FSA Credential Level I Study Guide PDF

FUNDAMENTALS OF SUSTAINABILITY ACCOUNTING (FSA) CREDENTIAL™ LEVEL I STUDY GUIDE I The need for sustainability disclosure standards II The sustainability information ecosystem III Understanding IFRS Sustainability Disclosure Standards IV Corporate and investor use: going beyond disclosure FSA CREDENTIAL LEVEL I STUDY GUIDE DISCLAIMER DISCLAIMER Among other critical knowledge, the FSA Credential equips candidates with a strong under- standing of the International Sustainability Standards Board (ISSB), how the IFRS Sustainability Disclosure Standards are designed and what the IFRS Sustainability Disclosure Standards are designed to achieve. The concepts and information provided in this study guide empower professionals to make informed decisions related to sustainability disclosure and the use of investor-focused sustainability information. It does not, however, aim to equip candidates with a comprehensive knowledge of all requirements detailed in the IFRS Sustainability Disclosure Standards. The content within the FSA Credential study guides should not be considered technical application guidance or interpretive guidance for the purpose of preparing sustainability-related financial disclosure. All official technical and interpretive guidance for the IFRS Sustainability Disclosure Standards can be found in the IFRS Sustainability Standards Navigator on ifrs.org. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 2 FSA CREDENTIAL LEVEL I STUDY GUIDE PREFACE PREFACE The Fundamentals of Sustainability Accounting (FSA) Credential® is useful for all professionals who benefit from understanding the link between sustainability information and companies’ finan- cial performance. The FSA Credential is designed to create a common language and establish a baseline understanding of core concepts across capital markets so that companies, investors and other capital markets stakeholders effectively communicate and work together. The curriculum does not assume any baseline level of expertise in corporate disclosure, accounting, finance or investment analysis. Candidates will likely encounter concepts they already know and recognize in addition to concepts that are brand-new. The material seeks to present content that is relevant across professional roles. For example, investors benefit from understand- ing corporate performance management and reporting processes so they can better engage with and evaluate portfolio companies; companies benefit from understanding how investors use sustainability information in their investment decisions so that they can recognize how the sustain- ability information communicated via disclosure can help or harm access to capital. The curriculum does not elaborate on concepts that lack relevance across multiple roles. For instance, methods for integrating sustainability information into the portfolio construction process may be highly rele- vant to investor audiences but do not offer much use to a company evaluating how sustainability information can improve management outcomes. For the purposes of this curriculum, a few terms are used interchangeably. ‘Sustainability’ and ‘ESG’ are used interchangeably when referring to information about environmental, social and corporate governance as well as operational governance matters. Chapter 7 discusses material- ity in the context of sustainability disclosure, including the terms ‘impact materiality’ and ‘double materiality.’ Outside of Chapter 7, the terms ‘material’ and ‘materiality’ when used alone refer to investor-focused materiality, also referred to as financial materiality, denoting the concept of materiality linked to the evaluation of a company’s financial position, financial performance and prospects. The rapid increase in the use of sustainability information in capital markets represents a powerful opportunity to create financial value while contributing to a more sustainable world. However, the full benefits of investor-focused sustainability disclosure can be realized only when professionals across markets use a common language and foster a shared understanding. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 3 CONTENTS PART 1: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS............................ 9 1. Demand for Sustainability Information..................................................... 10 1.1. What is sustainability?....................................................... 10 1.2. Growing investor demand.................................................... 11 1.3. Demand within companies................................................... 13 1.4. Other institutions driving demand.............................................. 14 2. The Historical Basis for Disclosure........................................................ 17 2.1. The aftermath of the stock market crash of 1929................................... 17 2.2. D isclosure as the basis of regulatory reform...................................... 18 2.3. The road to standardized accounting procedures.................................. 19 3. Materiality: a guiding principle for required disclosure....................................... 25 3.1 A long-standing legacy of investor decision-making................................. 25 3.2. General characteristics of materiality........................................... 28 3.3. Materiality changes over time................................................. 33 3.4. N uances throughout the disclosure ecosystem.................................... 33 4. The limitations of financial disclosure..................................................... 35 4.1. F inancial information beyond financial statements: the use of non-GAAP................. 36 4.2. The changing nature of market value............................................ 36 4.3. The scope of financial reporting expands........................................ 37 4.4. New tools for investors...................................................... 41 PART II: THE SUSTAINABILITY INFORMATION ECOSYSTEM................................... 45 5. Introduction to the sustainability information value chain and the role of data providers........... 46 5.1. G rowth of the ecosystem: a maturing industry..................................... 46 5.2. The role of data providers................................................... 47 5.3. Sustainability data’s unique challenges......................................... 52 6. The Role of Standards And Frameworks: From Fragmentation to Cohesion in Sustainability Disclosure..................................................... 55 6.1. The role of standard-setters.................................................. 55 6.2. Formative standards and frameworks........................................... 56 6.3. D istinguishing characteristics of sustainability disclosure guidance.................... 57 6.4. C reating a coherent system for comprehensive reporting – simplification through consolidation.6 1 7. Materiality: going beyond investors....................................................... 66 7.1. M ateriality applied to sustainability disclosure..................................... 66 7.2. M ateriality in the IFRS Sustainability Disclosure Standards........................... 67 7.3. Materiality in the GRI Standards............................................... 70 7.4. M ateriality in the European Sustainability Reporting Standards........................ 71 7.5. Process vs. outcomes....................................................... 73 8. Sustainability disclosure across jurisdictions............................................... 77 8.1. The relationship between standard-setters and regulators............................ 77 8.2. The growing prevalence of regulatory disclosure guidance........................... 79 8.3. C ommon types of sustainability reporting rules.................................... 80 8.4. Types of guidance shaping global disclosure rules................................ 83 8.5. The influence of corporate governance codes.................................... 87 8.6. B alancing flexible implementation with usable information............................ 88 Last Updated: December 2023 4 PART III: UNDERSTANDING IFRS SUSTAINABILITY DISCLOSURE STANDARDS................... 90 9. What is useful sustainability-related financial information?.................................... 91 9.1. The importance of standards.................................................. 91 9.2. Sustainability: a unique context................................................ 92 9.3. The goals of the International Sustainability Standards Board......................... 92 9.4. A dditional characteristics of the IFRS Sustainability Disclosure Standards............... 95 9.5. The primary objective of the IFRS Sustainability Disclosure Standards................... 97 10. The IFRS Sustainability Disclosure Standards.............................................102 10.1. Core content............................................................ 103 10.2. Conceptual foundations................................................... 104 10.3. Determining what information to disclose....................................... 107 11. Setting IFRS Sustainability Disclosure Standards......................................... 116 11.1. The structure of the IFRS Foundation......................................... 116 11.2. D eveloping the first IFRS Sustainability Disclosure Standards....................... 118 11.3. Maintaining the SASB Standards............................................ 123 11.4. The initial development of the TCFD Framework................................. 125 12. How companies disclose sustainability-related financial information......................... 127 12.1. Introduction to sample disclosures........................................... 127 12.2. Why do companies disclose investor-focused sustainability information?............... 128 12.3. Where do companies disclose investor-focused sustainability information?............ 131 12.4. What investor-focused sustainability information are companies reporting?............. 139 12.5. How is investor-focused sustainability information being disclosed?.................. 146 PART IV: CORPORATE AND INVESTOR USE: GOING BEYOND DISCLOSURE.................... 157 13. A closer look: investor demand for sustainability information................................ 158 13.1. A global call for enhanced disclosure......................................... 158 13.2. A shift in market paradigms................................................ 159 13.3. Companies come to call................................................... 163 14. Considerations for corporate use....................................................... 164 14.1. B usiness roles applicable to sustainability disclosure............................. 164 14.2. Preparing for disclosure.................................................... 170 14.3. Preparing quality data..................................................... 173 14.4. Reporting material sustainability data......................................... 178 14.5. Managing sustainability performance......................................... 182 15. Considerations for investor use........................................................ 191 15.1. Overview of sustainability in investing......................................... 191 15.2. A Spectrum of the use of sustainability information............................... 193 15.3. I nvestor application of cross-industry vs. industry-specific sustainability data........... 199 15.4. The pre-investment stage................................................... 201 15.5 Index construction and sector allocation........................................ 210 15.6. Post-investment engagement............................................... 213 15.7. Investor reporting........................................................ 216 15.8. Creating an effective framework............................................. 217 15.9. Data is the backbone...................................................... 217 CONCLUSION........................................................................ 222 PREPARING FOR THE EXAM............................................................ 223 CHECK YOUR UNDERSTANDING: CHAPTER EXPLANATIONS................................. 224 SAMPLE QUESTIONS................................................................. 238 GLOSSARY OF KEY TERMS............................................................ 275 5 LEARNING OBJECTIVES 1 IDENTIFY the factors influencing investor use of sustainability information. 2 RECOGNIZE why financial accounting and disclosure have evolved to meet the needs of global capital markets. 3 IDENTIFY how sustainability disclosure has evolved and why it is an important component of general purpose financial reporting. 4 DISTINGUISH how ‘materiality’ is defined and used globally in the context of reporting. 5 RECOGNIZE the relationship between standard setters and regulators, the types of regulatory disclosure requirements and their implications for capital markets. 6 RECOGNIZE the roles of the organizations that make up the sustainability information value chain. 7 RECALL the inaugural goals of the ISSB and the characteristics of useful sustainability-related financial information. 8 RECALL the core content, conceptual foundations and sources of guidance of the IFRS Sustainability Disclosure Standards. 9 RECOGNIZE the ISSB’s standard-setting process, including the processes originally used to develop the SASB Standards and TCFD Recommendations. 10 DISCERN the implications of the Sustainability Industry Classification System® (SICS®). 11 DIFFERENTIATE how companies disclose sustainability-related financial information. 12 IDENTIFY how investor demand for sustainability information shapes corporate disclosure and performance management practices. 13 RECOGNIZE the cross-functional nature of preparing sustainability disclosures. 14 DISTINGUISH the stages of sustainability disclosure. 15 IDENTIFY the influence of board governance, internal controls, and third-party assurance on the reliability of sustainability information. 16 RECOGNIZE the role of sustainability management in corporate strategy and risk management. 17 IDENTIFY how sustainability information is used in public equities (active and passive). 18 IDENTIFY how sustainability information is used in corporate fixed income. 19 IDENTIFY how sustainability information is used in private markets. 20 UNDERSTAND the challenges investors face in using sustainability information and how those challenges impact the market. 6 FSA CREDENTIAL LEVEL I STUDY GUIDE EXECUTIVE SUMMARY EXECUTIVE SUMMARY Today, thousands of companies around the world disclose sustainability information. Each disclosure is the product of a complex system of workflows, involving dozens or even hundreds of professionals with specific corporate, accounting, legal, environmental or other expertise. These processes yield a wealth of information about a company’s approach to and ability to manage sustainability-related risks and opportunities. For such a broad and diverse group of professionals to communicate effectively on the right topics—not just with one another but also with the investors, creditors and lenders whose capital helps fund their business—a common language is required. For centuries, accounting has served as the ‘language of business.’ Like any language, it has evolved—along with the world around it—to meet the needs of its users. Over time, languages gain new words, inflections, and even grammatical constructions, while others fall into disuse. Likewise, concepts new and old have regularly entered and disappeared from the accounting lexicon—from the rise of double-entry bookkeeping in medieval Europe to the establishment of decision-useful financial accounting standards in the 1970s. In today’s rapidly changing world, companies face a unique set of challenges that call for the accounting of new information and for a new set of standards to ensure that information is useful. Large-scale issues such as population growth, resource constraints, urbanization, technological innovation and climate change can and do have profound effects on business outcomes. As a result, managers are incorporating sustainability information into their decision-making processes, and investors are looking beyond traditional financial statements for a more complete picture of how companies create value over the short, medium and long term. The language of busi- ness is evolving yet again to meet this growing demand. However, sustainability initiatives have struggled to effectively sharpen their focus on the factors most relevant to companies’ finan- cial position, financial performance and prospects. Consequently, the market is faced with two opposing challenges: first, there is often more than enough sustainability information available from large companies, but it frequently lacks comparability, reliability and usefulness for investor decision-making; and yet there is also not enough investor-grade information from companies to be able to fully assess sustainability-related opportunities and risks. Increasingly, a wide range of market participants, including companies, investors and their respective advisors and solutions providers, recognize the need for a shared understanding of how sustainability matters can either threaten or drive value. The International Sustainability Standards Board (ISSB) addresses this need by developing global standards that help companies disclose material sustainability information to investors. The IFRS Sustainability Disclosure Standards (sometimes colloquially referred to as the ISSB Standards) facilitate the disclosure of sustainabil- ity information that is comparable and decision-useful. In doing so, the Standards empower both COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 7 FSA CREDENTIAL LEVEL I STUDY GUIDE EXECUTIVE SUMMARY corporate and investor decision-making, risk management, strategy and communication. Against the backdrop of today’s changing business landscape, practitioners in sustainability, finance, operations and investing must understand how to identify, quantify and communicate sustainability matters that affect financial performance. In the content that follows: Part I provides historical context for standardized accounting and disclosure and describes the factors that have led to the uptake of sustainability information in capital markets; Part II explores the sustainability information ecosystem, clarifying the roles of key entities and their relationships, and the factors that led to the creation of the ISSB; Part III introduces the IFRS Sustainability Disclosure Standards, discussing how they are designed and what they are designed to achieve; and Part IV explores the ways companies and investors utilize material sustainability information. In addition to equipping candidates with a common language, the FSA Credential Level I curriculum is intended to help candidates understand and navigate the sustainability disclosure ecosystem, and to make informed decisions to the benefit of their own professional development, their organization, capital markets and society at large. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 8 PART I THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS In today’s capital markets, high demand for sustainability information is driven by investors and companies alike as the advantages of sustainabil- ity in investment and corporate performance management are realized in practice and proved through scholarly research. However, it was not always this way. The history of financial disclosure illuminates the core objectives, defining developments and past limitations that underpin the need for stan- dardized sustainability disclosure Part I provides: an exploration of the drivers of demand for sustainability information; an overview the history of financial disclosure; an introduction to the concept of materiality established for investor-focused reporting; and a discussion of how financial disclosure meets and does not meet the needs of companies and investors. FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS DEMAND FOR SUSTAINABILITY INFORMATION 1 LEARNING OBJECTIVE(S) COVERED IN THIS CHAPTER: 1 IDENTIFY the factors influencing investor use of sustainability information. 16 RECOGNIZE the role of sustainability management in corporate strategy and risk management. 1.1. WHAT IS SUSTAINABILITY? Today, the term ‘sustainability’ commonly appears in corporate and investor vernacular, though it can mean different things to different people. Perhaps the most widely accepted meaning of the term originates from the pivotal 1987 Brundtland Report published by the World Commission on Environment and Development. Titled Our Common Future, it states that ‘human- ity has the ability to make development sustainable to ensure that it meets the needs of the present without compromising the ability of future generations to meet their own needs.’1 Many others have articulated the concept of sustainability for different purposes. A few examples are listed below: ‘In a sustainable society, nature is not subject to systematically increasing: 1. concentrations of substances extracted from the earth’s crust, 2. concentrations of substances produced by society, 3. degradation by physical means, 4. and, in that society, people are not subject to conditions that systemically undermine their capacity to meet their needs.’ —The Natural Step Framework, first developed in 1989 by Karl-Henrik Robert ‘The possibility that human and other life will flourish on the planet forever.’ —John R. Ehrenfeld, academic and executive director of the International Society for Industry Ecology [A sustainable investment is] ‘an investment in an economic activity that contributes to an environmental or social objective, provided that the investment does not signifi- cantly harm any environmental or social objective and that the investee companies follow good governance practices.’ —The European Commission, as stated in The Sustainable Finance Disclosure Regulation 1 World Commission on Environment and Development, Our Common Future (Oxford: Oxford University Press, 1987), Part I, Section 3. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 10 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS No two interpretations are exactly alike. Their differences lie in the context within which they were developed—each shaped by different societal, political, industrial and organizational circumstances at different points in time. The Brundtland Report sought to define ‘sustainable development’ to inform global policy in response to growing concern for the environmental and social problems associated with a rising standard of living and the global population in the 1980s. The Natural Step Framework sought to define a ‘sustainable society’ to support orga- nizational planning in the early 1990s. 2 John R. Ehrenfeld defined sustainability in the context of industrial ecology in 2009.3 The European Commission defined ‘sustainable investing’ within regulation that seeks to improve transparency among financial service providers in 2019.4 Though no single, universal interpretation of sustainability exists, one common directive permeates them all: actions and decisions made today must not threaten our ability to function and thrive in the future. The FSA Credential focuses on sustainability information in the context of capital markets. For the purpose of this curriculum, sustainability information (sometimes called sustainabil- ity-related financial information or ESG information) is the information about companies’ environmental, social and governance matters that effect financial performance but are not traditionally captured in financial reports—in other words, the sustainability-related information needed to evaluate companies’ ability to function and thrive in the future. One cannot ignore that within capital markets the increasing prevalence of the terms ‘sustainability’ and ‘ESG,’ with all their intended meanings, reflects mounting evidence of the usefulness of some sustainability information for achieving business objectives. Companies and investors have come to a shared realization that financial returns can be sustained only if companies are well governed and the social and environmental assets underlying those returns are not depleted. Far more than an exercise in altruism, sustainability constitutes a key focus area of even the most financially motivated companies and investors. 1.2. GROWING INVESTOR DEMAND Many institutional investors demand sustainability information to improve fundamental performance, manage risk and volatility to protect against diminished returns and, in some cases, achieve above-market returns. Other investors seek to improve environmental and social investment outcomes with financial returns as an equivalent or a secondary consideration. A robust body of independent research provides a compelling picture of the benefits of sustain- ability information for achieving investors’ objectives. 1.2.1. IMPROVED INVESTMENT PERFORMANCE Some research demonstrates that companies committed to sustainability outperform in stock market performance—evidence that more sustainable companies can ‘adopt environmentally and socially responsible practices without sacrificing shareholder wealth creation.’5 For exam- ple, a controlled model developed by researchers at Harvard Business School predicted that 2 The Natural Step, ‘The Four System Conditions of a Sustainable Society,’ Accessed June 2023. 3 MIT Sloan Management Review, ‘Flourishing Forever, An interview with John R. Ehrenfeld,’ Reprint. No 51120. 14 July 2009. 4 European Commission, ‘Annexes to the Commission Delegated Regulation (EU),’ Annexes 1-4, 31 October 2022, p.1. 5 Robert G. Eccles, Ionnis Ioannou and George Serafeim, ‘The Impact of Corporate Sustainability on Organizational Processes and Performance’ (working paper), Harvard Business School, 29 July 2013. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 11 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS an investment of US$1 made in 1993 in a value-weighted portfolio of a company performing well in sustainability would have grown to US$22.6 by the end of 2010, while a control portfolio of non-sustainability performers would have grown to only US$15.4 in the same time period (see figures below).6 This finding suggests that sustainability information can support evaluation of market value. Various studies have found that ESG performance has also been linked to improved profit- ability. Companies focused on sustainability have ‘reduced costs, improved worker productivity, mitigated risk potential, and created revenue-generating opportunities.’7 Where sustainability performance is directly linked to profitability, sustainability information supports analysis of fundamental corporate performance. Figures 1 and 2: Sustainability performance benefits on a value-weighted portfolio Figure 1: Evolution of $1 invested in the stock market Figure 2: Evolution of $1 invested in the stock market in value-weighted portfolios in equal-weighted portfolios HIGH LOW HIGH LOW 25.00 15.00 20.00 12.00 15.00 9.00 10.00 6.00 5.00 3.00 0.00 0.00 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Source: Robert G. Eccles, Ioannis Ioannou, and George Serafeim, “The Impact of Corporate Sustainability on Organiza- tional Processes and Performance” (working paper), Harvard Business School, 29 July 2013 1.2.2. RISK MANAGEMENT Research also demonstrates that sustainability information can be a strong signal for price volatility. For example, one study found that companies with higher sustainability or ESG ratings have lower price and earnings per share (EPS) volatility than those with low sustainabili- ty-performance scores.8 Based on historical data, Bank of America Global Research found that companies in the top quintile of ESG performance experienced the lowest volatility in earnings per share in a subsequent five-year period. By contrast, ‘companies with the worst environmen- tal, social and governance records averaged 92% volatility.’ Notably, the researchers found that sustainability information was the only reliable signal for predicting EPS volatility, providing better insight than traditional measures such as return on equity. Sustainability information can be important to investors when assessing risk and the predictability of investment outcomes. 6 Eccles, Ioannou and Serafeim, ‘Impact of Corporate Sustainability on Organizational Processes and Performance.’ 7 S&P Global Ratings, ‘The ESG Advantage: Exploring Links to Corporate Financial Performance,’ 8 April 2018. 8 Bank of America, ‘Equity Strategy Focus Point,’ 18 December 2016. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 12 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS Relatedly, sustainability information has been shown to help avoid major losses. The same Bank of America Global Research study found that, if investors bought only stocks from compa- nies with above-average ESG scores five years ahead of a company’s bankruptcy, they would have avoided more than 90% of the bankruptcies that occurred in the S&P 500 from 2005 to 2015.9 Similarly, research indicates that poor sustainability performers have a higher likelihood of experiencing major negative credit events.10 Investors in public companies increasingly rely on sustainability information to support risk analysis, to identify signals of future volatility and value declines and to protect portfolio value. While these studies tend to focus on public equity for its availability and abundance of data, it is important to acknowledge that investors in private companies also increasingly rely on sustainability information. Many private equity investors recognize ESG investing as a means to improve portfolio performance, mitigate risk and generate alpha.11 Robust public, academic and scholarly research on the benefits of sustainability information in private markets is limited, in part due to the less transparent nature of reported data and corporate value in private markets. As with all research, one can find flaws in individual studies that identify the benefits of sustainability to investors. However, the benefits of sustainability information are borne out when looking across a large sample of research. A 2015 meta-analysis of more than 2,000 empirical studies found that the majority of studies demonstrate a positive relationship between sustain- ability performance and financial performance. In the sample, 90% of studies demonstrated a non-negative relationship between sustainability and corporate financial performance. In other words, a corporate focus on sustainability need not come at the expense of financial objectives. Rather, it enhances companies’ abilities to achieve those objectives. Part IV expands on the diverse range of investor use cases for sustainability data. 1.3. DEMAND WITHIN COMPANIES The factors described above drive investor demand for sustainability information from companies. Some leading companies also generate their own internal demand for this informa- tion for similar reasons: sustainability data can help provide insight into financial performance and contribute to success in the near, medium and long term. Some studies suggest that most corporate executives today recognize the link between sustainability information and business success. According to a 2019 CEO study “About 12 years ago, several people jointly conducted by the UN Global Compact thought sustainability would cost money and Accenture, 94% of CEOs believe that and was nice to do. Now, 12 years later... ‘sustainability issues are important to the creating value for our society and planet future success of their business’ and ‘recog- can go hand-in-hand with business nize that sustainability can drive competitive successes.” advantage.’ Moreover, 40% ‘are seeing busi- ness value through revenue growth’ and — Feike Sijbesma, CEO of Royal DSM, 2019 are creating ‘genuine value’ through risk 9 Bank of America, ‘Equity Strategy Focus Point,’ p. 194. 10 Witold J. Henisz and James McGlinch, ‘ESG, Material Credit Events, and Credit Risk,’ Journal of Applied Corporate Finance 31, no. 2 (Spring 2019). 11 Bain & Company, Global Private Equity Report 2020, 2020. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 13 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS mitigation, cost reduction and competitive advantage gained through ‘new markets, products and services, resource productivity and efficiency.’ 12 A company’s ESG performance can also impact its access to and cost of capital. In fact, in 2015 researchers from the University of Oxford evaluated 200 empirical ESG studies and found that ‘90% of the studies on the cost of capital show that sound sustainability standards lower the cost of capital for companies.’13 Independent of investor demand for sustainability information, companies increasingly seek to generate better sustainability performance data and insights for internal use to directly inform strategic decisions, drive financial performance and foster long-term success. 1.4. OTHER INSTITUTIONS DRIVING DEMAND In addition to demand from investors and within companies, a number of organizations in the broader business ecosystem shape the public dialogue and practices surrounding the produc- tion and use of sustainability reporting. 1.4.1. PUBLIC POLICY AND REGULATION Policy-based initiatives stimulate sustainability disclosure by enacting national recommen- dations or requirements for publicly listed companies in order to foster more stable, sustainable economies. For example, the European Commission released the Action Plan for Financial Sustainable Growth, a sweeping, multifaceted policy directive that sets forth a comprehensive strategy and action plan to ‘further connect finance with sustainability.’ The plan contains 10 key initiatives distributed among three core categories: ‘reorienting capital flows towards a more sustainable economy,’ ‘mainstreaming sustainability into risk management’ and ‘fostering trans- parency and long-termism.’14 Individual nations have also taken up policy initiatives aimed at corporate sustainability disclosure, including Australia,15 India,16 Japan,17 South Africa18 and the United Kingdom19. In instances where jurisdictions adopt the Paris Climate Accord into local policy, global policy efforts promote the disclosure and use of sustainability information at a country level. 1.4.2. INDUSTRY BODIES Non-policy efforts also influence the use of sustainability information. For example, the Sustainable Stock Exchanges (SSE) Initiative is focused on building the ‘capacity of stock exchanges and securities market regulators to promote responsible investment in sustainable development.’ It offers ‘a global platform for exploring how exchanges, in collaboration with 12 UN Global Compact and Accenture Strategy, The Decade to Deliver: A Call to Business Action, September 2019. 13 University of Oxford and Arabesque Partners, ‘From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,’ March 2015. 14 European Commission, ‘Renewed Sustainable Finance Strategy and Implementation of the Action Plan on Financing Sustainable Growth,’ 8 March 2018. 15 Corporations Act, 2001. 16 India Companies Act, Section 135. 17 Ministry of Economy, Trade and Industry, ‘Guidance for Integrated Disclosure and Company-Investor Dialogues for Collaborative Value Creation.’ 18 Johannesburg Stock Exchange, ‘Regulation,’ accessed November 2020. 19 FRC, ‘Future of Corporate Reporting,’ 8 October 2020. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 14 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS investors, companies, regulators, and policymakers and relevant international organizations, can enhance performance on ESG issues and encourage sustainable investment, including the financing of the UN Sustainable Development Goals.’ In large part due to the leadership of the SSE, most stock exchanges provide guidance to listed companies delineating why and how to report sustainability information. Statements from various other industry bodies also contribute to growing demand for sustainability information in the market. For example, Accountancy Europe’s ‘Interconnecting Standard Setting for Corporate Reporting’ states: ‘Global challenges, such as climate change, depletion of raw materials, biodiversity loss, access to resources, planetary limits, human rights and social concerns are increasingly core issues for companies … The nature of risks and the drivers of value for companies today mean that broader information about long-term strategy is essential for resilient businesses and sustainable investment decisions.’20 Other industry orga- nizations, including the Global Asset Owner Forum, 21 Global Financial Markets Association, 22 the Institute of International Finance, 23 the International Corporate Governance Network, 24 the Network for Greening the Financial System25 and the Securities Industry and Financial Markets Association, 26 have all published calls related to the benefits of reporting sustainability infor- mation. Such coalitions and associations build mutual understanding of the impacts of ESG information and reinforce the demand for quality sustainability disclosure from members. Recognition of the relationship between social and environmental responsibility and financial success has initiated a torrent of demand for sustainability information. Investors and business professionals alike recognize the need for business reporting to evolve. Indeed, change within the disclosure landscape is nothing new. Disclosure expectations have been continuously evolv- ing for the past 100 years, as markets become more sophisticated and key players within the ecosystem evaluate the usefulness of disclosure and refine its purpose. The benefits of sustain- ability information for corporate and investor decision-making represent a natural continuation of this evolution. 20 Accountancy Europe, ‘Interconnected Standard Setting for Corporate Reporting,’ December 2019. 21 Global Asset Owner Forum, ‘Summary of the Fifth Global Asset Owners’ Forum,’ 4 March 2019. 22 Global Financial Markets Association, ‘GFMA Letter on TEG EU Sustainable Taxonomy Report,’ March 2020. 23 Institute of International Finance, ‘Building a Global ESG Disclosure Framework: A Path Forward,’ 10 June 2020. 24 International Corporate Governance Network, ‘Letter to Corporate Leaders,’ 23 April 2020. 25 Network for Greening the Financial System, ‘First Comprehensive Report: A Call for Action Climate Change as a Source of Financial Risk,’ April 2019. 26 Securities Industry and Financial Markets Association, ‘Sustainable Finance/ESG,’ accessed October 2020. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 15 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS CHAPTER REVIEW This chapter contains information related to the following Learning Objective(s): 1 IDENTIFY the factors influencing investor use of sustainability information. 16 RECOGNIZE the role of sustainability management in corporate strategy and risk management. ? CHECK YOUR UNDERSTANDING 1. Why are investors demanding quality sustainability information? 2. What factors drive demand for quality sustainability information within companies? 3. B esides companies and their investors, what other institutions influence demand for sustainability information? JUMP TO ANSWERS COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 16 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS 2 THE HISTORICAL BASIS FOR DISCLOSURE LEARNING OBJECTIVE(S) COVERED IN THIS CHAPTER: 2 RECOGNIZE why financial accounting and disclosure have evolved to meet the needs of global capital markets. Today, standardized financial reporting is a global norm. Companies consistently report accurate and timely information to investors through well-established reporting channels, often reinforced by legal requirements, creating the rich bedrock of financial information on which capi- tal markets rely. Investors know they can rely on companies’ regularly reported income statements and statements of cash flows, for example. However, comparable, consistent and reliable corpo- rate disclosure did not always exist. 2.1. T HE AFTERMATH OF THE STOCK MARKET CRASH OF 1929 In September 1929, the London Stock Exchange crashed after prominent fraud claims came to light. The New York Stock Exchange crashed the following month, largely due to fraudulent investment practices, declines in consumer demand, misguided economic policy and over- extended credit, as well as other factors. These events led to the Great Depression. Virtually every country around the world felt the effects of the Depression, marked by a wave of bank fail- ures, record unemployment rates and declining income.27 Global gross domestic product (GDP) fell by an estimated 15%,28 though the effect on individual countries varied greatly, with some countries’ GDP falling by more than 30%.29 In comparison, worldwide GDP fell by less than 1% from 2008 to 2009 during the Great Recession.30 In the UK and the US, the crash led to more than an 80% drop in market value by the end of June 1932. The public reacted angrily, with most of the ire aimed at the financial industry, leading to broad support for reform and regulation of the capital markets. During subsequent investigative hearings, legislators uncovered evidence of many unethical and risky financial practices. Bankers and companies failed to fully disclose information about the companies whose securities were being offered for sale, creating widespread securities sales using false or misleading information.31 27 Richard H. Pells and Christina D. Romer, ‘Great Depression,’ Encyclopedia Britannica, 10 September 2020. 28 John A. Garraty, The Great Depression (1986), Chapter 1. 29 Pells and Romer, ‘Great Depression.’ 30 Garraty, Great Depression. 31 Senate Banking and Currency Committee, Stock Exchange Practices (Fletcher Report), S. Rep. No. 73-1455 (1934). COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 17 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS The 1929 stock market crashes—and the shock waves they sent through global markets—provide one of the most striking examples of how a lack of transparency can lead to disastrous consequences and erode investor confidence. They also demonstrated the real-world impacts of market failures on the lives of everyday people, including retirees who rely on pensions and retirement savings.32 2.2. D ISCLOSURE AS THE BASIS OF REGULATORY REFORM The following sequence of events in the US provides a useful case study for why corporate disclosure became the target of regulatory reform around the world. Prior to the Great Depression, in 1914 the US Supreme Court justice Louis D. Brandeis articulated the benefit of disclosure: Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.33 In other words, public exposure and transparency are the key to monitoring the companies and investors that collectively shape capital markets. Brandeis’s thinking significantly influenced the regulatory reform that followed, including the establishment of the US Securities and Exchange Commission (US SEC) in 1934. The mission of the US SEC is to protect investors; maintain fair, orderly and efficient markets; and facilitate the flow of capital. Disclosure was at the heart of regu- latory reform in the 1930s, building on previous sentiments of the benefit of transparency. At the time, scholars saw mandatory disclosure as a method to hold manage- CAVEAT EMPTOR ment accountable to their shareholders and to promote the public interest.34 They posited Prior to the formation of the US SEC, that disclosure would advance the ability of US investors operated under the the capital markets to efficiently price securi- principle of caveat emptor, which ties.35 Supporters of reform also emphasized postulates that the buyer alone is that disclosure, by nature, is about investors responsible for vetting the quality of a making informed decisions, as it ‘is intended to security before purchase. The US SEC reveal facts essential to a fair judgment upon did not supplant caveat emptor; it sup- the security offered.’36 plemented the principle with the obli- The legislative history of the formation gation for companies to disclose to the of the US SEC demonstrates two important investing public. Investors were still free purposes for the US SEC’s existence: to make poor investment decisions. 1. to protect investors; and 2. to influence corporate behavior. 32 Lynn E Turner, ‘Speech by SEC Staff: Quality, Transparency, Accountability,’ 26 April 2001. 33 Louis D Brandeis, Other People’s Money and How the Bankers Use It (1914; Harper Torchbooks, 1967), p. 62. 34 Adolf A. Berle and Gardiner C. Means, The Modern Corporation and Private Property (1932; Harcourt, Brace & World), p. 310; and Cynthia A. Williams, ‘The Securities and Exchange Commission and Corporate Social Transparency,’ Harvard Law Review 112, no. 1197 (1999): 1217. 35 Williams, ‘The Securities and Exchange Commission and Corporate Social Transparency,’ p. 1216. 36 Felix Frankfurter, ‘The Federal Securities Act: II,’ Fortune 7, no. 2 (August 1933): 53. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 18 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS The second point is sometimes overlooked as a guiding principle for disclosure. In a historical analysis of the emergence of the US SEC, Professor Cynthia A. Williams explains: Yet, following Brandeis, disclosure was not an end in itself nor meant solely to protect investors, although investor protection was clearly a major goal … In the spirit of Brandeis—who was specifically invoked—Congress hoped that disclosure of this information would change the way business was conducted.37 Professor Marc I. Steinberg concludes that the US Congress’s intent regarding corporate conduct has come to fruition: ‘There is little question that disclosure has had a substantial impact on the normative conduct of corporations.’38 Supporting this claim, in the 1970s while proposing corporate governance regulations, the US SEC acknowledged the positive effects of disclosure on corporate behavior.39 The regulatory reforms catalyzed in the 1930s—built upon the seminal values of transpar- ency, corporate governance and informed decision-making at the service of market efficiency and price discovery—are reflected across global capital markets. Although the evolution of disclosure requirements was unique to each country in the 20th century, the purpose for disclosure is largely the same globally, particularly the goals of protecting investors and fostering sound markets. For example, Japan’s Companies Act states that ‘the principal objective of the disclosure requirements for a stock company under the Companies Act is to protect the interests of both cred- itors and shareholders.’40 In the EU, national security regulation has two goals: ‘1) protection and functionality of the market and 2) protection of investors and debtors.’41 The Hong Kong Securities and Future Ordinance, in establishing the regulatory objectives for corporate disclosure, identifies the purpose of protection for the investing public.42 In addition to their protective functions, some jurisdictions also highlight the role of disclosure in preserving societal well-being. In a speech to the New Zealand Bankers’ Association, the association’s deputy governor stated that disclosure is ‘about avoiding the consequences of poor disclosure, building stakeholder confidence, making informed decisions, and creating market efficiency in the service of scarce resource allocation and public welfare.’43 However, aligning on the purpose of disclosure does not mean corporate reporting practices changed overnight. Establishing common reporting practices to achieve this purpose required the accounting profession to evolve. 2.3. T HE ROAD TO STANDARDIZED ACCOUNTING PROCEDURES As transparency and disclosure crystallized as cornerstones of the capital markets, the accounting profession began a journey that would eventually result in the establishment of 37 Williams, ‘The Securities and Exchange Commission and Corporate Social Transparency,’ pp. 1233–34. 38 Marc I. Steinberg, Corporate Internal Affairs: A Corporate and Securities Law Perspective (Praeger, 1983), p. 29. 39 Sec. Ex. Act Rel. 15,384, 16 SEC Dock. 348, 350 (1978). 40 Japanese Institute of Certified Public Accountants, Disclosure in Japan Overview, 6th ed., 2010. 41 Penn Law: Legal Scholarship Repository, ‘Securities Regulation in Germany and the U.S.: Brief Introduction to the ‘History’ of German and European Securities Regulation,’ 22 February 2016. 42 Securities and Future Ordinance (Cap. 571). 43 Geoff Bascand, ‘The Effect of Daylight: Disclosure and Market Discipline: A Speech Delivered to Members of the NZ Bankers’ Association in Auckland,’ 28 February 2018. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 19 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS generally accepted accounting principles (GAAP) aimed at improving the consistency and comparability of financial reporting procedures. Today, it can be easy to take for granted the fact that financial statements are prepared similarly from company to company, producing information that allows for apples-to-apples comparisons and with the integrity and reliability enabled by third-party audits. However, the road to today’s robust and reliable systems of financial disclosure saw significant hurdles, which were overcome through collaboration, innovative thinking and time. Indeed, it took decades after the stock market crash of 1929 to establish the financial accounting system in use today. 2.3.1. D EFINING THE PURPOSE OF FINANCIAL INFORMATION: THE ROLE OF HISTORICAL COST ACCOUNTING Financial accounting was originally developed to record accurate information. In the 1930s, best practices for preparing financial statements relied on historical cost accounting, which measures an asset’s value as the actual cost paid for the asset at the time of purchase. Under this accuracy-focused approach, the original nominal value is reported on the balance sheet even if the value of the asset changes over time. Yet, even with some generally accepted practices, financial statements were largely prepared according to the practices and preferences of major accounting firms, contributing to fragmented disclosure at the industry and market levels. In the 1940s, the American Institute of Accountants’ Committee on Accounting Procedure (CAP), the part-time committee that first established GAAP in the US,44 was established to help define what types of accounting practices were generally accepted in that era when multiple accounting methods were in use and exceptions to historical cost accounting gained prominence. In 1959, the part-time Accounting Principles Board (APB) succeeded the CAP. Before the full-time Financial Accounting Standards Board (FASB) succeeded the APB, in 1973, the APB sponsored research into problematic areas of accounting and issued recommendations for the improvement of accounting standards and practices, often facing opposition from the SEC, which, favored efforts to ‘narrow the areas of difference in accounting principles’ over departures from historical cost accounting.45 During this time multiple accounting methods were recognized under GAAP and significant debate ensued about whether GAAP should standardize one set of methods or allow for flexi- bility and diversity of practice. On the one hand, non-standardized accounting practices cater to the needs of more reporting companies, in that companies can disclose information in the manner they feel best represents their business. On the other hand, the fragmentation that exists in the absence of standardization reduces the usefulness of disclosed information in the market. The higher the variation of disclosure for similar events and transaction, the less comparable and decision-useful the information becomes to investors, creditors and lenders. 2.3.2. DECISION-USEFULNESS ADVANCES STANDARDIZATION EFFORTS Once aligned on the need for standardization, the accounting profession then endeavored to find common ground on the fundamental objective of financial statements. Debates about histor- ical cost accounting versus other asset-valuation methods centered on the view that financial 44 American Institute of Accountants, Examination of Financial Statements, January 1936. 45 Stephen A. Zeff, ‘The Omnipresent Influence of the SEC in the Work of the Accounting Principles Board, 1959–1973,’ Journal of Accounting and Public Policy 7, no. 3: pp. 254–63. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 20 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS accounting exists to accurately identify the value of assets, which, some argued, changes over time. In the 1960s, the accounting profession re-envisioned the purpose of financial statements by introducing the concept of decision-usefulness in A Statement of Basic Accounting Theory. The document defined ‘accounting’ as ‘the process of identifying, measuring, and communicating economic information to permit informed judgments and decisions by users of the information.’46 This new focus on decision-usefulness shifted the emphasis of disclosure away from strict histor- ical asset valuation and toward the decision-usefulness of reported information to the users of disclosed information. Accounting measurements were recast to serve a specific purpose (to inform decisions) rather than to perform a singular function (to provide accurate measurement).47 In other words, the accounting profession recognized the importance of providing forward-look- ing information rather than just historical accuracy. The purpose of accounting definitively shifted, and financial statements were now intended ‘to provide information which will be of assistance in making economic decisions.’48 Coalescing around this redefined purpose for financial accounting helped the profession move closer to standardization. Without a clear purpose, financial accounting practices would likely be difficult to standardize. A standard-setter would not be able to apply a consistent framework for making decisions and assessing trade-offs throughout standard-setting activities. (More detail on standard-setting is in Part II.) The accounting profession thus aligned behind ‘a coherent theory which effectively linked decision-usefulness to the information required to make investment deci- sions: using discounted future cash flows as the most relevant attribute of assets and liabilities.’49 2.3.3. TOWARD INTERNATIONAL STANDARDIZATION The establishment of a coherent theory of accounting marked a vital step toward standard- ization. However, alignment on purpose and theory was not sufficient to address the global fragmentation of accounting and disclosure practices in use. For example, although accounting practices in Australia, Canada, New Zealand, the UK and the US were similar in many ways, they differed in key areas. Accounting methods in Australia, New Zealand and the UK uniquely allowed companies to revalue their property, plant and equipment (PPE), including investment property, while other jurisdictions still required companies to adhere to historical costs. Significant differences also existed among accounting practices of continen- tal Europe and Japan, ‘where income taxation drove accounting practice, where reported profit determined by law the dividend to be declared, and where financial results could be manipulated by secret reserves.’50 Globally, two key developments in the 1970s established the financial accounting system as it exists today. First, the International Accounting Standards Committee (IASC) was founded in 1973 to develop international accounting standards. The IASC began as a joint initiative of national accounting bodies from Australia, Canada, France, Germany, Ireland, Japan, 46 American Accounting Association, A Statement of Basic Accounting Theory (Evanston, IL: AAA, 1996), p. 1. 47 Robert Sterling, ‘A Statement of Basic Accounting Theory: A Review Article,’ Journal of Accounting Research 5, no. 1: 95–112. 48 George J. Staubus, The Decision Usefulness Theory of Accounting: A Limited History (1961), p. 11. 49 Stephen A. Zeff, ‘The Objectives of Financial Reporting: A Historical Survey and Analysis,’ Accounting and Business Research 1, no. 4 (January 2013), accessed November 2020. 50 Stephen A. Zeff, ‘The Evolution of the IASC into the IASB, and the Challenges It Faces,’ Accounting Review 87, no. 3. (2012). COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 21 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS Mexico, the Netherlands, the UK and the US, though many other countries later joined. 51 The standardization effort started simply at first, with the intention to focus on ‘the policies and principles that have been established in the more sophisticated markets around the world.’52 As the IASC gained credibility and buy-in, it grew beyond the efforts of national accounting bodies and in 2001 became the International Accounting Standards Board (IASB), an independent standard- setting organization with robust governance and due process. Today, IASB oversees the develop- ment of the International Financial Reporting Standards (IFRS Accounting Standards), the goal of which is to ‘develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based upon clearly articulated principles.’53 The IFRS Accounting Standards are required by public companies domiciled in more than 140 jurisdictions and can be used in other jurisdictions—including China, Japan and the US— to meet all or some regulatory reporting requirements. One month after the IASC was formed, the FASB was established in the US to resolve dissatis- faction about the lack of widespread support for standardized accounting. The FASB emerged to serve as an independent, full-time organization dedicated to the development of financial account- ing standards. The FASB was thus recognized as the authoritative source of US GAAP. When the FASB was founded, the American Institute of Certified Public Accountants (AICPA) published a report to definitively align on the purpose of financial disclosure, based on the under- lying belief that clear financial reporting objectives would support the establishment of financial accounting standards. The report seconded and bolstered the decision-usefulness objective that had emerged in the profession, with a strong emphasis on the importance of discounted future cash flows for identifying decision-usefulness to investors. Interestingly, the report also stated that the economic and social goals of business are equally important.54 The committee pointed to envi- ronmental externalities, such as pollution, to illustrate that some corporate activities impose costs on the rest of society. In addition to providing decision-useful information to investors, the report determined that the objective of financial statements is ‘to report on those activities of the enterprise affecting society which can be determined and described and measured and which are import- ant to the role of the enterprise in its social environment.’55 As it turns out, sustainability-related disclosures are not a radically new concept, and were even referenced in mainstream accounting literature in the early 1970s. Over the course of several decades, global accounting standards organizations achieved global principles-level alignment and standardization for financial disclosure. Notably, global stan- dardization does not completely preclude some degree of local flexibility in financial reporting. Companies have the freedom go beyond the standards from the FASB and IASB to report addi- tional metrics and/or provide context for the information that standards require. The diversity of global markets means it is unlikely that companies in every country will ever apply the same accounting standards in precisely the same way. However, the high level of alignment and adop- tion of global accounting standards that exists today allows for a comparison of financial reports around the world and has contributed greatly to well-functioning global capital markets. 51 Kees Camfferman and Stephen A. Zeff, Financial Reporting and Global Capital Markets: A History of the International Accounting Standards Committee, 1973–2000 (Oxford University Press, 2007). 52 J.P. Cummings, ‘International Accounting Standards: The Outlook,’ Ross Institute Seminar on Accounting, Vincent C. Ross Institute of Accounting Research, New York University, 2–8 May 1976. 53 IFRS, ‘Who Uses IFRS Standards?,’ accessed October 2020. 54 Zeff 1999, p. 101. 55 American Institute of Certified Public Accountants, Objectives of Financial Statements (Trueblood Committee Report), 1973, p. 54. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 22 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS Figure 3—Timeline of early advancements in standardized disclosure 1938 1966 1973 The Certified Public Accountants (CPA) The first financial reporting standards were The Mexican Institute of Public Law was enacted in Japan, establishing issued in Australia by the Australian Society Accountants was established to the accounting profession, though the first of Accountants (ASA) (later became the develop the first accounting accounting regulation was enacted much Australian Accounting Standards Board) standards in Mexico earlier in 1895 by the Commercial Code 1918 1946 1968 The Institute of Chartered Accountants in The Dominion Association of Chartered The first guidance on accounting and England and Wales (ICAEW) established the Accountants took up the role of financial reporting was issued in New first Accounting Standards Committee (ASC) establishing accounting standards in Zealand with the establishment of the to develop accounting standards in the UK Canada (later renamed the Canadian Financial Reporting Advisory Board (FRAB) Institute of Chartered Accountants) 1970s 1930s 1939s The International Accounting Standards Global stock market crash leads The American Institute of Committee (IASC) is established to jointly to the Great Depression Accountant’s (AIA) Committee on develop accounting standards for use across Accounting Procedures (CAP) is nations 1934 established in the US to provide The Financial Accounting Standards Boards US SEC established, guidance on accounting methods (FASB) replaces the ABP in the US marking the advent of mandatory corporate 1959 2001 disclosure and regulatory The Accounting Principles The IASC evolves into what is know today reform Board (APB) replaces the CAP as the International Accounting Standards to resolve fragmentation in Board (IASB) under the IFRS Foundation financial accounting practices IASB Standards are used today in over 140 jurisdictions Widespread use Growing awareness Multiple accounting methods The concept of decision usefulness is of historical cost of the consequences are permitted and exceptions introduced, shifting the emphasis of accounting of capital markets to historical cost accounting financial accounting and disclosure to that lack are allowed, causing include forward-looking information transparency fragmentation and limiting and creating a coherent theory that usefulness to investors enabled global standardization Disclosure becomes the basis of regulatory reform in financial markets The importance of standards for the disclosure of financial information—resulting in reliable, comparable, decision-useful information across markets—can be easily overlooked but cannot be understated. US Treasury Secretary Lawrence H. Summers notably remarked in 1999: There is no innovation more important than that of generally accepted account- ing principles: it means that every investor gets to see information presented on a comparable basis; that there is discipline on company managements in the way they report and monitor their activities; that there are whole groups of people all seeking to refine the way in which we measure and understand how companies’ prospects are being described and presented.56 Over the years, financial disclosure requirements came online across all major jurisdictions, creating a common language for companies and investors to communicate across borders and facilitating the global exchange of capital. Companies now operate in an environment where financial disclosure using common reporting standards is required by law. However, just because companies are held to higher standards of transparency achieved through reporting does not mean they are required to disclose all relevant or interesting information about their business. 56 Lawrence H. Summers, ‘Japan and the Global Economy,’ US Department of the Treasury Press Center, 26 February 1999. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 23 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS CHAPTER REVIEW This chapter contains information related to the following Learning Objective(s): 2 RECOGNIZE why financial accounting and disclosure have evolved to meet the needs of global capital markets. ? CHECK YOUR UNDERSTANDING 1. hy was disclosure the basis of regulatory reform in the wake of the 1929 stock market W crash? 2. H ow has the purpose of accounting changed since the 1930s, and why did financial reporting move toward standardization? JUMP TO ANSWERS COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 24 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS MATERIALITY: A GUIDING PRINCIPLE FOR REQUIRED DISCLOSURE 3 LEARNING OBJECTIVE(S) COVERED IN THIS CHAPTER: 4 DISTINGUISH how ‘materiality’ is defined and used globally in the context of reporting. As just learned in Chapter 2, informed investor decision-making was a primary driver of the early-to-mid-1900s reforms introduced to protect the interests of the investing public. Required disclosure exists in large part to ensure companies provide complete, comparable and reliable information about their financial position, financial performance and prospects, which is used to make informed investment decisions. However, not all information about a company’s financial performance is so important that it would influence investment decisions. Disclosing every single detail, no matter how insignificant, would result in an overwhelming amount of information that can hinder rather than help investment decisions. For instance, investors may look at the total number of widgets sold or the costs involved in operating a business, as these pieces of information are useful when assessing a company’s prospects and can make a difference in their investment decision. Investors would likely not look at the number of sales from small product lines or small, routine transactions such as incidental maintenance expenses or employee training costs, as this information does not alter the overall financial position, financial performance or prospects of a company. Within early disclosure-fo- cused reforms, the concept of materiality emerged to help draw a line between the information companies must disclose and the information they are not required to disclose. Today, materiality continues to act as a filter companies apply when deciding which information to disclose to those investors who may (or already do) provide the company with financial capital. 3.1 A LONG-STANDING LEGACY OF INVESTOR DECISION-MAKING In the context of corporate disclosure, financial regulators first defined ‘materiality’ to commu- nicate companies’ disclosure requirements and to assess compliance with those disclosure requirements. For example, the following two definitions were written into early legal doctrines governing cases of misrepresentation and deceit applied to the sale of securities: COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 25 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS The 1885 Lord Davey Report, a prospectus heavily influenced by the English Chartered Accountants which shaped early provisions of the British Companies Act,57 stated, ‘Every contract or fact is material which would influence the judgment of a prudent investor in determining whether he would subscribe for the shares or debentures offered by the prospectus.’58 Materiality emerged prominently in the US in the Securities Act of 1933, and at least since 194059 the US SEC has defined ‘material information’ as ‘those matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.’60 One may notice that, though written for different jurisdictions and separated by nearly 50 years, the two definitions are relatively consistent. They are based on the fundamental premise that investors are entitled to the information that may affect their decision to buy shares in a company, and that companies are therefore responsible for identifying and disclosing that information. Of course, the requirement to disclose material information is not the only requirement set forth by regulators. Financial regulators across the globe mandate the disclosure of specific docu- ments and types of information to meet investor needs, such as financial statements, known risks and uncertainties, corporate governance information and so on. Some of these requirements are specific, such as the company’s legal name and executive compensation, while others are more ambiguous. So, while disclosure formed the basis of regulatory reform instituted to curb harmful corporate behavior and to protect the investing public, it became clear that companies needed more specific guidance to meet the requirements set forth by those very regulations. Accounting standards were developed to do just that, and as a result, the definitions of ‘materiality’ used by accounting standard-setters generally correspond to the regulatory definitions. The table below presents a sample of early ‘materiality’ definitions for accounting standards. Table 1—Sample of materiality definitions adopted by accounting bodies YEAR ACCOUNTING BODY MATERIALITY DEFINITION The American Accounting ‘An item should be regarded as material if there is a 1954 Association Committee on reason to believe that knowledge of it would influence Concepts and Standards the decisions or attitude of informed investors.’ The Institute of Chartered ‘A matter is material if its non-disclosure, 1968 Accountants in England misstatement or omission would be likely to distort and Wales the view given by the accounts.’ ‘An item must be regarded as material if its omission, non-disclosure or misstatement would result in distortion The Australian Accounting of, or some other shortcoming in, the information being 1974 Research Foundation presented in the financial statements, and thereby influence users of the statements when making evaluations or decisions. Source: H. Gin Chong, ‘A Review on the Evolution of the Definitions of Materiality,’ International Journal of Economics and Accounting 6, no. 1 (2015). 57 William Holmes, ‘Toward Standards for Materiality(?),’ Auditing Looks Ahead: Proceedings of the Touche Ross/University of Kansas Symposium on Auditing Problems, p. 71, 1 January 1972. 58 The Lord Davey Report, 1895, Cmd. 7779, paragraph 14(5), 1895. 59 David A. Katz and Laura A. McIntosh, Wachtell, Lipton, Rosen & Katz, ‘Corporate Governance Update: ‘Materiality’ in America and Abroad,’’ Harvard Law School Forum on Corporate Governance, 1 May 2021. 60 Securities Act of 1934, ‘17 CFR § 230.405—Definitions of terms.’ COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 26 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS Common language among these early definitions of ‘materiality’ points to concepts that have been foundational to today’s understanding and application of the term for investor-focused reporting: Materiality is a function of the report user. By focusing on ‘the prudent investor,’ the ‘informed investor’ and ‘users of the statements,’ the first definitions consistently establish that information is material if it can influence the judgments investors and other providers of capital make when deciding to provide financial resources to a company. Materiality is not about every investor or any one investor. By describing investors as ‘prudent,’ ‘average’ or ‘informed,’ these definitions acknowledge that investors are not universally the same. They bring different objectives and levels of expertise. Rather than attempt to accommodate the information needs of every possible investor, preparers are asked to consider those who have a baseline level of knowledge and understanding. Materiality is contextual. By identifying the ‘omission,’ ‘nondisclosure’ or ‘misstatement’ of information, these definitions focus on the assessment of materiality and maintain that preparers must consider how investor decisions may be influenced if significant information is absent, inaccurate or otherwise presented in an unfair manner. In other words, materiality is not strictly about whether a given piece of information is accurate or not. Rather, it is about the effect of that information, misstatement or error in the context of a specific company. If important information is omitted or misstated, investors may be led to make investment decisions they would not have made otherwise. On the other hand, if a piece of information, misstatement or error is not pertinent or is too small to influence investor decisions, it can be left out. Material information is not always monetary in nature. Rather than specifying the type of information that can be considered material, these definitions identify information using general terms such as ‘an item’ or ‘a matter.’ While it is certainly true that material financial information is often expressed in monetary terms (i.e., as currency), no definition specifies that materiality applies only to monetary information. Materiality for investor-focused reporting can apply to non-monetary metrics (such as the useful life of assets) as well as qualitative information (such as a discussion of strategy and risk provided in the management commentary). All material information relates to the financial position, financial performance and prospects of a company, but it is not always expressed in monetary terms. Leading up to the 1970s and ’80s, many jurisdictions adopted variations of these ‘materiality’ definitions as they developed their own standards for the disclosure of information in financial statements. As will be discussed further in Chapter 6, fragmentation across global accounting rules and standards created challenges for the users of financial statements, as lack of consistent, comparable information hindered effective corporate-investor communication. The International Accounting Standards Committee (IASC), which was succeeded by the International Accounting Standards Board (IASB), was formed to develop universal accounting standards. When the IASC issued its first standards, it started the journey to establish a globally applicable definition of ‘materiality’ for the first time. Today, its definition has been adopted by more than 140 jurisdictions. COPYRIGHT © 2023 IFRS FOUNDATION. ALL RIGHTS RESERVED 27 FSA CREDENTIAL LEVEL I STUDY GUIDE PART I: THE NEED FOR SUSTAINABILITY DISCLOSURE STANDARDS 3.2. GENERAL CHARACTERISTICS OF MATERIALITY The IASB uses the following definition of ‘materiality’: Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports…make on the basis of those reports, which provide financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.61 One will notice similarities between this definition and those developed historically. For instance, it relies on the concept of omissions and misstatements and focuses on investor decision-making. However, the concept of investor-focused materiality (sometimes referred to as financial materiality) has evolved over time. A closer look at materiality as it has been defined by the IASB is useful to understand how it is characterized and applied throughout most of the world today. 3.2.1. A MATTER OF JUDGMENT When preparing financial reports, determining whether information is material is not prescrip- tive or formulaic. Rather, it is a matter of judgment specific to a company. Standard-setting bodies play the important role of setting disclosure requirements, but they cannot decide what information is appropriate to disclose for any specific company. After all, each company’s circumstances are unique. Companies have different models and capital structures, belong to different industries and operate in different areas with unique political, economic, regula- tory and social environments. When setting standards, the IASB identifies the types of information it expects will meet the needs of a broad range of primary users for a wide variety of entities under a range of circumstances. Disclosure standards therefore provide a starting point fo

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