A much-needed dose of reality

by James van den Heever
By now, we understand that “the numbers” simply don’t tell the objective truth, as demonstrated by Steinhoff and Tongaat Hulett, among others. Of course, a major part of the problem is unethical conduct on the part of accountants or auditors, but there is a good case to be made that the issue is more profound.

What if the problem is not just a lack of ethics but also that accounting and accounting metrics do not, as commonly believed, offer a definitive and objective view of the actual effects of management decisions on a company’s performance and, more importantly, how decisions should be taken now to ensure future success? What if, in fact, the principles accountants use to draw up a company’s figures are not the best way to understand exactly what is going on in the business and are ill-suited to provide a basis for decision-making about where budget should be allocated and strategies adjusted?

Dr. Pieter Pretorius, a senior lecturer at GIBS, is convinced that accounting practices and metrics are ill-suited for management decision-making. This is a major issue because accountants have long been considered the gold standard for business, and a high proportion of South Africa’s CEOs are accountants by training. The assumptions underlying accounting thus inform much of business.

Pretorius argues that the key goal of management is to make decisions that lead to increased profits over time. Thus, at the most fundamental level, managers need to be able to measure how the company is performing and how to improve that performance: increasing net profit and return on investment and improving cash flow.

It sounds simple, but, of course, getting this right depends on understanding the interplay between a vast number of variables and ensuring they all work together in sync. The obvious, overworked analogy is the orchestra, where the individual excellence of the lead violin or the tympanist is only truly valuable if that excellence contributes to the overall piece. It is the conductor’s task to ensure this integration of the various parts of the orchestra into a coherent whole that expresses the composer’s intention.

However, if a manager relies solely on accounting to guide their “conducting” activity, they are condemned to looking backwards. “Accounting deals with an exact past, while management decisions address an uncertain future,” says Pretorius.

Perils of following the rules

The other problem is that accounting follows certain rules that are tightly regulated by authorities or industry bodies, for example, the Generally Accepted Accounting Principles (GAAP) or the International Financial Reporting Standards (IFRS). These standards do not even do a good job of representing a certain view of the company’s financial position since bad management decisions show up positively within the accounting system, making them a poor foundation for business decision-making. These accounting standards are more suited for regulatory purposes (although they are far from perfect), but they are wholly unsuited to provide the basis for good management decisions.

Consider, for example, the accrual system, which is generally used to record all expenses and revenue. Under this system, sales made in 2020 will be recognised in that year’s accounts even though the money might only be received in 2021.

Even worse is the requirement that all the costs incurred in manufacturing goods in 2020 but not sold in 2020 be taken out of the income statement and added to the balance sheet as an asset. This creates a misleading “paper profit” with several negative effects, including reduced cashflow since cash is now tied up in inventory and increasing warehousing costs. These practices allow companies to time things so that their financial statements look as good as possible at year-end, thus keeping shareholders happy (and often ensuring that incentive targets are reached for performance bonuses).

“Those are just the direct effects,” Pretorius points out. “The indirect and often invisible effects not considered by the accounting system are even more devastating and include long lead times, a reduced ability to meet deadlines, reduced quality and less flexibility in responding to market needs. In addition, future sales are dependent on the above, which means the company’s ability to generate future sales is jeopardised by attempts to make the books look good.

“Accountants produce highly detailed and stylised pictures of the past, but their figures are not useful at all when it comes to business decisions relating to the future. When we’re looking at strategy, we need to concentrate not on the GAAP or IFRS rules but in meeting the business' goals to improve profit and investment return, and strengthen cashflow.”

Taking a step back, one could argue that accounting’s accuracy is actually disconnected from the gritty realities of decision-making. In fact, when it comes to decision-making, Pretorius argues that relevance is more important than accuracy and that accuracy is, in any event, impossible since decision-making deals with an uncertain future.

That excessive focus on cost

On the question of relevance, consider the typical emphasis in businesses on cost and cost-effectiveness. Cost-effectiveness is generally assumed to be the foundation of competitiveness, both between nations and individual companies. This appears to be self-evident, perfect common sense. However, as the most successful people know, the mentality is simply “rinse and repeat”. In contrast, we live in a volatile, uncertain, complex and ambiguous (VUCA) world where fundamental mutability is amplified as everything gets “smarter” and more connected.

“Experience, training, habit and received wisdom are less and less useful in a VUCA world and are likely to be damaging,” Dr. Pretorius says. “If we constantly have to change the way we do things, why do we continue to use the same measurements?”

So, for example, there is often a focus on cost cutting in the real world as a way to improve profits, but reducing the cost per unit may actually reduce profit because it increases volumes and thus unsold inventory, which, as noted above, is not a positive development. Unit cost reduction also often doesn’t affect the fixed costs, so the reduced cost per unit simply creates the illusion that actual costs have been reduced.

Once again, we are confronted by the disconnect between the paper-based, theoretical world of accounting on the one hand and reality on the other. For example, unit cost, used in both accounting and decision-making and often calculated using accepted approaches such as activity-based costing, assumes a negative relationship with profit, i.e., a reduction in unit cost will lead to an increase in profit and vice versa. This, unfortunately, is a false assumption since the metric used to measure the company’s profit (i.e., rand profit per time period) and the metric used to measure the profit of each unit produced (i.e., rand profit per unit) are incompatible. Therefore, the negative relationship cannot be proven. As a result, unit costs and unit cost reduction cannot be used as the basis for any decision to prove profit improvement.

Pretorius notes that while the problems relating to unit cost have been recognised, it remains widely used. “Current thinking is to use the contribution margin, but this does not always solve the problem since contribution margin alone is not sufficient for a good decision when a company suffers from an internal constraint,” he adds.

Cost-cutting also inevitably leads to a loss of capacity, weakening the company and preventing it from being able to respond to changing market conditions and new opportunities.

Pretorius argues that a key issue is that many managers ignore the need to look at the business as a system. If analysed from a systems perspective, very often the most profitable course is actually the most counterintuitive.

“Real-life systems are complex, and there are many uncertainties. You have to sit down and establish how the system works, what the constraints are, and how each decision affects the others and the whole while keeping your goal in mind,” says Pretorius. “You have to keep reminding yourself that your goal is not to minimise cost, but rather how to continuously increase real profit, return on investment and cash flow.”

Useful resources:
Gordon Institute of Business Science
Making an impact to significantly improve the competitive performance of individuals and organisation through business education to build our national competitiveness. GIBS is a leading business school in the heart of Sandton’s business hub, offering a wide range of executive and academic programmes.
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