The metric system

Regulatory and market initiatives are affecting aspects of the reporting of metrics, and giving investors new information to attempt to gather, understand and use. In light of this, the Financial Reporting Council’s Financial Reporting Lab (‘the Lab’) initiated a project on performance metrics to understand whether the changes have met the needs of investors, and what investors consider to be best practice reporting.

Different approaches

The Lab has been speaking to companies and investors throughout 2018 about their approaches to reporting, monitoring and use of performance metrics. Not surprisingly, these conversations highlighted that the selection and reporting of metrics is key to investors’ assessment of the credibility of management. Investors seek to understand performance through the eyes of management, and the metrics being used internally are instructive for them in assessing what management is focusing on and trying to achieve.

Investors not only want to understand how a company monitors, manages and views its own performance, but may also use the metrics for a range of other purposes, including to:

• Assess a company’s use of capital or its capacity to add value 
• Value a company 
• Get a greater understanding of a company’s business model, strategy and risks 
• Understand whether management are incentivised to drive the strategy of the company 
• Make a forecast or assessment of future performance 
• Understand a company’s position within a market more fully; or
• Make an assessment of management credibility

These wide-ranging uses raise a number of questions for companies and investors as to which metrics are most important to disclose and to provide the best picture of performance. When discussing performance metrics, the project addressed all types, including GAAP, non-GAAP and wider metrics. Investors use all information that they consider may be useful, so the presentation of a range of metrics was felt to be helpful.

Investor perspective

Our initial discussions with investors resulted in the publication of Performance metrics – an investor perspective in June. That report outlined what investors want from metrics, namely that investors want metrics to be aligned to strategy, transparent, in context, reliable and consistent.

“Investors expect the board and audit committee to be challenging the relevance and reliability of metrics”

The investor perspective also posed a series of questions for company management and boards to consider when carrying out an assessment of the effectiveness of their performance metric reporting. These questions remain relevant even as the reporting season approaches.

The final project report, published in November, provides practical examples of how the principles can be addressed, in light of the challenges faced by companies when seeking to meet those expectations and the requirements of the regulatory framework. The report also expands on the investor views which informed the five principles and provides a high-level overview of how investors use metrics.

Investors told us that they want to understand what metrics the management and board is monitoring and managing internally. Investors use metrics for a range of purposes, but one of the key reasons is to understand the direction of the company. Metrics that are not only outputs of management over a historic period are considered most helpful. Metrics that are aligned to strategy are key, and companies can display how their metrics are aligned to strategy by: disclosing metrics which management uses internally, including where and how they link to remuneration; providing a combination of metrics linked to their strategic objectives, competitive advantage and business model, which may involve incorporating operational metrics alongside higher-level KPIs; and explaining what the metrics are and why they are important.

• Do our metrics clearly link to our company’s strategy and value drivers? Have we addressed all relevant financial and wider metrics?
• Are we reporting the metrics that are being monitored and managed internally?
• Is there a clear link between the metrics that drive our business model and strategy, and our remuneration policy?

Meaningful metrics

If performance metrics are to be of value they must be meaningful, and a significant element of that meaning comes from metrics presented transparently. Displaying metrics in a transparent way, can be achieved by: providing an explanation for the use of metrics and a full break down of non-GAAP to GAAP metrics; being consistent and using the same, transparent format over a number of years; and demonstrating that metrics that investors would expect to be attributable to specific numbers in the financial statements or reconciliations are directly drawn from them.

• Is it clear to investors why we use these metrics and what performance they are trying to represent?
• Are we transparent about the way in which our metrics are calculated and defined?
• Where we report non-GAAP metrics, do we explain why and how they more appropriately represent our business model and strategy? Where we make adjustments to exclude cost items do we also exclude the related gains? Do we explain why we have made specific adjustments, at least at a material level?

The presentation of performance is key to understanding what went well and what went less well, and an explanation of the wider context is an important part of this. This includes explaining what a company was trying to achieve and what it has achieved, with explanations for where this is good or poor; the company’s position and prospects in the market and its longer-term objectives. Companies can ensure that their metrics are presented in context by: disclosing targets for metrics, showing where performance has not achieved its target; referencing an industry benchmark when disclosing performance where this is relevant; and providing a market context which is linked to how that context affects the company.

• Do we explain what performance we were expecting to achieve, what we actually achieved, and why?
• Do we explain what performance our metrics are trying to achieve in the future, and provide an understanding of our overall long-term objectives?

It is important to investors that metrics be reliable. Investors want to understand that there is sufficient governance and oversight over the use and reporting of metrics and they expect the board and audit committee to be challenging the relevance and reliability of metrics. Companies can help report that their metrics are reliable by: making the governance and oversight over metrics clearer; explaining the levels of scrutiny to which metrics have been subjected; and highlighting third party information in conjunction with internal information where relevant to strategic objectives.

• Do we provide an overview of how our metrics have been developed and monitored to allow investors to assess their reliability?
• Do we explain the level of scrutiny to which metrics are subject to allow an assessment of whether they are fair, balanced and understandable? Do we outline the Audit Committee’s (or other Executive or non-Executive Committee) oversight and whether they consider the appropriateness of specific metrics or adjustments in addition to the way in which the metrics are reported? Do we explain what additional scrutiny may be given to adjusted metrics used in remuneration?
• Is the boundary of each metric clear (for example, the timeframe, parts of business covered etc)?

The role of standardisation

Consistent reporting, including of definitions across time, and across reporting formats, helps build credibility. There were differing views on the balance between alignment to strategy and the benefits of standardisation. Most investors supported the disclosure of metrics monitored and managed internally. However, ultimately investors spend a great deal of time comparing companies, and as such, some investors were positive about more standardisation. Companies can show that their reporting is consistent by providing: consistent information across reporting formats, even if it is presented differently for different audiences; performance with reference to industry benchmarks or standards; and at least a five-year track record. Questions companies can ask themselves when considering whether their metrics are consistent include:

• Are our metrics consistent year-on-year? If our metrics have changed, do we provide a clear explanation as to why the change has been made and why the new metric is better? Do we provide comparatives for a number of years?
• Are our metrics calculated consistently every year? If they are not, do we provide an explanation for any change, and an outline of the impact of the change?
• Are the same metrics reported consistently across the investor presentation, preliminary announcement, annual report, press releases and other documents?
• Is a track record of our performance provided, preferably over five years?
• Are our metrics consistent with an industry standard or our close competitors? If not, 
• do we explain why our metrics are more appropriate?

The practical examples included in the Lab’s final report demonstrate how companies have overcome the challenges of materiality, reliability, presentation and commercial sensitivity in order to communicate more effectively with their investors. Companies may find the insights from investors above, and the company examples, helpful in moving their reporting closer to the investor expectations outlined in the five principles and questions.

The Lab encourages company management and their boards to consider the questions from investors, and the highlighted examples, in assessing whether their reporting is as effective as possible at communicating their story, performance and outlook.

Phil Fitz-Gerald is director of the financial reporting lab at the FRC