Accounting for goodwill

This issueAccounting for goodwill p25The OFR p28Equity investment p32CPM p34

FINANCIAL May 2005 MANAGEMENT 25

TECHNICAL MATTERSAccounting for goodwillWhy are firms willing to pay so much for takeovers when the goodwill burden isso onerous? Kenneth Dogra examines the asset that dare not speak its name.

takeover that leads to a plannedapproach to growth, its chances offailure are high. For financial managerswho have been involved in acquisitions,the crucial point in all negotiations isprice. Sellers tend to have an inflatedopinion of their companies and seekhigh prices, especially when the worldeconomy is booming. But, with aplanned approach to growth, buyers canidentify certain synergies that lookinteresting on paper and carry a certainvalue. They can use a number offinancial models to calculate the valueof a takeover target. The most commontechnique used is the discounted cashflow method. This relies on the inputof realistic cash flow forecasts,discounted to give net present value,for a period in the future.

The consequent numbers game fuelsthe negotiations – and the urge to win.In larger transactions involving quotedcompanies a second bidder may appearand push up the offer price, and theboard of the target company has a dutyto get the best price for its shareholders.Recent examples include VivendiInternational’s acquisitions in thetelecoms industry, where the prices itpaid exceeded fair-value net assets byastronomical sums, resulting in thecharging of huge goodwill amortisationamounts to the profit and loss account.

Other companies are more aware ofthe goodwill burden and, much to theircredit, walk away from a transactionwhen the price is too high. A strikingexample of this came in 2003 with thebidding war to acquire Centerpulse, aSwiss manufacturer of medicalprosthetics. When the transaction pricerose to a ridiculous level, UK healthcarecompany Smith & Nephew withdrewand let its US competitor, Zimmer

What is goodwill? Under internationalfinancial reporting standards it’s definedas the excess of the cost of acquisitionover a group’s interest in the fair valueof the identifiable assets and liabilitiesof a subsidiary, associate or jointlycontrolled entity at the date ofacquisition. Goodwill is recognised as anasset. Annual impairment tests must beconducted and any loss in value of theassets acquired is written off via theprofit and loss account. Accounting forgoodwill changed from an amortisationmethod to an impairment-only approachon January 1, 2005, when IAS22 wassuperseded by IFRS3.

Under US Gaap, the definition ofgoodwill is the same – ie, it’s the excessof the purchase price over the fair valueof the net identifiable assets acquired –although SFAS142 changed accountingfor goodwill from an amortisationmethod to an impairment-onlyapproach as long ago as July 1, 2001.A number of international groups

changed to using US Gaap after thisdate to avoid the negative effect ofhaving to amortise goodwill. This moveimproved their results considerably.

The French have an appropriate termfor when the purchase price exceeds thefair-value net assets: écart d’acquisition,or difference on acquisition.

All this leads us to the conclusionthat, when a business takes over anotherentity, it needs to find a method bywhich it can avoid reducing the netassets of the group by the excess overthe fair-value net assets of the firm it haspurchased. So we call this difference anasset that’s not really identifiable.

Acquisitions are complex, high-riskprocesses. Unless there is a logic to a

Illustration: Julian Mosedale

The prices Vivendi paid exceededfair-value net assets by astronomicalsums, resulting in the charging ofhuge goodwill amortisation amounts

p29-36 Tech_FM May 05 v2 8/4/05 4:00 pm Page 25

FINANCIAL 26 MANAGEMENT May 2005

Accounting for goodwill

CASE STUDY:ZIMMER HOLDINGS’ ACQUISITION OF CENTERPULSE

In October 2003 US company Zimmer Holdingsacquired Centerpulse, a Swiss-based manufacturerof orthopaedic medical devices. The attractionsfor Zimmer were as follows:� Becoming the biggest orthopaedics company

in the world.� Fulfilling key priorities by strengthening its

European market position and entering therapidly growing market for spinal devices.

� Adding established products and a morecomprehensive research effort inorthobiologics to its portfolio.

� Increasing its presence in the reconstructivedental market.When the deal was signed on October 2,

Zimmer paid a consideration of $3,453.4m.The sum comprised a purchase considerationof $3,410.9m plus acquisition costs of $42.5m.This was paid for in cash ($1,187.1m) andshares ($2,223.8m).

The fair-value net assets at October 2, 2003were as follows:

$mCurrent assets 796.8Property, plant and equipment 169.9Trademarks and trade names 243.0Intangible assets subject to amortisation:Core technology 116.0Developed technology 309.0Trademarks and trade names 31.0Customer relationships 34.0In-process research and development 11.2Deferred taxes 537.4Other assets 83.9

Less liabilities:Short-term debt 306.3Deferred taxes 250.3Other current liabilities 274.6Integration liability 75.7Long-term liabilities 176.6Net assets 1,248.7

The key elements of the purchase considerationcan, therefore, be analysed as follows:

Net assets acquired $1,248.7m Acquisition costs $42.5mExcess $2,162.2mTotal purchase consideration $3,453.4m

It appears that included under the intangibleassets heading is what could be classified as a

deferred expenditure in respect of R&D andmarketing costs of $490.0m. Would this result inimpairment costs in future? The goodwill wouldbe $2,162.2m + $42.5m = $2,204.7m,representing 63.8 per cent of the purchaseconsideration. It’s no wonder that Smith &Nephew, Zimmer’s rival bidder, dropped out.

It’s interesting toexamine Zimmer’s 2003annual report to see itsoperating ratios beforeand after the acquisition(profitability ratios excludeadjustments in 2003concerning the acquisition):

2003 2002 Gross profit/sales 72.8% 74.9%Operating profit/sales 24.3% 29.2%Net profit/sales 20% 18.8%Days in receivables 93.4 days 57.1 daysDays in suppliers 90.2 days 63.3 daysDebt/equity* 130.2% 42.3%Free cash flow/sales 16.8% 13.4%Break-even % of sales 61.9 62.1Break-even of sales $1,176m $853m

Although there are improvements in someareas, do they justify a purchase price of $3.4bn?Zimmer’s future results will provide the answer.

*Excluding goodwill.

Costing an armand a leg: didZimmer pay overthe odds in itsbid to become theworld’s biggestorthopaedicscompany?



Holdings, complete the purchase. Seethe case study on the opposite page tofind out whether it was a case of the oldIAS versus US Gaap or simply goodbusiness sense.

Many groups’ profits after tax andearnings per share have been affected byexcessive goodwill write-offs. As a result,they are reporting operating profitbefore goodwill amortisation andimpairment. It has been suggested thatinvestors and analysts look at cash flow,where there is no goodwill amortisationeffect. But there is still a strain on thefinancial resources of a group wheredebt has to be repaid if it borrowedfor acquisitions and increased interestexpense, irrespective of the accountingengineering it has introduced.

The goodwill factor consists of thefollowing characteristics:� An asset on the balance sheet that

cannot be identified as such (which iswhy it’s called an intangible).

� Transaction costs lumped in withgoodwill – and anything else, if youcan get away with it.

� Amortisation and impairmentcharges to the profit and loss account.

� In a liquidation: no value.Consider the example of a typically

overpriced acquisition in panel 1.Assuming a borrowing rate of 3 percent, the purchaser will incur an extra£27m in interest payments in the firstyear. On the assumption that the loan isto be repaid over seven years, a further£128.7m will need to be found,hopefully out of cash flow. This type ofsituation can lead to corporatemanipulation in respect of financialreporting when profits and cash floware insufficient.

In order to curb such overspendingcompanies could consider changing how

they account for acquisitions by writingoff any difference between the purchaseprice and fair-value net assets togetherwith transaction costs to a specialsection in the profit and loss account

under the heading “Acquisition costs”.This could be stated as in panel 2.Such an approach would make boardsmore accountable for the decisions theymake when expanding their companiesby acquisition.

Goodwill at the date of the changein the accounting treatment foracquisitions could be written off toreserves. Similarly, the surplus againstnet assets on a flotation could be nettedoff against the share premiumgenerated and not left on the balancesheet as goodwill.

The standard setters and theaccounting profession have acquiescedto the hue and cry of industry and thefinancial community in the past. Isn’t ittime that we brought some reality intofinancial reporting for investors? FM

Kenneth Dogra FCMA is managingpartner at the Amerac Consultancy(www.amerac.ch). He is also the authorof Reflections for the UnsuspectingShareholder, which can be obtained,price £15, from Amerac Publications,c/o The Better Book Company,Warblington, Havant, Hants PO9 2XH.

PANEL 2A NEW APPROACH TOACQUISITION COSTSSales

Gross profit

Operating costs

Operating profit

Non-operating costs

Financial expense net

Acquisition costs (detail given in note to the accounts)

Pre-tax profit

Taxation

Profit after tax

Note to the accounts

Acquisition costs

Difference between purchase price and fair value of

the net assets of X Ltd

Transaction costs

Total

PANEL 1A TYPICALLY OVERPRICED ACQUISITION

Transaction Balance sheet

(£m) (£m)

Fair-value net assets 400.5

Transaction costs 89.5

Difference 410.0

Purchase price 900.0

Fair-value net assets 400.5

Goodwill 499.5

Debt 900.0



The final OFR standard from theAccounting Standards Board (ASB) isstill being prepared as FinancialManagement goes to press. But the draftstandard, issued in November 2004, laidout the key principles that the OFRshould be comprehensive (although itshouldn’t be expected to cover allpossible matters), and that boards shouldbe required to focus on “matters that arerelevant to the interests of investors”.

The ASB has supplemented theseprinciples with a statement thatdirectors would need to consider“key issues”. CIMA argued in itsresponse to the draft standard that thecombination of all these terms did notadequately convey the concept thatthe directors should focus on mattersmaterial to investors. The institute’sfull response can be found under“Resources” in the consultationsdatabase at www.cimaglobal.com.

How big a change is the mandatoryOFR to the various groups involved? The extent of the change depends onthe preparer’s starting point. TheASB acknowledges that best practiceadvanced considerably between 1993,when the original OFR guidance wasissued, and 2003, when it was revised.But the consensus is that the mandatory

requirements will not stretch companiesthat currently produce good voluntaryOFRs. For examples of good practice,look at Barclays, Co-op FinancialServices or Unilever – all of which wereidentified by PricewaterhouseCoopersin the 2005 edition of Good Practices inCorporate Reporting.

CIMA argues that the informationcollected for the OFR should be anatural extension of the managementinformation presented to the board fordecision-making. If this is not the case,

the information required for the OFRwill highlight these deficiencies. This willsurely raise the standard of informationused by boards to manage companiesand create value for investors.

Directors may also be wary aboutmaking forward-looking statementswith the confidence and clarity requiredin a good OFR. There isn’t yet a “safeharbour” provision protecting themfrom legal liability for statements,although the government’s guidance on

forward-looking information advisesreaders to “treat some or all of theseelements with caution”.

The mandatory OFR also imposesnew responsibilities on boards. Therewill be a new criminal offence of“knowingly or recklessly approving anOFR that does not comply with therelevant provisions of the act” underwhich directors risk unlimited fines.This parallels the offence of approvingdefective accounts. Directors may alsobe required to revise OFRs for omissions(from Companies Act requirements);for non-compliance with the reportingstandard; for material misstatements;or for publishing an OFR that “containsan opinion which no reasonable boardcould have formed if it had followed aproper process of collecting andevaluating evidence”. (Note that theFinancial Reporting Review Panel’senforcement duties do not start until themandatory OFR has been in effect forone year – ie, for financial years startingon or after April 1, 2006.)

Auditors also have new duties,because they are required to reviewthe mandatory OFR. The originalintention was that they would assesswhether directors had used “due andcareful enquiry” in preparing an OFR.But respondents to the governmentconsultation – including CIMA –advised that this responsibility wasunduly onerous and would subject theOFR to a higher level of assurancethan the rest of the accounts, so theDepartment of Trade and Industryagreed to compromise. Auditors arenow required to state their opinion onwhether the information in the OFRis consistent with the accounts, andwhether any matters that have come totheir attention are inconsistent with

TECHNICAL MATTERS

The operating and financial reviewThe mandatory OFR creates a number of new responsibilities – and conundrums– for directors. Louise Ross considers whether it’s revolutionary or evolutionary.

THE BACKGROUNDThe operating and financial review is a legal requirement for British quoted companies for financialyears beginning on or after April 1, 2005. What’s special about the OFR is that, unlike traditionalfinancial reporting, it requires the board of directors to analyse both the current performance andthe future development of the business, and also to report non-financial information such asenvironmental, social and employee matters. The objective behind the mandatory requirement isthat companies will become more transparent, which in turn helps investors to make moreinformed decisions.

The information for the OFR shouldbe a natural extension of themanagement information presentedto the board for decision-making



information in the OFR. This is not aradical new demand; it merely extendstheir traditional requirement to be alertto any information that doesn’t fit.

The remaining people to be affectedare those for whom the OFR is intended:the shareholders. Arguably, institutionalinvestors can already access most of theinformation in the mandatory OFR,either because of their ability to drawsome of that information by analysingthe financial statements, or because oftheir closer relationship with the chiefexecutive – a significant proportion ofwhose time is apparently taken up withimproving investor relations.

A mandatory OFR will have agreater impact on small investors – ifthey ever receive it. Most small investorschoose to receive the summary financialstatements (SFS) rather than the full setof accounts. The OFR is a stand-alonestatement in the annual report and so isautomatically made available only to therecipients of the full annual report andaccounts. Companies that offer SFSmust publish the OFR on their website,tell shareholders that it’s there and offera hard copy to those who request one.

This modified distribution was aconcession to objections made to thegovernment by CIMA and othersabout the significant estimated cost ofdistributing an OFR to all investors– hundreds of thousands of pounds forfirms with many shareholders.

Thoughts on key performance indicatorsThe mandatory OFR requires directorsto use key performance indicators (KPIs)to assess and report progress againststated objectives. The main challenges forcompanies in this area will be to decidewhat to report and to balance thefollowing competing OFR principles: the

requirement to focus on matters relevantto the interests of investors, yet becomprehensive; and the requirement tobe balanced and neutral, yet to focus ontrends and factors that affect theperformance of the business.

The right to choose KPIs is double-edged. You can choose the measures thatreflect the mechanics of your business,but you may be guilty of perceived oractual bias. You can change measures orrecalibrate existing measures to reflectnew risks, trends and opportunities,but you sacrifice the chance to compareperformance over time. You can tailora suite of measures to your business,which tells a powerful story, but usersmay then struggle to compare you withyour peers. Some of the challenges willbe resolved gradually. The developmentof narrative reporting will beevolutionary – consider KPIs in thecontext of financial reporting standards,which took many years to develop andare still being improved.

David Larcker, CIMA’s visitingprofessor in 2004, suggested that “a fewvital KPIs are better than a laundrylist”. He acknowledged that the lack ofan agreed approach meant thatmeasuring non-financials accurately was

“damn hard”, but argued that too fewcompanies were identifying the rightdrivers. Instead, they were unthinkinglyapplying templates, frameworks ormodels promoted by consultantswithout tailoring them to reflect theirown mechanics. He said that fewidentified drivers that connected to long-term value, citing research showing thatmost firms failed to relate performancemeasures to strategy or to validate therelationship between non-financialmeasures and future financial results.

“Please excuse such a long letter;I didn’t have time to write a short one.”This quote, attributed to Blaise Pascal,Napoleon Bonaparte and Mark Twain,reminds us that the OFR should be asmuch about discrimination ascommunication. Both the regulation andthe standard emphasise that the OFRshould be concise. The trend towardslong annual reports is regrettable, notonly because of the costs of publicationand distribution, but also because such amass of information, audited andexamined to different levels, can obscureimportant messages. FM

Louise Ross is an accounting specialist inCIMA’s technical services department.

The operating and financial review

FURTHER INFORMATION� The government’s response to the public consultation includes the rationale behind the

concessions it made on distribution of OFRs, the revised scope for auditors and estimates of theextra assurance costs. www.dti.gov.uk/cld/21_12_gov_response.pdf?pubpdfdload=04%2F1822.

� DTI draft guidance for directors includes information on how to interpret the requirements ofthe OFR, how it will affect directors and stakeholders, how it will be examined by auditors and howit will be enforced. www.dti.gov.uk/cld/OFR_Guidance.pdf.

� ASB implementation guidance. This will be included in reporting standard 1 and will suggestwhat disclosures will be required to satisfy the OFR, specifically in relation to KPIs. Reportingstandard 1 should be available by June 1. www.frc.org.uk/asb/technical/standards.cfm.

� Auditors’ responsibilities in relation to the OFR. Guidance for external auditors examiningOFR disclosures will be prepared as part of the 2005-06 work programme of the Auditing PracticesBoard. www.frc.org.uk/apb.

� The Financial Reporting Review Panel’s enforcement role. The Financial Reporting ReviewPanel is currently consulting on its operating procedures. www.frc.org.uk/images/uploaded/documents/Revised%20Operating%20Procedures.pdf.

� David Larcker’s presentation, “Performance measures: insights and challenges”.www.cimaglobal.com/cps/rde/xchg/SID-0AAAC564-141BD7D2/live/root.xsl/document_broker.htm?filename=Larcker_Presentation_2004.ppt.

� CIMA’s response to the ASB exposure draft for the OFR reporting standard can be found under“Resources” on the consultations database at www.cimaglobal.com.



Is it possible to predict the stock marketaccurately? If it is, surely you couldmake a fortune over a period of years.Let’s look at a range of methods ofanticipating turning points in a marketand whether they work or not.

Despite the apparent absurdity ofastrology, a surprisingly large numberof intelligent and well-educatedinvestors take it into account whenmaking investment decisions.Unsurprisingly, there’s no record ofanyone making a substantial amountof money using this approach.

A slightly less controversial methodis the wave theory developed by RalphElliott in the 1930s. Its guiding principleis that the market moves in waves ofdifferent lengths from 70 years or longer,down to a few days, hours and minutes.The patterns often conform to specificnumerical sequences and percentages,such as Fibonacci constants.

According to the FT, some fans of theElliott wave theory reckon that the marketpeak in 2000 was the top of a five-wavepattern that began at the market’s lowpoint in 1932, meaning that a massivesetback is imminent. It will, they believe,take the Dow Jones industrial averagedown to about the 1,000 mark and hitthe FTSE 100 by a comparable amount.Apparently, this is likely to happen in abear market that could last for a decadeor more. The only problem is that theyhave been predicting disaster for years.Is it going to be any different this time?

It has been said that chartists usuallyhave dirty raincoats and large overdrafts,but some of them have actually made alot of money. The technique must,therefore, have a certain amount ofcredibility. Chartists believe that achart showing the history of a shareprice reflects the hopes and fears of all

investors and is based on the oneindisputable factor: how a share hasperformed in the market. The market’sperception of the share is a constantlychanging illusion, according to thechartists, so it’s more important tofollow trends than to try to work out acompany’s likely earnings per shareseveral years ahead.

Jim Slater, a legendarily successfulstock market investor, states in his bookThe Zulu Principle that he uses chartsas one tool in a whole kit. They eithergive him further confirmation that he isproceeding along the right lines orprovide a warning signal, sometimeswell in advance of any deterioration inthe fundamentals.

A more anticipatory tool is theCoppock indicator, which has givenexceptional results. In the depths of abear market you should always look outfor an upturn in the Coppock curve,which is normally a strong buy signal.It was devised by Edwin Coppock in the

1960s and based on a mechanical systemknown as the long-term buying guide.

Coppock, a devout Christian, wasasked to work out a long-term low-riskbuy signal for his church’s funds. Theadministrators wanted to know whento step up purchases and when to standaside. He asked the church ministershow long they thought it generallytook for the human mind to adjust tobereavement, divorce, illness,unemployment, financial loss, relocationand retirement – the greatest stresses ithas to handle. He adopted their answerof 11 to 14 months as a yardstick.

“Do major long-term buying ofstrong stocks when the curve first turnsupwards from below the zero line,” hewrote in his 1962 paper, Emotions MakePrices. But he added: “The technique isof no value whatever to an in-and-outtrader; it is a technique for long-terminvestors – their low-risk buying guide.”

The indicator is not a sign of a trendreversal, but it shows that the risk

TECHNICAL MATTERS

Equity investmentStock market investors have a wide range of forecasting tools to choose from, buteven the most accurate method has its limitations, as Michael Goddard explains.

Getty



factor in the market is low and usuallyheralds a sustained advance. If youapply it to the Dow Jones industrialaverage from 1919, it gives only onefalse signal (1930). Brian Marber, aleading chartist, wrote in the FT that,although Coppock used his indicatoronly on the Dow, its principles make itapplicable to all markets, although itdoesn’t seem to work on foreignexchange. If applied to the Londonmarkets since 1940, for example, it alsogives only one false signal (1948).

The technique does not give a sellsignal – Coppock would becomeincensed if his followers tried to use atrend-line downturn as one.

So how is the Coppock curve ortrend line derived?� Compare the Dow’s end-month

level with those prevailing 11 and14 months earlier.

� Express the differences as percentages.� Combine them and multiply by ten.� Repeat this exercise the following

month, multiplying the previousmonth’s figure by nine. In the thirdmonth, multiply by eight and so ondown to one.After ten months you obtain a

weighted average of the previous 22months’ data. A version of thiscalculation can be found, for all theworld’s major stock markets, in the firstissue of Investors Chronicle of everymonth. This uses a rolling 12-monthaverage rather than the 11- and 14-month figures that Coppock devised.

The general outlook for buying moreshares is usually unattractive when aCoppock buy signal occurs, but historytells us to be guided by this signal ratherthan the outlook. The problem is thatCoppock generates very few of these –only seven over the past 30 years. This is

both a strength and weakness. It is astrength because a buy signal, when itcomes, warrants serious consideration.It is a weakness – and one reason whyCoppock is given little attention – becauseif it were our only guide we would die ofboredom waiting for a buy signal.

The Coppock indicator’s few falsesignals also give cause for concern. In1948 it would have encouraged Londoninvestors to buy, but a 20 per centdecline in the FT 30 index was to follow.

At least it took only four years forthe market to recover in that case. Thewrong message that Coppock wouldhave given Dow investors in 1930 wouldhave been much more serious. OnNovember 13, 1929 the Dow crashed to

its low for the year, losing 48 per cent ofits value a mere ten weeks after it hadpeaked. Then came the so-called fools’rally: in the five months after November13, the index recovered half of the valueit had lost. But in May 1930 the dreadedbear market was under way again andthose caught in the rally knew they’dbeen duped. By the end of the year themarket had plummeted 60 per cent fromthe peak of the rally. There were furtherdowndraughts in 1931, but the finalslaughter came a year later, when shareprices plunged to depths visited half acentury earlier.

From September 1929 to June 1932the Dow’s value fell by 89 per cent. Itspeak of 381 points in 1929 would not bereached again for 26 years. The Dow’s

fall from its 1929 low to the 1932 lowwas 79 per cent. If the Coppockindicator had existed at the time, thatwould have been the approximatepercentage loss suffered by its users.

Most professional equity investorssay it’s virtually impossible to predict thestock market. They advocate pound-costaveraging for the private investor – ie,putting a fixed sum every month intoequities. This has the advantage ofbuying more shares when the stockmarket is low and fewer shares whenthe market is high. But, when theCoppock indicator starts rising whilethe numbers are still negative, thebuying signal it gives will be correctmore than 90 per cent of the time.

When it comes to protecting yourportfolio against future bear markets,Jim Slater’s advice is to have 100 per centof your patient money invested if youfeel bullish and 50 per cent if you feelbearish. When pruning your portfoliodown from to 50 per cent, keep yourmore defensive stocks. This shouldhappen naturally as you sell shares thatfulfil your investment objectives.

In early January 1975, at the bottomof a bear market, the FT 30 ordinaryshare index had fallen to 146 points, thelowest it had been since May 1954. TheUK market price/earnings ratio was 3.8with a dividend yield of 13.4 per cent.At the end of that month the Coppockindicator gave a buy signal that was toprove a stupendous money-makingopportunity for long-term investors.If such an opportunity occurs again,let’s grasp it with both hands. FM

Michael Goddard is the former FD ofConcorde Express Transport. Since hisretirement he has become a journalistspecialising in financial matters.

It has been said that chartistsusually have dirty raincoats andlarge overdrafts, but some of themhave actually made a lot of money



After a lull over the past few years,many organisations are upgrading theirperformance management systems togive them a better insight into futurerevenues and profitability. But there’snothing like new legislation to focusthe mind: UK-listed companies will forthe first time be required to preparestatutory operating and financialreviews (OFRs) for financial yearsstarting on or after April 1, 2005.

The OFR is a narrative reportintended to help shareholders andpotential investors assess a company’sstrategies and capacity for success inthe future. Companies faced by newlegislation often see it merely as anobstacle to overcome. This usually leadsto short-term solutions, which mightmeet the basic statutory requirementsbut will fail to take advantage of thesituation and the potential returns.Firms that make this mistake will incurthe costs of compliance and reap noneof the rewards.

In 2003 specialist monitoringcompany GovernanceMetricsInternational found a strong linkbetween investor-friendly governancepractices and high shareholder returns.It’s not hard to see why this might bethe case. Compliance requirements thatfavour greater transparency give allstakeholders more confidence. Thisleads to more investment and createsa virtuous circle that increases thecompany’s value.

Of course, none of this comeswithout committing the necessaryresources. In particular, the rightinformation systems and controls needto be in place. The better solutionsavailable from corporate performancemanagement (CPM) vendors provideseveral features that help to satisfy the

requirements of the OFR legislation.Key among these is the ability tocombine financial and non-financialinformation. An OFR can potentiallyreport on many different areas. Theseinclude customer and marketstatistics, innovation, employee skillsand (self-referentially) governanceissues. Formal reporting on these topicswill be new to some, but a companyshould ideally be managed using suchmeasures – the drivers of its business– anyway. So, once again, there aretangible benefits to be gained fromcommitting to the OFR.

Directors will be expected toexercise the same level of care inpreparing the narrative report as for thefinancial accounts. Furthermore, theOFR, like the annual financial report,will be audited. The underlyingsystems must, therefore, providetransparency so that the report can beshown to be reliable and unbiased –and, indeed, so that the actual cost ofthe audit is lower. An effective CPM

system will provide this transparency,which should be seen as a benefit formanagers, who can be confident inthe information they are using to runthe business.

The OFR is intended to beforward-looking and to provide a viewof the company’s prospects. Thebetter CPM systems offer predictivefunctionality, with the ability todefine rules that forecast performance.The advantage of having a system thatcan do this is that, once the predictiverules are defined, the results aredemonstrably unbiased.

The requirements of the OFR willforce management accountants to gobeyond their traditional domain offinancial information and get to gripswith both the external and internaldrivers of financial performance.This will entail working alongside themarketing department to ensurereliable and robust measures of marketsize, growth and share, and developingan in-depth understanding of how thewhole enterprise works.

Although some companies willundoubtedly try to meet the minimumOFR requirements by using externalconsulting organisations to cobblesomething together, the companiesdestined to benefit the most are thosethat can provide credible, meaningfulinformation to the satisfaction ofinvestor groups. These successfulcompanies will have CPM systems inplace, but they won’t simply be usingthem to satisfy the OFR requirements.These systems will allow them tomanage their businesses better andoutperform their peers. FM

Richard Barrett is vice-president ofglobal marketing at ALG Software.

TECHNICAL MATTERS

Corporate performance managementEnlightened companies will see the statutory operating and financial review not as a barrier to clear, but as a chance to get into a virtuous circle, writes Richard Barrett.


Documents

Accounting for goodwill