From Accounting Profit to Economic Value

Inside this chapter

Quick Summary First, examine sales and profit Capital has a cost too What changes in management Capital tied up in the business Sales and transaction terms Growth and capital allocation Targets and executive compensation Research, development and engineering build the company’s future The accounting treatment The treatment in economic measurement Engineering is assessed according to its purpose How an improvement in the financial statements can weaken the company Accounting expertise alone is not enough for a Board What the economic approach requires of the Board A question for the reader One Step into Practice Further reading

Quick Summary

Accounting profit alone does not tell us whether value has been created. We must also examine invested capital and its cost. A new capability requires an assessment of progress and learning, alongside oversight of the investment.

Creating possibilities requires investment before we know what will happen. Managing business in an age of uncertainty therefore requires economic measurement. It must examine both the capital required today and the capabilities and possibilities the investment builds.

Two companies have the same level of sales. One reports a higher accounting profit margin. Is it also the better business?

First, examine sales and profit

Amounts are in millions of $. Sales and profit are annual figures. Capital is the annual average. Profit in this example is operating profit after tax and before financing costs.

Measure	Company A	Company B
Sales	100	100
Profit	10	5
Profit margin	10%	5%

Which company do you think is better?

Company A earns more. Its profit margin is also higher. Now let us add the capital each company has tied up in its operations.

Measure	Company A	Company B
Invested capital	200	25
Return on invested capital	5%	20%

The return on invested capital is profit divided by invested capital. Company A earns 10 on capital of 200. Company B earns 5 on capital of 25.

The picture now changes. Company B generates more profit from every $ invested in its operations. Its return on invested capital is four times as high.

Capital has a cost too

Providers of capital expect a return for their money and the risk they take. The weighted average cost of capital is called WACC. Let us assume it is 10% for both companies.

Measure	Company A	Company B
Cost of capital	10%	10%
Capital charge in shekels	20	2.5
Economic profit	Minus 10	2.5

Economic profit is the profit remaining after deducting the capital charge. Company A earns 10, but its capital charge is 20. Company B earns 5, and its capital charge is 2.5.

Company A reports an accounting profit but a negative economic profit. Company B covers its cost of capital and creates a positive economic profit. The comparison concerns the year examined and does not determine the companies’ valuations.

What changes in management

Financial statements also report assets and liabilities. But accounting profit is not charged with the full cost of capital. The cost of equity is not recorded in it as an expense.

Economic measurement connects profit to capital and its cost. A Board satisfied with reported profit may fail to see value destruction. Profit has risen. The company has not necessarily become stronger.

Capital tied up in the business

Inventory, customer credit and equipment tie money up in operations. A Board that examines profit while ignoring the cost of capital may approve capital waste and call it business success. Economic measurement exposes the cost and requires it to be justified.

Sales and transaction terms

A transaction can increase profit but require substantial inventory and customer credit. When the additional profit does not cover the cost of the additional capital, the company can sell more and lose value. The transaction price and payment terms must therefore reflect the capital required too.

Growth and capital allocation

Growth is not an achievement in itself. When the return on invested capital remains below its cost over time, expansion destroys value. A Board that celebrates only profit growth rewards the mistake.

Targets and executive compensation

Rewarding annual profit alone can pay a manager for cutting into the future. The bonus is paid today. The cost of lost capability becomes apparent later. The Board must examine how the improvement was achieved and what was lost along the way. Even an annual economic measure alone is not enough.

Research, development and engineering build the company’s future

The money goes out today. The benefit may arrive in later years. The method of measurement influences the decision to invest, expand or stop. Here, the Board’s ability to see beyond the annual report is tested.

The accounting treatment

Under IAS 38, research costs are expensed as they are incurred. They reduce reported profit in that period. Development costs are recognized as an asset only when all the standard’s criteria are met. These include technical feasibility and expected economic benefits. This is precisely where I see a managerial problem. At an early stage, we do not know what will happen. Accounting recognition criteria are no substitute for strategic judgment.

When the criteria are not met, development is expensed too. A development asset is amortized from the time it is available for use, over its useful life. [1]

The treatment in economic measurement

In economic analysis, R&D can be viewed as an investment in future capability. In the approach presented by Damodaran, research and development costs are accumulated as an economic asset. Amortization of the accumulated investments replaces the full annual expense. The amortization is spread over the estimated benefit period. The unamortized balance is added to invested capital and bears a capital charge. Development already recognized as an asset in the financial statements is not added a second time. Both profit and capital are therefore adjusted. The return does not necessarily improve. The cash paid does not change. [2]

Engineering is assessed according to its purpose

Engineering that supports current production is part of operating costs. Engineering that builds a product or capability for future years is assessed as an investment. Its recognition as an asset in the financial statements depends on the applicable standards and criteria. Economic analysis requires a justification for the future benefit. The department’s name does not determine the nature of the expenditure.

How an improvement in the financial statements can weaken the company

When development is expensed, cutting it can improve profit immediately. But the cut may disperse knowledge, dismantle a team and delay a new product. The saving appears in the current financial statements. The damage appears later in reduced differentiation and pricing power. Rebuilding the capability takes time and money. An opportunity that has closed may not return.

This is a dangerous mechanism: a reported improvement alongside economic erosion. In my view, a Board that rewards it participates in weakening the company. It trades the ability to compete in the future for a result that looks good today. The financial statements may be entirely compliant. The decision may be destructive.

Accounting expertise alone is not enough for a Board

A Board can know how to read every line of the financial statements and still fail to understand how the company creates value. When it lacks strategic, economic and financial expertise, accounting precision can give it confidence in mistaken decisions.

Compliant financial statements are not a certificate of sound strategy.

In my view, making accounting profit the supreme compass is a failure of the Board’s responsibility. Its role requires understanding what builds competitive advantage, what consumes capital and what generates returns over time.

Accounting does not require cuts to research or development. The Board chooses how to use measurement. Responsibility for the damage begins when it turns reporting rules into decision rules without examining their economic meaning.

What the economic approach requires of the Board

Before cutting development: what capability will we lose? Before approving growth: what will we receive for the additional capital? Before paying a bonus: was value created, or did only the financial statements improve? These are fundamental questions of business responsibility.

Research opens possibilities. Development and engineering build capabilities. We must examine what we have learned and what we can now do that we could not do before. No change in accounting treatment creates this by itself.

On the possibility card, we will specify the next expenditure and the capital required. We will also examine the cost of maintaining the capability, the time needed to rebuild it and its other uses. We will not present an invented number as the known value of the possibility. We will define what progress would justify the next commitment.

Nor does capitalization turn failed development into a good investment. The economic approach requires a justification for the future benefit, an examination of progress and a willingness to stop when continuing is not justified. It examines the cost of capital together with the possibilities being built.

In an age of uncertainty, we have no way to know which possibility will mature. Discipline in allocation and learning is required. We will fund a justified test, examine the findings and decide on the next stage. Alongside the economic result, we will examine which capabilities have been built and which possibilities will be lost if we stop investing. This is how measurement serves the ability to create possibilities.

A question for the reader

Does your Board reward building a better company, or presenting better financial statements? And what possibility for the future could be built if you changed what it measures and rewards?

One Step into Practice

Choose one activity and examine its profit alongside the capital it uses. If it is building a new capability, include evidence of progress too. Examine whether the measurement changes the recommendation to management.