January 20, 2015 Bookkeeping en_US Measurements of the wrong things can drive out good judgments of the right things. Find out the pitfalls of putting too much emphasis on accounting measurements. https://quickbooks.intuit.com/cas/dam/IMAGE/A7TshfDkr/6c071f0f6b3a0f4dbc7a4526241590dc.png https://quickbooks.intuit.com/r/bookkeeping/the-7-moral-hazards-of-accounting-measurements The 7 Moral Hazards of Accounting Measurements

The 7 Moral Hazards of Accounting Measurements

By QuickBooks January 20, 2015

Exact measurements of the wrong things can drive out good judgments of the right things, which can put the future of our businesses at risk. The illusion of certainty in our measurements creates—to borrow an important concept from the insurance industry—a moral hazard. If people are insured, they may just act carelessly and cause the very thing they are insured against. Fire insurance facilitates arson; unemployment insurance allows people to not be as diligent in finding a job; life insurance can lead to suicide or, worse, murder.

Our current cult of calculation—perpetuated by the infamous McKinsey maxim of “What you can measure, you can manage”—creates the same type of risk, offering today’s business executives the illusion of control and mastery of knowledge. It allows them to substitute statistics for thinking. It gives them a false sense of security where doubt should otherwise exist.

To help business owners and executives avoid these risks and favor effectiveness over efficiency, here are seven moral hazards of measurements they should be wary of.

Moral Hazard 1: We Can Count Consumers, But Not Individuals

Because benefits and costs are inherently personal and subjective, aggregation misses the individual. We can measure the objective temperature in a room at 70 degrees, but any one person may feel either warm or cold, and the differences cannot be used to cancel each other out.

We simply cannot mathematically manipulate or categorize people.

Moral Hazard 2: You Change What You Measure

Scientists call it Heisenberg’s Uncertainty Principle: The observer in a scientific experiment affects the result.

Central bankers call it Goodhart’s Law: Any target that is set can quickly lose its meaning because it can be manipulated.

In other words, people will always find ways to reach their numerical targets, even if it sometimes leads to ineffectiveness or unethical behavior.

Moral Hazard 3: Measurements Crowd Out Intuition and Insight

Once a measure becomes entrenched as part of the conventional wisdom, it also typically becomes impervious to logic, intuition, critical thinking or innovation.

For example, if you’ve ever been bribed off an oversold airplane—with a free flight voucher, upgrade or airline money equivalent—you have the late economist Julian Simon to thank. Until 1978, travelers were bumped off overbooked planes rather capriciously, and this caused enormous amounts of customer complaints and ill will. But the measurements didn’t help solve the problem; instead, it took an outsider to find the solution. Simon did not analyze countless numbers and statistics; on the contrary, he used his intuition to solve a quite vexing problem.

Moral Hazard 4: Measurements Are Unreliable

A country’s per-capita gross domestic product increases when a sheep is born but decreases when a child is born. And divorce actually increases the GDP since almost two of every commodity must now be purchased rather than just one.

Yet these measurements mask the joy of a child and the agony of divorce.

Why would we want to put so much faith in these numbers? Picasso once said, “Art is a lie that tells the truth.” In business, however, it seems, in some instances, that measurements are truths that tell lies.

Moral Hazard 5: The More We Measure, the Less We Can Compare

Engage in this gedanken: You or a loved one needs heart surgery. You talk to nurses, friends and other people you trust and respect, and two surgeons are consistently recommended to you. You go online to do some research on these two particular practitioners and discover their mortality rates (i.e. the risk of dying from surgery): Surgeon A has a 65% mortality rate, whereas Surgeon B has a 25% mortality rate. Which surgeon would you choose?

I have conducted this gedanken in seminars attended by various educated professionals who certainly have taken a statistics class or two, and the overwhelming majority astonishingly select Surgeon B.

But wouldn’t you want to know what type of patients the two doctors serve? What if Surgeon A takes a disproportionate share of hard cases and thus has a higher failure rate? He or she may be the better surgeon. The point is that we simply do not know enough to make a decision without gathering more information, both quantitative and qualitative, and making further judgments based on our own risk profile.

Seeing the two numbers side by side compels people to compare the two, which can lead to a false sense of precision and, in this case, could result in a deadly decision.

Moral Hazard 6: The More Intellectual the Capital, the Less You Can Measure It

Ideas only come from sentient beings, not inanimate objects or pets. Since approximately 80% of a developed country’s wealth-creating capacity resides in its human capital, how could it be otherwise?

To complicate matters, a lot of that knowledge is tacit, which is hard to capture in spreadsheets and pie charts. We may be able to count the physical assets of Google or Apple, but traditional accounting pays no attention to its human capital, which has been labeled the “invisible balance sheet.”

Traditional book-value accounting—assets minus liabilities equals equity—can only explain about one-sixth of the value of the market capitalization on the nation’s stock markets. Accountants call the difference between market value and book value “goodwill,” but that is just a label for their ignorance.

Moral Hazard 7: Measurements Are Lagging

Imagine driving your car with your dashboard gauges informing you of last month’s speed, fuel level, temperature, oil pressure, RPMs and the rest.

This is precisely the status of accounting information: It is like timing your cookies with a smoke alarm. It’s a lagging indicator, informing us where we have been, but never telling us where we are going.

The Future Cannot Be Measured

The Danish philosopher Søren Kierkegaard wrote: “Life is lived forward but understood backward.” There’s no doubt that measurements help us reflect on past events and aid us in improving our theories. But they can never take the place of dreams, imagination, passion and the soul of enterprise where entrepreneurs toil and struggle to create our future.

No measure is capable of capturing the richness of free minds operating in free markets and dreaming of better ways to improve our future, and it is folly to believe otherwise. It may even lead us into moral hazards, or a world where we are so preoccupied about measuring past performance that we do not take the time to dream about the future.