Sustainability Reporting: A Financial Reporting Perspective

ABSTRACT

This paper examines incentive effects of sustainability reporting, based on proposals for mandatory sustainability reporting standards in the EU, the US, and the IFRS Foundation, and highlights conceptual differences between sustainability and financial reporting. Sustainability reporting is an instrument of transparency regulation intended to influence management decisions. It requires disclosure of a large set of data points but does not provide aggregate measures. It is production-oriented and does not include accruals. It expands reporting to include disclosure of long-term policies and targets, and of information of firms in the value chain. Consequently, sustainability reporting is not very useful for tracking sustainability performance and for comparisons across firms. Overall, it would benefit from applying more generally accepted accounting concepts.

Keywords:

• sustainability reporting
• reporting incentives
• disclosures
• aggregation
• value chain

1. Introduction

Consider the following financial accounting episode. Recently, both the FASB and the IASB undertook reviews of their standards on the accounting of acquired goodwill.¹ Probably the most contentious issue was, once again, the subsequent measurement of goodwill, annual amortization or impairment-only. In the end, both standard setters settled on retaining the impairment-only approach, but considered ways to make the impairment test simpler and more effective. Ideas included, among others, a so-called headroom approach, which would take into account the unrecognized goodwill of the acquirer’s existing business when testing for impairment of the acquired goodwill in the same accounting unit. As is often the case, if a topic is ‘too difficult,’² accounting standard setters resort to additional disclosures. Yet, disclosure is not a substitute for the accounting, but is anchored on an accounting item, providing more information to better understand what that item purports and how it contributes to financial performance.

Viewed from a sustainability reporting perspective, discussions like this appear pretty alien. Sustainability reporting, as it is about to be mandated in many countries, rests on fundamentally different concepts from those underlying financial accounting. Discussions about how to account for a sustainability topic are absent in the sustainability reporting domain. Instead, sustainability reporting consists of the disclosure of ‘data points’ without meaningful aggregation and measurement and with little effort to allocate data to time periods, as it is done through accruals in financial accounting. Sustainability reporting also includes data from firms in the whole value chain of the reporting firm, which are outside its boundary and control. Furthermore, it includes data about the firm’s long-term strategies and targets and requires reporting progress against these targets.

This paper examines key features of sustainability reporting that are akin to financial reporting and compares the approaches with emphasis on incentive effects.³ Sustainability reporting has recently gained strong momentum in Europe, the US, and internationally. The EU is developing the European Sustainability Reporting Standards (ESRS) as part of the Green Deal that also includes other finance and governance initiatives. The sector-agnostic set includes twelve standards that will be legally enacted in 2023 and become effective in 2024. Two more sets will include sector-specific standards and standards for listed SMEs, which should become effective in subsequent years. In the US, the SEC published a proposal for climate-related disclosures for investors in 2022. And internationally, the IFRS Foundation created the International Sustainability Standards Board (ISSB) alongside the established International Accounting Standards Board (IASB) to develop a global baseline for sustainability reporting, starting with general requirements and climate-related disclosure exposure drafts in 2022.

These standard-setting initiatives take into account earlier sustainability reporting frameworks and standards, for example, those from the Global Reporting Initiative (GRI), Task Force on Climate-related Financial Disclosures (TCFD), Climate Disclosure Standards Board (CDSB), Sustainability Accounting Standards Board (SASB), and International Integrated Reporting Council (IIRC); the latter three are meanwhile consolidated in the IFRS Foundation.⁴ In contrast to these earlier initiatives, which were standards that are voluntarily adopted by firms, the new standards will become mandatory in many countries. In particular, mid-size and closely held firms in Europe will be subject to these disclosure requirements. Sustainability reports will also be subject to assurance.

Currently, the ESRS are the most ambitious and comprehensive general standards,⁵ which is the reason to refer primarily to them as illustrative examples in the analysis. Across this paper, references to ESRS and IFRS Sustainability Disclosure Standards mean their drafts.

2. Fundamental objective

The objective of financial reporting is to provide decision useful information to capital providers of the reporting firm. For example, the IFRS Conceptual Framework (para. 1.2) defines it as follows: ‘The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions relating to providing resources to the entity.’ Implicit in this objective is that financial reporting should be ‘neutral’ (as part of the qualitative characteristic of faithful representation), that is, it should report on the firm’s economic resources and the effectiveness and efficiency of their use over the reporting period.

Despite the intention to report about the outcome of management’s decisions, but not alter them through the reporting, in reality, accounting methods do affect decisions directly or indirectly, creating real effects. Management is likely to anticipate possible effects of a financial report on capital providers’ decisions and on the market price. Provided it has an incentive to influence these decisions or the price, it may engage in accrual-based and in real earnings management (e.g. Kanodia & Sapra, 2015). Earnings management has been shown to be prevalent in reality (e.g. Graham et al., 2005). Accounting standard setters consider the potential for accrual-based earnings management when drafting the standards, e.g. when evaluating costs and benefits of fair-value and historical-cost measurement.

A similar issue arises in tax legislation, which takes into account firms’ incentive to minimize the net present value of income taxes when drafting income tax laws. Ideally, income taxes should not influence management decisions, but they of course do so as taxes reduce firm value. Yet in some cases, governments also use tax schemes to influence firms’ decisions, for example, to increase investment through investment tax credits.

In contrast, mandatory sustainability reporting is politically intended to influence management behavior to pursue environmental, social, and governance (ESG) goals. This so-called transparency regulation works indirectly through providing stakeholders with information they can use to take action or make decisions that affect the reporting firm’s profitability and value.

Particular examples are the climate-related disclosure standards ESRS E1 and IFRS S2, both of which require firms to report on their climate-related targets, which should be derived from long-term targets in international political agreements on climate change.⁶ For example, by mandating disclosure of CO₂ emissions the regulator aims to arouse awareness of a greater public regarding the reporting firm’s efforts to reduce emissions.

More generally, ESRS 2 requires that firms disclose policies, actions, and resources to manage sustainability matters and disclose targets and metrics used to track the effectiveness of the actions and the progress towards the targets. The difference with other disclosures is the future-oriented content, which creates a self-commitment on the part of managers. If a firm has no such policies and targets, it must explain the reasons for that, which adds to the pressure.

Several empirical studies provide evidence of transparency regulation across various topics, e.g. mine safety (Christensen et al., 2017), extraction payments (Rauter, 2020), carbon reporting (Downar et al., 2021), human rights in the supply chain (She, 2022), and on corporate social responsibility activities generally (Fiechter et al., 2022). While these studies show that there is an effect (measured against the assumed null hypothesis of no effect), they are less helpful to assess regulatory efficiency as it is a priori unclear how strong a particular effect ‘should’ be.

One may question if transparency regulation is the best policy instrument to induce firms to internalize ESG goals. The underlying economic problem is that the operations of firms produce externalities (in a broad sense) that are not included in their financial performance measures. Other regulatory instruments are pricing or taxing externalities (e.g. a CO₂ emission tax or trading scheme or subsidies for investment in clean technologies), use licenses and prohibitions or bans of particular activities or use of products and technologies. These regulatory instruments differ in their effectiveness, accuracy, and efficiency, and they also depend on the specific legal environment such as litigation rights. Relative to these other instruments, the efficiency of transparency regulation is probably the most difficult to assess empirically, particularly when it is used jointly with other instruments, as for example in the case of CO₂ emissions.⁷

3. No aggregation

The standards that define the content of a sustainability report and a review of actual sustainability reports reveal similarities with the footnote disclosures section of a financial report and with a management report. It includes both quantitative metrics and qualitative information on various ESG topics. To get a sense of the sheer volume of the disclosures, an EFRAG count of mandatory data points in the draft ESRS from November 2022 reports 250 quantitative metrics within a total of 1,144 data points.⁸

For many stakeholders, except for professional and sophisticated users, it will be difficult to get a more holistic picture of firms’ sustainability performance if they wish so. In fact, as we know from other areas, like fine print in voluminous contracts or package inserts of medications, many people will ignore most of the information contained in a sustainability report.

How can users navigate through this large amount of individual data and digest them? The ESRS and IFRS sustainability disclosure standards require that disclosures be tagged using an XBRL-based taxonomy that is currently developed. XBRL enables users to search through the report and find the data points they are interested in. The focus on disaggregated data is reminiscent of the late 1990s when XBRL was developed. There was euphoria about new opportunities for users of new information technologies. For example, suggestions included that users could customize the contents of financial reports, choose their own assumptions and accounting rules, define the frequency of the report, demand continuous reporting, and the like.⁹

What is missing in a sustainability report is aggregate sustainability information equivalent to the information in a balance sheet, an income statement, and a cash flow statement. Sustainability reports do not include aggregations of data points and do not provide overall ESG outcomes and performance measures.¹⁰ The lack of aggregates also reflects the (formal) arbitrariness of the selection of data points, which is not tied to an overall concept but is based on the opinion of the respective standard setter of what is important. However, standard setters are currently discussing whether there is a need for a conceptual framework for sustainability reporting and what a conceptual framework should address. And research should help to provide more evidence on relevance.

Probably the closest concept in financial reporting are cash flow statements. They portray real transactions in a period, but even there some measurement is needed, e.g. for foreign currency translation or the definition what is considered cash indeed. Back in the 1960s, debates of accounting theories that would underlie financial accounting standards already included the discussions about more or less aggregation,¹¹ and aggregation was generally found useful and is still a key feature of financial reporting.

From a financial accounting perspective, sustainability reporting misses most aspects of what makes financial accounting important, useful, interesting, and also difficult. The core of the financial accounting theories and financial reporting standards include recognition, measurement and classification principles, conservatism, along with how to deal with uncertainty, and the like. These principles are needed to aggregate the raw data into meaningful key performance measures such as period profit, equity, and many others.

For example, many quantitative data points consist of inputs into the productive processes rather than outputs from those processes (Grewal & Serafeim, 2020). It is not clear whether these inputs produce the desired outcomes and, importantly, whether these inputs are efficient to achieve the outcomes. This approach is particularly apparent in social and governance topics. For example, disclosures comprise investments in training of employees, targets and intentions, and governance processes.

There are many institutions that produce aggregated information. Management itself must aggregate financial and sustainability data to make investment and operative decisions in the firm. Most management decisions require a tradeoff between the achievements of different objectives, for example, an investment in a cleaner production process, which reduces future profits, but may increase customer demand and decrease environmental risks. The particular aggregation reflects management’s view of the relative importance, and weights, of individual key performance indicators for financial and sustainability issues. The weighting also implies a ‘cost’ of environmental or social objectives and places an inherent ethical dilemma of explicit weighting them on management, for example, when required to trade off workers’ increased health against higher profits.

Sustainability reporting standards require management to disclose the firm’s strategy, including market position, business model, impacts, risks, and opportunities in its sustainability report (e.g. ESRS 2 more generally, IFRS S1 for investors to assess sustainability-related risks and opportunities). These disclosures provide some information about the underlying weights. More explicit information about weights can be obtained from the detailed disclosure of the incentive schemes of management and boards, as required, e.g. in ESRS 2. Incentive schemes are based on a subset of relevant measures to reduce complexity. They include functions of these measures with assumed weights that indicate the relative importance of the respective objectives to users of the sustainability report. However, there are issues with such an interpretation. Some objectives are qualitative in nature, and a quantification suggests a hard measure that does not necessarily exist. The weights are biased if the metrics are not in the same scale and range or not appropriately normalized.¹² The weights also depend on the size or importance of specific stakeholders that are interested in only few measures.¹³ Optimal weights need not be constant, but may be nonlinear or step functions in particular ranges. Measures are likely correlated, which should be considered when determining the weights. As correlations are not observable by outside users, the weights themselves may be difficult to interpret as their respective importance.¹⁴

Another important group that aggregates sustainability information and financial performance are investors, when they make investment or disinvestment decisions. Sustainability has become more relevant for many of them, either for assessing risks and opportunities with regard to sustainability or for catering investors’ intrinsic preferences besides financial returns. Information aggregators such as rating agencies and financial analysts are also relevant players. There is an increasing market for ESG ratings, for example those provided by rating agencies like MSCI, Thomson Reuters, and Sustainalytics. Christensen et al. (2022) analyze agreement across ratings and find, perhaps surprisingly, that with higher amounts of sustainability disclosure available their ratings disagree more. A possible reason is that the rating agencies are more likely to select different metrics and interpret and weigh them differently. ESG ratings are also increasingly used in debt contracts, for example, for sustainability-linked loans.¹⁵

A different approach to aggregation has been taken by the EU as a regulator in its sustainable finance initiative. The Taxonomy Regulation (EU 2020/852) establishes criteria for economic activities that qualify as environmentally sustainable and, thus, ‘green’. It defines six environmental categories, climate change mitigation and adaption, water and marine resources, circular economy, pollution, and biodiversity and ecosystems. Essentially, an activity is classified as environmentally sustainable when it contributes substantially to one of the six objectives and does not significantly harm the other objectives. Firms must disclose the proportion of their revenue from products and services of their qualifying activities and the proportion of their capital expenditures and operating expenditures. These percentages are used in finance contracts and by financial market participants that create ‘green’ financial products.

There have been several proposals and suggestions how to monetize sustainability data. Externalities that induce legal obligations by firms, such as environmental cleanup costs, are already recorded in the financial statements as provisions or contingent liabilities under IAS 37. For other externalities, the literature developed various forms of social and environmental accounting.¹⁶ Recent work includes, for example, Barker and Mayer (2022), who propose using the remediation costs of the firm’s externalities as an opportunity cost that are deducted from financial profit to arrive at a ‘sustainable profit’. Another example are impact-weighted financial accounts (Serafeim et al., 2019), which use a variety of non-financial metrics for environmental and social impact. They are more useful for internal decision making but less so for sustainability reporting as they are subjective and, thus, soft information. So far, no approach has proved superior. Indeed, Grewal and Serafeim (2020) see the measurement of corporate sustainability performance as the single biggest opportunity for researchers.

4. No accruals

The reporting period of a sustainability report is usually the same as for financial statements (ESRS 1, IFRS S1), that is, one year. Each quantitative or qualitative data point is reported for this period. This is a strict production-specific input or output measurement and similar to cash flow accounting. A distinction into stocks and flows, as used in financial accounting, is missing. Investments into sustainability improve future ESG metrics but may negatively affect ESG metrics in the short term. For example, building a wind turbine requires cement, which has a high greenhouse gas footprint and increases emissions, but helps to reduce electricity emissions in future years. In an accrual-based system, the emissions associated with building the turbine would be recognized as an ‘asset’ and accrued to the future net emissions. Otherwise, the strong increase in emissions in the year of investment might disincentivize the investment. In financial accounting, there are also some investments that are not recognized and accrued, particularly research and some development expenditures, training of employees, and advertising, which creates similar incentive issues.

The production-based sustainability reporting is not aligned with the sales-based financial performance measurement in financial accounting. For example, reducing production volume (as a ‘real sustainability management’ activity) directly reduces emissions (in scopes 1, 2, and 3) but may not have a financial effect if sales in the same period remain unaffected (e.g. by reducing inventory). Sustainability reporting requires comparison of metrics over time, anchoring on targets and milestones in a base year for reference. With the dependence of the metric on real decisions, firms can influence the reported path towards the targets.

Finally, financial accounting follows a clean surplus relation, whereby (broadly speaking) the sum of profits equals the sum of the cash flows over periods. That is, over- or under-valuation catch up in future periods, as do earlier errors in a later period. There is no such concept in sustainability reporting.

5. Value chain reporting

The reporting entity in sustainability reporting is similar to that in financial reporting (ESRS 1, IFRS S1), which is based on the control concept defined in IFRS 10. This implies that associates and joint ventures are not included in the reporting entity,¹⁷ but are part of the value chain in the firm’s sustainability report.

A key feature of sustainability reporting is an extension of disclosure requirements to the firm’s upstream and downstream value chain if this is necessary to understand impacts, risks and opportunities (see ESRS 1) and, specifically, for reporting on climate- and social-related disclosures. The intentions behind extending the scope to the value chain are twofold. First, disclosures allow for assessing compliance with desired sustainability objectives in the upstream and downstream value chain. This should motivate the reporting firm to put economic pressure on firms in the value chain to avoid undesirable behavior, due to the presumed market power of its business, as the firm has no direct control of firms in the value chain. Second, the disclosures should help users to understand reporting firms’ contribution to sustainability issues and nudge firms to consider reconfiguring their own operations to improve sustainability performance.

For social-related disclosures, the intention is primarily to increase compliance with social standards and regulations in firms in the value chain, regardless of the legal environment and jurisdictions in which they operate. This includes disclosure of processes and mechanisms to monitor compliance. Such social standards include, particularly, the UN Guiding Principles on Business and Human Rights and the International Labour Organization’s Declaration on Fundamental Rights and Principles at Work. An example is ESRS S2, which is explicitly related to workers in the value chain and mandates disclosures, including on the firm’s actions to prevent or remediate negative impacts. Other examples are ESRS S3 for disclosures on affected communities, including communities in the firm’s value chain, and ESRS S4 for disclosures on consumers and end users, particularly possible risks of the firm’s products on their health. Parallel to these sustainability reporting requirements, the EU has proposed a Corporate Sustainability Due Diligence Directive (CSDDD), to improve corporate governance practices and accountability of firms regarding its value chain. Interestingly, the EU uses two complementary regulatory approaches to ensure compliance, direct legal requirements and transparency regulation through sustainability reporting.¹⁸

The second intention of sustainability reporting along the value chain is to help users understand the firm’s position in the value chain and push for possible reconfiguration of activities to improve sustainability performance. This intention underlies primarily environmental issues, particularly climate change (see below). However, it is also helpful to address social concerns, for example, by substituting suppliers with high negative impact on social matters.

6. GHG reporting

The value chain plays a particularly important role in environmental reporting. All five sector-agnostic ESRS environmental standards comprise the operations and the value chain of the reporting entity. The most common reporting standard is the Greenhouse Gas (GHG) Protocol, consisting of the Corporate Accounting and Reporting Standard (2004) and amended by the Corporate Value Chain (Scope 3) Standard (2011) and the Scope 2 Guidance (2015). The GHG Protocol is the basis of the recommendations by Task Force on Climate-related Financial Disclosures (TCFD), which are embedded in ESRS 1, IFRS S2, and the SEC proposal for climate-related disclosures.

The key concept of the GHG Protocol is the definition of three scopes of emissions, scope 1 with direct emissions by the firm’s production processes, scope 2 with indirect emissions from purchased electricity, and scope 3 with other indirect emissions over the firm’s upstream and downstream value chain. Scope 2 emissions are conceptually similar to scope 3 emissions. A reason to define a special scope is that purchased electricity is often one of the largest sources of emissions (GHG Protocol, 2004, p. 27). A practical reason is that it is easy to measure these emissions.¹⁹ In fact, the difficulty to measure scope 3 emissions explains why the GHG Protocol does not mandate reporting of scope 3 emissions, but leaves it optional to the reporting firm. In contrast, the new sustainability reporting standards mandate scope 3 reporting.

The GHG Protocol is designed to provide time-consistent information for internal use by firms to manage their part in the value chain and as a basis for considering a reconfiguration of the value chain. The GHG Protocol (2011, p. 6) explicitly states: ‘Use of this standard is intended to enable comparisons of a company’s GHG emissions over time. It is not designed to support comparisons between companies based on their scope 3 emissions.’ In contrast, the objective of sustainability reporting standards is to provide information for external users, who will make comparisons between firms. This change of the primary use is problematic and creates difficulties for users interpreting the data and compare firms with their peers and within their industry (Jia et al., 2022).

The GHG Protocol is an accounting and reporting standard, and it refers to accounting concepts on several occasions. One such concept is the allocation of emissions to different products, which is similar to conventional cost accounting methods.²⁰ In other cases it violates fundamental accounting concepts. The reporting anchors on the period of production as the cause for past and expected future emissions by the firm itself and along the value chain. Production is a useful measurement base for scope 1 and 2 emissions, but not for scope 3 emissions, which depend on sourcing based on planned production (scope 3 upstream) and on sale of the products (scope 3 downstream), respectively. Hence, as the standard acknowledges, ‘reported emissions may have occurred in previous years’ or ‘emissions are expected to occur in future years’ (p. 32). A related issue is that ESRS E1 requires disclosure of the GHG intensity, defined as GHG emissions per net revenue, which mingles production- and sales-based metrics.

While actual data on scope 2 and many upstream scope 3 emissions can be collected, downstream scope 3 emissions must rely on expectations and rough estimates of the future use of the products, estimated over perhaps many years, which the firm does not control.²¹ To emphasize, this is not a problem if the data are used for internal decision making by the firm. It becomes an issue if the report is addressed to external users and should allow for meaningful interpretation and assurance.

Scope 3 includes emissions that arise from the use of purchased materials and long-term capacity in the production. Albeit they are disclosed separately according to the GHG Protocol, the emissions from the latter are reported in the period of the investment into the capacity and are not allocated (like depreciation or amortization) over the useful life of the asset. The same holds for self-produced capital goods.

Scope 3 emissions raise another concern. Long-lived products are disadvantaged in the reported scope 3 emissions relative to those of shorter-lived products with the same functionality. Suppose one product can be used 6 years and another only 3 years. Then the scope 3 downstream emissions of the first product are twice those of the second product. In fact, taken over 6 years of usage, two products would have to be produced, so that scope 1 and upstream scope 2 emissions of this product double and it performs actually worse.

Perhaps the most salient feature of GHG accounting and reporting is the double, triple and so on, accounting of the same emissions over the value chain. Each firm in the value chain reports its own emissions as scope 1 emissions, and emissions from upstream and downstream firms as scope 2 and scope 3. The GHG Protocol aims to prevent double-counting of scope 1 and 2 emissions between firms but, by design, not of scope 3 emissions.²² Scope 1 emissions of a firm will show up as scope 2 or 3 emissions of other firms perhaps multiple times. If users attempted to add up total emissions of firms in a value chain, double-counting arises and may convey a wrong picture.

A peculiar feature of the GHG Protocol from a financial accounting perspective is the reporting by a firm of scope 3 emissions in firms within its downstream value chain. The reporting firm has no control over them. The reported emissions are based on the firm’s expectations of later uses of the products by other firms and consumers over the full expected life cycle of the products. These future emissions may realize many years later or never. The data are very difficult to estimate and to assure by a third party, and they do not catch up with real uses later as they would in an accrual system. As emphasized earlier, this does not matter for the internal use of such a planning tool by the firm to support its decision making, but it is an issue for external reporting.

Kaplan and Ramanna (2021) propose an accounting for upstream emissions (‘cradle-to-gate’) with an E-liability that accumulates the emissions in each stage in the upstream value chain plus the firm’s own emissions. These are actual prior emissions and not hypothetical future ones. The firm transfers the E-liability with the sale of the associated products or services along the downstream value chain. Allocation to products and services could apply methods from activity-based costing. Reichelstein (2022) describes a full accounting method for emissions in an accrual accounting system. Such a system would be understandable and auditable.

7. Targets reporting

Another feature of sustainability reporting, which is uncommon in financial reporting, is that firms are required to report on long-term targets related to sustainability topics and to track their future performance towards these targets.²³ Under ESRS, firms must disclose the metrics and targets for each material sustainability matter and the overall progress towards the targets starting with a base year. ESRS 1 defines three time horizons, a short-term (one year, consistent with financial reporting), a medium-term (generally one to five years), and a long-term (generally over five years) horizon. In climate-related reporting the targets should be emission reductions for scope 1, 2, and 3 for an even longer period of up to 2050. These periods are significantly longer than those for required disclosures in financial reporting, although for measurement of long-term assets and liabilities information over such periods is necessary.

In financial reporting, firms are reluctant to disclose targets, and if they do, these targets are mostly short-term.²⁴ Reasons for a reluctance to disclose financial targets is possible commercial sensitivity of such disclosures, for example, to avoid damaging competitor reactions, and shareholder litigation in case they are not met (provided there are no safe harbor rules).²⁵ In fact, litigation is a major cost of sustainability reporting according to a study commissioned by the EU.²⁶ It remains to be seen how ambitious firms will set their targets and what are the risks not achieving them in the future.

8. Connectivity of sustainability and financial reporting

The proposed sustainability reporting standards include requirements related to the connection to financial reporting (ESRS 1, IFRS S1). Sustainability reporting provides information about impacts of environmental, social, and governance topics and thus on financial risks and opportunities, which are often long-term. These impacts need to be considered in financial accounting and disclosure. In particular, financial accounting incorporates many assumptions made about the future, which are aggregated into measurement. The assumptions should be consistent and coherent across sustainability and financial reports.

Relevant accounting themes include impairment of property, plant and equipment, and intangibles, for example, because of expected reductions in the useful life or lower future cash flows and residual values; lower fair values of assets due to higher cost of capital; loss on financial instruments due to increasing risks that counterparties cannot fulfill their contractual duties; higher provisions and contingent liabilities due to expected environmental damages or levies or of missing reported net-zero targets; and measurement of insurance contracts.²⁷ Notably, financial reporting is mainly concerned with risks but not with opportunities, whereas sustainability reporting has no such conservatism principle, but reports on positive and negative impacts generally, although negative impacts are presumably in the focus of standard setting.

An interesting issue is how to incorporate endogenous real effects of sustainability reports in financial reporting. Recall the underlying mechanism of mandatory sustainability reporting that is designed to put pressure on firms due to possible adverse reactions by stakeholders or regulatory risk. It will be difficult to assess such potential risks, and the mandatory reporting on those risks may well amplify the risks.

The reverse direction, the influence of financial reporting on sustainability reporting, is less apparent. The reason is the disclosure of data points without aggregation in sustainability reporting, which do generally not depend on financial information. Yet, consistency is required for disclosures that directly contain financial information, for example, training costs or the use of net revenue as a basis for environmental metrics, and financial effects from physical and transition risks over different time horizons (e.g. ESRS E1).

A formal link between sustainability reporting and financial reporting exists through the qualitative characteristics of useful financial information in the IFRS Conceptual Framework (chapter 2), which are also referred to in sustainability reporting standards. IFRS S1 Appendix C lists the same qualitative characteristics as for financial reporting, and ESRS 1 includes quite similar characteristics (also in an Appendix C). They include, among others, comparability and verifiability, both of which are by construction or nature difficult to achieve for many sustainability disclosures. Standard setters, including in particular EFRAG and IASB/ISSB, continue to work on the topic of connectivity between financial and sustainability reporting²⁸ and on conceptual frameworks.

Besides these immediate connectivity matters, there have been discussions of a more holistic corporate reporting. According to the CSRD, the sustainability report is a dedicated, and distinct, section of the management report. In the longer run, financial and sustainability reports may be unified in a corporate report, with the same level of assurance. The IFRS Foundation has consolidated the Value Reporting Foundation and with it the International Integrated Reporting Council that issued the International < IR > Framework (IIRC, 2021), which is a possible way to integrate financial and sustainability reporting.

9. Summary

This paper compares sustainability reporting, as mandated by upcoming sustainability reporting standards, such as the ESRS, the ISSB Sustainability Disclosure Standards, and SEC regulation, with concepts fundamental to financial reporting. Sustainability reporting standards require firms to produce an enormous amount of data points, whose utility for users is not clear, but imposes high costs on firms. In many areas, the data points comprise of inputs rather than outputs, which should be the ultimate information of interest. Sustainability reports do not aggregate data points and therefore do not measure sustainability performance, effectiveness, and efficiency. In other words, there is no such concept equivalent to profit and equity of a firm, which are the key aggregate financial measures. The reported data points will be aggregated by others outside the firm, such as individual user groups and rating agencies, in different ways, hindering comparability of aggregate evaluations.

Sustainability reporting includes data from firms in the value chain, over which the reporting firm has no control. Such information is mandated to allow users to better monitor compliance with standards, for example, in social and governance topics. The value chain information is useful to firms to reconfigure its place in the value chain, for example, to improve on environmental concerns. However, it is not helpful in comparing firms with respect to their environmental engagements.

Overall, it would be a good idea to resort to generally accepted principles and concepts in financial accounting, which have a long tradition of aggregating data and providing useful financial information to compare firms and also dealing with incentives of firms.

Acknowledgments

The paper has benefited from comments by Gilad Livne (editor), Andrea Sternisko, Theresa Wittreich, and from participants of a presentation in the initiative Business Valuation Accounting & Auditing at the University of Linz.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Funding

This work was supported by Austrian Science Fund: [Grant Number P 35265-G].

Notes

1 See FASB (2019), IASB (2020a).

2 See Schipper (2022) for reasons of such difficulties.

3 For an overview of distinguishing features between sustainability and financial reporting see also Christensen et al. (2021) and EFRAG (2023).

4 For an overview of sustainability reporting standards and frameworks see, e.g. Stolowy and Paugam (2023).

5 In terms of industry-specific standards, the SASB has published 77 standards.

6 See IFRS S2, para. 23, and ESRS E1, para. 32. In an EFRAG Conference on December 7, 2022, Sven Gentner, Head of Corporate reporting at the European Commission, described the ESRS as ‘not policy-agnostic.’

7 See also Christensen (2022).

8 While this is a large quantity, it should be noted that IFRS disclosure checklists that are available from big audit firms also comprise 100–200 pages, but these are all disclosures of information underlying the preparation of the financial statements.

9 See, e.g. Lymer et al. (1999), Xiao et al. (2002). Many of these analyses would require more granular tagged data than is available in an annual report.

10 An exception is the aggregate measure of CO2 equivalents, which is based on physical properties of six greenhouse gases.

11 See, e.g. Sorter (1969) with an events approach.

12 El Gibari et al. (2019) review methods of forming composite measures from individual data.

13 See Bebchuk and Tallarita (2022).

14 This also holds for a balanced scorecard. See, e.g. Rotaru et al. (2020).

15 See, e.g. Loumioti and Serafeim (2022).

16 For surveys see, e.g. Frost and Jones (2015) and Sellhorn and Wagner (2023).

17 The GHG Protocol (2004) offers an option between the control and the equity share and approach.

18 It should be noted that the scope of sustainability reporting is broader than that of the CSDDD, as sustainability reporting is mandated for a larger set of firms.

19 See Kaplan and Ramanna (2021), p. 123.

20 For examples, see GHG Protocol (2011), ch. 8.

21 Note that information technologies allow to collect actual data on customer usage of products, these are unhelpful to forecast future usage, particularly for long useful lives of products.

22 The definition of scope 2 emissions has been amended in the revised GHG Protocol (2004) to exclude emissions from electricity purchased for resale.

23 A firm that has not adopted targets needs to explain the reasons for that and whether it tracks effectiveness otherwise (ESRS 2, para. 79). The implicit assumption is that pressure on firms by stakeholders would induce it to set acceptable targets.

24 For example, in the exposure draft on amending the accounting of business combinations mentioned in the Introduction (IASB, 2020a) there was strong opposition by preparers to require disclosure of targets and their achievements for business combinations.

25 For example, the SEC (2022) climate-related disclosure proposal includes a safe harbor for scope 3 emissions disclosure. Article 19a (3) of the CSRD offers a limited member state option for not disclosing information that is seriously prejudicial to the firm’s commercial position.

26 CEPS and Milieu (2022), pp. 55-57. Litigation is also mentioned as a major risk in GHG reporting (GHG Protocol, 2015, p. 12).

27 See, for example, IASB (2020b). In March 2023, the IASB added a narrow-scope project on climate-related risks in the financial statements.

28 See, e.g. EFRAG (2023).