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Friday, 06 January, 2017

We need a new measurement standard.

Summary : The reason we need a new business measurement standard is simple - our current standard isn’t serving our needs properly. In fact, it’s hurting and holding business back. It doesn’t even serve shareholders well, despite many believing this to be true. If you hurt or hold business back, then surely you hurt shareholders?

From a broader society perspective, it’s the root cause of our most serious social, environmental and economic problems. There’s a simple logic to follow here, if you hurt, harm, or destroy the environment or people around you through your activities, then your future trading conditions are going to get tougher and tougher, until you can’t operate anymore. By looking after your broader trading environment, you make it easier for yourself in the future - that’s business sense. It’s also about being morally responsible and doing the right things. Furthermore, it’s a well-established fact, on our current trajectory, whether it’s social, economic, environmental, or business it's not looking good. We have to change and it starts with our business measures.

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Why do we need a new business measurement standard?

From a business perspective, our current measures inhibit growth. From a wider society perspective, it is the root cause of many of our most serious social, environmental and economic problems.
Reasons enough to change!

The business perspective.
Accountants are the first to admit the inadequacies of their financial measures, making it an inappropriate business measure. This immediately highlights the distinction between finance and business. Finance is not business - it’s only a small part of business. In fact, it makes up a very small part. It is estimated that financial measures account for less than twenty percent of the value creation potential of business.

Of course, that does not mean we don’t measure and manage the remaining eighty percent. What it does mean is that every business implements their own interpretation of what and how they should measure. These measures are not comparable and therefore of little value to investors.

This creates a major problem. No matter how good these other measures are, they will be compromised, thereby weakening the business over the long-term. Let me explain...

Business needs investors, and investors need comparable and reliable measures upon which to base their decisions. Only financial measures meet this need as only they are universally comparable across all businesses (irrespective of sector or size.) That means businesses are compelled to produce strong financials (if they are dependent on external investments, which most businesses are.)

Non-financial, internal measures, no matter how good they are, are inconsequential externally. As a result, internal measures are often compromised to achieve strong financials. Businesses make decisions they know are counterintuitive (based on their non-financial measures) in favour of producing strong financials. Not only investments but executive salaries, bonuses and careers are dictated to by financial results (our only comparable measures.)

So, while we have non-financial measures, they are of no value to investors as they are not comparable nor verifiable. We provide investors with financial measures, which are limited and often misleading as they are often bolstered by compromising non-financial measures. This does not serve the long-term interests of investors, and it certainly does not serve the long-term interests of business.

Both business and investors need to gain a broader and deeper insight into the long-term value creation potential of business. This will foster a true “investment culture” amongst investors, rather than promote a “commodity trading mentality,” which prevails (i.e. shares are simply a commodity.)

Business desperately needs a structure to guide it in optimising its full value creation potential. A structure which will support a universally applicable measurement standard, thereby ensuring its measures are not compromised by financial measures. Where its measures can stand on equal ground, and not in the shadow of financial measures.

This structure will be very useful to SMEs as a roadmap to value creation. SMEs don’t have the ability to employ specialists in every field, so they require greater guidance and support. This structure will provide that. We must not lose sight of the fact that the backbone of our economy is made up of SMEs and that in the future, they are likely to contribute even more. This important sector is often the last to receive any attention, as it isn’t fertile ground for large management consultancies.

In summary, business growth is hindered in large businesses by adopting a short-term financial perspective to attract investment, meet shareholder profit objectives and guarantee executive salaries, bonuses and careers. Non-financial measures are easily and readily compromised to strengthen financials, as non-financial measures are unseen. Executives can “rob Peter to pay Paul,” weakening the business, while markets applaud them. Patting them on the back as they increase their salary and bonus. All this, while unbeknown to them, the business has been seriously weakened. It’s much easier to create profits when so much can be hidden.

In smaller businesses, it hinders growth because we have not provided them with a value creation roadmap. These are businesses, which can’t afford to employ experts in all fields. Often it’s only one or two individuals who have to “wear many hats.” They need a structured approach to assist them. Furthermore, because our current measures only focus on financials, the long-term value creation prospects of smaller businesses are hidden. As a result, they are excluded from investment opportunities, because investors have no comparable and verifiable means of assessing potential. Lack of access to suitable investment is one of the biggest reasons for hindering growth in this very important sector.

The society perspective.
We give business free access to resources, yet they are only accountable (within the limits of the law) to their shareholders for profit. How wise is that?

I would suggest it’s reckless in the extreme, particularly as we have just learnt how businesses, through their executive, are quite prepared and willing to compromise facets of their own business in pursuit of strong financials. What chance do external resources, such as the environment and community have in being treated fairly and wisely, when short-term self-enrichment is the order of the day? None whatsoever! The collective proof of this is all around us. I have written extensively about it, as have many others. (Please read the other articles on my blog concerning these matters.) I will not labour the point further here, but rather move on to address objections others may have in defence of doing something about it.

Some may say that for the very reasons mentioned above, CSR (Corporate Social Responsibility) reporting was introduced. I will be the first to acknowledge the noble intent and work done by many in this regard, but also condemn it as worthless, in the same breath. CSR has been with us for over two decades, and it hasn’t made any difference. The reason it has made no difference is not because its intentions are flawed but because of the way it has been implemented.

This brings me back to our core problem. Unless you have universally comparable measures, they have no relevance in the market and are ignored. CSR is just one of the many other internal (non-financial) measures a business has. Like any other internal measure, they are often compromised or manipulated, to produce strong financials. Right now, CSR reporting is nothing more than a PR farce, which corporates use to manipulate, painting a rosy picture of themselves, in the hope of bolstering investor and consumer confidence. Volkswagen is a classic example. They were just unlucky that they got caught lying. Others have been more fortunate, yet are no more sincere or responsible.

In 1994 the Balanced Scorecard (BSC) was introduced, to help provide business with a more balanced perspective of performance. It was well received because even then, business acknowledged the need for a more balanced and informed approach to managing business. Today there are very few followers, not because what they suggested was wrong. To the contrary, it’s better than what we’ve got today, but again, its measures were not universally applicable. They represented just another set of internal measures. Like all internal measures, they fell under the shadow of financial measures and were compromised. Slowly, but surely, their relevance waned. The same for CSR - the same for any, and every internal (non-financial) measure.

Towards a solution.
In light of the obvious failings of the Accounting Model as a suitable business measure, accountants are supporting a concept called IR (Integrated Reporting.) More specifically, they support the IIRC (International Integrated Reporting Council.)

There’s no question - we need an integrated solution. We need to integrate the interests (and measures) of all stakeholders, in a new measurement standard. We need a balanced approach. It’s how we go about achieving this, which poses the big question. Our new measurement standard needs to be based on the realities of business. The realities of business would indicate that our measurement standard needs to be based on the value creation causal model. Why? Because we know all components of business are integrated and interrelated in a cause-and-effect model. We also know that value creation is the common denominator of business. We also know the structure, and therefore the measures, need to be universally comparable.

The question is, does the IIRC’s approach embody these business realities? No, they don’t. It’s based on the “Six Capitals” model, which in no way resembles the value creation causal model. They talk glibly about value creation, but their approach in no way explains how business goes about creating value for all its stakeholders. If value creation for all stakeholders is important, then surely you explain how this is done. This is what we need - but it’s not what we get. We want to see a structure - a roadmap of how business creates value for all stakeholders (like the Du Pont model demonstrates the financial components which affect ROI (Return On Investment.))

The IIRC has no understanding of the value creation processes. Therefore, they cannot provide the structure, or measures necessary, to conform to our basic requirement of being universally comparable. As a consequence, their measures will be no more useful than those of the BSC and CSR. We are wasting time and resources on the IIRC.

I have spent over twenty years understanding how businesses go about creating value and investigating to what extent these processes are common across all businesses. I believe my work provides a strong basis for a solution. It provides the components, structure and measures, which are universally applicable. To learn more, please contact me.

Adrian Mark Dore

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Posted by Adrian Mark Dore at 4:23 PM
Edited on: Sunday, 19 November, 2017 2:20 PM
Categories: Problems with current measures.