Explaining company performance: using ‘unofficial’ financial metrics
We can all think of many matters COVID-19 has affected this year – but the use of non-statutory performance measures in company reports might not be top of your list.
KPMG has just released a study on ASX200 companies use of ‘unofficial’ measures of financial performance – while this area may not seem an obvious source of headlines, the financial press and analysts have in fact been interested for a long time.
So, given the world (outside the US) took so many years to agree on one set of financial standards (International Financial Reporting Standards, or IFRS Standards) why do we need unofficial, or ‘alternative’ metrics.
The use of non-statutory measures is greatly valued by investors as a means for management to explain company performance, providing useful insights and telling a story that is unique to their organisation. That these measures feature heavily as key performance indicators in management incentive plans aligns the interests of directors, investors and management and reinforces their value to the company’s value creation story.
Any standards, no matter how principles-based, as IFRS Standards are, have a certain rigidity and there can be occasions where an alternative approach (outside of these constraints) proves to be a helpful communication and evaluation tool.
But the risk is that this flexibility can be stretched too far. Globally there is an acknowledged inconsistency in their use along with the quality of information provided supporting them. This is why, in Australia, these measures are currently allowed in the directors’ report, but not inside the core financial statements. Even in the Operating & Financial Review, or OFR (part of the director’s report) they have to be reconciled to statutory measures and given no more prominence than the statutory equivalent.
The international accounting standard-setter, the IASB Board, is now planning to go one stage further and require these non-statutory measures to be included in the financial statements, believing it will ensure global comparability and transparency and enhance the discipline with which they are prepared, making them subject to external audit.
In Australia, we have had ASIC regulatory guidance and active surveillance on the presentation of non-statutory measures in annual reports and other corporate documents for almost a decade. The focus of this guidance is to minimize the possibility of misleading users and it has meant that non-statutory measures communicated by Australian companies are, in the majority, presented in a more transparent and disciplined way, albeit not routinely subject to separate audit or review.
The key findings of our study of over 100 ASX200 company reports from 2019 and 2020 include:
- 97 percent of companies reported at least one non-statutory measure in the OFR – underlying profit being the most frequent
- The proportion of companies recording impairments of non-financial assets as reconciling items rose from 29 percent in 2019 to 51 percent in FY20, while restructuring and/or redundancy costs rose from 21 percent to 31 percent.
- 21 percent increase in use of non-statutory segment (ie business unit) measures for FY20 over FY19 due to COVID-19 environment.
- 88 percent of entities used non-statutory measures to determine performance incentives awarded to key management personnel
Our analysis reveals a notable increase in the volume of adjustments to non-statutory measures in directors’ reports during FY20. This shows the impact of the Covid-19 crisis on companies’ performance and financial position, although only a small number identified specific reconciling items as arising solely from COVID. But the number of companies recording impairments of non-financial assets and restructuring and/or redundancy costs as reconciling items has risen significantly this year.
We were a little surprised that only 75 percent used non-statutory measures as their segment measure of performance in the notes to the accounts, compared with the 97 percent of directors who used them in the OFR to explain and contextualise their company’s performance and financial position – notably on underlying profit. We would generally expect similar measures to be used by management to assess performance of key business units as is used to explain performance to investors in the directors’ report.
We also have a slight quibble with the IASB Board’s exposure draft in its plan to mandate the disclosure of specific non-statutory measures, referred to as Management Performance Measures (MPMs), in the notes to the financial statements. The proposal curiously limits MPMs to sub-totals of income and expenses. In Australia it is not uncommon for companies to use measures like free cash flows and return on equity to communicate their financial performance. We believe it would have been better for investors if the ED had allowed these as well.
As non-statutory measures will continue to have a role to play in explaining company performance – enhancing transparency and discipline can only be seen as a good thing.