Annual reports fail to capture the full value of companies’ innovative activities, particularly in the services sector, according to research funded by the Economic and Social Research Council shows.
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.
For further information contact:
Professor Chris Hendry at City University, Tel: 020 7040 8666, email: c.n.hendry@city.ac.uk
Professor David Citron at City University, Tel: 020 7040 8665, email: D.B.Citron@city.ac.uk
ESRC press office:
Alexandra Saxon Tel: 01793 413032, email: alexandra.saxon@esrc.ac.uk
Annika Howard Tel: 01793 413119, email: annika.howard@esrc.ac.uk
Note to editors:
1. The project, 'Facilitating Innovation through the Measurement and Management of Intangibles', was funded by the ESRC. It was carried out by Professors Chris Hendry, Clive Holtham, Georges Selim and David Citron at City University's Cass Business School. Papers have been given at seven conferences and the findings have been widely published in professional journals.
2. Methodology: Researchers analysed two datasets on the intangible factors involved in innovation and their relation to business performance, for 437 manufacturing and 260 service organisations respectively. They built a robust model of the drivers of innovation and their relationship with the three forms of intangible capital – human, structural and relational – using more than 600 detailed cases from the CBI Probe innovation audit.
3. The Economic and Social Research Council (ESRC) is the UK's largest funding agency for research and postgraduate training relating to social and economic issues. It supports independent, high quality research relevant to business, the public sector and voluntary organisations. The ESRC’s planned total expenditure in 2007-08 is £181 million. At any one time the ESRC supports over 4,000 researchers and postgraduate students in academic institutions and research policy institutes. More at http://www.esrcsocietytoday.ac.uk
4. ESRC Society Today offers free access to a broad range of social science research and presents it in a way that makes it easy to navigate and saves users valuable time. As well as bringing together all ESRC-funded research and key online resources such as the Social Science Information Gateway and the UK Data Archive, non-ESRC resources are included, for example the Office for National Statistics. The portal provides access to early findings and research summaries, as well as full texts and original datasets through integrated search facilities. More at http://www.esrcsocietytoday.ac.uk
5. The ESRC confirms the quality of its funded research by evaluating research projects through a process of peer review. This research has been graded as 'good'.
6. Cass Business School, City University, London, delivers innovative, relevant and forward-looking education, training, consultancy and research. It is located on the doorstep of one of the world's leading financial centres, and its dialogue with business shapes the structure and content of all programmes of study, executive education and research. The Cass Executive MBA is ranked 15th in the world by the Financial Times. The School undertakes research of national and international significance and supports almost 100 PhD students. Cass has the largest Finance Faculty and the largest Actuarial Science and Statistics Faculty in Europe. Cass’s finance research is ranked 2nd in Europe and 4th in the world outside the US by Financial Management Magazine and our insurance and risk research is ranked 2nd in the world by the Journal of Risk and Insurance. For further information visit: http://www.cass.city.ac.uk