Essay: Influence of research and development intensity on integrated reporting

1. Introduction
Organizations change their way of disclosure according to the expectations of their stakeholders. However, these expectations are also changing over time due to the rapid development of technology, economic uncertainty, and the financial crisis. While historically the stakeholders focused the financial statements, there is increasing attention to the nonfinancial perspectives such as environmental, social and governance aspects.
This study examines the influence of the research and development (R&D) intensity on the integrated reporting <IR>. The reason for the emphasis on the R&D and the integrated reporting is that both activities aim to create value on the long-term and boost the competitive strategies for the firm.
1.1. Background
Traditional reporting or what we know as financial reporting was for many years a subject for a lot of critics due to its provision of insufficient information to the stakeholders (Adams et al. 2011; Cohen et al. 2012). As a response to these critics, many companies provide additional non-financial information via stand-alone sustainability report to satisfy their stakeholders ( Cohen et al. 2012). The Global Reporting Initiative (GRI) introduced guidance for this sort of non-financial reporting, nevertheless, this way of reporting was ambiguous, cluttered and it lacked connection with other parts of business activities (Adams & Simnett, 2011, p.293).
In 2010, IIRC introduced the framework of the integrated reporting in a purpose of linking these isolated form of reporting by recombining the financial and the non-financial reporting in one integrated report.
IIRC states that the integrated reporting is an organization’s strategy to communicate its governance, performance, and prospects to the outsiders in order to create value not only over the short-term but also over medium and long-term. (IIRC, 2013, p.7)
Thus the integrated reporting is a relatively new concept, it became to the light after the economic crisis in 2007 when the traditional financial reporting was under question. According to stakeholders, the traditional financial reporting is not enough to get a whole picture about the business activities as it only covers a part of these activities ( Burrit et. al. 2010, p. 831). The demand for a different way of corporate reporting was raised, and The International Integrated Reporting Council (IIRC) was formed with a purpose of the “enlightened” the stakeholders (Humphrey, O’Dwyer and Unerman, 2017). In view of the fact that the integrated reporting is a new concept, there are not enough researches about the benefits of it ( Dumay, Bernardi, Guthrie, and Demartini, 2016, p. 178 )
According to IIRC, the objective of the integrated report is to create value over the short, medium and long-term for the company by communicating transparently with the stakeholders ( IIRC 2013b, p. 8). However, the moving from only the reporting on the financial performance to the reporting on both financial and non- financial reporting has gradually developed.
Since the establishment of the integrated reporting, many companies adopted it as a way to communicate transparently with their stakeholders. South Africa was a pioneer in this field as it made it compulsory to the listed companies to adopt the integrated reporting. According to Zhou et al (2017), the reason behind the compulsory of the integrated reporting in South Africa is that the belief of the lack of ability of the traditional reporting to fulfill the requirements of the current disclosures.
1.2. Prior studies
Since the establishment of the integrated reporting, the researchers did plenty of studies on the effect of this new concept on the different sides of the business activities. Most of these studies focused on the advantage of the adoption of the integrated reporting on both firms and stakeholders.
Nevertheless, there were contradictory arguments about the effectiveness and the efficiency of this way of a corporate report. Some researchers argued that the integrated reporting will lead to a more comprehensive and coherent form of communicating with the stakeholders that allow to build a sustainable relationship with them and to create value over time, while others argued that the value of the integrated reporting is overestimated and it will cause plenty costs to companies.
Churet and Eccle (2014) Studied the relationship between the integrated reporting and both quality of management and financial performance. They found a significant relationship of integrated reporting on the quality of management, but nuance improvement of the financial performance (Churet and Eccle 2014, p.64). while Wen and Heong (2017) found that the association between integrated reporting and financial performance is indeed positive.
Zhou et al. (2017) found that integrated reporting improves the information environment and contribute to the reduction in the cost of equity capital and the realized market return (p.123). Moreover, the integrated reporting can also boost the forecast’s accuracy due to the provision of better information that helps to reduce the estimation of the risk. (p.100)
Owen (2013) elucidates the advantage of the integrated reporting and how it creates value on the long-term on the contrary of the traditional financial reporting that only focuses on the transactional levels of the business and consequently only concentrates on the short-term performance. (2013, p.349).
Barth et al. (2017) conduct research on the effect of the quality of integrated reporting on the firm value using data from South Africa, where mandate the use of integrated reporting in the listed companies. They found a positive relationship between the quality of integrated reporting and liquidity, expected future cash flow and subsequently improves the internal decision making(p.60)
Thus, the integrated reporting provides accumulate benefits to the users and companies such as better decisions, cost reduction, improved risk management, better investment opportunities enhance public image and lower costs of capital. (Frias-Aceituno et al., 2014, p.58)
Despite the aforementioned benefits, there are still criticisms to the framework of the integrated reporting. The critique is related to its focusing on creating the value of the investors instead of the value of the society, or in other words, the abandonment of the legitimacy theory and focusing on the stakeholder theory. According to Rodrigue (2015), p.129) the integrated reporting focus on a strategy that creates value in the long-term rather than focusing on sustainability. Adams (2015, p.23) outlined that the integrated reporting is insufficiently developed and she called for more researches to ensure the development of this accounting practice.
1.3. Research question
According to Stubbs and Higgins (2014), the integrated reporting does not form new innovations in the way of reporting or revolutionary change, but it is gradually developing to the sustainability reporting (p.1085). Both R&D and CSR activities can create assets and provide firms with a competitive advantage. (Padgett and Galan, 2010, p.407). They also illustrate that these activities contribute to the satisfaction of the stakeholders and the community. Furthermore, in their study, they found that the relationship between R&D intensity and CSR is positive.
Because of the complex nature of R&D and the demands of the investors to understand the information about R&D, it is interesting to investigate whether the R&D intensity effects the financial performance mediated by IR
This study will provide an important opportunity to understand whether R&D impacts the integrated reporting and subsequently the financial performance. There is considerable literature studied the relationship between IR and the financial performance, albeit, none of them includes the effect of R&D intensity on the on the financial performance of the firms adopted integrated reporting. This research builds on the recent investigation about the relationship between IR and the financial performance by Wen and Heong (2017) who found that IR is positively associated with the financial performance. This leads to the following question:
Does R&D intensity improve the financial performance in firms adopted integrated reporting?
1.4. Contributions:
Integrated reporting is a relatively new practice. Several kinds of literature conduct research on the relation between the integrated reporting and firm’s value, stock market, financial performance, albeit none of them investigated hoe R&D intensity can effect on the financial performance in firms adopting the integrated reporting despite the importance of R&D in fostering the firm’s performance. Therefore, the contribution of this study is twofold: first, academic contribution, this study will contribute to the existing studies about the beneficial aspect of the integrated reporting by examining the influence of R&D intensity on integrated reporting. Second, on the practical side, this thesis conducts empirical research on the relationship between R&D, IR and financial performance that hat until now not been studied before.
2. Theoretical framework
Current literature about integrated reporting mainly focuses on the R&D intensity and its influence on the integrated reporting. The integrated reporting is a relatively new way of reporting, it involves not only communicate business performance but also produce connection across different parts of the business. (PwC, 2015, p.5).
The prior studies primarily focus on the benefits of integrated reporting for making a decision by the investors or the value relevance and how integrated reporting creates value over time. For instance, Churet and Eccles (2014) studied the effect of the integrated reporting on the quality of management and financial performance, while Indrawati (2017) did a research on the effect of the integrated reporting on the accuracy of the earnings forecast.
This paper mainly focuses on how R&D intensity impacts the integrated reporting and financial performance.
The following section provides some related definitions that elucidate the R&D intensity and its effect on integrated reporting concept. Subsequently, I will explain the development of the hypothesis and the research methodology.
2.1. research and development :
In spite of the importance of R&D expenditure on financial performance, it is not often included in the financial measurement. The objective of this research is to illustrate that there is a positive association between R&D intensity and the financial performance in firms adopted the integrated reporting. This assumption is based on the stakeholder theory that managers act to the demand of the powerful stakeholders (Jensen, 2010, p.32).
Companies in their struggle to influence their stakeholders will improve their productivity and products and that leads to increasing the R&D intensity.
Organization for Economic Cooperation and Development OECD, 2002 defines research and development as “creative work undertaken on a systematic basis in order to increase the stock of knowledge, including knowledge of man, culture and society, and the use of this stock of knowledge to devise new applications.”
Companies in today’s business are exposed to a lot of pressure from their stakeholders to develop their sustainable products, they respond to these demands by increasing R&D expenditures. Thus as a result of the rapid technology and the highly competitive business environment, the companies tend to expense more on the R&D activities to boost their business position in the market and to satisfy their stakeholders.
The report of Deloitte 2011 showed that investment in R&D activities positively related to decreasing cost of production, more efficient business process and subsequently the firm will enjoy future economic benefits.
Odagiri (1986) did research on the effect of the R&D on productivity in Japanese manufacturing companies and they found that R&D is associated with the improvement of productivity. (p.19). R&D activities aim to boost innovation and improve the products and thus there is a positive association between innovation and financial performance (McWilliams and Siegel (2000) and Hull and Rothenberg, 2008). Thus innovation is necessary to sustain profitability (Hamel (2000)
R&D is a fundamental base for innovation and because of that it is expected to result in improvement of the business performance, especially when the outcome of the business activities is uncertain like in the case of the technological innovation that causes the firm to rely heavily on the R&D (pinkse & Kolk (2010), p.262)
Prior studies shed lights on R&D activities and their associated with firm’s financial performance due to its influence on the development of the products and process innovation ( McWilliams and Siegel, 2000, Hull and Rothenberg, 2008).
Lin et al. (2006) found evidence that R&D activities have a positive impact on the technology commercialization and this commercialization in turns effect positively on firm performance.(p.684). Also, higher R&D intensity is positively related to the stock-price (Chan et al, 1990 p.275). Chauvin and Hirschey, 1993, p.140)Conclude that R&D activities provide valuable information to assess the future cash flows, growth, risk, and market share.
2.2. Integrated reporting:
The report over the social, environmental and economic activities was used by the companies for decades as a way to report on their strategies. This form of non-financial information was reported separately from the financial reporting in a Corporate Social Reporting (CSR) or sustainability report. CSR was introduced by Wood in 1991 who define the CSR as a way to incorporate the relationship between business and society ( 1991, p. 695). According to Carroll, business has economic, legal, ethical and discretionary obligation towards the society ( 1979, p.499). in 2008 the definition of the CSR was adjusted by adding the environmental factor ( Dahlsrud, 2008, p.4).
Sustainability is defined by Bruntland (1987) as “development that meets the needs of the present without compromise the ability of future generations to meet their own needs”
According to the European Commission (2017), CSR report is “ the responsibility of enterprises for their impact on society”. The European Commission also determines that this sort of reporting is necessary for the improvement of the competitiveness and the innovation of EU business and economy.
However, due to concerns to meet the expectations of stakeholders, the stand-alone CSR became long and complex ( Villiers et al., 2014, p. 1042). The readers have difficulties to understand all details in the report and to connect information with the different practices ( Hopwood et. al., 2010, P. 239) and there had a demand for a single report that covers social, environmental and financial strategy ( Villiers et al., 2014, p. 1042). The combination of both financial and non-financial report forms what we now know as integrated reporting.
The IIRC defines the integrated reporting as: “ A concise communication about how an organization’s strategy, governance, performance, and prospects, in the context of its external environment, lead to the creation of value over the short, medium, and long-term.” IIRC, 2018, p.8.
Thus the integrated reporting gives a lucid representation of the business activities and how an organization creates value over time. “ Organizations are using integrated reporting to communicate a clear, concise, integrated story that explains how all their resources are creating value. Integrated reporting is helping business to think holistically about their strategy and plans, make informed decisions and manage key risks to build investor and stakeholder confidence and improve future performance.” (IIRC, 2017)
PwC elucidates that integrated report is more than the combination of financial and non-financial reports, it induces the firm’s strategy and creates value on short, medium and long-term ( PwC, 2013). An explicit objective of the integrated reporting is to encourage integrated thinking and its focuses on prospective practice rather than retrospective practice. Six capitals were confirmed in the framework of the integrated report as a potential source of value to convey the sustainable value creation. Those “six capital” are financial, manufactured, natural, human, intellectual, and social. (Churet et al., 2014, p. 56).
there was no clear guidance for the use of integrated reporting until 2013 when IIRC introduced the framework of the integrated report with no hard requirements and based on principles. Opposite to the traditional financial reporting, the integrated reporting gives rich information of an organization by bringing insight not only into short-term value, but also into the medium and long-term value creation, and this involves using qualitative and quantitative data ( Owen, 2013, p. 349)
IIRC also illustrated that the integrated reporting is not only interest to providers of financial capital but also to others, including “ employees, customers, suppliers, business partners, local communities, legislators, regulators and policy-makers” (IIRC, 2013, p.7)
Eccles and Saltzman (2011) articulate that integrated reporting has three main advantages: making better internal decisions, building better relationships with stakeholders and diminishing reputational damage.
According to PwC (2015), the integrated reporting can create direct and indirect value to the company. The direct value could be achieved through first, cost reduction such as eco-efficient cost savings reduces the cost of compliance and reduced procurement costs. Second, revenue growth, such as business model innovation, product innovation, and new revenue streams.
The indirect value could be achieved through, first risk management, such as reduced cost of capital, reduced reputational, operational, supply chain or regulatory risk and reduced dependency on scarce resources. Second: brand and intangibles such as brand enhancement, employee engagement, attraction and retention, improved market access or license to operate and improved security and quality of supply. (p.8)
To sum up, the integrated reporting as a combination of financial and nonfinancial report forms a great leap in the way of reporting that leads to a better forward-looking strategy and performance. It is a solution to the challenges of the previous way of reporting. Furthermore, it tends to assess the investors and the stakeholders to identify the best opportunities and estimate risk. The widespread of integrated reporting and the large numbers of companies that adopted this new concept is an affirmation of the benefit of the integrated reporting and demonstrates that integrated reporting attains the needs of the present time. ( Villiers et. al., 2017, p.938).
2.3. Legitimacy theory
The legitimacy theory states that firms are part of the society and they have to act according to the expectations of this society. It is also defined by Lindblom (1994, p.2) as: “ a condition or status which exists when an entity’s value system is congruent with the value system of the larger social system of which the entity is a part”
When it is incongruent between the business activities and the acceptable values of the society that leads to threat the legitimacy of the company. However according to Deegan and Blomquist, 2006, p347. the society expectations differ over time, thus the organizations need to change their behaviors as a response to this change in the expectations.
2.4. Stakeholder theory
Freeman (1983, p.89) defines the stakeholder theory as “there are other groups to whom the corporation is responsible in addition to stockholders: those groups who have a stake in the actions of the corporation”. Also, Freeman elucidates that managers react to the demand of powerful stakeholders and ignore the demands of the others without power.
Those stakeholders are the organization’s shareholders, its employees, customers, suppliers, community organizations, environmentalists, governments, special interest groups, competitors and the media (Clement, 2005, p.255).
3. Hypothesis development:
This thesis aims to shed light on the concept of R&D and whether it positively associates with the integrated reporting and financial performance.
There were a lot of researches linking the R&D activities with firms’ improvement in the long-term (Griliches 1979, McWilliams and Siegel, 2000). because the integrated reporting objective is to create value in the long term, it is expected to find a positive relationship between R&D intensity and IR. Companies are increasing their R&D intensity to meet the demands of their stakeholders that put a lot of pressure on those companies to provide them with more comprehensive and coherent reporting about the future strategy of the firms. And therefore the firms tend to disclose the integrated reporting. La Rosa and Liberatore, 2014 suggest that there is a positive relationship between R&D expenditure and voluntary disclosure, thus firms with higher R&D expenses tend to release more reporting. Thus it is assumed that firms with a high level of R&D expenditure tend more to disclose IR. Thus the first hypothesis:
H1: there is a positive relationship between R&D intensity and the integrated reporting
Dragu and Tiron-Tudor (2013, p. 432) studied the relationship between financial and non-financial disclosure in a sample of 16 Asian-Pacific companies that participate in the integrated reporting programme and they suggest that there is a direct and indirect correlation between this metrics, while Cheurt et al. found a neutral relationship between integrated reporting and financial performance. Thus the next hypothesis:
H2: there is a positive relationship between R&D intensity and the financial performance in firms adopted integrated reporting.
4. Methodology:
In order to provide empirical evidence on whether companies that use integrated report tend to have a higher R&D intensity, an analysis will be conducted on the publicized IR disclosures using archival data from European and US firms. The timeframe of the study is 2013 – 2017, and the data is retrieved from different databases.
To calculate the R&D intensity I will use the model of Padgett and Galan (2009): R&D intensity is the division of R&D expenditure on total sales. Also, other variables are included in this model like company size, return on assets, risk, and growth opportunities.
According to Waddock and Craves 1997, the larger companies tend to disclose CSR more than smaller firms, thus it is expected that the firm’s size plays an important role in adopting the integrated reporting. (the proxy of the firm size is the total assets)
To measure the risk I will use the model of Waddock and Graves 1997, total debt divided by total assets
Growth opportunities: I will use the market-to-book value of equity.
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