Management: Innovators avoid market: Short-termism is still driving decisions. Roger Trapp reports

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The Independent Online
SPEAK to any manager of a quoted British company in a field requiring heavy investment in research and development, and it will not be long before he complains of the short- termism of the stock market. Indeed, the perception that the City does not understand - or, some might say, understands all too well - the workings of such businesses is cited by many successful owner- managers as the prime reason for not succumbing to the temptation of a flotation.

So it would not seem to require much investigation to conclude that managers often make spending decisions with more than an eye on the stock price. However, the report Management's Economic Decisions and Financial Reporting, published last month, should perhaps not be too eagerly dismissed.

Not only does it bring a little hard evidence to an area dominated by anecdote, but the document, by David Collison, John Grinyer and Alex Russell of Dundee University, also demonstrates the potentially detrimental effects that managers' perceptions about the capital markets' lack of sophistication can have on innovation - and hence companies' ability to compete.

Perception is the key word, for what is important here is not so much what is the case, but what managers believe it to be. The study's finding that two-thirds of the 246 managers who responded believed that the capital market 'values companies primarily by reference to the current year's prospective earnings' means that this view must be regarded as the norm.

But the report does not stop there. Though couched in cautious academic language, it analyses the motivation for this attitude and lays the blame largely with the rules on financial accounting.

The idea is that because companies' share prices and their managers' remuneration are generally closely linked to reported profits, managers may be tempted to do what is necessary to maximise them in the short term rather than what would be to the long-term benefit of shareholders.

The Accounting Standards Board is - through its adherence to the principle of disclosure - seeking at least to show account users what is going on. In particular, it is tackling the thorny issue of accounting for goodwill on acquisitions - an area of grave concern for the authors of the report.

As far as they are concerned, though, this misses the point. The ASB says the objective of financial reporting is 'to provide information about the financial position, performance and financial adaptability of an enterprise that is useful to a wide range of users in making economic decisions,' while seeking to ensure the accountability of management for the resources entrusted to it. But the Dundee team argues that this approach gives insufficient attention to the effects of financial reports on managers' decisions.

The other problem area for the researchers is 'revenue investment' - expenses such as research and development, advertising and training, charged to the profit and loss account, which have been incurred at least partly to enhance future profitability. Pointing out that it has attracted little regulatory attention, they nevertheless point to a trend for greater disclosure of development spending - and hence greater effect on managers' decisions.

The catalyst for this development is believed to have been the collapse in the mid-1970s of the Rolls-Royce aero-engine company after it had reported a series of profits that might have been inflated through capitalisation of the R&D costs of the RB211 engine. Thereafter it became the widespread practice to write off research expenditure, and against this prudent background accounting rules allowed capitalisation and amortisation of development costs only in certain, restricted, circumstances.

This is all very well, Professor Grinyer and his colleagues suggest, but it has made company managers equally cautious about committing large sums to this critical area, for fear that the markets will take a dim view. Indeed, the survey found that while US experience suggests that innovative projects typically do not generate accounting profits for eight years, 80 per cent of UK finance managers would be looking for profits within three years. Follow-up interviews with a selected group indicated that only 4 per cent would be prepared to wait more than five years for a return.

The connection with acquisition accounting is not hard to make. One interviewee is quoted as saying: 'You have to ask yourself, why does one launch a title when you can go out and buy a title, and not have the launch costs against your P&L (profit and loss account)? Every publishing group in the country buys titles, often they are from sole proprietors.'

As he acknowledged, this last fact is not coincidental. The sole proprietor does not have to answer to outside shareholders, so can do what he or she wants to make the most of an opportunity.

As a start in correcting this situation, the report recommends that the ASB make disclosure of all types of revenue investment mandatory, as proposed in Fred1, the exposure draft on this area, before widespread opposition killed the idea.

Otherwise it does little more than suggest that the ASB re-examine the effect of accounting rules on executive motivations and call for more research into attitudes and behaviour. But changes are unlikely to be quick in coming. So it is little wonder that many dedicated innovators feel they are better off out of the glare of the market.

'Management's Economic Decisions and Financial Reporting', available from the Research Board, Institute of Chartered Accountants in England and Wales, pounds 15.

(Photograph omitted)