As CFOs prepare new disclosures related to environmental, social and governance (ESG) issues — either voluntarily or due to evolving regulatory requirements — their experiences complying with the U.S. Securities and Exchange Commission’s (SEC) new human capital disclosure requirements can help. After all, aspects of the human capital discussions relate to both the “S” and the “G” in the ESG reporting framework.
Initial data gathering activities, collaborations with business partners and the budding effort to capture human capital data more efficiently offer guidance on how to ramp up these activities on the myriad topics underpinning ESG reporting. In doing so, companies can reach the endgame in the form of optimized ESG data gathering and reporting that tells the company’s story and resonates with investors.
The SEC’s human capital disclosure requirement prompted CFOs to address two underlying questions with major repercussions:
- How do our human capital management strategies and decisions affect the bottom line?
- And, how can their impacts drive changes throughout the organization, both now and in the future?
These fundamental questions apply to all material topics incorporated into a company’s ESG reporting. The answers will help CFOs ensure that any ESG reporting topic — whether it focuses on environmental, social or governance matters—evolves beyond a mere compliance exercise to reporting on a strategic imperative, the execution of which generates tangible value over the long haul.
By way of background, in August 2020, the SEC issued a rule that requires companies to report on human capital metrics. The rule requires human capital disclosures “to the extent such disclosure is material to an understanding of the registrant’s business taken as a whole.” The new requirement is designed to modernize financial reporting by adding an element that is being scrutinized increasingly by investors, customers, shareholders, employees and, now, regulators.
The rule took effect in November 2020, and year-end reports that companies have filed since then include these disclosures. While the language of the new rule grants companies latitude to shape the content and format of their human capital reporting, commonly identified disclosure topics have emerged. These include data and metrics related to headcount, diversity and inclusion, training and employee development, and employee compensation.
How does this apply to ESG reporting? As CFOs have led or contributed heavily to the development of human capital reports, we’ve seen cross-functional collaboration and automation techniques from that exercise emerge as enablers of ESG reporting success.
Although CFOs sign and certify financial statements containing the human capital disclosures, they often work closely with the chief human resources officer to collect and understand the data, design the metrics, interpret related KPIs, and finalize the reports. Companies without a strong human resources information system platform or a payroll application that tightly integrates with an ERP system usually require much more time and effort to generate their initial reports—and wrestle with both ambiguity and data quality while doing so. The ability of organizations to track the human capital metrics they disclose over the long term requires repeatability, accuracy and efficiency. Automation and access to quality data have delivered these reporting capabilities, as they will for ESG reporting.
Beyond these essential components, the following practices have aided initial human capital reporting efforts, and they’re likely to do the same for other types of ESG reporting, including climate-related disclosures:
- Start with purpose: While ESG reporting boils down to a data capturing activity, the endeavor should begin with a discussion among key stakeholders of the organization’s focus: How do we define our organization’s purpose? How do ESG disclosures help articulate our business? How do ESG metrics help us validate what the organization views as materially important? The SEC’s human capital disclosure requirements encourage CFOs to reflect on what employees value most about the organization and how key business decisions influence people engagement, productivity, loyalty and other measures. Without a direct link to purpose, ESG reporting becomes merely another presentation of compliance information.
- Compare your ESG metrics to the competition: The principles-based approach the SEC espouses for human capital reporting leaves plenty of “running room” for variation. As a result, the collection of metrics organizations include in their disclosures may change significantly over time, even during the next 12 months. Forward-looking CFOs have already pored over the disclosures and best practices of competing companies to identify what human capital attributes they are tracking, which helps generate ideas for improving their respective company’s reporting.
- Lean on your internal audit partners: Human capital and ESG disclosures are only as effective as the data used to create them. That’s why new ESG reporting activities represent an ideal point of engagement for the internal audit group. Internal auditors can scrutinize the data collection processes and underlying controls over those processes to provide comfort to the CFO (and, in some cases, board committees) concerning data quality and consistency.
- Get to real-time monitoring: Focus on improving data collection and information sharing so that ESG information drives positive behaviors and outcomes throughout the enterprise. Once ESG metrics have been integrated with performance management, business unit and operational leaders can use the ESG data to make better decisions, just as they would to improve financial performance. As the returns on improved decision-making accumulate, business partners will want to monitor ESG metrics in real time so that they can keep the various ESG strategies on track.
- Harness ESG performance links to enrich MD&A narratives: CFOs should strive to include assessments of ESG performance impacts in the management discussion and analysis section of the public reports. Those narratives will shed light on why a company is more or less profitable due to decisions and actions related to ESG matters.
The ESG reporting endgame is all about providing investors relevant insights on material matters pertaining to the continued viability of the company. Succeeding at this endgame requires CFOs and their many varied and new partners in ESG data collection and analysis to think well beyond the confines of a compliance reporting mindset to embrace the sharing of a compelling strategic narrative that will resonate in the market.
This article originally appeared on Forbes CFO Network.
