Annual Reports Fail To Capture Value Of Innovation

For the most innovative companies this may means that analysts do not have enough information to work out their true market value.

Reforming this area should be a key part of any proposal to reinstate a requirement for an operating and financial review (OFR) section in company reports, reform of which was unexpectedly dropped by the Government two years ago.

A team of academics at Cass Business School at London’s City University analysed three unseen factors involved in innovation – often known as 'intangibles' – and their relation to business performance in almost 700 manufacturing and services companies.

The factors were human capital (people and teams), structural capital (the processes, information systems and patents that remain when employees leave), and relational capital (links with customers, suppliers and other stakeholders).

They found that conventional measures, typified in the DTI’s Innovation Index’s focus on R&D spend and patents, fail to reflect the drivers and effects of innovation in services. The new analysis provides a better way of viewing innovation in service firms, and gets beneath the surface of such factors as R&D spend to identify the underlying processes that ensure this is used effectively.

A separate analysis of 2003 annual reports for 150 companies revealed that their coverage of intangibles was skewed towards their relational capital and away from human capital (60 per cent of commentary focusing on this) with just 14 per cent of mentions relating to human capital.

One likely explanation is that companies want to assure the market of their prospects by focusing on relations with customers and suppliers. The authors warn this risks taking attention will be drawn away from longer-term drivers of innovation involving people working in teams.

“While intangibles have grown in importance, conventional accounting technology, however, remains ill-equipped to account properly for them,” says Professor Chris Hendry, who led the research. “These findings suggest there is an economic rationale for firms’ current voluntary intellectual capital disclosures.”

However the weak focus on aspects of human capital that matter for innovation implies that much of what firms write about people in their annual reports has little bearing on future business performance. “This is not to say people don’t matter, but that firms either add much that is irrelevant to performance or that they do not emphasise what does matter,” he says

The authors say their findings show that any future attempt by regulators to produce a new OFR must ensure it selects the correct key performance indicators to accompany the text, which the revised UK OFR had required.

The research also highlights investors’ attitudes towards company strategy and risk. Interviews with 27 key figures including analysts and fund managers found that investors look for a clear innovation strategy, which has a short- and long-term view of where returns can be generated.

Risk is seen as something companies should respond to positively rather than quantify, moderate and manage downwards. Avoiding risk altogether certainly won’t generate abnormal or even acceptable returns in a competitive climate. This justifies innovation and provides a hook for reporting which any new OFR would do well to embrace.