A consensus is emerging that a new approach to accounting—Enhanced Business Reporting—could
significantly improve transparency across all asset classes. It would also meet demands by executives
and investors for more science and less art when
measuring business performance.
By John J. Ballow, Robert J. Thomas, Eric R. Noren and Paul J. Herring Outlook Journal, June 2005
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By some measures, Generally Accepted Accounting Principles have surely stood the test
of time. Standard accounting practices are doing today exactly what they were intended
to do—provide information on a company's historical performance and measure traditional asset classes. Trouble is, GAAP was designed in the 1930s, and in the years since the US Securities & Exchange Commission established the Office of Chief Accountant, both the economy and the way corporate performance is measured have changed dramatically.
Intangible assets—such as a company's brand or intellectual capital—and expectations for growth have become important drivers of shareholder value; neither is taken into account through traditional GAAP analysis.
According to GAAP, the key measures of business performance are net income and earnings per share. Yet there is a limited—and diminishing—correlation between those
measures and share prices. A company's income statement usually accounts for only about 4 percent
of market value for a stock with
a typical price/earnings ratio of 25, while the balance sheet covers about
25 percent. The remaining 70 percent of market value consists of intangible assets and expectations
of future growth (see "Future Value: The $7 Trillion Challenge," Outlook,
February 2004).
This inability of GAAP to account for a significant percentage of
value represents enormous exposure, and not only for investors.
It also means that a company's leadership team is now responsible for important value-creating assets that are underrecognized, underreported and, in fact, undermanaged.
Executives and investors alike
are looking for a new set of tools
to address this problem by improving reporting. The C-suite wants
a reporting framework that can more clearly communicate its
goals and its performance against those goals to investors. It also wants to standardize the increasingly divergent languages of its management team, investors and analysts. Stakeholders, for their
part, want the increased transparency that would result from
getting more accurate, appropriate information in the reports
they receive.
Financial accounting and management accounting diverged some time ago. To actually run the enterprise, the C-suite uses financial management tools to track product and
segment profitability, complete activity-based costing analyses, or capture intercompany pricing. The results
of these activities rarely appear in formal financial reporting. Outside the enterprise, the company's most sophisticated followers, such as buy-side analysts, rely increasingly on their own analytics, which are often based on proprietary valuation algorithms. Yet despite this divergence, public companies dedicate two and
a half months of effort every fiscal year to preparing ever more detailed 10-K reports (or their non-US equivalents) that cover diminishing portions of the enterprise value.
EBR is not a replacement for GAAP but
a complement to it. And it will not be
overly burdensome for companies. And what is covered in those reports can punish a company for pursuing goals that enhance shareholder value. Consider such classes of intangible assets as brands, skilled human
capital and proprietary networks.
Intangible assets are basically
created by investing in the future, which in current reporting terms means such sales, general and administrative (SG&A) costs as training and education, software development, research and salaries. Under GAAP reporting, SG&A expenses are a line item that is subtracted from revenues; as these expenses increase, earnings per share typically decrease. Therefore, current reporting frameworks actually encourage companies to underinvest in the future—that is, the frameworks discourage the kinds of investments that could add the most shareholder value.
A number of recent initiatives have begun to address these reporting issues. Conceptual frameworks such
as Economic Value Added (EVA), Cash Flow Return on Investment
and the Balanced Scorecard are all attempts to provide more relevant information. The proliferation of non-GAAP supplemental disclosures—EBITDA is a good example—are also ways that companies are trying to improve disclosure.
A consensus is emerging that a
new approach, called Enhanced Business Reporting (EBR), could
help respond to these needs. EBR
is not a replacement for GAAP
(or its non-US equivalents) but a complement to it. The goal of EBR
is to significantly enhance transparency across all asset classes.
At least one coalition of concerned participants, the Enhanced Business Reporting Consortium, is attempting to reach preemptive, formal agreement on basic conceptual standards (see Sidebar). Accenture
has developed an approach that
it has proposed to the consortium for consideration. The approach is based on widely accepted principles such as total return to shareholders (TRS), total economic profit (TEP), and concepts of current and future value. It would have the additional benefit of not being overly burdensome for companies.
A New Approach
The first step in the approach is to divide a company's assets into five categories: monetary, physical, relational, organizational and human. Each of these asset types is then further broken down into tangible and intangible assets. Tangible monetary and physical assets are the ones generally tracked with GAAP. None of the other assets—including things such as patents, credit ratings and leadership—appear on the typical balance sheet (except as part of goodwill following an acquisition).
By defining all the assets, it becomes clear how much of the company is not currently being measured. Including all types of assets provides a complete understanding of all of the drivers of shareholder value (see Figure 1).
The next step in our recommended approach is to create four new disclosure statements. These are built by supplementing traditional accounting data with six new calculations.
- Net operating profit after tax (NOPAT).
- Weighted average cost of capital (WACC).
- Return on invested capital (ROIC).
- Adjustments for off balance sheet financing, to be incorporated into the market value of debt.
- Disclosure of market capitalization data, specifically methodologies and sources of beta.
- The calculation of invested capital, which may have significant adjustments that include but are not limited to operating leases, goodwill and possibly stock options.
These calculations are then used to create the four new disclosures that help explain corporate performance with specific emphasis on the returns delivered to shareholders
by fiscal year.
 Statement of TEP: derived by calculating earnings before interest and taxes, then subtracting cash taxes, then subtracting an additional capital charge (consisting of WACC multiplied by invested capital).
- Statement of enterprise value: calculated by adding the market value of equity and the market value of debt.
 Statement of TRS, unadjusted: determined by adding dividends paid during measurement period to an increase in share price during same period.
- Statement of TRS, adjusted: derived by calculating performance relative to geographic market indices such as the S&P 500, FTSE or Hang Seng.
 Aligning Spirit and Letter
The accounting profession has reached junctures like this before. GAAP itself was created in response to the Great Depression to restore
the confidence of the investing public after the breakdown of the global financial system. While we do not foresee a similar crash, the current
de-linking of financial performance and market value needs to be addressed.
Of course, stakeholders will need time to adjust to any new business reporting system. There needs to
be considerable debate before stakeholders can agree on how to classify intangible assets and how they should be reported. And discrete stakeholder interests will maintain their own priorities in terms of ideal reporting formats.
Given its emerging conceptual foundation and its links to current accounting, we think the eventually agreed-upon EBR framework will be strong enough to accommodate all these factors. As long as methodologies and data sources are adequately disclosed, both sophisticated and basic users of EBR will have more science and less art in making decisions about shareholder value.  About the Authors John J. Ballow, a partner in the Accenture Finance & Performance Management service line, is the global lead for the company's Shareholder Value Analysis practice. He specializes
in economic value analysis, value
management, finance operations and strategy, and corporate financial management. Mr. Ballow brings more than 25 years' experience as a corporate finance officer, advisor and strategist
in financial management. He is based
in New York.
Robert J. Thomas is the executive director of the Accenture Institute for High Performance Business in Wellesley, Massachusetts. Dr. Thomas is also an associate partner in the Accenture Human Performance service line and
a leading authority on leadership and transformational change. He is a frequent contributor to Outlook, and his ideas on human capital development have also appeared in Harvard Business Review, Sloan Management Review and The Wall Street Journal.
Eric R. Noren is a manager in the Accenture Finance & Performance Management service line. He is a
certified public accountant with more than 15 years' experience in finance and accounting operations, financial reporting and performance management. Mr. Nolen is based in Florham Park, New Jersey.
Paul J. Herring, a partner at Grant Thornton, is currently serving as director of business reporting, assurance and advisory services under a two-year secondment to the American Institute of Certified Public Accountants
(AICPA). In addition to helping launch the Enhanced Business Reporting Consortium, he chairs the Public Company Task Force to the AICPA's Special Committee on Enhanced Business Reporting. Based in Chicago, Mr. Herring is a fellow of the Institute
of Chartered Accountants in England and Wales.
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