Most people are familiar with financial statements – often referred to as”…the accounts” of an organization. These statements typically comprising a balance sheet, earnings or income statement and cash flow statement plus other supporting materials present the financial affairs of an organization as at, and up to a specific point in time. Auditors, where required review these statements and, although they clearly indicate that the accounts remain the responsibility of management, will certify that they also present a “fair view in all material aspects.”
These statements presented in the form of annual reports, typically required by statute, have become a core aspect of an investors understanding of financial performance. The challenge being faced today is that financial reporting – especially an organizations balance sheet, falls way short of communicating the true “worth” or value of an entity. This is evidenced by the gap between its book value that represents what’s on the balance sheet and its market value that represents what it is worth to an investor. Today on average only about 20% of an organizations worth is included on its financial balance sheet.
This means that there is another “phantom balance sheet” somewhere that contains the rest of the information – being all the assets and liabilities that an investor is willing to pay for to gain ownership of the business and access to its capacity and capability principally in terms of generating earnings. Today there is a growing recognition of the importance of the phantom balance sheet and what it contains but unfortunately accountants and the accounting profession is unable to capture and present this information. One of the most well-known phrases in business is that “people are our most important asset;” the intent of this statement is good but unfortunately misleading because organizations don’t own people like they own a piece of equipment; it is also almost impossible to attribute a value to people and put them on a financial balance sheet. The reality is more like “the contribution of our people has become one of the most important aspects of our business success.” For an investor a statement like this would probably then open up the question of “…so what are you doing to make sure that your people are well-trained, productive and happy wand want to continue to give 110%?”
The new approaches being suggested for integrated reporting might help answer this question; this <IR> framework has defined five “new capitals” that complement the traditional financial capital in their importance of an organizations business model. This should help give investors a clue as to what additional information to seek from the phantom balance sheet; people, or human capital as it is referred to is probably the most important hidden “asset” as people create so many of the other capitals. As an example <IR> also includes intellectual capital and social / relationship capital that rely heavily on the actions of people to create and sustain them. In addition human capital contributes to manufactured capital, another category through the added value of effective systems and organizational capabilities. Why is understanding the impact of human capital critical other than determining a “value” for a phantom balance sheet? Because the impact of human capital also impacts a phantom earnings statement (and through that phantom cash flow); the difference is that in the case of earnings, it isn’t so much that the value is missing (although it may be if it’s not being utilized) its more that the impact of having it has been hidden.
Phantom earnings statements are important because users “don’t know what they don’t know” and that is typically what impacts on earnings the phantom “assets” are having. Examples would include facts such as a high reputation and brand value would probably be impacting margins and driving down sales and marketing expenses; an innovative and creative workforce would probably be contributing to enhanced margins as well as greater productivity this decreasing labour cost per unit of output. Growth is probably being impacted by innovation and creativity in the workforce leading to new products and services. Waste is probably being eliminated and costs reduced through an attentive and committed workforce; effective internal relationships between managers and others are probably contributing to the engagement required to achieve the above. (You can have the best people in the world but if they are not motivated to contribute it won’t matter). Great relationships with suppliers who work as partners are probably contributing to rapid response times and greater innovation, and possibly lower overall costs through mutually shared savings. How much of this do investors and the users of financial statements really know or understand? Conversely, the poor utilization of human capital is probably depressing potential financial earnings because these types of benefits are not being achieved as part of current earnings – thus creating an opportunity to significantly increase performance. One of the core problems created by the absence of this type of insight is that short term financial performance can in fact be enhanced by cutting costs in areas that are destroying many of these capabilities discussed above; however no one in the investment community knows until earnings and growth start to flatten and the decline – and by then it’s too late.
This is where the need for effective implementation of integrated thinking and reporting needs to go; the outcome should not be just a menu of metrics that talk about activities and outcomes under the new six categories of capital but a holistic representation of the organization as a system where financial outcomes are seen within the context of the sustainability of operational capacity and capability. The current approaches to evaluating corporate performance have increased in risk because of the lack of insight into the drivers of sustainable capability.
One example of a holistic framework designed to provide the type of insight into the phantom earnings statement and balance sheet is the OMS evaluation and rating system as developed by the UK based Maturity Institute. Users of this framework can begin to at least start asking the right questions that will lead them to understand the real content of the phantom earnings statement and through that assess the real value of the phantom balance sheet.