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A digital gauge for company reports

26 January 2018 by John Stittle

A digital gauge for company reports - Read more

Future IT shifts will demand a new kind of corporate reporting

From autonomous cars driving Californian streets, to the machine learning systems beating chess grandmasters, it is clear the fourth industrial revolution is already underway.

Its effects will be far reaching and have more impact than most people can currently imagine. This revolution could radically transform all aspects of life – including most types of businesses and organisations.

This is according to the likes of Klaus Schwab, founder of the World Economic Forum, which holds a yearly meeting in Davos where leading business and political figures discuss world affairs. And many tech entrepreneurs and computer scientists agree.

Whatever your scepticism, the fourth industrial revolution is already creating major structural, operational and technological challenges at the heart of company reporting. It will reform, challenge and often completely rewrite conventional reporting policies and practices.

In short, it will demand a reformed model of corporate reporting.

Accounting for change

Beginning nearly 40 years ago, the third industrial revolution saw a massive business and industrial switch to digital, the internet, advanced information processing, personal telephony and data connectivity.

But that is gradually making way for more widespread and profound changes that will usher in the fourth generation of social, economic, technological and business changes. This fourth revolution will be based on automation, robotics, nanotechnology, autonomous vehicles, generic editing, advanced artificial intelligence and the Internet of Things.

Indeed, in November 2017, the UK government’s white paper on industrial strategy claimed that the fourth industrial revolution will be ‘of a scale, speed and complexity that is unprecedented’.

This white paper predicted that the ‘seismic global change’ will ‘disrupt nearly every sector in every country, creating new opportunities and challenges for people, places and businesses’. The impact on businesses, and consequently on business reporting, will be still greater.

“Business life has changed beyond recognition but accounting has made little progress in many respects”

Already some forward-looking business sectors and organisations are starting to recognise the need for reporting reform. Some of the more progressive and astute firms of accountants are flagging aspects of the current corporate reporting model that are broken and need fixing.

EY, one of the Big Four international accounting firms, is worried about the nature of information revealed or obscured in the traditional annual report and accounts.

In spring 2017, the firm warned that the ‘traditional’ reporting model needs ‘to evolve to reflect the reality of modern business’. It pointed out that current reporting is based on a model that dates back to the 19th century. Business life has changed beyond recognition but accounting has made little progress in many respects.

To illustrate their point, EY highlighted the work by New York University professor Baruch Lev, author of The End of Accounting. Lev showed how structural aspects of accounting have ‘changed little … over the last 100 years’, proving ‘remarkably stable and enduring despite repeated calls for’ reform.

Lev pointed to the US Steel Corporation to show how the basic principles and structures of accounting have stagnated and failed to adapt as the nature of business changes.

Comparing the financial statements of this steel company in 1902 and again in 2012, he found a ‘remarkable similarity’ in terms of content and structure of the financial statements over this 110 year period.

In future, accounting reform will be necessary as many business systems and regulatory and legal structures cannot currently capture and report on new developments.

Intangible assets

In Victorian times, businesses were typically composed of tangible assets of land, buildings, plant and machinery.

But the current reporting model increasingly appears obsolete as businesses incorporate the growth in the service, technology and advanced knowledge-based sectors, ditching traditional assets in favour of intangibles like intellectual property and high-level knowledge-based skills.

Indeed, EY point out that intangible assets ‘now account for around 50% of the market value of many organisations’. The problem is that traditional accounting often does not even try to account for this new generation of assets.

Company balance sheets are not reflecting the total extent of these intangibles. As EY points out, companies ‘often report the wrong things – measuring what is easy rather than what is right’. It particularly flags the failure to account fully for the importance of human capital.

Hywel Ball, UK managing partner of EY, points to the ‘growing disconnect … between traditional reporting and the true value of a company’. As a result, this disconnect already brings a ‘lack of clarity’ and is ‘exacerbating the breakdown of trust’ between companies and a variety of stakeholders.

The growing importance of people-driven and knowledge-based businesses needs to be recognised by accounting regulators, with the International Accounting Standards Board (IASB) needing to work out how human capital can be classed as assets in company balance sheets.

“Human resources are often the prime determinants of cash flow generation in the knowledge-based economy”

Just how many times do company chairmen state in their company’s annual report that employees are the business’ greatest asset? Such sentiments are not reported as such in accounting models.

Traditionally, employees have been accounted for as a ‘cost’ in the form of salaries and wages and recognised in the income statement. Clearly, it is easy to quantify a salary cost of employees in the income statement but considerably harder to measure the value of employees in the balance sheet.

But since human resources are often the prime determinants of cash flow generation in the knowledge-based economy, there is a strong argument that employees should be capitalised as assets in the balance sheet.

Retreat to advance

Perhaps companies should look back in order to go forward. Earlier research, especially from the US in the 1970s, suggested differing methods of capitalisation of employees’ historic ‘costs’.

The costs of recruiting, training and staff development could be capitalised as an asset rather than being treated as an income statement cost. Other supporters of human asset accounting suggested capitalising the replacement cost of employees by determining the present value of their future earnings or capitalising their profit contribution to the company.

Another innovation from the 1970s may provide a basis for further development in the fourth industrial revolution. The middle of the decade gave rise to the value added statement which some companies voluntarily adopted for a few years.

In this statement, the cost of brought-in goods is deducted from total sales and the difference is termed the ‘value added’ – that is, the value generated by the ability and skills of employees. With companies in the future relying more heavily on knowledge-based skills, a value added statement can highlight the full amount of ‘value added’ by companies.

In the future, intangible assets such as brands and intellectual property will become more significant drivers of corporate earnings.

However, some of the existing accounting regulations on intangible assets are out-dated and inappropriate for the new era. For example, IAS38 Intangible Assets currently prohibits many types of intangible assets, such as ‘home-grown’ brands and some types of intellectual property, from being recognised in the balance sheet.

Other intangible assets such as intellectual property, trademarks, patents, copyrights and even perhaps trade secrets (protected by confidentiality agreements) become more important. In many instances these types of assets are written off to the income statement, with others capitalised at cost.

There is now a need for more of these types of assets to be shown in the balance sheet at fair value.

Big Tech

The five largest US companies – IT giants Apple, Amazon, Alphabet (parent of Google), Facebook and Microsoft – dominate the New York Stock Exchange. Last summer, the combined market capitalisation of these ‘new generation’ companies exceeded over $3 trillion.

But, like elsewhere, so much of the reporting of these companies remain based on 19th century accounting. In many cases, the traditional model fails to meaningfully capture and report on the performance of these corporate giants.

“Traditional accounting needs to be replaced in order to reliably measure performance and shareholder value in Big Tech”

For example, in its latest financial statements, Facebook’s traditional tangible assets of property and equipment amount to only $8.6 billion from a balance sheet total of nearly $65 billion. From this relatively small base, the company’s business model generates annual revenue of $27.6 billion and with net earnings of over $10 billion.

Likewise, Alphabet’s $90.3 billion turnover is generated from tangible assets of property and equipment of $34.2 billion, but its balance sheet is overshadowed by total intangible assets and securities and cash, exceeding over $167.5 billion.

Traditional accounting policies and practices need to be replaced in order to reliably measure performance and shareholder value in Big Tech – and in small technology companies too. 

Incoming earthquake

The accounting function itself will also face substantial upheaval. Robotics, artificial intelligence and advanced digital and blockchain technologies will prove to be major industry and commercial disruptors.

Vast data sets will be processed and interpreted rapidly at low cost and in real time, lowering risk levels and combining with artificial intelligence systems to eliminate much human intervention.
Indeed, many accounting jobs may disappear altogether.

In 2015–16, a report from Osborne and Frey of Oxford University evaluated the susceptibility of professions to automation. The research identified that there is a 95% probability that accounting jobs will be lost by automation.

But the better news is that company secretaries are considered almost irreplaceable by technology. There was only a 7% chance of automation affecting the jobs of chartered secretaries, placing them in one of the lowest risk categories.

Even if the World Economic Forum’s Schwab is only partially correct in his predictions, the impact of the fourth industrial revolution in the next few decades will be momentous on business models.

Whatever direction technology takes, and however businesses adapt, it is vital that accounting can measure and report corporate activity and performance. Accounting models and regulations need to reform to remain relevant.

John Stittle is a senior lecturer at the University of Essex

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