Have Accountants Lost Their Balance? What's Missing From Financial Reports

A new book by author Nick Shepherd, an accomplished finance professional, asserts that today’s accounting profession is failing to report on what truly counts: human capital.
 

Accounting has lost touch with reality, asserts Nick Shepherd, in his new book, How Accountants Lost Their Balance. Shepherd is a retired financial officer with decades of practical management experience and is a Fellow of the Chartered Professional Accountants of Canada in Ontario. He is also an active proponent of the concept of Integrated Reporting. 

 

“The days of relying on audits and financial reporting to verify the health of a company are no longer enough. Relying on an audit to verify that a business is a going concern has proven to be clearly misleading,” Shepherd writes.

 

“The application of financial standards to the way that cash is used in today’s organizations fails to disclose the significance of investments in the key intangible assets that form a critical part of today’s business model. The risk to business continuity posed by maximizing profitability while depleting critical intangible resources is often not discovered until the damage is done. Inadequate attention to human behavior as a key element of internal controls can result in unplanned surprises and unethical conduct,” he asserts. 

 

While the world has changed over the last fifty years, he says, “the profession of accounting has become less relevant and no longer fit-for-purpose. There are clearly cracks in its’ ability to demonstrate that it remains independent, objective, and aligned with societal expectations of ethical behavior.” 

 

As a result, he argues, audit reports are no longer a quality stamp of approval on a set of accounts. “Financial records that used to underpin some 95% of an organizations market value, today only represent about 15%. While this 15% of value at risk remains well recorded, visible, and verifiable by accounting, the balance of 85% is represented by something else: something that cost money to create, but for which there are no financial records. When the money was spent it was written off against current year earnings, depleted shareholders’ equity, and reduced accounting value. Yet for the investor, if it was developed and nurtured, it created value.” 

 

Organizations, he points out, “have spent billions creating global supply chains and in developing state-of-the-art processes. They have spent billions in developing managers and leaders to create an innovative, responsive, and creative workforce, as well as developing the skills and capabilities of the workforce. They have invested large sums to identify, collect, develop, and use the knowledge contained within and about their organization. They have spent billions building their brand and with it their reputation and customer loyalty. Yet almost none of this is reflected as an organizational asset. It is there. It cost money to create. It contributes to the creation of value. But it disappears from the financial records.” 

 

The income statement used to explain how the profit was generated, he points out. How much revenue was billed, and the expenses incurred to generate that revenue. Not anymore. Many of the expenses charged against income today are costs incurred to create income in the future.

 

This book explains how the economy and structure of business has changed and how the practise of accounting, especially financial reporting, has failed to adapt. It suggests a number of improvements.

 

Firstly, reporting of expenses must be expanded and improved to explain “where the money went,” he says. How much was invested to earn current income? How much was spent to build the intangible assets and how much was spent to sustain these assets? The gross aggregation of payroll costs is no longer acceptable.

 

Second, he continues, “accounting must embrace the reporting of intangible assets that consume a significant portion of an organizations cash flow and which contribute a substantial portion of market value. There must be some explanation of where all the investment went to create these intangible assets, and some level of transparency as to their continued existence and health as drivers of value creation.”

 

Accounting must also lead the effort to create a bridge between financial reporting of intangibles and the growing use of non-financial indicators, he adds. “If an organization is making training commitments, how much expense is this consuming and what is its impact on current earnings and the value of the workforce? How much revenue is being generated from new products and services and how does this compare to the investment being made to create a climate for innovation and creativity? How much investment has been made in supply chain’s and how do these impact innovation, creativity, and earnings?”

 

The reasons for change are apparent when considering that the stocks of Facebook, Amazon, Apple, Netflix, and Google “collectively are worth close to $5 trillion, yet their financial records reflect about less than 10% of that. Their brand values alone are worth about ¾ of a billion dollars, yet even that amount is not recorded, audited, or reported as part of an annual report.” 

 

Shepherd says, “New approaches to corporate reporting have been developing over the last thirty years that have identified many of these non-financial resources that are strategically critical. These reports provide some level of insight into what these intangible assets are, but there remains no link between these reports and the financial records.” 

 

There is much talk about integrated thinking and integrated reporting, but real resource integration, which is what business leaders do on a day-to-day basis, remains a collection of stand-alone performance indicators, he argues.

 

Shepherd’s book suggests where the gaps might be and what types of changes could be made to work towards more realistic integration. The author addresses:

• How the flow of funds has shifted from tangible “bricks and machinery” to intangible people, processes, and relationships. 

• How these investments by management have created operational assets that form the core of today’s business model. 

• How investments continue to be made in keeping these underlying capabilities healthy. 

• How effective management is managing the risks among all the key resources, to ensure system sustainability while optimizing performance. 

 

“Change is a journey,” he writes. “The journey for the accounting profession must include a reflection of its underlying principles and the development of an approach that provides valuable information that adds value to both the internal decision maker and the external investor.” 

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