Ever greater macroeconomic fluctuations call for more attention to the link between the "noise" that they constitute and the way the company develops. The effects of the "noise" must be weeded out so that a clear picture of the long-term, sustainable profits can be obtained and with this a picture of how the company’s intrinsic competitiveness is fostered. An understanding of the effects of the fluctuations also forms the basis for risk assessment. Current reporting practice does not provide the external stakeholders with adequate views of the character and magnitude of the macro-economic influence on the company. IAS 1 (rev. 1997) indicates that an improvement in this important area may be in the making. This paper discusses four different interpretational levels of IAS 1 (rev. 1997) according to the possibilities for transmittance of relevant information that the MUST-analysis provides a company.
1999-08-10
Crisis in Asia, crisis in Russia, crisis in Latin America. Turbulency in the world economy is rampant. New scenarios about the economic development are constantly being envisioned. How, then, will my investment be affected under different scenarios? My job? My debtor? My trusty supplier? Many stakeholder categories besides management have reason to ask themselves what effect the crises will have on their "own" company. Most of them search to no avail in the company’s external reporting for information that will enable them to gain an idea of the crises’ potential effects. Choi (1991) asserts that financial managers and accountants who are wedded to "generally-accepted accounting principles" are likely to find themselves replaced by those who embrace the notion of "decision-relevance". However, the reporting practice of today, indicate no change in that direction. Practice is not geared to answer questions like "what happens if". Neither is it geared to give an understanding of how much of the profits during the reporting period are generated by fluctuations in the macroeconomic environment of the firm and how much are sustainable profits and therewith an expression of the firm’s intrinsic competitiveness. Hence, not much progress has been made as regards how to reach one of the basic goals of external reporting: to provide information about the future prospects of the company.
Recurring crises of such a dramatic character as we see today will presumably work in the direction toward a content in external reporting that will make it possible to answer questions of this nature. The contents of the standard - IAS 1 - issued and newly revised by the International Accounting Standards Committee (IASC) provide an indication that such a shifting may be on the way. The standard - effective for reporting periods from 1 July 1998 - encourages reporting that elucidates the macroeconomic impact on corporate performance.
The purpose of this paper is to show how IAS 1 (rev. 1997) with the "right" interpretation and implementation can elevate the external stakeholders’ understanding of the company’s future profit opportunities and macroeconomic risks in a crucial way. Four different interpretations are discussed, where "right" means interpretation and implementation in congruence with the furthering of the results of a MUST (Macroeconomic Uncertainty Strategy) - analysis (see Oxelheim and Wihlborg, 1997) in the external reporting. This involves the disclosure of sensitivity coefficients to relevant macroeconomic factors based on hard data that enables management and other stakeholders to distinguish exchange rate and other macroeconomic risks from inherent business risks. In terms of accounting tradition we follow Ijiri (1975) and his view that:
Accounting is a system for communicating quantitative information about the economic events of an entity
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A measurement scheme must be carefully designed in the light of the known real relation among the attributes and the objects.
The major theme of this article is that as long as exchange rate changes are viewed independently of other prices it is impossible to develop a consistent accounting principle for measuring the impact of that variable on performance; historically by "filtering" as well as in the future by estimation of exposure coefficients. Many researchers have emphasised that exchange rates are correlated with other macro variables and this should be taken into account when measuring exchange rate exposure (see e.g. Adler and Dumas, 1983; Cornell, 1980; and and Hekman 1985). However, there is little emphasis on the measurement - for accounting purposes - of different kinds of macroeconomic sensitivity coefficients simultaneously
The paper is organised as follows: Section 2 addresses efforts to create a global accounting standard in general and one embracing the impact of macroeconomic variables on corporate performance in particular. Alternative interpretation of IAS 1 (rev. 1997) are put forward in this section. Section 3 contains a brief presentation of the MUST analysis, whereas Section 4 compares the current reporting practice of the global automotive industry with the requirements of IAS 1 (Rev. 1997). Section 5 exemplifies how the result of the MUST-analysis should be reported to external stakeholders along the lines suggested by IAS 1 (rev.1997). Finally, implementation aspects are discussed in Section 6.
Increased integration among the world’s equity markets has created a growing need to bridge the international information gap that has arisen as a result of the fact that reporting practices in countries are in general developed independent of what happens in other countries. The increased integration has meant that a search for a common, cross-border valid body of reporting rules and a co-ordination of practice have become international issues of concern.
The external reporting of the impact of macroeconomic fluctuations is a matter of signalling and choice of relevant information content. On overriding problem for external accounting is that objectives used to guide the choice of relevant information do not immediately permit a formulation in operational terms. This is due to the difficulties in aggregating the objectives of different stakeholder groups. Whose goals should be considered in accounting? The answer may be that the information must meet some minimum requirement satisfying everyone with a stake in the firm.
Chambers (1966) offers some guidelines about the normative goal of external accounting: It should provide
"..... a method for retrospective and monetary calculation the purpose of which is to provide a continuos source of financial information as guide to future action in markets."
Translated into more general terms; all stakeholders require information with predictive value for evaluating a firm’s prospects and risks. Moreover, information should pave the way for intertemporal comparisons internally as well as cross firms (benchmarking) and national borders. Even if IAS (1997) points the way, there is still a bit to go until we have a global standard for information that will enable an interpretation of the impact of macroeconomic variables on corporate performance.
Many undercurrents in the form of conflicting viewpoints and complex of rules are in flux. The American ruling instance (GAAP) stands vis-à-vis the EU’s. The standard-setting boards in the large countries, like FASB in the US and ASB in the UK, are trying to show the way. Governmental regulators of stock exchanges with SEC at the lead are making their demands known. The international co-operative organisation for the exchange board, IOSCO, is contributing in its own way, while the international auditing bureaux are functioning like catalysts in disseminating the international auditing standard. Contrary to the striving among the dominating national or regional opinion-makers, there is also an international actor in the form of IASC. This private organisation, which dates itself to 1973, creates - with its members in the form of auditing organisations or their analogy from more than 80 countries - credibility for a global implementation of the way it recommends companies to report in order for outsider stakeholders to get an answer to "what happens if" questions.
IAS 1, Disclosure of Accounting Policy (rev. 1997), which applies for all types of companies with profit as a goal, including banks and insurance companies (for which further requirements are specified in IAS 30, Disclosure in the Financial Statements of Banks and Similar Institutions), contains as point 8 under the heading, "Components of Financial Statements", the following formulation:
Enterprises are encouraged to present, outside of the financial statements, a financial
review by management which describes and explains the main features of the
enterprise’s financial performance and financial position and the principal
uncertainties it faces. Such a report may include a review of:
the environment in which the enterprise operates, the enterprise’s response to those
changes and their main effect, and the enterprise’s policy for investment to maintain
and enhance performance, including its dividend policy;
policies; and
(c ) the strength and resources of the enterprise whose value is not reflected in the
balance sheet under International Accounting Standards.
It is point 8 that marks a change toward information channelling as appropriate for scenario analysis including profit filtering and risk assessment. The standard in its entirety states the minimal requirements regarding the content of reporting. Financial information of an interim character is not included. The standard may be seen as a global compromise and in this capacity, it has a very loose framework. Environment can be given different interpretations, and mine tends towards the macroeconomic environment. I interpret factors and influences as macroeconomic variables with an impact on the corporate profit capacity (performance) in product, service and financial markets, i.e. currencies, interest rates and consumer/producer prices. The enterprise’s response to those changes and their main effect can be expressed in many ways, but in order to be used in a forward-looking manner, it should here be aimed at measurement in the form of sensitivity coefficients, i.e. a measurement of the change in a company’s profit as a consequence of a change in each and every one of the most important macroeconomic variables. With risk management policies under 8b, it should in line with my earlier interpretations pertain to strategies for how the company is handled with respect to the mentioned variables and if some changes in this respect will occur during the next reporting period. The company is expected here to give information about the type and extent of different hedging operations.
An explicit requirement for uniform, underlying analysis and quantification is missing, which opens up four categories of responses to point 8a-b:
As regards the impact of macroeconomic variables on the corporate performance, a prerequisite for there to be something informative to report about is that the firm has both carried out and continues to carry out purposeful analyses of this impact. In today’s economic and financially integrated world, no company is left unaffected by what happens in the world economy. Its influence is, thus, not only a question for multinational companies with cross-border activities. There is no longer an acceptable excuse for not carrying out analyses. Increased integration has placed most management teams in front of a new and challenging problem of analysis.
The central challenge for the management team is to create understanding within the organisation for how much of generated profits that depends on the quality of the product or service and how much that stems from changes in the macroeconomic environment. By, as a first step, filtering out the (temporary) macroeconomic "noise" from corporate profits, a picture is obtained of the "sustainable" profits, i.e. a measurement of the company’s competitiveness. Thus, after filtering, an apparently favourable result can come to be transformed to a strong signal about reduced competitiveness, i.e. to a "leading indicator" regarding the need of activities that develop the product/service and/or production process. Step two is the formulation of a risk management strategy, i.e. if and how the company should handle the risks generated by future macroeconomic fluctuations. Step three is about the external reporting to communicate to the stakeholders of the firm the results of the two first steps in the analysis.
The MUST-analysis (see Figure 1) constitutes a method for the company to carry out step one and two above. The MUST-analysis offers a basis for 1) identifying the macroeconomic variables that are the most important for the individual company, 2) determining the influence on the performance that is generated by fluctuations in these variables and 3) formulating a suitable strategy for handling these variables. The principal conceptual framework is that crises of the type that were mentioned at the beginning of this article may be expressed in scenarios composed of relative prices belonging to the categories exchange, interest and inflation rates. To this may be added a fourth relative price in the form of the political risk premium.
Figure 1 Components of a MUST-analysis
Source: Oxelheim and Wihlborg (1997)
The MUST- analysis contains a fundamental analysis of variables with potential explanatory value. The identification of the relevant macroeconomic variables from this set of variables then involves the use of multivariate regression analysis. As opposed to traditional approaches, the MUST-analysis acknowledges the interdependence between different kinds of macroeconomic variables. The interdependence between exchange, interest and inflation rates is neither seen as too strong thereby creating multicollinearity, nor so weak that a measuring of each variable separately is acceptable. The outcome of the initial search for explanatory variables and the analysis used to find those variables that prove to show the highest explanatory value can be demonstrated by Equation 1 taken from the Volvo Cars-case (see Oxelheim and Wihlborg, 1997).
(1)
where
CFSEK = Commercial cash flows in SEK
PSEK = Swedish price level
uFC/SEK = Swedish real effective exchange rate (FC/SEK)
iSEK = Swedish 3-month interest rate
iworld = World short-term interest rate (basket)
p PPI DE = Producer prices in Germany
and D denotes percentage change between time t-1 and t. For example, the coefficient -5.6 in the equation means that for the period under investigation the commercial cash flows of Volvo Cars decreased (increased) 5.6 percent for each percent the Swedish real effective exchange rate increased (decreased). Producer prices in Germany and interest (Swedish short term as well as a world basket) rates are other variables that should be considered important to the performance of Volvo Cars.
The most important market for Volvo Cars at the time of the study was the US-market whereas a large fraction of inputs were purchased in Germany. Based on a pattern like this there is a risk that the outsider will infer a positive effect from a depreciating Krona versus the USdollar and a negative effect from a depreciating Krona versus the Deutchemark. The estimation of an equation containing the most important bilateral exchange rates, however, showed the SEK/DEM exchange rate to be the only significant one, but with a positive sign; implying a positive effect on cash flows from a depreciation of the Swedish Krona versus the Deutchemark. This model did also include the German producer prices and Swedish short term interest rates reflecting both cost of debt changes and changes in demand of capital goods (Volvo cars).
The high importance of variables related to Germany is explained by the fact that the most important competitors of Volvo Cars are the German companies Mercedes (lower end), BMW (lower end), Audi and Volkswagen. The positive effect of a depreciating Krona versus the Deutchemark should be interpreted as a result of gains in competitiveness exceeding higher costs for imputs purchased in Germany. The lesson told by the Volvo Cars-case is that the currency denomination of actual cash flows does not necessarily tell the true story of the sensitivity of corporate cash flows. The outsider stakeholder need information from the company to sort out things like this.
In a comprehensive study of companies from different sectors and countries, we have been following for many years how these companies report the impact on performance of changes in their macroeconomic environment (Oxelheim and Andrén, 1998). The analysis takes as a starting point the presentation of relevant variables, measurements and strategies. We conduct also a follow-up in the form of charting how the companies de facto handle these issues. Herewith is obtained a picture of how big a difference that exists between the information that is given in the external reports and that which is produced in the company. We also follow up by charting how the financial analysts look at the macroeconomic impact (as reflecting the most sophisticated processing of the information provided by the firm), as well as conduct our own conclusive analysis of the magnitude and character of the impact.
A first conclusion is that the company in general is not more sophisticated in its analysis of the macroeconomic impact than what appears in the annual reports. My experiences as consultant in the field of corporate competitiveness leads to the same conclusion. This will, of course, influence the interpretation of IAS 1. An implementation according to alternative 4) above will, thus, demand a considerable adjustment within most companies in the direction of an improved business intelligence, of which the MUST-analysis is the key component.
Table 1, whose column numbering coincides with the numbering of categories in Section 2, provides us with a second conclusion: as late as 1997 no company within the vehicle industry (study carried out on a group basis) left information in its external reporting which enabled the filtering of historic profits. In none of the companies were the external stakeholders provided the possibility of seeing what had happened with the sustainable profits, i.e. the profits after the macroeconomic noise had been eliminated. There was also no possibility for the external stakeholders to make any form of analysis of what would happen with the company given a certain development of the type of the Asian crisis. The output of competing scenarios is generous, but the key components in the form of information that enables a translation of a particular scenario to corporate effects in, for example, kronor for the Swedish company or dollars for the American are missing. No opportunities were given as regards an assessment of the character and magnitude of macro-economic risks. Since what is reported seems to reflect available information within the company, in order to comply with the most ambitious interpretation of IAS 1 (rev. 1997) a big step remains for companies within the vehicle industry. Japanese companies as a group exhibit the lowest inclination to release relevant information and should thereby probably also need the strongest upgrading of internal systems to handle macroeconomic influences on the firm. A comparable analysis of the practice within the paper and pulp industry (see Oxelheim and Wihlborg, 1997) leads to the same conclusion.
The information that should be reported by companies for being listed in Column 4, Table 1 is the result of the MUST-analysis. The information needed by external stakeholder is a specification of the variables that are the most significant, i.e. those that have the greatest explanatory value with respect to result fluctuations. With help of the simple technique that the MUST-analysis is built upon, three to four variables are identified which explain the main part. The set of relevant variables may shift over time and the process of identification should therefore be followed up continuously by the company. With a US company as an example, the analysis can result in the following three variables: DEK/USD exchange rate, German long-term interest rate, and French producer prices. The MUST-analysis involves also an estimation of sensitivity coefficients for these variables which makes it possible to translate scenarios to direct result effects as well as filter out the macroeconomic impact on the profit for the latest reporting period. Furthermore, for the company these coefficients form the basis for hedging decisions and can be directly transformed to contracts on external financial markets.
The sensitivity measurements in the example express the change in the target variable due to a change in each and every one of the three identified macroeconomic variables. In accordance with the figures in Table 2, in our example every percentage unit increase in the DEK/USD exchange rate leads to a 3 percent increase in the profit. In this example, the profit is set as target variable, but the analysis in other examples can refer to sale proceeds, cash flow, etc. The measurement contains competitive aspects and provides, thus, an expression for how the company gains an advantage against competitors when the DEM/USD exchange rate is changed. A common mistake among the companies who try to give the most important macroeconomic variables for the company without conducting a MUST-analysis is to point to the exchange rate between the currencies of the company’s greatest sale- and purchasing markets, respectively, and the home currency. To only look at the currency distribution in the actual flows often leads to erroneous conclusions. Thus, the competitor in the company’s most important market, for example the Japanese, can be a German company with a manufacturing site in Germany. A MUST-analysis in this case would most probably point to the fact that the deutschemark is more important than the Japanese yen. The MUST-analysis also involves strategy formulation as a concluding step, regarding the handling of influences from the identified macro-price variables.
The information can be given with or without forecasting. Table 2 shows an example in which the result of the MUST-analysis is presented in connection with a forecast in the above-discussed company.
Table 2 Reporting according to alternative 4 involving information about macroeconomic impact on the company
Forecast: The results will increase next quarter with 15 percent compared with the preceding quarter. The seasonal effects make up 3 percentage points of that increase. The company’s policy is not to work with hedging operations of any kind on external financial markets.
The forecast is based on following changes in key variables |
Sensitivity coefficients: one percentage points increase as compared to the anticipated change will impact the profit by |
|
DEM/USD |
2% |
3% |
German long-term interest rate |
2% |
-2% |
French producer prices |
1% |
3% |
Assume that the external stakeholder at the beginning of the quarter believe in another macro-economic scenario than the one the company has built its forecast on. The information content of Table 2, now allow a re-calculation of forecasted profits considering the "new" scenario. Excluding macroeconomic influences of 5% (6% from the depreciation of the Deutschemark against the US dollar, -4% from the increase of the German long-term interest rate and 3% from the increase of French prices) and the seasonal effect of 3%, the company’s own forecast is built upon an assumption of a growth of 7% (15%-5%-3%). We can now dress up this forecast of growth with our own macroeconomic scenario. If we, thus, believe that the DEM/USD exchange rate will increase by 5% instead of the assumed 2%, that the German long-term interest rate will remain unchanged (i.e. change 0%) and that the French producer prices will increase by 3 percent, our own forecast will be an adjustment of the company’s forecast that the result compared with the preceding period shall increase by (3+7+15+0+9)%=34%. Likewise, the access of information of the kind presented in Table 2 will at the end of the quarter allow an analysis of what has happened with the sustainable profits; with both the latest actual and forecasted result as benchmarks.
6. Concluding remarks
The importance of paying attention to the impact of a volatile macroeconomic environment on the competitiveness of the firm should be clear to most managers with experience of the economic turbulency of recent years. An experience that should make most companies inclined to carry out analyses according to the MUST-concept. An open question, however, is if the results of these analyses will be passed on to the external stakeholders via corporate external reporting. The risk of exposing a weakness that can be exploited by competitors, as well as measurement problems, are reasons that will come to be used as arguments against presenting to external stakeholders such a detailed analysis of the company’s development that the MUST-analysis offers. However, six strong conditions speak for the fact that within a not too distant future the reporting practice should have come close to alternative 4 above:
* the mere presence of IAS 1 (rev 1997);
* the great competence increase within the financial analysts group with accompanying
demand for purposeful information in order to determine the value of the company;
* the presence of an analytical tool in the form of a MUST-analysis which now allows a proper analysis of how the company is affected by changes in its macroeconomic environment and by that opportunities to an adequate information release;
* the strongly growing interest in shareholder value analysis (SVA, EVA, etc) with
the accompanying need of being able to sort out what is temporarily created by macroeconomic fluctuations and what is sustainable value;
* the demand by banks and the financial institutions for information which allows an analysis of the sustainablility of profits and by that a determination of the appropriate credit rating of the company;
* the demand by prestigious international capital market authorities for information in the prospectus in connection with equity and bond issues about the vulnerability of the issuing company to macroeconomic fluctuations.
While waiting for a reporting about the influence of the macroeconomic factors to follow IAS 1 (rev. 1997) alt. 4, external stakeholders attempt in an approximate manner to conduct themselves something corresponding to a MUST-analysis. The most "ambitious" of these stakeholders - the financial analysts - have, of course, the possibility to technically carry out the analysis if the company reports the most necessary pieces of the information puzzle. More frequent reporting occasions increase the temptation to perform the analysis even without this information. However, without the company’s co-operation - in providing the required information pieces or the final result of a MUST-analysis as part of the external reporting - the prospects are limited for the stakeholders to obtain any idea about what is really going on with the company. An interpretation of IAS 1 (rev. 1997) in terms of alternative 4 is the only way to make progress and to give meaning to the goal of external reporting: to provide a fair view of the company’s future prospects and by that of its value, as well.
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