FREE online courses on Financial Management and Creating Value - Chapter 1 - Breaking the Accounting Habit

 

One of the most important steps to making the financial function a source of value is to depart from the traditional accounting model. This requires a different way of thinking about how we measure performance. In financial management, the emphasis is on increasing value and not necessarily earnings. In order to make this transition over to value-creation, it is important to understand why accounting runs contrary to value-creation.

 

When we talk about value, we are referring to the market value of the organization. Market values are determined by the future expected cash flows that will be generated over the life of the business. The problem with the traditional accounting model is that all of the emphasis is on earnings, especially the quantity of earnings. What counts in valuations is the quality of the earnings. In financial management, we call this economic performance (such as cash flows) as opposed to accounting performance (such as net income). Accounting distorts true measures of value and we are unable to understand economic performance.

 

For example, it is quite common to recognize earnings regardless if the cash is collected. Likewise, expenditures that involve cash disbursements may provide future economic benefits that are ignored by accounting. If you were to spend $ 45,000 obtaining an MBA from the Wharton Business School, accounting would expense this investment. However, when we look at economic performance we would realize that this investment provides substantial increased cash flows over the life of your career. Therefore, accounting performance and economic performance are dramatically different.

 

Unfortunately, most people look to financial statements when measuring performance. If you look at the Balance Sheet, you will find book values of assets and not market values of assets. The Balance Sheet discloses total amounts invested. It tells you nothing about the success of these investments; i.e. have the assets earned more than the cost of capital?

 

So why are we so confined to financial statements for measuring performance? Part of the problem is our obsession with earnings. Like kids addicted to sugar, we can't get enough of the stuff. One reason people are fooled over the connection between earnings and market value is the fact that cash flow and earnings often move in similar directions. As a result, it is easy to conclude that earnings are the source of value.

 

However, the real lesson is learned when the two (cash flow and earnings) depart. A good case in point are small capitalized companies, especially internet companies like ebay. Despite poor earnings, the market values for companies like ebay seems to escalate out-of-sight. What is going on? What is happening is that the marketplace determines value based on what it expects in the future and not on what past earnings were. The marketplace comprehends that ebay will generate a lot of future cash flows because it has reinvented how people buy and sell merchandise over the internet. Financial Statements lag behind and fail to recognize the true sources of value in the marketplace. As the President of Coca-Cola would say - "the guy with the biggest cash flow wins!" Therefore, it is imperative for accounting and financial management to think in terms of economic (cash flow) performance and not just accounting performance.

 

The financial function can play a lead role in emphasizing things that are important to true economic performance. For example, thinking outside the financial statements is critical. Many intangibles that are important to value-creation never show-up on the Balance Sheet. Things like human resource capital, information technology, new ideas from research projects, innovative marketing, key strategic partners, etc. All of this stuff (the so-called intellectual capital) is paramount to creating value.

 

Another important step is to balance financial forms of measurement with non-financial forms of measurement. Identify the strengths and weaknesses of the business and try to measure the non-financial parts that will be major elements of value-creation. Moving towards a single, unified system or data warehouse can help leverage the intellectual capital of the organization. Developing better analytical tools can improve the decision making process. Accounting and Finance needs to lead the way on these things and much more. This is how financial management creates value!