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Fluctuations in world economies the past fewyears have prompted organizations to rethink the way they define, assess and measure corporate performance. Board members andexecutives are continually seeking ways toenhance the tools that link corporate strategy to performance and so to improve effectivecommunication with investors and stakeholdersin their narrative reporting.

It’s not what youthink it isThe importance of narrative reporting

Narrative Reporting

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Information provided in financial statements alone maynot be sufficient for investors and stakeholders to gaugethe economic value that a company has already createdor its value-creating potential and to foresee thesustainability of current performance and cash flows.

Providing consistent quantitative and narrative reports toaccompany financial statements is key to enhancing therelevance and transparency of the information disclosedby a company. Narrative reports can be presented in theform of “Management Discussion and Analysis,”“Operating Financial Review” or other “ManagementCommentary.” Narrative reports are reinforced byfinancial and non-financial Key Performance Indicators(KPIs) that support the explanation of business strategyand explain progress towards stated goals.

IFRS Practice Statement Management Commentary (MC)On 8 December 2010, the International AccountingStandards Board (IASB) published an InternationalFinancial Reporting Standard (IFRS) Practice StatementManagement Commentary, a broad, non-bindingframework for the presentation of narrative reporting toaccompany financial statements prepared in accordancewith IFRS.

Management Commentary is a narrative report thataccompanies, but is presented outside of, the financialstatements, setting out management's explanation ofthe enterprise's financial condition, changes in financialcondition, results of operations and causes of changesin material line items. Many entities see ManagementCommentary as an important element of theircommunication with the capital markets,supplementing, as well as complementing, the financial statements.

In a press release, the IASB said that managementcommentary fulfils an important role by providing usersof financial statements with a historical as well as aprospective commentary on the entity’s financialposition, financial performance and cash flows. It servesas a basis for understanding the management’sobjectives and strategies for achieving those objectives.

The IASB added that the Practice Statement allowscompanies to adapt the information provided toparticular aspects of their business, including the legaland economic circumstances of individual jurisdictions.This flexible approach will generate more meaningfuldisclosures about the most important resources, risksand relationships that can affect an entity’s value andhow they are managed.

The Practice Statement is not an IFRS. Consequently,entities applying IFRS are not required to comply with it.IASB Chairman Sir David Tweedie said, “ManagementCommentary is one of the most interesting parts of theannual report. It provides management with anopportunity to add context to the published financialinformation, and to explain their future strategy andobjectives. It is also becoming increasingly important inthe reporting of non-financial metrics such assustainability and environmental reporting. Thepublication of this Practice Statement will benefit bothusers and preparers by enhancing the internationalconsistency of this important source of information.”

Management Commentary is one of themost interesting parts of the annualreport: it provides management withan opportunity to add context to thepublished financial information, and to explain their future strategy and objectives

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Key Performance IndicatorsKPIs have become largely used by practitioners and arean essential part of narrative reporting. Organizationshave long used and reported various performancemeasures, but to what extent are KPIs well understoodand properly labeled? Below are fundamentalcharacteristics of each component of the term “KeyPerformance Indicators.”

KEY indicatorThere are large numbers of performance indicators, butfew are ‘Key.’ Board of Directors and ExecutiveCommittees need to set out and define the performanceindicators that are truly key and relevant to theirorganization. The essential elements that can beconsidered to make indicators a performance keyinclude the following:

• Focusing on KPIs that align with the business strategyto link and measure an organization’s progress and itsstrategic priorities;

• Focusing on the industry in which the organizationoperates: different measures are applied acrossindustries;

• Choosing KPIs that are used in a company’s internaldecision-making process and in managing thebusiness and assessing progress against definedstrategies;

• Choosing KPIs that are relevant to the company butare not necessarily used or reported by peers. In thiscase, management should provide adequateexplanation for its choice of KPIs, which should beaccompanied with details on the measurementmethods used in order to allow external readers tobenchmark with other peer groups.

Using and reporting a wide number of performancemeasures, without focusing on leading indicators,weakens the level of transparency and potentiallymisleads readers. It is also likely that, internally,managers become overwhelmed and frustrated whiletracking multiple performance measures and struggle toenhance them. Consequently, they become less focusedon those measures that directly relate to strategicobjectives. Generally, the number of KPIs should befewer than ten.

PERFORMANCE managementKPIs should effectively measure the organization’s‘performance’ by only taking into consideration factorsthat are influenced by management. It is essential tounderstand and quantify factors affecting anorganization’s performance that are outsidemanagement’s control. Take for example the case of abank whose improving profits are attributable tochanging rates and not to increased efficiency, or thecase of a steel producer, whose growing earning pershare comes from rising steel prices. These factorsshould be stripped out or adequately explained whenmeasuring performance.

INDICATORS of future performanceExcessive reliance on historical financial measuresprevents KPIs from being true indicators. Assessingfinancial performance based on current and past resultsremains subjective in certain cases. For instance,organizations can easily manipulate earnings per shareand managers can decide when to book revenues andcosts. Accordingly, measuring an organization’s financialperformance based on historical growth and returns oncapital should be supplemented by ‘indicators’ of futureperformance, which allows for assessing thesustainability of that performance and provides aglimpse into the future. On the other hand,performance measures should be reported in a timelymanner in order to allow management to react quicklyand take corrective action where necessary.

The continuous enhancement of narrative reporting iscritical to gain and build the trust of investors. It simplyentails the disclosure of relevant financial information ina consistent way while avoiding redundant and complexinformation and ensuring balance between transparencyand confidentiality.

by Zahi Zeini, partner, Audit, Deloitte, Lebanon

Narrative Reporting

There are large numbers ofperformance indicators, butfew are ‘Key’