September 2003
Can Non-financial Indicators Succeed Where GAAP Fails?

On Wednesday, September 3, 2003, AEI hosted a conference on the emergence of non-financial indicators and its impact on financial statements prepared under the generally accepted accounting principles (GAAP).  Non-financial indicators are numerical measures that indicate whether companies are meeting their stated goals or otherwise adding value for their shareholders.  The first panel included Hans Johnsson of Sound Communications and Baruch Lev of New York University and addressed the usefulness of GAAP.  In the second panel, Rick Frazier, Booth Morgan Consulting; Pam Kalafut, Cap Gemini Ernst & Young; Robert Kaplan, Harvard Business School; and Mike Willis, PricewaterhouseCoopers discussed how non-financial indicators can assist investors in assessing the value of companies.  In the third panel, Carol Stacey, SEC; Bob Eccles, Advisory Capital Partners; and Peter J. Wallison of AEI focused on developing non-financial indicators and the role of the SEC.

Baruch Lev
New York University

The usefulness of accounting is multifaceted.  The fundamental goal the Financial Accounting Standards Board (FASB) is to provide information that facilitates prediction of future cash flows.  It continues to say that information from earnings provide better predictions of future cash flows than cash flows themselves, partially because earnings are based on a large number of estimates, including bad debts that will not be repaid.  If managers are able to make good estimates and if they are honest in conveying these estimates, then a system that tells you something about the future from managers' perspectives should better predict future cash flows than just historical cash flow data; this is a testable proposition.  Most studies find that earnings do not predict future cash flows.  Other studies find that regression analysis correlates earnings cash flows with future cash flows.  Results are more favorable in the direction of earnings but do not present an entirely closed case in favor of using earnings as such a measure.  Accountants use accruals as the difference between cash flows and earnings.  Accruals are based on changes in working capital items-i.e., inventories and accounts payables that affect cash flows.  All of these changes are facts.  The others are real accruals, including restructuring charges, employee stock options, in-process research and development-most of which are estimates.  A major problem with accruals is that they are based on managers' estimates that are never publicly verified.  This is an invitation to manipulation.  Indeed, extensive research also shows that on average, accruals are widely manipulated, and investors are systematically deceived.  After all this, accruals are still the most common tool for predicting future cash flows.
 
In my opinion, there are three main reasons for the failure in this type of accounting.  First, we are dealing with fundamentally deficient accounting rules and procedures.  Second, in an uncertain environment, large estimation errors frequently occur.  Finally, the manipulation of accruals and other financial items raises questions as to the soundness of the information. 
Now that we have addressed the problems, there are things that can be done, including minimizing managerial estimates in financial reporting, separating estimates from financial facts in financial reports, and periodically revising earnings based on a comparison of key estimates with realizations. 

Hans Johnsson
Sound Communications

We need to move toward a reporting system focused on business (non-financial) indicators.  Financial and business data have different time perspectives.  Financial data reflect the past, while business data reflect the present.  Their origins are also different.  Financial data come from accounting, and business data is generated from business situations/cycles.  Financial data use only monetary units, while business data includes broader success factors.  The value drivers of financial data show only physical and cash-related items, while business data incorporates people and relationships.  The functions of financial data serve legal and tax-related purposes, and business data serve as a basis for strategic decisions.  Using baseline reporting, success factors can be defined, structured, and measured.  It combines financial and business data and relies on four bases: business idea, business position, business performance, and cash performance.  First base, business idea, measures the company's strategies, successes, and failures.  Without a clear definition of why and how the company intends to make money, there is no way to assess the company.  Second base, business position, shows the company in its context and defines all strategic relationships.  Third base, business performance, recognizes that most of the decisions that influence a company's success or failure are made outside the company.  The company does not control this decision-making, but it can influence it.  Finally fourth base, cash performance, links baseline reporting to traditional, accounting-based reporting.  It begins with cash flow and defines and monitors two new ratios, change and focus, that link cash performance to company strategies.  Baseline reporting combines these four bases and leads companies to survival, earnings, and growth. 

Panel II

Rick Frazier
Booth Morgan Consulting

Customer asset value is a non-financial indicator of future financial performance.  For financial services firms, it is important to accurately value the customer as an asset.  It can indicate the ability to generate future cash flow, improve the usefulness of underlying indicators, and guide operational improvements and resource allocations.  The customer asset really counts, but there are ground rules in this analysis:  total customer costing, economic profit, lifetime value, and inductive analysis.

Pam Kalafut
Cap Gemini, Ernst & Young

At least 50 percent of a company's value lies in its intangible drivers.  Employing a firm's invisible advantage is the only way to improve firm performance and sustain a competitive advantage.  Non-financial performance accounts for 35 percent of institutional investors' valuation.  In fact, the more sell-side analysts rely on non-financial performance, the more accurate are their earnings forecasts.  We have identified twelve intangible drivers that tend to be consistent across industries: leadership, strategy execution, communication and transparency, brand equity, reputation, networks and alliances, technology and processes, human capital, workplace organization and culture, innovation, intellectual capital, and adaptability.  For the first time, we can quantify what was previously considered immeasurable. 

Robert Kaplan
Harvard Business School

Creating value from an intangible asset is different.  Intangible assets do not have a direct impact on financial results-instead, they have second- or third-order impacts.  The value is contextual.  Measuring performances is based on four linked perspectives:  financial, customer, internal, and organizational learning.  Measurement is the language that gives clarity to vague concepts.  It is used to communicate, not control.  It is important to have a balanced scorecard to build consensus and teamwork throughout the organization.  The balanced scorecard allows an organization to align and focus all its resources on its strategy. 

Mike Willis
PricewaterhouseCoopers

Non-financial indicators assist investors in assessing the value of companies, but we need to learn from past mistakes.  We need to focus on transparency, usability, frequency, and comparability.  Standard business-reporting language needs to meet needs and concerns of investors and the company. Frequency can be established through a media-independent format for all inbound and outbound data.  Comparability is achieved through a common data dictionary shared across agencies, institutions, and jurisdictions.  Changing requirements require software that can change and adapt.  Compliance costs can be reduced with open, royalty-free standards for any software platform.  XBRL is a market-oriented supply chain focused on business information.  It promotes information democracy and a more effective supply chain.  For consumers it enhances analytical capabilities, provides timely, accurate data, and is easy to use.  For producers it is precise and clear, accelerates adoption of new reporting models, and gives management better control of the business environment.  XBRL is the platform for non-financial standards.  It provides a structure that is robust for distribution, implementation, and consumption. 

Panel III

Carol Stacey
SEC

There is room to talk about non-financial metrics.  We recognize that filings are different from one industry to the next.  Every filing is an experiment in disclosure, yet we have the responsibility that certain performance measures are disclosed to ensure safety and soundness of the company to investors.  Our goal is to maintain balance, accuracy, and some degree of comparability that companies provide.  I think it is important to use "plain English" to help investors understand.  It is also important for companies to explain how they are managing the business and build on this kind of disclosure to help investors understand the business.  It is our job to encourage companies to pursue this, but we do get some resistance from companies.  Operational and financial metrics can explain to investors what the intangible assets are and the impact they will have long term.  I am unsure if it is a good idea to standardize these measurements.  It continues to be an important debate, and I have not figured out why it should be standardized.  If you are using non-GAAP filings, it must be disclosed.  If you are going to use it, management must explain why and how they use it.  We want to make sure companies do not try and spin the results.  Likewise, we think estimates are also important to the financial health of the company; we just need the company to better explain them when included in financial statements.  Disclosure is important.  We assume that estimates are made in good faith. 

Bob Eccles
Advisory Capital Partners

Insights from industry research indicate that executives in all industries regard a broad range of measures to be highly important.  These measures are about both financial and non-financial value drivers and tangible and intangible assets.  GAAP measures are a small proportion of highly important measures in every industry.  Earnings and cash flow are typically not ranked at the top in order of importance, although they are important in nearly every industry.  Some value drivers require external data not typically captured by a company's information systems, such as market growth and market share.  It is important to encourage industry-based collaborations.  In doing so, one can identify the key value drivers in each industry.  It can determine which ones lend themselves to quantitative measurements and identify the ways these value drivers are used by analysts, companies, and investors.  Once standards are established they can be published on third party websites.  However, companies do have objections to setting standards for non-financial measures. It can reduce the freedom of external reporting, leading to a "one-size-fits-all" approach.  Costs can also increase due to implementation of new information systems.  In addition, many companies focus on more than one industry where the standards would differ.  Ultimately, I believe standards will be set for non-financial indicators since users will demand them.  It will be difficult, but it is a learning process. 

Peter J. Wallison
AEI

Non-financial indicators measure how well a company is doing in adding value for its shareholder, and if properly structured, can provide investors with information about the value of specific intangible assets that simply cannot be determined from GAAP financial statements.  Although GAAP financial statements attempt to measure the going concern value of business entities, these results are highly inferential and derivative. Non-financial indicators, sometimes also called business indicators or business performance measures, are intended more directly to describe the health of the underlying business. The accounting profession-which has long recognized the deficiencies of GAAP for intangible assets-has been studying and developing non-financial indicators for almost fifteen years, but with little interest from the SEC, financial analysts, or the business community. There are reasons in each case why no one in any of these groups has made an effort to bring non-financial indicators into general use, but none of them-even the SEC-seems to be looking at the issue from the perspective of investors. 

AEI research assistant Jessica Browning prepared this summary.