ABSTRACT

The objective of this paper is to analyze impacts of sustainability reporting, based on the sustainability reporting standards in the EU, and the IFRS Foundation, with a special emphasize on their sustainability disclosures’ differences in terms of  target stakeholders, scope of application, materiality and reporting boundaries (Giner and Luque-Vílchez, 2022; Wagenhofer, 2023) through the lens of legitimacy theory. Beyond the increasing requirements, the companies will face with sustainability reporting divergence according to the standards chosen among the two different set of standards,which will leads to higher compliance costs and additional challenges. The collaboration between the two standard-setters would smooth the widespread adoption.

Keywords: Sustainability Reporting, Standardization, Legitimacy Theory

1.Introduction

The years 2020 and 2021 witnessed a remarkable surge in sustainability reporting (SR) particularly within the European Union (EU) but also globally. Prior to this period, the development and leadership of SR standards were primarily driven by private institutions such as the Global Reporting Initiative (GRI), the Task Force on Climate-related Financial Disclosures (TCFD), the Climate Disclosure Standards Board (CDSB), the International Integrated Reporting Council (IIRC), among others (Machado,2020). Significant advancements have taken place in the realm of sustainability reporting, leading to the emergence of new influential standard-setting bodies alongside established institutions. Firstly, within Europe, the European Commission has entrusted the European Financial Reporting Advisory Group (EFRAG) with the responsibility of developing new sustainability standards, with a target release date before December 2022. As a part of the Green Deal, the EU has issued the European Sustainability Reporting Standards (ESRS) alongside other finance and governance initiatives. This comprehensive set of standards, applicable across various sectors, comprises twelve regulations that are adopted by European Commission on July 31, 2023, and will take effect from 2024. Additionally, the plan includes two more sets of standards: one catering to sector-specific requirements and the other tailored for listed SMEs, expected to come into effect in the following years (EFRAG, 2023). Secondly, The International Financial Reporting Standards (IFRS) Foundation has collaborated with prominent sustainability organizations and formed the International Sustainability Standards Board (ISSB). The evolving landscape underscores the uncertainty surrounding SR and prompts a critical examination of its trajectory and the role of longstanding institutions. Each of them asserts its authority and influence in the realm of corporate sustainability reporting, with the aim of setting standards and guidelines that shape reporting practices (IFRS, 2021a). As of June 2023, the International Sustainability Standards Board (ISSB) has released its initial set of IFRS Sustainability Disclosure Standards. These standards include IFRS S1General Requirements for Disclosure of Sustainability-related Financial Information and IFRS S2 Climate-related Disclosures (IFRS, 2023a).

In 2020, two new players, the European Commission (EC) partnering with the European Financial Reporting Advisory Group (EFRAG), and the International Financial Reporting Standards (IFRS) Foundation, entered the SR domain alongside established pioneers. These newcomers later integrated with select SR bodies. We argue that, given the abovementioned trends, The roles of both the EFRAG and the IFRS Foundation are projected to expand concerning our primary research focus, which centers on the SR standard developing landscape. In a way, the continuous harmonization effort, and the discussion around the alignment of SR standards mirror a trend like what started in financial reporting more than 40 years ago, but at a faster rate. By reducing differences between distinct local standards, accounting harmonization aimed to improve comparability in reporting procedures (Nobes, 1991). This was accomplished in the EU with the implementation of EC accounting rules in the 1980s, and it was further advanced with the adoption of IFRS in 2005. The research on SR emphasizes several benefits of harmonization, such as increased transparency in reporting procedures (Einwiller et al., 2016). This has prompted some scholars to advocate for public engagement in sustainability information as a means to enhance the quality of such disclosures. (Deegan, 2002). As we consider the involvement of the EFRAG and the IFRS Foundation in the realm of sustainability reporting, it becomes apparent that their perspectives diverge significantly. The EFRAG's move to establish SR standards aligns with the goals outlined in the European Green Deal, reflecting a dynamic approach aimed at influencing firms' behavior towards sustainable development. In contrast, the Foundation's entry into the area has been more susceptible, responding to external calls. Unlike the EFRAG's intention, the Foundation's focus has been on drawing economic reality through standards, rather than actively driving change (IFRS, (2021b); (IFRS, (2021c).

Potential future SR standards, oriented towards stakeholders' needs, might be perceived as communication tools for uniform reporting across contexts. However, this could overlook the transformative power of reporting in shaping behavior, as observed with IFRS, leading to unintended consequences. Given the sensitive nature of sustainability information, these incidental outcomes could have significant repercussions. At this point, it is important to remind that, particularly within the context of.new regulations, the approach of addressing the information asymmetry between society and corporations, which is one of the regulatory theories, particularly the Public Interest Theory, will create a social contract between society and corporations and ensure the legitimacy of corporations. The basis of legitimacy theory is the unwritten and stated anticipations that society holds regarding how a business should conduct its operations (Abbott & Monsen, 1979; Ramanathan, 1976). The social contract is dynamic, it is renewed according to the expectations of the society.

Especially in sustainability reports, considering stakeholders as the entire society and creating reports that encompass this perspective will be crucial for economic and social impacts.

Given this, we have conducted an analysis of crucial documents recently issued by the aforementioned institutions: the European Commission's Corporate Sustainability Reporting Directive (CSRD) proposal (European Commission, 2021a), the IFRS Foundation's Consultation Paper on Sustainability Reporting (CPSR) (IFRS, 2021a), along with IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information, IFRS S2 Climate-related Disclosures (IFRS, 2023), ESRS 1, and ESRS 2. We focus on how important SR factors, such as target stakeholders, scope, materiality, and reporting border, are taken into account in both proposals with a special emphasize on their sustainability disclosures’ differences (Giner and Luque-Vílchez; 2022) through the lens of legitimacy theory.  

The paper will be organized into sections addressing the following key areas: Firstly, the newly established standard setters will be discussed. Secondly, their reporting perspective on target audience, scope, materiality, and reporting boundaries will be examined. Finally, conclusions and suggestions will be elaborated.

2.Evolution of the New Standard Developer Authorities: EFRAG and ISSB-IFRS Foundation

In this section the historical milestones and the perspectives of the newly established standards developers will be explained relatively with their backround.

2.1. The European Financial Reporting Advisory Group (EFRAG)

In the realm of financial accounting reporting, the European Commission (EC) has been involved for over 40 years, issuing directives to standardize accounting practices across Member States. The EC has also mandated the adoption of International Accounting Standards (IAS) through regulations. In this context, the European Financial Reporting Advisory Group (EFRAG), established in 2001, has played a pivotal role by providing endorsement advice on new or revised IAS.

The European Commission's commitment to sustainability dates back to the early 2000s when it started advocating for corporate social responsibility and accountability. A pivotal moment occurred with Directive 2014/95/EU, which made non-financial disclosure obligatory for large corporations. Nevertheless, there have been ongoing apprehensions about the quality of the disclosed information (EC, 2021a).

The update to Directive 2014/95/EU brought about a new strategy, placing EFRAG in a central position. In 2020, EFRAG was entrusted with the responsibility of establishing a task force to offer technical guidance on potential European non-financial reporting standards. This task force, under EFRAG's leadership, promptly produced 54 comprehensive recommendations for the forthcoming European Sustainability Reporting Standard (ESRS) (EFRAG, 2021).The speed of EFRAG's work can be attributed to its commitment to collaboration and avoiding duplication of efforts. EFRAG aimed to establish a strong collaborative partnership with other European and international standard-developers, selecting the Global Reporting Initiative (GRI) as the initial collaborator. The shared objectives of EFRAG and GRI, focused on public interest and sustainable development, reinforced this partnership (GRI, 2021)

EFRAG's revised governance framework included a Sustainability Reporting Board responsible for developing ESRS, which is adopted by European Commission in July 2023 and will be transmitted to European Parliament in the latter part of August 2023 to become mandatory in the EU. This development aligned with the revision of Directive 2014/95/EU, now named the Corporate Sustainable Reporting Directive (CSRD), which closely followed EFRAG's recommendations and acknowledged EFRAG's responsibility in shaping sustainability standards (EC, 2021b).

In essence, EFRAG's role in the roadmap of ESRS has been crucial, encompassing collaboration with key partners, driving recommendations, and shaping the evolving landscape of SR in Europe.

The concept behind the European Green Deal revolves around transforming Europe into the world's inaugural climate-neutral continent while simultaneously establishing a sustainable, equitable, and thriving society. CSRD is one of the milestone such as Sustainable Finance Disclosure Regulation, Taxonomy Regulation, European Green Bond Regulation to reach this aim (EC, 2023).

2.2. The International Financial Reporting Standards Foundation (IFRS Foundation) and International Sustainability Standards Board (ISSB)

IFRS Foundation, founded in 2001, has traditionally focused on financial reporting standards to ensure transparency and efficiency in global financial markets. However, since 2020, it has been taking significant steps in the SR domain, driven by the importance it places on capital markets and creditors (IFRS, 2023b).

With the influence of mounting insistence from the corporate entities and numerous position papers advocating for simplified sustainability reporting, the IFRS Foundation ventured into the realm of sustainability reporting. The release of the Consultation Paper on Sustainability Reporting (CPSR) in September 2020 marked a pivotal moment in this transition. The IFRS Foundation's efforts in this realm have been guided by a distinct perspective compared to EFRAG's approach. While EFRAG prioritizes public interests, the IFRS Foundation's primary concentration remains on the requirements of investors and creditors operating within capital markets (Wagenhofer, 2023).

Acknowledging feedback received on the CPSR, the IFRS Foundation's Trustees swiftly responded by proposing changes to their Constitution. These changes were aimed at accommodating the establishment of the International Sustainability Standards Board (ISSB), a new entity intended to craft international sustainability standards. Notably, the ISSB's core mission centers on addressing the information requirements of creditors and investors within the capital markets landscape (Afolabi et al., 2023). 

This focus on interconnectivity between financial and non-financial reporting is demonstrated by the IFRS Practice Statement 1 Management Commentary, which serves as a potential bridge between the existing International Accounting Standards Board (IASB) and the prospective ISSB. This Statement aims to provide comprehensive insight into companies' long-term likelihoods, encompassing sustainability-related matters. This alignment underscores the IFRS Foundation's commitment to ensuring that capital markets and creditors have access to holistic, meaningful information for making informed decisions (IFRS, 2021d)

EFRAG took the Global Reporting Initiative (GRI) as a reference and emphasized collaboration for the broader public interest whereas the IFRS Foundation's collaboration has been targeted towards institutions like the Task Force on Climate-related Financial Disclosures (TCFD), the Climate Disclosure Standard Board (CDSB), the Value Reporting Foundation (VRF), and the World Economic Forum (WEF). This strategic partnership approach emphasizes catering to the specific needs of investors, creditors, and capital markets participants (Wagenhofer, 2023).

The IFRS Foundation's transition into the SR has garnered support from influential bodies such as the International Organization of Securities Commission (IOSCO) and the International Federation of Accountants (IFAC). This support further underscores the Foundation's dedication to enhancing the relevance and comparability of sustainability information for capital markets participants (IOSCO, 2021).

In summary, the IFRS Foundation's entry into SR signifies its commitment to address the needs of capital markets and creditors. Unlike EFRAG, which emphasizes public interests, the ISSB's formation and activities are guided by the imperative to provide investors and creditors with comprehensive, comparable, and decision-relevant sustainability information. This approach aligns with the Foundation's history of fostering transparency and efficiency in financial markets and extends it to the domain of SR (Afolabi et al., 2023).

3. Critical Distinctions Between IFRS Sustainability Disclosure Standards and European Sustainability Disclosure Standards

This section will discuss the basic differences with key factors already categorized in the literature (Adams, 2021; Christensen et al., 2021).

3.1.Target Stakeholders

According to CDSB, Trustee Task Force has engaged informally with a diverse range of stakeholders engaged in sustainability reporting, incorporating investors, central banks, preparers regulators, auditing firms, service providers and public policy makers. This engagement revealed a unanimous recognition of the growing significance of SR for these stakeholders. IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information as well as IFRS S1 Accompanying Guidance on General Requirements for Disclosure of Sustainability-related Financial Information define primary users as “existing and potential investors, lenders and creditors. Besides, in CSRD paragraph 9 and ESRS 1 paragraph 22 the stakeholders are divided into two groups: those impacted by a project's actions and users of sustainability statements, including investors, creditors, business partners, unions, civil society, governments, and analysts, who rely on these statements to evaluate a project's effects and sustainability practices across its value chain. In brief, for EFRAG, the stakeholders cover the society as a whole.

3.2. Scope

Based on existing frameworks and standards, including TCFD and SASB, the first two standards introduced by the ISSB establish a framework for companies to report on various sustainability-related subjects (IFRS, 2021a). These areas encompass governance, risk management, strategy as well as metrics and targets. The first standard provides a foundational framework that can be utilized to a broad spectrum of sustainability-related subjects, enabling companies to disclose relevant information across various areas while the second standard, referred to as the climate standard, offers more detailed guidance specifically focused on reporting climate-related risks and opportunities (IFRS, 2023)

Source: KPMG, (2023a), p.4

The ESRS consist of the same twelve standards as in the preceding drafts, comprising two cross-cutting standards, which address General Requirements and General Disclosures, along with ten standards focused on specific topics. Every company is obliged to adhere to the general requirements outlined in ESRS 1 and fulfill the general disclosure prerequisites outlined in ESRS 2, irrespective of materiality. It's important to note that ESRS 2 is mandatory for all companies within the scope of the CSRD. For the ten topical standards, as well as the specific disclosure prerequisites and data points within them, a materiality assessment is required. This assessment helps ascertain which aspects are material to the company's operations (EC, 2023).

Source: KPMG, (2023b), p.4

The ISSB standards have been crafted by an international entity that lacks regulatory authority. As a result, these standards are intended to be adopted on a voluntary basis by jurisdictions, regulators, and companies. This means that their application is not obligatory, and their adoption will depend on the willingness of the involved parties. In contrast, the ESRS (European Single Reporting Format) was established with a distinct purpose. It was introduced to facilitate the enforcement of mandatory sustainability disclosures mandated by the CSRD (Corporate Sustainability Reporting Directive). As of 2024, large companies operating within the EU are obligated to adhere to these SR requirements. Unlike the ISSB standards, the ESRS carries legal weight and enforceability within its specified jurisdiction, ensuring that applicable companies comply with the stipulated SR obligations (Wagenhofer, 2023).

3.3. Materiality

Materiality plays a pivotal role in numerous deliberations aimed at upholding or enhancing the relevance of corporate reporting to its intended users (Edgley, 2014).

While the implementation of the concept might pose challenges, relying on the discretion of those preparing the information (IFAC, 2017), the IASB, as it operates on a principle-based approach, has offered a relatively lucid description in its Conceptual Framework. Hence, it asserts that “Information is material if omitting it or misstating it could influence decisions that the primary users of financial reports [. . .] make on the basis of those reports” (IASB, 2018, paragraph 2.11). The IASB provides additional guidance, examples, and illustrative material alongside the financial materiality to help preparers and auditors apply the standards consistently and appropriately (IASB, 2017), to address the challenges such as judgment, subjectivity, and consistency. 

The concept of materiality in the sustainability domain introduces additional complexities compared to its traditional usage in financial reporting. Materiality within the scope of sustainability denotes the significance of an environmental, social, or governance (ESG) matters concerning company's overall sustainability performance and its impact on various stakeholders, which seek to legitimize their actions and behaviors to maintain their social and moral standing in the eyes of stakeholders. The views and interests of various stakeholders (such as employees, communities, customers, and NGOs) play a significant role in determining what is considered material, whereas This assessment is influenced by the need to maintain legitimacy. In long term, avoid disclosing some ESG issues would affect the company's societal consensus and reputation over time. In the realm of business, regaining social agreement and earning back trust, once they've been lost, entails significantly higher costs (Khan et al, 2016) Legitimacy theory underscores the importance of fostering openness and responsibility in businesses. Therefore, legitimacy theory encourages businesses to adopt practices of transparency and accountability from the outset. This proactive stance is aimed at maintaining alignment with societal values and expectations, ultimately safeguarding the company's credibility and favorable standing in the eyes of stakeholders and the public The concept of double materiality closely intertwines with legitimacy theory. Double materiality recognizes that issues can be material not only from a financial perspective but also from a societal viewpoint. By being transparent about their societal materiality, companies uphold their legitimacy by demonstrating responsiveness to the broader concerns of society. In doing so, businesses enhance their credibility, mitigate risks, and contribute to a sustainable and resilient relationship with their stakeholders (Jørgensen et al, 2021). The European Green Deal outlines specific targets and initiatives to achieve climate neutrality, reduce greenhouse gas emissions, and promote sustainable energy, among other goals. This reflects the EU's commitment to addressing climate change while fostering economic growth and job creation.  Hence, the core principles of "double materiality" and the "multi-stakeholder perspective" form the bedrock of EU sustainability standards. EFRAG has introduced the concept of double materiality, which encompasses both "financial materiality" and "impact materiality." It's essential to note that disclosure requirements tied to materiality aren't optional; information must be disclosed if it's considered material. The evaluation of materiality within a company's operations is also subject to external verification, in accordance with the guidelines detailed in the Accounting Directive (EFRAG, 2021). The IFRS Foundation draws guidance and input from a select group of influential organizations, including IOSCO, Accountancy Europe, and IFAC and they have an outside-in-perspective-financial materiality- which showcases how social and environmental matters influence an organization's capacity to generate value.

Incorporating materiality into the sustainability domain acknowledges that a company's value and impact extend beyond just financial metrics, recognizing the importance of being responsive to a broader array of factors that contribute to long-term success and sustainable development.

3.4. Reporting Boundary

The term "reporting boundary" is elucidated as the foundation for establishing the scope within which entities, activities, transactions, and impacts are included in the reporting process (Layne, 2022). Financial boundary based on financial control is not enough for SR which considers sustainability control (Antonini and Larrinaga, 2017). This latter is connected to organizational boundaries and operational boundaries. Organizational boundaries are related to the continuum of ownership structure whilst the other one refers to the value chain. This perspective, adopted by CSRD, is totally new for organizations and must be distinguished especially when evaluation the materiality of climate-related information cross the entire supply chain from upstream to the downstream (European Commission, 2018). The ISSB, in line with TCFD, follows an inside-out perspective through the disclosure of GHG Emissions under Scope 1, Scope 2 and Scope 3.

Conclusion

The echoes of sustainability reports cannot and will not resemble those of financial reports. While financial reports primarily cater to the primary users defined within a conceptual framework, the essence of sustainability reports should be rooted in businesses giving back to society what they receive from it. Many businesses, especially those in sectors with significant environmental impact, share indicators and outputs in their sustainability reports to signal their efforts in preserving the environment and contributing positively to society. However, in our current world, society is cognizant of and evaluates businesses' environmental and social effects.

The anchoring of sustainability reports to specific standards rests on the premise of widespread implementation and providing accurate and reliable information to society. This approach facilitates not only the reduction, even elimination, of carbon emissions, but also progress in social, human rights, and corporate governance aspects. The ESRSs developed by EFRAG are essentially pieces of the puzzle aligned with the goals of the European Green Deal. Conversely, the scope of the ISSBs developed by the IFRS Foundation is narrower than that of the ESRSs in terms of target audience, materiality, and reporting boundaries. Beyond the increasing requirements, the companies will face with SR divergence according to the standards chosen among the two different set of standards, which will lead to higher compliance costs and additional challenges. The collaboration between the two standard developers would smooth the widespread adoption. 

While the argument holds that an excess of information might diminish its significance, it's important to remember that every segment of society is a part of sustainability and that accessing information is a fundamental right. As known from regulatory theories, new regulations bring about political influences, lobbying by interest groups, and stakeholders' attempts to influence standard setters. However, this issue concerns societal interests, and losing legitimacy in the eyes of society is easy, while regaining it is highly costly

Therefore, taking a comprehensive perspective, the collaborative creation of standards by the IFRS Foundation and EFRAG, serving every facet of society, will be for the greater good. This harmonization process is a challenging journey. Numerous parameters will be considered, and standards, similar to the evolution seen in the development of accounting theories, will evolve as they are applied and the impacts of their implementation results shape their trajectory.

Research Funding: This work has been supported by the Scientific Research Projects Commission of Galatasaray University under grant number FBA-1056.

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