If I was to report that my company’s net income for 2008 was 100, it would not tell you very much. If I add that net income has increased by 3%, you start to learn a little more. If I now give you a complete set of financial statements, you will have a clearer picture of my company’s performance and financial position. But is that all you need? Do you know anything about my company’s strategy, the risks it faces, the resources at its disposal?
Companies in some parts of the world provide a supplementary narrative report (for example, ‘management’s discussion and analysis’ or ‘operating and financial review’). The nature and scope of these has largely been a matter for governments and securities regulators. But last month the IASB published its own draft guidance for management commentary.
It is proposing that the information to be included should present management’s view on not only what has happened during the period, but also why management believed that it happened and what the implications might be for the company’s future. Specifically, it proposes that the management commentary should accompany the financial statements and should include information about the nature of the business; its objectives and strategies; its resources, risks and relationships; its results and prospects; and the critical performance measures used by management. This looks straightforward and uncontroversial.
An international PricewaterhouseCoopers survey of investors and analysts in 2007 (Corporate reporting: Is it what investment professionals expect?) revealed little investor demand for prescriptive standards on narrative reporting. Here again, the IASB is not being controversial as the proposed guidance would not be mandatory. This is not to say that information about markets, strategies and value-creation isn’t important. On the contrary, investors and analysts consider it critical. However, narrative reporting in annual reports was seen by some respondents to the survey as more of a public relations tool than a source of information that helps to place the financial statements in context. One exception was when talking to specialists in industries that use established metrics to assess performance. For example, retail analysts were interested in same-store sales or sales per square foot, and telecoms analysts wanted to know about average revenue per user.
Of course, alternative measures of performance attract strong opinions both in favour and against. The US SEC generally discourages or prohibits adjusted earnings measures, particularly on the face of the income statement; in the Netherlands, both the stock exchange regulator and Institute for Public Auditors have opposed the use of measures like EBITDA. On the other hand, in France, the local standard setter has recommended separate reporting of certain line items and sub-totals in income statements, while in the UK alternative performance measures are accepted provided they are explained and the GAAP information is given equal prominence. This approach is broadly in line with the 2005 recommendation of the Committee of European Securities Regulators.
The management commentary proposals and IFRSs themselves seem to be aligning more with the information used by management to run the business. IFRS 7 requires financial risk disclosure based on information provided internally to key management personnel. Segment analysis under IFRS 8 is driven by information used by the chief operating decision-maker. And the recent discussion paper on financial statement presentation refers to a ‘management approach’ to classifying items in the financial statements. At a conceptual level, there is a lot to be said for aligning external reporting with information actually used to manage the business.
Where alternative performance measures are presented, the IASB draft proposes that this fact should be disclosed. Importantly, the measures should then be defined, explained and reconciled to the financial statements – a proposal not unlike some existing practices.
Does all of this mean that alternative measures of earnings might be gaining more widespread acceptance, at least at the IASB? Might the management commentary become the natural home for alternative performance measures? Used responsibly and consistently, and properly explained, such measures can add a great deal of colour and aid understanding when presented alongside financial statements. The key is to understand what has been included or left out and why, and to be presented with the data in a readily accessible and comprehensible manner. Surely even the strictest of regulators would agree with this approach in principle.
I would be interested in your thoughts, either by commenting here or by email.
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