Jan 06, 2017
Audit committees must ask the right questions about the unaudited information management chooses to present. As companies increasingly turn away from standardized financial measures, choosing to highlight unaudited information to chart their performance, it is essential that audit committees make sure the data are comparable, consistent, reliable and transparent. Chartered Professional Accountants of Canada (CPA Canada) is developing guidelines to help audit committees understand their responsibilities and to ask the right questions about these key performance indicators. Stefan Mihailovich, principal of corporate oversight and governance at CPA Canada, recently sat down with Axel Thesberg, a senior adviser to CPA Canada and former partner at KPMG Canada, to discuss the issue.
To start off, give us a definition of what key performance indicators actually are, their different facets and the level of assurance that goes with these measurements.
I think the terms are used differently by different people, so for purposes of this discussion and what we’re working on, I think KPIs are the key performance indicators that a public company uses to report and to tell its story. You can then break those KPIs into various categories. The first category is probably GAAP measures. Generally accepted accounting principles are standardized financial measures that are contained in the
financial statements. For example, there are standards for revenue, net income and things like that.
The next one is referred to as non-GAAP measures, or non-GAAP financial measures. They are generally
measures that start from a number in the financial statements and then get adjusted for various reasons, such as excluding certain expenses. A company might exclude certain expenses to try to come up with a measure that it considers a better indicator to the market as to the company’s performance. You can get a little bit of a challenge in that line between GAAP measures and non-GAAP measures because sometimes, some of those non-GAAP measures actually are in the financial statements. You’ll see some issuers that will create subtotals, for example, on the income statement that say “earnings before undernoted items” and there’s nothing in GAAP that says how you determine it, but it’s in the financial statements. That distinction between GAAP measures and non-GAAP can be a little bit blurred.
The next category is what I would call financial KPIs, and those are things which might start with a financial number and then combine non-financial measures. In the retail industry, the classic one is same-store sales. So the sales come from the financial statements, but the “same stores” information comes from a different system.
The final category is pure operational KPIs. These are non-financial KPIs, such as the oil and gas industry’s barrels of oil produced. And again, we don’t know what systems have been used to come up with those.
So for an audit committee looking at these categories, it has several responsibilities. First, it needs to review
the management discussion and analysis filing [MD&A] and take responsibility for all KPIs in the MD&A, regardless of whether they are defined as GAAP, non-GAAP financial or non-financial. As an audit committee, you arguably have a comparable responsibility to review all KPIs. The comfort you have with some KPIs might be very different than that which comes from the financial statements. If it’s a non-GAAP financial measure, the information started with a GAAP measure and you can probably get a reconciliation as to where it comes from. In some of the other cases, that’s harder to do. So one of the real challenges audit committees have is trying to determine whether these are good KPIs or not-so-good KPIs. The audit committee also has a responsibility under securities regulation that goes a bit further when dealing with financial information that’s derived, or extracted from, the financial statements. In any case, the audit committee has a responsibility for all of the KPIs and it can struggle with that.
I suppose that’s why CPA Canada is developing guidance, which should be coming out in the next six months
or so, that will help audit committees understand their responsibilities and ask the right questions about KPIs.
Yes, part of the way we are approaching the project is thinking about what are the characteristics or attributes of good KPIs.
And audit committees have to be dynamic because each company is a little bit different, but guidelines can be tailored, as long as they’re following key principles.
Yes. So the first characteristic we’re looking at I’d define as strategic. These are key performance indicators that actually measure the success of the organization in getting to where it strategically wants to be three, five or 10 years from now. Some good questions to ask here include, “Is it the same measure that we’re using internally to measure performance?” and “Is it the same measure we use to compensate management?” If it’s
neither of those, then ask “Is it really a key measure of our performance in achieving our strategy?” So I think it’s very important that audit committees ask, “Are these actually key strategic measures?”
A second factor concerns transparency. Securities regulators both in the U.S. and Canada have weighed in on this a lot. They’re focused primarily on the non-GAAP financial measures. So here you first have to be absolutely clear what adjustments you’ve made from the GAAP measure. Second, you must say why you’ve made those adjustments and why you think they are a good measure of performance. And third, you must make sure you don’t give these non-GAAP measures more prominence than the comparable GAAP measure, and that’s always a bit of a trade-off because quite frankly sometimes they are a better measure of what’s happening in the organization than the GAAP measure. But regulators can get very concerned if you give them too much prominence.
Consistency is another key issue. It’s important that KPIs are calculated the same way year after year. Sometimes you see that a company uses a KPI in a year when it looks good, then in a year when it doesn’t look so good, maybe they drop it. There are no standards as to which ones to use, so you want to be absolutely clear that you’re consistent year-over-year, and this is something an audit committee can challenge management on.
Next an audit committee needs to ask, “Is the KPI comparable?” “What do others in your industry do?” “Do they show the same KPIs, do they calculate them in the same way?” “Are they excluding certain expenses that you’re not, or vice versa?”
Another characteristic to consider is reliability and auditor involvement. The auditor gives an opinion on the
financial statements, and they have an obligation to read the MD&A and to inform management, and maybe the audit committee, if there is something inconsistent in that MD&A based on their knowledge of the audit. But the auditor has no requirement whatsoever to actually give any opinion or assurance on MD&A. So as an audit committee, how do you get satisfied that all KPIs in the MD&A are as reliable as GAAP measures? When you get into these financial KPIs and non-financial KPIs, you have less comfort about their reliability. And that’s where audit committees need to think about the process the company has gone through on disclosure controls and procedures. If they have a disclosure committee, have they specifically looked at all of these KPIs and are they satisfied with them? So audit committees need to make sure this information is reliable and complete.
It seems like the business press is looking more closely at KPIs today. Do we actually see investors putting reliance on these numbers even though they’re not audited? What’s your sense?
Well you know there’s lots of things being written, including research that has studied a lot of Canadian companies. That research indicates a couple of things. First, the number of KPIs that companies use is growing. Almost everybody is doing it, and if you talk to analysts there’s more and more reliance placed on KPIs. But there is also growing apprehension. The Canadian Securities Administrators have expressed concern about the trend and have given some guidance on non-GAAP financial measures. I think as the market is relying on KPIs more and more, regulators want to make sure they are comparable, consistent, reliable and transparent. Where there aren’t standards, it’s becoming a bigger challenge and audit committees are key.
We’ve heard that KPIs move markets, and if they’re not audited, that’s a scary thought. So audit committees have a responsibility to make sure that they’ve asked the right questions, so they have some level of understanding of how the KPIs were selected and calculated, and why they’re being presented.
I think auditors can provide a lot of additional value through their knowledge and insights. If they have audited many companies in the same industry and seen many comment letters from securities commissions, they can be a valuable participant in a discussion about “Where did this number come from? Is it the same as others are doing?”
There are discussions going on about whether the standard should change so that auditors do something more with respect to the KPIs that are in the MD&A or earnings press release.
More and more, people are questioning how reliable KPIs are, how consistent, how comparable. They want
to make sure the information is relevant and transparent.
So what other advice would you offer to audit committees with regards to KPIs?
Spend more time on them – or at least really get organized in how you look at them. One thing an audit committee can do is have management list all the KPIs a company uses in a grid or matrix, and then ask basic questions about each one: Is it really a key indicator? Is it showing progress against strategy? Has the company disclosed why the KPI is important and how it is calculated? Is it consistent year-over-year? Is it comparable to others in the industry? Those key questions can form a framework for audit committees. Once this has initially been done, in subsequent periods audit committees can then just ask whether there have been any changes from the previous period.
Axel Thesberg, FCPA, FCA, is a senior advisor to CPA Canada providing advice on various projects related to enhancing the value of audit and financial reporting. He was project co-ordinator for the recently completed "enhancing audit quality" joint initiative between CPA Canada, the Canadian Public Accountability Board and the Institute of Corporate Directors and is currently working on a project developing guidance to assist audit committees in overseeing key performance indicators. He is a former partner of KPMG Canada, chair of the finance and audit committee at Kingston General Hospital and served as chair of the audit committee for the Toronto 2015 Pan American and Parapan American Games.
Source: Director Journal (January/February 2017)