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Thursday, 17 November, 2016

Problems with our business measures.

Summary: We have known about the problems with our Accounting Model for well over two decades. In fact the problems were first highlighted way back in 1987 in a book called “Relevance Lost” by Thomas and Kaplan. So, in reality, we have known of the problems for three decades, but perhaps it took a few years for this to sink in. However, it doesn’t explain why thirty years on we still haven’t addressed them. Do you think vested interest has anything to do with it?

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We’ve known the following about our Accounting Model for the past thirty years:-

1. It does not provide the correct measurement base.
The Accounting Model measure less than 20% of business’s value creation processes. This assertion is based on the discrepancy between Book Value (i.e. the value ascribe to the business by the Accounting Model) and Market Value (the value ascribed to the business by the market.) The difference lies in what Accountants refer to as “Intangible Assets”; assets they cannot measure. Put simply - we cannot measure the vast bulk of business value creation potential. Businesses do measure non-financial aspects, but because we cannot compare these measures with other businesses, they are not consider as useful by the investment market, as comparison is critically important.

2. It masks value creation activities, hindering long-term growth.
There is no relationship 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 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 financials.

3. It measures inappropriate things while ignoring what’s important.
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:

  • Ability to create or influence market demand.
  • Ability to meet demand.
  • Ability to optimise demand.
  • Supply Chain opportunities
  • Staff skills, knowledge and motivation, etc, etc…

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.

4.1. Responsible for a deteriorating risk / return investment profile.
As the Accounting Model cannot provide investors with sufficient and useful information upon which to base their long-term investment decisions, they are at greater risk of ineffectively directing resources in our economy. 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 is unknown.) This has, to a large degree, promoted our “casino investment” mentality. Without knowledge you are investing “blind”, so you may as well push it to its limits.

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 we 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.

4.2. Impedes economic growth.
We encourage "strong financials," because it’s our only comparable measurement standard. This is often achieved at the expense of the value creators (which are not represented in the Accounting Model.) For example, outlays on R & D (Research & Development) represent investments in potential new income streams, which should generate revenue well into the future. However, the Accounting Model treats R&D expenditure as an expense. This lowers the profit, so to appear profitable the investment is stopped or reduced. This impedes long-term growth.

4.3. Misdirects critical, finite resources.
The consequence of being unable to determine accurately business performance and underlying value, together with a short-term profit focus, means critical, finite resources (i.e. financial, people, materials and the environment) are being ineffectively employed in our economy; scarce resources are being ineffectively directed.

4.4. Financial data can be highly misleading.
We live in a world of constant change; what relevance can you ascribe to myopic, one-sided, historical financial data? Business needs insight, not limited hindsight.

4.5. Helps promote boardroom and strategic 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. This negatively impacts strategic direction, imposing a visionary bias on the business.

4.6. Dominates all other measures.
Because our Accounting Model is our only universally comparable measure it is used as a business measure (as our economy needs comparable measures.) This means businesses, through their executive, are quite prepared to compromise non-financial measures to ensure they achieve strong financials. This is extremely harmful to a business’s long-term value creation prospects.

5. Supports a "profiteering" approach.
As a financial measure, the Accounting Model is good as it focuses on profit creation for shareholders, but as a business measure it’s entirely inadequate and inappropriate. Finance is not business. This is demonstrated through the fact that it measures only 20% of the value creation potential of business. The problem, however, is that it focuses business on short-term profit generation for the exclusive benefit of shareholders. This by definition makes it a profiteering system. Any system which unfairly favours one party over others in the creation of profit means the favoured party is a profiteer. A measurement standard which excludes others and provides shareholders unfair advantage, makes them profiteers.

6. Promotes inequality within society.
As business is short-term profit obsessed, for the exclusive benefit of shareholders at the expense of other stakeholders, It directly contributes to a widening rich/poor divide. This serves nobodies long-term interests well.

7. It provides limited management measures.
To be fair to our Accounting Model - it's perfectly good at measuring financial results, the task for which it was developed. We can hardly blame it for it’s inadequacies and inappropriateness in measuring tasks for which it was not intended. When change is limited, past performance is useful in predicting the future, but today change is rapid and relentless. Our focus has to be on the future. We have to anticipate and respond to the dynamics of our rapidly changing markets. We cannot use the Accounting Model for this purpose. We have to understand and measure the value creation processes to give us a clear insight into possible future performance.

8. Linked directly as the root cause of our most serious social, environmental, economic and business problems.
Business is given free access to global resources, but they are only accountable to their shareholders to make a profit nothing else (within legal limits.) Provided they make a profit (which is measured and compared with other businesses) everything else is off the radar, so how they mistreat or abuse these resources is unknown. What we know, is that collectively, these resources have been mistreated, abused and in some cases destroyed or irreparably damaged, to shareholder’s exclusive benefit. We can directly link poor business behaviour to our most serious social, environmental, economic and business problems. Some of these problems have been mentioned above, but not all. The point is, our inadequate and inappropriate business measures (i.e. the Accounting Model) is the root cause of our most serious problems. Capitalism has been getting stick for these problems, but the reality is that’s it’s our inadequate and inappropriate business measurement standard at fault. What a mess.

The bottom-line is - we need a new measurement standard and we need it now.

Adrian Mark Dore.

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Posted by Adrian Mark Dore at 2:17 PM
Edited on: Tuesday, 21 November, 2017 3:00 PM
Categories: Problems with current measures.