Do accountants kill innovation?

Posted by on Jun 7, 2013 in Accounting Innovation | No Comments

 

It is suggested that many companies focus almost all of their attention firefighting in their established business activities and no time establishing new pastures of growth. Innovation has been a management buzzword for a while now but how many organisations incorporate it into their norms of business activity?

Many large firms are under pressure to achieve 4% to 6% organic growth each year which in a mature established market is likely to prove to be very difficult. Add a depressed economy into the mix and it is almost impossible. However if businesses were to give just a little attention to  focus on potential new products and services the growth target is likely to be more attainable. New products exist in less competitive markets where margin potential is higher and give a company a first mover differentiated advantage.

It all sounds easy until you then throw accountants into the mix. When evaluating new product and service development initiatives accountants rely on valuation methods which are counterproductive. In such situations evaluation techniques using discounted cashflow (DCF) to calculate net present value (NPV) are the norm. However such techniques cause managers to underestimate the real returns and benefits of innovative investments.

DCF analysis involves consolidating future cash flow streams into a present value. In other words it shows you how much you will get from your investment opportunity if all the expected profits are paid today. In order to bring profits forward from the future to equate to todays value a discount rate will be applied to future earnings which will reflect the return on the money had you invested it elsewhere and this is influenced by interest rates and inflation. Although the technique is mathematically sound it doesn’t help investments in innovation in the following ways:

The first problem is that it the cost of staying where you are (i.e. doing nothing ) against investing . It is assumed that by doing nothing you will continue to generate your current earning indefinitely into the future. It is this last assumption which makes the argument flawed as doing nothing is unlikely to generate infinite returns. Good examples of a company choosing to do nothing would be Blockbuster choosing not to invest in an internet and mail order service with the arrival of Netflix and HMV’s choice not to go digital. An NPV evaluation would have backed both decisions up and we know what happened in the end!

Also the assumption of doing nothing is flawed as the future cashflows are likely to diminish as a result of competitor action forcing margins to be lower.

So how can we improve this situation? For now I think the main challenge is to get accountants to accept that their investment criteria is flawed and not really congruent with investment in new unproven initiatives. Once there is an acceptance hopefully then a consensus can be reached on the best ways in which business can assess investment in innovation on which there are many suggestions by the academic community.

…be more than just an accountant!