Who is capable of assessing the future value creating capacity a business?

The International Integrated Reporting Council (IIRC) is a global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs. This coalition shares the view that communication about value creation should be the next step in the evolution of corporate reporting. It recently released a report, Creating Value: Value to the Board.

It is an interesting document which begins by explaining the reason for focusing on the board - “Corporate reporting, and the thinking that has to accompany it, are boardroom issues”, and adds that, “This [the board] is where strategy, performance and the development and communication of long-term value are best understood, aligned and led”. A view that is apparently, “endorsed by the International Corporate Governance Network (ICGN) whose revised Global Governance Principles now include the recommendation that boards should produce an integrated report”. It also shares the view that “reporting is firmly placed among the responsibilities of top management”. And the IIRC report goes on to say, “Board members are best placed to ensure overall organizational and cultural alignment and to achieve the benefits that come from effective reporting practices”.

The words “should be” ought to be inserted each of the statements made above. For example, the board should be where strategy, performance and the development and communication of long-term value are best understood, aligned and led”. There is plenty of evidence to indicate that to suggest it “is”, rather than should be, is just wishful thinking, as I will explain.

The report also says, “At the same time, boards are increasingly pursuing long-term strategies that integrate wider sources of value creation”, and “It will be a natural part of boardroom thinking to report organizational performance in relation to long-term value creation”. More wishful thinking?

There may be a few early signs of improvement, particularly amongst those involved in the IIRC pilot programme, but as the report itself goes on to say trust and accountability in corporates remains a big issue. It cites a report by the accountancy body, the ACCA, which points to a general loss of confidence in corporate reporting, criticised for being unable to provide investors and wider stakeholders with the information they need to hold boards to account in an effective manner.

I totally agree with a statement made later in the report, “Boards need to address this information gap, to express clearly and concisely how their strategy creates value over time, and how they generate profits and manage risks”. Boards need to do so because, “It is precisely the board’s view of how the organization’s strategy, governance, performance and prospects – in the context of its external environment – lead to the creation of value in the short, medium and long term that investors want to know”.

These statements are not suggesting that boards are already meeting these requirements. In fact, reference is made to a report by PwC which says, “Substantial gaps are perceived between the importance of these topics and the effectiveness with which companies report on them”. Another report by KPMG is cited as saying, “Boards have an essential role to play in ensuring that the content of their reports addresses what they consider to be the most important drivers of their business”. But finds that, “at present, the weight of reported information does not reflect the drivers of business value, and therefore could align better with investor perspectives of value”.

There are good reasons for the “substantial gaps” which I will refer to shortly, but first I will cite a quote in the IIRC report from the Chairman of the organisation and a co-author. They say. “Good corporate governance in the modern world is the understanding of the inseparability of the company’s strategy, risks, opportunities and financial performance and the impacts it has on society and the environment. This requires effective leadership by the board with an integrated thinking approach to setting integrated strategy, performance and reporting. It requires an integrated and inclusive governance approach in considering the needs of key stakeholders. It requires that decision-making aims at making business judgement calls that result in the company continuing to create value in the long term.”

Again, I agree that boards should be doing all of these things. But let me now turn to the evidence that indicates why it is that most boards are not performing these roles.

Two months after publication of the IIRC reporting November 2014, The January 2015 issue of Harvard Business Review included an article with the title Where Boards Fall Short by Dominic Barton, the Global Managing Director of McKinsey & Co. It began with the following statement. “Boards aren’t working. It’s been more than a decade since the first wave of post-Enron regulatory reforms, and despite a host of guidelines from independent watchdogs such as the International Corporate Governance Network, most boards aren’t delivering on their core mission: providing strong oversight and strategic support for management’s efforts to create long-term value. This isn’t just our opinion. Directors also believe boards are falling short, our research suggests”.

The evidence paints a picture of catastrophic failures, and the reasons for them. In doing so, it also indicates why most boards cannot perform the tasks that integrated reporting requires of them.

Consider these few findings. A mere 34% of the 772 directors surveyed by McKinsey in 2013 agreed that the boards on which they served fully comprehended their companies’ strategies. Only 22% said their boards were completely aware of how their firms created value, and just 16% claimed that their boards had a strong understanding of the dynamics of their firms’ industries.

Whilst the IIRC are right that boards “should be” doing the things it is suggesting, the findings prove that, by their own admission, they cannot.

Let me repeat the numbers mentioned above, but in a slightly different way. If only 1 in 3 directors are thought capable of fully comprehending their companies’ strategies”, less than 1 in 4 are thought to be properly aware of how their firms created value, and less than 1 in 5 are thought to have a strong understanding of the dynamics of their firms’ industries”, it is hard to come to any other conclusion than the one Barton and Wiseman draw, “Boards aren’t working”. Until they are working, boards will not be able to fulfil what the IIRC, the ICGN and others regard as their duty.

If investors want to see better returns they ought to be demanding better reporting from boards. Until they do boards are effectively unaccountable. Worse, from an investor perspective is the fact they are under-performing. If institutional investors are not paying attention to this they are, in turn, neglecting their duties to their clients.

To illustrate this I will refer to research published by McKinsey & Co in 2011. In “How to put your money where your strategy is” the authors said, “For the past two years, we’ve been systematically looking at corporate resource allocation patterns, their relationship to performance, and the implications for strategy. We found that while inertia reigns at most companies, in those where capital and other resources flow more readily from one business opportunity to another, returns to shareholders are higher”. So, companies that do not operate in this way are forgoing the opportunity to add value.

How big is this problem? The article gives some indication, “Companies that reallocated more resources—the top third of our sample, shifting an average of 56 percent of capital across business units over the entire 15year period—earned, on average, 30 percent higher total returns to shareholders annually than companies in the bottom third of the sample”.

The problem is therefore massive in scale. Investors, and all other stakeholders, should be very concerned but do not seem to be. The reason they are not is that performance is bench marked against other underperformers leading to what I call Satisfactory Underperformance.

This problem is related to a reporting paradox. Investors call for reporting in a way that facilitates comparability. At the same time the competitive advantage a company may earn is strengthened by being unique. On other words not comparable. This begs the question, are investors really interested in understanding how a business generates value, or is their reliance on benchmarks generating the problem of satisfactory underperformance? The evidence suggests the latter. And, in turn, this begs the question, would investors have the ability to really understand how a business adds value even if they wanted to? The answer, I believe, is that they would not. There are very good reasons for this.

The IIRC report refers to “Research in 2010 by US merchant bank Ocean Tomo, an intellectual capital specialist, looking at trends over four decades, found that net assets of S&P 500 companies represented only around 19% of market capitalization in 2009, compared to 90% in the 1970s. In other words, intellectual capital and other intangible assets not captured on the balance sheet now drive market value”.

The big problem is that there are no generally accepted standards for valuing these intangibles, or even of measuring them in non-financial terms. Nor would the training that most investors or analysts have had equip them to make assessments or understand their implications in terms of future value creating potential. And these factors have a further impact on the incomparability issue.

The missing information, or the inability to understand how the business creates value, and will do so in future, if forcing the reliance on the benchmarking approach and the satisfactory under performance. It also increases risk and results in a risk premium being added to the cost of capital. Altogether this is, or should be, a very unsatisfactory situation for all concerned.

The IIRC, and the framework it has developed, represent a big step in the right direction, but it does not yet offer all the answers. Actually, one of the biggest benefits is that attempts to bring about integrated corporate reporting are putting a spotlight on the issues that need to be dealt with. It will also force both integrated management thinking and integrated management reporting. Both must, necessarily, come before integrated corporate reporting is possible.

In conclusion, this article has answered the question, who is capable of assessing the future value creating capacity of a business? All the evidence says the answer is, not most boards, analysts, accountants or investors! This is a massive issue since all are making, or influencing, large investment decisions. The decisions being made are poor, resulting in serious under performance and negative consequences for individuals, the economy and society as a whole.

The solution requires representatives of all functional silos adopt a broader strategic management perspective to establish an understanding of the way they create value as part of a business system, and how the business as a whole creates value. This may then be articulated and understood internally and externally. The CEO, Head of Strategy or CSO might facilitate this process, but it will also require the deep involvement of all functions on an ongoing basis, to facilitate dynamic decision making and resource reallocation.

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The views expressed in this article are those of Paul Barnett. They are not the views of the Strategic Management Forum.

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The Strategic Management Forum is a social enterprise run for the benefit of members. Its purpose is advancing the professional practice of strategic management, amongst strategic decision makers in all functions and at all levels of businesses and organisations in all sectors.

We are developing a number of Focus Groups (Think Tanks) that will explore some of the issues raised in this article in much more detail. They include:

• The Strategic Importance of Business Reporting
• The Future of the Board
• The Future of the Strategy Function in Corporations

If you would like to join any of these groups please email us for more details: pbarnett@strategicmanagementforum.org