Generico Report identifies five areas for improving corporate reporting. By Nick Topazio, business and financial reporting specialist, CIMA. This is the first in a series of three articles on the Report Leadership initiative.
The nature of financial statements has changed dramatically over the past few decades. Around 25 years ago, it was estimated that 80% of the market value of the S&P 500 was reflected on the balance sheet. The remaining 20% covered intangibles and future growth opportunities. Today that ratio is roughly reversed.
It therefore falls to narrative reporting for directors to set out and explain the remaining contextual information. This includes the business environment, strategy, forward-looking information and key performance indicators (KPIs).
The Report Leadership initiative, which includes CIMA, PwC, Radley Yeldar and Tomkins, was set up to challenge thinking on corporate reporting. It has produced a company report on a fictitious firm, Generico. The Generico Report was designed as a blueprint to stimulate debate and focuses on three areas: modelling the future, rethinking the financials and effective communication.
In terms of modelling the future, the report identifies five areas for improvement in corporate reporting.
Value creation
Users want to be able to assess management accountability from the annual report. Have managers protected and added value to investors’ capital? Current and potential investors also want to gauge future value growth. Before investors can start to model the future they need to understand how value has been created in the past. However, financial statements usually fail to explain adequately the value generated for shareholders given the company’s capital employed, risk profile and required returns.
Traditional financial reports show as costs the returns paid to some stakeholders, such as employees and debt holders. However, they fail to take into account a charge for the expected return required by equity shareholders.
The Weighted Average Cost of Capital (WACC) indicates the return that can be expected from the capital employed, given a business’s relative risk profile. One of the aims of the Generico Report is to help users understand the quality and sustainability of future cash flows.
They can then assess whether the return generated on the capital investment exceeds the estimated WACC. This should allow investors to decide whether value is being created or destroyed.
Ideas in the report for improving this area of reporting are:
- a section dedicated to the group’s performance in creating value
- clear identification of the group’s key measures for assessing value creation
- publication of the non-GAAP measures used by management to supplement the traditional financial data
- disclosure of the group’s estimated WACC and value creation metrics such as cash-added value and economic return
- the inclusion of a comprehensive set of non-GAAP financial data, including historical trend and forecast data
- a clear explanation of actual performance against previous year targets
- details of how the business has used cash generated during the year
- the provision of alternative scenarios and resulting sensitivities in financial numbers to help users model the future.
Forward-looking orientation
Traditional financial reporting focuses on past performance. This is important for management accountability but is inadequate as a guide to future returns. Investors need forward-looking contextual and non-financial information to support their cash flow projections.
Managers are usually reluctant to publish forecasts. They want to avoid giving sensitive information to investors and they fear litigation if they fail to achieve forecast results. Investors want more information about a company’s expectations of future performance and what will drive it.
However it is in management’s interest to put forward a convincing investment case. This requires an explanation of the way the company’s markets and performance could develop. The Generico Report suggests the following ways to help investors model the future:
- use forward-looking attitudes and language throughout the report
- use the group’s strategy as the basis for describing current and future performance
- describe the external trends likely to affect the group’s business environment, supported by quantifiable forecast data, externally sourced
- give targets for each KPI
- identify products in the pipeline and their market potential
- provide an outlook section for each operating division.
Business environment
To understand and evaluate a company’s strategy and performance, investors need a clear grasp of its business environment. They need to understand the market forces - regulatory, macro and competitive - that affect business performance. They also need to consider forecasts of market trends and factors likely to have an impact on the business.
All too often annual reports describe a company’s performance in isolation from its business environment. Even when the external context is discussed the narrative is often too backward-looking or high-level to be helpful.
Investors that specialise in a particular sector will have their own views on market trends. They will know how well a company can respond to developments. But they will still be interested in management’s interpretation of market trends as this will affect strategic decision-making.
Other investors will benefit from understanding a company’s markets. Without knowing the context in which a certain level of performance has been achieved, performance may be misjudged and strategy misinterpreted. To improve investors’ understanding of the business environment, CIMA’s Report Leadership team suggests the following improvements:
- dedicate a section to setting the group’s business activities in their market context
- discuss the marketplace and the trends and factors affecting the group’s sales within it
- discuss competitive and macro-economic factors
- report externally sourced market statistics
- identify competitors and quantify their market positions
- include both historical and forecast market data.
Strategy
To assess the quality and sustainability of a company’s earnings, investors need to understand its strategy. They need to know how management intends to address market trends and the threats and opportunities inherent in such developments.
Many statements lack the detail necessary to understand the priorities for action, the resources to be managed, and how success is measured. Investors also need to be clear about the relationship between strategic objective, management action and executive remuneration.
Investors want a clear statement on a company’s direction and a timeframe over which to assess the achievement of strategic objectives. To address these concerns the Generico Report suggests the following:
- use the group’s strategy to underpin the whole report
- clearly outline the group’s strategy and priorities early on in the report
- set out a strategy progress statement - for each strategic priority identify the person ultimately responsible for its delivery with a clear link to relevant KPIs, performance and risk
- use graphics as well as text to express the strategy simply, consistently and memorably
- identify actions necessary to make the strategy a reality
- use the strategic priorities to bring consistency to the discussion of segmental performance.
Key performance indicators
Managers use critical measures to help them track company performance and progress. If disclosed to investors, these KPIs would improve the understanding of progress and achievements within a business. However, this rarely happens in any meaningful way leaving investors’ external perceptions of performance potentially at odds with that of the management.
Traditional measures of performance contained within statements are also inadequate for this purpose. It takes both financial and non-financial KPIs to give a clear picture of strategic progress. Often non-financial KPIs will give an early indication of the future direction of financial KPIs. To be effective, KPIs need to be clearly linked to the achievement of strategic objectives and realistic targets.
Best practice in this area of reporting incorporates the following principles:
- make clear the distinction between output measures and KPIs
- state early in the report where KPIs can be found
- provide a clear link between strategy and KPIs, setting out a progress statement giving the key measures of success for each strategic priority
- give each KPI a definition, previous year comparisons of performance and targets for the forthcoming year
- disclose KPIs at a group and segmental level, depending on the availability of data
- explain the actions taken by management to improve and maintain their performance on each KPI.
The Report Leadership initiative does not anticipate a sudden shift in corporate reporting towards these proposals. Some will feel that they go too far - others that they do not go far enough. But each proposal adopted will be a step towards improved corporate reporting.
Future articles in this series will cover ‘effective communication’ and ‘rethinking the financials’. For illustrations of the proposals, to participate in the debate, or simply to find out more about this initiative, visit Report Leadership.