On October 3 2008, Dr. Eric Melse, assistant professor of Business Intelligence at Nyenrode, obtained his doctoral degree from the University of Maastricht with a dissertation entitled: ‘Accounting for Trends. Relevance, explanatory and predictive power of the framework of triple-entry bookkeeping and momentum accounting of Yuji Ijiri’. In his dissertation, Melse demonstrates that the framework of momentum accounting as developed by the Japanese-American scientist, Yuji Ijiri, is highly useful in practice.
Momentum accounting: An example
Eric Melse says that he often explains momentum accounting using the dashboard of an automobile as a metaphor. Melse: “A company’s balance sheet is the odometer of a car. This shows you how far you’ve come since you started your out. The income statement may be compared with a car’s trip meter. Using momentum accounting, you can calculate your equity’s rate of growth. This is the speedometer. However, this meter won’t be found in the company’s annual accounts. This can be calculated on the basis of the information available and by using the framework developed by Ijiri, whose most important work dates back to the 1980s.”
An example:
Source: Eric Melse
Melse explains: “In this momentum measurement, we can see that in ten years, the rate of growth in equity for recruiting company Robert Half is fairly stable at just over 6%. During the dotcom crisis of 2001, it crashes downwards. After that, the momentum returns. If you have the same profitability percentage for 10 years, this means that the company is well managed. Investors like this; after all, the company is stable and this generates predictable profitability.”
Lehman Brothers: Poor performance three years in a row
Melse continues: “My son recently said to me, ‘Can you make a statement about Lehman Brothers then, if you look at it the same way?’ So I retrieved the quarterly figures on Lehman from Compustat for the last few years. I first looked at the return on equity—a classic, generally accepted benchmark for the performance of banks. Using this information, an analyst could have seen that a reversal was already in progress at Lehman, even one year before the credit crunch became a reality.”
Source: Eric Melse
Melse: “The question is whether or not people could have seen this coming any earlier using momentum accounting. To find out, I first looked at the nominal growth in equity (in dollars): what is known as the net wealth momentum. The graph that this generates is somewhat similar to that for the return on equity, with an aberration now and then. When this happens, the equity experiences a ‘growth spurt’, and then drops back down. It is interesting to see that the growth in equity was considerable over the past year. The figures suggest that things were going well.”
Source: Eric Melse
Melse: “However, if we look at the common size format net wealth momentum ratio, we see a completely different picture. The momentum ratio is the net wealth momentum as compared with the total change in the composition of the balance sheet. Now we see something interesting.”
Source: Eric Melse
Melse continues: “When we look at the common size format net wealth momentum ratio, we can see that three years ago, the momentum ratio had almost dwindled to zero before stabilizing, quarter after quarter. This means that there was practically no growth in equity. Lehman Brothers business model was high risk, so you expect peaks and drops, as long as the average is good. If the equity barely grows for longer periods of time, the company will start becoming more dependent on borrowed capital. A financial institution such as Lehman uses capital to earn money. Although they made so much profit in the past that their equity increased substantially, this petered out nearly entirely, in comparative terms, over the past three years. There have been brief periods in the past in which the momentum ratio had been low, but on the basis of these figures, I could have seen two years ago that things were already going badly. The crucial point actually occurred when there was no recovery in momentum. An analyst would have noticed this using the common size format momentum ratio.”
Rewards: Not based on profit figures alone
According to Melse, the momentum accounting theory says that management is no longer rewarded only on the basis of profit figures. “The result achieved today is dependent on the momentum that was created in the past. It is not true that a manager hired in March who can show good profit figures one quarter later, has managed to do all that in March. His predecessors did this for him. He hopped on a moving train.” According to Melse, it is better to look at what the manager did personally to improve momentum. Melse: “In the case of Lehman, one can see that the momentum deteriorated considerably three years ago. Equity was growing, while return on equity wasn’t really that bad yet, since it was still at 6% one-year prior. However, the momentum came to a standstill, and this means that something is going on. Momentum accounting therefore offers supplemental information which can be particularly useful in evaluating company performance.”