Accounting as generally taught at university, at least when I did it many years ago, and by observation since, does not suit the 21st century.
It has served us well for centuries since the double entry system evolved from 15th century monk and mathematician Luca Bartolomeo de Piccioli, and has not changed much since. Alfred Sloan who was CEO of General Motors for 23 years between 1923 and 1946, created what we would see as modern cost accounting, as he drove GM to be the biggest company in the world in his time. However, the context in which accounting is now used has again morphed into something completely different. Accounting practise has not followed quickly enough in 3 very fundamental ways.
It does not recognise a company’s most valuable assets.
The three fundamental parts of an accounting package are the Profit and Loss account, Balance Sheet and Cash flow statement. Together they offer what has been seen as the basis of analysis of the value of an enterprise, and forms the backbone of all management and reporting systems.
Why is it then that the value of many businesses as represented by their balance sheet, bears no resemblance at all to the valuations placed on them by the market?
Value in most enterprises now resides in ‘intangibles’, largely absent from the balance sheet because of the measurement difficulties. Intangible assets often walk out the door at 5.30, and have the confusing characteristic of being able to appreciate with use, unlike physical assets that depreciate.
A balance sheet, which records physical assets owned by an enterprise, is unable to adequately make this leap to intangible assets in preference to the easily measured physical assets, once the backbone of a valuation, but no longer. The occasional exception to this paradox is of course when a business is sold, or changed in some significant way, and an amount labelled ‘Goodwill’ can be added to the balance sheet. This amount rarely passes the ‘pub test’ and in any event, as the business has usually been sold, it is too late to be of any value to the now previous owners.
Financial reports only the dollar outcome of asset deployment, not the value outcome.
I recall the zeal with which Michael Hammers book ‘Reengineering the corporation,’ published in 1993, was embraced by corporate management. They proceeded to outsource everything that was not considered ‘strategic’ in the race to deliver ever increasing returns on net assets, a key measure for investors and analysts, driven by short term considerations. In the process of outsourcing, they failed to recognise the seemingly minor items that cumulatively delivered the value their customers were prepared to pay for.
The classic case is that of Dell Computer, who built a massive company quickly by redrawing the business model of PC sales, and then went public. This made Michael Dell a billionaire, but in the process of maintaining their impressive returns upon which the IPO had been based, progressively outsourced their design, procurement, and manufacturing processes. Korean company ASUS became their primary supplier, then taking what they had learnt, turned around and became a competitor, leaving Dell without the operational capability to compete.
Listening to those working with the financial reports led them down this path, when they should have known better. After all, it was them that disrupted the previous manufacture/distributor model in order to maintain control of their own destiny, which they then gave away.
Accounting systems cannot tell the future
We are notoriously bad at telling the future, nor can it tell us what has not happened. About all we know is that it will be different to the past, yet we accept an enterprise valuation that is a multiple of past cash flows. We also accept the numbers delivered as an unchangeable fact, that gives us little scope to record the savings made by removing transaction costs and the hidden costs of waste in every system. Those deploying lean accounting systems are setting out to identify those cost savings, and recognise them, but the irony is that they need two sets of books. The traditional set, into which the lean accounting is back flushed to meet the accepted accounting standards, and the Lean books that identify the outcomes of actions taken to improve the processes that drive the costs of waste out.
The businesses that thrive in the 21st century will be assisted by the recognition of the paradox presented by the statutory accounts compared to ‘lean’ operational accounts, and effectively manage the inherent conflicts.
Cartoon Credit: Scott Adams and Dilbert, who bravely faces interrogation by accounting. Dilbert seems to be ever more common as the header to this blog, is it that I am getting older, or that Dilbert after 25 years is becoming even more relevant?
