Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1

Maruszewska, Ewa Wanda; Tuszkiewicz, Maciej Andrzej Article Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1 Central European Economic Journal (CEEJ) Provided in Cooperation with: Faculty of Economic Sciences, University of Warsaw Suggested Citation: Maruszewska, Ewa Wanda; Tuszkiewicz, Maciej Andrzej (2024) : Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1, Central European Economic Journal (CEEJ), ISSN 2543-6821, Sciendo, Warsaw, Vol. 11, Iss. 58, pp. 1-16, https://doi.org/10.2478/ceej-2024-0001 This Version is available at: https://hdl.handle.net/10419/324603 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by/4.0/ ISSN: 2543-6821 (online) Journal homepage: http://ceej.wne.uw.edu.pl To cite this article Maruszewska, E.W., Tuszkiewicz, M.A. (2024). Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1. Central European Economic Journal, 11(58), 1-16. DOI: 10.2478/ceej-2024-0001 To link to this article: https://doi.org/10.2478/ceej-2024-0001 Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1 Ewa Wanda Maruszewska, Maciej Andrzej Tuszkiewicz Open Access. © 2024 E.W. Maruszewska, M.A. Tuszkiewicz, published by Sciendo. This work is licensed under the Creative Commons Attribution 4.0 International License. Ewa Wanda Maruszewska University of Economics in Katowice, Department of Business Informatics and International Accounting, ul. 1 Maja 50, 40-287 Katowice, Poland corresponding author: [email protected] Maciej Andrzej Tuszkiewicz University of Economics in Katowice, Department of Business Informatics and International Accounting, ul. 1 Maja 50, 40-287 Katowice, Poland Boundaries of management performance measures (MPMs) disclosed in primary financial statements prepared in accordance with new standard planned to supersede IAS 1 Abstract We outline the management performance measures (MPMs)’ boundaries based on the upcoming introduction of MPM’s definition to International Financial Reporting Standards (IFRS). The literature investigates business performance measures concentrating on managers’ needs, while IFRS aims to provide financial information to external users who provide resources to the entity. This indicates a gap between how performance metrics have been investigated so far and how IFRS will adopt them. We used analysis of the exposure draft of the planned standard together with working materials developed in the consultation process. Further, a case study is presented. Results show that the scope of MPM to be introduced to IFRS is limited compared to the broad spectrum of performance measures presented in the literature. We contribute by showing the avenues for future performance measures research using signalling and agency theory and by indicating the limited scope of MPMs and thus bound prospects for using them for a full assessment of the entity‘s performance. Keywords management performance measures | MPM | performance measurement | IAS 1 | IFRS 18 | signalling theory | agency theory JEL Codes M00, M40, M41 1. Introduction In 2014, International Accounting Standards Board (hereinafter IASB) has started a project named “Primary Financial Statements.” The project aims to increase transparency and comparability of financial statements, thus enhancing the relevance of the information disclosed. As a result, an exposure draft was published in 2019, General Presentation and Disclosures ED/2019/7 (later referred to as ED), which presents a standard planned to supersede IAS 1 “Presentation of Financial Statements”. Since then, the European Financial Reporting Advisory Board (EFRAG), working on developing IFRS Standards from a European perspective, in parallel collects opinions and organises field tests of the ED. It led to amendments within the scope and content of the planned IFRS 18 Presentation and Disclosure in Financial Statements (IFRS Accounting, 2023, July). The authors were a part of the expert groups testing and stating their opinions on the original ED and its amended versions. This article aims to outline the boundaries of the MPM based on the upcoming changes to financial reporting. This need arises from the fact that the definition of MPM will be introduced by IFRS for the first time in 2024 (IFRS Foundation, 26.07.2023), with an effective date in 2027. Based on the analysis of regulations developed since 2019, the authors show the necessity for preparers of financial statements to examine the new regulations as well as the obligation for the users of financial statements to understand these new elements of financial statements to properly CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 3 use them in their decision-making processes. To achieve the stated objective, the authors ask a research question: What are the boundaries of MPM prepared in accordance with the planned standard? This question is essential, as performance measures (business performance measures, performance measurement and management systems (PMMSs), or performance metrics) already exist in the theoretical and empirical literature. Further, qualitative characteristics of financial reports are built upon faithful representation and relevance; thus, MPM, being a part of IFRS, must comply with them, forcing managers to make wellthought-out decisions about the type of MPM that is made public and used by the economy participants. 2. Business Performance Measurement: Literature Review The importance of business performance measurement in assessing the efficiency and effectiveness of an entity’s past actions is broadly emphasised in management literature, including accounting studies (Mavropulo et al., 2021; Neely et al., 2000). Hence, it is an area of constant research, both theoretical and practical. Considerable interest in this topic began with the criticism of business performance metrics used in the 1970s and 1980s (Berliner & Brimson, 1988; Chandler, 1977; Cooper & Kaplan, 1988). The main complaint was that business performance measures do not provide a clear answer as to which actions influenced which results (Taticchi et al., 2009), and thus different performance measurement and management models were designed like the Du Pont Pyramid of Financial Ratios (1977), results and determinants framework (Brignall et al., 1991), the performance pyramid (Lynch & Cross, 1991), the balanced scorecard (Kaplan & Norton, 1992), the process-based approach (Neely et al., 2000) or the Cambridge performance measurement process (Neely, 2002). Further, developed measures were adjusted and/or amended to the changing business environment (Kennerley & Neely, 2003). In addition, the literature as a whole deals with the adjustment of designed models to the needs of small and medium entities that have some specific characteristics, such as no separation of the owner from the manager, lack of formal strategy that should be included in the model, or no clear organisational structure, and concern mainly for short-term cash flows (Bahrl et al., 2016). This stream of literature clearly indicates that performance measures are mainly based on the information disclosed in the financial statements but also on non-financial measures. This is because performance measures must measure both financial and non-financial aspects of performance (Bahrl et al., 2016), like profitability, efficiency, customer satisfaction, or quality of services (goods produced). Clever integration of financial and non-financial and internal and external data builds the strength of performance measurement used in contemporary entities. Further, performance measures should be prepared based on the information available in the entity (as additional collecting of data makes the system too expensive). They should not only measure past performance but, beyond the above, guide managers for future activities, and in addition, they should implicitly convey the entity’s strategy (Boselie et al., 2005; Van der Hauwaert et al., 2022). The above description of performance metrics is incomplete, as the literature highlights various characteristics central to the approaches under investigation (Taticchi et al., 2009), indicating a multifaceted approach to evaluating an entity’s performance, aiming at complete business description. To summarise, research interest in measuring business performance seems to adhere to the principle that when one can measure something, one possesses knowledge about it; thus, one can improve it (Micheli & Mari, 2014). Sharing knowledge with those outside the entity seems to be a basic premise for introducing MPM into IFRS. 3. Theoretical Underpinning For many years in the accounting literature, a great deal of attention was paid to the need of market participants for reliable and relevant information (Chen et al., 2021; Cutler et al., 1989; Kadous et al., 2012; Marilen et al., 2013) as well as to the accounting struggle for achieving it (Alexander & Archer, 2003; Burchell et al., 1985; Hartmann et al., 2018; Lambert et al., 2007; Macintosh, 2009; Macintosh et al., 2000; 7). One can say that researchers agree on the need to provide information about the entity’s performance that market participants use to make their decisions. CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 4 Signalling theory and agency theory seem to dominate the literature cited above. Both theories refer to managers who decide about the information provided to investors, creditors, and other uninformed parties outside the entity. Based on signalling theory, it can be argued that managers—who have superior knowledge, inter alia, about the entity’s future cash flows—make accounting choices to reveal their expectations to uninformed participants of the economy (Holthausen, 1990). Signals derive from an intent to imply something in the hope that the market (external parties) will change the company’s valuation (Connelly et al., 2011). The theory was widely used over the years with relation to accounting (Aljughaiman et al., 2023; Gomoi & Pantea, 2016; Khan et al., 2019). Management performance metrics investigated in the prior literature, as well as MPM in a way defined in the planned IFRS, provide information about the entity’s present condition and prospects. We also underpin our research on agency theory, which describes the incentive problems caused by the separation of ownership and management, called the principal-agent problem (Ross, 1973). Agency theory is one of the four most used concepts within behavioural accounting (Chapman et al., 2007). It results in managers’ use of discretionary accounting choices influencing finance management, earnings management (Białek-Jaworska and Dec; 2019; Harrison & Harrell, 1993; Jassim et al., 1988; Liang et al., 2023), and financial reporting (Ayu et al., 2020; Knoeber & McKee, 1991; Maruszewska et al., 2023; Palas et al., 2023). Thus, agency theory can be used not only for accounting policy choices and voluntary disclosures but also for obligatory disclosures in the form of, e.g., managerial commentary where managers are to decide about the details of data presented and the form of presentation of financial information. Thus, we argue that new MPM requirements under planned standard can also be subject to the agency problem. As both theories address similar accounting issues, concentrating on the provision of information to those outside the entity, it should be noted that agency theory pays little attention to signalling, while signalling theory ignores the agency problem (Morris, 1987), we find both theories as suitable theoretical background for our study. On the one hand, the planned introduction of MPM can be seen as an opportunity to signal positive outcomes of an entity’s performance. However, on the other hand, when negative information is revealed through MPM, it can be subject to the agency problem. 4. MPMs in the Planned Standard 4.1. The Understanding and the Scope of MPMs The changes in financial statements upcoming in the new standard have been divided by IASB into four main areas: 1) classification and presentation of operations in the profit-and-loss statement, 2) management performance measures (hereinafter MPMs), 3) classifications of operating costs by function and by nature, 4) unusual incomes and expenses (EFRAG IASB Joint Online Roundtable, 2022, November). Regarding the classification and presentation of operations in the profit-and-loss statement, the planned changes include (among others) the introduction of financial and investment activities segments besides the already existing operation activities segment. It also introduces unusual incomes and expenses and forces new presentation of operating costs. New segmentation is important from the point of view of MPM, as new categories among profitand-loss segments may end up with changed or new perspectives for business performance measurement. Regarding MPM, the project of the new IFRS states that “Management Performance Measures are subtotals of income and expenses not specified by IFRS Accounting Standards that are used in public communication outside financial statements” (ED, 2019). Drawing from this definition, a few key points require explanation and were already clarified in the development of the new standard process. Regarding the first part of the definition, IASB proposed a graph to clarify the scope of MPMs, as per Figure 1. The definition states that MPMs are subtotals of income and expenses. That implies that only measures resulting from the subtraction of income and expenses are within the scope of MPMs. As shown in Figure 1, the above excludes all performance metrics that are not drawn from financial values, but also all the financial indicators that are not a result of subtraction of income and expenses, like return on assets, CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 5 earnings per share, or economic value added (EVA). In addition, ED states that MPMs are not specified by IFRS Accounting Standards, meaning that, as shown in Figure 1, operating profit is not MPM, as it will be required per standard to present the operating profit on the profit-and-loss statement scheme. The second part of the definition, “used in public communication outside financial statements”, brought much discussion, as there was confusion about whether any verbal communication or any statement placed on social media would automatically incline to include a specific measure to MPM if it meets the first part of the definition. Accordingly, the IASB has tentatively decided to add a note that the definition excludes “oral communication, transcripts and social media posts” and add a rebuttable presumption, presented in Figure 2. As observed, the rebuttable presumption is used as a form of logical explanation that when an entity uses a measure in its public communication, it communicates management’s view of an aspect of an entity’s financial performance. The rebuttable presumption is meant to be used as guidance and reduction of subjectivity, but also as a possibility to avoid the requirement to present a measure that is not in its essence an MPM but happened to be communicated in public. Therefore, the new standard will mandate the presentation of a measure communicated in public if there is reasonable and supportable evidence that it communicates management’s view and is done consistently. As a result, the company could not enumerate a specific measure as MPM if it was used incidentally. This is important for preparers of financial statements, but also for users of financial statements, who should be aware of this fact to differentiate MPMs from other performance information that does not meet strict requirements reducing, e.g., subjectivity. Once management decides on a measure that falls within the MPM definition, it is required to prepare a disclosure within the financial statement. IASB has outlined four main points for the disclosure note, as presented in Figure 3. As shown in Figure 3, the first and probably the most time-consuming part of the disclosure preparation will be the reconciliation of the MPM to the closest subtotal that IFRS specifies. The closest subtotal means the subtotal presented in the profit-and-loss statement prepared according to the standards. The reconciliation builds the high quality of the information disclosed with MPMs in terms of faithful representation and relevance, as it makes it transparent and sometimes may enable users of financial statements to compare MPMs between Specified by IFRS, e.g.: • Operating profit, • Profit before tax. MPMs, e.g.: • Adjusted Gross Profit, • Adjusted EBITDA, • Adjusted profit or loss. Performance measures Non-Financial performance measures, e.g.: • Customer satisfaction, • H&S score, • Number of new clients. Financial performance measures Other measures, e.g.: • Working capital, •Return on assets, • Instant liquidity ratio. (Sub)totals of income and expenses Figure 1. Scope of Management Performance Measures Source: (IFRS Accounting, 2023, July) Are used in public communications outside financial statemnts = Communicate management's view of an aspect of an entity's financial performance Subtotals of income and expenses not specified by IFRS Accounting Standards that: Figure 2. Rebuttable Presumption for the Definition of MPM Source: EFRAG, 2022, September CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 6 entities based on the algorithms used. However, it is necessary to remind the reader that MPM may not necessarily be comparable between entities to avoid direct comparison of measures with the same name without checking how they were calculated. Also, the company must outline the changes to how MPM was presented or calculated between successive years if any changes were made. Further, the entity is to explain reasons for including specific measures such as MPM, focusing on its usefulness to the user of financial statements. Although the scope of MPM is limited to financial information and incomes and expenses only, the link between performance results and the entity’s strategy and/or short-term entity’s objectives articulated by investors, products’ groupings (or assortments), or a sale’s geographical differentiation can be described. New financial and investing segments in profit-andloss statements show prospects to disclose MPM informing about these activities in the form of revenues and expenses from financial and investing managerial decisions. 4.2. Reconciliation between MPM and the Most Directly Comparable Subtotal Specified by IFRS As there is a requirement for each MPM disclosed in the financial report to provide a reconciliation, an example is presented in Figure 4. In the example presented in Figure 4, the adjusted operating profit in MPM disclosed in the financial report is a management view of operating profit, excluding incidental restructuring in country X. Through subtraction of restructuring costs and revenue adjustments, it is reconciled to the most direct subtotal, which in this case is operating profit. The two right columns affect income tax and noncontrolling interests (later referred to as NCIs), as the entity is also obligated to include these effects for each reconciliation. The new standard does not include a graphical sample of the reconciliation. During the discussion at the IASB meeting in July 2023, there seemed to be an agreement that the standard would not require one specific methodology with regards to reconciliations but might propose examples to ease the process for entities having trouble accommodating the differences Reconciliation Reconciliation between MPM and the most directly comparable subtotal or total specified by IFRS Accounting Standards, including the income tax effect and effect on non-controlling interests Why an MPM communicate s management's view Includes an explanation of how the MPM is calculated and how the measure provides useful information about the entity's performance. Explanation should refer to individual reconciling items where necessary Not necessarily comparable with other entities A statement that MPM provides management's view of an aspect of the entity's financial performance and is not necessarily comparable with measures provided by other entities Changes in calculation Explanation of and reasons for any changes in how the entity calculates its MPMs or which MPMs it provides Disclosure requiremenets for MPMs Figure 3. Required Disclosures Regarding MPM Source: Own elaboration based on FASB IASB Joint Educational Meeting (2022, September) CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 7 between MPM and the most directly comparable subtotal specified by IFRS. One of the points was of the new methodology was to show the MPM first (at the top), which then gets reconciled to a subtotal. 4.3. Tax Effect on Reconciled Items Another topic discussed was the proposal to include the tax effect of reconciled items. On the one hand, tax effect was requested by the users of financial statements. It was strongly voiced as necessary to strengthen the reliability of financial statements and the ability to analyse them properly. On the other hand, preparers voiced difficulty in calculating the tax effect, which may be affected by many factors that might be difficult to explain to the user of financial statements and hence actually hurt the faithful representation and relevance. To satisfy both sides, IASB tentatively decided to include a requirement to show the tax effect on reconciled items but to allow simplification of this by applying either (IFRS Accounting, 07.2023): • Statutory tax rate(s) applicable to underlying transaction(s) in the relevant jurisdiction(s), or, • reasonable pro rata allocation of the current and deferred tax, or, • another method achieving a more appropriate allocation due to specific circumstances. Irrespective of the chosen methodology, the entity ought to explain how the income tax effect was calculated and should be presented separately for each item if more than one method was used. In summary, the overall description of MPM in the planned standard does not provide detailed information about what should be disclosed as MPM. Instead, it focuses on a framework (or model approach), as standards used to be. This, on the one hand, leaves room for management to decide what to choose as MPM and to show management’s view on the entity’s performance, allowing for selected, and not very detailed information. On the other hand, it underlines that an individual approach directed at high-quality MPM is crucial for users of financial statements, and it should guide a manager when making decisions. From the preparers’ point of view, the decision about MPM should encompass technical issues as a possibility to make detailed reconciliation, including the tax issues. 5. Case Study The case study is based on company A, whose data were drawn from accounting books for three consecutive years, from 2020 to 2022. The company chosen for this case study prepares its financial data following IFRS for consolidation purposes only. The data presented in the case study were anonymised, maintaining the scale of significance of individual transactions discussed in the case study. In this empirical part, the project of the upcoming IFRS standard will be recalled as “IFRS X”. Company A uses presentation per function for providing operating costs in its statement of financial performance and decided to distinguish the gross profit. For the three analysed periods, the company paid the income tax at a lower effective rate than the nominal tax rate because it was granted a tax exemption for investing in a special economic zone. The short version of the current statement of financial performance as per IAS 1 is presented in Table 1. To be able to present the notes regarding MPMs, there is a need to present a transformed statement of financial performance in accordance with new IFRS X guidelines and explain the main differences. Transformed data from company A are presented in Table 2. When comparing statements of financial performance prepared per IAS 1 and IFRS X, the first difference worth noting is an introduction of additional segments: investing and financing. Adjusted operating profit (MPM) 60,000 Tax effect NCI - Restructuring in Country X (incl. In employee benefits) -5,000 1,000 -800 - Revenue adjustment (incl. in revenue) -6,000 1,200 - Operating Profit (IFRS-specified) 49,000 Figure 4. Reconciliation of the MPM Source: Own elaboration based on FASB IASB Joint Educational Meeting (2022, September) CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 8 Table 1. Statement of Financial Performance for 2020–2022 in Accordance With IAS 1 Year (amounts in PLN) 2022 2021 2020 Revenue from the sale of goods 22,132,991 16,381,185 11,589,068 Cost of goods sold –15,447,701 –11,298,542 –8,178,590 Gross profit 6,685,290 5,082,644 3,410,478 Other income 410,245 201,756 414,358 Selling expenses –1,701,360 –1,192,527 –914,645 General and administrative expenses –2,554,044 –2,208,843 –1,738,436 Other expenses –453,009 –399,870 –514,536 Finance costs –8,058 –10,119 –153 Profit before tax 2,379,064 1,473,041 657,067 Income tax expense 128,469 154,669 57,164 Profit for the year from continuing operations 2,250,595 1,318,372 599,903 Loss for the year from continuing operations 0 0 0 Profit for the year 2,250,595 1,318,372 599,903 Source: Own elaboration Table 2. Transformed Statement of Financial Performance for 2020–2022 in Accordance With IFRS X Year (amounts in PLN) 2022 2021 2020 Revenue from the sale of goods 22,132,991 16,381,185 11,589,068 Cost of goods sold –15,447,701 –11,298,542 –8,178,590 Gross profit 6,685,290 5,082,644 3,410,478 Other income 265,245 102,756 376,358 Selling expenses –1,701,360 –1,192,527 –914,645 General and administrative expenses –2,554,044 –2,208,843 –1,738,436 Other operating expenses –444,009 –401,108 –510,036 Operating profit 2,251,122 1,382,922 623,720 Investment income 145,000 99,000 38,000 Investment costs –9,000 –6,000 –4,500 Profit before financing and income tax 2,387,122 1,475,922 657,220 Finance income 0 0 0 Finance costs –8,058 –2,882 –153 Profit before tax 2,379,064 1,473,041 657,067 Income tax expense 128,469 154,669 57,164 Profit for the year from continuing operations 2,250,595 1,318,372 599,903 Loss for the year from continuing operations 0 0 0 Profit for the year 2,250,595 1,318,372 599,903 Source: Own elaboration CEEJ • 11(58) • 2024 • pp. 1-16 • ISSN 2543-6821 • DOI: 10.2478/ceej-2024-0001 15 EFRAG IASB Joint Online Roundtable. 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