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Intellectual Capital

Intellectual Capital A Brief Overview of Intellectual Capital and Analysis of the Edvinsson/Malone Framework A Brief Overview of Intellectual Capital and Analysis of the Edvinsson/Malone Framework II. Definition of Intellectual Capital (pg. 4-6) III. The Importance of Intellectual Capital (pg. 6-7) IV. Analysis of the Edvinsson/Malone Framework (pg. 7-13) V. General Arguments Lodged Against Intellectual Capital (pg. 13-14) Accounting is a science based on observation. As companies change, the way accountants observe companies must change. Traditional balance sheets, income statements, and statement of cash flows no longer adequately describe a company due to the rapid growth of knowledge-based companies, especially in technological sectors. The Internet and a growth in service industries are also accelerating the need for a change in the way we analyze a firm. Financial statements are failing to adequately describe “corporate vital signs” by ignoring the importance of ideas, brands, ways of working, and franchises. Intellectual Capital (IC) is important to the growth of a company, and investors need to know how a company maintains and evolves the IC within the organization, and how it channels the IC into its products and services. It is believed that the economic boom of the last two decades is due to recent scientific breakthroughs and new information technology. A constant stream of innovations and productivity gains have enhanced the performance of the economy and driven up stock prices. There is a link between the IC of a firm and its ability to contribute to the economy. The commissioner of the Securities Exchange Commission claims that it is because of lack of good measures that we see tremendous volatility in the knowledge sector . The investor demands higher return because of higher perceived risk, leading to an increases the cost of capital. Moreover, the market becomes inefficient because investors are allocating funds with limited information. This paper is designed to outline the current state of the IC. The importance of IC and compatibility with current accepted accounting principles will be discussed. The Edvinsson and Molone proposal for a “knowledge balance sheet” will also be analyzed. The terms "Intellectual Assets" and "Intellectual Capital" are both used to define intangible assets which are not reported in corporation's balance sheets but are a driving force in the creation of corporate wealth. The definition of Intellectual Capital (IC) is elusive. Since the study of intangible assets is a relatively new field, varying definitions appear. Steven Wallman, commissioner of the Securities and Exchange Commission, defines IC as the value of brand-names and the customer base of a firm, as well as the brainpower of the employees and the Research and Development of the firm. Similarly, according to Leif Edvinsson, co-author of the book Intellectual Capital, IC is broken into two main categories : 1. Human Capital: The combined knowledge, skill, and the ability of the company's individual employees to meet the task at hand. It also includes the company's values, culture, and philosophy. Human capital cannot be owned by the company, but the company’s training, support programs, and hiring policy contribute to human capital. 2. Structural Capital: The hardware, software, databases, organizational structure, patents, trademarks, and everything else of organizational capability that supports the productivity of the employees. In a sense, structural capital is knowledge-based assets left at the office when the employees go home. Structural capital also includes customer capital, the relationships developed with key customers. Unlike human capital, structural capital can be owned and thereby traded. Thomas A. Stewart, author of Intellectual Capital, The New Wealth of Organizations, sees three main components of IC: Human Capital, Structural Capital, and Customer Capital . Stewart defines Human Capital as "the capabilities of individuals required to provide solutions to customers.” His definition of Structural Capital is "the organizational abilities of the organization to meet market requirements . . . to codify bodies of knowledge that can be transferred, to preserve the recipes that might otherwise be lost . . . to connect people to data, experts, and expertise--including bodies of knowledge--on a just-in-time basis.” Finally, Stewart adds Customer Capital, which is the value of the business relationships forged by a company. Stewart further narrows the definition by stating that IC must be: 1. “Knowledge that exists in an organization that can be used to create differential advantage.” Therefore, any knowledge in the company that offers a competitive advantage is IC. 2. "Intellectual material that has been formalized, captured, and leveraged to produce a higher-valued asset." One virtue of this definition is its distinction between "intellectual material" and capital. The key point here is that IC must be formalized. Intelligence becomes an asset when some useful order is created out of free floating brainpower. Only when knowledge is given coherent form (e.g. a new customer base, a database, a detailed description of a process) is it considered IC. Knowledge is captured in a way that allows it to be described, shared, and exploited. IC is knowledge that can be deployed to do something that could not be done if the knowledge was not formalized. The Importance of Intellectual Capital The old system of accounting no longer accurately reflects a firm’s position because it ignores IC. There has been a dramatic shift in the production functions—assets that create value and growth—of companies. The shift is moving from tangible assets to intangible assets. In the 1960s and 1970s, 25% of differences in stock prices could be attributed to differences in reported earnings. In the 1980s and 1990s, only 10% of stock price differences are connected with earnings, indicating the rise in influence of intangibles. A popular way of determining the IC of a company is to look at the market price of a company versus its book value. This ratio will show what assets the company must have above and beyond its balance sheet. At a time when Microsoft’s book value was $7 a share, it was trading for $70 a share. Investors perceived Microsoft’s intangibles: strong customer/distributor relationships, employee competency, and innovation. In 1995, the S&P 500 companies had assets worth $1.2 trillion while the market value of these firms was $4.6 trillion, yielding a market-to-book ratio of 3.83. By 1999, the S&P 500 companies showed an average market-to-book ratio of 6.25. This indicates that IC accounts for six out of every seven dollars of corporate market value. What could cause such an increase in just four years? Intangible assets account for such great value because of unlimited leveraging. It is difficult to get increased value from a tangible asset because it must remain at one place at one time. On the other hand, there is no limit on where an intangible asset can be, and how many people can use it. Since these facts prove that IC is an important part of today’s businesses, it must be determined how to measure IC in its various forms. Analysis of the Edvinsson/Malone Framework The following proposal comes from Edvinsson and Malone, authors of Intellectual Capital. The tables show a framework for measuring IC, divided into the categories of finance, customers, humans, renewal & developmental, and process efficiency. Edvinsson and Malone offer one of the most comprehensive guides for IC reporting, but their framework is not without flaws. Efforts to have more meaningful analysis of knowledge capital run into the problems of subjectivity. The following questions are raised: 1. Will IC measurements and disclosures reveal too much to competitors? 2. If there is too much subjectivity, will managers pressure accountants to make the IC numbers look better than they really are? 3. What about stockholder lawsuits over inaccurate measurement of IC? 4. Is it too difficult to obtain the information required for the IC report? 5. Revenue resulting from new business operations ($) 6. Profits resulting from new business operations ($) 8. Customer Time/Employee Attendance (%) 10. Lost business revenues compared to market average (%) 11. Revenues from new customers/Total Revenues (%) 14. Return on net assets resulting from new business operations If the firm has a good information technology (IT) infrastructure, there is no data required for this part of the IC report that is not relatively easily obtainable. For firms that do not have the IT in place, some portions of this IC report would not be available, or investment would be required to obtain this data. This portion of the IC report provides forward-looking information to an investor. The investor would know the effect on revenue of new customers, lost customers, and new operations of the company. Measures such as Value-Added/Employee and Value-Added/IT Employee attempt to measure the intellectual knowledge employees bring to the company. An issue raised by this report is giving too much information to competitors too easily. This type of data is principally used for internal purposes. 5. Average duration of customer relationship (#) 8. Customer visits to the company (#) 13. Average time from customer contact to sales response (#) 17. IT investments/Service and support employee 19. Service Expense/Customer/Year ($) 20. Service Expense/Customer/Contact ($) Firms that exhibit a low number of customers lost and a high duration of customer relationships clearly have a competitive advantage. The Customers/Employee and the Sales Closed/Sales Contacts ratios can be used to gauge efficiency of a firm. However, not all firms have the infrastructure in place to measure such data. For example, not all salesman record each sales contact. Moreover, this data could easily be manipulated by a salesman if he or she desires a better ratio. There is a high likelihood of corruption if these figures are tied to bonuses or rewards. Edvinsson and Malone have assumed that satisfaction data can be obtained from the customer. Unfortunately, the customer may not desire to be bothered with a survey of his or her satisfaction. Administering such surveys carries a considerable cost, as well. 1. Adminstrative expense/Total revenues (%) 2. Cost for administrative error/Management revenues (%) 4. Contracts filed without error (#) 5. Function points/Employee-month (#) 8. Administrative expense/Gross premium (%) 10. IT expense/Administrative expense (%) 11. Administrative expense/Gross premium (%) 15. Corporate performance/Quality goal (%) 16. Discontinued IT inventory/IT inventory (%) 17. Orphan IT inventory/IT inventory (%) The number of laptops or PCs per employee is not a good reflection of IC. It is puzzling why Edvinsson and Malone included such a measure, unless it were to aid an investor in understanding the operations of a company he or she is completely unfamiliar with. The number of contracts filed without error is a good indicator of a well-trained staff, which falls under IC. Firms may be unwilling to disclose a great deal about their process IC, however, because there is a gray area concerning intangible assets and property rights. While a tangible asset has inarguable ownership, intangibles must constantly be defended in court cases, etc. If too much information is disclosed about process IT, it could result in theft of the asset, and subsequently legal fees to defend the property. 6. Average employee years of service (#) 10. Share of employees less than 40 years (%) 11. Time in training (days/year) (#) 14. Number of full-time employees (#) 15. Average age of full-time employees (#) 16. Average years with company of full-time employees (#) 17. Annual turnover of full-time employees (#) 18. Per capita annual cost of training and support of full-time employees ($) 19. Percentage of full-time employees (%) 20. Per capita annual cost of training and support ($) 21. Number of temporary employees (#) 22. Average years with company of temporary employees (#) 23. Per capita annual cost of training and support of part-time employees ($) 24. Number of part-time employees (#) 25. Company managers with advanced degrees: This table shows the status of the workforce. In the end, it is people, not companies, who create knowledge, making it important for investors to have access to this type of information. If a firm has a high employee turnover rate, it must constantly re-train its staff, leading to considerable training costs (as shown in the per-capita training costs) and a lack of experienced personnel. There may also be employee dissatisfaction. These factors will influence the productivity of a company, and should appear in the financial statements. Edvinsson and Malone seem to believe the female composition of the workforce has some connection with productivity. This portion of the report is irrelevant given the current business environment. Reporting of the average employee age is a controversial topic. While a younger average employee age could indicate a more innovative, technically-savvy staff, such is not always the case. Also, such reporting could lead to discriminatory hiring practices. 1. Competence development expense/Employee ($) 6. Employee's view (empowerment index) (#) 7. R&D expenditure/Administrative expense (%) 9. Training expense/Administrative expense (%) 10. Business development expense/Administrative expense (%) 11. Share of employees below age 40 (%) 12. IT development expense/IT expense (%) 13. IT expenses on training/IT expense (%) 14. R&D resources/Total resources (%) 19. Average customer duratin with company (#) 20. Training investment/customer ($) 21. Direct communications to customer/Year (#) 22. Non-product-related expense/customer/year ($) 23. New market development investment ($) 24. Industry development investment ($) 25. Ratio of new products (*two years old) to product family (%) 26. Ratio of new products (*two years old) to company catalog (%) 27. R&D invested in basic research (%) 28. R&D invested in product design (%) 30. Investment in new product support & training ($) 31. Average age of company patents (#) While Edvinsson and Malone again include some frivolous elements (such as the average customer age and customer education), there are other segments of the report that are highly valuable. The ratio of new products to old products is a gauge of innovation. The number of patents pending and the breakdown of R&D into basic, product, and process research is helpful to an investor. It must be noted that well-informed investors already seem to recognize such intangibles. If Company X issues a press release indicating the acquisition of a new customer base or the patenting of an innovation, investors perceive a rise in Company X’s value due to these intangible assets. For example, in 1999 Warner-Lambert Co. had the highest ratio of knowledge capital to book value in its industry (4.3 to 1). Soon after, competing pharmaceutical firms launched bids to buy the company based on their R&D. It is managers who may resist offering such information. When R&D fails to be useful, the manager may receive criticism from the shareholders. If the shareholders do not know where R&D money has been spent, they are less likely to lay blame on the manager. It should also be noted that companies have been purchased and then lost the knowledge base of people within the group who made the company so attractive for purchase in the first place. This is due to a lack of understanding on the part of the buyer of how to manage the knowledge capital of the firm. General Arguments Lodged Against Intellectual Capital Detractors lodge a variety of arguments against accounting for IC. Generally, it is argued that intangibles are too uncertain and risky to be considered assets and to be capitalized. Some detractors, such as John Rutledge, the chairman of a Rutledge & Company, claims that there is no relationship between a company’s knowledge and its application of that knowledge. For example, if Company X has a genius working in R&D, it is a positive thing. But if his work does not generate cash flow, he is not an asset to Company X. Accountants resist accounting for IC because accounting in today's world is complicated enough without trying to put a price tag on the growing knowledge base within an organization. Some of the measures required by IC reports are complicated to obtain, and are not guaranteed to be accurate. On this front, firms fear shareholder lawsuits based on inaccurate representation of IC. In the past, the theory of “goodwill” has functioned as the market's way of pricing the intrinsic value of a company, including its knowledge base. One element of goodwill is "turn-key" value (this concept acknowledges that an on-going business has more value than the same business in the start-up stage). Turn-key value encompasses knowledge capital. Using generically applied knowledge management concepts, companies can generate substantial savings across most corporate departments. Another fear is that amortization of capitalized values for intangibles could be misused by corporations. Under IC accounting, intangibles would be capitalized over their expected life rather than expensed immediately. This methodology leaves room for corruption on the part of the firm, or at least accusations of corruption. In 1994 and 1995, AOL was attempting to acquire a larger customer base. AOL capitalized some of its customer-acquisition cost, citing the customer base as an asset. Immediately, they were lambasted for manipulating their financial records, and after much deliberation, AOL gave up and expensed the whole amount. Market-to-book ratios indicate that IC is undeniably important in the modern economy. Since accounting is a science of observation and things are changing constantly, accounting must adapt to these changes by observing firms in new, more revealing ways. However, many questions arise in designing an IC report sheet. For example: 1. Will IC measurements and disclosures reveal too much to competitors? 2. If there is too much subjectivity, will managers pressure accountants to make the IC numbers look better than they really are? 3. What about stockholder lawsuits over inaccurate measurement of IC? 4. Is it too difficult to obtain the information required for the IC report? The Edvinsson/Malone framework has some features that can better aid investors and managers in assessing knowledge capital, thereby bringing stability to this highly turbulent area. However, the Edvinsson/Malone framework contains some frivolous aspects that should be removed. The framework serves as a good starting point from which refinement may occur. The Edvinsson/Malone framework needs to be refined. The authors included frivolous materials such as gender ratio of managers and number of laptops and computers per employee. These measures do not incorporate with the definition of IC outlined in the beginning of this report. Bibliography:

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