Re-discovering Measurement
2. The inherent limitations of traditional accounting measurement

(16) "Accountants Can't Count Intellectual Capital", declared Tom Stewart, formerly with Fortune magazine and now the editor of the Harvard Business Review. "Armies of clerks and banks of computers track physical and financial assets, but those accounting systems cannot cope with brainpower." (Intellectual Capital, The New Wealth of Organizations, 1997, pages 56-58.)

(17) Over the past decade, Stewart and many others have convinced a large proportion of the business community that the reason that intellectual capital is not on the balance sheet is because accountants do not know how to measure intangibles.

(18) This view is not technically correct. Accountants are perfectly capable of measuring intangibles, just as they are capable of measuring tangibles, so long as there is a transaction. The issue that arises with attempting to expand recognition of intangibles in financial statements is not their intangibility, but rather that most intangibles are internally generated, and do not therefore arise as a result of a discrete third party transaction. (So far, corporate executives are not convinced that it would be worth the effort to implement systems to accumulate internal development costs and allocate them to specific intangibles.)

(19) This example illustrates that the bedrock of traditional accounting is transactions with third parties. This reliance on transactions is both the greatest strength of traditional accounting, and the source of its inherent limitations.

(20) The fact that most of the numbers are based on transactions with third parties is the most important reason why financial statements are considered by many to be "reliable".

(21) But the transaction-based, inherently backward-looking nature of the traditional accounting paradigm is also arguably its greatest weakness. It is the most important reason why more and more people question the relevance of performance measurement based on past transactions.

(22) A transaction is, by definition, something that has happened in the past. When people characterize traditional accounting as "backward-looking", they are only being factually correct. Traditional accounting is inherently backward-looking, because transactions, by definition, happen in the past. Yes, on occasion, in the preparation of financial statements, we anticipate transactions that might happen in the future. On occasion, we may restate certain assets at "fair market value" -- in effect, substituting a value based on a hypothetical current transaction for that derived from a past transaction. But in most jurisdictions, the vast majority of the numbers financial statements are based on past transactions.

(23) It is still necessary and useful for anyone interested in the performance of an enterprise to know what has happened in the past.

(24) But it is not sufficient for anyone -- management, investors, shareholders, regulators, and other stakeholders -- to know only about what has happened in the past. Most people are at least as interested, if not more interested, in what will happen in the future.

(25) What has happened in the past can often provide some insight into what may happen in the future. However, in a world of accelerating change (a premise that in today's context is hard to dispute), what has happened in the past is increasingly less relevant to understanding what may happen in the future.

(26) To further illustrate the problem, consider the following fictional example. Assume that BioPharm is a well-financed startup biopharmaceutical company focused on developing genetic therapies which will ultimately be licensed to and distributed through major pharmaceutical corporations. BioPharm's business plan calls for it to carry out research and development over a 10 year period, during which it does not anticipate it will have any licensing revenue.

(27) Using traditional accounting measurement, BioPharm's financial statements will show a string of increasing losses, year by year, as the R&D is expensed. However, could one reasonably conclude that during this 10 year period, BioPharm as an enterprise is creating absolutely no value for its owners or stakeholders?

(28) Whatever value BioPharm is creating over time will not be revealed by a transaction-centric accounting system. This is true regardless of how the transactions are accounted for: whether or not R&D is written off, intangible assets are capitalized, or assets are restated at fair values. BioPharm's progress in creating value is a function of the creativity of its people, the effectiveness of its research processes, the strength of the intellectual property it develops, the activities of competitors, and so on. None of this can be measured through its recent financial transactions.

(29) BioPharm is an admittedly extreme example, since it has no current revenue, and since its product development cycle is so long. But even if it had current revenue, or a shorter product development cycle, all of the above points are still valid. The fact is that there is no necessary connection between progress in creating value in an enterprise, and the organization's recent financial transactions with third parties.

(30) One could argue that this is as true in the manufacturing enterprises of the past as it is with the knowledge-based enterprises of the present and future. However, with the manufacturing enterprises of the past, measuring recent transactions appeared to be a satisfactory proxy for measuring progress in creating value. When value creation was closely followed by value realization through a transaction (the mouse trap was manufactured in March and sold in April) concentrating on just value realization alone was good enough. This is no longer true today.

(31) This train of logic leads to two fundamental conclusions:

(32) This last point is the main stumbling block. Given that traditional accounting is transaction-centric, how could it be possible to discover a basis for measurement other than transactions?

(33) The situation of financial accounting today is analogous to that of physics a century ago. At that time, leading scientists knew that Newton's laws could not be used as the basis for explaining gravity, the behaviour of the components of the atom, or the mechanics of light. To explain these and other phenomena, scientists had to progress beyond the inherent limitations of Newtonian physics.

(34) In 1962, Thomas Kuhn wrote a landmark work on The Structure of Scientific Revolutions that popularized the concept of the "paradigm shift". Using a series of historical examples, Kuhn showed that scientific progress is not characterized by a steady stream of discoveries, each building on the previous one. Rather, we see a relatively small number of scientific revolutions, in which our understanding of the world shifted dramatically from one paradigm to another. A scientific paradigm consists of a set of accepted laws, theories, applications, and instrumentation. The research activities of the vast majority of scientists are characterized by Kuhn as "mopping-up operations" within the confines of a particular paradigm. Each scientific paradigm has fundamental limitations, revealed by the problems that cannot be explained within the boundaries of the paradigm. Hence, it was necessary for Einstein to develop a new paradigm -- built around the theory of relativity -- to account for phenomena that could not be explained by Newtonian physics.

(35) In accounting as in physics, the issue is one of relevance. The need to transcend the limitations of the traditional transaction-based accounting paradigm arises because we need to be able to measure value creation in the modern economy, just as the scientists of a century ago needed to explain phenomena at the stellar and atomic levels that could not be modeled through Newton's equations.

(36) Traditional accounting can be depicted as follows, recognizing that there is some debate about precisely where to locate the boundaries of the traditional accounting paradigm, which are determined mainly by the degree to which values other than historical cost, such as fair market values, are used to portray certain classes of assets.

(37) Does the need for a new accounting paradigm mean abandoning transaction-based accounting? Not at all. While we talk of paradigm shifts, the fact is that in physics, multiple paradigms coexist. Newtonian physics is still useful, and perfectly adequate for predicting the behaviour of objects in motion as we drive to work in the morning. However, it does not provide an adequate basis for modern medical diagnostics or operating a nuclear power station.

(38) Similarly, tracking an organization's performance based on historical financial transactions with third parties is still useful. However, it does not provide an adequate basis for measuring the value creation potential of knowledge-intensive organizations nor for tracking progress in achieving that potential.

(39) Accounting standard setters have been and continue to be engaged in Kuhnian "mopping-up operations" within the traditional accounting paradigm, as they introduce new standards for accounting for acquired intangibles, or methods for accounting for financial derivatives. These, and similar incremental improvements to traditional accounting, are necessary and useful. However, they do not provide a way for traditional accounting to overcome its inherent limitations, which is that it cannot measure using transactions things that cannot be measured using transactions. Traditional accounting is inherently unable to provide insights into future value creation potential: it can only measure the ultimate realization of that value as transactions ultimately occur.

(40) The idea that we might need a new value measurement paradigm in accounting is and will continue to be controversial. This too is perfectly predictable, based on Kuhn. We no longer physically burn scientific revolutionaries at the stake, but anyone who has followed an intense scientific debate, such as the one that rages on about climate change, will understand that we still do so, metaphorically.

(41) Kuhn observes that the transition from one scientific paradigm to another does not occur because leading scientists change their minds. He quotes Max Planck, "surveying his own career in his Scientific Autobiography, sadly remarking that 'a new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it'."

(42) Hopefully, we would not need quite so drastic a solution as this in the world of accounting.

(43) However, we could not expect that any proposed non-transactional accounting paradigm would be easy for the accounting profession or for corporate reporting standard-setters to accept or grasp, in part because the conceptual frameworks that accountants and standard-setters use are located entirely within the boundaries of the transaction-centric accounting paradigm.

(44) We can expect that any proposals for a non-transaction-based approach will be attacked, as they have been already, by some adherents of the traditional paradigm. Such attacks will continue to take place despite the fact, to emphasize the point again, that there is no need to leave the transaction-centric accounting paradigm behind.

(45) Within the context of its own paradigm -- that is, within the boundaries of its inherent limitations -- there is nothing wrong with transaction-centric accounting. It is what it is, and performs as advertised.

(46) Just as Newtonian physics and Einsteinian physics co-exist in the real world, so too could the traditional value realization measurement paradigm and a new value measurement paradigm, as parallel systems.