Are non-financial KPIs in annual reports really 'key'? An investigation of company disclosure and analyst reports in the UK

The rise of an information-based economy has intensified the importance of non-financial indicators among both management and stakeholders (Beattie and Smith, 2013). Some academic studies claim that the inclusion of non-financial indicators in a company’s performance-measuring system contributes to an organisation’s strategic alignment (Dossi and Patelli, 2010) and has a profound impact on organisational effectiveness (Upadhaya et al., 2014). At the same time, non-financial indicators are necessary “to understand past performance, future potential and make well-informed investment decisions” (PwC, 2015), because they shed light on critical aspects of a business that cannot be represented by financial measures, such as human capital (Royal and O’Donnell, 2008), relational capital (April et al., 2003), and organisational capital (Lev and Radhakrishnan, 2003). Most regulatory frameworks consider non-financial indicators —which are usually identified as non-financial Key Performance Indicators (KPIs)— to be firm-specific information that needs to be identified and conveyed according to the “through the eyes of management” principle. For instance, the Financial Reporting Council (FRC) maintains in its Guidance on the Strategic Report (hereafter referred to as the FRC’s Guidance) that a company should disclose indicators “that the directors judge to be most effective”, while also considering the specific characteristics of the company (FRC, 2014, § 7.44). However, it is likely that external users are unable to fully understand the “effectiveness” of company-specific, non-financial KPIs, especially if the users are not provided with information that explains why a certain indicator is important for managers —how it is related to the company’s strategy and how it contributes to value creation processes (ICAS, 2010). A recent survey conducted on a panel of global investors by PwC reveals that only 26% of UK investors agree that managers are sufficiently transparent about the metrics they use to plan and manage their businesses (PwC, 2017). This study investigates disclosure practices of UK companies, with special emphasis on non-financial information in annual reports. Our analysis focuses on the information reported in the 2016 annual reports of 67 listed UK companies, which operate in five different industries. Annual reports for the 2014 financial year are also examined to account for any experience effect. We determine whether and to what extent the indicators communicated by companies in their annual reports are really “key”. In the context of our research, “key” is defined as whether the information features a disclosure approach that illustrates, in quantitative terms, the value drivers that characterise the business model (BM) of a company. According to several scholars, a company’s BM represents a valuable tool for interpreting information related to value creation (Holland, 2004; Mouritsen and Larsen, 2005). It has been stated that the BM constitutes a useful reference model for disclosure, because it enables the creation of a comprehensive and accurate set of non‐financial value drivers (Bukh, 2003). The objectives of the research are to: • Propose a new means of assessing non-financial KPI disclosure, which is anchored to the value drivers that underlie a company’s BM; • Develop a detailed procedure, based on a content analysis, to assess whether a certain indicator published by a company can be considered as “key”, according to the definition adopted in this project; • Measure to what extent the non-financial KPIs published in annual reports can be genuinely regarded as “key”; • Verify whether the information communicated by companies is also used by financial analysts in their reports. As regards financial analysts, they play an essential role in financial markets, and their reports are consistently used by scholars to investigate the usefulness of a piece of information. Thus, a comparative approach allows us to perform an assessment of the effectiveness of non-financial KPI disclosure. Indeed, the presence of overlapping information —information that shows up in both company and analyst reports— supports the hypothesis that companies’ disclosure practices about non-financial KPIs are focused on key aspects that can be useful for external users. For this purpose, the analyst reports available on the Bloomberg database concerning the examined companies are contentanalysed. The results of the empirical analysis based on our evaluation method challenge the quality of non-financial KPI disclosure in annual reports. In particular, we find that: • Approximately 40% of the companies did not report any non-financial indicators in their 2016 Strategic Reports (49% in 2014). • In both 2014 and 2016, only approximately half of the disclosed non-financial indicators can be defined as “key”, as they are linked to the value drivers cited by the companies in their BM description. • Among the non-financial indicators that cannot be identified as “key” according to our approach, environmental and social measures are the most frequent. This result is likely to be influenced by the specific legal requirement which obliges businesses to disclose quantitative measures relating to relevant environmental and employee issues. • Disclosure practices vary considerably among industries. We observed that many non-financial indicators disclosed by chemical and pharmaceutical companies are more often related to companies’ value drivers. The importance of intangible resources in these sectors could explain, at least in part, this result. • Overall, our findings suggest that non-financial KPI disclosure provided by the companies examined is not entirely driven by the “through the eyes of management” principle. Companies seem to use much different criteria to identify their “key” indicators. A non-financial indicator can be marked as KPI if it is anchored to the company’s value drivers, but also if it is required by law, or if it is the result of an established disclosure practice. • The results confirm previous surveys showing that, despite a gradual improvement over time, non-financial KPIs are still scarcely communicated by UK companies (Deloitte, 2017) and are rarely linked to other sections of the reports (PwC, 2016). The empirical analysis focused on the investigation of analyst reports shows that: • Non-financial indicators are rarely reported in analyst reports, and neither are the value drivers that differentiate a company from its competitors. It may be the case that analysts prefer to focus only on the overall performance of a company owing to the concise nature of their reports (Simpson, 2010). • An overlap between the information mentioned by analysts and that reported in annual reports is shown only for the Food and Beverage industry. These findings seem to suggest that a disparity exists between what companies actually disclose and what financial analysts include in their reports. This analysis contributes to the debate concerning companies’ performance reporting with regard to the application of the “through the eyes of management” principle to non-financial KPI disclosure. Our proposal provides a first attempt to translate the disclosure principle into an operative tool, which identifies the characteristics that a non-financial indicator should have to be identified as “key”. In this respect, we emphasise the role that a company’s BM description can assume as a powerful platform for integrated non-financial disclosure (FRC, 2014). This perspective is primarily related to the ongoing process of regulation, which requires companies to describe their BM in the Strategic Report. Moreover, our proposal of linking non-financial KPI and BM disclosure contributes to the integration of different information included in the Strategic Report. The results show that more is needed to ensure that a company’s non-financial KPI disclosure mirrors management’s view. More specifically, detailed guidelines on nonfinancial indicator disclosure could support companies in improving their disclosure practices. In particular, these guidelines should: • Clearly explain what makes a non-financial indicator a “key” indicator; • Emphasise the importance of linking non-financial KPIs to a company’s value drivers; • Encourage companies to provide a description of the components of their BM that enable the identification of value drivers. Finally, from a preparer perspective, our findings provide a benchmark for companies to comply with the requirements of the Companies Act 2006 (Strategic Report and Directors’ Report) Regulations 2013 (thereafter referred to as the CA Regulations). To this end, we offer companies a specific tool to refine their communication strategies. • The identification of a company’s value drivers in our proposal is based only on information reported in the BM description. Future research should improve our tool, considering different sources of information, both primary sources — i.e. interviews with company insiders — and secondary sources — i.e. conference call transcriptions. • Our findings show that many UK companies do not disclose any non-financial indicators in their Strategic Reports. Many conjectures can be formulated to explain these results. Thus, specific studies could be useful to shed light on the determinants of this disclosure. • Qualitative analyses based on interviews and/or questionnaires can be conducted in order to investigate the managers’ viewpoint about non-financial measures and their disclosure in annual reports. This could contribute significantly to interpreting disclosure practices and orienting ongoing regulation. • Our empirical analysis is focused on UK companies operating in five industries. Future research should enrich our results, examining companies from other countries and/or different industries. • We found that financial analysts rarely make explicit mention of specific value drivers and non-financial measures in their reports. This does not mean that they do not consider this information in their evaluation processes. More research focused on the users could improve our understanding of the importance of non-financial information from an investment decision perspective.