Alan Mitchell: Measuring profit should be about fact, not fiction

There was a time when people were convinced that witches existed. We now know this to be fantasy, much like companies’ profits argues Alan Mitchell

In the Middle Ages suspected witches were routinely tried in court and duly burned or drowned. In some cases, even bewitched farmyard animals such as chickens had justice meted out to them via due process of law. In the Middle Ages, people thought witches were as a real as the bread on their plates.

Today we invest other phantoms with similar reality – such as “profit”. Today’s equivalent of a chicken trial, is the trial of companies’ results by EBITDA (or earnings before interest, tax, depreciation and amortisation).

As Alex Batchelor, vice-president of worldwide branding for Orange, pointed out at a Marketing Society event on finance for marketers last week, it’s very easy to see the absurdity of this concept. Just imagine sitting down with your partner to discuss your financial problems and saying: “Well, first let’s ignore our mortgage and debts, so we don’t have to count interest payments. Let’s also assume we don’t have to pay any tax. And we’ll also say that everything we’ve bought – such as our car – is worth exactly the same as the day as we bought it. See! Our ‘underlying’ performance is excellent!”

Yet, despite this breathtaking absurdity companies (especially in the US) routinely report their performance in terms of EBITDA, as though this was actually telling people something. But EBITDA is just an extreme case. Like belief in witchcraft, the whole notion of profit objectifies a human-invented fiction. Here’s a couple of reasons to question its current sway.

For a start, the profits we measure today are assessed only by the lights of one particular group of people – shareholders – while ignoring others such as customers and employees. Behind this stewardship reporting function of accounting lies one huge value judgement: that this is what companies are for.

You could do the arithmetic very differently. If you agreed that, crudely speaking, profit equals income minus expenses, you could decide to measure a company’s performance by the degree to which it enriched employees. You would then take salaries and benefits out of the “costs” and place them on the other side of the equation as “profit”; and put payments to shareholders on the other side as a cost. The profit numbers would look very different. The underlying reality would be untouched.

Another problem with today’s measures of profit is that they only measure transactions that go through the company’s books. This ignores any off balance-sheet ventures or beneficial multiplier effects that the business might generate for local communities or corporate partners. Because Coca-Cola spins off its capital-intensive bottling operations to separate companies, for instance, looking at Coca-Cola’s accounts in isolation will vastly underestimate the wealth generated by the Coca-Cola brand.

The other side of the coin is that “profit” routinely ignores externalised costs – costs which the company shrugs off on to third parties, such as environmental degradation. So reported profit tells you very little about how much wealth the company is actually creating – or destroying.

Also, the difference between real cash flow and profit creates massive room for subjective judgement: valuing work in progress and stock, recognising the income from long-term contracts, depreciation of plant and machinery, amortisation of acquired goodwill and so on. Yes, there are “standards” for reporting these things. But we have to keep changing them.

Related absurdities – the aunts, uncles and stepsons of profit – include the accountants’ rule that only “separately identifiable assets” can be itemised on balance sheets. Result: so-called “intangible” assets can account for 85 per cent or more of a company’s value as measured by stock markets. As a recent EU report on intangibles remarked, “our economic and business measurement systems are tracking – with ever increasing efficiency – a smaller and smaller proportion of the real economy”.

Another in-built problem: the gulf between financial accounts as historic rear-view-mirror documents and managers’ need to plan for the future. As London Business School senior fellow Tim Ambler pointed out at the Marketing Society event, concepts like shareholder value (and profit) are the cart that follows the horse. “They tell you nothing about where future cash flows will come from – customers.” Companies that focus on building their brand equity – the source of future cash flow – basically find that “the bottom line takes care of itself,” he suggested.

Ambler’s comments highlight a deeper challenge. Numbers and assumptions always go hand in hand. Modern accounting is based on a set of assumptions about wealth creation that aren’t justified any more. As the EU report remarks, “intangibles such as research and development, proprietary know-how, intellectual property, workforce skills, world-class supply networks and brands are now the key drivers of wealth production, while physical and financial assets are increasingly regarded as commodities”. The “clarity of 20th century markets based on a system of fixed boundaries, with one-to-one trading relationships, linear value-chains and balance-sheet accounting concepts” has disappeared.

Yet, too often, debates about marketing accountability and measurement seek to shoe-horn this emerging reality back into an early 20th century Heath-Robinson accounting framework.

To be fair, the accountants are responding. On June 10, the Accounting Standards Board (ASB) published a new exposure draft on an enhanced Operating and Financial Review statement (PN 202), which recommends “discussion of the strengths and resources of the business (brand equity, market dominance or product research for instance) and of activity to enhance future performance (such as human capital management or customer support)”. ASB chairwoman Mary Keegan says: “High-quality financial statements are only part of the information that investors need to assess the potential of companies.”

But more is needed. As Ambler points out, when boards are asked what measures they really need to judge the performance of their business – like brand equity – the debate quickly moves beyond accounting numbers to uncover crucial assumptions about how the business generates wealth: its particular business model.

It’s often said that what gets measured gets managed. Perhaps. What’s truly important however is boardroom determination to measure what it really needs to manage.

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