CFO Corner: Inadequate Financial Reporting Leads to Bad Decisions

By Nick Shepherd

Nick Shepherd, a retired chief financial officer now active as an author of books and articles on financial management and human capital, argues in this new ESM column, CFO Corner, that the financial information provided by organizations today leads to bad decisions because it provides no way to measure the financial impact of stakeholder engagement. The accounting system, says this highly experienced financial officer, does not account for the future value created by investments in people today, nor the future value destruction that occurs in short-term layoffs, such as those occurring at Twitter.

The Inadequacies of Financial Reporting
The Shortcomings of ESG Reporting

Because of inadequate financial reporting, shareholders may celebrate enhanced profits in the short term only to realize later—maybe when a CEO has moved on—that these improvements have been depleting the underlying health of the business. Improvements are needed in financial reporting to account for the fact that many operating expenses are in fact being incurred to create what has been termed “future-oriented intangibles.” A better way of accounting for investment in people is needed to provide a true picture of an organization’s financial health.

People expenses, better called investments, include the cash flow that organizations assign to activities related to building employee engagement. These include investments in enhanced approaches to hiring, on-boarding and orientation (getting the right people “on the bus”); leadership and team development; effective communications and collaboration; job design; training and development (especially in the areas of soft/inter- and intra-personal skills; effective rewards and recognition; DEI (diversity, equity, and inclusion), relationship-building internally and externally leading to silo busting, etc. Today, these activities are fully expensed annually, meaning that there is no way to account for their contribution to future value creation.

The Inadequacies of Financial Reporting

Financial results have long been the preferred approach to assessing management performance. Profit after all is the ultimate composite measurement of managements’ ability to bring all the required resources together, and through the effective operation of its business to generate outcomes that include profits. In effect, effective management is the ability to add value through creating products or services for which the amount buyers are willing to pay for the outcomes exceeds the cost inputs.

Today, this method for analyzing finances is no longer adequate because the underlying business model has changed. The current approach to tracking, categorizing, and reporting on one and organization’s largest costs—those related to people—is completely out of date. Historically, the work that most people performed day-by-day was directly related to generating current revenues: operating machines, purchasing supplies, sustaining information technology (IT) systems, serving customers. But this has changed. The manufacture of many products today is highly automated with few people operating machines. Many services are delivered by technology such as on-line banking. Work has shifted. While employment has not declined overall, the deployment of people has changed.

These changes have created a major inaccuracy in financial reporting—in many cases overstating current operating expenses and understating profits. As a result, investor equity appears to be declining; yet, in fact much of the work in which people are now engaged is creating future operational capacity and capability and thus value. One outcome of this insufficiency is the growing gap between the economic value of organizations in the marketplace and the apparent book value as illustrated by accounting records.

The Shortcomings of ESG Reporting

While the evolution of new reporting approaches such as integrated reporting and ESG (Environmental, Social, Governance) attempt to broaden transparency and create greater accountability, current methods of financial reporting completely fail to align and support these gaps. Financial ratios related to ROI, ROIC (Returns on Invested Capital) and EBIT (Earnings Before Income Tax) are increasingly misleading as significant current expenses are not related to current income. Attempts to dig deeper by using ratios such as Human Capital Return on Investment (HCROI) can also be misleading because employee expenses are an aggregation of both current operational expenses together with investment in future-oriented intangibles. Worse still, attempts to use revenue per employee, which has long been somewhat misleading due to partnering and outsourcing, is increasingly inaccurate as large portions of the employees have nothing to do with current revenue generation.

While the current financial accounting treatment can be considered conservative, it masks the reality of real underlying performance. For instance, enhanced bottom-line performance can be achieved by reducing employee related costs, but is this being achieved by true operational improvements or by reductions in resources assigned to creating future operational capacity—those “future-oriented intangibles?” One only need watch activities at Twitter and wonder whether the employee reductions being made as “necessary to enhance the bottom line” will eventually destroy the business.

Efforts to enhance reporting clarity will be helped by the application of a new range of metrics, but to truly add value, financial reporting can do a better job of accounting for people. This starts with enhanced labor reporting to allow the segregation between real, current operating expenses and costs incurred in creating future-oriented intangibles. Financial reporting related to future-oriented intangibles must be linked to non-financial metrics such as levels of employee turnover. Greater insight into the retained value created from spending on future oriented intangibles must be provided by in some way capturing the cumulative – i.e., multi-period spending and indicators such as employee engagement levels.

Only when a far clearer link can be made between financial performance and the health of investments made and retained, relative to the creation of a healthy workplace environment, will employee engagement start to be recognized as a major factor in financial performance.

For More Information
Nick A. Shepherd, FCPA; FCGA; FCCA; FCMC
Principal,
Eduvision Inc.
Nick@Eduvision.ca