Doing Business: Accounting Profession - Case Study Example

I. Introduction The of doing business over the years has evolved, and radical changes that occur in the information age have left industrial-age business practices behind. These changes include a shift in philosophy in selling products, from mass marketing and mass manufacture, to target marketing and serving a profitable segment well. As both the market and competition grow more sophisticated, this shift in paradigm causes a shift in investors’ emphasis on intrinsic value to market value, which is driven by a lot of other factors aside from just manufacturing and selling a product. This paper aims to discuss the following statement: “In the current business context the Accounting profession has been criticised for its lack of progress in accounting for the notion of the Intangible and its associated performance output.” By exploring the factors that contribute to creation of shareholders’ value in this information age, accounting’s shortcomings in terms of providing measure to incorporate these intangibles to a company’s financial standing. II. Body A. Rules of the game redefined: from intrinsic value to market value Over the course of the years, along with technological advancement come changes in doing business. As markets evolve and new management theories have been introduced, the shift in emphasis from the intrinsic value to market value in terms as regards valuation of shareholder wealth marks our markets’ adaptation in the information age, leaving the industrial-age notion of creating value through mass-manufacture and selling behind. This adaptation to the opportunities and challenges that the information age offers has given more emphasis on creation of shareholder wealth based on market value, which is driven by information. As business processes evolve, the major criticism in the world of finance is accounting’s failure to evolve in order to address and incorporate these changes in accounting practices and financial reporting. This is the main point of this paper. In Tom Duncan’s book “Principles of Advertising and IMC,” management consultant Peter Drucker’s take on branding is mentioned, “building customer relationships—a series of interactions between customers and a company over time—will produce more sales and profits than will focusing on sales transactions alone. This is why more companies are placing greater emphasis on retaining customers (2005, 67).” This shift in paradigm, as previously discussed is prompted by the increasing sophistication of both the market and the competition. In order to get ahead in the market, customers should be provided with more value by addressing their needs and wants well; at the same time companies are faced with considerations on costs in order to provide value for shareholders. B. Shift to strategic management due to markets’ increasing sophistication As the markets grow more sophisticated, mass-manufacturing in our age makes players who are unable to respond to the changing environment become driven out of business. Mass-manufacturing and marketing is no longer the rule of the game. It has been replaced by strategic management. In order to create value for the customers, companies employ strategic management in order to focus their resources in the most productive way in order to fulfill their corporate objectives. When in the older days the emphasis is selling anything to the market in the lowest possible cost through mass manufacture, the shift in paradigm to strategic management requires firms to look for the most profitable segments in the market that they can serve best. This change prompts the shift of emphasis, from the shareholders’ point of view from a company’s intrinsic value, to its market value. C. Creators of market value Market value is determined by emotions of people who invest in the stock market, bidding prices according to their future expectation of a company’s profitability. This market value, as value perceived by the shareholders at a price they are most willing to pay is driven by a lot of factors. Hence, the major shift in emphasis from intrinsic value to market value is driven by factors outside the assets that are reported by the firms according to generally accepted accounting principles. As the price-to-book value ratio of stocks have been increasing over the years, the weakness of accounting reporting to adjust and incorporate these changes to a company’s financial standing has long been the subject of criticism. 1. Brand equity Brand equity is one of the intangibles that have been hard for current accounting practices to measure and incorporate in a company’s value. According to Tom Duncan in his book “Principles of Advertising and IMC”, companies create profitable relationships to its stakeholders when they create brands (2005, 67). According to him “the stronger the brand is, the more value it has. Positive brand relationships generate profits (Duncan 2005, 67).” When a company creates relationships with customers that result in repeat sales by constantly satisfying their needs and desires, the strength of the brand is determined. The brands, having current relationships with customers who are likely to have repeat purchases of the company’s products, represent future streams of revenue, thus future earnings for the company. As brand equity increases as more and more customers are being served and satisfied by it, the greater the value it provides the company. While in theory, it is these relationships represented by brands that promises future streams of income for the company, thus the company’s profitability which drives the market value of the company—in practice, failure to incorporate this value as an asset to the firm is a major weakness of accounting. 2. Technological infrastructure and information systems that contribute to lower costs but increasing value to customers Because of this shift in focus to customers, the company could incur higher costs in operations. Tailoring products to segments of the market in order to provide value is a challenge for the company if driving the costs down to, in turn create value for itself is also part of the objective. Thus, tighter cost controls and more efficient systems are necessary. In order to support promises of brand at the same time driving the costs of a company down, advancement in technology has been utilized by firms in order to make their operations more efficient. This results in better information systems and communication infrastructures but in a much lower cost. Due to their contribution to customer value, and decrease in a company’s costs, these systems have a significant impact on the firm’s profitability. Although the physical attribute of these systems are included by current accounting principles, their effect on value is not, which is another weakness of accounting that is still criticized. 3. Current work force as a competitive advantage; human resource practices A brand can only deliver its promise if the business systems as well as the people who constitute those systems are well-equipped and trained. In the information age when manual labor has been replaced by machines, and human resources comprise a significant contribution to intellectual capital of the company, this type of intangible is also not incorporated by accounting. The business system is supported by human resource practices, such as competitive recruitment, selection and compensation policies of the company to retain the best and most creative talents who will contribute to a company’s intellectual capital. Also, organizational factors such as corporate culture and corporate structure that leads to pursuit of strategies in fulfillment of objectives constitute this competitive advantage of a company based on human resource. As a company’s promises to customers are fulfilled in the form of excellent products and services, it is the company’s work force which is behind it. Thus, these human resource practices are a strategic partner to the creation of value for the company. Accounting’s failure to incorporate these still constitute one of the criticisms against it. 4. Significant R&D efforts According to Horngren, Harrison and Bamber in their book “Accounting”, “GAAP requires companies to expense R&D costs as they incur those costs. Only in certain circumstances may the company capitalize an R&D asset (2002, 408).” While the general rule for either capitalizing or recording as an expense a cost is to “capitalize all costs that provide future benefit for the business; [and] expense all costs that provide no future benefit (Horngren, Harrison & Bamber 2002, 409),” the accounting for R&D as expense is most controversial. R&D provides value to a company either by product development or innovation through current processes that decrease the costs of a firm’s operations. Therefore, R&D provides future benefits to the business. If the general rule is to be followed, R&D should be capitalized. However, due to accounting conservatism, the value that R&D contributes to the business can only be represented by the patented cost of it, which is then amortized in the long run. This is another weakness of accounting in terms of incorporating intangibles in the value of the business. D. Major probable reasons why intangibles are not currently included in the valuation Accounting has always been conservative by nature. Businesses operate in complex environment where change is inevitable and the future is very uncertain. Due to this, in order to provide more accurate reports of a firm’s financial standing, accounting retains it conservatism. This can be one of the most probable reasons for the lack of progress in the discipline to incorporate these intangibles. These value creators promise a stream of future income by providing value to the customer, thus creating value for the shareholders in turn. Because business environments are very complex and dynamic where unforeseen incidents can affect a company’s entire operation, it is probable that accounting as a profession then resorts to a more conservative approach to financial reporting, where the tangible assets which benefits are more concrete are the ones that are only included. Another probable reason could be cost-benefit trade off of determining the value of these intangibles in order to be incorporated in the company’s financial standing. There has been a major difficulty in coming up with a certain way to measure, for example brand equity. While the value of other intangibles is tied with market prices, identifying the value of each of these in order to determine their contribution can be harder to measure, if not very costly. The trade off between the cost and benefit of determining the intangibles may be very high, that determining them can be economically infeasible. III. Conclusion The changes that happen to the market place have also entailed radical changes to the course of doing business. With the shift of paradigm from manufacture to creation of customers’ value, and then shareholders’ value in turn, significant factors that contribute to the creation of value have evolved in the form of intangibles. These intangibles usually comprise the bigger premium that investors give over a company’s book value, as these intangibles such as brand equity promises the future profitability of the company. However, the accounting profession has not been able to evolve and cope with these changes, in such a way that these intangibles become part of a company’s report of its financial standing to reflect their true contribution to shareholders’ value. This has been the major criticism over the accounting profession. However, as discussed previously, this lack of progress in the profession to incorporate intangibles in reflecting their true contribution to value may be attributed to two causes: accounting conservatism in order to safeguard the company’s financial standing in the face of unforeseen events, and the trade off between determining the cost of doing business. These intangibles are both hard to measure, as well as come up with a standard measure for all types of businesses. Also, as these intangibles are valued according to their future potential to bring profit to the companies, sudden incidents in the environment can affect the value of the firm at any time, which can distort its perceived financial standing. Although these arguments are only derived from the logic of accounting’s relation to business and with no empirical data to support them, the probable causes can provide some insights in accounting’s lack of progress to address these intangibles. References Brealey, R. A., Myers, S. C., & Marcus, A. J. (2004) Fundamentals of Corporate Finance. 4th ed. New Jersey: McGraw Hill. Keown, A. J., Martin, J. D., Petty, J. W., Scott, Jr., D. F. (2005) Financial Management: Principles and Applications. New Jersey: Pearson Education, Inc. Kotler, P., & Armstrong, G. (2004). Principles of Marketing. 10th ed. New Jersey: Pearson Education. Pickton D., & Broderick A. (2001). Integrated marketing communications. 2nd ed. United Kingdom: Pearson Education Limited. Bibliography Duncan, T. (2005). Principles of Advertising & IMC. 2nd ed. New York: McGraw-Hill. Horngren, C. T., Harrison Jr., W. T., & Bamber, L. S., (2002) Accounting. 5th edition. New Jersey: Prentice-Hall International, Inc. Read More