We Need To Re-thinking ‘The Fundamental Bargain’ On Which Business Operates?
In a past article Four Ways to Save Capitalism, Build Strategic Muscle and Advance the Professional Practice of Strategy, I said, “time is running out to save capitalism from the capitalists”. This was the headline of a CityAM article by the editor at that time, Allister Heath. Far from being anti-capitalist, Heath believes that “capitalism and free markets are the only way forward, and business and the profit motive [are a] huge force for good”. But making this case has been increasingly difficult for him due to “the incompetence and stupidity” of too many companies and business leaders. “Capitalists have become capitalism’s worst enemy”, Heath says. This is rather simplistic. There are far more fundamental problems that need dealing with — as discussed below.
Of the four ways to save capitalism introduced in the article (sustainable growth, integrated strategic management, valuing intangibles and re-thinking the future of the board), one is much more important than all the others. It has such a strong impact in itself, and on each of the other issues. It is valuing intangibles.
Today it is widely accepted that up to 90% of the current value, and future value creating capacity, of businesses comes from intangibles. That value does not appear on a balance sheet, and there are still no agreed measures of quantifying, reporting or auditing the intangibles. Yet these intangible assets (processes, patented and tactic knowledge, skills and talent, among others) are vital to strategy and to the growth of a business, and, therefore, to predicting its future value. Without agreed standards for measurement, trust, the lifeblood of capitalism, is destroyed.
When accounts cannot be trusted to reflect the value of a business today, let alone to help predict the future, it is impossible for shareholders to have faith in the valuations arrived at by analysts and investment managers, or for pensioners to have faith in the projected value of their pension funds.
As Peter Martin wrote in his FT column back in 2002, “accounting accuracy is important to the capitalist mechanism because it measures the extent to which our continuous bargain between the present and the future is being kept in practice. Doubts about accounting integrity have a chilling impact on the economic mood”. In short, doubts undermine one of capitalism’s most important organising principles: the motivational link it provides between present action and future reward”, the willingness to “act today, despite the cost or inconvenience, in order to gain tomorrow”.
Martin goes on to make the point that “confusions or miscalibrations in the engine lead to distorted valuations of corporations and assets and so sap our ability to act confidently”. This gets to the heart of the problem: the inability to accurately measure and / or value intangibles, or to understand their impact on the future value of the business using current accounting practices. It also has a “far wider impact than a few disputes about accounting standards”. In short, accounting no longer tells us exactly what today’s effort or sacrifice can be expected to generate in future gains. Nor does it provide anything close to a reasonable indicator.
In this context, the importance of the intangibles takes on huge significance to companies whose value is not being accurately assessed, to investors who cannot accurately value companies, to pensioners who can have no confidence in income projections, and to society, which is impacted in many ways. The knock-on effects are massive, and the very foundation of capitalism that accounting is supposed to provide is undermined. Today, capitalism is in very dangerous territory.
As mentioned, Heath suggests that we need to save capitalism from the capitalists, but who does he mean by “the capitalists”? He cites the mistakes made by businesses. Clearly a number have inflicted great reputational damage on capitalism, but the problems are far more fundamental. And capitalism is a system composed of many interdependent players, all of whom need to understand the problem and what needs to change. They must also be a part of that change. They must recognise the importance of the intangibles, as drivers of business value. Until they do, we will not be able to determine the current or future value of a business, or the ability of a business to generate value.
This problem needs to be addressed with urgency. Finance is trying to address it with initiatives such as the Integrated Reporting Framework from the International Integrated Reporting Council (IIRC). The Framework tries to measure (not value) the intangibles, so that the investment community can make better decisions. As a company, how do you report on the intangibles if you do not know how to measure them? More importantly, how do you understand the value derived by the interdependencies between them, or assess potential risks?
In truth, most companies talk about the value of synergies between operations, but they often still operate through a structure of function-focused departmental silos, and this has well-documented negative consequences. In short, they do not think in an integrated way, or manage in an integrated way. So what are the chances of them reporting coherently in an integrated report, even if they knew what to measure and how to measure it? No chance, is the answer in the case of most companies.
The responses needed must come from Finance and from enlightened management thinkers. They must solve this problem jointly. The big question is: will managers be minded to do so, or does opaque reporting suit them better? This question arises because when times get tough they often get myopia, claiming not to be able to predict their future performance, even in the relatively short-term. Or, as it has been suggested by investors, they see very clearly, but do not like what they see and do not wish to report it. Opaque reporting, whilst not illegal, it is nevertheless a means of share price manipulation where information is power, and is in the hands of management rather than investors.
This, it has been argued, “reflects a breakdown in the fundamental bargain on which business has operated since ownership first diverged from management”. A bargain that provided the conditions in which “professional managers were left to run the company in the interest of the shareholders, within a framework of broad oversight, shared accounting principles, and a reasonable division of the resulting financial spoils”. But even as long ago as 2002 Peter Martin, in his FT column, argued that “almost all those elements are now close to collapse” and are having a significant impact on the agency relationship.
Martin referred to specific problems, citing big corporate scandals as evidence that “board oversight has demonstrably failed”, and not just because improper management actions were permitted, but also because “boards have apparently failed to steer the management away from decisions which, though taken perfectly properly at the time, in retrospect have clearly damaged long-term shareholder value”. And, as a consequence, he notes that “investors could be forgiven for thinking that board oversight…can no longer be relied on as an unimpeachable element of the agency relationship”.
Another element of the bargain Martin referred to was shared accounting principles. He argued that they were “notoriously close to collapse” due to “a loss of consensus on the true purpose of accounting”. He noted that “in the past, it was a tool for the board to assess the performance of managers, and for investors to assess the value of the company compared to its peers”. But “instead, it has become a means for managers to deliver a steady flow of announcements to the market in ways that will push up — or at least prop up — the share price”.
Then he went on to call on organisations to state clearly their opposition to the practice of earnings management, because it also undermines another element of the agency relationship — the reasonable division of the spoils between managers and shareholders. It allows managers to influence the share price upon which a significant part of their remuneration packages is based. This breakdown, favouring managers with a disproportional share of corporate rewards, is, Martin suggested, “the breakdown of the fundamental relationship between capital and management”.
Alignment of the interests of managers and shareholders, a concept that took hold during a period of sustained economic growth, runs into trouble during an economic downturn. When ever-increasing revenues and profits are expected, but cannot be delivered, opaque reporting is a tool that managers can use to buy themselves time, said Martin. Often this is just enough time to leave and secure a CEO role in another company before the consequences of the short-term decisions are realised, and is said to explain the fact that the tenure of CEOs has tended to shrink significantly. These days their role in a company tends to last just a few years.
So, saving capitalism from the capitalists will require more than just dealing with the incompetence and stupidity of companies that Heath referred to. It also means dealing with the agency problem. Board oversight needs to be re-established. Key to this will be understanding the true purpose of accounting — to enable oversight by the board by providing them with information that is material to the future performance of the business (the intangibles), and providing the same to investors, so that the “fundamental relationship between capital and management can be re-established”.
This is all easier said than done, of course. To repeat, current accounting practices do not yet have the capacity to measure and value the intangibles, the greatest drivers of value in most businesses. Until there are agreed means or standards for doing so, the opacity which gives management power will continue to threaten the current form of capitalism, based on the divergence of ownership and management. A solution must be found, or capitalism will need to evolve to survive, as it has in the past.