Sugar-coating performance measures

As part of an ongoing (and probably lifelong) quest to visit all 50 states in the US, I was fortunate enough to go to New York, which was certainly one bringing more excitement than Delaware or North Carolina.

While clearly excited to see some of the more famous sites, the greedy child inside me was also taken by the M&Ms store. One trip later, I emerged with far too much chocolate in an incredibly bright yellow bag. The only issue with this is that it appeared to limit our entry into some of the nicer restaurants around Central Park. After wandering for far too long, it became clear that I was not classy enough for these establishments. Clearly, I refused to ditch the bag and we settled for a slightly lower bar of eatery, much to the disappointment of Mrs Deller.

Anyway, a similar problem is emerging with management performance measures (MPMs) in the financial reporting world. Many preparers simply cannot resist the temptation of them, and they have found their ways into the financial statements of many large entities. Much like me in a nice New York restaurant, they are becoming increasingly scrutinised and often unwelcome.

Distortion tactics

These MPMs are alternative measures used by companies to highlight performance. In their purest form, they can be used to highlight some key metrics or measures for the users to assess. Unfortunately, all too often they are used to provide ‘adjusted’ profit figures, which can conveniently seem to be higher than those pesky statutory measures.

The use of these came to a head during the height of the pandemic, with a number of companies disclosing a measure of ‘EBITDAC’, stating what the earnings would be before interest tax, depreciation, amortisation and Covid-19. Such a measure was, thankfully, widely criticised and therefore not widely adopted.

The regulators are also highlighting this as a problem. In the UK, the Financial Reporting Council (FRC) issued a warning to companies in late 2021. In its annual review of financial statements, it found that these MPMs generally made companies look more profitable than the statutory measures required by accounting standards.

In a review of 20 listed companies, the FRC found that 19 excluded more expenses than income in producing these ‘underlying profit’ calculations, meaning that profits were increased, sometimes turning operating losses into operating profits.

Forefront figures

The findings highlight that these measures continue to be displayed more prominently than the statutory measures. This continues to be echoed by final-year students at the University of Liverpool, who often note that the headline figures in annual reports mention ‘profit before adjusting items’ or ‘underlying profit’ far more than the statutory profit figures.

These figures can sometimes only be found many pages in, often treated slightly dismissively as if to say ‘well, I guess this is technically the profit figure, but let us show you what we think the real figure is’.

IASB wades in

This problem is far from just being a UK-based issue. The International Accounting Standards Board (IASB) has included this in the Primary Financial Statements project, which is looking at whether the presentation and disclosures around financial statements can be improved.

In its January 2022 meeting, the IASB confirmed a number of items regarding these MPMs. The decisions aren’t to prohibit these, or limit their usage, but it does want clarity. The IASB has tentatively confirmed that it will require an entity to disclose a reconciliation between an MPM and the most directly comparable subtotal or total specified in IFRS Accounting Standards.

This proposal has been generally met with approval, particularly from users. Perhaps unsurprisingly, some preparers have raised concerns, stating that there should be an exception for confidential information. The IASB does not propose such an exception, stating that the use of MPMs is optional and that if firms wish to use them, there should be full disclosures around what they include.

In addition to this, the IASB has also tentatively confirmed that it will require an entity to disclose why an MPM shows management’s view of performance. As part of this, preparers will be required to explain how the MPM is calculated and how it is useful for the users.

US still cogitating

While the proposals noted do seem to potentially increase clarity, it is important to note that there is no significant move proposed by US regulators. There is a slight issue, in that the Financial Accounting Standards Board has no authority over alternative metrics, with this falling into the jurisdiction of the Securities and Exchange Commission (SEC).

While the SEC has raised concerns, and even issued penalties to companies in the past, there has realistically been little action or regulation proposed to reduce the proliferation of these potentially ‘sugar-coated’ measures of performance.

This is identified as a global reporting issue, and one that is not easy to resolve, but the major regulators appear to be taking a different approach. The IASB may be looking to minimise its usage in IFRS financial statements, but it may well be that the US becomes the home of the MPM as well as the M&M.