The IASB’s practice statement on management commentary and the MASB’s SOP 3 provide a framework, explains Ramesh Ruben Louis
This article was first published in the June 2014 Malaysia edition of Accounting and Business magazine.
Studying this technical article and answering the related questions can count towards your verifiable CPD if you are following the unit route to CPD and the content is relevant to your learning and development needs. One hour of learning equates to one unit of CPD. We'd suggest that you use this as a guide when allocating yourself CPD units.
The users of financial information come in all shapes and sizes, with distinct needs and expectations. Many generally look for information that enables them to better understand what has taken place in the organisation, as well as to get a ‘sneak peak’ at its potential, prospects and future plans.
With this in mind, the International Accounting Standards Board (IASB) issued a practice statement on Management Commentary on 8 December 2010, thereafter issued in Malaysia by the Malaysian Accounting Standards Board (MASB) as Statement of Principles 3 ‘Management Commentary’ (SOP 3) on 28 February 2013, which is equivalent to the IASB’s International Financial Reporting Standard (IFRS) practice statement.
It is important to note that the practice statement/SOP 3 is not a financial reporting standard but instead provides a broad, non-binding framework for the presentation of management commentary to accompany financial statements prepared using IFRS/MFRS, which may also be applied by non-listed entities that prepare IFRS financial statements that include management commentary.
A management commentary is a narrative report that provides information to interpret the financial position, financial performance and cashflows of an entity. It also provides management with an opportunity to explain its objectives and its strategies for achieving those objectives. Users routinely use the type of information provided in management commentary to help them evaluate an entity’s prospects and its general risks, as well as the success of management’s strategies for achieving its stated objectives.
The underlying principle of management commentary is to provide management’s view of the entity’s performance, position and progress; and to supplement and complement information presented in the financial statements. This is best achieved when the commentary is forward looking and provides qualitative characteristics that supplement and complement information contained in the financial statements – providing additional explanations of amounts presented in the financial statements and including information that is not presented there. Ultimately, the information should be useful for decision making.
Management commentary should be clearly identified and distinguished from other information (say, in the annual report) and should incorporate a statement on the extent of compliance with the practice statement/SOP 3.
The practice statement/SOP 3 sets out five key elements that are regarded as crucial information for the understanding of the users.
Presentation of management commentary
While the practice statement/SOP 3 sets out the principles, qualitative characteristics and elements that are essential in providing users of financial reports with useful information, the form and content of management commentary may vary by entity, depending on the particular circumstances of their business, including the legal and economic circumstances of individual jurisdictions. This flexible approach is envisaged to generate more meaningful disclosure relating to matters that are most relevant to their individual circumstances.
Whatever the form chosen, the management commentary should:
- address the principles and five key elements set out in the practice statement/SOP 3
- be consistent with its related financial statements. For example, if the financial statements include segment information, the information presented in the management commentary should reflect that segmentation
- avoid duplication of disclosures made in the notes to its financial statements in its management commentary
- avoid generic disclosures that do not relate to the practices and circumstances of the entity and insignificant disclosures.
Nature of business
Usually set forth as a starting point for users to assess and understand an entity’s performance, strategic options and prospects, this element encompasses a description of the business to help users of the financial reports gain an understanding of the entity and the external environment in which it operates. Among others, this would entail a discussion of macro-level information such as:
- the industries in which the entity operates
- the entity’s main markets and competitive position within those markets
- significant features of the legal, regulatory and macroeconomic environments that influence the entity and the markets in which the entity operates, and micro-level information
- the entity’s main products, services, business processes and distribution methods
- the entity’s structure and how it creates value.
Management’s objectives and strategies
Under this element, management should disclose information to enable users to assess the strategies adopted by the entity and the likelihood that those strategies will be successful in meeting management’s stated objectives, including action to be undertaken and resources that must be managed to deliver results.
For example, information about how management of a mobile phone company intends to address new technology, rapid consumer behaviour and expectations, and its related threats and opportunities, provides users of financial reports with insight that can help in their assessment of the entity’s future performance. Management’s measurement of success and time frame to achieve those objective and strategies should also be discussed.
Management should discuss significant changes in an entity’s objectives and strategies from the previous period or periods. Discussion of the relationship between objectives, strategy, management actions and executive remuneration is also helpful.
The discussion in this section will likely not be lengthy as many entities would consider that a detailed discussion would risk divulging commercially sensitive information and give away competitive advantage.
Resources, risks and relationships
An entity’s value has a direct correlation to how it manages its resources, risks and relationships. Therefore, information in these three areas would provide users with a better appreciation of the entity’s management capabilities.
Management should set out critical financial and non-financial resources (such as its employees) available to the entity and how they are used in meeting management’s stated objectives as well as its long-term sustainability. Analysis of the adequacy of the entity’s capital structure, financial arrangements (whether or not recognised in the statement of financial position), liquidity and cashflows, and human and intellectual capital resources, as well as plans to address any surplus resources or identified and expected inadequacies, are examples of disclosures that can provide useful information.
In terms of risks and disclosures about the entity’s principal risk exposures (and changes), coupled with its risk-mitigating strategy and how effective those are, would form the crux of the discussion. This information is crucial to assess the risks faced by the entity and possible/potential uncertainties. The key risks that should be included in the analysis would be strategic, commercial, operational and financial, and should be discussed not only from the perspective of adverse consequences but also in light of potential opportunities to the entity, if managed properly. It would be imperative that the » discussion on risks (and risk management) be aligned with the entity’s objectives and strategies.
Under this element, management should also identify significant relationships that the entity has with its stakeholders, how these relationships are managed and how they are likely to affect the performance and value of the entity.
Results of operations and performance
For many, this may likely be the highlight and focal point of the management commentary. It is undeniable that many users of financial information look for supplementary and complementary analysis that will enable them to make better sense of the main financial statements, especially in terms of whether the entity has delivered results in line with expectations and, implicitly, how well management has understood the entity’s market, executed its strategy and managed the entity’s resources, risks and relationships.
It is quite common that the following information, where presented and discussed for the current and prior periods, will equip users to meet those needs and concerns:
- operating results and profitability
- shareholders’ value or returns
- net worth and market values
- debt management.
Many entities usually provide this information as ‘financial highlights’ in their annual reports.
Management should provide an analysis of the prospects of the entity, which may include targets for financial and non-financial measures and, where quantified, the risks and assumptions used.
Critical performance measures/indicators
Users of financial information are more familiar with performance-related information that is used and monitored by management to enable them to assess and evaluate the entity’s performance against stated objectives and strategies. To address this need, management should disclose performance measures and indicators (both financial and non-financial) that are used by management to assess progress against its stated objectives.
Some key pointers to take note of when discussing performance measures and indicators include:
- comparability with industry and/or in general
- if there are changes from prior period, an explanation of why and how it has changed
- any adjustments or variations from that presented in the main financial statements
- definition and explanation of measures and indicators not defined or required by IFRS/MFRS, including its relevance to users
- reconciliation of measures and indicators with those that are presented in the main financial statements.
Conclusion and outlook
Management commentary is a component of a more coherent and integrated form of reporting that sets out a context for better understanding and usefulness of financial information, especially the financial statements. When prepared with the needs and concerns of the users in mind, management commentaries will certainly add value to the financial statements. With the issuance of MASB’s SOP3 in 2013, it is hoped that the ‘full benefits’ of financial reporting will be further enhanced in Malaysia in the coming years.
Ramesh Ruben Louis is a professional trainer and consultant in audit and assurance, risk management and corporate governance, corporate finance and public practice advisory.