (such as Dyck et al., 2019). As highlighted 11 For example, Kothari et al. (2022) highlight that evidence for US Stock Exchange EC capture is somewhat mixed, depending on the type and time of SEC decisions examined.

246  Research handbook on financial accounting by Christensen et al (2021) it is difficult to predict whether the firm responses are net positive or negative from the perspective of investors, other stakeholders, or society. The effect of the mandatory disclosure on value creation is still a matter that must be subject to empirical investigation.

CONCLUSIONS AND FINAL REFLECTIONS The concept of public interest in the accounting field is not unique, and seems to have changed significantly in the last decade; from having an economic angle linked with efficiency in the capital market, to promoting financial stability, to achieving a more sustainable world. In addition, the contracting role of information and the real effects, either intended or unintended, are becoming more prevalent in policymaking decisions related to corporate reporting. The growing importance of considering the public interest in the field of accounting requires empirical studies that provide evidence about whether this is really considered and how. That said, empirical research should be based on a theoretical framework that contemplates theories and arguments related to the public interest. These theories exist in other fields, mostly in the political and legal science but their use in the accounting research is scarce. The recent developments in corporate reporting, in particular the emergence of SR, suggests a change in paradigm from the one referred to the usefulness to the one associated with behavioural changes, which drives new challenges for researchers. Future research will allow to see the consequences of the introduction of the new sustainability standards, and confirm if they have achieved the objective, which is a more sustainable behaviour of entities. Besides, this new form of reporting has considerably enlarged the number and typology of stakeholders, which might have different views, and researching how they are balanced by the standard setter when acting in the public interest is quite a challenge. This new scenario puts added pressure on accountants and other preparers of the information, as well as on auditors and assurers. The development of high-quality standards, both on audit and ethics, is on the agenda of the relevant standard-setting bodies. This opens up a new avenue of research that delves deeper into the behaviour of those actors and how they act in the public interest. In our view, the main contribution of the study is to show different theories and perspectives to be used in future accounting research, which will provide a more interdisciplinary foundation to the development of hypotheses, related with standard setting, as well as corporate reporting practices and their consequences. We also argue that more critical thinking on the role(s) of corporate reporting, and the potential conflict of interests among stakeholders (including politicians) is required when making hypotheses.

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14. The importance of corporate governance information and disclosure for investors Raffaele Manini

INTRODUCTION The study of corporate governance is concerned with understanding the mechanisms that have evolved to mitigate incentive problems created by the separation of the management and financing of the business entities. (Sloan, 2001)

For this reason, investors need financial accounting information not only to address companies’ performance in general, or to extract the information related to the risk and return that are needed to make optimal portfolio allocation decisions, but also to address corporate governance issues. In fact, financial accounting information through the various statements and disclosures, such as the 10-Ks and the DEF14As, are the main sources of data related to managers’ performance, board of directors’ composition, committees’ responsibilities, and risk oversight. There is a plethora of studies and articles explaining how accounting numbers can contribute to investors’ knowledge. These studies touch upon a multitude of very relevant topics that cover the use of accounting numbers and estimates to calculate stock market valuation, managers’ incentives, earnings management, etc. Most of these studies tend to look at the main financial statements as the key source of accounting information. This makes total sense because the income statement, balance sheet, statement of cash flow, and the statement of shareholders equity offer both quantitative and qualitative information about firms. For instance, the financial statements provide all the numbers needed to compute ratios and perform analyses to assess firms’ performance, creditworthiness, assets quality, credit scoring, debt quality, and much more. At the same time, the financial statements also provide some important qualitative information about firms that both professionals in the private sectors as well as academics are trying to explore increasingly more over time. This information is the so-called footnotes, where managers disclose significant accounting policies and practices, income taxes, pension plans and other retirement programs, and stock options among other complex items that need a thorough qualitative explanation beyond their mere numerical representation. On top of that, there is a section in the quarterly or annual reports where managers explain in words the performance of the firm. This section is named “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, also known as MD&A. According to the SEC, in the MD&A investors should be able to find information that the management believes is important for the understanding of the company’s performance and trends. It is basically a way to see the company’s results through the eyes of its management. Despite the significant amount of information that could be gathered from the classical financial statements, investors could also access another key disclosure that could help them better understand the firm situation, not only from a managerial perspective, but from an 251

252  Research handbook on financial accounting overall corporate governance perspective. The disclosure statement I am talking about is the DEF14A also known as “definite proxy statement”. “This form is intended to furnish security holders with adequate information to be able to vote confidently at an upcoming shareholder meeting.” Information included in the form DEF14A is on the background of the firm’s nominating directors, top shareholders and holding details, potential conflicts of interests among directors, board and executive compensations, audit fees, committees’ description and composition, risk monitoring statements and other important details. Unlike the classical financial statements, the definite proxy statements have been much less considered by professionals, academics, and investors as a key source to value a company. However, after the various corporate scandals that made regulators tougher on corporate governance practices, and more recently with the rise of ESG-related issues, this disclosure is becoming increasingly more relevant to investors. Throughout the chapter I will deal with just some of information investors could access and exploit when analyzing one of the US companies’ main corporate governance disclosures. Furthermore, I will focus mainly on the US regulatory environment because it is the one that academics tend to explore the most when publishing high impact research and, consequently, has become the benchmark of corporate governance practices around the world. The first aspect that I would like to discuss is the human capital one. Nowadays, regulators, institutional investors, and even the media put substantial emphasis on the crucial role that human capital plays in the evolution and development of the business world. With trends promoting innovation, long term focus, and stakeholders’ governance, being able to address who is in charge within a firm becomes essential to establish whether to trust a business agenda or not. In this respect, the DEF14A forms are an excellent tool because, in there, investors can find relevant information about the reasons why directors are sitting in the company’s board of directors. In fact, Item 401(e) of regulation S-K states the following: Briefly discuss the specific experience, qualifications, attributes, or skills that led to the conclusion that the person should serve as a director for the registrant at the time that the disclosure is made, in light of the registrant’s business and structure. If material, this disclosure should cover more than the past five years, including information about the person’s particular areas of expertise or other relevant qualifications.

This means that by accessing the proxy statements, investors can read about the company’s directors’ backgrounds and qualifications and through this information they can make more informed decisions about their investments. Indeed, there are many reasons why investors should care about who is sitting on the company’s board of directors. For a start, the role that the board of directors is called to perform is increasingly complex. It must perform an oversight role within the firm by advising and monitoring top management on the firm’s overall performance (Fama and Jensen, 1983). In addition, the board must assess, amend, and approve major strategic decisions made by management; select, monitor compensate and fire top management; and provide advice to top management (Coles et al., 2020). All these decisions require sound, solid and diverse expertise among the board members. To further stress the importance about knowing who is sitting on a company’s board of directors, the literature and history of corporate scandals teaches us that individuals are always at the root of any kind of business misconduct, so knowing about their background and qualifications becomes paramount to fairly judge the way they might lead the company. On top of that, the call for diversity within the C-suites of companies is becoming pressing. Large

The importance of corporate governance information and disclosure for investors  253 institutional investors such as Blackrock made clear statements about the importance of having diversity within firms’ board of directors, and such move is key for the development of a more stakeholders-oriented business landscape. These moves towards an ESG-centered corporate world comes with its challenges both from the companies’ perspective and from the investors’ perspective. In fact, while it is true that companies must incur sometimes substantial costs not only in financial terms to adjust to a very mutable scenario, but also as investors, who seem to care increasingly more about how their investments impact the planet and society, need to face the uncertainty related to whether these companies are actually implementing the measures they called for. Once again, the proxy statements could help bridge the gap between investors and companies. In fact, besides the board of directors’ description mentioned in the previous paragraphs, nowadays companies are trying to make investors feel comfortable about who is sitting on their board. For this reason, besides the mandatory director nominees’ descriptions, companies are trying to add quantitative charts to show investors where they stand and what moves they made towards having a more diverse governance structure. Human capital focus, ESG-oriented investments and a broader view of the business landscape do not only translate into more opportunities. In fact, each one of these areas incorporates relevant risks. Or at least it points the investors’ attention towards certain kinds of risks that were not previously considered as such. Climate change risk, the consequences of social segregation, and cyber risk come immediately to mind when thinking about the health of the planet and society, so companies must be able to address these kinds of issues as well. Not too long ago, when we lived in a merely stockholders-oriented world, the focus of investors was much narrower, so there was a clearly identified focus towards financial risk. Nowadays, instead, there are many more areas to take into consideration when establishing a company’s risk policy. Also in this situation, the financial statements could be of tremendous help to investors to understand how a company is thinking about and preparing for these new risks. Both the 10-ks and the DEF14As have sections dedicated to risk awareness and oversight. Specifically, the 10-ks have a section in which companies must disclose their risk factors, which should correspond to those kinds of risks that the company deems material to their business. At the same time, companies should disclose in their DEF14A forms how they plan to monitor and oversee such risks. Investors can find in this disclosure information about how the company’s corporate governance structure addresses these risks. Investors could even track which committee within the board of directors is responsible for which risk, as well as check whether the company has a board committee fully dedicated to the issue. To sum up, there are many reasons why investors should care about corporate governance, and through this introduction I have simply tried to scratch the surface of some relevant information that investors could grab from a less advertised and exploited financial disclosure. However, to fully understand the benefits that investors can gain through the understanding of companies’ corporate governance structure, it is worth understanding and examining the interplay between financial accounting and corporate governance. Figure 14.1 shows exactly how financial accounting information is supplied from managers to investors. Once again this is a circuit that belongs to the US system, but looking at the big picture, it can be applied to many other countries as well, especially European countries. Therefore, following the framework depicted in Figure 14.1, we see that the overall financial accounting process is normally regulated by the government and its legal system.

254  Research handbook on financial accounting

Source:

Based on Sloan (2001).

Figure 14.1

Illustration of the role of financial accounting and corporate governance mechanisms in facilitating the separation of management and financing

The government performs such duty through a specific commission, which corresponds to the Security and Exchange Commission in the US, The Comision Nacional del Mercado de Valores CNMV in Spain, or the Commissione Nazionale per la Società e la Borsa (CONSOB) in Italy. The determination of the generally accepted accounting principles (GAAP) is left to the profession, which has its own supervisory bodies (FASB, AICPA, etc.), then the financial statements supplied by the management are audited by an external auditor to certify its validity according to the statutory and professional principles established by the regulatory and professional bodies mentioned previously. Finally, firms appoint an audit committee from the board of directors that has the duty to oversee the preparation of the financial accounting disclosure and to communicate with the auditors on behalf of the investors. Simply describing the process that brings the financial statements into the hands of the investors already enables understanding of the importance that corporate governance mechanisms play within such a process. Consequently, investors could make wise use of the proxy statements to have a better feeling of who is taking care of the auditing process, oversight, and even of the accounting disclosure choices. Bear in mind that each step within these mechanisms as well as how each step is conducted may vary widely from country to country, but this

The importance of corporate governance information and disclosure for investors  255 does not subtract strength from the interconnection between financial accounting information and corporate governance. I started this chapter quoting a sentence that clearly explains why it is important to study corporate governance, and the reason is to understand the mechanisms through which the incentive problems created by the separation of the management and financing of business entities are mitigated. This leads to the idea that accounting information could be used for this scope, and in fact, according to Sloan (2001), such information could be used both explicitly and implicitly. There are several ways through which accounting information enter the corporate governance realm, and perhaps one of the most studied and visible ways has to do with the stipulation of contracts between managers and financiers. Among these contracts, the ones that use accounting-based performance measures in managerial compensation contracts represent the most known and studied intersection between financial accounting information and corporate governance. On this note, if the reader is interested in discovering more about this topic, Bushman and Smith (2001) provide a very detailed and comprehensive review on the topic, and the next sub-section of this chapter will provide some further insight about it. Once again, understanding the incentives driving managerial behavior might be extremely useful to investors, especially when assessing the viability of a project, and whether the people who are supposed to accomplish particular tasks to promote the project have incentives that are aligned to it. There are also other explicit ways through which accounting information enters the management compensation area, which goes beyond accounting-based performance matrices. For instance, the use of accounting information to design financial contracting is another channel through which accounting information enters into the corporate governance picture. When organizations use performance pricing to reach private lending agreements, they are simply linking the interest rate attached to the debt contract to measures of financial strength, which are heavily based on accounting data. Therefore, the pricing of debt is explicitly connected to accounting information. There are also implicit ways through which financial accounting and corporate governance intersect and complement each other. In this case, the area of securities valuation comes immediately to mind. In fact, the willingness of investors to invest or not in a particular stock is usually the result of the informational efficiency and liquidity of the capital markets in which they decide to trade. This means that any kind of accounting-based valuation technique is implicitly related to corporate governance as well. Nonetheless, this field has been extensively explained in various ways and from various perspectives, so I will not deal with it any further since the topic is extensive and it can be approached from many distinct perspectives. On the other hand, returning to Figure 14.1, it is possible to understand that there are several channels that allow financial accounting information to affect corporate governance decisions. The legal channel, for example, represents a very interesting avenue by which accounting information implicitly touches upon corporate governance. The enforcement of investors’ legal rights towards management is a striking example of the relevance of the legal channel. Certainly, investors cannot simply blame management and hence sue its components because the stock price declined or because investors think that executives performed poorly. According to US law, these statements must be supported by concrete evidence. A common avenue that investors walk through in these cases is to prove that they have relied upon material misstatement or omission when purchasing or selling a security. Since

256  Research handbook on financial accounting financial accounting information through financial reporting is the primary way through which managers communicate to investors, then most investors’ lawsuits allege material misstatements or omissions contained in the financial statements. That is why managers seem to adjust their disclosure strategy to avoid or at least to mitigate the costs of litigations (e.g., Kellogg, 1984; Francis et al., 1994; Skinner, 1994). Notice that not only investors can use accounting information to exercise their rights towards business organizations. Creditors can also rely on accounting information to prove their rights in case of a company default or bankruptcy. However, since this is not the main topic of the chapter, I will not spend further time on it. The next category to address when assessing how accounting information can help to facilitate the function of some corporate governance mechanisms is through the board of directors. The board of directors has the authority to hire and fire top management, and research has shown that one tool the board uses to justify its firing decisions is leveraging accounting earnings performance (Weisbach, 1988). On top of the board of directors there are large investors. These investors can affect management’s decisions through the board of directors, but sometimes this is not enough, so they decide to take more critical initiatives such as takeovers. Once again, peer reviewed research supports the idea that accounting-based performance measures are a tool behind takeover decisions. Essentially, accounting information provide a fundamental tool for investors to understand, in depth, several corporate governance processes.

UNDERSTANDING THE RELATIONSHIP BETWEEN CORPORATE GOVERNANCE AND FINANCIAL ACCOUNTING INFORMATION The previous sub-section explained the general framework through which financial accounting information impacts corporate governance. This section focuses on understanding more in detail the channels through which this relationship takes place. Ertimur and Ferri (2019) provide a very interesting separation of how the two disciplines are intertwined. Although the authors’ focus is in explaining how corporate governance research can be relevant to accounting, they provide a very well-defined separation among the channels that represent the connection between the two fields. Therefore, this part of the book will borrow their separation and main insights to convey to the reader how corporate governance and accounting can complement each other to understand some key business mechanisms. According to Ertimur and Ferri (2019), there are four main channels that connect financial accounting and corporate governance. The first is executive compensation, briefly discussed in the previous section, the second is when a governance mechanism is at the base of a process and the outcome is an accounting one, the third is when a shock to corporate governance helps to understand some accounting mechanisms, and finally the fourth is when a corporate governance mechanism is essentially an accounting mechanism. Even though the general idea of how executive compensation and financial accounting information has been briefly described in the previous section, it is important to show how this channel connects accounting and corporate governance. Most of the studies that try to go deep into executive compensation contracts could be divided into those that analyze the design of executive compensation contracts based on the use of performance metrics, so they focus on the weight and choice of performance metrics when executive contracts are designed. Then there are the studies that put at the center the level and structure of executive compensation,

The importance of corporate governance information and disclosure for investors  257 while others focus on the measurement of executive compensation, and finally there are some studies looking at the consequences of executive compensation. Just looking at each subsection definition, it is possible to infer how accounting information and corporate governance are interlocked. In fact, whether investors need to understand the choice, weight, level, measurement, or overall structure of performance metrices within executive compensation contracts, they need to understand and rely on accounting numbers. Therefore, loosely speaking, when looking at the consequences of executive compensation, investors are basically observing the results of managerial choices under the influence of accounting-based incentives. Since this chapter does not want to be a literature review of any of the subsections listed above, the most relevant studies with the academic literature will not be analyzed in detail, but some relevant research areas are worth mentioning because this can further raise investors’ awareness about how deeply connected are corporate governance mechanisms, hence its related information and disclosure and accounting. In fact, some interesting research papers tackle the issue of the sensitivity of CEOs’ compensation to matrices based on earnings and cash flows performance. Other studies show that sometimes executive compensation schemes can be used as a monitoring mechanism. Some researchers looked at how the adoption of new accounting standards is related to the design of executive compensation contracts. Even more populated is the literature looking at the consequences of executive compensation contracts’ design, comparing the latter with strongly related accounting outcomes such as financial reporting quality, restatements, and accounting manipulation. Moving away from executive compensation to return to the original classification that Ertimur and Ferri (2019) provided, the next category to analyze is the so-called “Governance as determinant studies”, which represent the category of research trying to address the relationship between corporate governance mechanisms and accounting-based outcomes. In a nutshell, the research identified within this area tries to understand whether better governance leads to better accounting choices. For example, are different types of ownership structure, board of directors’ composition, or managerial behavior associated with firms’ accounting quality? The next category is defined as “Governance as a shock studies”. Superficially, this category seems to be the least important for the chapter because the studies belonging to it merely take advantage of governance-related regulations or court rulings to accomplish the increasingly complex task of identification. Even though this might be partially true from a certain perspective, it is also true that these studies show how important governance-related changes can be to understand the importance of accounting information and the reason behind certain accounting choices. Think about how litigation risk might affect firm disclosure, or how and if disclosure requirements are an effective tool in addressing information asymmetry. Finally, there are the “Governance as outcome studies”. These studies can be further divided into those utilizing accounting related corporate governance mechanisms as a construct of interest and those that do not. Once again, given the nature of the chapter, it will be mainly focused on the first category where the corporate governance mechanisms under investigation are accounting related. Some governance mechanisms are clearly related to accounting because their purpose is to ensure the integrity of financial reporting. Both audit committees and enforcement actions for financial misrepresentation play this role. There are several studies out there trying to address the effectiveness of audit committees, and how a board of directors reacted after governance-related shocks, such as the passage of the Sarbanes Oxley Act of 2002 (SOX), which represented a major change both from a corporate governance

258  Research handbook on financial accounting perspective and an accounting perspective. In fact, this regulation is the policymakers’ answer to the big corporate scandals of the 2000s, with the Enron case being the most representative example. What SOX did was to reinforce the connection between corporate governance practices and financial reporting, consequently stressing the connection between accounting information and corporate governance. In summary, the intersection between corporate governance and accounting is something that has been studied from different angles and perspectives, and independently of these perspectives this relationship seems to always generate relevant results for investors who want to make informed decisions. In fact, both statistical and anecdotal evidence show that this relationship goes both ways. Understanding corporate governance mechanisms helps understand accounting decisions and vice versa. This is something investors might want to bear in mind when assessing their investment opportunities, maybe factoring in corporate governance information on top of pure valuation outcomes when deciding where to invest their finances.

DISCLOSURE AS A CORPORATE GOVERNANCE TOOL This chapter so far has been examining how the fields of corporate governance and accounting are interrelated. It started with a qualitative introduction of the topic, then examined how the overall structural framework naturally brings the two areas together, and then, it finally showed how academics tried and still try to disentangle and provide empirical evidence to this relationship, exploiting all aspects that surround it. Up to this point, the connection among the two worlds should be clear, but there is one important aspect that deserves further development. In fact, so far, the analysis has been focused on how investors can exploit corporate governance information and disclosure to make sound investment decisions, but it is also key to analyze how the players within the corporate governance framework, mainly executives and directors of the board, can use disclosure as a tool to inform investors about their good practices and the direction the firm is taking. Specifically, disclosure is a two-way information tool and just as investors might want to profit from that by understanding it and relate it to the company’s decisions, firms’ governance actors also need to be able to use it to efficiently communicate their real intention to their potential investors. In addition, the firm does not depend on a unique corporate governance mechanism, but rather on a combination of them, which means that corporate governance disclosure could also help the firm address some internal issues that might not be apparent at first sight. For instance, consider the interaction between product market competition and the use of accounting information to design executive compensation contracts, and to assess managerial turnover probabilities. Taking into consideration how accounting numbers are affected by the industry performance and characteristics and knowing that a firm might design executive compensation contracts using accounting-based performance metrices, it becomes natural to link the nature of product market competition and the design of compensation contracts as well as the board’s hiring and firing decisions. Aggarwal and Samwick (1999) maintain that, in more competitive industries, companies try to incorporate strategic considerations into the design of wages to disincentivize aggressive price competition. This is a clear finding that underlines the bridge connecting the firms’ external environment, firms’ decisions and how they use their corporate governance mechanisms as a tool to implement those decisions. Another example of these key connections between

The importance of corporate governance information and disclosure for investors  259 investors, the business environment and corporate governance mechanisms, is represented by the CEOs’ turnover probabilities. According to DeFond and Park (1999), in more competitive industries it is possible to obtain more precise performance evaluations because comparisons are more readily available. Besides underlining the multiple connections between corporate governance information and the overall business landscape, these studies open up the possibility of using corporate governance information to picture an interesting strategic picture of the firm. Changes in the legal environment could also be reflected in changes in firms’ corporate governance mechanisms that consequently an investor can use to figure out in which direction a firm is going. Think about the changes in legislations. When a new law passes, or a previous regulation is amended, firms might need to face different burdens of compliance. Depending on how heavy this burden is, corporate governance mechanisms might be adjusted accordingly. Some relevant examples are gender diversity quotas, or the demand for more independent directors, or regulations shifting the risk landscape in which a firm operates. These regulatory changes can have significant effects on the firms’ corporate governance structure. Kim and Stark (2016) for example show that having women sitting on the board of directors provides a set of unique skills to the firm. On a different note, but still relevant to the issue of gender diversity, Billings et al. (2022) show that having a certain number of women sitting on the board results in a shift in the firm’s corporate culture. Klein et al. (2021) show that firms respond to a change in the cyber risk environment by appointing more tech and cyber risk savvy directors on the board. Finally, Dutchin et al. (2010) provide evidence that directors’ independence matters, and the degree by which it matters is affected by the information environment. Once again, to assess the percentage of diversity within the board of directors, along with how many independent directors are sitting on the board, and how and if the firm’s corporate governance structures changed in response to external shocks, investors can always rely on form DEF14A, which every year tends to increasingly address the demand for more diversity disclosure and transparency of information. However, the next big question that this chapter will try to address is whether there is any significant connection between corporate governance information and the economy. Even though this might seem a bit of a stretch to the less experienced readers in the field, financial accounting information and the way this impacts corporate governance also has a significant impact on the economy. According to Bushman and Smith (2001), this might happen in four circumstances, or themes. First, in the case where the availability of financial information has any impact on economic performance. This theme is better understood if we think about how financial information can affect economic growth and productivity through specific corporate governance mechanisms. The second theme highlights the importance of financial accounting information in the governance role and how this impacts the economic performance. The third aspect emphasizes the link between the external environment – which includes the industry environment, the legal environment, and competition, just to mention a few – and the economic effect of financial accounting information. Basically, how a certain shift in the external environment impacts some corporate governance mechanisms and financial accounting information. Lastly, how do financial accounting disclosure choices impact the economy? To be able to understand how financial accounting information, corporate governance, and economic performance are related, it is important to have a solid background regarding the research findings and methodologies adopted so far. Once again, following in the footsteps of

260  Research handbook on financial accounting Bushman and Smith (2001), this section will quickly go through two seminal papers that tried to contribute to this field. The academic studies that Bushman and Smith (2001) use to help the reader better understand the field are Rajan and Zingales (1998) and Carlin and Mayer (2000). Both studies analyze the same phenomenon, they investigate the economic effects of financial accounting regimes. Using the CIFAR index as a proxy for the quality of financial accounting information available in an economy, and various economic measures of economic input and output, these studies try to explore the relation between these two realities. Rajan and Zingales (1998) document a significantly higher GDP growth in those industries with a strong exogenous demand for external financing in countries with a higher quality of accounting information. In addition, their results suggest that a high-quality accounting information index is connected to the growth of new enterprises within an economy. Using a similar research design, Carlin and Meyer (2000) show that GDP growth and growth in R&D spending as a share of value added are much higher in certain industries within countries showing a higher CIFAR index, so those countries have higher-quality accounting information. On top of that, both studies find that the industries showing the highest growth in GDP and R&D spending are those requiring higher external equity financing. This explains why the quality of accounting information plays such a key role within the context. As for every academic study, it is important to bear in mind the limitations they have. Both Rajan and Zingales (1998) and Carlin and Meyer (2000) rely on selected measures of economic performance as well as financial accounting quality, so it is not possible to overgeneralize their findings. However, what they find seems to make sense within the framework promoting the idea that financial accounting information is the main source of “business communication” and so produces high-quality information related to corporate performance, not only at the individual firm level but also at the level of the economy in its broader meaning. A very interesting extension of the idea that high quality financial accounting information promote growth in several areas would be to investigate how the corporate governance mechanisms enter the picture. Specifically, it would be interesting to analyze how financial accounting information interacts with certain corporate governance mechanisms, which in turn should promote growth. For example, it is expected that through high-quality accounting information, managers could make better informed decisions, so that firms could improve their overall productivity and performance. By simply looking at the linear relationship described above, it is immediately possible to notice the intermediary work performed by the firm’s management. In fact, financial information must be interpreted even before being able to act upon it. The duty of interpreting financial accounting information with the aim of improving the firm’s outcome is delegated to managers. Managers and executives are a key component of the corporate governance machine that works behind a firm. High quality management can make the most out of high-quality accounting information and hence generate wealth for the firm. Contrarily, poor management could lose the opportunity to take advantage of high-quality financial accounting information and hence penalize the firm. In addition, the production of high-quality financial accounting information, not only its use, is key for firms. Firms need to effectively communicate to investors their value, and the more they are efficient at this the more financing, trust, and partnerships they can earn. Once again, this connection is mediated by corporate governance mechanisms corresponding to the executives in charge of generating and revising the firm’s financial accounting information, and the board of directors – through its audit committee – should ensure that the financial accounting information they produce respects the mandated standards. This train of thought

The importance of corporate governance information and disclosure for investors  261 leads us to think about how external factors influence the production and use of financial accounting information, and how this is translated into economic performance. In summary, the next topic of interest for this chapter is the understanding of how the economic effects of financial accounting information vary with other factors. As mentioned in the previous paragraph, it is expected that there exist some key interactions among financial accounting information and other fundamental players within the economy. These interactions are nicely shown in Figure 14.2.

Source:

Derived from the relationships described in Bushman and Smith (2001).

Figure 14.2

Interactions between financial accounting regimes and other factors in affecting economic performance

Figure 14.2, based on the model described by Bushman and Smith (2001), shows how many external factors influence the financial accounting regime, which in turn impacts economic performance. More related to this chapter, there are several corporate governance factors that influence financial accounting information, and hence economic performance. Investors can gather this information and use it for their investment decisions. For example, investors expect that greater rigor through which financial accounting information is produced and disclosed should benefit economic performance. If this is the case, then the auditing regime plays a key role, and each firm needs to have an audit committee at the board level. In addition, how firms decide to communicate and how they interact with the press, television and the internet could have significant impact on the economic performance, especially nowadays, as we live in a digital era. Therefore, it is key that executives make the right choice about what to disclose and how to disclose this information to the various communication professionals. Similar reasonings could be applied to the financial analyst’s community, the legal environment and the relationships that firms decide to entertain within the political landscape.

262  Research handbook on financial accounting All these interactions have corporate governance implications to a certain degree. Therefore, returning to the original idea behind this chapter, it is fundamental for investors to be able to access corporate governance disclosure, analyze it, and contextualize it with the rest of the financial accounting information they have available. After looking at the income statements and cash flow results as well as the firm’s general financial position through the balance sheet, investors might want to understand who are the executives leading the firm. What is their expertise, what kind of incentives does the firm provide them to accomplish the firm’s goals. In addition, who oversees the internal auditing process, who monitors the executives’ decisions, and who oversees the hiring and firing process at the executive level. All this information is publicly available through the DEF14A’s financial disclosure.

CONCLUSIONS The scope of this chapter is to help readers, investors, and people interested in finance understand the importance of corporate governance information and its interactions with the most traditional accounting disclosures. Corporate governance is a very multidisciplinary field that touches upon several academic branches, including but not limited to accounting, finance, management, and law. Given the interdisciplinary nature of this field, its disclosure becomes a source of incredibly valuable information for investment decisions. To help the readers figure out such connection, this chapter exploited some of the most relevant corporate governance academic literature and used it in conjunction with a less formal narrative approach to establish a level of connectedness between the disciplines of accounting and corporate governance, always keeping an eye on investment decisions. The way the chapter is split resembles the ways through which corporate governance could be interpreted from different perspectives, always starting from an investor perspective, but also including the firm perspective, the academic perspective, and even touching upon a more general economic perspective. This chapter simply aims at being an introduction to this area; in fact, given its introductory scope, it does not go deeply into several more sophisticated issues. However, for those readers interested in these more sophisticated nuances, they can refer to the academic literature mentioned in the text because these works are the basis of the chapter, but they go much deeper into each individual issue.

REFERENCES Aggarwal, R. and Samwick, A. (1999). The other side of the trade-off: The impact of risk on executive compensation. Journal of Political Economy, 107, 65–105. Billings, M.B., Klein, A. and Shi, Y.C. (2022). Investors’ response to the #MeToo movement: does corporate culture matter? Review of Accounting Studies, 27(3), 1–41. Bushman, R. and Smith, A.J. (2001). Financial accounting information and corporate governance. Journal of Accounting and Economics, 32, (1-3), 335–347. Carlin, W. and Mayer, C. (2000). Finance, investment and growth. Working Paper, University College London and Said Business School, University of Oxford. Coles, J.L. Daniel, N.D. and Naveen, L. (2020). Director overlap: Groupthink versus teamwork. Working paper. University of Utah, Drexel University, and Temple University. DeFond, M. and Park, C. (1999). The effect of competition on CEO turnover. Journal of Accounting and Economics, 27, 35–56.

The importance of corporate governance information and disclosure for investors  263 Dutchin, R., Matsusaka, J. and Ozbas, O. (2010). When are outside directors effective? Journal of Financial Economics, 96(2), 195–214. Ertimur, Y. and Ferri, F. (2019). When is corporate governance research relevant to accounting? Evidence from JAR 2002-2018. Invited virtual issue for the Journal of Accounting Research. Fama, E.F. and Jensen, M.C. (1983). Separation of ownership and control. Journal of Law and Economics, 26(2), 301–325. Francis, J., Philbrick, D. and Schipper, K. (1994). Shareholder litigation and corporate disclosure. Journal of Accounting Research, 32(2), 137–164. Kellogg, R. (1984). Accounting activities, security prices, and class action lawsuits. Journal of Accounting and Economics, 6, 185–204. Kim, D. and Stark, L. (2016). Gender diversity on corporate boards: Do women contribute to unique skills? American Economic Review: Papers and Proceedings, 106(5), 267–271. Klein, A., Manini, R. and Shi, Y.C. (2021). Across the pond: How us boards of directors adapted to the passage of the general data protection regulation. Contemporary Accounting Research, 39(1), 199–233. Rajan, R. and Zingales, L. (1998). Financial dependence and growth. American Economic Review, 88(3), 559–586. Skinner, D. (1994). Why firms voluntary disclose bad news. Journal of Accounting Research, 32, 38–60. Sloan, R.G. (2001). Financial accounting and corporate governance: A discussion. Journal of Accounting and Economics, 32(1-3), 335–347. Weisbach, M. (1988). Outside directors and CEO turnover. Journal of Financial Economics, 20, 431–460.

15. Typology and classification of crypto-assets based on the MiCA regulatory framework: contributions and limitations Luz Parrondo

INTRODUCTION TO CRYPTO-ASSETS In recent years, we have seen the widespread adoption of blockchain technology driven by increasing interest from investors, industry, and public institutions. This interest is reflected in three main areas: (1) the growing acceptance of digital currencies and digital assets among the public; (2) the development of a growing ecosystem; and (3) the emergence of an incipient regulatory framework.1 Despite this economic and legal progress, digital assets are still largely navigating outside existing legal frameworks, which creates a significant amount of uncertainty and insecurity for those involved.2 The anonymity, ease of transfer, decentralized nature, and speculative power of crypto assets have led policymakers to recognize the need for a legal framework to protect issuers, service providers, and especially holders of blockchain-based digital assets. However, the International Accounting Standards Board (IASB) has decided to observe and monitor crypto assets, issuers, and service providers before modifying or developing a set of specific standards, due to the relatively small number of crypto practitioners preparing financial statements. The IASB is currently focused on understanding the uses and risks of crypto assets and will then decide whether to create or adapt an appropriate accounting regulatory framework.3 However, before any standards can be created, we need to develop adequate definitions for the taxonomy of crypto assets for accounting purposes. A first step in this direction has been taken by the European Financial Reporting Advisory Group (EFRAG) in a Discussion Paper published in July 2020. The paper defines a crypto asset as “a digital representation of value or contractual rights created, transferred, and stored on some type of distributed ledger technology (DLT) network (e.g. blockchain) and authenticated through cryptography”. The goal of this chapter is to provide regulatory guidance for the classification and financial disclosure of crypto assets. The EFRAG Discussion Paper also

Proposal for a Regulation of the European Parliament and of the Council on Markets in Crypto-Assets, and amending Directive (EU) 2019/1937 (MiCA). 2 The parties involved in the use and trade of crypto assets include issuers, service providers, and holders. Issuers are responsible for creating and issuing crypto assets, while service providers offer various services related to the use and management of crypto assets. Holders are individuals or entities who own or possess crypto assets. 3 EFRAG Discussion Paper, page 8, 2020. 1

264

Typology and classification of crypto-assets based on the MiCA regulatory framework  265 highlights the need to clarify these definitions to provide better guidance in IFRS standards for each type of crypto asset.4 In November 2022, the European Commission approved the MiCA Proposal, taking a significant step toward defining this new asset class. MiCA’s scope includes all non-financial crypto assets, including E-money Tokens, Asset-Referenced Tokens (ARTs), and Utility Tokens. This proposal introduces definitions for each type, including a general definition of crypto assets and, indirectly, a definition of Security Tokens, which as a financial asset (or liability) is not within the scope of MiCA. MiCA represents a comprehensive and ambitious regulatory initiative aimed at reducing uncertainty around these new digital assets and protecting crypto asset holders. Additionally, this regulation aims to foster a wider cross-border market, reduce the complexity that has arisen with the coexistence of multiple regimes within the EU, and take advantage of the benefits of an internal market.

DEFINITIONS OF TYPES OF CRYPTO-ASSETS FOR IFRS GUIDANCE The general term crypto-asset is defined in MiCA as “a digital representation of value or rights that can be transferred and stored electronically, using distributed ledger technology or similar technology”. Expanding, MiCA differentiates four different types of crypto-assets depending on the purpose and architecture of the token: 1. Utility Token, which is defined as “a type of crypto-asset which is only intended to provide access to a good or a service supplied by the issuer of that token” (description based on purpose). 2. Asset-referenced Token (ART), which is defined as “a type of crypto-asset that is not an electronic money token and that purports to maintain a stable value by referencing to any other value or right or a combination thereof, including one or more official currencies” (architecture-based description). 3. E-money Token is defined as a “type of crypto-asset that purports to maintain a stable value by referencing to the value of one official currency” (description based on architecture). 4. Security Tokens (token value) that are indirectly defined as financial instruments that are expressly excluded from the application of MICA and that follow financial regulation. Accordingly, MiCA proposes to amend MiFID to include financial instruments issued and managed by the DLT in its legislative framework (purpose-based description).5

The EFRAG discussion paper also refers to the subcategories of E-money Tokens, hybrid tokens, ARTs, tokens pre-functional and SAFT typically issued with tokens pre-functional. The following sections clarify in which major category these are included for accounting purposes. 5 Directive 2014/65/EU is amended as follows: in Article 4(1), point 15 is replaced by the following: “‘financial instrument’ means the instruments specified in Section C of Annex I, including instruments issued using distributed ledger technology”. See Art. 6(1), Proposal for a DIRECTIVE OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL amending Directives 2006/43/EC, 2009/65/EC, 2009/138/EU, 2011/61/EU, EU/2013/36, 2014/65/EU, (EU) 2015/2366 and EU/2016/2341 - COM(2020)596 final. 4

266  Research handbook on financial accounting MiCA’s classification of crypto assets is based on two criteria: purpose and architecture. The criterion of ‘purpose’ is used in the definition of Utility Tokens and Security Tokens, as these tokens are defined based on their underlying purpose. On the other hand, E-money Tokens and ARTs are defined based on their structure or mechanism for determining or stabilizing the value of the token. E-money tokens maintain their value by linking them to a fiat currency, while ARTs determine their value by linking them to other assets. This dual-based criterion creates an overlap for accounting purposes. To clarify this overlap, we need a deeper understanding of the economic and legal characteristics of crypto assets, as sometimes their characteristics match multiple MiCA definitions. For example, a token can qualify as both an E-money Token and a Utility Token simultaneously. These “hybrid” tokens can pose accounting challenges, as they have multiple economic characteristics that can also change over time depending on the context and/or effective use by their holders. For example, the Syscoin network is primarily a peer-to-peer means of payment, but it also includes “on-chain” governance through staking, a decentralized marketplace for goods, a coin-mixer, and a custody and arbitrage service, all of which can only be accessed with Syscoin. Another example of hybrid tokens is Ethereum, whose native cryptocurrency, Ether, combines utility features (running decentralized applications) and payment features, as it is commonly accepted as a means of exchange. The overlap in the definition of crypto assets is caused by two factors: 1. the dual standard in the definitions provided by MiCA, and 2. the presence of multiple purposes in the design of crypto assets. Challenges in accurately classifying and accounting for crypto assets can arise due to this overlap in the criteria. To address this, regulators and industry participants should focus on the purpose of the token rather than its structure. For example, the European Financial Reporting Advisory Group (EFRAG) has proposed considering the primary purpose of the token or breaking down hybrid tokens into their components. Additionally, the Loi Pacte in France, which was passed in 2019, suggests basing the accounting treatment of tokens on the rights, obligations, and commitments outlined in the token’s White Paper. These approaches can provide clarity and guidance for applying accounting standards to crypto assets. According to Parrondo (2020), an alternative approach to classifying crypto assets for accounting purposes is to evaluate their economic substance and determine whether they should be classified as financial assets. The proposed approach involves four criteria: a. Existence of a legal claim against another party b. Existence of intrinsic value and (therefore) functionality c. Stability of the token value d. Existence of investment risk and functional equivalence with ordinary securities (for example, you can grant financial rights to an investor, such as capital, dividends, profit sharing, voting rights, and repurchase rights). Based on these criteria, crypto assets can be classified into three main categories: Payment Tokens, Utility Tokens, and Security Tokens. Payment Tokens lack a legal claim against a counterparty, Utility Tokens have a legal claim against a counterparty and the value of the token is reasonably stable, with token holders not experiencing investment risk, and Security Tokens have a legal claim against a counterparty, investment risk, and functional equivalence

Typology and classification of crypto-assets based on the MiCA regulatory framework  267 with ordinary securities. This classification system aims to provide a clear definition for the application of accounting regulations and may result in certain crypto assets that are advertised as Utility Tokens by their issuers being considered as security Tokens for accounting purposes. This classification aims to provide a useful definition in the application of accounting regulations and could therefore result, for example, in certain crypto-assets advertised as Utility Tokens by their issuers being considered Security Tokens for accounting purposes (i.e. potentially eligible to be treated as financial assets). The EFRAG document warns of the difficulty of putting these four criteria into practice, since it can, for example, be difficult to evaluate the notion of stability in the value of the token; however, MiCA’s contribution to the description and legitimization of these assets seems to reduce this difficulty. MiCA Contributions and Limitations We must bear in mind that the objective of MiCA is not to facilitate the regulation in accounting terms of crypto-assets. MiCA is developed on four fundamental objectives: 1. Legal clarity on whether and how EU legislation on financial services applies to crypto-assets. 2. Encourage innovation and fair competition, by creating an enabling environment for the issuance of crypto-assets and provision of related services. 3. The protection of consumers and investors of high quality and market integrity. 4. Financial stability and risk management of monetary policy. Although some of these points, in particular legal clarity and consumer and investor protection, may converge with the objectives of accounting regulation, they are not the primary objective and therefore suffer from a lack of specificity. On the other hand, MiCA focuses primarily on controlling the ART that may become a “significant” asset.6 Significant tokens may represent a risk to the financial stability of the eurozone, especially if they are issued by companies with millions of users, as in the case of some Big Tech such as Amazon, Meta, or Alibaba. Although MiCA alone is insufficient for accounting guidance, it represents a necessary step to identify, define, and set the legal requirements for the issuance and exchange of crypto-assets.

(MiCA art 39) The EBA shall classify asset-referenced tokens as significant asset-referenced tokens on the basis of the following criteria, as specified in accordance with paragraph 6 and where at least the same three of the following criteria are met either in the first report following the authorization, as referred to in paragraph 2, or in at least two consecutive reports: a. the number of holders of the asset-referenced tokens is larger than 10 million; b. the value of the asset-referenced tokens issued, where applicable, their market capitalization or the size of the reserve of assets of the issuer of the asset-referenced token, is higher than €5 billion; c. the number and value of transactions in those asset-referenced tokens, is higher than 2,500,000 transactions and €500 million respectively, per day. 6

268  Research handbook on financial accounting

PAYMENT TOKENS AND STABLECOINS, A PROPOSAL FOR ACCOUNTING TREATMENT Money and means of payment have evolved considerably throughout history. Money has been represented as a precious metal, then convertible notes, and since 1971 as fiat money. Notice that the transition from the use of precious metal to paper currency is comparable to the tokenization mechanism. In this case, we issue a digital asset (the token) that represents a real asset (the legal tender) to improve the efficiency and liquidity of the system. Similarly, a previous innovation was the invention of commercial bank money (private money), which prevailed over central bank money (public money, cash) for reasons of efficiency, speed, and low costs, although it offers fewer guarantees. In the twenty-first century, the proliferation of digital technologies has led to the obsolescence of traditional systems. Distributed ledger technologies, such as blockchain, have emerged as a means of upgrading efficiency, speed, and cost reduction. For instance, blockchain technology enables the issuance of digital public money. This allows central banks to circumvent the physical limitations of paper currency and issue digital metallic money, enabling citizens to possess 100 percent centrally-backed funds on their mobile devices.

Source: html).

Blockchainsider (https://blockchainsider21.blogspot.com/2021/12/stablecoin-una-piedra-en-el-rinon-iv.

Figure 15.1

Typology of money (simplified)

Today, money can be classified into several types, including physical currency, digital currency, and virtual currency: 1. “Public Money” (issued by a central bank) a. Paper money (physical money). b. CBDCs (digital money – to be delivered). 2. “Private Money” (issued by a private entity including banks) a. Bank Money, in which a bank carries out the custody of deposits.

Typology and classification of crypto-assets based on the MiCA regulatory framework  269 Electronic Money Entities that are legal entities authorized to issue electronic money, by the central bank, without custody.7 c. E-Money Tokens (a Stablecoin): A type of stable value crypto asset that is issued from a private body and usually backed by another asset or basket of assets. b.

Let’s now understand the characteristics of stable and non-stable tokens, and why E-money Tokens may be considered money, while the rest of the tokens are considered assets. Characteristics of Stable and Non-stable Tokens Stablecoins can be defined as cryptocurrencies that aim to maintain a stable value in relation to a specific asset, or a group of assets. There are three main mechanisms by which stablecoins keep their values stable (although, in practice, an issuer could use these mechanisms in combination): 1. Linking the value of the token to legal asset(s). For example, a third party collects deposits in US dollars and issues stablecoins pegged to each dollar deposit. Under this approach, the value of the stablecoin is guaranteed by the issuer, who fully guarantees the claim and undertakes to redeem coins at face value in the same currency in which they were purchased. The most common stablecoin backed in US dollars is Tether (USDT). These single-currency pegged stablecoins are categorized as E-money Tokens as their function is very similar to the function of electronic money defined in Article 2, point 2, of Directive 2009/110/EC1 of the European Parliament and of the Council. In addition to one currency, stablecoins can also be backed by commodities such as gold, government securities, or a combination of these assets. These are defined as Asset Referenced Tokens (ART). 2. A second mechanism is to link the value of the token to another crypto-asset (either a single cryptocurrency or a cryptocurrency wallet so that each stablecoin is compatible with the corresponding cryptocurrency. This price stabilization mechanism does not need to be backed by legal assets; however, it comes at the cost of further fluctuation in market prices. These tokens also classify as ART. 3. A third mechanism is to use an algorithm to control the supply of the token. The algorithmic ‘stablecoins’ aim at maintaining a stable value in relation to an official currency of a country or to one or several assets, via protocols, that provide for the increase or decrease of the supply of such crypto-assets in response to changes in demand, classify as ART. Those that do not aim to establish a value referencing to one or several assets should comply with Title II of MiCA regulation. On the other hand, Payment Tokens that are not backed by any underlying asset or do not intend to maintain a stable value, but rather allow their value to fluctuate based on supply and demand are denominated Cryptocurrencies or crypto-assets (Parrondo 2022). Owing to their greater volatility, these tokens are susceptible to speculative use, yet retain their functionality as a medium of exchange or payment. An example of this token is Bitcoin. These types of companies have the capacity and authorization of the Central Banks to be able to issue Private Money (Stablecoin). They are not banks, nor do they require a banking licence. In Europe this activity has been regulated since 2009, through Directive 110/2009/EC. 7

270  Research handbook on financial accounting Accounting Treatment of Payment Tokens The EFRAG Discussion Paper refers to Payment Tokens as: tokens issued through DLT platforms that have no claim against any issuer, are not backed by any central authority, are not legal tender, and are not entitled to any counterparty.

Notice that this definition does not refer to the value-stabilizing mechanism or the fact that it is referenced to any asset. Furthermore, de the paper argues that in the absence of explicit contractual agreements between the decentralized network that manages the issuance of cryptocurrencies and their holders, combined with the absence of the legal tender feature, no formal rights (or claims) can be attached to payment tokens. However, market participants in payment tokens would be aware of the implicit contractual arrangements built within the consensus mechanism/protocol governing the issuance of these tokens.

From this definition, we understand that Payment Tokens do not have any legal claim on the issuer, but involve rights to exchange goods, services, and other assets with counterparties that accept that token. From here, accounting intuition suggests that Payment Tokens should be considered as equivalent to cash. However, this is not simple. IAS 7 defines cash equivalents as “short-term investments of high liquidity, which are easily convertible into specified amounts of cash, being subject to a negligible risk of changes in value”. Additionally, IAS 32 Financial Instruments includes ‘cash’ in the definition of a financial instrument: currency (cash) is a financial asset because it represents the medium of exchange and is therefore the basis on which all transactions in the financial statements are measured and recognized. A cash deposit with a bank or similar financial institution is a financial asset because it represents the depositor’s contractual right to obtain cash from the institution or to write a check or similar instrument against the balance in favour of a creditor in payment of a financial liability. As of the closing of this chapter in January 2023, only El Salvador and the Central African Republic have recognized Bitcoin as a legal tender and therefore would classify it as cash. The rest of the jurisdictions do not recognize Bitcoin as legal tender. However, these jurisdictions do acknowledge the function of Bitcoin as a medium of exchange. Recognition as a medium of exchange alone is not a sufficient condition to meet the definition of cash or cash equivalents under International Accounting Standard 7 (IAS 7), as these tokens are subject to significant value change risk. Supporting this argument there are formal resolutions across the international regulatory authorities: 1. The European Banking Authority (EBA) understands that virtual currencies are a digital representation of value not issued by a central bank or by a public authority and not necessarily associated with a fiat currency. However, the EBA considers that they can be accepted by natural or legal persons as means of exchange that can be transferred, stored, or negotiated by electronic means; the fact that virtual currencies are fundamentally based on distributed ledger technology – Blockchain, the technological base of more than 900 virtual currency systems – facilitates exchanges between counterparties.

Typology and classification of crypto-assets based on the MiCA regulatory framework  271 2. In 2016, the Australian Accounting Standard Board (AASB) published the document “Digital Currency – A Case for Standard-Setting Activity” which suggests that digital currencies meet the definition of intangible assets, as defined in IAS 38 Intangible Assets, because digital currency is an identifiable non-monetary asset with no physical substance. 3. Likewise, in 2020 EFRAG suggests that payment tokens primarily meet the definition of intangible asset under IAS 38 as an identifiable non-monetary asset with no physical substance. IAS 38 defines an intangible asset as: 1. “a resource controlled by an entity (i.e., the entity has the power to obtain the economic benefits that the asset will generate and restrict others’ access to those benefits) as a result of past events and from which future economic benefits are expected to flow to the entity; 2. identifiable, because it can be sold, exchanged, or transferred individually; 3. non-cash or a non-monetary asset; and 4. it has no physical form.” IAS 38 seems the most appropriate standard for the treatment of Cryptocurrencies. However, there are some exceptions tied to the different characteristics and nature of these tokens. IAS 38 excludes from its scope intangible assets held by an entity for sale in the ordinary course of business. Such intangible assets should be accounted for as inventory in accordance with IAS 2. The classification of crypto-assets as being held for sale in the ordinary course of business, despite not fitting the typical definition of materials and supplies meant for consumption in the production process, hinges on the unique facts and circumstances surrounding the holder's situation. Note that IAS 2 does not require inventory to be tangible and that the standard defines inventory as an asset (1) held for sale in the ordinary course of business; (2) in the production process for such sale; or (3) in the form of materials or supplies to be consumed in the production process or in the provision of services. For example, a bitcoin miner or exchange could have crypto assets for sale in the ordinary course of business. This analysis suggests that Cryptocurrencies fall within the scope of: 1. IAS 38 ‘Intangible assets’ when they behave as a means of exchange. 2. IAS 2 ‘Stocks’ when they are held for sale in the ordinary course of business. However, according to MiCA definitions, there might be three types of Payment Tokens: 1. E-money Tokens (Title IV). 2. Asset Referenced Tokens “ART” (Titel III). 3. Those that are not ART nor E-money tokens (Title II). E-money tokens (MiCA Title IV) MiCA specifically differentiates between tokens that are pegged to a single official currency (E-money tokens) and other types of tokens. The regulatory framework stipulates that the goal of stablecoins is to provide a means of payment and that their stability is increased when they are backed by a reserve of fiat assets. These stablecoins can have similarities to electronic money, as long as they have a claim against a counterparty (the issuer) in compliance with the Second E-Money Directive (EMD2). The European Financial Reporting Advisory Group (EFRAG) discussion paper proposes the potential development of International Financial Reporting Standards (IFRS) requirements by providing an explicit definition of cash or cash equivalent under IFRS and clarifying

272  Research handbook on financial accounting whether stablecoins that qualify as electronic money according to jurisdictional definitions can be classified as cash or cash equivalent. It is worth noting that IAS 7 defines cash equivalents as short-term, highly liquid investments that can be easily converted to known amounts of cash and are subject to insignificant risk of changes in value. Based on this definition, E-money Tokens that meet the jurisdictional requirements of electronic money can be considered as cash equivalents as they can be easily converted into cash and are subject to insignificant risk of change in value (see Table 15.1). This assimilation of this type of crypto-asset as equivalent to cash is logical and to some extent desirable. Table 15.1

Classification of crypto-assets: three main categories

Type of token

Characteristics

Payment Tokens

lack a legal claim against a counterparty

Utility Tokens

have a legal claim against a counterparty the value of the token is reasonably stable token holders should not partake in investment risk

Security Tokens

a legal claim against a counterparty investment risk functional equivalence with ordinary securities

Asset Referenced Tokens (MiCA Title III) and those that are not ART nor E-money tokens (MiCA Title II) Tokens that do not classify as E-money Tokens represent a greater regulatory challenge. The ambiguity and diversity of the underlying assets makes it difficult to consider these tokens as cash equivalent. Despite the need for a revision of the definition of cash, it is difficult to accept that assets referenced to one or more cryptocurrencies, or even those referenced to commodities, can be accepted as cash equivalents. The most viable proposal, for the time being, would be to consider them intangible assets according to IAS 38 or inventory according to IAS 2 (see Table 15.2). The non-stable tokens, which qualify as cryptocurrencies, are more complex due to their value fluctuations. We should consider whether the initial recognition and the following valuations should be carried at cost or at fair value. Table 15.2

Classification of payment tokens for accounting reasons

 

Functionality

Token value

Token type

Payment tokens

As a medium of

Not stable

Cryptocurrencies

exchange

For sale in the ordinary course of business

IFRS IAS 38 “Intangible assets”

Stable

Asset-Referenced

IAS 38 “Intangible

(Stablecoins)

Tokens (ART)

assets”

E-money Tokens

IAS 7 “cash equivalent”

All

IAS 2 “Stocks”

All

Typology and classification of crypto-assets based on the MiCA regulatory framework  273

UTILITY TOKENS, A PROPOSAL FOR ACCOUNTING TREATMENT Introduction to Utility Tokens In MiCA, Utility Tokens fall into the classification of “Other than ART or E-money tokens” (Title II) and are defined as a “type of crypto-asset which is only intended to provide access to a good or a service supplied by the issuer of that token”. However, for accounting purposes, this definition may not be comprehensive enough. While utility tokens are primarily used as a means of payment, they may also possess hybrid characteristics that enable access to performance-based or random rewards, thus introducing an element of “investment risk” for the user. Additionally, it is important to note that Utility tokens may be distributed prior to the initiation of commercial activity as a means of financing, and, in such cases, they may be considered financial instruments depending on the level of risk involved in the operation. As such, they may be deemed financial instruments, regardless of whether they fit the definition of Security tokens, for accounting purposes. Therefore, the definition for accounting purposes of Utility tokens should include the risk factor, as crypto-assets that constitute a legal claim against a counterparty (the issuer), with intrinsic value due to the functionality and with absence of investment risk that are intended to provide digital access to a good or service available in a DLT. (Parrondo, 2022)

Once, the token has been classified as Utility Token, it should be accounted for in the following manner: 1. “Intangible fixed assets” (IAS 38), when the activity of the company is different from the sale of cryptocurrencies, and it has only acquired them for investment purposes. 2. “Inventory” (IAS 2), as long as the activity of the company is the purchase and sale of this type of assets. First, let’s analyse whether utility tokens may fit the definition of asset. The EFRAG Discussion Paper states that they are assets as they meet the revised definition of the Conceptual Framework for Financial Reporting (“Conceptual Framework”) of the IASB. The Conceptual Framework defines an asset “as a resource controlled by the entity as a result of past events and from which future economic benefits are expected”. EFRAG considers crypto-assets to fall within this definition because they: 1. are a present economic resource (as they may be a medium of exchange, may have investment value or confer economic benefits related to participation in network configuration or consumption of network goods or services), 2. expect future economic benefits (from supply and demand dynamics, intrinsic value; or expected economic utility), 3. may be controlled by the holding entity (control is defined as the power to obtain the economic benefits that the asset will generate and restrict the access of others to those benefits (IFRS 15, IFRS 16, IFRS 10 Consolidated Financial Statements), and 4. arise from past transactions on the DLT network (through the purchase of crypto-assets with fiat currency or exchange with other crypto-assets and throughout mining activities). Interestingly, the EFRAG document supports the consideration of crypto assets as IASB-based assets despite

274  Research handbook on financial accounting the degree of opacity and uncertainty about applicability and insufficient documentation and contractual arrangements that some of these crypto tokens have demonstrated in recent decades.8 Following the argument above, as means of payment they meet the definition of intangible asset in IAS 38 or inventory IAS 2. However, the legal and the functional nature of the token are key to provide a proper accounting guidance.

Second, the “utility” or functionality of these tokens is to provide access to goods and services in a DLT: The right to future consumption of goods or services is classified as prepayment. IFRS on the accounting of advance payments is very limited. IAS 38.70 states ... ‘when incurred’ means when the entity receives the related goods or services. If the entity has made an advance payment for the foregoing items, that advance payment is recognized as an asset until the entity receives the related goods or services. In this regard, the EFRAG raises concerns as functionality can be difficult to evaluate and is prone to manipulation. Maas (2019) considers that Utility Tokens have two possible sources of economic value, and therefore, functionality: 1. functional utility value or value in use, 2. financial value or value in return where the financial advantage undermines the functional use of the token. As the financial advantage of holding such tokens for business or investment increases, the functional value of a Utility Token decreases over time. To resolve the conflict, Parrondo (2020) proposes that items treated as “Utility Tokens for accounting purposes” must have intrinsic value in terms of the presence of well-defined token functionality and have no investment rights or liabilities attached to them. A well-defined token functional value and the long-term justifiable value and utility of the Utility Token should be detailed in the technical description and business model of the White Paper. Despite this, the EFRAG discussion paper rightly suggests that “it can be quite difficult to put these criteria into practice, as it may, for example, be difficult to determine the intrinsic value of tokens due to the typically embryonic state of the business models employed by ICO issuers.” In any case, it is important to set the regulatory objective in the proper determination of the intrinsic value and risk associated with the issuance and distribution of Utility Tokens.

Accounting Proposal Following the previous reasoning, companies that operate with cryptoassets must disclose the operations dependent on the nature and functionality of the tokens in each operation. Let’s provide different examples of functionality given the economic nature of the token: 1. Issuance, sale and redemption of native tokens. 2. Sale and purchase of goods and services in exchange for non-native tokens. Issuance, sale, and redemption of native Utility Tokens Tokens issued as a form of ‘utility’ tokens offered to platform customers should be recorded by debiting the intangible asset and crediting a prepayment liability.

8 Ciphertrace cited in Kataryzna (2019) claimed that $1.3 billion in crypto assets were stolen between 2016 and 2018. One of the most famous examples is the theft of USD 70 million from DAO in 2016. This usually occurs when the holder's private keys are obtained fraudulently or through hacking events and/or hard forks due to programming errors.

Typology and classification of crypto-assets based on the MiCA regulatory framework  275 Let’s suppose that a company issues two native tokens (MYT) and assigns them an initial market value of €4.80 each. First, the carrying value of both tokens should be calculated based on their cost of issuance. For instance, if the cost of issuing one token is €0.03 (including direct costs such as gas fees and indirect issuing costs), then this should be the value assigned to each token (see Table 15.2). Second, once the tokens have been issued, the company can sell one of them for €4.80. In this case, the company will credit the sold native token account for €0.03 (the value at cost), credit VAT for €0.80, and credit a new liability for €3.97. The company will also debit €4.80 from the cash account. It’s important to note that the company has assumed a liability of €4 for the token − €0.03 for the cost and €3.97 for the market value of the token (see Table 15.3). Table 15.3

Example of accounting for the issuance and sale of Utility Tokens MYT

Issuance of two native tokens (cost 0.03€/unit)

Debit

Credit

(2) Native token MYT (Intangible asset)

€0.06

 

(6) Token production cost (activation)

  Debit

€0.06 Credit

Sale of one native token at market price (5) Banks

€4.80

 

(4) Native token MYT (Amount sold in ICO)

 

€0.03

(4) Sales VAT (4.16€ x 0.84€ (20%VAT) = 5.00€)

 

€0.80

(4) Issuance of native tokens (Liability)

 

€3.97

Source:

Own elaboration.

Let’s suppose that when the token holder exchanges MYT for a good or service, the token’s price has increased to €6.00. In this scenario, the company will cancel the €3.97 liability and credit €5.60 of revenue and €0.40 of sales taxes. Additionally, the company will debit a €2.03 loss resulting from the revaluation of the token from €4.80 to €6.00 (see Table 15.4). Table 15.4

Example of selling a service in exchange for a native Utility Token MYT

Redemption of the native token previously sold

Debit

Credit

(4) Issuance of native tokens (Liability cancelled)

€3.97

 

(7) Sale of goods

 

€5.60

(4) Sales VAT (€5.00 × 0.20 = €1.00)

 

€0.40

(6) Loss due to token revaluation (from €4.80 to €6.00)

€2.03

 

Source: Own elaboration.

The issuer may also use their own Utility Token MYT to purchase goods or services. In this case, the Intangible asset at cost (MYT = €0.03) cancels, and the company recognizes the liability against the holder of the token (see Table 15.5).

276  Research handbook on financial accounting Table 15.5

Example of purchase of goods using Native Utility Tokens MYT

Redemption of the native token previously sold

Debit

Credit

(6) Purchase of goods

€3.60

 

(4) Purchase VAT (€5.00 × 0.20 = €1.00)

€0.40

 

(4) Native Token MYT (Intangible asset)

 

€0.03

(4) Issuance of native tokens (Liability)

 

€3.97

Source:

Own elaboration.

   

It is of significance to point out that the regulation of intangible assets varies depending on the jurisdiction in which they are located. ● Under US GAAP, intangible assets with a finite life are reported at historical cost less any accumulated amortization recognized to date. Except in impairment cases, fair value is ignored completely. ● Under IFRS, intangible assets are measured initially at cost. After initial recognition, an entity usually measures an intangible asset at cost less accumulated amortisation, however it may choose to measure the asset at fair value in rare cases when fair value can be determined by reference to an active market. Given the inherent uncertainty and risk9 associated with the issuance of utility tokens, particularly in light of the current lack of regulation (although MiCA represents a first step in this direction, it has yet to be implemented), we propose utilizing a cost-based valuation approach for native tokens, with market value only updated at the point of sale. Sale and purchase of goods or services in exchange for non-native Utility Tokens Table 15.6

Example of buying an item using a BNB token as payment

Purchase of BNB tokens (300€/unit)

Debit

Credit

(4) Binance’s Utility Token, BNB (as Intangible asset)

€300.00

 

(5) Bank

 

€300.00

Purchase of goods or services with the BNB Tokens

Debit

Credit

(6) Purchase of goods

€330.50

 

(4) Purchase VAT

€69.50

 

(4) Utility token (at cost)

 

€300.00

(7) Gain due to token revaluation

 

€100.00

Source:

Own elaboration.

Initially, a corporation must acquire tokens, which are subsequently recorded as intangible assets at their acquisition cost. The utilization of these tokens as a form of payment constitutes a commercial exchange or barter transaction. The variation in market value of the tokens will result in a corresponding gain or loss at the time of exchange. In the example provided in Table 15.6, the company acquires 1 unit of Binance’s utility token, BNB, for €300. At the time

There have been financial frauds associated with the market valuation of native tokens. In the recent case of FTX and Alameda Research, both companies controlled by Sam Bankman-Fried, Alameda had over two-thirds of its assets value derived from FTX’s native token, valued at current market price. 9

Typology and classification of crypto-assets based on the MiCA regulatory framework  277 of the commercial exchange, the token’s value is €400, resulting in a gain of €100 due to the revaluation of the token. When goods are sold in exchange for BNB, the intangible asset acts as “cash” in a typical journal entry, as shown in Table 15.7. Table 15.7

Example of selling a good in exchange for BNB

Sale of a good in exchange of BNB Tokens

Debit

Credit

(4) Binance’s Utility Token, BNB (as Intangible asset)

€400.00

 

(7) Sale of goods

 

€330.50

(4) Sales VAT (€5.00 × 0.20 = €1.00)

 

€69.50

Source:

Own elaboration.

Under current accounting standards, native tokens should typically be valued at cost and any gain or loss should be recognized when the commercial exchange or trade takes place. However, it is possible that accounting standards may be revised in the future to require the valuation of tokens at market price if a well-developed market for the tokens exists. Policymakers should carefully consider this option and its potential implications in the near future. The question of how to properly measure native tokens on a company’s balance sheet is an important one that requires further analysis and consideration. While it is not discussed in depth in this chapter, it is important to carefully consider the implications of both the cost and fair value approaches.

TOKENS SECURITY, A PROPOSAL FOR ACCOUNTING TREATMENT Security Tokens are digital securities that are based on blockchain technology and are subject to current regulations on financial instruments. In recent years, many start-ups have begun issuing Security Tokens instead of Utility Tokens, and even established companies such as Tesla have converted their existing shares into Security Tokens. One of the advantages of tokenized stocks is that they can be divided into smaller, more affordable units, which allows for a potentially larger number of investors to benefit from the return on equity capital. Companies often offer a wide range of Security Tokens to investors through Token Offerings, including tokens redeemable for precious metals, real estate-backed tokens, and tokenized shares. Between 2017 and 2019, there were numerous large token sales that took place outside of any regulatory control. Currently, legislation has been put in place to regulate these massive sales, and there are fundamentally two types of token trading that are contemplated by the law: Initial Coin Offerings (ICOs) or Sales of Utility Tokens and Security Token Offerings (STOs) or Sales of Security Tokens. STOs are delimited within the MiFID regulatory framework and are controlled by each jurisdiction’s financial authority. On the other hand, the issuance and sale of Utility Tokens falls outside the scope of financial regulation, as they are not considered financial instruments, and the regulatory framework will be delimited with the MiCA.

278  Research handbook on financial accounting Generally, a token will be considered a security whenever: ● They provide rights or expectations of participation in the potential revaluation or profitability of businesses/projects or if they grant rights equivalent or similar to those of shares, obligations, or other financial instruments; or ● They provide the buyer the right to access services or receive goods or products, which are offered by reference, explicitly or implicitly, to the expectation of obtaining from the buyer or investor a profit as a result of its revaluation or any remuneration associated with the instrument or mentioning its liquidity or possibility of trading in markets equivalent or similar to the securities markets subject to regulation. The second requirement challenges discerning between Utility and Security Tokens as both provide the buyer the right to access services or products. The token will classify as a security on the condition that there exists an expectation of a profit because of its revaluation or any associated remuneration. The challenge comes when tokens sold as utilities may also confer some of these expectations, as these tokenized discount coupons can be traded on an “Exchange” and provide a profit or a loss to the token holder. The MiCA and DORA regulatory proposals represent the European Commission’s commitment to homogenize and strengthen the crypto-assets legal ground. The former lays out the foundations for the issuance and distribution of non-financial tokens, and the second is a draft legislation designed to improve the cybersecurity and operational resilience of the financial services sector (Digital Operational Resilience Act). Security Tokens in the MiCA Regulation Proposal MiCA does not provide a formal definition of Security Tokens; however, the proposal mentions that “some crypto-assets that qualify as financial instruments as defined in Article 4(1) (15) of Directive 2014/65/EU of the European Parliament and of the Council”. In addition, MiCA Amendment 159-152 urges the European Securities and Markets Authority (ESMA) to “develop draft regulatory technical standards describing the criteria and conditions under which a crypto-asset may be considered in substance as equivalent or highly similar to a financial instrument, regardless of its form”10 (European Securities and Markets Authority (ESMA), 2019). Following this reasoning, Parrondo (2022) proposes to define Security Tokens for accounting purposes as a type of crypto-asset with a legal claim against a counterparty (the issuer), subject to investment risk with functional equivalence to ordinary financial instruments as defined in point (15) of Article 4(1) of Directive 2014/65/EU of the European Parliament and of the Council. As mentioned before, some tokens are hybrids of utility, payment and security characteristics, challenging the classification. Parrondo (2020, 2022) proposes the existence of investment risk as the determining criterion to classify hybrid tokens, as Token Security for accounting purposes.

10 Amendments 149-502 Markets of crypto-assets and amendment of Directive (EU) 2019/193. https://​www​.europarl​.europa​.eu/​doceo/​document/​ECON​-AM​-693740​_EN​.pdf.

Typology and classification of crypto-assets based on the MiCA regulatory framework  279 The Hummingbot project serves as an example of hybridization. Hummingbot is a decentralized network that allows any user to provide liquidity, receive rewards in ETH or BNB. The network uses an anti-manipulation feature to convert rewards into ETH or BNB without affecting the price too much, minimizing the risk on its DYP Utility Token. All group rewards are automatically converted from DYP to ETH/BNB via a smart contract, isolating the DYP from price volatility. Another example of hybrid tokens is crypto assets used in staking. Cryptocurrency staking consists of “blocking” a digital asset to act as a validator in a decentralized cryptographic network to ensure the integrity, safety, and continuity of the network. As an incentive to help secure the network, stakers are rewarded with newly minted cryptocurrencies. This would define the token as a Utility Token. However, users are exposed to the risk of a possible adverse price movement in the assets they are blocking. For example, a staker earns 15 percent of APY (Utility Tokens), for locking a crypto asset for a year, but the value of the crypto asset falls by 50 percent, generating a loss for the holder. Crypto-assets in both cases are issued as Utility Tokens; however, the suggestion is that the holder register the tokens as “non-financial assets s held for investment purposes”. European Regulatory Approaches in IFRS The EFRAG Discussion Paper (July 2020) opens the debate on Security Tokens in two aspects: 1. Requires guidance on whether IFRS 9 is applicable for Security Tokens. 2. Requires guidance on the accounting treatment of Security Tokens that do not meet the IFRS definition of financial instruments (financial asset). In the same document, EFRAG proposes two possible solutions: 1. Amend the definition of financial asset in IAS 32 to include securities and asset statements that have functional equivalence with securities; and 2. Develop a new standard that treats crypto assets as a single asset and can allow holders of securities and asset tokens to have an accounting treatment similar to financial assets. IAS 32 defines a financial instrument as “any contract giving rise to a financial asset of one entity and a financial liability or capital instrument of another entity”. Additionally, a contract is defined as an agreement between two or more parties that has clear economic consequences, where the parties have little or no discretion to avoid, usually because the agreement is enforceable by law. Following this definition, Security Tokens must have a “contractual” claim against a counterparty that generates a financial asset of one entity and a financial liability on another entity and must have economic consequences. IAS 32 defines as financial assets: 1. cash, 2. a capital instrument of another entity, 3. a contractual right to receive cash or other financial assets from another entity or to exchange financial assets or liabilities with another entity on terms that are potentially favourable to the entity, or 4. a contract that will be liquidated or may be settled in the entity’s own capital instruments provided that certain criteria.

280  Research handbook on financial accounting Based on this definition, tokens representing equity and debt instruments could be classified as financial assets or liabilities. These could include coins that are redeemable for precious metals; real-estate-backed tokens; and share-based tokens that have stock-like characteristics (e.g., property rights or right to share profits). In addition, the economic rights, and obligations of these types of tokens are extensively documented in a private purchase memorandum (PPM) or through a prospectus in a manner similar to traditional capital markets securities. These issuance documents may relate to contractual cash flows, exposure to profits of the issuing entity (discretionary dividend), voting rights or any residual interest in the issuing entity. A token that is not a capital or derivative instrument would still meet the definition of a financial asset if it were contractual and embodied a right to receive cash or another financial asset. For example, a crypto asset that entitles the holder to a cash payment, or the delivery of bonds or shares would meet the definition of a financial asset. In such cases, the crypto asset would be similar to a digital deposit voucher, which exposes the holder to economic risk on the underlying financial asset, as well as counterparty risk. On the other hand, with respect to hybrid tokens, even though they may have economic attributes similar to financial assets (risk profile, return and cash flow and functional equivalence to ordinary securities), they do not always fit the definition of such instruments. There are several points of view in this regard: ● The 2016 AASB publication proposes the development of a new standalone Crypto Asset Standard, as it considers that the modification of the IFRS classification may alter the well-established principles of accounting for financial instruments. ● Sixt and Himmer (2019) suggest that a modification of the definition of financial assets would be the best option to improve IFRS requirements to allow accounting for some crypto assets (e.g., Utility Tokens that have predominantly investment value). ● Aligned with the above proposal, MiCA proposes a clarification in the existing definition of ‘financial instruments’ – which defines the scope of the Markets in Financial Instruments Directive (MiFID II) – to include DLT-based financial instruments, as well as a pilot scheme on DLT market infrastructures for these instruments (DORA). The pilot scheme will allow experimentation in a safe environment and provide evidence for possible further modifications. ● Parrondo (2022) suggests that it may be enough to adapt existing standards, including crypto assets in the definition, and establishing the basic criteria for classifying a token as, Intangible Asset, in the case of Payment Tokens and Utility Tokens, and as a Financial Asset in the case of Security Tokens and Hybrid tokens with associated investment risk. Accounting Proposal As an alternative to Utility Tokens, Security Tokens should be accounted for as debt or equity instruments. When issuing Security Tokens, it is proposed to initially recognize them as “Outstanding Issued Capital” or “Debt traded with negotiable securities” within the company’s net worth, as appropriate, against the account of the “Native Token MYTOK”. As the tokens are sold in the STO, the “Native Token MYTOK” account will be credited and debited with the proceeds from the sale (see Table 15.8). The “Outstanding Issued Capital” account will be held against Share Capital for the amount paid up by the investors.

Typology and classification of crypto-assets based on the MiCA regulatory framework  281 This approach ensures proper accounting treatment of the Security Tokens, reflecting the company’s debt or equity position. Table 15.8

Example of accounting for the issuance and sale of Security Tokens

Issuance of Security Tokens (10,000 at €1/unit)

Debit

Credit

(2) Native token MYTOK (Financial asset)

€10,000

 

(1) Outstanding Issued Capital / Debt traded...

 

€10,000

Sale of 5,000 tokens in the STO

 

 

(5) Banks

€5,000

 

(2) Native MYTOK

 

€5,000

(1) Outstanding issued capital

€5,000

 

(1) Share Capital

 

€5,000

Source:

Own elaboration.

As previously noted, the challenge arises with hybrid tokens, as they fall into a grey area between Utility Tokens and Security Tokens. These tokens are legally issued as Utility Tokens but possess characteristics similar to those of Security Tokens. Therefore, we propose not recording them as intangible assets, but instead as “Non-financial assets held for investment purposes” (see Table 15.9). This approach allows for a more accurate representation of the company’s financial position and aligns with the hybrid nature of the tokens. Table 15.9

Example of the acquisition of hybrid tokens

Account

Debit

Credit

(2) Non-financial asset held for investment purposes

€10

 

(5) Banks

 

€10

Source:

Own elaboration.

CONCLUSIONS Differentiating utility and security tokens can be a challenging task due to the similarities in their characteristics and functions. Both types of tokens can be used to access a product or service, and both can appreciate in value. However, the key difference between the two is that a security token represents an investment in a company or asset, while a utility token is used to access a specific product or service. Designing an accounting regulation for these new digital assets can also be challenging due to the lack of precedent and the fast-changing nature of the industry. The accounting treatment of these assets can vary greatly depending on their specific characteristics, and there is currently no widely accepted standard for their valuation. Additionally, the decentralized and global nature of these assets can make it difficult for regulators to enforce accounting standards. Furthermore, the regulatory environment around digital assets can vary greatly from country to country, making it difficult for companies to ensure compliance with all applicable laws and regulations. This can create additional challenges for accounting and financial reporting.

282  Research handbook on financial accounting Overall, the accounting and regulatory challenges surrounding digital assets are significant and will likely continue to evolve as the industry matures. It requires a comprehensive understanding and collaborative effort from stakeholders, including regulators, accounting professionals, and industry experts, to develop effective accounting and regulatory frameworks for these new digital assets.

REFERENCES AASB. (2016). Australian Accounting Standards Board. Digital currency – A case for standard setting activity. ASAF meeting, December, ASAF Agenda ref 5. European Financial Reporting Advisory Group (EFRAG). (2020). Discussion Paper Accounting for Crypto-Assets (Liabilities): Holder and Issuer Perspective. July. European Securities and Markets Authority (ESMA). (2019). Advice Initial Coin Offerings and Crypto-Assets. Available at https://​www​.esma​.europa​.eu/​sites/​default/​files/​library/​esma50​-157​ -1391​_crypto​_advice​.pdf. Accessed 5 May 2021. Katarzyna, C. I. (2019). Cryptocurrencies: Opportunities, risks, and challenges for anti-corruption compliance systems (pp. 20–21). Paris: OECD Conference on Global Anti-corruption and Integrity Forum. Maas, T. (2019). Initial coin offerings: When are tokens securities in the EU and US? Available at SSRN 3337514. Parrondo, L. (2020). DLT-based tokens classification towards accounting regulation. Proceedings of the 2nd International Conference on Finance, Economics, Management, and IT Business – FEMIB, 1, 15–26. Parrondo. L. (2022). Definitions and IFRS guidance to cryptoassets accounting. Intelligent Systems in Accounting, Finance and Management, forthcoming. Sixt, E., & Himmer, K. (2019). Accounting and taxation of cryptoassets. Available at: https://​ssrn​.com/​ abstract​=​3419691 (accessed 30 June 2020).

Index

AASB see Australian Accounting Standard Board (AASB) access to education 224 accountability 7, 8, 108, 115, 121, 150, 152, 176, 177, 180, 182 to stakeholders 26, 146 AccountAbility guidance 157–8 accounting comparability 8, 10–12, 15 conservatism 34–5 cost 14 entries 88 information 233, 234, 237, 238 misrepresentations 92–3 policy indicators 92 quality 8, 11, 12, 32–4 regulation theories 236–7, 244–5 regulators 236–7 research 243–6 standards 115 accounting convergence 1, 5, 6 benefits of 9–14 costs of 14–15 accounting deception 87, 91, 92, 97 warning signs of 91–2, 98–101 accounting fraud 88, 91–2 accounting manipulation and 89 defined 89 high probability of qualitative warning signs 98–100 quantitative warning signs 100–101 warning signs for detecting 93–7 accounting manipulation 87, 93 concept of 88–9 and fraud 89 legal practice 90 theoretical framework of 90–92 accounting profession, institutional context of 238–40 accounting regulation 90, 91, 264, 267 MiCA 265–7 accrual manipulation 1–2 ACFE see Association of Certified Fraud Examiners (ACFE) Adams, C. A. 131, 166 adjusted R-squared 53, 55, 57 ADT Inc. earnings release 76–7 non-GAAP reporting 76–8

Agarwal, S. 48, 55 agency theory 28, 32, 234, 243, 244 Aggarwal, R. 258 aggregation of interests 245 Ahmed, A. S. 11, 12, 47 air pollution 216 Albrecht, S. W. 93 Alfraih, M. M. 198 Almadi, M. 47 Alsahali, K. F. 126 Amiram, D. 13 Anagnostopoulou, S. C. 35 Anandarajan, A. 47–8 Andersen, M. L. 33 Anderson, S. B. 75, 82 André, P. 195 Andrew, J. 172 Apostolou, B. 93 Arena, C. 75 Arguelles, M. 37, 39 Ariff, A. M. 192 ART see Asset-Referenced Tokens (ART) Arvidsson, S. 151 Asset-Referenced Tokens (ART) 265–7, 269, 272 assets defined 220 definition of Conceptual Framework of the IASB 273 digital 264, 268 environmental 220–22, 228 governance 229–30 intangible see intangible assets intellectual 229 and liabilities 220, 224, 225 social 222–4, 229 Association of Certified Fraud Examiners (ACFE) 89 assurance of sustainability 126–7, 134 Attig, N. 31 audit committees 74, 75 auditing standard 93 Australian Accounting Standard Board (AASB) 271 Badertscher, B. A. 65 Bae, K. H. 11 bailed out 54 balance sheet 192, 195, 221, 223 environmental 228–9

283

284  Research handbook on financial accounting extended 219, 230 governance 230 non-financial information 218–20 social 229 balancing approach, on public interest 237–8, 243, 245 Ball, R. 10 Bank of Spain, regulations on loan loss provisions 53–4 Barker, R. 179 Barth, M. E. 8, 10, 37, 65, 189, 198 Bartov, E. 9 Basel III framework 47, 58 Basu, S. 48 Bauman, M. P. 195 Baumker, B. 64 Baumüller, J. 125 Bebbington, J. 107 Beck, T. 49 Beneish, M. D. 13 Bengtsson, E. 172 Bernardi, C 39 Beske, F. 166 Bhattacharya, K. 49 Biddle, G. C. 13 Billings, M. B. 259 Binance’s utility token (BNB) 276–7, 279 Bitcoin 270 Black, D. 64 Black, E. 65 blockchain 264, 268, 270, 277 board of directors 252–4, 256, 257, 260 diversity 259 Boecking, H. J. 47 Box, R. C. 235 Bozanic, Z. 73 Bozzolan, S. 31, 33 Brammer, S. 31 brand value 197 Breijer, R. 123 Breton, G. 88 bribery 226, 230 Bricker, W. 74 Brochet, F. 12 Brown, N. C. 80, 81 Brüggemann, U. 10 Brundtland Report 216 Burke, Q. L. 34, 35 Bushman, R. 255, 260, 261 business ethics 226, 229, 230 Byard, D. 13 Calabrese, A. 150 Calegari, M. F. 33 Callao, S. 11

cap-and-trade mechanism 111 capital investment efficiency 13 management 47 market 12–13 Capkun, V. 11 capture theory of regulation 236–7, 245 see also ideology theory of regulation; public interest CAQ see Center for Audit Quality (CAQ) carbon accounting standard 115 markets 111 pricing mechanisms 110–11 tax 111 Carbon Disclosure Project (CDP) 116 Carlin, W. 260 Cascino, S. 11 cash deposit 270 cash flows, future 174, 181 Castilla-Polo, F. 185 Cazavan-Jeny, A. 193 CD&A see Compensation Discussion and Analysis (CD&A) CDP see Carbon Disclosure Project (CDP) CDSB see Climate Disclosure Standard Board (CDSB) Center for Audit Quality (CAQ) 74 CFOs see Chief Financial Officers (CFOs) Chen, C. 13, 14 Cheng, B. 28, 31 Cheng, C.-L 34 Chen, H. 11 Chen, L. H. 13 Chief Financial Officers (CFOs) 74 Chih, H. L. 32 child labor 131 Cho, S-Y. 29, 34 Chow, C. 51, 57 Christensen, H. B. 10, 12, 29, 30, 178, 179, 246 Christensen, T. 65 Chung-Hua S. 47 CIFAR index 260 Ciftci, M. 197 CII see Council of Institutional Investors (CII) climate change 106–7, 217 bidirectional impact 107–10 carbon pricing mechanisms 110–11 costs of 108–11, 117 externalities 107–11, 118 financial implications of 110–18 global campaigns 117 global warming 112, 115–16 greenhouse gas (GHG) emissions 106–8, 110, 111, 114–16

Index  285 inside-out impacts 108–10, 117 internalization 107–10 International Financial Reporting Standards (IFRS) 112–14, 117 outside-in impacts 107–9, 111, 112, 114 rise of sea levels 107 rules and laws 110 sustainability reporting standards 113–14 voluntary initiatives 115 voluntary investor frameworks 116–17 Climate Change Levy 111 Climate Disclosure Standard Board (CDSB) 114 Clinch, G. 189, 198 Cochran, C. E. 235 code of conduct/ethics 229–30, 238 CO2 emission 108, 110–11, 216, 217 reduction of 111, 115–16 see also global warming; greenhouse gas (GHG) emissions collective bargaining 130 common good 235, 236, 238, 240 see also public good; public interest company valuation, ESG reporting impact on 143 Compensation Discussion and Analysis (CD&A) 80 compliance cost 14 comprehensive model of warning signs 98–100 Consultation Paper on Sustainability Reporting (CPSR) 133 content-focused verification, sustainability reporting 142 Convention on the Rights of Persons with Disabilities (CRPD) 223 Cooper, S. 125 Cornett, M. M. 47 corporate ethical behavior 27 fraud 89 reputation 197 corporate governance 31, 74–9, 82, 125, 128, 161, 162, 167, 252–6, 262 disclosure 258–62 factors to influence economic performance 261 and financial accounting information 256–62 mechanisms 257–60 regulatory changes 259 corporate reporting 233, 234, 245, 246 financial reporting standards 240–42 sustainability reporting standards 242–3 corporate social irresponsibility (CSiR) 31 corporate social responsibility (CSR) 1, 25, 39, 245 and accounting conservatism 34–5 assurance 35–6

beneficiaries of 26 credibility of reporting 36 decomposition 32 defined 25 earnings management/accounting quality 32–4 impact on firm performance 28–9 investment 27, 29 measurement 30–32 multi-stakeholder approach 26–7 orientation 26–7 overview 26–8 performance versus disclosure 29–30 reporting 29–30, 35–6 strengths and weaknesses 30–31 Corporate Sustainability Reporting Directive (CSRD) 1, 2, 35, 113, 121–7, 133, 134, 242 proposal 2021 122–5, 134, 234 corruption 89, 226, 230 cost accounting 172, 175, 178 historical 174, 176, 177, 180–82 Costanza, R. 114 costs and benefits, non-GAAPs disclosures 80–82 Council of Institutional Investors (CII) 80 Covrig, V. M. 10 Cox, P. 31 CPSR see Consultation Paper on Sustainability Reporting (CPSR) creative accounting 87, 88, 90 Cressey, D. 89 crypto-assets/cryptocurrencies accounting regulations 267 definitions 265 of types 265–7 equivalent to cash 271–2 IFRS guidance 265–7 MiCA regulation 267 Payment Tokens see Payment Tokens Security Tokens (token value) see Security Tokens (token value) stable and non-stable tokens 269 types of 265, 271–2 Utility Tokens see Utility Tokens CSiR see corporate social irresponsibility (CSiR) CSR see corporate social responsibility (CSR) CSRD see Corporate Sustainability Reporting Directive (CSRD) Cummings, J. R. 47, 58 Curcio, D. 47, 48 currency (cash) 270 Darnall, N. 141 Daske, H. 12 DeBoskey, D. G. 47

286  Research handbook on financial accounting debt investment 13 debt market benefits 13 “Decent Work Agenda”, of ILO 223 Dechow, P. 47, 48 Deepwater Horizon disaster, BP 141 DEF14A 252, 254, 259 definite proxy statement 252–4 DeFond, M. L. 13, 259 De George, E. T. 14 Degeorge, F. 48 Demirgüç-Kunt, A. 49 De Villiers, C. 39 Dhaliwal, D. 30 Di Fabio, C. 245 digital assets 264, 268, 279, 281 see also crypto-assets/cryptocurrencies direct reputational risk 227, 230 disclosure requirements (DR) 127–32, 179 European Sustainability Reporting Standards (ESRS) 127–33 International Financial Reporting Standards (IFRS) 133 discretionary accruals 11, 12 discrimination 223, 229 distributed ledger technology (DLT) 264, 265, 268, 270, 273–4, 280 distribution of wealth 227 DLT see distributed ledger technology (DLT) DORA regulatory proposals 278, 280 double materiality 124–6, 133, 134, 147, 158, 225, 242 DR see disclosure requirements (DR) Dugar, A. 197 Dumay, J. 151, 196, 198 Durbin-Watson statistic 53, 55 Durocher, S. 177, 181 Durrani, K. J. 47, 58 Dutchin, R. 259 Du Toit, E. 93 Dye, R. A. 15 earnings before interest, taxes, depreciation, and amortization (EBITDA) 67, 74, 76, 78 earnings management (EM) 10–11, 15, 32–4, 38, 45–6, 55–8, 88, 90, 194 literature review 47–8 earnings smoothing 10, 11 EBA see European Banking Authority (EBA) EBITDA see earnings before interest, taxes, depreciation, and amortization (EBITDA) EC see European Commission (EC) economic-based accounting research 243 economic control 221 economic cycle 45–6, 51, 57, 58 economic performance 259–61

Edgley, C. 158 EFRAG see European Financial Reporting Advisory Group (EFRAG) Elbannan, M. A. 196 Electronic Money Entities 269 El Ghoul, S. 31 Ellis, H. 191 EM see earnings management (EM) EMD2 see Second E-Money Directive (EMD2) E-money Tokens 265, 266, 269 MiCA Title IV 271–2 employment contract 130 enlightened shareholder value logic 159 Enron scandal 88, 91, 258 environmental, social and governance (ESG) 25, 29, 30, 34, 219, 220, 222, 242 balance sheets 230 disclosures 151–2, 156, 159, 160, 166 environment (E) of 227 factors 138, 143, 150 governance (G) in 226, 229 investments in 220, 230 liabilities in 230 performance 31, 38, 138–40, 143, 151–3 reporting 2, 138–9, 150, 152–3, 162 according to EFRAG 139–40 avoiding the greenwashing by EFRAG 152 cost of 143–4 credible, transparent and trustworthy 152 EFRAG’s set of standards 150–51 on firm’s information quantity and quality 141–2 guidelines 140–42, 147 institutional rules 141 mandatory 144 materiality in 149–51, 153 regulation 143–51 requirements, challenges faced by regulators 145–6 stakeholder engagement 150–51 standardization 144 third-party verification 141–2, 152 social (S) in 223, 229 environment/environmental assets 220–22, 228 balance sheet 228–9 damage 216 in environmental, social and governance (ESG) 227 impacts 107 personhood status 218, 228 environment-society-corporate governance 128

Index  287 epistemic commitment, to fair value accounting 177, 181 equality 223 equal opportunities 130 equities 219, 227, 230 equity market benefits 13 Ertimur, Y. 256, 257 ESG see environmental, social and governance (ESG) ESMA see European Securities and Markets Authority (ESMA) ESRS see European Sustainability Reporting Standards (ESRS) ESRS S1 129 ESRS S2 129–30 ESRS S3 130 ESRS S4 130–31 Ether 266 Ethereum 266 ethical analysis, non-GAAPs financial measures 79–81 EU see European Union (EU) European Banking Authority (EBA) 45–6, 49–51, 53, 55, 57, 58, 270 European Commission (EC) 113, 124, 144, 146, 241, 242 European Financial Reporting Advisory Group (EFRAG) 2, 113–14, 121, 125, 127–32, 134, 139–40, 144–6, 152–3, 157, 158, 242, 243, 266, 267, 271 to avoid greenwashing 152 Discussion Paper 264, 265, 270, 271, 273–4 set of standards 146, 150 sustainability reporting 150–53 European public good 241 European Securities and Markets Authority (ESMA) 143, 278 European Sustainability Reporting Standards (ESRS) 113, 114, 121, 134–5, 242, 245 disclosure requirements (DR) 127–33 drafts 127–8, 132 versus GRI proposals 131–2 social drafts 128, 132, 134 European Union (EU) 7, 121–2, 134, 144, 145, 150, 244–5 corporate reporting standards 240–43 implementation of International Financial Reporting Standards (IFRS) in 241 standards 138–9 sustainability reporting standards 124, 127–33, 146–7 EFRAG roadmap 146 Sustainable Finance Action Plan 153 Task Force 25, 146 Taxonomy Regulation 123

European Union Emissions Trading System (EU-ETS) 108, 111 executive compensation contracts 255–8 explosions, air pollution by 216 extended balance sheet 219, 230 externalities 107–11, 118 fair remuneration 130 fair value accounting 15, 172–4, 176, 181, 182 company-level policies 181 determination 181 and related challenges 178–80 resistance to 177, 180 South Africa 178–81 Fan, W. 194 Farooq, M. B. 125 Farooq, O. 196 FASB see Financial Accounting Standards Board (FASB) Fatemi, A. 151 Fauver, L. 31 FCA see full cost accounting (FCA) FCF see free cash flow (FCF) FDI see foreign direct investment (FDI) Ferri, F. 256, 257 fiat currency 268, 270 fidelity 225–6, 229 financial capital 219 contracting 255 crisis 237, 239, 241 disclosure 254 fraud/scandals 2, 88, 91, 234, 258 instruments 265, 270, 273, 277–80 materiality 158, 242, 243 stability 241–2, 244, 245 statements 251, 253, 254, 256 financial accounting 2, 108, 255 in carbon pricing 111 environmental impacts in 107 financial accounting information 251, 253, 255, 256 corporate governance and 251, 253, 255, 256–62 economic effect of 259–61 economic performance 259–61 legal channel 255 quality of 260 Financial Accounting Standards Board (FASB) 107, 172, 182 financial assets, IAS 32 definition 279–80 financialisation process 172 financial reporting (FR) 32, 33, 224, 229, 256–8 accounting conservatism 34–5 integrated 36–9

288  Research handbook on financial accounting research 244 standards 240–42 financial reporting quality (FRQ) 10–12 Fink, L. 216 firm performance 25, 27, 33 versus CSR disclosure 29–30 impact of CSR on 28–9 flexible adherents 177, 182 resistance by 181, 182 Florou, A. 13 Fonseca, A. R. 48 forced labor 131 foreign direct investment (FDI) 7 inflows 14 foreign equity investments 13 Fortanier, F. 122 Francis, J. R. 13 Francis, R. N. 34 Frankel, R. M. 47, 48 Franzen, L. 194 fraud/scandals accounting see accounting fraud corporate 89 defined 89 Enron 88, 91, 258 financial 2, 234 risk factor 69 warning signs for detecting the 93–7 free cash flow (FCF) 74 Freeman, E. 217 Friedman, M. 27, 217 Fritzche, D. J. 28 FRQ see financial reporting quality (FRQ) full cost accounting (FCA) 107, 108, 110, 117 further effects analysis, standard-setting process 244–6 future cash flows 174, 181 Gao, Z. 34 Garanina, T. 185, 196, 198 Garcia i Pujades, X. 216 García-Zambrano, L. 196 Gassen, J. 9, 11 Gavious, I. 196 GDP growth 260 Gendron, Y. 176, 177, 181 generally accepted accounting principles (GAAPs) 1, 2, 5–8, 14, 15, 254 adoption 9–10 financial measures 74 German 9–10 measure 67 UK 6, 12 US 7, 9–10, 15, 276 Georgescu-Roegen, N. 217

GHG emissions see greenhouse gas (GHG) emissions GHG Protocol 115–16 Giner, B. 122, 133, 237, 238, 243, 245 Gisbert, A. 88 global campaigns, for climate change 117 globalization 1, 5, 7 of quantitative accounting standards 17 Global Reporting Initiative (GRI) 115, 121, 122, 124, 125, 131–2, 134, 140, 143, 152, 157, 161, 242 global warming 112, 115–16 Gombola, M. J. 47 Gomez, E. A. 73 Gong, J. J. 192 Gonzalez, F. 48 good governance 226–7 Gordon, L. A. 14 governance 122, 133 assets 229–30 and capital 225–7 bodies 225, 229 corporate see corporate governance as determinant studies 257 in ESG 226, 229 liabilities 230 and management 129 mechanisms 256–7 as outcome studies 257 as a shock studies 257 Graves, S. B. 29 greenhouse gas (GHG) emissions 106–8, 110, 111, 114–16 greenwashing 152 GRI see Global Reporting Initiative (GRI) GRI Emissions 2016 Standard 115 Guenther, T. 196 Guix, M. 125 Güleç. F 186 Guo, J. 34, 35 Habib, A. 31 Han, B. H. 196 Han, S. 47 Harjoto, M. A. 29, 30 Hasan, I. 47 Hasan, M. M. 31 Hasselmann, K. 217 Hawn, O. 31 health and safety management 129 Heiman-Hoffman, V. B. 93 Hemingway, C. 28 Henry, T. F. 74 Hewlett, V. 179 high-quality accounting information index 260

Index  289 Himmer, K. 280 historical cost 174, 176, 177, 180–82 Hoepner, A. G. 151 Holthausen, R. W. 185 Hong, Y. 33 Ho, V. H. 149 Hsiang-Lin, C. 47 Huang, X. 31, 33 Huber, W. D. 238 human capital 196, 252, 253 human rights 222–3, 229 conventions 223, 224 treaties 222 violation of 228 Hummingbot project 279 Hwang, J. 33 hybrid tokens 278–81 IAASB see International Accounting and Assurance Standards Board (IAASB) IAS see International Accounting Standards (IAS) IAS 1 112 IAS 2 271–4 IAS 7 270, 272 IAS 16 112 IAS 32 270, 279 IAS 38 192–4, 199, 271–4 IAS 39 241 IASC see International Accounting Standards Committee (IASC) IC see intellectual capital (IC) ICOs see Initial Coin Offerings (ICOs) ideology theory of regulation 237, 244 IESBA see International Ethics Standards Board for Accountants (IESBA) IFAC see International Federation of Accountants (IFAC) IFRS see International Financial Reporting Standards (IFRS) IFRS 1 132–3 IFRS 2 113–14, 132–3 IFRS 3 195 IFRS 9 241–2, 279 IIRC see International Integrated Reporting Committee (IIRC) impact materiality 158, 242, 243 implementation credibility 13 income smoothing 57, 58 indirect reputational risk 227, 230 information 29, 225–6 quality/credibility 141–2, 147 quantity 141 Initial Coin Offerings (ICOs) 277 initial public offering (IPO) 90 inside-out impacts 108–10, 117

see also climate change; outside-in impacts institutional logics 157, 161 intangible assets 229, 230, 271, 277, 281 IAS 38 271–4 regulation of 278 value-relevance of see value-relevance of intangible assets intangible-intensive industries 197 integrated reporting (IR) 36–9, 156, 159–61, 163, 164, 167 intellectual assets 229 intellectual capital (IC) 192, 193, 195–8, 224, 229 internal environmental costs 108 International Accounting and Assurance Standards Board (IAASB) 238–40 International Accounting Standards (IAS) 6, 112, 220 adoption 9–10 International Accounting Standards Board (IASB) 8, 11, 15, 16, 107, 112, 157, 172, 175, 182, 240–43, 264, 271 “Conceptual Framework” 2 crypto-assets 265–7 development timeline 6–7 legitimacy 244 standard-setting process 245 International Accounting Standards Committee (IASC) 6 International Bill of Human Rights 222, 223 International Ethics Standards Board for Accountants (IESBA) 238–40 International Federation of Accountants (IFAC) 150, 238, 240 International Financial Reporting Standards (IFRS) 1, 5, 112–14, 117, 160, 174, 178–82, 192, 195, 220, 224, 240–41, 243–5, 274 accountability 8 development timeline 6–7 EFRAG in Security Tokens 279–80 FDI inflows in 14 Foundation 6, 7, 112, 113, 121–2, 133, 233, 241, 243 guidance for crypto asset 265–7 intangible assets 276 market efficiency 8 mission of 7–8 for SMEs 16–17 Standards, adoption of 8–10 Australian firms 14 Canadian firms 11 capital market benefits 12–13 costs of 14–15 financial reporting quality (FRQ) benefits 10–12

290  Research handbook on financial accounting liquidity effects 12 macroeconomic benefits 13–14 transparency 7–8, 14 International Integrated Reporting Committee (IIRC) 36, 157, 158, 242 International Labor Organization (ILO) 229 objectives 222–3 International Sustainability Standards Board (ISSB) 17, 112–14, 122, 132–4, 243 inventory (stock), IAS 2 standard 271–3, 275 investment 218, 219, 223, 224, 226, 253 decisions 258, 261, 262 in good governance 227 Ioannou, I. 31 IPO see initial public offering (IPO) ISA 240 93 ISSB see International Sustainability Standards Board (ISSB) Jarne, J. I. 11 Jayaraman, S. 11 Jeanjean, T. 193 Jennifer, J. J. 47 Jennings, M. 79 Jiang, W. 47 Jilani, F. 47 Jiménez, G. 53 Jo, H. 30 Johannesburg Stock Exchange (JSE) 179 Jo, J. 29 Jo, K. M. 73 Jones, D. A. 194 Jones, T. M. 28 Jørgensen, S. 125 Kallapur, S. 195 Kanagaretnam, K. 47 Kang, F.-C. 33 key performance indicators (KPIs) 147, 149 Khan, M. 151 Khurana, I. K. 13 Kim, D. 259 Kim, I. 33 Kim, Y. 30–31, 33 KLD (Kinder, Lyndenberg and Domini) database 30 Klein, A. 259 Kosi, U. 13 Kothari, S. P. 236 KPIs see key performance indicators (KPIs) KPMG Survey of Sustainability reporting 2020 121, 126 Krüger, P. 30 Kulshrestha, A. 192, 196 Kumari, P. 197

Kung, F.-H. 34 Kwan, S. Y. S. 195 Kyoto Protocol 110, 111 labor rights 222–3 Laeven, L. 47 Lambert, R. 234 Landsman, W. R. 12 law of nature 217–18 Lazic, P. 47 Lazzem, S. 47 Lee, D. L. 217 Lee, K. W. 37 Leuz, C. 9, 10 Lev, B. 188, 189 Leventis, S. 48 Levitt, T. 27 LGD see loss given default (LGD) Lin, L. 243 Lins, K. V. 29 liquidity effects 12 Li, S. 12 Litt, B. 33 Liu, C. 11 Liu, G. 11 Li, Y. 141 loan loss provisions 47–50, 52–5, 57, 58 lobbying regulators 237 Loi Pacte in France 266 Lok, J. 159 loss given default (LGD) 49–50, 52–5, 57 Louis, H. 13 Lourenço, I. C. 189 loyalty 225–6, 229 Luque-Vílchez, M. 122, 133 Lys, T. 29, 31, 32 Maas, T. 274 McGuire, S. 238 Maclagan. P. 28 macroeconomic benefits 13–14 McWilliams, A. 27 Majnoni, G. 47 Malagueño, R. 126 Manabe, S. 217 managerial turnover probabilities 258, 259 Maniora, J. 38, 39 Manry, D. 196 marked-to-model fair values 174 market efficiency 8 market logic 159–62, 164, 166 Markets in Financial Instruments Directive (MiFID) 277, 280 market value of firm 193–6 Marques, A. 79

Index  291 Márquez-Ramos, L. 14 Martínez Alier, J. 217 Maso, L. D. 36 materiality 157–8 company analysis 163–6 compliance preparers view 161, 163, 166 defined 149, 153, 157, 164 determination 158–60, 166 disclosures 125–6 double 124–6, 133, 134, 147, 158, 225, 242 ESG reporting 149–51, 153 for financial reporting 164 institutional logics 161 integrated reporting 159–61, 163, 164, 166, 167 interpretive preparers view 162–4, 166 market logic 159–62, 164 in non-financial reporting context 157–8, 161–3, 166 professional logic 158–64, 166 stakeholder-aware preparers view 162–4, 166 stakeholder engagement 157, 159, 161, 164, 166–7 stakeholder logic 159–61, 166 sustainability reporting 159, 163 Mayer, C. 260 Maystadt Report of 2013 241 Mervelskemper, L. 38 MG see Monitoring Group (MG) MiCA 265–6, 269, 280 contributions and limitations 267 regulation for Security Tokens 278–9 Title II 272, 273 Title III 272 Title II of 269 Michelon, G. 36, 125 MiFID see Markets in Financial Instruments Directive (MiFID) Miller, W. 79 Mintz, S. M. 79 Mishra, C. S. 197 money 268 typology of 268–9 see also Bitcoin; crypto-assets/ cryptocurrencies Monitoring Group (MG) 239–40 Mora, A. 237, 238, 243, 245 Morgan, K. P. 93 Morrós Ribeira, J. 217 Moyes, G. D. 93 multiple objective hypothesis 32 multi-stakeholder approach 26–7, 242, 244, 245 Murrell, A. J. 29 myopia avoidance hypothesis 32

Nastanski, M. 122 natural capital 216–17, 220–22, 228–9 natural law 218 rights 221 neoliberalism 172–7, 182 new trends 2 NFRD see Non-Financial Reporting Directive (NFRD) Nikolaev, V. 178 Nobes, C. W. 8 non-financial assets 230 liabilities 230 reporting 140, 157–9, 161–3, 220 non-financial information 163 balance sheet 218–20 Non-Financial Reporting Directive (NFRD) 121–4, 135, 139, 146–8, 234, 242 Directive 2014/95 25, 35 non-generally accepted accounting standards (GAAPs) 62–3 ADT Inc. reporting 76–8 corporate governance 74–8 disclosures 69–75, 78 earnings 63–5, 74, 76, 78–81 financial measures 66, 67, 71, 73–5 costs and benefits 80–82 ethical analysis 79–81 external auditors, role of 74, 75, 79, 82 fraud risk factor 69 metric prominence, C&DIs’ guidance on 70 metrics 64, 65, 69, 70 US SEC Regulations see US Securities and Exchange Commission (SEC) non-monetary asset 271 non-performing loans 45–6, 48–50, 52–4, 57, 58 non-stablecoins 269 non-stable tokens 272 Norwalk Agreement 7 Obeng, V. A. 38, 39 Ohlson model 189, 197, 198 ordinary least squares (OLS) regression 50, 51 Orij, R. P. 123 outside-in impacts 107–9, 111, 112, 114 overreliance, on fair value 15 Pacioli, L. 218 Pandya, A. 179 paper currency 268 see also crypto-assets/cryptocurrencies Paris Agreement 110, 112, 132 Park, C. 259 Parrondo, L. 266, 274, 278, 280 Pastor, D. 185

292  Research handbook on financial accounting Patro, A. 192, 196 Pawsey, N. L. 14 pay inequalities 130 payment of salaries 224 Payment Tokens 266, 269 accounting treatment of 270–71 Asset Referenced Tokens (ART) 272 other than ART or E-money tokens 271 types of 271, 272 PCAOB Standard 75, 82 PD see probability of default (PD) Perez, D. 48 personhood status, environment 218, 228 Petrovits, C. 28, 33 Petty, R. 191 Pflugrath, G. 36 PIOB see Public Interest Oversight Board (PIOB) Plakhoknik, M. 92 Pozharny, J. 197 PRI see Principles for Responsible Investment (PRI) pricing accuracy 12 Principles for Responsible Investment (PRI) 144 Prior, D. 32, 33 privacy at work 131 private money 268 probability of default (PD) 49–50, 52, 53 process-focused verification, sustainability reporting 142 production of wealth 214 product market competition 258 professional logic 158–64, 166 profitability 224, 227, 229 profit manipulation 33 property, plant, and equipment (PP&E) 112 public good 233, 235, 241 public interest 2, 233–4, 246 accounting profession in 238–40 aggregative perspective 235–6 balancing approach 237–8, 243, 245 capture theory of regulation 236–7, 245 financial reporting standards 240–42 ideology theory of regulation 237, 244 market-driven theories of regulation 236–7 process perspective 236, 237, 244 role of the accountants and their incentives 243–4 stakeholder involvement 237 standard-setting in corporate reporting 240–43 substantive perspective 235 Public Interest Oversight Board (PIOB) 239 public money 268 qualitative warning signs 91–6

high probability of accounting fraud 98–100 quantitative warning signs 92, 93, 97 high probability of accounting fraud 100–101 Race to Zero Campaign 117 Radhakrishnan, S. 194 rainwater 221 Rajan, R. 260 Ravenscroft, S. 175 Razous, F. P. 214 R&D see research and development (R&D) real transactions 88–9 Reason, T. 79 RECs see renewable energy certificates (RECs) red flags 91, 93, 98 regulation 30 accounting 90, 91, 264, 267 ESG reporting 143–51 of intangible assets 278 MiCA 265–7, 269 public interest capture theory 236–7, 245 ideology theory 237, 244 market-driven theories 236–7 sustainability reporting (SR) Corporate Sustainability Reporting Directive (CSRD) 121–6, 134 International Sustainability Standards Board (ISSB) 122, 132–3 US SEC Regulation G 62, 64–7, 74, 79 Regulation S-K Item 10(e) 62, 64–6, 79, 252 remuneration 130 renewable energies 115–16 renewable energy certificates (RECs) 115 reporting quality 141–2, 147, 150, 153, 196 reporting quantity 141 reputational risk 226–7, 230 reputation of entities 229 research and development (R&D) 192–3 capitalization of 194, 199 costs 193–5 spending 260 resistance 176–8 to fair value accounting 177, 180 by flexible adherents 181, 182 by proponents of historical cost accounting 180 Rieg, R. 185 rights of nature (land, water, and air) 221, 228–9 risk management 133, 143, 144, 159, 163 of non-compliance 226 reputational 226–7, 230

Index  293 Roberts, J. 176 Rocco, T. 92 Rockström, J. 106 Romney, M. B. 93 Ruch, G. W. 34 Ruiz-Lozano, M. 125 Ruiz-Rodríguez, C. 185 Russ, M. 196 Ryan, V. 82 Sakakibara, S. 191 Samwick, A. 258 Sarbanes Oxley Act of 2002 (SOX) 62, 64, 257–8 SASB see Sustainability Accounting Standards Board (SASB) savings, equities and liabilities from 219 SBTi see Science-Based Target initiative (SBTi) Schiemann, F. 196 Schleicher, T. 13 Schmidt, J. 238 Scholtens, B. 33 Schons, L. M. 31 Schuermann, T. 46 Schulte, S. 179 Schwaiger, M. 189, 191 Science-Based Target initiative (SBTi) 115 SDGs see Sustainable Development Goals (SDGs) SEC see US Securities and Exchange Commission (SEC) Second E-Money Directive (EMD2) 271 sector-agnostic sustainability reporting 145, 147, 149 sector-specific sustainability reporting 145, 147, 149 Security Token Offerings (STOs) 277, 280 Security Tokens (token value) 265–7, 277–8 accounting proposal 280–81 digital securities 277 EFRAG Discussion Paper 279–80 investment risk 278 issuance and sale 281 MiCA regulation 278–9 right to access services of buyer 278 Sellhorn, T. 9 Seng, D. 191 Sepúlveda-Alzate, Y. M. 126 Serafeim, G. 31, 38, 39, 151 SFDR see Sustainable Finance Disclosure Regulation (SFDR) shareholder model 10 Shaw, K. W. 195 significant asset 267 Simnett, R. 126 Sixt, E. 280

Slack, R. 39 Sloan, R. G. 255 small and medium-sized enterprises (SMEs) 124, 145, 147–9 International Financial Reporting Standards (IFRS) for 16–17 SMEs see small and medium-sized enterprises (SMEs) Smith, A. J. 255, 260, 261 Smith, A., wealth of nations 214–16 smooth earnings 47 social assets 222–4, 229 balance sheet 229 capital 222–4 dialogue 131 in ESG 223, 229 responsibility 2 Song, X. 8 Sopp, K. 125 Sougiannis, T. 188, 189 South Africa integrated reporting (IR) 36–8 resistance to fair value 178–81 SOX see Sarbanes Oxley Act of 2002 (SOX) Spanish banking sector earnings management 45–8, 55–8 financial system 49, 51 stress tests scenarios by EBA 45–6, 48, 49, 51, 57, 58 economic models 49–58 loan loss provisions 47–50, 52–5, 57, 58 loss given default (LGD) 49–50, 52–5, 57 non-performing loans 45–6, 48–50, 52–4, 57, 58 probability of default (PD) 49–50, 52, 53 SR see sustainability reporting (SR) stablecoins 269, 271–2 stakeholders concept of 217 engagement 132, 144, 146, 150–51, 157, 159, 161, 164, 166–7, 237 logic 159–61, 166 model 10 theory 32 standard-setting process corporate reporting 240–43 further effects analysis 244–6 Stark, A. W. 39 Stark, L. 259 Steienmeier, M. 31 stewardship 172–5, 177, 180–82 Stolowy, H. 88

294  Research handbook on financial accounting STOs see Security Token Offerings (STOs) strategic CSR 32 Streit, D. 38 stress test scenarios 45–6, 48, 49, 51, 57, 58 structured literature review, of value-relevance of intangible assets 186–99 Sunder, S. 15 Sun, J. 11 supranational organization 15 sustainability 139–41 accounting 107 assurance of 126–7, 134 environmental 216 information 141–2, 145 logic 159 performance 29–31, 34, 143, 144 Sustainability Accounting Standards Board (SASB) 125, 152, 242 standards 17–18 sustainability disclosures, assurance of 126–7, 134 sustainability reporting (SR) 1, 2, 17, 25, 35–6, 39, 121–2, 141, 142, 156, 159, 163, 234, 245 assurance of sustainability disclosures 126–7 double materiality concept 124–6, 133 regulation 121 Corporate Sustainability Reporting Directive (CSRD) 121–6, 134 International Sustainability Standards Board (ISSB) 122, 132–3 sector-agnostic 145, 147, 149 sector-specific 145, 147, 149 standards 113–15, 131–2, 145, 146–7, 242–3 development of 148 setting 145–8 voluntary 126 sustainable accounting 2 sustainable development 145 Sustainable Development Goals (SDGs) 138, 139, 227 Sustainable Finance Disclosure Regulation (SFDR) 123, 148 Syscoin network 266 tangential reputational risk 227, 230 target audience 242 Task Force, EU 25, 146 Task Force on Climate-related Financial Disclosures (TCFD) 114, 116–17 Taylor, G. 34 Teach, E. 79 Tepalagul, N. 243 Tesla, SEC’s Common Letters to 71–3 Tether (USDT) 269

theft of assets 89 third-party verification, sustainability reporting 141–2, 152 Tobin’s q 191, 199 traditional balance sheet 218 transparency 7–8, 12, 14, 150, 152, 226, 229 to stakeholders 26, 146 Tremblay, M.-S. 176, 177 Trimble, M. 8 Trump, D. 79 Tsalavoutas, I. 39 Tschopp, D. 122 Tunyi, A. A. 195 Tutticci, I. 191 UK generally accepted accounting standards (UK GAAPs) 6, 12 Unerman, J. 109 Universal Declaration of Human Rights 223 Urcan, O. 13 US generally accepted accounting standards (US GAAPs) 7, 9–10, 15, 276 US Securities and Exchange Commission (SEC) 82, 113, 114 audit committees 74, 75 Comment Letter to Tesla and Tesla’s response 71–3 Compliance and Disclosure Interpretations (CDIs) 62, 64–6, 69–71, 79 Regulation G 62, 64–7, 74, 79 Regulation S-K Item 10(e) 62, 64–6, 79 Utility Tokens 265–7, 273–4, 278, 281 access to goods and services 274 accounting proposal 274–6 for accounting purposes 274 definition of 273 economic value 274 EFRAG Discussion Paper 273–4 fit to the definition of asset 273–4 functionality/functional value 274 introduction to 273–4 issuance, sale, and redemption 274–6 native 274–5, 277 non-native 276–7 as other than ART or E-money tokens 273 right to access services of buyer 278 sale and purchase of goods or services 276–7 Vafaei, A. 198 value-at-risk (VaR) 46 value creation 37 value-relevance of intangible assets 185–6 book value and earnings 191, 197 IAS 38 standards 192–4 research 186–91

Index  295 on academic papers 186–99 advertising cost 196 analytical framework 186–7 balance sheet 192, 195 citations per year (CpY) of papers 189, 198 content analysis 186, 189, 198, 199 country of 191, 198 customer-related intangibles 197 development 187–93 on financial firms 193 industry focus 193 intellectual capital 195–8 knowledge-related intangibles 197 limitations of 199 methodology/methods 186, 189, 191 number of citations (NoC) of papers 189, 198 other topics 196–7 period 192–3 research and development (R&D) costs 193–5 trends and future directions 193–6 type of data used 191 structured literature review 186–99 Value Reporting Foundation (VRF) 114, 242 Vanini, U. 185 Van Zijl, W. 179 VaR see value-at-risk (VaR) Velte, P. 33 Venkatachalam, M. 33 Ventner, E, D. 79 Verdi, R. 11 Verrecchia, R. E. 9 Verschoor, C. C. 81 Vidal, I. 217 virtual currencies 270 voluntary climate initiatives 115 voluntary sustainability reporting 126 VRF see Value Reporting Foundation (VRF) Waddock, A. W. 29 Wang, C. 11 Wang, S. I.-L. 192

Wang, W. 198 Wang, Y. 194 warning signs of accounting deception 91–2, 98–101 comprehensive model of 98–100 for detecting fraud 93–7 on qualitative information 91–6 quantitative 92, 93, 97 water (environmental asset) 221–2 Watson, L. 31 Watts, R. L. 34, 185 wealth of nations, Smith, A. 214 Williams, P. F. 175 Wong, J. B. 189 workforce 129 working condition issues 129–30 work–life balance indicators 130 work-related discrimination 130 work-related rights 130–31 World Economic Forum (WEF) 114 Wu, Y. 38 Wymeersch, E. 239 Xie B. 47 Yang, S. 73 Yeo, G. H. H. 37 Yi, H. 79 Yip, R. W. Y. 11 Young, D. 11 Young, J. J. 234 Young, S. 12, 79 Zambon, S. 185 Zeff, S. A. 8, 234 Zeghal, D. 11 Zeng, Y. 12 Zhang, Q. 189 Zhang, Y. 172 Zhao, X. 29 Zhou, S. 37, 38 Zingales, L. 260