Financial reports have become unuseful for investors.
Accounting is dead. Long live accounting? In his new book Innovation Accounting, Dan Toma, one of the keynote speakers at Innov8rs Barcelona, concludes conventional financial reports won't provide investors and leaders with the intelligence they need when measuring innovation performance. Most financial reports are out of date and provide little value.
A 20-year study carried out by NYU Stern professor Baruch Lev shows that in 1993, financial reports contributed to 10 percent of all investors' information. In 2013, the same reports contributed to just 5 percent, meaning they decreased their usefulness by half. Coincidentally or not, this correlates to the coming of age of internet-based businesses and business models.
Dan uses the analogy of a hockey game without a scoreboard. In this scenario, spectators, players, and coaches don't know the score or how many minutes are left in the game. A scoreboard provides this information but lets everyone operate independently while remaining in-sync.
This analogy can be applied to business, where financial reports take the place of the scoreboard. There are three main financial reports that businesses typically use — the profit and loss statement, the cash-flow statement, and the balance sheet. But these documents won't provide business owners with the insights they need. They were made for brick-and-mortar businesses and don't take into account innovations in technology. The "scoreboard," in the business sense, is dated and only paints half the picture. It is overdue for a complete overhaul.
Why Financial Reports are No Longer Relevant
Financial reports have less relevance in a digital world. Dan refers to companies like Apple, which have few physical products and almost no inventory. Balance sheets, for example, provide these companies with almost no value.
Dan ponders three conundrums which might explain why financial reports are no longer relevant:
#1 - The most valuable assets of a company are not accounting recognized as assets.
#2 - Accounting-based financial reports show only the final outcome of asset deployment: Revenue and earnings.
#3 - The accounting system can’t measure something that hasn’t happened.
#1 - The Most Valuable Assets of a Company are Not Accounting Recognized as Assets
Many digital companies — Apple, Netflix, Airbnb, etc. —don't have much in physical assets to report on balance sheets. Dan mentions that Airbnb is valued at $31 billion but has no hotel rooms, but Hilton is valued at $23 billion ($8 billion less) and has 900,000 hotel rooms. In this scenario, Airbnb won't have assets to record on balance sheets, making these financial reports irrelevant for their modern digital-based business model.
"Accounting recognized assets are getting constantly commoditized through advances in technology and manufacturing," notes Dan. "Assets such as buildings, production machinery, cars, ships, and planes are more or less equally available to all competitors."
Financial reports don't take into account processes like innovation and value creation. These concepts can't be listed on a balance sheet. Many modern processes are completely intangible in form and can't be listed as liabilities.
This is the problem: The current financial accounting system doesn't recognize the value creation process. It's redundant and obsolete. It just can't be applied to today's modern business values, where innovation is just as important a commodity as profit.
There's another issue. Dan points out that the financial accounting system encourages businesses to report elements of human resources as operating expenses. Essentially, then, all employees are liabilities, at least from the CFO's perspective. This lies in stark contrast to the notion that employees are an integral part of the business and not a liability. Unfortunately, this attitude can be dangerous — it can and often does lead to lay-offs when employees become too much of an operating expense.
"By classifying employees as assets, it would then be in the company’s best interest to try to increase the value of these assets," adds Dan. "This can be done by the company investing time and money, through training, mentoring, developing and improving. If the employees feel valued their sense of job satisfaction will increase."
The result? A more committed workforce, higher engagement, lower staff turnover, better-qualified employees, and a boost in productivity.
#2 - Accounting-Based Financial Reports Show Only the Final Outcome of Asset Deployment: Revenue and Earnings
The current financial accounting doesn't consider the phases assets pass through as they are converted back into money. They only show the final outcome of asset deployment — revenue and earnings.
As a result, financial accounting doesn't showcase the value creation process or innovation used by companies who achieve specific revenue targets.
Dan refers to the example of Dell, who outsourced the majority of its capabilities to ASUS in pursuit of return on net assets (RONA). First, Dell outsourced manufacturing of its motherboards and circuits to ASUS but later outsourced computer design and supply chain management, which increased its RONA numbers and pleased investors.
When ASUS launched its own computers, however, Dell couldn't respond as quickly because they had outsourced their capabilities to a company that was now their competitor. Financial reports overemphasized Dell's financial outcomes because they focused on earnings and revenue, and not on the company's value creation system.
#3 - The Accounting System Can’t Measure Something That Hasn’t Happened
Another problem with the current financial accounting system is that it doesn't measure the innovation process and only records successes and failures in a monetary fashion. Take small start-ups, for example, who take months or years to bring a product to market. Their financial reports might only show the costs the company incurred at the beginning of a new venture — what has already happened, and not what is going to happen.
"The problem with financial accounting used in innovation management only deepens when we try to put a dollar sign before learning gathered from a failed experiment," says Dan. "Financial accounting can only measure the things that have happened — good or bad."
Dan says this problem isn't just visible in innovation management. Manufacturing companies that use lean management might have "cost avoidance" that doesn't appear on financial accounting sheets.
The three considerations above prove that there's a real need for improving the standards and science associated with business accounting, and it's time for a new type of financial accounting system that takes into account innovation and value creation and meets the needs of the digital economy.
What is Innovation Accounting?
Coined in the 2011 book The Lean Startup by Eric Ries, innovation accounting focuses on new methodologies that analyze the market progress of products and services.
Innovation can mean different things to different people. Dan found this out when he moderated an executive off-site workshop where attendees were asked to devise a strategic business road map. It seemed as though everyone viewed the term "innovation" differently.
"From the directors' perspective moving away from paper-based maps to an app and NFC sensors meant innovation. However, for the CEO that only counted as keeping up with the times," remembers Dan.
In his book, Mapping Innovation, Greg Satell says there are four different types of innovation and that leaders shouldn't take a "one-size-fits-all" approach to this concept.
- Sustaining innovation, where companies want to improve their current processes and capabilities in existing markets.
- Breakthrough innovation, where leaders understand a problem needs solving but don't know how to solve it.
- Disruptive innovation, where companies have big ideas that disrupt current market behavior. This includes transforming existing solutions and value propositions.
- Basic research, where companies need to carry out more research because they don't understand the problem or solution well enough.
"As you can see, clarifying the type of innovation one talks about will help sharpen the conversation, align expectations and help identify the right KPIs through which progress is measured," says Dan.
Different types of innovation need to be measured differently, too. Sustaining innovation and basic research focus on efficiency and how well projects stack up against actual and forecasted economic returns. Breakthrough and disruptive innovation, on the other hand, require different measurements — they require innovation accounting.
Innovation accounting, Dan says, is an organized system of tools, principles, and key performance indicators that gather, analyze, record, classify, and present timely and accurate data about an organization's breakthrough and disruptive innovation efforts. Innovation accounting complements a company's existing financial accounting system.
What Should an Innovation Accounting System Actually Do?
Companies benefit from innovation, but many of them still don't fully understand it. An innovation accounting system lets them measure and comprehend innovation in their organization. Conventional financial accounting metrics won't do this because they don't meet the needs of innovation management, and this is something that is unlikely to change soon. Financial indicators such as profit and loss and return on investment just won't cut it in a digital innovation-driven world.
"An innovation accounting system needs to provide a company-wide framework of chained leading indicators, each of which predicting the possible success of the ventures being evaluated," says Dan. "Every link in the chain is essential and, when 'broken', the entire venture is red-flagged."
Dan says organizations should deploy their innovation accounting system company-wide so comparisons can be made between two or more ventures.
Moreover, an innovation accounting system needs to be able to translate innovation projects and convert them into digestible insights that help executives make quicker smarter decisions.
"The system needs to be designed and deployed in a way that ensures the seamless upstream flow of actionable data from product teams to the board."
In addition, an innovation accounting system should improve the entire innovation ecosystem, which encompasses human resource capabilities, culture, and partnerships, and uncover causal relationships between all of these. It should also replace the unusefulness of traditional financial reports and place a greater emphasis on intangibles and non-accounting assets like people and processes.
"Some companies need to focus on strategic resources like patents, brand, organizational culture or unique process," adds Dan. " However, ironically, most of these strategic resources and growth assets are not reported in the financial accounting system, since the investments made in these are immediately expensed and listed under costs (mainly operational expenses)."
Finally, an innovation accounting system should be designed in a way that highlights a company's risks of disruption.
"Regardless of where you stand on the disruption theory debate, change is inevitable and is impending across all industries as digital 4.0 take effect globally," says Dan. "The fact that Uber became a market leader without owning any traditional assets (cars) can't be ignored."
Takeaway
The existing financial accounting system has major flaws and just doesn't benefit some digital companies who appreciate innovation and the value creation process. Using an innovation accounting system for certain types of innovation can benefit companies who want deeper insights into their systems and processes.
Unlike conventional financial metrics and reports, a good innovation accounting system can identify a company's disruption risk, outline the specific use of a company's growth assets, abstract information, and improve the innovation ecosystem.
