My new favorite Key Performance Indicator (KPI) is carbon adjusted earnings per share. A metric recently constructed by a global food leader based in Europe.
The measure is calculated on the theoretical cost per share of greenhouse gas emissions, which is then subtracted from its IFRS earnings per share. While innovative KPIs often get labelled as aggressive, this strikes a different chord and aims to satisfy increasing demands for quantifiable environmental, social and governance (ESG) exposure.
KPI metrics are important vehicles for companies to tell their stories and to supplement financial reporting, where standardization is often insufficient or lags economic progress and emerging business models. These measures are also often key variables to determine executive remuneration and incentives.
However, KPIs have a mixed track record as they are primarily self-defined by management, construction is often vague, and they generally receive minimal attestation procedures.
Given the importance of KPIs to all stakeholders, CRUF recommends the following action points to improve KPI reporting.
A key issue many investors face today is lack of clarity on how KPIs are constructed. Without an understanding of why a measure has been chosen, and whether or not it has been adjusted from a GAAP/IFRS measure, users may have difficulty assessing the appropriateness of a KPI. This issue is particularly acute for early stage companies where profits, if not revenues, are years away. It is critical for companies to clearly communicate why a measure is being used and how that measure aligns with the economic performance of the business.
Inconsistency of KPI inputs and adjustments also creates challenges for users. Investors ultimately rely on trends to understand the past and forecast the future. Changes in KPIs and their definitions distorts the user’s ability to understand these trends. As a best practice, any changes should be infrequent and, when they are made, clearly quantified and explained. We also recommend parallel reporting of the old and new definitions for a period of time to improve understandability and reliability.
Perhaps the biggest benefit to market participants would be increased third-party assurance of KPI metrics and methodologies. We find it odd that the key measures most important to management and investors often receive little to no attestation. KPI metrics may be reviewed by auditors, but generally are outside the scope of attestation requirements in most jurisdictions.
Link to executive pay
It is critical for investors and stakeholders to understand how company and management performance is aligned with remuneration and incentives. KPIs are often significant inputs in compensation plans. For startups and emerging business models, they are frequently the dominating factor. Clearly disclosing both the KPIs used to determine executive pay, and the targets that were set, would add further transparency to how pay is determined. Certain jurisdictions have already raised the bar. For instance, these elements are already required in the UK under Schedule 8 to the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 and Companies (Miscellaneous Reporting) Requirements 2018.
In conclusion, we believe increased transparency and assurance will improve the integrity of the reporting ecosystem, where KPIs play a critical role.
KPIs are powerful tools for companies to tell their stories and to facilitate investors’ needs, such as linking the impact of climate change to financial performance. A few improvements will make this a Quick Win for all.
Todd Castagno is an Executive Director and head of Global Valuation, Accounting & Tax (GVAT) within Morgan Stanley’s Research division. He provides accounting, tax, valuation and financial consultation services to investors and analysts and publishes research on these topics. He has been ranked as a top analyst and named to Institutional Investor’s All-American Research Team. Todd serves on the Financial Accounting Standards Board’s Investor Advisory Committee (IAC). He is a CFA charter holder and a Certified Public Accountant in the state of New York. Todd has co-chaired CRUF USA since 2015.
Disclaimer: The views expressed in the blog are those of the author(s) and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the our views section of the CRUF website.