Performance measurement is the new income statement

The Income Statement

The income statement is the universal scorecard for business. It is the way that a company tracks and communicates its progress month to month and year to year to tell its operating story. The key components are the revenues the company earns by selling goods and services to its customers, the direct costs of those goods and all the other current year operating costs of the organization. The difference between the two, the “bottom line,” is profit.

The income statement is still the main tool we have to measure the profitability of an organization. It is the one place that all the financial flows come together—revenues, expenses and amortization of capital expenditures. But the income statement has been distorted by the rise of the knowledge economy. This has led to the rise of a new kind of reporting of the operating story, called the performance measurement system.

As organizations began to invest more heavily in intangibles beginning in the 1970’s and 80’s, this expense led to a gap between corporate value and the balance sheets (because these intangible investments are not eligible to be capitalized).

This investment also distorts the income statement. It is important to understand these because, while most businesspeople appreciate the distortions of the balance sheet caused by the shift to the knowledge era, few appreciate its affect on the income statement. Here are two big distortions:

1 – Understated Earnings

The first consequence of the rise of the knowledge economy on the income statement has been that earnings have been understated for the past thirty years. By a lot. If you have ever created or used an income statement you probably know the accountants’ definition of the income statement is that it contains revenues and expenses related to the current year’s operations. Revenues and expenses related to future periods have to be moved off the income statement because they would distort the operating story. Investment in building future value or infrastructure which is expected to be used over more than the current year should be excluded from the income statement. But that’s not the way that it has worked with intangibles. And organizations across the U.S. and across the globe have invested trillions of dollars in intangibles and “paid” for it through their current year earnings.

Of course, this situation is favorable because it lowers taxable income. Further, the cost of building intangibles infrastructure such as process and IT is not as concentrated as building a brick and mortar factory; it is often built up incrementally over the years. In fact, it is often advisable to spread spending over time to allow the organization to adjust and adapt itself to the changes that the automation of process often require.

There are those that will read this and say it was all for the better. It forced companies to be judicious in their spending and to ensure that they got return on their investment. It saved on taxes. It was the conservative approach to accounting, which would rather err on the side of understating revenue and overstating costs. You may see this picture and say, “We’ve done OK so far, why shake things up?” Why not leave well enough alone? The truth is that there have been real consequences of this distortion. Earnings that are diminished by intangibles investments put a company that is building for the future at a disadvantage. This is a point that is often lost in conversations about growth companies with high valuations. The business press always marvels at how the company can be worth so much if it is not making money (it’s not always the case that they are investing in intangibles but if there is a high valuation, investors understand something about the income statement beyond the short term profits).

2- The Lost Operating Story

Beyond the distortion of earnings, there has been a second significant problem in the income statement caused by the shift to a knowledge economy. Financials no longer tell the operating story of a company. Most people have gotten used to this fact and don’t really think about it. But it is a pretty big deal.

We learned as bankers to trace the full operating cycle of a company from the purchase of raw materials all the way to collection of the accounts receivable. By using simple calculations, we could compare current period revenue and costs (usually on a monthly basis) with different classes of assets to know whether the operations were staying in synch. These calculations included ratios for days of different kinds of inventory on hand, days of receivables and payables—which examined month to month and year to year told us the operating trends of the operation.

Behind the scenes, there was a whole other level of tracking called cost accounting. This was the marriage of accounting and engineering, enabling a manager to understand the cost of each step in a process, the use of overhead by different parts of the production process and other operating units. In sum, the financial system could be used to measure and track almost everything of import going on inside a company. Until the knowledge era came along.

This system falls down when the operations include information flows through and into knowledge assets. Think back to the models we showed you of knowledge factories in Chapter 3. Let’s talk about how you account for the functioning of these factories. Sometimes, there is a physical product involved—you already know how account for that. But even physical products have knowledge components. And knowledge flows in companies are much harder to track. The use of a process does not lower the “inventory” of knowledge contained in the process. In fact, as we have seen, use of knowledge can increase the knowledge by adapting to lessons learned during use. You can allocate the cost of human capital to the work they are doing. But you cannot account for the “use” of a relationship because it is not a financial asset. In order to tell the operating story of the knowledge factory, you need to move beyond financial measures.

Next time: intangibles and non-financial indicators

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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