Management Commentary and Interpretation of Financial Statements
1 Management commentary
In December 2010 The International Accounting Standards Board (IASB) published an International Financial Reporting Standard (IFRS) Practice Statement Management Commentary, a broad, non-binding framework for the presentation of narrative reporting to accompany financial statements prepared in accordance with IFRSs.
Management commentary fulfils an important role by providing users of financial statements with a historical and prospective commentary on the entity’s financial position, financial performance and cash flows. It serves as a basis for understanding the management’s objectives and strategies for achieving those objectives.
The Practice Statement permits entities to adapt the information provided to particular circumstances of their business, including the legal and economic circumstances of individual jurisdictions. This flexible approach will generate more meaningful disclosure about the most important resources, risks and relationships that can affect an entity’s value, and how they are managed.
The Practice Statement is not an IFRS. Consequently, an entity need not comply with the Practice Statement to comply with IFRSs.
The Practice Statement suggests the commentary should include narrative and numerate information about:
Nature of the business
Management’s objectives
Strategies for achieving the objectives
Entity’s most significant resources, risks and regulations
Results of operations and prospects
Critical performance measures and indicators (financial/non-financial)
2 Interpretation of financial statements
2.1 Stakeholder analysis
Remember that different stakeholders are interested in different information:
Investors and potential investors may be primarily interested in PROFITABILITY.
Lenders and suppliers may be primarily interested in the survival of the company in the short term (LIQUIDITY) and the long term (SOLVENCY).
2.2 Traditional ratio analysis
When you studied Financial Reporting you learned the basic ratios:
Performance – ROCE, profit margin
Liquidity – Current and acid test ratio
Efficiency – Asset turnover, Inventory days, receivable days, payable days
Solvency – gearing ratio, interest cover
Investor – EPS, PE ratio, dividend cover
If you need to revise these ratios, please review the relevant chapters and lectures in the Open Tuition Financial Reporting materials.
2.3 Alternative performance measures (APMs)
For SBR, you also need to be familiar with EBITDA / EBITDAR.
EBITDA – Earnings before interest, tax, depreciation, tax and amortisation
EBITDAR – As EBITDA but also add back rental expense.
EBITDA is widely used to analyse businesses because it does not allow the underlying result to be distorted by ‘arbitrary / subjective’ decisions about depreciation and amortisation.
However, EBITDA is NOT cash flow, because it takes no account of the movements in working capital. For example, a business with a positive EBITDA can still find itself in trouble if it ties all its money in inventory which may prove difficult to sell.
2.4 Management Performance Measures (IFRS 18)
IFRS 18 introduced the concept of Management Performance Measures (MPMs). This refers to some but not all Alternative Performance Measures .
MPMs:
Are financial measures used in public communications (e.g. press releases).
Form a sub-total in the profit and loss, but which are not required to be disclosed.
Thus:
Average wage paid is NOT a MPM because it’s not a sub-total.
Operating profit is NOT a MPM because it has to be reported anyway.
But ‘operating profit before restructuring costs’ may be a MPM . In fact, may companies use this a sub-total in order to separate out their trading activities from ‘one-off’ items.
MPMs must be audited and a note to the financial statements must:
State that the MPM is not necessarily comparable to the MPMs of other companies.
Explain why the MPM is useful.
Reconcile the MPM to a sub-total that is required by IFRS (e.g. operating profit).
A measure only qualifies as a management performance measure if it is a subtotal of income and expenses used in public communications that IFRS 18 does not already require; a ratio such as gearing never qualifies. A question on one wants the definition test, the required note disclosures, and why investors find them useful.
The popularity of EBITDA was discussed earlier. IFRS 18 implies that companies should use term OPDAI (operating profit before depreciation, amortisation and impairment) rather than EBITDA.
2.5 ESMA Guidelines
There is concern that users may be misled by so-called ‘alternative performance measures’ in financial statements. In Europe the European Securities and Markets Authority have produced guidelines. If you learn these, they could be very useful in a discussion question. The principal guidelines are as follows:
APMs should be clearly defined in the financial statements.
A reconciliation should be published between the APM and the ‘traditional’ measure. For example, EBITDA should be reconciled to ‘earnings’, as used in Earnings per Share.
The relevance and reliability of any APMs used should be explained.
APMs should not be more prominent than traditional measures (e.g. EPS).
APMs should presented alongside comparatives for the prior year.
The method of calculation of the APM should be consistent from year to year.
Relevant examiner articles on the ACCA (students) website:
Additional performance measures
Giving investors what they need
Using the business model of a company to help analyse its performance