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The 3 Conundrums Of Financial Accounting

Accounting is as old as time. It can be traced all the way back to ancient Mesopotamia. And there, its origins are closely intertwined with the ones of writing, counting and currency.

Progressing in time, the double entry bookkeeping used today by companies around the world was introduced in the late 15th century by the Italian mathematician Fra Luca Bartolomeo de Pacioli. And it hasn’t changed much since.

However, the service driven digital world we live in, fits harder and harder in a system created before the invention of electricity. A research spanning 20 years (from 1993 to 2013) done by NYU Stern Professor Baruch Lev shows how unuseful financial reports are becoming for investors.

This drop in relevance of financial reports can be attributed in part to three conundrums of financial accounting:

1. The most valuable assets of a company are not accounting recognized as assets.

Let’s look at a company’s balance sheet. Assets reported on it have to be physical in nature and the company needs to own them.  However, digital companies often have assets that are intangible in nature. And many of them go for accessibility over ownership – deciding to rent rather than own assets.  Many have also ecosystems that extend even beyond the company’s brand. Furthermore, digital companies have little to no physical products and almost no inventory. Therefore, the balance sheets of physical and digital companies depict entirely different pictures.

Consider this: Airbnb has a valuation of $31 billion owning exactly 0 rooms. While at the same time the Hilton group owns approximately 900,000 rooms world wide and has a valuation of (only) $ 23,3 billion. 

Furthermore, contrast Walmart’s $160 billion assets and its $300 billion valuation against Facebook’s $9 billion dollars assets for its $500 billion valuation.

Accounting recognized assets are getting constantly commoditized through advances in technology and manufacturing. Assets such as buildings, production machinery, cars, ships and planes are more or less equally available to all competitors. A logistics company, for example, can’t rise above its competitors through accounting recognized assets alone. The quality of their planes or trucks is similar (if not identical) to the one used by other companies in the industry too.

However, what’s setting companies apart, are the resources and processes (such as innovation) credited with value creation through the exploitation of the accounting recognized assets. But these resources and processes are either intangible in form, not recorded at all, or even listed as liabilities.

Take for example the network & viral effects, making platforms like Uber, Airbnb or Spotify so successful. There is no place in financial accounting for such concepts. Actually, the fundamental idea behind the success of digital companies (increasing returns at scale) goes against a financial accounting principles: assets depreciation with use.

Or consider innovation labs or innovation departments tasked with creating the company’s future growth avenues. These entities are viewed by any CFO – through the lens of financial accounting – as cost centres.

Furthermore expenses incurred in the innovation process are recorded as operating expenses (OPEX). These heart the company’s bottomline, which in term hears the stock price (which in term affects the yearly bonuses).   

2. Accounting-based financial reports show only the final outcome of asset deployment: revenue & earnings.

Financial accounting is totally silent on the phases an asset passes through as it is converted back into money. Financial accounting is not telling any story about the value creation process nor the innovation process used by a company to achieve specific revenue targets.

A great example is Dell, whose pursuit of RONA (return on net assets) led them to outsource most of their capabilities to ASUS. Christensen and colleagues refer to the Dell-ASUS story as a Greek tragedy. At the beginning, Dell outsourced the manufacturing of circuits and motherboards to ASUS. Later, they started outsourcing their supply chain management and computer design work. Every time Dell outsourced its capabilities to ASUS, its RONA numbers went up. They were making more money with fewer assets, which pleased the markets. The problem then occurred when ASUS decided to launch its own computers. This move was a blow to Dell, who no longer had the capabilities to respond quickly, because they had outsourced them to a company that then decided to become a competitor.

Corporate leaders overemphasizing financial outcomes, shows a lack of understanding of a company’s value creation system.

3. The accounting system can’t measure something that hasn’t happened.

This one is impacting directly the innovation process. Bringing an idea to market is not a linear process. Many unsuccessful small scale experiments go by before something sticks. The only problem with that is, that from a financial accounting perceptive, the costs incurred in those iterations are recorded. But the savings made by not committing to a wrong avenue are not. The problem with financial accounting used in innovation management only deepens when we try to put a dollar sign before a learning gathered from a failed experiment.

Financial accounting can only measure the things that has happened – good or bad. And this issue is not only visible in the innovation department. Manufacturing companies committed to the lean methodology perform major cost avoidance too. But this cost avoidance doesn’t appear on any financial accounting sheet. 

As digital companies become more economically prominent and physical companies becoming more digital there is a clear need for improving the science of accounting and the standards that go with it. There is a need for an update of the financial accounting system to meet the needs of the digital, innovation driven, economy. However, it’s unlikely that accounting standards will change in the near future. 

But there are things companies can do today to convey their real worth to stakeholders and to have a better picture of their value creation process. Constantly disclosing value-relevant developments such as major customers acquired, distribution alliances, introductions of new products, time-to-market optimizations, improvements in portfolio distribution etc. can change the way stakeholders view a company.

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