Improving Financial Reporting

Today’s financial crisis is a harsh reminder that our financial reporting model, created more than 70 years ago, does not provide the information necessary to allow investors to understand business risks and performance. This ‘information gap’ requires a fundamental rethinking of the information that corporations should be disclosing to keep investors properly informed about corporate financial prospects. Given the cost and ramifications of the credit crisis and drastic slowdown in the economy, the US and the entire international financial community cannot afford to ignore the urgent need to enhance business reporting.

I was honoured to spend the past year as a member of the SEC Advisory Committee on Improvements to Financial Reporting (CIFiR). Our firm heartily endorsed the recommendations of the committee, calling its report “a catalyst for future action to make public company financial reporting more relevant, accessible and reliable.”

CIFiR’s August 2008 report included a number of recommendations for improving financial reporting. One recommendation, ‘Disclosures of KPIs and Other Metrics to Enhance Business Reporting’, urged the SEC to “encourage private-sector dialogue, involving preparers, investors (including analysts), and other interested industry participants, such as consortia that have long supported KPI-like concepts, to generate understandable, consistent, relevant, and comparable KPIs….”

Key performance indicators (KPIs) are measures used to evaluate progress made toward an objective. The most effective KPIs are not only leading indicators of performance, but also provide insight into intangible factors such as intellectual assets, human capital and customer relationships.

For example, it would be of great value to real estate investors to be able to assess qualitative factors, such as the effects of a volatile market, rental rates, leasing incentives, emerging markets, capital expenditures and occupancy and/or operating costs. Equally useful for investors looking at manufacturers might be measures of customer satisfaction, conformity to product requirements, characteristics and trends of process and products, and cost effectiveness of suppliers. Similarly, retail bank investors would want to assess rate of borrowing risk, average number of default borrowers per year, rate of default risk or the ratio of active depositor to dormant depositor.

It is important to note that there are no magic-bullet KPIs for an industry sector. There could be 10 to 12 typically used in manufacturing, more than 25 used in banking and another 25 used for the insurance industry. The goal – and the challenge – is to identify which five or so are appropriate for any given company based on its business model.

Surely, providing key performance information on a broad range of parameters would enable or enhance assessment of the quality, sustainability and variability of a company’s cash flows and earnings. However, such performance indicators are rarely found in existing financial reports. As demonstrated in the examples given, KPIs would vary by industry to correspond with unique features of each environment.

US CFOs also agree that our financial reporting system needs an overhaul. In a recent Grant Thornton survey of nearly 700 US CFOs and senior comptrollers, 73% said that financial reporting was too complex to be understandable by investors, and 84% would support supplementing financial statements with non-financial measures that provide more relevant information about their organisation and its value drivers.

For the greater good of the capital markets, Grant Thornton encourages the business community to join us in our efforts to bring the CIFiR’s recommendation to life. The Enhanced Business Reporting Consortium (EBRC), of which Grant Thornton is a founder, in collaboration with Gartner, is engaging business executives, financial analysts and investors in a study to identify which KPIs are most important to analysts and investors. This private-sector initiative to develop KPIs is necessary to ensure that capital market participants have a solid understanding of exactly what is being measured. This effort will also ensure that agreed-upon KPIs permit direct comparison between companies within an industry.

A scan of corporate annual reports typically reveals a presentation or discussion of marketshare. Defining marketshare is no simple task. Do all food and beverage companies define and measure marketshare in the same way? Is there consistency in defining marketshare across the financial services and consumer goods sectors? The EBRC/Gartner collaboration will produce accessible definitions of performance indicators – definitions that explain both the components of a metric and how that metric is calculated.

Our primary purpose in raising these issues is to provoke discussion about KPIs and then enlist the support and leadership of CEOs in identifying and publishing the KPIs they use to run their respective businesses. Our secondary purpose is to provoke a similar discussion between CEOs and industry analysts to arrive at some consensus about the KPIs that would be of greatest value to investors.

The development of KPIs is only one element needed to create a new global framework for business reporting. The highly beneficial results of these efforts will translate to robust capital markets, markets that thrive on a steady flow of timely, comprehensive, relevant and reliable information.

Could KPIs have prevented the present financial trauma? Probably not, but it should be the accounting profession’s goal to work continually on behalf of the investor to provide clear and relevant information that can be relied upon for making informed decisions. KPIs represent a major leap forward in doing so.