Episode #97 - VeraSage Laws Part II

First Segment

Ron and Ed discussed the upcoming Sage Summit, where Daniel Susskind will speak on his book, The Future of the Professions.

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Our show with Doug Sleeter from last week (#96) was very well received, so we interviewed Doug again, and went deeper on the topic of the Blockchain. This show will appear sometime in the coming months.

Ed has updated the Archive section of the website, along with the Live Events section for the speaking events we’ll both be doing in the coming months.

Our show on Basic Income from June 4th was posted on Ron’s LinkedIn Influencer blog, generating over 32,000 reads and 190 comments.

Finally, on June 7th, Ron attended a talk given at the Independent Institute by George Gilder on his recent book, The Scandal of Money. This is the follow-up book to Gilder’s Knowledge and Power, which posits an information theory of capitalism that is profound. Ron believes it is worthy of a Nobel Prize in economics. You can watch the entire talk, including audience Q&A here:

Quick Review VeraSage Laws, Part I

Our show from July 24, 2015 dealt with five VeraSage Laws:

  1. Baker’s Law - Bad customers drive out good customers.
  2. Kless’ First Law - He who liveth by the discount, shall ye also perish by the discount.
  3. Kless’ Second Law - All measurements are judgments in disguise.
  4. VeraSage Axiom - Ideas are always and everywhere more important than their mere execution.
  5. VeraSage adoption of the Second Law of medicine - Prescription before diagnosis is malpractice (First Law of Medicine: Do No Harm).

These laws spring from deeply held beliefs we have, based on empirical evidence, and have become part of our vocabulary. Peter Thiel, in his book Zero to One, offers one question he always asks before hiring someone: Tell me something you believe that defies conventional wisdom?

Some of these lies defy conventional wisdom, which tends to be far more conventional than actual wisdom.

Three More VeraSage Laws

1. Growth without profit is perilous.

We start with profitability, rather than revenue, because we are not interested in growth merely for the sake of growth—the ideology of the cancer cell. As many companies around the world have learned—some the hard way, such as the airlines, retailers, and automobile manufacturers—market share is not the open sesame to more profitability. We are interested in finding the right customer, at the right price, consistent with our purpose and values, even if that means frequently turning away customers.

Adopting this belief means you need to become much more selective about whom you do business with; even though that marginal business may be “profitable” by conventional accounting standards. Very often the most important costs—and benefits, for that matter—do not ever show up on a profit-and-loss statement. There is such a thing as good and bad profits. Accepting customers who are not a good fit for your firm—either because of their personality or their unwillingness to appreciate your value—has many deleterious effects, such as negatively affecting team member morale, and committing fixed capacity to customers for whom you simply cannot create value. Growth without profit is perilous.

2. Non-rival assets provide more leverage than rival assets.

Knowledge and Abundant ideas are what economists describe as non-rival assets—meaning more than one person can use it at a time.   Contrast this with traditional rival assets, such as a building or an airplane, which can only be used for one purpose at a time.   

If I give you the tie off my shirt, now you have it and I don’t; but when I give you an idea, now we both have it, can expand upon it, test it, and make it more valuable.   Ideas are subject to increasing, rather than diminishing, returns.

Economists have always struggled with how to explain economic growth.   Many of their models embody the physical fallacy, a world where traditional factors of production—land, labor, and capital—are rival resources, innovation and entrepreneurship are treated as unexplained luck, and ideas are ignored since they cannot be quantified.

Even Adam Smith, who did so much to falsify the physical fallacy, thought that only industrial work could be “productive.”   The work of a service provider, in contrast, “adds to the value of nothing.”   This is the hamburger-flipper argument of the eighteenth century.   

As usual, Thomas Sowell explains in Knowledge and Decisions the impact on a country’s standard of living between generating ideas and the physical act of carrying them out:

Many of the products that create a modern standard of living are only the physical incorporation of ideas—not only the ideas of an Edison or Ford but the ideas of innumerable anonymous people who figure out the design of supermarkets, the location of gasoline stations, and the million mundane things on which our material well-being depends.   It is those ideas that are crucial, not the physical act of carrying them out.   Societies which have more people carrying out physical acts and fewer people supplying ideas do not have higher standards of living.   Quite the contrary.   Yet the physical fallacy continues on, undaunted by this or any other evidence.

George Gilder has a wonderful way to sum up these concepts: Wealth = Knowledge, and Growth = Learning.

3. In the real world, debits don’t equal credits.

In any transaction, both the buyer and seller must believe they profit. However, when the transaction is booked on both sides, it’s booked at the same dollar value. However, transactions are not equal, they take place precisely because of the inequality of the perception of value.

Traditional accounting ignores the customer’s profit, which economists call the consumer surplus. This is why, in the real economic world, debits can’t equal credits.

The following is from Ron’s book, Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth:

But Ric, in the real world debits don’t equal credits. -Dan Morris, in an inspired moment at dinner with Ric Payne, founder of Principa, and Ron Baker
Goodwill is the word we use to label our ignorance. –Paul O’Byrne, chartered accountant, partner, O’Byrne and Kennedy; senior fellow, VeraSage Institute (RIP)
A lot of rules have been added since the Venetian monk Luca Pacioli published the first accounting textbook, Summa de arithmetica, geometrica, proportioni et proportionalita, in 1494, introducing double-entry bookkeeping. It was a creation for future accountants that was as big as the invention of zero for mathematicians.
Unfortunately, one could also make the argument that it was the last revolutionary idea to come from the accounting profession. As quoted in Intellectual Capital, David Wilson, CPA and partner at Ernst & Young:
“It has been 500 years since Pacioli published his seminal work on accounting and we have seen virtually no innovation in the practice of accounting—just more rules—none of which has  changed the framework of measurement.”
The balance sheet dates from 1868; the income statement from before World War II. Generally accepted accounting principles (GAAP) fits an industrial enterprise, not an intellectual one. Currently, GAAP measures the cost of everything, and knows the value of nothing. As Robert K. Elliott pointed out in an essay entitled “The Third Wave Breaks on the Shores of Accounting”:
 [GAAP] focuses on tangible assets, that is, the assets of the   industrial revolution. These include inventory and fixed assets: for example, coal, iron, and steam engines. And these  assets are stated at cost. Accordingly, we focus on costs, which is the production side, rather than the value created, which is the customer side.
The traditional accounting model is over 500 years old, and it is in bad shape. Financial statements presented in accordance with GAAP are based on a liquidation value of a business, essentially historical cost assets less liabilities—a heroic attempt to assign static value to a dynamic and going concern.
Even though intellectual capital is the main driver of wealth, you will look in vain to find it in the traditional GAAP statements—the balance sheet, income statement, and statement of cash flows. Increasingly, these statements are being referred to as the “three blind mice.”
Abraham Briloff, a professor of accounting at Baruch College and irritant to the auditing profession, contends that accounting statements are like bikinis: “What they show is interesting, but what they conceal is significant.”
According to Dr. Margaret Blair, in a study for the Brookings Institution, in 1978, 80 percent of a company’s value could be attributed to its tangible assets; by 1988, only 45 percent; in 1998, only 30 percent.
In effect, 70 to 80 percent of the average company’s value cannot be explained by traditional GAAP financial statements. Adding more arcane and picayune rules to GAAP, or converging existing GAAP with international accounting standards, will not solve this problem.
The accounting model is suffering from what philosophers call a deteriorating paradigm—the theory gets more and more complex to account for its lack of explanatory power.
In all fairness to accounting, it never was meant to predict value prospectively, only to record transactions retroactively. In effect, accounting can only measure exchanges after they have taken place.
This is why accounting can only record the “goodwill” of a business until after is has been sold. Accounting has no way to place a value on that goodwill until a transaction takes place. That is why our colleague Paul O’Byrne says goodwill is the name we give to our ignorance, since to value goodwill before a business is sold would require a theory, since theories are the only way to peer into the future.
The accounting profession proffers little help in achieving this objective, for a very fundamental reason: Accounting is not a theory. The best an accountant can do is to extrapolate the past into the future, and unless one believes that the future is going to be the same as the past, this technique is fraught with hazards.
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Ed Kless

Ed Kless joined Sage in July of 2003 and is currently the senior director of partner development and strategy. He develops and delivers curriculum for Sage business partners on the art and practice of small business consulting. Courses include: Sage Consulting Academy, Business Strategy and Customer Experience Workshops. Ed is the author of The Soul of Enterprise: Dialogues on Business in the Knowledge Economy, a compendium of a few of the episodes of his VoiceAmerica talk-show The Soul of Enterprise: Business in the Knowledge Economy with Ron Baker, founder of the VeraSage Institute where Ed is also a senior fellow.