The Profitability Analytics Perspective Improves Ethical Culture

It is a paradox: A finance organization that focuses exclusively on ethical external financial reporting can find itself contributing in significant ways to a poor organizational ethical culture.

How can this happen? In two ways:

First, much of the accounting profession’s ethical training is exclusively focused on external financial reporting and the audit of that report. Over my 34 years, in the accounting profession (of which none has been involved in audit, all management accounting) I have been forced by state accounting societies to take numerous (over 20) annual ethics courses that were exclusively about public accounting and auditing. In some recent years, I’ve had the opportunity to take some ethics courses for accountants working in business. But in many states, the only authorized ethics courses deal largely with public accounting and external reporting and have very little related to management accounting. The result is an overwhelming majority of accountants get the impression and come to believe the only ethical information they can present or even use is information prepared in accordance with external financial reporting standards.

Second, accounting and finance often don’t think about the impact of their behavior, work practices, and financial information on the rest of the organization. They are acting ethically and presenting ethically prepared information in accordance with accounting standards…How could that contribute to unethical behavior or an unethical culture?

The underlying reason for the problem is that financial accounting rules and standards don’t follow the causality principle. Financial accounting is under no obligation to reflect the operations or resources of the organization as the majority of the organization see them…the obligation is to follow accounting/financial reporting rules and standards. Once performance incentives are linked to financial accounting/statement results the standards and rules become the subject of gaming, interpretation, and too often manipulation…not by ethical accountants, but everywhere else.

What ethical problems can be created?

Budgets are a primary source of cultural ethical deterioration. In fairness, senior management demands, or pressure, can contribute to accounting and finances' bad practices. The major problems occur when performance evaluations or awards are tied to a traditional annual budget process. The very idea that you can predict what will happen next year 3-9 months before the year starts is absurd. Every manager can and should set goals and make plans, but firm commitments? The annual budget process is often a game of liar’s poker with one side (finance) out to find savings and the other side (manufacturing/operations) determined to protect resources and flexibility; or budgeting is a frustrating compliance exercise to concoct the numbers and stories to fit top-down direction…and leave some wiggle room. Neither scenario is a pleasant experience. Both diminish the integrity of everyone involved and the ethical culture of the organization. Additionally, there is the year end spending by departments to ensure their budget isn’t cut for next year (use it or loose it), which is far more painful than the possible “attaboy” they may get for coming in under budget. This is an incentive to act against the best interests of the organization. Good ethical encouragement?

Many improved approaches to budgeting have been devised and implemented; but traditional, static annual budgets stubbornly persist in most organizations…and it is led by accounting and finance.

Cost/Expense Characterization and Allocation Gaming – Ethical accounting and finance staffs focused on financial reporting won’t manipulate these (though they will construct them with limited regard to causality, behavioral impact, or organizational performance); however, others in the organization may have incentives to do so - particularly when their performance evaluation and incentives are tied to budget or financial statement metrics. Actions such as recharacterizing staff from direct to overhead or administrative can improve the appearance of product cost. Another flaw is using financial statement-oriented information for analysis and decisions where that data does not present the whole economic picture. Conceivably product cost can be reduced with cheap offshore labor, but what happens to quality, supply chain resilience, shipping and logistics costs, responsiveness to customers, etc. If operations presents these scenarios for consideration, but finance fails to causally model them, operations loses confidence in the integrity of the organization’s (and finance’s) analysis and decision support. This type of flawed analysis can happen in many smaller ways for decisions like special order pricing, outsourcing, and internal cost reduction targets.

Ignoring Idle/Excess Capacity Cost - For many types of operations, the first indication of successful process improvement is idle personnel or equipment. Many CFO’s take a hard line that “savings” only count when cash is saved – meaning people or equipment eliminated. This overlooks the more immediate effect of improvements and is often counterproductive to an effective process improvement program. The very people who have made the improvement are those most likely to be cut. The appropriate response is to put pressure on sales and marketing to create more demand to use the greater capability and capacity. Good work going unrewarded, or much worse punished, is clearly counter to a positive ethical environment.

Historical Cost Depreciation - New equipment often carries a high depreciation expense, old equipment often remains in use and have no depreciation charge. Should either situation effect the price of a product or service? The answer is NO! Depreciation is a fiction, a poor proxy for estimating the recapitalization needs of a business. The correct way to handle this for internal decision making is to have a strategic recapitalization plan and develop a relevant capital preservation allowance for products and services based on FUTURE recapitalization and improvement needs. Historical cost is a sunk cost…not relevant. When I speak to groups of manufacturers, absurd depreciation assignments to product cost is the number one complaint. The fact that accountants hold them to absurd numbers undermines their confidence in both accounting and the organization’s performance system.

A second issue with depreciation is the lack of recognition of intangible investments in initiatives like training, process improvement, analytics, etc. These continue to be treated like expenses even though they are the forefront of today’s competitive advantage.

Poor or irrelevant performance measurements, even based on highly ethical (but irrelevant) information does not contribute to an ethical culture.

Revenue Recognition – Financial reporting standards for revenue recognition have become stricter and more rigorous. While there is good reason for the changes, the end result is to separate (in time) a number of sales and operating actions from the income statement impact. This situation may call for changes in performance metrics that de-link them from financial statement impact. A failure to do this could be demoralizing, and less than fair, for many components of the organization. Companies often take “rush” actions to make shipments by financial statement deadlines, and many have engaged in manipulations to boost financial statement performance.

ROI – Shrinking I vs. Growing R – Return on Investment is a highly regarded financial metric, but it can result in behavior that promotes the short term metric over long term survival when companies act to minimize investment in the future (denominator) to make the numerator (the return) look good…rather than taking action to increase the R (return). People within the company often see this as manipulative and view senior management and the board as promoting a “win at all costs” or “ends justify the means” approach to management and business. ROI metrics also typically overlook intangible investments and assets such as unique capabilities, workforce training and skills, networks, etc. that should always be factored into internal decision making.

Conclusion

I once listened to the deputy Chairman of the Board and former CFO of the company explain how the company (a Fortune 100 company) had a $20B liability on the balance sheet purely because of a financial reporting standard. He was very proud of spending about $2M to set up a new offshore currency trading desk that was able to eliminate this $20B liability from the balance sheet. The new desk did not contribute any profit to the company, it was purely an expense, and it required many business units to follow more complex procedures, probably adding to their costs. I contend this was a bad initiative, he spent money to legally circumvent a financial reporting standard but created no real economic value for the company beyond changing the appearance of the balance sheet. Was this ethical? He thought it was the right thing to do. He thought it created value for his shareholders.

Profitability Analytics is always focused on looking beyond the financial statement to the real economic impact and the cause-and-effect relationships within operations and the value chain. This perspective promotes ethics because it is linked to real actions and resources. There are no legal arguments about the level of compliance or appearance. Your focus is on improving.

Financial reporting standards exist for good reason, and they are valuable for capital markets. But they are not designed for internal management decisions…they are not the often cited “One Version of the Truth”. Profitability analytics and managerial costing based on cause and effect is a necessary – and sadly an all too often overlooked - perspective to balance financial reporting’s highly publicized and over-inflated sense of importance.