Section 5
Measuring Performance
SECTION OVERVIEW
Janette Rutterford
As I mentioned in the Introduction, one of the changes affecting organisations, whether privately owned or public sector, has been the increased emphasis on performance measurement. The UK 1980s privatisation of the major utilities has led to traditional monopolies being run by private sector firms, subject to regulators imposing both financial and operating performance targets. For example, hospitals, prisons, train companies, all have their operating performance measured and this performance, relative to pre-set benchmarks and published as league tables, affects their revenues. Late trains mean that the train operating companies incur fines. Schools failing to achieve the requisite numbers of A level passes receive less funding. And so on. One example of the introduction of financial performance into the public sector is the introduction of Best Value for local authorities through the Local Authorities Act of 1999. This required English local authorities, from April 2000, to implement the 4Cs: consult about the level and method of providing services, compare its performance with other authorities and past performance, challenge the status quo of its provision and assess the competitiveness of its service provision in comparison with other authorities and the private sector.1
The UK privatisation programme was accompanied by the modernising of public sector accounting. Instead of the traditional cash-based accounting systems, with annual budgets, the public sector has now switched to accrual accounting, in line with the private sector. At the same time, assets owned by the government were valued and, if the return being achieved was under the required rate of return, these assets – such as shipyards, soldiers' homes, unused public buildings – were sold to the private sector.
Also, in the UK, new public sector projects such as hospitals, prisons and schools are no longer automatically funded, owned and managed by the public sector. Any new projects have to be assessed both under conventional public ownership, using a government imposed required real rate of return, and under private ownership, owned and possibly run by the private sector, providing services for the public sector in return for an annual charge. At the end of the life of the project, ownership may or may not return to the public sector, depending on the terms of what is known as the Public Private Partnership contract. Such partnerships raise interesting issues to do with risk transfer, which are exacerbated by the long lives of some of the projects. Again, the private sector is judged in such projects according to predetermined performance measures, which, if not met, incur financial penalties. The private sector funding of these projects has also meant a new approach to the capital structure decision – instead of projects being 100% debt funded by government, these projects now have a number of types of debt finance, with a small element of equity. The relatively higher overall cost of capital is deemed to be compensated for by more efficient management and hence lower overall cost cash flows.
This has been not just a British phenomenon, but a global one. Other countries, from Malaysia to Germany, from Eastern Europe to Australia, from Japan to Russia, have implemented privatisation programmes and private sector funding of public sector projects. This has meant imposing financial performance measures on organisations previously measured according to outputs, or not measured at all.
In the private sector, there has also been change. The traditional demarcation between finance and accounting is being removed. The situation where accounting was based on historic cost, and where management accounts bore little relation to financial market values is changing. As well as using discounted cash flow concepts for ex ante project appraisal, discounted cash flow and market values are also being used for ex post performance measurement. Examples of such measures have included Economic Value Added (EVA®) and cash flow return on investment (CFROI). Management compensation is now commonly linked to financial market performance and not just to accounting measures such as earnings growth. In this way, it is believed, management will act in such a way as to maximise shareholder value, rather than just trying to beat accounting measures based on, for example, historic cost. The use of options to remunerate executives was an attempt to ensure that managers behaved in a way which would enhance shareholder value. The disadvantages, though, of executive options are brought out in Case Study 14, an interview with Microsoft's CFO. It is difficult to motivate managers in a bear market when half of them are sitting on realised gains from their options and the other half on options with no intrinsic value. What is certain, though, is that the performance measurement system by which managers are judged affects the way that managers behave. Behavioural finance, again!
Another major change in the private sector is in financial reporting and the link with financial values. There has been pressure from the two major accounting bodies, the FASB in the US and the IASB in Europe and beyond, to move towards market values in financial accounts, away from historic costs. The aim here is to help the investor or stakeholder to get a better estimate of the value of the firm and of its true risk. So, for example, accounting rules for goodwill, for pension liabilities and for derivatives now require current rather than historic estimates of value to be taken into consideration. Executive options, previously off-balance sheet, now have to be expensed. Such changes are affecting companies across the world. Today, the FASB in the US and the IASB in Europe dominate the financial reporting of major companies. To be taken seriously, wherever a company is based, managers have to produce financial statements according to one or other of the two major bodies. However, as financial reporting requirements change, the less scrupulous managers take steps to enhance accounting performance rather than true performance. The more emphasis that the financial markets place on earnings, for example, the more pressure there is on managers to deliver the expected performance. This has led to some unpleasant surprises when apparently high-performing companies such as Enron turn out to have feet of clay.
The article by Gilbert Gélard, “What can be Expected from Accounting Standards?”, looks at the impact of the introduction of common accounting standards, those of the International Accounting Standards Board, for all listed companies in the European Union. The change is relatively limited for UK companies, since the UK financial reporting body has had a major influence on the contents of the IASB accounting standards. The change is quite dramatic for French and German companies, which, apart from multinationals, have not hitherto felt the need to produce accounts which are of great relevance to stakeholders, in particular investors, preferring to conform to the law and concentrate on tax minimisation rather than profit maximisation. The change is even greater for companies based in Eastern Europe; such companies have had to switch, in a period of under ten years, from communist forms of accounting to an emphasis on reporting for investors.
Case Study 11, “Queens Moat Houses plc”, gives an example of creative accounting. Although a relatively old example, it is a classic of its kind. The case consists simply of an extract from the 1992 Annual Report and Accounts of Queens Moat, a UK company which used a number of accounting methods to appear more profitable than it actually was. The 1992 accounts show how, by creative accounting, a 1991 loss of £56 million appeared as a profit of £90 million. These numbers pale into insignificance when we look at companies such as Enron, Royal Ahold, Parmalat and WorldCom. But what is interesting is that, despite the example of Queens Moat and others in the 1990s, and despite the increasingly stringent requirements of the financial reporting bodies, company collapses of greater magnitude could happen in the most sophisticated stock markets in the world. In the next section, in Case Study 15, the example of Parmalat will be looked at in greater depth.
Case Study 12 is an article by Keith Boyfield, “Learn by Numbers”, on the impact of the switch to international accounting standards from January 2005 on utility companies. The main point that he makes is that even stock market analysts, used to studying such companies closely, had difficulty with the changes which led to quite different earnings and balance sheet values. Some companies had to spend substantial amounts of effort in trying to explain the impact of the changes in terms of what were real changes and what were merely accounting changes. In a few years' time, researchers will be able to estimate how investors valued the accounting changes and whether they were able to separate real and accounting movements.
The Economist article, “A Star to Sail By?”, looks at financial performance measures, such as financial ratios and Economic Value Added, and the balanced scorecard approach, which uses both financial and non-financial numbers, as means of assessing organisational performance. The aim of all such measures is to make sure that managers take decisions which are optimal for the shareholder, that is, to make sure that they add value to the firm. However, each financial performance measurement system will have flaws and will lead to perhaps non-optimal behaviour. For example, if shortterm remuneration depends on a particular measure, managers will attempt to maximise this, perhaps at the expense of long-term performance. Similarly, if there is too much concentration on financial performance measures, customer satisfaction may suffer. This article gives a good overview of a number of financial performance measurement systems. The following articles go into more depth on each one.
For example, “EVA Implementation, Market Over-Reaction, and the Theory of Low-Hanging Fruit”, by Barbara Lougee, Ashok Natajaran and James Wallace, not only has an interesting title, it also looks at the impact – perhaps unexpected – of introducing a particular kind of financial performance measurement system, in this case, Economic Value Added. Economic Value Added measures the difference between the return on capital employed (operating profit after tax) and the cost of capital (WACC) – all multiplied by the capital employed. Such a measure will be high for firms which make high profits, use limited capital employed or have a low WACC and in theory forces managers to concentrate on adding value through both investment and financing, at both the divisional and group level. The authors of the article look at a sample of over 70 firms which introduced EVA® as a performance measurement scheme, linked to manager remuneration, and analysed the impact on the financial markets and on manager behaviour. What is interesting is that markets initially reacted extremely positively to the introduction of EVA® in a firm – which seems to show that just announcing a change can have perhaps more impact than the change itself. Also, manager behaviour changed. Not surprisingly, managers were keen to sell divisions or subsidiaries which did not earn a return on capital employed equal to the WACC. They also reduced their WACC by such financial restructuring as share repurchases. It is worth thinking back as you read the article to the economic environment at the time that EVA® programmes were being introduced. Interest rates fell throughout the 1990s, having a windfall benefit on WACC and on EVA®. Would managers introduce such incentive schemes in an era of rising interest rates?
“Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part I” is an article by the authors of the balanced scorecard approach, Robert Kaplan and David Norton. This article is essentially an update and expansion of their initial article in 19922 which proposed the use of a wider set of performance measures, both financial and non-financial. This is specifically designed to avoid the pitfalls which can arise when purely financial goals are set. The authors also propose that the measures chosen should be specifically linked to the firm's strategic objectives, a point on which they elaborate in this more recent article. Part II of this article3 gives case study examples of the balanced scorecard approach in practice.
Such ideas are also relevant to the public sector. As I have already mentioned, the UK has introduced a number of changes to performance measurement in the public sector, in particular the switch from cash to accrual accounting. These were masterminded by Sir Andrew Likierman, the author of the last article in this section, “Performance Indicators: 20 Early Lessons from Managerial Use”. In the article, Sir Andrew gives a first-hand analysis of the successes and problems which arose from using a wide range of performance measures and indicators in a number of UK public sector organisations.
NOTES
1. For further information on this local authority (municipality) programme, consult the website of the Local and Regional Government Research Unit, Cardiff University, www.cardiff.ac.uk/research/lgru.
2. R. Kaplan and D. Norton (1992) “The Balanced Scorecard – Measures that Drive Performance”, Harvard Business Review, 70 (1), pp. 71–80.
3. R. Kaplan and D. Norton (2001) “Transforming the Balanced Scorecard from Performance Measurement to Strategic Management: Part II”, Accounting Horizons, 15 (2), pp. 147–60.