Professional Documents
Culture Documents
Chapter- 4
Strategic performance management
1 Performance management
1.1 Performance measurement and control
All systems of control can be analysed using the cybernetic model. The essence of this model is the
feedback of control action to the controlled process: the control action itself being generated from the
comparison of actual results with what was planned.
Performance measurement has become such an accepted part of business life that sometimes we lose
sight of its purpose.
(a) Performance measurement is part of the overall cybernetic (or feedback) control system, providing
the essential feedback spur to any necessary control action.
(b) It is a major input into communications to stakeholder groups, including the widening field of
corporate reporting.
(c) It is intimately linked to incentives and performance management systems, providing evidence of
results against agreed objectives.
(d) Motivation may be enhanced since managers will seek to achieve satisfactory performance in areas
that are measured.
1.1.1 Feedback loops
To some extent, planning and controlling are two sides of a single coin, since a plan is of little value if it
is not put into action, while a system of control can only be effective if the people running it know what
it is they are trying to achieve.
In the cybernetic system, an objective is established: for the organisation, this might be the current year's budget.
Actual achievement is measured, perhaps by means of monthly reports, and a process of comparison
takes place (for example, by comparing actual figures to budgeted ones).
Managers can then take control action to try to make up for any failures to achieve the plan. This
control action feeds back into the activity of the organisation and its effects should become apparent in
the next monthly report.
This kind of feedback loop is the essence of any control system, though sometimes it may be difficult to
discern its existence and operation.
Definition
Feedback: Feedback occurs when the results (outputs) of a system are used to control it, by adjusting
the input or behaviour of the system. Businesses use feedback information to control their performance.
However, when considering feedback loops, it is important to distinguish between single loop feedback
and double loop feedback.
In single loop feedback, changes are made to the system's behaviour in order to try to meet the plan.
By contrast, double loop feedback can result in changes being made to the plan itself.
Using a simple example, if an organisation's operating profit is below budget, managers could be asked to
identify ways to reduce costs in order to help bring profits back in line with budget. This is single loop feedback.
Alternatively, the organisation might realise that an adverse variance on costs is due to a rise in raw
material costs which is outside its control. Therefore, the organisation could reforecast its original cost
budget, but it could also consider whether it needs to revise its sales prices in the light of the change in
costs. Any such changes to re-forecast the original budget would be double loop feedback.
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Organisations as open systems
Importantly, the simple illustration above in relation to double loop feedback shows how external
factors (in this case, a rise in raw material input costs) can affect an organisation's performance.
However, external factors can affect performance more generally. 'PESTEL' analysis identifying
opportunities and threats to an organisation, but the changing business environment and other external
factors can equally have a significant influence on an organisation's current performance.
The fact that performance is influenced by external and environmental factors highlights that organisations
are open systems, and therefore, there are likely to be aspects of performance which are beyond an
organisation's control.
However, this can raise difficulties in relation to performance management in an organisation.
Consider the following simple example. An organisation has noticed that it has been failing to meet
revenue targets in recent weeks, and it has identified that problems with its website have meant that
some customers have not been able to make orders online. Consequently, the organisation devoted a
considerable amount of resources to improving its website to make it more reliable and user-friendly.
However, when the improved website went live, the organisation noticed that its revenues were still
behind budget. Now managers realised that one of the organisation's major competitors had reduced
their prices and another competitor had launched a new market-leading product. Both of these
initiatives had enabled the competitors to increase their market share at the organisation's expense.
This simple example illustrates that the 'open system' nature of organisations means that, often, managers
cannot attribute performance to a single issue, but need to look at it as a combined effect of many variables.
Equally, the idea that different business units or functions within an organisation are also open systems,
means that managers need to be aware of the inter-dependencies of different operations and
processes within an organisation, as well as the overall environment in which the organisation operates.
1.1.2 Scope of performance management
Our discussion of feedback and control has looked mainly at organisational performance. However, performance
management can be applied at different levels within an organisation (corporate, business unit, team, individual).
This highlights the issue of goal congruence when designing performance reward systems. In
particular, reward systems need to be designed in such a way that individuals' goals (in order to earn
their rewards) are aligned to team goals and the organisation's goals overall.
It is also important to note that aspects of human resource management (HRM) (such as setting
performance objectives and reward management) play an important role in the performance
management and control of the organisation.
In this respect, HRM follows a similar control model as is used for the overall strategic and operational
control of an organisation:
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Purpose of budgets
To compel planning
To co-ordinate activities
To communicate ideas
To provide a framework for responsibility accounting
To motivate employees and management
To evaluate performance
Negative effects of budgets include
Limited incentives if the budget is unrealistic
A manager may add a percentage to his expenditure budget to ensure that he can meet the figure
Manager achieves target but does no more
A manager may go on a 'spending spree'
Draws attention away from the longer term consequences
Problems with budgetary control
The managers who set the budgets are often not responsible for attaining them
The goals of the organisation as a whole, expressed in the budget, may not coincide with the
personal aspirations of the individual managers
Control is applied at different stages by different people
How to improve behavioural aspects of budgetary control
Develop a working relationship with operational managers
Keeping accounting jargon to a minimum
Making reports clear and to the point
Providing control and information with a minimum of delay
Ensuring actual costs are recorded accurately
Allow for participation in the budgetary process
Limitations to the effectiveness of participation
Some people prefer tough management
A manager may build slack into his own budget
Management feels that they have little scope to influence the final outcome
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uncertainty about the problem, the various responses which management could undertake or the likely
impact of those actions.
Decision support systems are intended to provide a wide range of alternative information gathering and
analytical tools with a major emphasis upon flexibility and user-friendliness.
DSS have more analytical power than other systems, enabling them to analyse and condense large
volumes of data into a form that helps managers make decisions. The objective is to allow the manager
to consider a number of alternatives and evaluate them under a variety of potential conditions.
Executives at small and medium sized companies are making critical business decisions every day based
on the information available to them.
This information can come from a variety of sources: opinions from peers and colleagues; a personal sense of intuition
or business judgment; or data derived internally or externally to the organisation. This is worrying, however, given the
lack of confidence in the data available to decision makers.
2.3.4 Value added networks
Definition
Value added networks: VANs are networks that facilitate the adding of value to products and (particularly)
to services by the strategic use of information. Typically, VANs will link separate organisations together through
electronic data interchanges (EDIs), contributing to the development of business networks.
Also, they are often business ventures in their own right, with companies subscribing to the services available. Good
examples are the SABRE, Amadeus and Galileo airline flight booking systems. A simpler example is the electronic data
interchange systems between manufacturers and their suppliers that facilitate the operation of just-in-time (JIT) logistics.
VANs give mutual competitive advantage to all their subscribers, but only so long as some competitors are left
outside of the system. As soon as membership of the VAN (or a competing VAN) becomes a standard feature of
the industry, the original competitive advantage is lost. Competitive advantage based on VAN membership can
then only exist if there is more than one VAN and each VAN in the industry offers a different degree of benefit in
terms of cost reduction or differentiation.
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The IS strategy is supported by:
Information technology (IT) strategy
The information technology strategy, by contrast is technology-focussed and looks at the resources,
technical solutions and systems architecture required to enable an organisation to implement its
information systems (IS) strategy.
IT strategies are likely to look at the hardware and software used by the organisation to produce and
process information. They may also include aspects of data capture and data storage, as well as the
transmission and presentation of information.
Information management (IM) strategy (IM)
Earl subsequently also highlighted the need for an information management strategy. The emphasis
here is on management: managing the role and structure of IT activities within an organisation, and
managing the relationships between IT specialists and the users of information. In this respect, a key
feature of IM strategy is its focus on roles and relationships.
IM strategy also plays an important part in ensuring that information can be accessed by all the people who need
it, but, at the same time, access to information is restricted to those people who need access to it.
We might sum up the three levels of information strategy in very simple terms by saying that: IS strategy
defines what is to be achieved; IT strategy determines how hardware, software and telecommunications
can achieve it; and the IM strategy describes who controls and uses the technology provided.
This model of information strategy has the advantage of being internally consistent and quite simple
to understand. Unfortunately, the picture is spoiled by a different use of the term information
management. You may come across a rather narrow use of this term to mean 'the approach taken to
storing and accessing data'. Since this is really just an aspect of the information technology strategy, as
defined above, we do not recommend the use of the term in this way.
2.5 The challenge for accountants
The availability and appreciation of the myriad of new information systems has challenged the role of
the accountant in the control framework. These new systems, such as EIS, have highlighted a number of
perceived failings in the traditional accounting systems organisations had relied upon.
(a) Direction towards financial reporting. Historical costs are necessary to report to shareholders, but the
classifications of transactions for reporting purposes are not necessarily relevant to decision- making.
(d) Internal focus. Management accounting information has been too inward looking, (for example
focusing on achieving internal performance targets, like budgets). However, organisations also
need to focus on customers and competition.
(b) Strategic issues are not easily detected by management accounting systems.
(c) Financial models of some sophistication are needed to enable accountants to provide useful information.
2.5.1 Objectives of management accounting information
Management accounting information is used by managers for a variety of purposes:
(a) To measure performance. Management accounting information can be used to analyse the
performance of the business as a whole, and of the individual divisions, departments or products
within the business. Performance reports provide feedback, most frequently in the form of
comparison between actual performance and budget.
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(b) To control the business. Performance reports are a crucial element in managing a business. In
order to be able to control their organisation, managers need to know the following:
(i) What they want the business to achieve (targets or standards; budgets)
(ii) What the business is actually achieving (actual performance)
By comparing the actual achievements with targeted performance, management can decide
whether corrective action is needed, and then take the necessary action when required.
Much control information is of an accounting nature because costs, revenues, profits and asset
values are major factors in how well or how badly a business performs.
(c) To plan for the future. Managers have to plan, and they need information to do this. Much of the
information they use is management accounting information.
(d) To make decisions. As we have seen, managers are faced with several types of decision:
(i) Strategic decisions (which relate to the longer term objectives of a business) require
information which tends to concern the organisation as a whole, is in summary form and is
derived from both internal and external sources.
(ii) Tactical and operational decisions (which relate to the short or medium term and to a
department, product or division rather than the organisation as a whole) require information
that is more detailed and more restricted in its sources.
2.6 What is strategic management accounting?
The aim of strategic management accounting is to provide information that is relevant to the process of
strategic planning and control.
Definition
Strategic management accounting: A form of management accounting in which emphasis is placed
on information about factors which are external to the organisation, as well as non-financial and
internally-generated information.
3 Performance measurement
Performance measures must be relevant to both a clear objective and to operational methods, and their
production must be cost-effective.
3.1 Deciding what measures to use
Clearly different measures are appropriate for different businesses. Determining which measures are
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used in a particular case will require preliminary investigations along the following lines.
(a) The objectives/mission of the organisation must be clearly formulated so that when the factors critical
to the success of the mission have been identified, they can be translated into performance indicators.
(b) Measures must be relevant to the way the organisation operates. Managers themselves must
believe the indicators are useful.
(c) The costs and benefits of providing resources (people, equipment and time to collect and
analyse information) to produce a performance indicator must be carefully weighed up.
3.1.1 Critical success factors
Organisations use critical success factors (CSFs) to determine their information requirements.
However, CSFs are also relevant here. CSFs highlight the elements of performance that are vital to an
organisation's success. In turn, however, this means it is important for organisations to measure how well they
are performing in those key areas of performance. For example, if an organisation identifies that 'quality of
service' is a CSF, then the organisation also needs to monitor the level of service it is providing its customers.
3.5.1 Ratios
Ratios are a useful way of measuring performance for a number of reasons.
(a) It is easier to look at changes over time by comparing ratios in one time period with the
corresponding ratios for periods in the past.
(b) Ratios are often easier to understand than absolute measures of physical quantities or money
values. For example, it is easier to understand that 'productivity in March was 94%' than 'there was
an adverse labour efficiency variance in March of £3,600'.
(c) Ratios relate one item to another, and so help to put performance into context. For example the
profit/sales ratio sets profit in the context of how much has been earned per £1 of sales, and so
shows how wide or narrow profit margins are.
(d) Ratios can be used as targets. In particular, targets can be set for ROI, profit/sales, asset turnover, capacity
fill and productivity. Managers will then take decisions which will enable them to achieve their targets.
(e) Ratios provide a way of summarising an organisation's results, and comparing them with
similar organisations.
3.6 Measuring performance in the new business environment
As well as arguing that organisations need to rethink the basis on which they prepare budgets ('Beyond
Budgeting', Hope and Fraser have also argued that if organisations are serious about gaining real
benefits from decentralisation and empowerment, they need to change the way in which they set
targets, measure performance and design reward systems.
Hope and Fraser suggested the following scenario to highlight the relationship between targets and
management responsibilities:
A strategic business unit (SBU) manager is asked for a 'stretch target'. However, under the Beyond
Budgeting model, the manager knows that 'stretch' really means their best shot with full support from
the centre (including investment funds and improvement programmes) and a sympathetic hearing
should they fail to get all of the way. Moreover, the manager alone carries the responsibility for
achieving these targets. There is neither any micro-management from above, nor any monthly 'actual
versus budget' reports.
Targets are both strategic and financial, and they are underpinned by clear action plans that cascade
down the organisation, building ownership and commitment at every level. Monthly reports
comprise a balanced scorecard set of graphs, charts and trends that track progress (eg financial,
customer satisfaction, speed, quality, service, and employee satisfaction) compared with last year and
with other SBUs within the group and, where possible, with competitors. Quarterly rolling forecasts
(using broad-brush numbers only) are also prepared to help manage production scheduling and cash
requirements, but these forecasts are not part of the measurement and reward.
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Performance review. If there is a significant blip in performance (and the fast/open information system
would flag this immediately), then a performance review would be signalled. Such reviews focus on the
effectiveness of action plans and what further improvements need to be made. The review might even
consider whether the targets (and measures) themselves are still appropriate.
There are a number of reasons why this approach is successful.
(a) Managers are not punished for failing to reach the full target.
(b) The use of the balanced scorecard ensures that all key perspectives are considered.
(c) Because managers set their own targets and plan the changes needed to achieve them, real
ownership and commitment are built. Feedback and learning takes place as a result of the tracking
of action plans. (Contrast this with numerical variances that tell managers nothing about what to do
differently in the future.)
(d) Beating internal and external competitors is a constant spur to better performance.
(e) Managers share in a bonus pool that is based on share price or long-term performance against a
basket of competitors. Resource and knowledge sharing is therefore encouraged.
3.7 Leading and lagging indicators
An important element of performance management is developing appropriate performance metrics. As
far as possible, performance measures should be linked to a company's strategy, value drivers and
critical success factors, as well as short-term and long-term goals.
Many companies now adopt the balanced scorecard concept – or a similar multi-dimensional performance model –
with performance measures in a number of categories, such as financial, operations, customers, human resources.
However, whilst it can be beneficial to monitor performance in a range of areas, managers should avoid
measuring too many aspects of performance. Instead they must concentrate on the metrics that are
most important, in order to avoid succumbing to information overload.
Nonetheless, when identifying which metrics to measure, it is important to balance traditional financial
measures with non-financial ones.
In particular, measures should be selected to provide a balance of leading and lagging indicators.
Most traditional, financial performance measures are lagging indicators, connected with past
performance and past events. However, such indicators do not necessarily help managers or directors to
understand the future challenges an organisation will face.
By contrast, leading indicators can point to future performance successes or problems. For example,
declining customer satisfaction levels could point to future revenue issues and a longer-term erosion of
the value of a company's brand.
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Research on more than 3,000 companies in Europe and North America has shown that the strongest
drivers of competitive achievement are the intangible factors, especially intellectual property,
innovation and quality. Non-financial measures have been at the forefront of an increasing trend
towards customer focus (such as TQM), process re-engineering programmes and the creation of
internal markets within organisations.
Arguably, some non-financial measures may be less likely to be manipulated than traditional profit-
related measures and they should, therefore, offer a means of counteracting short-termism, since
short-term profit at any expense is rarely an advisable goal.
However, while there may be a danger of manipulation in financial information systems, which may be
exacerbated by inappropriate reward systems (eg a 'bonus culture'), this does not mean that financial
performance indicators are inherently more vulnerable to manipulation than non-financial performance
indicators. For example, which are likely to be subject to the more stringent controls: financial, or non-
financial information systems?
Remember also, the ultimate goal of commercial organisations in the long run is likely to remain the
maximisation of profit, and so the financial aspect cannot be ignored.
A further danger of non-financial measures is that they might lead managers to pursue detailed operational goals
and become blind to the overall strategy in which those goals are set. Consequently, using a combination of
financial and non–financial measures is likely to be most successful; as, for example, in the Balanced Scorecard.
3.8.2 The performance measurement manifesto
Eccles argues that financial measures alone are inadequate for monitoring the progress of business
strategies based on creating customer value, satisfaction and quality, partly because they are historical
in nature and partly they cannot measure current progress with such strategies directly. He also notes
the impulse to short-termism given by such measures.
There is a need for a performance measurement system that includes both financial and non-financial
measures. The measures chosen must be integrated, so that the potential for discarding non-financial
measures that conflict with the financial ones is limited. Eccles argues that too often firms prioritise
financial measures above non-financial ones, and if the two clash the financial priorities take priority.
However, Eccles points out that non-financial measures such as quality, customer satisfaction and
market share are now equally important as purely financial measures.
Eccles says that the development of a good system of performance measurement requires activity in five areas.
(a) The information architecture must be developed. This requires the identification of performance measures
that relate to strategy and the gradual, iterative development of systems to capture the required data.
(b) An appropriate information technology strategy must be established.
(c) The company's incentives system must be aligned with its performance measures. Eccles proposes
that qualitative factors should be addressed by the incentive system.
(d) External influences must be acknowledged and used. For example, benchmarking against other
organisations may be used, while providers of capital should be persuaded to accept the validity of
non-financial measures.
(e) Manage the implementation of the four areas above by appointing a person to be responsible
overall as well as department agents.
3.9 Value for money (VFM) audits
Value for money audits can be seen as being of particular relevance in not-for-profit organisations. Such
an audit focuses on economy, efficiency and effectiveness. These measures may be in conflict with
each other. To take the example of higher education, larger class sizes may be economical in their use
of teaching resources, but are not necessarily effective in creating the best learning environment.
The balanced scorecard seeks to translate mission and strategy into objectives and measures, and
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focuses on four different perspectives. For each of the four perspectives, the scorecard aims to
articulate the outcomes an organisation desires, and the drivers of those outcomes.
Performance targets are set once the key areas for improvement have been identified, and the balanced
scorecard is the main monthly report.
The scorecard is balanced in the sense that managers are required to think in terms of all four
perspectives, to prevent improvements being made in one area at the expense of another.
3.11 Linkages
Disappointing results might arise from a failure to view all the measures as a whole. For example,
increasing productivity means that fewer employees are needed for a given level of output. Excess capacity can be
created by quality improvements. However, these improvements have to be exploited (eg by increasing sales).
The financial element of the balanced scorecard reminds executives that improvements in quality,
response time, productivity or new products, only benefit a company when they are translated into improved
financial results, or if they enable the company to achieve a sustainable competitive advantage.
3.12 Implementing the balanced scorecard
The introduction and practical use of the balanced scorecard is likely to be subject to all the problems associated
with balancing long-term strategic progress against the management of short-term tactical imperatives.
3.13 Strategic application of the balanced scorecard
If an organisation decides to introduce and use a Balanced Scorecard, it will then have to decide what
performance indicators (KPIs) should be collected, and how should these be reported in a way that
helps the organisation make better decisions.
The choice of KPIs could be informed via the hierarchy identified by Robert Anthony (see Section 2.1).
Once the organisational strategy has been defined, this can be distilled into a sequence of vertically
consistent objectives. These objectives should be orientated in a manner that allows the organisation to
improve performance in the business critical processes that support its Critical Success Factors (those
things the organisation must excel in to be competitive). The balanced scorecard can then be used to
track performance against the CSFs via the KPIs selected.
It follows therefore, that the balanced scorecard can be used to track performance at the hierarchical levels
identified by Anthony. Thus, some KPIs will be derived to track operational efficiency; others, to assess
management's tactical performance; and still others, to illustrate the success of the overall organisational strategy.
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3.17 Problems with using the balanced scorecard
As with all techniques, problems can arise when the balanced scorecard is applied.
It may also be worth considering the following issues in relation to using the balanced scorecard:
It doesn't provide a single aggregate summary performance measure. For example, part of the popularity of ROI
or ROCE comes from the fact that they provide a convenient summary of how well a business is performing.
In comparison to measures like economic value added (EVA), there is no direct link between the
scorecard and shareholder value.
Culture: Introducing the scorecard may require a shift in corporate culture; for example, in
understanding an organisation as a set of processes rather as departments.
Equally, implementing the scorecard will require an organisation to move away from looking solely
at short-term financial measures, and focus on longer-term strategic measures instead.
The scorecard should be used flexibly. The process of deciding what to measure forces a business to
clarify its strategy. For example, a manufacturing company may find that 50% – 60% of costs are
represented by bought-in components, so measurements relating to suppliers could usefully be added
to the scorecard. These could include payment terms, lead times, or quality considerations.
3.18 Assurance and performance indicators
We have mentioned a number of potential performance measures in this chapter, but in order for an
entity to use KPIs as a basis for management decision-making and control, it needs to be confident that
the indicators are calculated reliably, and consistently, across different periods or divisions.
Many companies now publish a selection of key performance indicators (KPIs) in their annual reports. By
definition, these KPIs should focus on the aspects of performance that are most important to the
continued success of the company.
Some KPIs may be financial (such as ratios based on the financial statements) but the majority of KPIs should be
non-financial. Therefore, despite the insight they can give into a company's performance – and the fact that they
are likely to be picked up on and discussed by analysts and investors – these KPIs will not have been audited as
part of the financial statements. Similarly, the systems which generate these non-financial KPIs are unlikely to
have been scrutinised by internal or external auditors in the way that financial systems have been.
Consequently, from both an internal (management) and external perspective it will be valuable for
entities to seek additional assurance over these KPI figures.
The assurance approach towards KPIs should consider how the KPIs have been defined, how they have
been calculated, and why they are reported.
The ICAEW Audit & Assurance Faculty’s paper ‘The journey milestone 1: assurance over key performance
indicators’ suggests that the process of providing assurance over KPIs should be relatively straightforward. An
entity’s management have already chosen the indicators, developed a rationale for the use of each indicator, and
a method for calculating it. An independent practitioner can then gather evidence to support an opinion on
whether the KPIs have been prepared in accordance with the disclosed method of calculation.
The ICAEW paper suggests that there are three elements for an assurance provider to consider:
The design of the methodology – Is the methodology used to prepare the KPI appropriate for
providing an indicator that will give a robust measure of an aspect of performance?
The implementation of the methodology – Have the calculations in relation to the indicator been
carried out correctly?
The quality of the raw data – Have the underlying inputs into the calculation been correctly
derived from an appropriate source?
Definition of the KPI – When considering the design of the methodology, an assurance provider needs
to assess whether the methodology used to measure the KPI is consistent with the definition of the KPI.
The ICAEW paper illustrates this point with the following example: If a railway company decided to
exclude cancelled trains from its definition of ‘delays’, and if it did so without amending its definition of
the indicator, its apparent performance in relation to ‘train delays’ would be improved, despite
passengers being left waiting on platforms for long periods due to trains being cancelled.
Quality of the raw data – Even if the methodology used is appropriate and is implemented correctly, a
KPI could still be misstated as the data being used to calculate it is inaccurate – either due to poorly
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designed systems, or ineffective controls over those systems. Therefore testing the design and operation
of the systems which produce the underlying data can be an important part of gaining assurance over
the fair presentation of KPIs. This testing can also provide a degree of on-going comfort over the
presentation of the same KPIs over a period of time.
Choice of KPIs
In addition to checking the accuracy of the indicators disclosed, an assurance provider should also consider the
choice of KPIs, together with the context in which they are presented. This could be complicated because the
assurance provider will need to consider what other KPIs could have been included, and therefore whether the
selection of KPIs reported on might distort a reader’s impression of an entity’s performance.
In this context, an assurance provider might need to consider the following questions:
Is each KPI described in a way which is not misleading, and allows an informed user to make
worthwhile comparisons, year-on-year, and with other businesses?
Are KPIs linked in the narrative reporting to underlying strategic imperatives, as well as associated
targets and trends, thereby giving the reader sufficient context to understand how they relate to
value creation within an entity?
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Discussion is often in terms of designing a remuneration package that encourages directors to avoid excessive
risks. However, directors' remuneration can also be designed to encourage cautious directors to take more
risks. Shareholders, who hold diversified portfolios, may be keener for a company that undertakes a risky
investment than its directors, whose livelihood may be threatened if the investment is not a success.
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options in one package, these options should not all be able to be first exercised at the same date.
If the price of the shares rises so that it exceeds the exercise price by the time the options can be
exercised, the directors will be able to purchase shares at lower than their market value. Share options
can therefore be used to align management and shareholder interests, particularly options held for a
long time when value is dependent on long-term performance. The main danger is that the directors
will have an incentive to manipulate the share price if a large number of options are due to be exercised.
Options can also be used to encourage cautious directors to take positive action to increase the value
of the company. Shareholders should be holding a wide portfolio that diversifies away unsystematic
risk, but directors have less opportunity to diversify their careers and are dependent on their
recommendations being successful. An investment opportunity that would attract shareholders because
the returns are high relative to the systematic risk, may be rejected by directors because they are
exposed to the total risks of it going wrong.
Shareholders therefore need to find a way of encouraging directors to accept the same risks as they
would tolerate themselves. Share options can assist in this process because for options, the upside risk is
unlimited – there is no boundary to how much the share price can exceed the exercise price.
However, initially at least, there is no corresponding downside risk. If the share price is less than the
exercise price, the intrinsic value of options will be zero and the options will lapse. In these
circumstances, it will make no difference how far the share price is below the exercise price. If directors
are awarded significant options, the value of these options will rise if a risky investment succeeds and
they will not suffer any loss on their options if the investment fails. However, if the options become in-
the-money over a period of time, then directors may become risk averse as they stand to lose the
accumulated gains on the options if an investment fails.
The performance criteria used for share options are a matter of particular debate. Possible criteria
include the company's performance relative to a group of comparable companies.
There are various tricks that can be used to reduce or eliminate the risk to directors of not getting a
reward through options. Possibilities include grants that fail to discount for overall market gains, or
are cushioned against loss of value through compensatory bonuses or re-pricing.
The UK Corporate Governance Code states that non-executive directors should not normally be offered
share options, as options may impact upon their independence.
4.8.1 Share options and IFRS 2
Newly established entities with limited cash resources may use the promise of share growth as a way to
attract and retain high calibre individuals. Before the publication of IFRS 2, Share-based Payment, the
provision of, say, a share option was not recognised at all in the employing entity's income statement
under international accounting standards. This led to significant employee benefits provided by an
entity not being recognised in its financial statements.
IFRS 2 requires an expense representing the fair value of the options to be recognised over the period
from the grant date to the vesting date.
The fair value is initially ascertained using a model such as Black-Scholes and includes the following variables:
Market price of shares
Exercise price
Volatility
Risk free rate of return
Length of option
However, additional vesting conditions and long time periods make employee options more difficult to
value than traded options.
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fruition. In such circumstances, the motivational impact of the option scheme may be nil or negative.
A further negative aspect of share options is that they may tie unhappy employees into an ongoing employment
relationship past the point at which they wish to leave. For instance, an unhappy worker may stay in a post and
be consequently unproductive, merely to stay on long enough to collect a share option pay-out.
4.10 Pensions
Many companies may pay pension contributions for directors and staff. In some cases however, there
may be separate schemes available for directors at higher rates than for employees. The UK Corporate
Governance Code states that, as a general rule, only basic salary should be pensionable. The Code
emphasises that the remuneration committee should consider the pension consequences and associated
costs to the company of basic salary increases and any other changes in pensionable remuneration,
especially for directors close to retirement.
The Walker report on UK financial institutions responded to concerns raised about aspects of pension
arrangements. It recommended that no executive board member or senior executive who leaves early
should be given an automatic right to retire on a full pension – that is, through enhancement of the
value of their pension fund.
4.10.1 Pensions and strategic decision making
Increasingly pension fund liabilities are influencing strategic decisions.
For private companies with their own pension schemes, the actuarial valuation of the company's
pension plan can be a deal-breaker in relation to mergers and acquisitions, as any liability to pay future
pensions will pass to the new owners in that any deficit will be charged to the company's future profits.
Under UK pension regulations, employers operating schemes that have deficits have to agree with the
scheme's trustees a plan to pay off the deficit, generally by making extra payments.
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How much to pay
Whether monetary rewards should be paid on an individual, group or collective basis
How much emphasis to place on monetary reward as part of the total employment relationship
However, there is no single reward system that fits all organisations. Irrespective of what type of system
is implemented, an organisation should pursue three behavioural objectives.
It should support recruitment and retention.
It should motivate employees to high levels of performance. This motivation may, in turn, develop
into commitment and a sense of belonging, but these do not result directly from the reward system.
It should promote compliance with workplace rules and expectations.
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Controllable costs
Controllability can also be a particular issue when looking at costs within companies.
Consider the following example:
A company has three operating divisions and a head office. The divisional managers think it is unfair that
a share of indirect costs – such as central finance, HR, legal and administration costs – are included in
their divisional results because the divisional managers cannot control these costs.
Importantly, there is a distinction here between considering the divisional manager's performance and
the division's performance as a whole.
In order to evaluate the performance of the divisional manager, then only those items which are
directly controllable by the manager should be included in the performance measures. So, in our mini
example, the share of indirect costs re-apportioned from the head office should not be included. These
costs can only be controlled where they are incurred. Therefore, the relevant head office managers
should be held accountable for them. As the divisional managers have suggested, it would be unfair to
judge them for this aspect of performance.
However, in order for the head office to evaluate the division's overall performance for decision-making
purposes (for example, in relation to growth, or divestment) it is appropriate to include a share of the
head office costs. If divisional performance is measured only on those amounts the divisional manager
can control, this will overstate the economic performance of the division. If the divisions were
independent companies, they would have to incur the costs of those services which are currently
provided by the head office (for example, finance and HR costs). Therefore, in order to measure the
economic performance of the division, these central costs, plus any interest expenses and taxes, should
be included within the measure of the division's performance.
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measurement and performance management. Instead of concentrating on financial performance, and
particularly on short-term financial performance, companies should also pay greater attention to the
longer-term social, environmental and economic impact that they have on society.
In turn, this means that they need to develop performance measures that address these factors, as well
as measures focusing on short term financial performance.
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The Companies Act Regulations apply to all emissions sources for which the reporting company is
responsible, not just those sources in the UK. This means that multinational companies will have to have
data collection systems for gathering information from global operations, as well as a set of global
emissions factors to measure performance against.
Perhaps equally importantly, the legislation could encourage companies to make energy efficiency part
of their business strategy and, for example, when evaluating a new strategic option, to consider the
energy implications of that option rather than focusing solely on financial or commercial factors.
5.2.4 Implications of the increased importance of environmental issues
The increased focus on environmental issues and environmental performance also means that
companies should introduce procedures to try to prevent non-compliance with environmental laws and
regulations, and to avoid the fines or penalties which accompany such non-compliance.
In this respect, companies should consider the following procedures:
Monitoring legal requirements and ensuring that operating procedures are designed to comply
with these requirements.
Implementing an appropriate system of internal controls and regularly reviewing the controls over
environmental risks.
Developing and operating a code of practice for environmental issues, such as accidental spills and
the disposal of waste, especially hazardous waste.
Environmental information
A company's internal reporting system also needs to record information about environmental issues, and
should be capable of providing sufficient information to enable the financial impact of any
environmental issues to be estimated with a reasonable degree of reliability.
In addition, it will be important to maintain regular communication between those responsible for
environmental issues in a company and the accounting staff, so that the financial implications of any
environmental issues are understood, and any necessary action can be taken promptly.
Environmental issues and the supply chain
Environmental issues are not confined within the normal financial reporting boundaries of an
organisation. For example, supermarkets' concerns over supply chain issues are driving significant
changes in supplier companies. To avoid a supplier's reputation being seriously damaged by sourcing
products in a way which harms the environment, suppliers are manufacturing products sustainably and
from sustainable sources.
1
The IIRC is a global coalition of regulators, investors, companies, standard setters, the accounting profession and non-
government organisations.
By encouraging organisations to focus on their ability to create and sustain value over the longer term,
IR should help them take decisions which are more sustainable and which ensure a more effective
allocation of scarce resources.
IR should also help providers of financial capital (primarily shareholders), and other stakeholders, to
better understand how an organisation is performing and creating value over time. In particular, IR
should help stakeholders make a meaningful assessment of the long-term viability of an organisation’s
business model and its strategy.
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At the same time, IR could also help to simplify annual reports, by highlighting critical information and
by removing excessive detail.
However, it is also important to consider integrated reporting as a process, rather than an integrated report as a
product. The report periodically delivered to stakeholders (reporting on an organisation’s current state and future
prospects) requires a comprehensive understanding of the strategies being adopted, the risks the organisation is
facing, the opportunities it is pursuing, details of its operations, as well as the organisation’s impact on the
environment and the wider society.
As such, the IIRC highlights that integrated reporting also reflects integrated thinking within an organisation
– management’s ability to understand the interconnections between the range of functions, operations, resources
and relationships which have a material effect on the organisation’s ability to create value over time.
5.3.1 Six capitals
All organisations depend on different forms of capital for their success, and these different capitals
should be seen as part of the organisation’s business model and strategy. These capitals are an
important part of an organisation’s value creation.
By implication, identifying these six different categories of capital suggests that an integrated report will
describe an organisation’s performance in relation to the different capitals – in contrast to ‘traditional’
annual reporting which focuses primarily on financial performance.
Similarly, an organisation will need information about its performance in relation to each of the different
capitals, in order to be able to report on them. As a result, introducing IR could have important
implications for the information systems in an organisation. For example, does the organisation
currently record non-financial (social; environmental) performance in a way which provides it with
suitable information to include in its integrated report?
5.3.2 Guiding principles of integrated reporting
5.3.3 Aspects of an integrated report
In addition to the guiding principles (above), the IIRC has suggested that an integrated report should
answer the following questions in general terms:
Organisational overview and external environment – What does the organisation do, and what
are the circumstances under which it operates?
Governance – How does the organisation's governance structure support its ability to create value
in the short, medium and long term?
Business model – What is the organisation's business model, and to what extent is it resilient?
Risks and opportunities – What are the specific opportunities and risks which affect the
organisation's ability to create value over the short, medium and long term; and how is the
organisation dealing with them?
Strategy and resource allocation – Where does the organisation want to go, and how does it
intend to get there?
Performance – To what extent has the organisation achieved its strategic objectives and what are
the outcomes in terms of effects on the six capitals?
Future outlook – What challenges and uncertainties is the organisation likely to encounter in pursuing its
strategy, and what are the potential implications for its business model and its future performance?
An organisation's business model draws on various capitals as inputs and, through its business activities,
converts them into outputs (product, services, by-products and waste). The outcomes of an organisation's
activities and outputs also have an effect on the capitals. Some of the capitals belong to the organisation,
but others belong to stakeholders or society more generally. The organisation and society therefore share
both the cost of the capitals used as inputs and the value created by the organisation.
In the context of this chapter on strategic performance management, one of the important implications
of recognising these different 'capitals' is that when measuring and managing performance, an
organisation needs to look beyond short-term financial performance, and to consider the wider
consequences of its strategies and activities.
5.3.4 Implication of integrated reporting for accountants in business and management accountants
As yet, there is no standard, accepted format for an integrated report, so the detailed implications of the
information required for an integrated report will vary from organisation to organisation. However, the
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general principles and aims of IR suggest that a management accountant will need to consider the
following issues when preparing information for an integrated report.
Forward looking information
In their 2012 report ‘What is Integrated Reporting?’ UBS noted that ‘there is a gap between the information
currently being reported by companies and the information investors need to assess business prospects and value.’
The reference to ‘prospects’ highlights that integrated reporting information should be forward-looking
as well as historical. The focus of IR is how an organisation’s strategy, governance and performance can
lead to the creation of value in the future. Equally, therefore, the performance information produced by
an organisation needs to give an insight into an organisation’s prospects and future performance – how
it can create value in the future – as well as reporting its past performance.
However, an organisation needs to think carefully about what kind of ‘forward looking’ information it discloses.
Any material providing information about the future prospects and profitability of the entity (particularly a
listed company) is likely to be regulated, and it could also be commercially sensitive. For example, an
organisation needs to consider the balance between disclosure and the loss of competitive edge.
Equally, the inherent danger of producing forward-looking information is that no-one can predict the
future: forecasts are inevitably wrong to some degree, and are necessarily dependent on the
assumptions an organisation’s management team have made about the future.
While management is likely to have (and will want to have) the best information available to make such
predictions, they still need to ensure that investors do not place undue reliance on that information.
Long-term performance
The idea of sustainability also highlights the need to evaluate performance and strategic decisions on a long-term
basis as well as in the short term. The idea of the potential for conflict between long-term and short-term
decisions has been one which we have highlighted already in this Study Manual, for example, in relation to the
limitations of the use of profit-based performance measures for measuring an organisation’s performance.
One of the key aims of IR is to reflect the longer-term consequences of the decisions which organisations make, in
order that decisions should be sustainable and create value over time. Therefore, the IR process highlights that,
when making a [strategic] decision, an organisation needs to consider the long-term consequences of that decision
– and its effect on the six capitals, both positive and negative – as well as its short-term consequences.
Similarly, in order to implement IR successfully, an organisation will need to select a range of performance
measures which promote a balance between achieving short-term and long-term performance.
Again, in this respect, the use of non-financial performance indicators is likely to be important, since aspects of
non-financial performance (for example, environmental performance) have a long-term time frame.
Non-financial information
One of the main potential benefits of IR is that it helps organisations identify more clearly the links
between financial and non-financial performance.
In particular, by focusing on value generation in a broader sense (rather than focusing on narrower
goals of revenue generation, for example) integrated reporting will also encourage organisations to
review the set of performance measures they use to monitor and manage performance.
Therefore, one of the main consequences of integrated reporting is likely to be the increased use of non-
financial data to gain a clearer picture of an organisation and its performance.
Introducing integrated reporting will reinforce the importance of looking at non- financial aspects of
performance as well as financial ones. For example, IR highlights the need to obtain a wider
understanding of value creation in an organisation, beyond that which can be measured through
traditional financial terms.
Equally, IR should also encourage greater attention being paid to non-financial data in strategic decision
making. For example, investment appraisals may need to include non-financial costs and benefits (and
sustainability information) as well as traditional financial costs and benefits.
Strategy, not just reporting
The guiding principles of IR note that an integrated report needs to provide insight into an
organisation’s strategy rather than simply reporting figures. Therefore, rather than simply presenting the
figures, an integrated report should highlight the significance of the figures being presented, and how
they affect an organisation’s ability to create value.
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In their report 'Integrated Reporting: Performance Insight through Better Business Reporting' KPMG
argue that 'Successful Integrated Reporting is not just about reporting, but about co-ordinating different
disciplines within the business, and focusing on the organisation’s core strategy'.
Connecting different teams within the business is an important step to achieving the integrated thinking
necessary to underpin IR. The IIRC’s own website also notes that: ‘Businesses need a reporting
environment that is conducive to understanding and articulating their strategy, which helps to drive
performance internally and attract financial capital for investment. Investors need to understand how
the strategy being pursued creates value over time.’
As such, the management accountant’s role should no longer be simply to report on financial
performance, but also to provide information which can provide insight into an organisation’s strategy.
This is also consistent with the wider change in the role of management accountants in organisations, in which the
traditional view of the management accountant as focusing primarily on financial control and being distanced from
an organisation’s operations has been replaced by a model in which they become more closely integrated with a
business’ operations and commercial processes, providing business support to operating departments and
becoming more actively involved in the decision-making of those departments.
Focusing on key aspects of performance
One of the guiding principles of IR is conciseness, and therefore one of the potential benefits of IR is
that it encourages organisations to produce shorter, more streamlined communications.
Crucially, integrated reporting should not be seen as a reason for simply producing more information or
longer reports. Instead, it requires organisations to identify which aspects of performance are truly key
to their future success – and then focus its performance metrics on them.
Although we have noted that IR encourages the use of non-financial data as well as financial data, the
range of data used needs to be considered within the context of brevity. Overall, organisations should
be looking to reduce the amount of information which is published, in order to make their ‘story’ more
accessible to stakeholders.
5.3.5 Potential benefits of Integrated Reporting
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Recognition of stakeholder interests
The guiding principles of IR highlight the importance of developing relationships with stakeholders and
responding to their interests. In relation to performance measurement and performance management,
as part of its preparation for producing an integrated report, an organisation could consult with its key
stakeholders, to identify what they want to know about the performance and direction of the
organisation. This consultation could then help to identify possible areas of performance which the
organisation should monitor, and report on in its integrated report.
If an organisation needs to include forward-looking information and information about its long-term
performance in its integrated report, this could also have important implications for the information
which the organisation’s management accountant produces.
In particular, the introduction of IR may require management accounting information to become more
‘strategic’ (as we discussed earlier in this chapter), rather than simply reporting on historical, internal,
financial performance. For example, since an integrated report should highlight the opportunities and
risks an organisation faces, there is likely to be a need for external analysis in order to identify the
opportunities, threats and risks presented by the external environment.
Implications of increased importance of non-financial information
Although including non-financial performance metrics in performance reports can help provide a clearer
picture of an organisation and its performance, there could be a number of practical considerations
linked to providing non-financial performance information. In particular:
Can the organisation’s information systems supply the full range of non-financial data which
stakeholders wish to see in an integrated report?
If this data cannot currently be obtained from an organisation’s information systems, how can the
management accountant get the information wanted for the report?
Can non-financial issues be embedded into existing financial systems?
How can the organisation’s information systems be improved in order to allow the required non-
financial information to be collected?
Can non-financial information be gathered and verified within financial reporting timelines?
How can the management accountant ensure that non-financial data is reliable, and more
generally, what assurance is there over non-financial data in a report? (Non-financial data is
typically not audited in the same way that financial data is; but, if stakeholders are going to rely on
this data then should an organisation obtain some kind of assurance over the data?)
In its paper ‘Understanding Transformation: Building the Business Case for Integrated Reporting’ the
IIRC notes that one organisation has developed a non-financial dashboard for its Executive Committee,
linked directly to remuneration packages.
If organisations are going to use non-financial information in this way, they will need assurance over the
accuracy and robustness of the figures, given their potential impact the executives’ remuneration.
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