Time to Focus on the Forgotten Middle across Financial vs. Non-Financial Information Spectrum
The nature of company information reported outside the primary financial statements — and within the management, discussion, and analysis (MD&A) or narrative reporting sections — can be thought of as falling along a financial to nonfinancial information continuum. At one end are non-GAAP financial measures (NGFMs), which are financial performance measures derived by adjusting GAAP/IFRS-defined totals and subtotals (e.g., adjusted earnings) or based on subtotals not defined by GAAP/IFRS presentation requirements (e.g., free-cash flow, EBITDA, operating profit). On the other end is environmental, social, and governance (ESG) information, which is often described as being “nonfinancial,” though refinements in the literature have also characterized these measures as “extra-financial” or even “prefinancial,” hinting at their ultimate connection to financial measures.
Reporting enhancement efforts often appear to be heavily focused on the two polar ends of the spectrum of financial versus nonfinancial supplemental information. Securities’ regulators and to a limited extent, accounting standard setters, have been strengthening the guidance around the reporting of NGFMs. Similarly, multiple initiatives are aiming to enhance the reporting of ESG information and its related metrics (e.g., greenhouse gas emission measures). Between these two polar ends of company-reported information [i.e., NGFMs (financial) versus sustainability measures (non/extra/prefinancial)], is a swathe of performance measures that have escaped the net of regulatory and standard-setting improvement efforts, including key performance indicators (KPIs) such as financial and operational metrics (e.g., same store or like-for-like sales). These latter measures are more like the “forgotten middle” across the financial to nonfinancial information continuum.
The guidance-setting bodies barely focus on this subset of potentially relevant investment decision-making information (i.e., financial, operational, customer, and intellectual capital metrics). This perceived regulatory neglect motivated a recent CFA Institute member survey, with the objective of assessing the extent to which investors apply and/or experience shortcomings in the reporting of these seemingly forgotten supplemental measures. The results of the survey, based on up to 250 responses to individual questions, were recently published.
Key takeaways from the KPI member survey results include the following:
• Top three most commonly used MD&A/Narrative reporting information. An analysis of the relative application by investors of information contained across 11 identified broad categories within the MD&A/narrative reporting portion of the annual report shows that the top three most commonly applied categories were a) operational metrics, b) contextualizing strategy and business model descriptions, and c) supplemental financial information. Sustainability reporting information was the least applied category (see table below). The findings on relative usage affirm the need for regulators, standard setters, and other authorities (e.g., stock exchanges) to go beyond focusing on NGFMs and ESG information and to also focus on financial and operational KPIs.
Sections within Corporate Report
|n||Never Use||Often or Always Use||Average Score*|
|Description of business model, business plans, and strategy||249||2%||81%||4.27|
|Supplemental financial performance, revenue, asset quality, funding, and liquidity information||249||2%||79%||4.19|
|Capital commitments (near and long term)||249||2%||78%||4.08|
|Principal risks and uncertainties||249||2%||70%||3.94|
|Going concern and business-viability–related information||250||3%||65%||3.82|
|Off balance sheet arrangements||250||2%||65%||3.82|
|Corporate governance information||249||2%||49%||3.51|
|Intellectual capital information||248||6%||44%||3.11|
|Sustainability information (environmental, societal, and reputational risk)||249||12%||25%||2.82|
*The Average Score is the weighted average of percentage responses: 1 (Never Use) to 5 (Always Use ).
• Top five financial and operational metrics. Across a subset of 16 financial, customer, and operational metrics, the top five most-used metrics are NGFMs, organic sales growth measures, gross margin disaggregation, market share, and future revenue potential measures. In contrast, customer metrics (5 of the 16) were clustered below the median ranking of relative usage and perceived reporting quality. The results likely reflect the relatively nascent reporting of customer metrics. In general, the survey found a positive correlation between the extent of use and the perceived quality of reporting of individual metrics.
• Top three intellectual capital metrics. Across a subset of 10 intellectual capital metrics, the top three most-used metrics are research and development expenditure as a percentage of sales, new product/research pipeline information, and intellectual property expiry exposure (revenue from products coming off patent in the next “x” years). As with the financial and operational metrics, the survey found a positive correlation between the extent of use and the perceived quality of reporting of individual metrics.
• Similar KPI & NGFM reporting concerns. NGFM reporting concerns also apply to financial and operational KPIs. Staple concerns around the reporting of NGFMs can be extended to other KPIs. These include: a) the lack of comparable reporting of these performance measures across similar business models; b) period-to-period inconsistencies in management definitions; c) misleading positive bias; and d) questionable reliability due to the lack of or inadequate assurances. These shortcomings were highlighted in the 2016 CFA Institute report “Investor Uses, Expectations, and Concerns on Non-GAAP Financial Measures.” Below are member comments reflecting concerns on the incomplete and often poor quality of reporting of these KPIs:
Sales per square foot (sq. ft.) is not uniform across Real Estate Investment Trusts (REITS) and retailers — some split out large shops and small shops, some split out selling sq. ft. and total sq. ft., occupancy also not uniform, rent per sq. ft. not uniform.
Companies tend to fudge their organic/same-store revenue numbers. They also often choose inappropriate definitions for non-GAAP measures, for example, excluding share-based payments or restructuring costs which are actually ongoing. I’ve even seen efforts to rig cash flow numbers by excluding pension or other costs.
Proposed Way Forward
Given the illustration by our member survey of either the widespread or reasonable use of financial, operational, customer, and intellectual capital KPIs by investors (and the accompanying problematic reporting), a strong case can be made for strengthening their related reporting guidance. In this vein, various standard-setter and regulator initiatives can fulfill a pivotal role in enhancing the reporting of these measures. This includes the IASB management commentary practice statement update, enhancing country MD&A/narrative reporting guidance (e.g. the US SEC modernization of disclosures, UK Financial Reporting Council (FRC) strategic reporting guidance), and the effective incorporation of the International Integrated Reporting Council (IIRC) integrated reporting principles by companies.
The regulatory guidance that exists for NGFMs should also be extended to these other KPIs to ensure greater clarity and consistency in their reporting, as hinted at by the member comment below, which points to both the problem and the solution (i.e., appropriate disaggregation):
I’ve encountered two companies this year that have outright lied (in my opinion) about organic vs. nonorganic revenue growth. This has been a systemic issue with many acquisitive companies. It would be extremely helpful if there was a really simple requirement to have a breakdown of organic vs. non-organic revenue growth in a more standardized format … this would at least prevent the kind of outright lying (or intentional misleading) I have come across a number of times.
Another idea that has gotten traction in several stakeholder conversations to ensure consistent reporting of KPIs over time, is the need for the three-year standstill requirements by securities regulators, whereby issuers have to stick to the same definition of individual metrics for a period of three years.
There is also a potential opportunity for a private-sector-driven industry/business model specific definition of relevant KPIs. It can be quite a balancing act between pursuing desirable comparability versus allowing companies discretion to “tell their story,” bearing in mind that these KPIs are voluntary supplemental measures and are not meant to be mandatory standardized information. Examples of business model-relevant guidance that currently exists includes the real estate investment trust (REIT) sector definition of funds flow from operations (FFO) and the gold mining sector definition of cash cost per ounce.
Finally, in tandem with improving reporting guidance, the audit standard-setting authorities and regulators, and the audit profession, should evaluate and respond to the demand for increased assurance of this type of information.
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