2009 PMA Conference – Professor Kenneth Merchant: Alternatives to accounting measures

The opening keynote speech of Day 1 of the 2009 Performance Management Association conference was given by, Kenneth Merchant, Deloitte & Touche LLP Chair in Accountancy and Professor of Accounting at the University of Southern California Marshall School of Business. Professor Merchant is an expert in management accounting and management control systems with numerous publications in this field.
His speech addressed the challenges practitioners are faced with in selecting and using performance measures. He discussed the flaws of accounting measures and presented four alternatives.

I have structured below my notes from this session. In part one of this blog post, a number of issues with using accounting measures were presented. Several alternatives answering the question “What to use instead?” are presented below.

Part 2: Alternatives to accounting measures

1. Use market measures of performance.

• They have an obvious appeal.
• They also have some problems due to market imperfections, noise, feasibility (i.e. “market expectations problem”).
• For private firms there is no data availability.

Example: The case of Christopher J. Steffen at Eastman Kodak Co.
• January 1993 – Christopher J. Steffen was appointed Chief Financial Officer (CFO) of Eastman Kodak Co.. He had a reputation of cutting costs. Within 2 days, the stock increased $2.2 billion dollars.
• April 1993 – After 11 weeks in the job, he resigns (with few accomplishments). The stock declines with 2.0 billion dollars.
• Questions: What if the period of stay changes with a few months? Should bonuses be paid for the increase in the stock price due to market reactions?

2. Extend the measurement window

• Extend measurement horizon to 3, 5, even 10 years.
• The analysis of profit / market correlation in different windows (1, 2, 5 10 years) by Easton, et al.
1 year: 0.22
2 years: 0.39
5 years: 0.57
10 years: 0.79
• Are you willing to wait 10 years for a bonus? Maybe not, however 3-5 years is doable.

3. Use more informative non-GAAP financial measures of performance.

• “Pro-forma” earnings – exclude line-items that are more distracting than informative.
• Funds from operations (FFOs) – seems to work with Real Estate Investment Trusts (REITs).
• Free cash flow (FCF).
• Earnings before interest, taxes, depreciation, and amortization (EBIRDA).

4. Use combinations of measures

• There are many different approaches. Market and/or financial and/or non-financial measures.

Measure combination example 1: The GE Management Development and Compensation Committee uses a combination of financial indicators and subjective measures in the list of the CEO Goals and Objectives for 2007 and 2008.

Financial Objectives (Continuing operations)

Earnings per share (EPS)
Cash from operating activities (CFOA)
Return on trading capital (ROTC)

Strategic & Operational Goals

Sustain operating excellence and financial discipline.
Create a more valuable portfolio of businesses
Drive organic revenue growth at 2 to 3 times GDP
Retain excellent teams and a strong culture
Manage the Company’s risk and reputation
Build an excellent investor base
Lead the Board activities

Measure combination example 2: The Balanced Scorecard, with up to 20-25 measures, with casual links between them, grouped in four perspectives: Financial, Customer, Internal Business and People, Learning and Growth.
• The majority of firms claim to have a Balanced Scorecard. They misuse the term.
• Which set of measures in that circumstances provide the best indication of the value creation?
• Combination of short-term backward looking measures with leading indicators of future performance.
• How many measures should be used? The function is non-linear:

Ken Merchant-perf-vs-meas

Historical background on the use of measures
1954 – General Motors started using measures – 3-7 measures
1960 – Critical success factors


• Good news: 
o We are accumulating more and more data about the relationship between market related measures, accounting measures and individual non-financial measures (i.e. customer satisfaction).

• Bad news
o Don’t know when to use each of the 4 alternatives presented. Individual or in combination, in any specific period of time.
o Don’t know about the effects of using concurrently multiple performance measures.
o Over satisfying customers is not good either, as this is generating diminishing returns. There is a limit to “profitable” customer satisfaction.
o The benefits of the BSC may not be sustainable (more research is required on what are the long term effects on BSC implementations in the BSC Hall of Fame companies).
o Still lots of research that needs to be done.

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