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Business has a serious problem – what is it?
Very few things affect business performance more than how we measure it. Yet, arguably, one of the biggest problems facing business, and wider society today is the inadequacies of our Accounting Model. It hinders sustained long-term value creation, increases business risk and ineffectively directs scarce resources. These are just some of its shortcomings. In this article I explain the problems and show why it's imperative that we replace it with a modern, more appropriate measurement standard.
Our Accounting Model may have served us well in the past, but now it's well past its "use by date" and a hindrance to sustained, long-term wealth creation.
I am not advocating the removal of financial measures, far from it. We need financial measures, but it cannot remain our sole measurement criteria, as it only shows a small part of a bigger picture. As our sole measurement standard the Accounting Model is dangerously inept, and causing considerable damage to our economy, as I will explain. Consequently, we need to replace it with a new, more appropriate measurement model, one, which provides an accurate and full understanding of business performance and underlying value. A measurement standard aligned with the business objective of sustained, long-term value creation.
There is such a management model, but before I elaborate on it, it's important for you to understand why the Accounting Model is no longer "fit for purpose". If you don't understand the need for change, and the urgency for this change, then change will never happen.
The most important thing affecting every business is how we measure it. It affects operational, tactical and strategic decisions everyday. I can think of very few things, which have a more profound effect on business than its measurement standard. As the old adage goes "What you measure is what you get", shows to what extent measures affect our actions. It, therefore, makes sense that the measurement standard we employ must align with the objectives of business, namely, sustained, long-term value creation, rather than align it with a measurement standard in conflict with this objective.
Let me explain the extent to which our Accounting Model conflicts with business objectives. There are six main reasons why the Accounting Model does not provide the correct measurement framework for measuring and managing long-term profit creation, and they are: -
1. It's entirely inappropriate for the job.
Most of us see profit as being exclusively and inextricably linked with the Accounting Model. Few of us question the Accounting Model's validity or appropriateness in driving the profit objective. We take it for granted; we do not question or challenge it. However, are these assumptions correct? Can we only achieve the profit objective through adopting a financial perspective? This is definitely not true! Only when we query the appropriateness of our Accounting Model are we lead, quickly, to some startling facts, such as:-
1. You can only use the Accounting Model to measure a few business processes; the vast bulk of business processes are excluded from measurement. What proportion is excluded? This is difficult to answer with any degree of accuracy, but as a "rule of thumb" we can use recently conducted research, which found Book Value (i.e. the value ascribe to the business by the Accounting Model) only to represent about 20% of Market Value (i.e. the value ascribed to the business by its shareholders) to infer that the Accounting Model only measures a similar number of business processes. So, as a rough guide, or rule of thumb, we can conclude the Accounting Mode excludes approximately 80% of our business processes from measurement.
2. The question we now need to ask ourselves is, "Do the business processes, which are excluded from measurement, add value?" I'll answer this with another question, "Why undertake a business process that doesn't add value?" The answer is self-evident, but if you need proof, then the earlier cited research bears' testament to the fact that substantial value is added to the business through business processes not measured by our Accounting Model. As we only manage what we measure, a failure to measure is a failure to manage.
As a highly exclusive measurement standard, the Accounting Model does not provide us with an appropriate measurement base, but if we dig a little deeper, the situation worsens...
3. What is profit? Profit is the value you add to your financial capital. So, profit is a value creation process. The objective of all business processes should be to add value; businesses are only successful when they add value to what they already have! Value creation is therefore, the common purpose of all business processes, and so, from this, we can deduce that value creation is the common denominator of business. Consequently, as the common denominator, we can use value creation criteria to measure every business process, but we can't do the same using financial criteria. Until all business processes are incorporated into the mainstream of business measurement and management, we will not get a true reflection of business performance and underlying value. To be able to incorporate all business processes, we need to base our primary measurement model on the common denominator of business. No degree of adaptation or tweaking will help the Accounting Model; it's fundamentally not suited to measure and manage the value creation process. And as profit is a value creation process, or put differently, "value creation is the source of all profit", the profit objective is best served through adopting a value creation perspective.
2. It masks value creation activities
What's the relationship, if any, between financial profit and value creation? We all know it's possible to make a financial profit yet destroy value, and we also know it's possible to create underlying value yet show a financial loss. So, from this we can conclude that there is no correlation between financial profit and value creation. Financial profit masks our value creation activities, yet it is these value creation activities that build underlying business value, which supports and sustains future profit. So while it's important that we measure financial performance, it's equally important that we measure value creation activities, unless we want to be "lead up the garden path" by your financials. Without the two, we are "flying blind". Financial and value creation measures are as different as chalk and cheese. You cannot use a single model (e.g. the Accounting Model) and hope to get an accurate picture of business performance; you need both models. However, our primary focus must be on value creation - the profit driver!
3. It measures inappropriate things
The Accounting Model never set out to explain "how to play the game but only how to keep the financial score", so it's totally inadequate in even identifying, let alone ascribing value to critical value creation components within the business. Consider how the Accounting Model ascribes value to the business (or what it calls "book value"), which is made up of such things as property, photocopiers, tables and chairs, etc. Yet the most valuable assets, which drive value creation, are absent, such as: -
* Customer and supplier relationships,
* Innovation,
* Brand equity,
* Market knowledge,
* Distribution channels,
* Systems and procedures,
* Staff skills and knowledge, etc. etc…
Inappropriate and inadequate financial measures have resulted in the huge chasm that has developed between book and market value. According to research (cited earlier), in the early 1980s a company's book value compared to its market value was approximately 60 percent. In the late 1990s, this had fallen to only 20 percent!
The consequence of being unable to determine accurately business performance and underlying value, means financial capital is being ineffectively employed in our economy; a scarce resource is being ineffectively utilised.
4. It has a negative effect on economic growth.
It may be difficult to appreciate that a measurement model that's been with us for hundreds of years and used extensively by all of us and accepted by most as being "the language of business", is, in fact, potentially a wealth inhibitor or destroyer; but the facts are clear enough.
Deteriorating risk / return investment profile.
As the Accounting Model cannot provide investors with sufficient and useful information upon which to base their investment decisions, they are at greater risk of ineffectively directing resources in our economy. The risk / return profile of investments has changed for the worst and is deteriorating as measurement standards have not changed to meet the needs of fiercely competitive and rapidly changing markets. Investment risk has therefore, increased (as full knowledge and understanding of the investment are unknown) without an appropriate increase in return.
Successful investors are those who supplement financials with sound market knowledge or "gut feel." We thus become reliant on the abilities of a few rather than on an effective and universally accepted model to guide and assist all of us in the evaluation and investment process. Reliance on a few is only good for the few, not the wider economy.
When considering the investment issue, we must not overlook the enormous difficulties facing management in making internal investment decisions. On what basis does management decide to invest in the so-called "Accounting Intangibles," which make up more than eighty percent of business value? Financial models can only be used to evaluate financial results; they cannot tell you where you should invest, which is the most important decision of all. Without a method for quantifiably identifying investment opportunities within the murky depths of the "intangibles", the probabilities of investing in the wrong projects increases substantially.
Impedes economic growth.
As our primary measurement model, the Accounting Model's negative influence extends further than the potential for inappropriately directing resources. What you measure is what you get - so by using the Accounting Model to measure business performance, we encourage "strong financials," often at the expense of the value creators (which are not represented in the Accounting Model.) As you are evaluated against your financials, you are not incentivised to invest in long-term wealth creating opportunities, because the more you invest in long-term value creators the lower the book value of your business in the short-term. The Accounting Model, therefore, incentivises management to impede value creation and hinder economic growth. Short-term earnings at the expense of long-term sustainability benefit few!
Outlays on R & D (Research & Development) represent investments in potential new income streams that should generate revenue well into the future. However, the Accounting Model treats them as worthless by expensing them. In effect, it takes the R & D asset and discards it. R & D is an asset as it enables the creation of income (i.e. it has value). The more you invest in R & D, the less profitable your business appears. The same applies to marketing costs invested to establish brands, enter new markets, or gain market share. All these outlays are investments to acquire new customers that should generate revenue well into the future, yet our Accounting Model expenses these outlays. Management is "incentivised" to cut back on potentially profitable marketing programmes and R & D just to make quarterly earnings look good!
The short-term tenure of senior managers encourages some of them to cut costs "below the bone" and to shun medium too long-term investment opportunities to further their own objectives. In some instances figures are even manipulated to "improve earnings." The extent of this practice is unknown yet it is believed to be prevalent. Enron and WorldCom are two cases in point. Some investors have now turned to evaluating cash flow and market share as being more indicative of business well-being. Ironically, the investment community have been "caught out" by a process they helped foster, namely, our obsession with quarterly earnings.
Financial data is almost meaningless.
We live in a world of constant change; what relevance can you ascribe to myopic, one-sided, historical financial data? It makes no reference to future trends and the business ability to survive, let alone prosper. Just how misleading is its data as it shows no, or very little, relation to market trends? For example, assets assumed to be important in the creation of wealth may be the complete opposite as their relevance to the market is unknown. An example could be finished stock that becomes obsolete because of market changes. What appeared to be a financial asset is in reality a liability.
Over the last decade or so we have seen the fortunes of big and small business slide as a result of "strong financials" belying market realities. In fact, any business blindly pursuing the Accounting Model is courting disaster. If your decisions are based on managing only twenty percent of your business, which the Accounting Model "manages", then the chances of you making the wrong decisions are high!
Boardroom bias.
The dominance of the Accounting Model has lead to another disturbing phenomenon. Boards are predominantly composed of those with financial backgrounds, to the exclusion of those with marketing backgrounds. Why has marketing always been under represented on boards across all sectors, given the obvious importance of marketing?
The answer is rather simple; marketers are to a large extent involved in the process of value creation and as the Accounting Model is inappropriate for measuring value creation activities, marketing has been marginalised as their performance cannot be fully evaluated in financial terms. Their apparent lack of accountability has forced them out of boardrooms. This narrow financial perspective is inhibiting marketing from contributing to the future direction and strategy of their organisation to their organisation's and economy's detriment.
Unsupportive of alternatives.
The problems with our Accounting Model are not new; we have known about them for over two decades. Consequently, there have been many attempts to address these problems. Models such as the "Balanced Scorecard", numerous intangible asset measures and literally hundreds of lesser known and proprietary models / procedures have been introduced. At best, they have shown modest results. This, I don't believe, is a reflection of the merits of some of these models. The problem is, they work within a system where the Accounting Model remains the dominant, overarching measurement standard, and they will ultimately be judged against it. As a consequence, decisions in favour of the overarching, universal measurement standard will always be made, even although the decision makers may feel their decisions favouring the Accounting Model to be counterintuitive. Any system, or model living under the shadow of the Accounting Model will never achieve its full potential. Like a small tree living under the canopy of a giant in the forest, has got no chance of survival until the giant topples.
5. It does not distinguish between profit and rent.
Adam Smith in his book The Wealth of Nations (considered by some to be the foundation of modern economic theory) divided incomes into profit, wage and rent. He reasoned that in seeking profit, businesses create value in a competitive environment by engaging in mutually beneficial transactions. In this way the economy grows, benefiting society. In rent-seeking, wealth is transferred from one party to another through the latter being able to benefit from favourable regulations, monopoly, oligopoly, cartels, quotas, licence or state support. Long-term value is not created through rent-seeking behaviour. Rent-seeking behaviour transfers slices of the cake from one person to another without growing the economic cake.
Rent-seeking activities are likely to be the explanation whenever profits are made that are higher than can be explained by competitive forces alone. Essentially, rent-seeking is the exploitation of the market using some unfair market advantage (obtained, or achieved through whatever means) to increase their turnover. It's about exploitation and not the creation of value, and is detrimental to the economy and therefore, wider society.
Our Accounting Model does not distinguish between profit and rent-seeking activities. It fosters a short-term "profiteering" attitude - optimise profits in the short-term through any means, at any cost. Destroy long-term value (tomorrow's another day), exploit rent-seeking opportunities, it doesn't matter as long as you return a good profit this year! This is what the Accounting Model encourages.
Long-term value creation cannot be achieved through any form of exploitation. You cannot exploit, or destroy, what ultimately sustains you. Long-term value creation is all about mutual benefit - all stakeholders must benefit from their mutual interactions, including the environment. This is a fundamental cornerstone for long-term, sustained value creation.
Because of the Accounting Model's myopic obsession with short-term profit, society is justifiably concerned with exploitation on a massive scale, and therefore issues of sustainability. Consequently, they are calling for improved reporting in the form of things like the "triple bottom-line" (also known as "people, planet and profit reporting".) This is a noble effort, but it's an add-on to a system that is fundamentally at odds with people and planet and therefore, doomed to mediocrity, or failure. We need a system that fosters sustained, long-term value creation for all; a system that identifies and outlaws rent-seeking activities in its many hideous guises.
6. It's an ineffective management tool.
How can we use the Accounting Model to manage business when it: -
a) Deals in absolutes only
It may appear to be an advantage in dealing with hard facts rather than supposition, but unfortunately this is not true.
Because the Accounting Model only deals in absolutes, it cannot incorporate intangibles (i.e. assets with no physical properties.) As a consequence, it expenses intangibles, thereby reducing profits and underlying value.
It discourages management from investing in intangibles, and yet, today, over 80% of a business's capital base is made up of intangibles. Nowadays, the value of business is held in things such as its brand, knowledge, relationships, systems, procedures, etc. It's difficult to ascribe monetary value to these intangibles, as you cannot just "pull figures from the sky." The only way to determine the value of an intangible (and any asset, for that matter) is through understanding the value creation process and the relative importance of the asset in terms of its probability in influencing future sales, margins or reducing costs. From these probabilities, a monetary value can be ascertained. Business today is less about absolutes and more about probabilities - and all about value creation.
b) Only keeps financial score.
The Accounting Model's role is to record what has happened in terms of financial transactions concluded during the period under review. It's a limited financial measurement system, and as such it records certain symptoms, i.e. it has nothing to do with the causes, or how the business creates value (or wealth).
c) Can't shed light on past results or possibilities for the future.
As it only records financial transactions, it cannot shed light on the critical factors which drive sales, margins or costs, and neither can it help in determining the possibilities for the future.
d) Can't help determine a best course of action
Because it's just an elementary financial recording system - nothing more, it can't identify critical business drivers or how they performed, so it can't highlight areas of opportunity.
Consequently, we need to expand our management system to incorporate the heart of business, or how a business creates value. We still need to record what has happened in business in terms of financial transactions, but it cannot remain our sole and dominant business measure. It will have to become part of a wider set of management tools, which will provide a more balanced view of business performance and of its underlying value. In the process, the Accounting Model needs to be revised (or substituted.) Its inherent measurement inadequacies (in only dealing with absolutes) need to be balanced against a system which provides the rules to value creation, so we can ascertain if investment in all assets (including intangibles) has the probability for improving profits.
In my other articles, I explore the solution to our measurement crisis, proposing an alternative measurement standard which aligns with our business objective of sustained, long-term value creation.
Business has changed considerably over the past five hundred years since the introduction of the Accounting Model; don't you think its time our measurement standard followed suit? I don't think we have an option – the situation is dire. We need a completely different approach to measuring and managing business. We need to focus on, and manage value within business – we need a new measurement standard.
A threat to our international economy?
I have written extensively about the inadequacies of the Accounting Model. Unfortunately, I have found that many people behave like an ostrich on this subject, burying their heads in the sand, reluctant to face the reality. However, these inadequacies potentially leave our internal economy open to attack from our enemies. It represents our "Achilles Heel" and could lead to devastating consequences. While this is only supposition, I thought it a good idea to explore these ideas in a novel to show the dark side of the problem, which very few have considered. My novel "A Silent War" shows how these weaknesses are exploited by an antagonist who brings us to the brink of losing the free democracies of the world without us knowing we are at war or who our enemy is. What is so frightening about the novel is that it could so easily happen – it's not some far-fetched storyline.
Copyright © Adrian Mark Dore
Wrington
North Somerset
United Kingdom
About the Author
Adrian is a business theorist and author who lives in North Somerset, United Kingdom.
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