Harvard Business School Professor V.G. Narayanan, senior associate dean for HBS Online and Executive Education, joins host Chris Linnane to uncover how financial statements communicate the essentials of business and why accounting is a universal language connecting companies of all sizes.
V.G. Narayanan, Thomas D. Casserly, Jr. Professor of Business Administration, Senior Associate Dean of Executive Education and Senior Associate Dean of HBS Online
HBS Online's Financial Accounting course (https://hbs.me/3nrrrr8t)
Narayanan’s latest book, Introduction to Financial Accounting (https://hbs.me/2p9bw8pv)
Related HBS Online blog posts:
Editor's Note: The following was prepared by a machine algorithm and may not perfectly reflect the interview's audio fileThe following was prepared by a machine algorithm and may not perfectly reflect the interview's audio file
Chris Linnane:
The Parlor Room is an official podcast of Harvard Business School Online.
Accounting is the language of business. And it's a way in which you measure transactions, but you also communicate several estimates about the future. This is the kind of information that only the person running the business knows.
So, accounting has always been very closely linked to the world of business. And if you didn't understand the world of business, you wouldn't make a good accountant.
[MUSIC PLAYING]
Chris Linnane:
Welcome to The Parlor Room. My name is Chris Linnane. I'm the creative director at Harvard Business School Online. From the smallest local shops to the largest global conglomerates, financial statements represent the essential form of communication. Accounting fulfills its role as the language that ties the entire business world together.
I could not be happier to welcome our next guest, HBS professor V.G. Narayanan, to The Parlor Room. Professor Narayanan is not only one of the kindest people I know, but his enthusiasm and passion come through in his engaging teaching style and the ability to illuminate even the most complex topics. So let's get right into it.
V.G., you and I have been in this HBS Online, HBX world together for a long time, 10 or 11 years or so. And your passion for online learning for HBS Online is unmatched. Tell me a little bit about why that is.
V.G. Narayanan:
So right out of high school, I was going to go to college. And my first year was what's called evening college, which wasn't regular college. It was evening 6:00 to 9:00. And then, after my first year of college, I dropped out of college and switched to what is called correspondence education. You got all your study material for the year in mail. And you studied that. And the end of the year, you went and took an exam.
And this was quite common in India back then, where not anyone-- or not everyone could go to college. And therefore, for other people who don't have access to this kind of post-secondary school education, this was the alternate route.
And I still feel for lots of people who are not able to come to Harvard or participate in what I think is an outstanding educational experience. I've been here 30 years at the Harvard Business School. And I'd love for more people to experience what I've experienced here, what I've seen here.
But we are limited by physical constraints of the classroom and the number of professors. And suddenly, technology has unlocked this ability to take what is great and special about HBS and share it with people all over the world. And that's the potential and power of HBS Online.
So I have a special connection because I saw something. And I've always benefited from, sort of, this ability to have distance education. And it feels very personal for me that I can help other people who are in my situation.
I always miss the fact that I never went to a regular four-year, in-person college. But there are other ways to make up for it. And I want other people in similar situations to have the same experience.
Chris Linnane:
And you've taught a lot of people through HBS Online. So comparatively speaking, classroom student numbers versus online numbers, what's the difference?
V.G. Narayanan:
So 10 years ago, when we first offered my financial accounting course, the very first year online, I had more students than I had had cumulatively in the first 20 years of my teaching at HBS.
Chris Linnane:
Wow.
V.G. Narayanan:
And each subsequent year after that, we have repeated that, that online has exceeded cumulatively-- I mean, online has exceeded my total in-person student numbers from the first 20 years until then cumulatively. So it's quite compelling. It's like an order of magnitude, at least, larger. Yeah.
Chris Linnane:
So your mission's totally being fulfilled through this online space.
V.G. Narayanan:
Yeah, I think so. I mean, I've always felt a little bit guilty about, like, you know, maybe I should've stayed in India. And the country invested so much in me. And now I get as many students online from India as I would've had if I'd stayed back and taught in person.
So I'm like, wow, somebody's watching out for me. They're opening a window and a door is shut kind of thing. It's remarkable that I have students from all over the world. I'm not making this up, but makes me feel special. I have a penchant for running into my online students in airports--
Chris Linnane:
Wow.
V.G. Narayanan:
Whether it's in Heathrow or airports in India, this happened a few times. And I'm like, wow, look at this. How cool is that that I can have students all over the world? Yeah.
Chris Linnane:
My mom's friend once ran into Rod Stewart in an airport. But I think I'd be more impressed--
[V.G. LAUGHS]
--if I ran into you in an airport, for sure. OK, so first question I have for you, what areas in accounting have you seen change the most in recent decades?
V.G. Narayanan:
Yeah. One area of big change in recent decades is the rise of what we call intangible assets. If you go look at the balance sheets of S&P 500 companies, the largest 500 companies in the US, from 1970s until now, the last, let's say, 50 years, the percentage of the balance sheet that was intangible assets used to be, like, maybe 10% or 15%. Now it's approaching 90%.
Chris Linnane:
So intangible assets, maybe you could give us some examples of what those are.
V.G. Narayanan:
Yeah. So it means what it literally says. Tangible is something you can touch. Intangible is any asset that you cannot touch. So examples of intangible assets would be brand names or patents. So these are all-- another example is goodwill, when you buy another company and you pay a premium over its fair market value of identifiable assets. You pay this premium that is called goodwill. These are the biggest intangible assets.
So this day and age, a lot of the assets of companies is in human minds. They're R&D, They're movies they may have produced, so the intellectual property. They're patents. So that's where all the assets of companies are these days. We're talking about close to 90% that-- and companies spend a lot more buying other companies than they do buying property plant and equipment or buildings. So the whole composition of balance sheets of companies have changed. And now it's dominated by intangible assets.
When you eval-- the valuation of a company was based on a lot of black and white information before. And now it seems like there's a lot of gray area.
The accounting really hasn't caught up. This is what's happening in the world of business. And the accountants have this concept called cost concept, where we use historical cost to put the value on some things. And only things that are bought in an arm's-length transaction can be capitalized as an asset.
So if you develop a patent in house, all the cost of developing the patent just gets expensed. But if you bought the patent from outside, you would capitalize it. So all our courses on HBS Online, we expense it, because it's developed in house. But if you went and bought a course that some other university or studio produced, we'd put it as an asset on our books, right? It would be an example of an intangible asset.
So that kind of accounting really is not ideal. Because you want to put-- whether a patent or a course is developed in house or purchased from the outside, if there are two comparable assets, they should have the same value on the balance sheet. Yet the accounting today, self-generated assets are not usually capitalized. But assets bought from the outside in an arm's-length transaction gets capitalized. So we have this kind of mixture of different kinds of accounting treatments.
Because accounting was developed for assets that were around, let's say, 200 years ago or 300 years ago, which was mostly tangible, physical assets that you could touch. Ships, and buildings, and manufacturing equipment really wasn't designed for today's knowledge economy.
And I think accounting needs to evolve. And it happens. It will happen. But it takes time. So we partially evolve for things that we buy from the outside. But self-generated assets, whether we'll one day be able to mark them to market, that's another trend we use in accounting, which we use for financial assets.
Let's say you have US Treasury, and you're a financial institution in the bank. You may be able to market to market, so violating the historical cost concept we talked about. We haven't done that yet for intangible assets and not for everyday companies. So it might change it. I'm hoping it'll change.
Chris Linnane:
Knowing that there's so much in the intangible asset area, how does a company send clear information to their investors?
V.G. Narayanan:
It's really difficult for them. Whatever they bought from the outside, they'll be able to say, this is what we bought from outside; here's the value. I think the biggest challenge is self-generated assets. So Coca-Cola, its biggest intangible asset is its brand. It's got to be worth hundreds of billions of dollars. It's not on its accounting books. Apple's brand name has got to be hundreds of billions of dollars worth. It's not on its books.
And so the market tries to infer what the value would be based on sort of how much profits they're generating and capitalizing it and sort of ignoring the fact that what helped to generate those profits comes from its brand. So it's not on it's-- without any help from its accounting, the market tries to-- the stock market tries to figure it out.
Where things get interesting is I had a former student. He's now started lending money against intangible assets. If you have a house, you can mortgage your house and get a loan from a bank. You have a car, you can mortgage your car and take a loan against your car. Now he's saying, I'll lend money against your intangible asset. As long as I can separate it from you and sell it in the open market, I'm willing to lend money.
So I think these are the ways in which people are able to sort of communicate their value, by saying, hey, I pledge for this much. So the market says, OK, if somebody's willing to lend money against it, it'd better be worth it. And I should give them credit for it when I'm valuing their stock.
Chris Linnane:
What skills are most important for accountants today, then?
V.G. Narayanan:
So accounting is the language of business. And it's the way in which you measure transactions. But you also communicate several estimates about the future, even things like, I have this equipment, I have a plane, I'm an airline. How long am I intending to use this plane before I have to discard it or sell it to someone else?
That tells the story of how you run your airline. If it's a flight that goes from Boston to New York, back and forth, a shuttle flight, it depreciates the plane very fast. Because every time you land and take off, the plane's body depreciates. But if you're going to fly this from Boston to London, the body doesn't depreciate, but the engines might depreciate more because it's flying a lot more.
So depending on your business, the same plane can be depreciated very differently. In fact, the engine and the body have to be depreciated very differently based on your business model, right? So this is the kind of information that only the person running the business knows.
So accounting has always been very closely linked to the world of business. And if you didn't understand the world of business, you wouldn't make a good accountant. In fact, the early accountants were called auditors. And the word audi comes from audio.
They would come and listen to the accountants sort of narrate their accounts. And they listen to it and they're like, OK, pass judgment on, do these financials reflect sort of how this company is actually performing? So they must have been very good at business, put together the numbers with the story about the business, marry the two, and say, OK, does this make sense or not?
And sadly, over time, this kind of judgment has weakened. And people are going for black and white rules. All planes should be depreciated over 23 years. Well, that looks good on paper. No one can play any games. There's fewer opportunities for accounting shenanigans.
But threw the baby out with the bath water. It's precisely this judgment where they say, I plan to use this for a shuttle flight, versus I plan to use this for an international flight that tells me what is the right depreciation. So the relevance of the accounting comes from an intimate knowledge of the business, rather than knowledge of the accounting rules.
And it's a skill that I think accountants have to regain. Because it's becoming more important that you be able to use your financial statements to tell the story to capital markets, to product markets to kind of sell your business.
Chris Linnane:
I like the idea of the auditors and the audio thing. I didn't know that before. And it makes it seem like they were a lot more in control, that they could make that judgment and listen. That's interesting. It gives me a lot more hope of what auditors. But you're saying--
[V.G. LAUGHS]
--at the same time, they're not doing it the same way anymore.
[MUSIC PLAYING]
V.G. Narayanan:
Have you seen the movie Forrest Gump?
Chris Linnane:
I've seen it, yeah.
V.G. Narayanan:
So the author of the script for Forrest Gump, the author of the story, he made a deal with the studio that said he'd get a share of the profits from the movie, OK?
Chris Linnane:
It's a good idea.
V.G. Narayanan:
Do you know what share the profits he got?
Chris Linnane:
I have no idea.
V.G. Narayanan:
Chris Linnane:
How's that possible?
V.G. Narayanan:
Right? A blockbuster movie, won all the Oscar awards, completely sold out. Yet, they told him, we didn't make a profit. The way they explained it to the author is that we are a studio. We make, let's say, 10 movies. One of them is going to be a blockbuster. The other 9 are going to be duds.
Now, you and I are thinking, this was the one profitable movie that pays for the other 9, right?
Chris Linnane:
Yeah.
V.G. Narayanan:
But the studios have a different version of that. They're like, I have to make 10 movies to create one successful one. Therefore, this successful movie has to bear the cost of the other nine duds. So by the time I allocate all those costs to this movie, I didn't make a profit on this movie.
Chris Linnane:
Wow.
V.G. Narayanan:
OK? And this author of this script is looking and saying; I didn't know you were going to play this game. He's feeling like he's created or participated in all this success. But yet, when it comes to his share of the profits, big fat zero, right?
So this is not the first time that happened. Steven Spielberg makes his movie Close Encounters of the Third Kind. I don't know if you've seen that one.
Chris Linnane:
Seen that.
V.G. Narayanan:
Chris Linnane:
So I think I know, actually. Usually I feel a little bit overwhelmed. And maybe I'm still wrong, but I think I start my own studio.
V.G. Narayanan:
Yeah, but you kind of-- you are a producer.
Chris Linnane:
Oh.
V.G. Narayanan:
You really don't want to go into the studio business. You would like to make more-- direct, more movies, let's say. But you really don't want to start your own studio. And it's a different business.
Chris Linnane:
It is. So maybe I just have to be more specific in my contracts, to separate from the big cluster of groups, and just be like, my contracts about my film, and that's it?
V.G. Narayanan:
Yeah, but it still leaves a fair bit of subjectivity to the studios. Because accounting is a social science. It's not a natural science. It's not like measuring the height of this microphone here. I pull out a measuring tape, I measure it. You pull out a measuring tape, measure it. Give or take, we should be roughly close.
Accounting depends on certain social constructs, like assumptions. Like, this is the useful life of this asset. This is the return that you're going to make. Or this is what we're going to collect from our movie theaters, all of that.
So Steven Spielberg had an elegant solution for it. He said, I want a percentage of the revenues, not the profits.
Chris Linnane:
Oh, OK.
V.G. Narayanan:
So, he took a different part of the accounting statement. He went to what we call the top line, instead of the bottom line. Because the bottom line has got more subjectivity into it. Because every line in between adds another layer of subjectivity. What costs get allocated? What costs gets subtracted or don't get subtracted? You go right to the top line. There is some subjectivity there, but not as much.
And so there is a pretty good knowledge of accounting there for Steven Spielberg, for a famous director to exhibit, kind of learned it on the field, I guess. So that's a cool accounting in the Hollywood space.
We have the same issues in professional sports. Every eight years, 8 to 10 years, baseball players, or NFL players, or basketball players, they are arguing with these team owners. The team owners are saying, oh, but we lose money. And the players are saying, no. I saw this team was sold for a few billion dollars. You must be making a lot of money.
So their argument comes down to accounting, every 10 years, when they're renegotiating the contracts and the collective bargaining agreements. And the owners want to say, we don't make profits. And the players want to say, you make a lot of profits. So give us our fair share. And usually it gets-- somebody, some arbitrator has to rule on a whole bunch of accounting issues until they figure out whether they're making money or not.
And that's when the players union says, we want the revenues, not the profits.
They ideally would like that. But it's part of the bargaining is, like, are we really making money or not. so that we can share it?
Chris Linnane:
So when we look at that story and knowing that the way in which accounting kind of governs all the system, what things can our students or our learners take away from that to better-- are we just saying it's just learn how accounting works and these things won't surprise you? What are the things that people can take away?
V.G. Narayanan:
Yes. I think we have this equation. We say accounting numbers is economic truth plus measurement error plus bias. And people are OK with economic truth. That's what they think it is. And then when I explain to them, I don't know how long this plane is going to last. It could last 30 years or 100 years.
I invite people to go to Harvard Square with me to see Harvard University buildings that were built 300 years ago. They're still there. They're doing great. But they're probably fully depreciated. Because no one had any idea that they last 300 years, 50 years would've seemed like a long time when they built those buildings.
So they can see that there's measurement error. We will not know-- we make a loan, we don't know whether it's going to go bad or not. We have to make some estimates. And we'll get it wrong. So they're OK with measurement error.
But what trips up most people is the bias part of it. And what I want them to appreciate is that, depending on the context, owners and players, then players have a bias to go in one direction. And owners have the bias to go in the other direction. When a-- studios and directors, one party wants to move it up, the other party wants to move it down. Managers and shareholders, managers want to show that they made great profits this year, because they want to collect a bigger bonus. And the shareholders are like, wait a minute, I don't want to pay all this bonus to you if it's not real.
So between shareholders and bondholders, between a company that's about to go public in two, three years from now, they start to want to show a trajectory of increasing profits. So context matters when you're trying to assess the bias.
And which direction is it going? Is it a monopolist trying to hide profits from the regulators? Or is it someone who's trying to collect a bigger bonus check? So the reader of the financial statements has to pay attention to who's preparing it and what is the context. So that's what I meant by accountants have to understand the business.
So you have to understand the overall context before you pass judgment on accounting or participate in even the estimates. And even on the outside, you need to be aware of the context when you evaluate accounting statements.
[MUSIC PLAYING]
Chris Linnane:
All right, we have some listener questions. This first one comes from one of my favorite names ever, Olivier. "How does a company's accounting approach and financial reporting style need to align with its culture and strategy?"
V.G. Narayanan:
Wow. That's a great question. I think it's very important for the financial reporting to take into account sort of the culture and the strategy of the company. Earlier we discussed about an airline, whether it's flying shuttle flights from Boston to New York, versus whether it's doing long distance across the Atlantic from Boston to London, impacts their financial statements, the depreciation policy. That's an example where a company's strategy makes a difference to their accounting, OK?
So the culture is a little bit more difficult one. There too, I think it's important. So we have this saying in accounting, faster the car, better the brakes need to be. And what we mean by that is let's say you're an organization where there's a hard-charging culture with very high expectations for performance. But also, we give you a lot of autonomy. We don't second guess everything. We're not constantly checking on you. We trust you. Huge upside for getting or hitting the metrics. But we're not going to constantly check on what you're doing.
Now, when opportunity and pressure for performance are there, there's a third lever that kicks in, which is called the-- this is called the fraud triangle, human beings bring in rationalization. And they use the rationalization to say, like, everyone does this. I'm doing this for the greater good of the company. If you want to succeed in my country or my industry, you have to cut some corners.
When we add this rationalization to the other two, then we have fraud, OK? And therefore, depending on the culture of the organization, we need to put in better control systems in certain organizations if they have this highly autonomous, decentralized organization structure, and high-powered incentives.
The culture could be very innovative. When you have this kind of high-powered incentives and autonomy, people tend to be very innovative. That's great. But cutting corners is also kind of innovation, not the kind of innovation we want. But it is a kind of innovation. So we need to have strong belief systems, boundary systems, internal controls that sort of compensate for this very aggressive culture, if you will.
Other cultures which are more, sort of, egalitarian, if you will, where there are no huge upside for winners and huge shame for people who are not seen his performing as well, moderately ambitious people, if you will, it's a different culture, where you don't have to worry so much about people sort of doing the wrong things. You can expect the fact that others are watching me, we are a team, therefore, I cannot let my buddies down, those things to kind of take care of sort of making sure people don't cut corners.
So culture is very important for the control environment. And control environment has a direct bearing on the financial statements that the organization is creating.
Chris Linnane:
This next question comes from Mossier. "Could you share some insights into how management accounting principles are applied in manufacturing, specifically in the realm of performance evaluation and incentivization strategies?"
V.G. Narayanan:
So I think one of the main uses of accounting is performance evaluation and incentives. In fact, that's probably how accounting was born. If you go back to medieval Italy when they were going on these voyages, that's where accounting was born in Venice. And Luca Pacioli documented the first-- writing the first accounting book, how accounting was done in medieval Italy.
It was invented when these captains of ships would go on voyages. And they would trade for silk, and spices, and gold. And they come back, and the question is how did they do? And because the people who financed the voyages were on land, and they wanted to give some share of the profits to the captain of the ship and then keep the rest for themselves. And if the captain had done very well, they'd get a higher fraction. And if they're not done as well, they get lower percentage.
So performance evaluation was sort of the main reason accounting was born. That's what allows you to separate sort of ownership from management or ownership from day-to-day running of the company. I can look at your report, see how you did, and here's your share. So using accounting information to evaluate people's performance and tying their compensation to their performance, sort of the main reason why accounting exists.
But it also changes the nature of accounting, where people have discretion, rather than they'd like to do great performance, but after the fact, they also like to change the metric so that they dress it up to look better.
So we have to then start worrying, it's a great signal, but when you start using it for incentives and performance evaluation, it starts changing the signal. So you have to start building in good controls as well.
And in manufacturing, what is the productivity for today? Well, if you link incentive compensation to throughput for today, people start playing games with quality. So immediately, we have to say, OK, we have to measure quality as well.
Well, is that enough? What if I can maximize my output today, but by putting off very important preventive maintenance? That can't be good for us in the long run. So we have to make sure we're measuring uptime, how much time did we spend on preventive maintenance, all of those things. So many factors come into play once you start using accounting information for performance evaluation and incentives.
But it's still the best game in town. Because the alternative is to not use it for performance evaluation. And then you get a low level of performance. So it's better to use it, have high expectations of people, use it for performance evaluation incentives, but also balance it with good values, beliefs, boundaries, controls.
Chris Linnane:
This next question is from Santiago. "What are the most common accounting or financial issues you've seen companies struggle with?"
V.G. Narayanan:
So whenever judgment is required, and there is no history to fall back on, and it's new, if you're facing this, how do we deal with this? New business models, new technologies, every time that comes up and there's a lot of judgment involved and make required to exercise judgment without knowing how this will turn out, that's when things get difficult for companies.
So I bet every new innovation that there is-- we have things like cryptocurrencies. How do I show that on my books? Is it like cash? I thought only a legal entity, like, a government, a sovereign body, like the US government, can issue currencies. Can people start mining it on their computers? Is this really currency? We haven't figured it out. Those are all difficult concepts. And already, they're trading in, like, billions of dollars worth circulating. And the best we know is it's an intangible asset.
So we don't really have good ways of dealing with it. But it takes time. It takes sometimes a few decades in experimentation innovation, and some people getting it wrong. That's when, by experience, we figure out, this is a better way to deal with it than the other way of dealing with it. So new innovations and business practices, new technologies, they always lead to judgment issues in accounting that are very difficult early on.
[MUSIC PLAYING]
Chris Linnane:
If you'd like to learn more about Professor Narayanan or his course, Financial Accounting, please visit theparlorroompodcast.com. You can also follow HBS Online on Facebook, LinkedIn, TikTok, Instagram, and X. My name is Chris Linnane. Thank you for listening.
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