Instead of Counting Beans

Gu, Zhaoyang（顧朝陽）, Yang, George Yong（楊勇）

How can a few tweaks in accounting procedures encourage more innovation within companies?

By Louisa Wah Hansen

By nature, the accounting profession is conservative and as a result, financial statements often don’t reflect the innovative potential of a company. How can investors get better guidance if they want to invest in innovative companies? And how can accounting procedures encourage more innovation within companies?

Innovation is such an intangible aspect in a company’s activity that it is often hard to reflect it in any financial statements.

Prof. Gu Zhaoyang, Director of the Accounting Department at CUHK Business School, admits that the accounting profession is backward-looking and inherently conservative and thus often inadequate in reflecting innovative activities that carry profit-making potential. However, he stresses there are ways in which financial figures can be interpreted so that investors can make sounder predictions on a company’s future performance as a result of its investments in innovation.

“The key to innovation is being forward-looking. Outcomes are highly uncertain,” says Prof. Gu. “But for accountants, investments in innovative activities are often recognized as a ‘cost.’ In reality, the potential benefits are expected to be higher than the cost. Unfortunately, this is not reported until benefits are realized. If we read the financial statements in the early stage of investments, we often see a bunch of seemingly bad projects—loss after loss or cash being burnt. So if you just want to use financial statements to guide your investments or for investors to get useful information regarding whether they should provide further funding, it would not be sufficient.”

In light of this, he recommends investors to focus on different aspects of financial statements at different stages of a company’s life cycle. For example, for a start-up company or for a company that has made some initial large investments, the bottom-line earnings are not the best performance measure that one should look for.

“Rather than the bottom line, you might focus on the top line, i.e., the revenue,” Prof. Gu says, citing Internet-related companies as examples. “It’s more useful to look at figures such as the number of clicks and revenue growth, rather than the huge cost and negative earnings, which may suggest value destruction on the surface, which is not true,” he says. “Sometimes you might also want to focus on the cash flow statement rather than the income statement.”

Besides looking at different aspects of financial statements, Prof. Gu suggests investors to look beyond the formal types of financial statements. “Accounting essentially is an information system. Firms may find alternative communication channels, such as press releases, conference calls, analysts’ corporate visits and so on to communicate those intangible aspects to investors, so that they are willing to invest in them.”

CSR Reporting and Compensation Strategy

One form of informal reporting system that has been gaining a lot of traction is CSR reporting, which usually appears as a supplementary section in a company’s annual report. According to Prof. Gu’s observation, CSR has been popular in management circles for decades but not until recently has the accounting profession started to pay more attention to it.

Prof. Gu cites the publication by Prof. George Yang and Prof. Albert Tsang in the School of Accountancy at CUHK Business School. They found that firms that publish CSR reporting and have good CSR performance enjoy a lower cost of equity financing, and that there is a strong association between CSR performance and improvements in financial performance. Also, investors consider such firms more transparent, and as such, financial analysts are better able to predict the firms’ future profitability. “These would help innovation in an indirect way — making innovative activities easier,” concludes Prof. Gu.

There is also a creative way to encourage investments in R&D and innovation through adjustments in the compensation structure and accounting figures.

Prof. Gu explains: “If a company ties a manager’s salary or bonus to accounting numbers, e.g. return on assets, this would discourage innovation because initial innovation investments reduce earnings so the salary or bonus would be lower as a result. But in compensation contracts, one can adjust away innovation expenses in calculating the ROA, so that any innovation investments would not lead to punishments on the personal level.”

One scenario is when a CEO is close to retirement and is faced with the dilemma of whether to further invest in R&D or not. What typically goes on in such a CEO’s mind is: “All the benefits will show up in five years but right now I will bear all the costs.” So it would not make sense for the CEO to make any long-term investments. Research shows that when the compensation committee removed the cost of R&D from the income figure, the above-mentioned short-termism, or myopia, was removed. “By using an adjusted number, the CEO is motivated to continue investments in R&D. This is a clever, alternative way of using accounting numbers,” says Prof. Gu.

Another way is to combine accounting numbers with stock returns. Stock prices are forward-looking, reflecting all the future benefits and costs. So if an innovation activity is value-enhancing to a firm, stock prices would be ahead of accounting numbers in reflecting the net benefits. “By shifting compensation weight from accounting numbers to stock returns, managers would be encouraged to invest more on innovation projects,” says Prof. Gu. “There are alternative ways of adjusting numbers. Numbers are numbers; it all depends on how you use them. Each should adapt the numbers to his or her purpose,” concludes Prof. Gu.

In conclusion, innovation in the accounting field is much more intuitive, and some tweaks in the way accounting figures are interpreted and in how executive compensation is tied to financial figures could actually encourage innovation within companies.