Following the demise of the OFR (Operating and Financial Review), UK legislation in the guise of the Companies Act 1985 has adopted the requirement for an Enhanced Business Review (EBR) which broadly governs narrative reporting and the publication of certain KPIs for all but the smallest of companies in accordance with the EU Accounts Modernisation Directive. Although, the reporting of environmental and employee KPI's remains controversial and confusing, the requirement to produce financial KPIs is mandatory, with much less scope for manoeuvre.
For the record, the statutory OFR has disappeared and the ASB's (Accounting Standards Board) Reporting Standard (RS1) has been 'demoted' from a standard, to a statement of best practice. Although voluntary, many companies have elected to produce OFR's some of which have been completed as though RS1 was in force. Nevertheless, practice is generally varied and few have included relevant KPI's.
On the other hand, the requirement to produce financial KPI's is mandatory for all companies (quoted or not) except the smallest, for year ends commencing on or after the 1 st April 2005. So, for example, companies with a 31 st December year end will now be considering the disclosures that will be published with their Annual Reports and Accounts early next year. Unlike the OFR, which was only required on a group basis, the EBR is required for all of the reporting entities in a group unless they slip into the 'small' category (currently less than 50 employees, turnover under €7.3m and/or balance sheet total less than €3.65m). But unlike the OFR, which set out explicit disclosures about KPIs, for example method of calculation and sources of information used in arriving at the KPI, the EBR is much less prescriptive. There are also severe penalties for Directors who knowingly or recklessly fail to comply – which should concentrate minds. Likewise, auditors are going to have to state that the EBR is consistent with the accounts.
Companies are required to produce KPIs "to the extent necessary for an understanding of the development, performance and position of the business of the company." Unlike non-financial KPIs which only need to be disclosed where "appropriate", it is inevitable that companies will need to disclose financial KPIs.
For many companies, the disclosure of financial KPI's will be undemanding, yet there are a number of important commercial, process and systems issues to consider as companies begin to contemplate exactly what they are going to say for the first time.
Received wisdom, supported by large accounting firms such as Deloitte, suggests that four to 6 KPIs is about the right number of items to disclose. But what exactly should be disclosed?
Most companies have a large number of financial and operational KPIs, particularly on a group-wide basis, so the pool of available KPIs can be quite large. There is also the complication that KPI's, even within the same group, can include variants calculated on a slightly different basis. But in broad terms the KPI's most likely to be included in the EBR are the KPI's that management use themselves to manage the business.
Nevertheless there are other factors to consider, bearing in mind the potential awkwardness of disclosing a certain KPI one year and, in unfavourable conditions, deciding to do something else in a future year. It seems clear therefore that any disclosable KPIs should be very well understood and controllable. A good question to ask might be "what would these KPIs have looked like in the last 3 years and would this have given rise to any embarrassment or unforeseen commercial sensitivity if disclosed externally?"
In a similar vein, it would be useful to explore the KPIs used more broadly across the industry and their method of calculation to determine whether the KPIs you intend to disclose are out of line with industry trends.
But it is also important to consider some of the long term issues surrounding KPI's, particularly if current proposals in the Companies Bill due to hit the statute books early next year take effect. In particular, the possible requirement to comment on "trends and factors" likely to affect the future performance of the company.
Given these more onerous requirements (which were in the OFR) and are likely to take effect when the Companies Bill becomes law, it is vital that the KPIs reported are deeply embedded in the companies reporting processes and systems. This is not only important from the point of view of communicating essential KPIs throughout the organisation but also from the point of view of managing directors' liability.
In the absence of 'Safe Harbour' provisions like the US, it is important that forward looking statements about performance based on current KPIs and patterns are defendable and supported by rigorous processes and systems which unequivocally demonstrate that the directors have acted properly and in good faith. In other words, if forward looking statements turn out to be off the mark, directors can fall back on well documented systems and processes which show that at the time, the forecast information was not unreasonable.
From a systems point of view, it means that scorecards, dashboards, forecasting, planning and budgeting systems become much more important. Scraps of paper, unconnected spreadsheets and PowerPoint presentations are unlikely to be sufficient.
So this is no time for complacency and in the coming months, directors and financial managers should not only be turning their attention to financial KPIs but also the systems and processes on which they rely.
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