Is Your Board and Senior Management Using the Right Financial Information? By Larry White

This is a bold question.  Corporations are enormously successful.  They compete to hire the smartest people who work hard and creatively.  Why wouldn’t they have the “right” financial information?

I’m targeting financial information with this question because organizations have lots of information – operational, sale/marketing, logistics, human resources, etc.   However, not all information suffers as extensively from a severe regulations and standards orientation as financial information.  No other information has an oligarchy of major firms, primarily the big four audit firms plus some other large audit firms, pushing a fallacy like the “one version of the truth” myth that is used to elevate required regulated financial accounting information to astronomical levels – far beyond its ability to deliver.  The world of accounting is nearly fully indoctrinated by this myth since it is taught in university curricula, nurtured in young accounting professionals – a large percentage of which go into auditing for their first job, and the focus of almost every professional accounting association.  The business community, by long association, is also largely indoctrinated based on years of experience and the fact that individuals who achieve good results with financial accounting metrics are generally promoted to leadership.

I seem to be painting a scenario for failure, and failure hasn’t happened.  Remember there is lots of information and frequently when a serious contradiction occurs between financial information and other information (which may make more “common sense”), management digs deeper and chooses the correct path.  So the choice isn’t between success and failure, the consequence of over-focus on financial accounting and reporting information is most often a choice between success and greater, wider success.   What do I mean by wider?   Senior management and board level decisions are well analyzed from many perspectives beyond just the financial perspective, but decisions made by many lower levels of managers and supervisors are not.  They will follow policies and practices prescribed and these are more likely to follow traditional financial accounting logic that may be far from optimal for internal decision support.

Where might Senior Management and Boards go wrong?

• One common error is basing executive performance and salary metrics on financial accounting metrics because they are “audited” and, therefore, more concrete.  However, financial accounting metrics are open to a wide variety of manipulations, particularly in the short term - some legal, some marginal, some fraudulent.  Any sort of manipulation of purely financial results to achieve short term performance goals leads to a deterioration of the ethical climate throughout an organization.   Executive performance metrics need to emphasize creating stewards of the organization, not gamers.

• Return on Investment is a great metric; however, there is often a focus on lowering the amount of investment to make a static return look better.   The focus needs to be on investing for the long term and boosting the return.   The definition of investment also needs to be carefully considered.  It’s not just capital investment anymore.  Investment in intangible capabilities (that are expensed on regulated financial statements) such as training, branding, efficiency and quality improvement, research & development, etc. may be the larger drivers of future profitability than physical capital.

• Customer costing is not required by regulated financial statements, but it is critical to optimizing profitability.   A wide variety of costs throughout the organization not included in product costs are causally driven by customer behavior.  If these aren’t known, they can’t be managed.

• Product Costs, in particular, are highly distorted by regulated financial statements.  A lot of organizational costs driven by products aren’t included (sales commissions, marketing, research and development, etc); and the costs that are included are often assigned in a distorted manner with highly generalized drivers and highly consolidated cost pools.  Sadly, Service Costing, when done, often follows the manufacturing model and doesn’t look causally throughout the organization to identify all relevant and causal costs.

• Depreciation provides next to no information and is based on the irrelevant “sunk” cost of a physical asset.   Profitability Analytics recommends using a forward-looking Capital Preservation Allowance.
  

I’ve really only scratched the surface of all the wrong financial information that an organization’s leadership could use to make less than optimal decisions.   Perhaps you can add to this list????