Before you start
This unit builds on the discussion in Unit 5 on what makes a reporting entity, and in Unit 12 on how financial information is tailored for different users. This unit can be read independently of those two, but it would help if they were read first.
Unit learning outcomes
By the end of this unit you should be able to:
- describe the social licence to operate that different forms of organisation may have
- explain where judgement is relevant in relation to the nature and content of financial reports
- evaluate the impact of law and financial reporting standards on financial reports
- discuss the interaction between financial reporting and tax.
15.1 Introduction
Financial statements are produced in an enormous variety of forms to suit differing needs both within a country and across the world.
From the simple income statement without a balance sheet attached – that might well suit the needs of many sole traders operating in their own names and without limited liability, and who only need such information to support the declarations that they make to their tax authority to support the calculation of their tax liabilities for a year – to the complex and lengthy financial statements of large multinational corporations, and everything in between, all of these things are financial statements. It is also important to note that professional accountants are engaged with the preparation of all such accounts. Each requires the exercise of its own form of professional judgement.
The duty of care that the accountant has to the organisation that they are accounting for, its management and members, and the wider community that grants both the reporting entity and the accountant their social licence to operate in their respective roles, is also the same in each case. That is why the Accounting Streams project treats these functions as being of equal importance.
In this unit we look very specifically at the reasons why the form and content of financial statements can vary significantly because of:
- differences in the scale of the activity that the reporting entity undertakes
- the varying expectations of management
- the requirements of different ownership structures
- the risk that a reporting entity creates for the society that grants it its social licence to operate
- differences between national and international businesses
- differing financial reporting standards
- varying legislative requirements specified by jurisdictions
- the demands of both related and unrelated parties with an interest in the activities of the reporting entity, including civil society groups
- varying expectations of tax authorities.
15.2 The social licence to operate
This unit makes reference to what it calls the ‘social licence to operate’ (SLO) that a reporting entity might have.
The term ‘social licence to operate’ is not to be found embedded in the law of many, if any, jurisdictions. Nor is it to be found in most financial reporting standards. It is infrequently used by many professional accountants. It is, however, commonly used by those non-governmental organisations and civil society organisations that seek to hold reporting entities to account for their activities. As such it is familiar to the investment community.
The origin of the term is explained by academics as follows:
Roughly 20 years ago Jim Cooney, a Placer Dome mining executive, coined the term ‘social license to operate’ (SLO) responding to the mining industry’s deteriorating public reputation and increasing social risk. Since then, the SLO has turned into an increasingly popular concept on a global level, addressing community-company relationships in high impact industries such as mining, bioenergy and energy cropping, agriculture and forestry, and even tourism.1
To establish its SLO an entity needs to win the support of the community that hosts its activities. The SLO of an entity can be seriously harmed by the negative profile that the failure to secure such acceptance can create.
As is noted in the piece quoted, this has particular significance in some high-profile sectors, but others can also be affected. Financial services and banking are other sectors where the SLO can be a significant issue, particularly if saver confidence in an institution is to be maintained.
The concept also applies more generally. Some businesses have, for example, been keen to highlight their egalitarian stances in a wide range of issues as part of their endeavour to secure an enhanced SLO. They believe that by doing so they will create a favourable profile among their potential customer base.
Not-for-profit organisations of all sorts also have a particularly strong reason for seeking a strong SLO. If their ability to raise grants, donations and other forms of funding depends on their ability to demonstrate support in the communities in which they operate, the creation of a strong SLO can be fundamental to their success. This can require considerable investment.
The following are some issues that can affect a reporting entity’s SLO:
Watch this video about the battle against tax abuse by multinational corporations.
- good environmental standards
- its approach to biodiversity
- transparent reporting
- clarity in both its attitude towards and practical policies on discrimination of all sorts
- effective reporting of its goals in the communities that it serves and the demonstration of its success in achieving their planned outcomes
- openness about its tax affairs, and most especially its use of tax havens
- candour about its executives’ pay and the reason why they are rewarded as they are.
Pause to reflect
- What businesses can you think of that have had difficulty in securing an SLO among the population at large? How might this impact their financial reporting and trading performance?
- You might want to consider this issue in the context of tax haven activity. Does the use of tax havens, or secrecy jurisdictions, harm a corporation’s SLO?
15.3 The social licence to operate and the exercise of judgement
No business is required to have an SLO. It can take the attitude that the matters referred to in the previous section are not its concern. Those taking this view might claim support for their stance from the well-known US-based economics professor, Milton Friedman, who wrote in 1970 that:
there is one and only one social responsibility of business—to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.2
This is the mantra of the profit-maximising firm. It seems diametrically opposed to the ideas implicit in the concept of an SLO. That, however, is not necessarily the case. There can be considerable commercial advantage to the achievement of a strong SLO and its loss may also have negative impact on a business. It is too cynical to assume that those businesses seeking to promote their ethical and other standards are doing so simply to secure additional commercial advantage for themselves, but to dismiss that idea would also be unwise. When the issue of extra-statutory reporting is being considered – as it is here – it is appropriate to ask whether profit motives are involved, while accepting that they may not be.
This then reveals the critical point when decisions on the nature and content of the financial reports issued by reporting entities are being considered, most especially when the disclosures made are not required by statute. Financial disclosures are almost invariably determined by a mix of the ethics and organisational goals of the entity’s management.
The accountant within the reporting entity has a critical role to play within this process. They might well guide the participants through the associated decision-making process. A possible decision tree is illustrated in Figure 15.1.
Watch the video ‘No accountant knows how to maximise profit, which doesn’t mean they think profit is unimportant’.
The flow chart in Figure 15.1 is not meant to be complete. For example, employee pressure to disclose data to secure an SLO is ignored, as is the pressure from relevant parties who have an interest in the reporting entity. What it does, however, make clear is that the content of accounts is as dependent on professional judgement as it is on legal requirements and that both must, as a result, be taken into consideration when discussing the nature and extent of the financial reporting of an entity.
Pause to reflect
- To what extent do you think an accountant should be involved in the decision to secure an SLO for a reporting entity, and what bias (if any) should they have when advising on this issue?
- Consider the case of the UK-based BrewDog PLC, a brewery that has courted significant publicity.
- Did its loss of a key component in its SLO have a significant impact on its fortunes?
- Did subsequent events at the brewery suggest that the loss was a warning of events to come?
Case study 15.1 Supplemental reporting
Suppose that a company wishes to report data on its relationship with women. It might do this because:
- It has high proportion of women among its employees.
- It makes products that mainly appeal to women.
- Its management believe that they have a duty to promote the role of women in society.
- It has previously been subject to criticism on this issue.
- It is seeking to promote causes that it believes align with women’s interests.
Pause to reflect
- Are these reasons sufficient for a company to wish to undertake additional reporting on this issue?
- Are they appropriate?
- What is the likely reaction of people in society to this action?
- Will there be cynicism regarding their actions?
As a result of this decision, the company considers undertaking additional reporting on:
- the proportion of its products that are sold to women, perhaps reported by differing marketplaces, and maybe by different age groups
- the gender split among its employees
- the gender pay gap among its employees; that is, the comparison of average female to male pay
- the gender employment split among different types of employee it engages, for example:
- manual labour
- administrative labour
- lower, middle and higher management
- the company’s support for women’s groups
- the support that the company provides for the education of girls.
Pause to reflect
- Are these appropriate ways for the company to indicate its commitment to the women it engages with?
- Are there other ways in which they might do so?
- Might there be cynicism about the choice of these indicators?
- Might there be a backlash from men because of this choice of indicators?
In addition to the chosen indicators, the company also decides to publish narrative explanations on its activities as they relate to women. These might include:
- tailored reports
- explanations on the roles of women within the company, including case studies
- reports on product development as they relate to meeting women’s needs.
Pause to reflect
- Does offering these narrative explanations make sense?
- Is there a risk that they might seen as patronising?
- Might they alienate some people as much as they garner support?
- How would you test these hypotheses?
15.4 The influence of law and financial reporting standards on financial reporting
As the discussion to this point makes clear, the nature and content of financial statements is heavily influenced by several factors.
Size is one significant factor: it is very likely that the accounts of a small entity will be considerably shorter and simpler than those of a large company, a quoted company or public-interest entity.
Legal requirements also have a considerable influence. A vast number of unincorporated entities that exist in many jurisdictions will not be subject to legal reporting requirements. Instead, they must meet the requirements of a tax authority or of third-party users of their financial statements, such as providers of capital. In these cases, locally approved generally accepted accounting principles (GAAP) are likely to be a bigger influence on the form and content of these statements than legislation.
This also applies to limited liability reporting entities that are required to produce financial statements by law, whether or not for display on publicly accessible registers or. In many countries, the legal specification of what is required from limited liability entities is quite limited in scope, with legislators now requiring accounting standards setters, whether local or international, to fill in the gaps.
Given their complexity, financial statements prepared in accordance with International Financial Reporting Standards (IFRS) tend to be much longer than those prepared in accordance with most local GAAP standards, but this is not always be the case.
Case study 15.2 Examining different reporting approaches
Look at the accounts of two large companies that you know. For example, find the accounts of the supermarket that you use most often or those of your bank, or any other company whose products you know.
Make sure you find the account of the parent company of the group you are looking at. If, for example, you regularly shop at Tesco in the UK, you will probably purchase your product from a company called Tesco Stores Limited, but it is a subsidiary of Tesco plc, and it is the accounts of this parent company that you need to find. For Tesco they can be found in the investors section of the website. The best place to find the account of a quoted company of this sort is in the investor section of that company’s website, which may not have the same web address as the company’s consumer-facing website. Knowing how to locate accounting data of this sort is an important part of becoming literate in accounting.
You might also want to look for the accounts of a smaller, but reasonably sized, unquoted company. You may need to do some research in your area to identify one.
Few of these companies put their accounts on their websites. Why this is the case is hard to understand because if the figures provide a positive view of their financial performance then they could be a valuable advertisement. Company accounts often must be sourced elsewhere. If you are in the UK, for example, you will most likely need to search the millions of such accounts filed with the UK Registrar of Companies. You are able to search this database for free. In other countries there are different registries to search.
Now compare the detail of the information included in the accounts of the quoted companies and that of the unquoted, but reasonably sized, company.
- What are the differences?
- Why are the notes to these accounts so different?
- What do you think is the reason for these differences?
Look at all the reports that are included in the accounts of the quoted company before you read the financial statements. There may be 100 to 200 pages of this information. Compare it with the reports in the smaller financial statements.
- What are the differences?
- Which one is communicating more effectively?
- Are these companies really meeting their users’ needs?
- Is there bias apparent in the reporting of any of the companies that you look at?
- Could there be excessive information in the large companies’ accounts? If so, why?
- Is the brevity of the information in a smaller company’s accounts trying to hide something, or are they just shy about their achievements?
There are no right and wrong answers to this case study. Nor does it matter which companies you choose. And if you are in a jurisdiction outside the UK, just adapt your choices to your own local circumstances. The case study will remain just as relevant.
The point is that the accountants in these organisations are involved in making decisions about financial disclosure and what is put on public record by their companies. Ask yourself what motivated them to make the decisions that they did. Why, if you look at multiple sets of accounts of companies of broadly similar size, do the range of decisions made differ so widely, even within the same commercial sector?
What you will appreciate from looking at accounts is just how diverse their disclosure is despite the apparent similarities in company law and accounting standards that affects companies. Are professional accountants are using their judgement wisely? Do you want to be one of those accountants making such decisions? What would you do when it came to disclosing what your company does:
- Would you tell all?
- Would you say as little as possible?
- Would you work out how might read your financial statements and plan to meet their needs?
- Would you do something else?
Pause to reflect
- Can law and financial reporting standards guarantee the supply of meaningful financial statements when so much discretion is given to management on the content of those statements?
- What is the role of the auditor in appraising whether the management’s opinion on the matters they choose to include in the accounts to meet their obligations is adequate?
- Is financial reporting too judgemental to be meaningful?
15.5 Financial reporting and tax
Most companies in most jurisdictions throughout the world are subject to tax on the profits that they make, although there are exceptions. For example, charities are rarely subject to tax on their charitable income, although they can be on trading income if they also undertake such activities. In addition, companies located in tax havens such as the Cayman Islands and Jersey are not subject to tax on their income, which is a major incentive for locating business activities in such places. These exceptions apart, profits are usually subject to tax.
The International Financial Reporting Standards Foundation says in paragraph 1.6 of its Conceptual Framework for financial reporting (IFRS, 2018) that:
General purpose financial reports do not and cannot provide all of the information that existing and potential investors, lenders and other creditors need. Those users need to consider pertinent information from other sources, for example, general economic conditions and expectations, political events and political climate, and industry and company outlooks.
As they also make clear, users other than the suppliers of capital will also have to resort to such methods to meet their needs: it is quite specifically not the intention of the IFRS Foundation to meet their needs
Among the ‘other users to whom the International Financial Reporting Standards Foundation refers are tax authorities.
There are some justifiable reasons for the indifference of financial reporting standards setters to the needs of tax authorities. These include:
- There is a wide range of differing demands that jurisdictions make for information on the activities of reporting entities trading within their domains.
- Tax authorities are backed by the rule of law and can impose a legal requirement on any reporting entity that has to make a declaration to them to provide any additional information not included in their financial statements that the tax authority might require to support a tax return.
Problems arise as a result of this indifference, particularly when it comes to the taxation of multinational groups of companies that might operate in many jurisdictions. In these companies there is a particular problem with the artificial relocation of profits into low-tax jurisdictions or tax havens. The Paris-based Organisation for Economic Cooperation and Development (OECD), which has to date been tasked with tackling this issue, describes this as ‘base erosion and profits shifting’.
To tackle this issue, it has endorsed a new form of accounting called country-by-country reporting which has previously been used by EU-based companies in the extractive industries and financial services sectors. This is referred to in Unit 5, but to date it has only been used for tax return reporting. A form of publicly accessible country-by-country reporting will be in use in the European Union from 2025 (Deloitte, 2024). The result is that for the first time the users of financial statements will have a more comprehensive understanding of the geographic spread of the activities undertaken by large multinational corporations. This will add to the content in financial statements, but also to their usability; the public will be better able to appraise the tax compliance of these public-interest entities as tax authorities are already able to do.
Pause to reflect
- Why might you want to know more about the geographic risks inherent in the operations of a multinational corporation?
15.6 Summary
This unit has highlighted the following ideas:
- The form and content of financial statements is influenced by the size of the reporting entity issuing a report, its legal form and the regulation and financial reporting standards that apply to it, but these factors alone cannot predict the actual form and content of those financial statements.
- Many reporting entities will wish to report on matters that they are not required to do by statute, regulation or accounting standards. This might be because they wish to secure an advanced social licence to operate in the communities that they serve. Such reporting entities might include:
- For-profit organisations seeking to win commercial support from particular interest groups
- For-profit organisations undertaking commercially sensitive activities that require public acceptance
- Those organisations, often in the not-for-profit, charity, civil society organisation or government sector, that undertake their activities for social purposes and wish to explain what their objectives are and how they are achieving them
- Those reporting entities whose directors believe it is socially responsible to offer such reporting
- Those commercial organisations that simply see the financial statements as another form of advertising
- Even those organisations that seek to be minimally compliant with disclosure requirements can, because of the varying factors that are material within their operations, deliver very different information in their financial statements from other organisations not wholly dissimilar to them.
The form and content of the financial statements of many reporting entities will be dictated by the professional judgement of the directors of the reporting entity, their accounting teams and their auditors, as well as those they engage to advise them on such issues as their SLO.
There is no right answer to the question as to what should, or should not, be included within financial statements: within the constraints of regulation, decisions on this issue are very largely a matter of professional judgement. Accounting is as much about judgement as it is about rules, and that is one of the things that turns the accountant into a person expressing professional opinion.
References
- Deloitte. (2024). EU Public Country-by-Country Reporting obligations for EU-headquartered and non-EU-headquartered multinationals from 22 June 2024.
- Friedman, M. (1970, 13 September). The social responsibility of business is to increase its profits. The New York Times.
- IFRS. (2018). Conceptual framework for financial reporting.
- Lesser, P., Gugerell, K., Poelzer, G., Hitch, M., and Tost, M. (2021). European mining and the social license to operate. The Extractive Industries and Society, 8(2), 100787.