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Intellectual Capital: Tomorrow’s Asset, Today’s Challenge
by Barry Brinker, CPA
When Netscape went public in 1995, it was a $17 million company with fifty employees. Yet after only the first day of trading, the stock market valued Netscape at $3 billion. What were investors buying? Certainly not fifty telephones and the company’s inventory of software.
In fact, what investors “bought” were the people who had built Netscape — their knowledge, skills, ideas and talent. They were also investing in the company’s demonstrated ability to innovate, create, and bring to market a product that makes the Internet accessible to the public at large. In short, they were paying an enormous premium for Netscape’s intellectual capital.
As technology continues to transform the workplace and markets, intellectual capital will undoubtedly become one of the most critical issues that CPAs must grapple with in order to continue providing clients and employers high-quality, value-added services and advice.
Intellectual Capital Versus Goodwill
Intellectual capital has been around for as long as companies have had customers. It’s what makes a company worth more than the sum of its countable parts. As an asset, it has been (inadequately) covered for years by the blanket of goodwill. Unlike accounting goodwill, intellectual capital appreciates.
Now that we have entered the information age (or, more accurately, the knowledge age), intellectual capital has become an issue of intense interest and concern. Because of information technology, companies rely more and more on expertise and technical ability, and less and less on manual labor. To provide some perspective, consider the names on following list of the twelve largest companies in the United States in 1900 — most of them natural resource companies:
Today, by contrast, most rapidly growing companies are knowledge-intensive and in fields such as the following:
A company’s “brains” — the know-how, relationships, secrets and collective knowledge of its employees — define its competitive advantage today. As we move into the next millennium, “brainpower” will continue to become far more valuable than muscle, mechanical power, or even technical power. Lester Thurow (author of The Future of Capitalism) goes so far as to say that the era of brainpower industries is causing a fundamental shakeup in classical capitalism, because strategic assets are now the brains of employees.
Intangible Assets
The gap between a company’s market value and the value of all its tangible assets has widened significantly over the last two decades.
| “Market-to-book ratios of U.S. companies are now roughly 2-to-1, roughly double the average between 1945 through 1990. Price/earnings ratios in the U.S. are at 25, vs. a historic average of about 17...At the same time, corporate investment in tangible capital stock is declining. The ratio of revenue to the sum of property, plant, equipment and inventory for U.S. companies has increased by some 20% over the past 25 years.”2 |
According to one observer, “roughly 40 percent of market value of the median U.S. public corporation was missing from the balance sheet.”1
According to Morgan Stanley’s World Index, the average value of U.S. companies typically ranges from two to nine times book value. Microsoft, for example, saw its stock climb to more than $100 per share when it announced Windows 95. As a result, Microsoft became more valuable than Boeing overnight.
Traditional accounting measures can no longer adequately determine the real value of companies. But if intangible assets cannot be measured, how can they be managed? Corporations and accounting firms alike are taking this problem seriously and have been working to develop systems to identify, value and manage intellectual capital.
The Emergence of Intellectual Capital
To get a better sense of where we are going, we need to have a basic understanding of where we started and what forces are propelling change today. And then we need to keep our vision set on the path ahead. Although it has been around forever, intellectual capital was not identified as a key asset until a few years ago. In 1994, Fortune carried several stories about intellectual capital (brainpower) based on pioneering efforts going on then in both the United States and Scandinavia. These articles helped generate awareness of intellectual capital in the mainstream of U.S. business.
In May 1995, Skandia (the largest insurance and financial services company in Scandinavia) released the first intellectual capital annual report, using its unique “Navigator” reporting model. The Skandia model has since been adopted and refined by other companies, some of which have created their own approaches to (and uses of) intellectual capital.
Hughes Aircraft, for example, created an intellectual capital program called the “Knowledge Highway.” The Canadian Imperial Bank of Commerce (North America’s seventh-largest bank) instituted a loan program to finance knowledge-based companies using intellectual capital valuations. Ernst & Young and Arthur Anderson were among the first accounting firms to develop intellectual capital tools for their clients.2
In 1996, the SEC sponsored a symposium on intellectual capital at which Commissioner Steven M.H. Wallman predicted that intellectual capital would one day become the heart of the modern corporate annual report. He also advised companies to begin experimenting with the disclosure of “hidden” assets through published supplements.3
But why all the fuss? What difference would it make even if intellectual capital could be measured? The sections that follow attempt to provide some answers.
Improved Investor Understanding
The knowledge economy is characterized by huge investments in both human capital and information technology. Under the existing reporting system, a typical investor does not receive an accurate picture of a company’s true value. Its “root system” and its long-term prognosis are invisible. Indeed, the more a company invests in its future, the less its book value.
As a result, “too many deserving companies are underoptimized and undercapitalized — and, thus, sometimes unable to complete their destiny. Other troubled firms, meanwhile, are artificially propped up until they collapse, pulling down shareholders and investors with them.”4 In this sense, intellectual capital is more about undervalued and overvalued assets.
Improved Internal Understanding
Evaluating intellectual capital can help make a company more efficient, more profitable and more competitive. By identifying and measuring intellectual capital, executives are better prepared to:
Improved Profitability of Hidden Resources
A recent study by the Gottlieb Duttweiler Foundation found that only 20 percent of the knowledge available to a company is actually used.6 Yet when companies use their untapped knowledge, the results can be dramatic.
A recent study by the Gottlieb Duttweiler Foundation found that only 20 percent of the knowledge available to a company is actually used. Yet when companies use their untapped knowledge, the results can be dramatic.
In 1993, for example, Dow Chemical created a new position — Director of Intellectual Asset Management-with the express objective of tightening up its patent portfolio. Dow discovered that it had been exploiting fewer than half its patents and that no one was responsible for bringing them to life. Simply by weeding out its less-valuable patents, Dow saved more than $1 million in maintenance costs (including filing fees, taxes and the like) in the first 18 months of the program. By bringing valuable but unused patents to light, Dow estimates an increase in patent licensing revenues from $25 million to some $125 million by the year 2000.7
Why the Accounting Profession Should Care
Intellectual capital holds far-reaching implications for the accounting profession, which should seize the opportunity to help measure and audit what makes companies valuable. Rather than the historical and (supposedly) objective approach that has characterized financial reporting to date, valuation of intellectual capital will require immediate and imprecise measures. Can the accounting profession adapt?
Valuing intellectual capital is undoubtedly fraught with risk (though not valuing it may prove even more risky if it means that accounting will increasingly lose relevance). Placing a monetary value on intangible assets creates the potential for abuse. Even well-intentioned, honorable companies are vulnerable to lawsuits for misrepresentation should their honest projections prove wrong.
Moreover, intellectual capital cries out for standardization, including a new auditing process and certified measurement. Helping companies measure intellectual capital thus represents an important opportunity for accountants to shape their future. If accountants fail to take the initiative, management consultants and other professional service-providers will likely fill the gap.
Defining Intellectual Capital
Before you can measure something, you have to know what you’re counting. How should intellectual capital be defined? A universally accepted definition is the first step toward standardization.
Some people mistake intellectual capital for nerds in a think-tank. Others confuse it with intellectual property (such as copyrights, patents, and the like), which is actually merely a subset of intellectual capital. The truth is, we are still working toward a universal definition of intellectual capital.
SEC Commissioner Wallman describes intellectual capital as assets currently valued at zero on the balance sheet, including items such as the following:
Annie Brooking (a consultant and author of Intellectual Capital: Core Asset for the Third Millennium Enterprise) defines intellectual capital as the “combined intangible assets which enable the company to function.” In other words, she sees an enterprise as the sum of its tangible assets and its intellectual capital, as shown in the following formula9:
Enterprise = Tangible Assets + Intellectual Capital
Leif Edvinsson (Corporate Director of Intellectual Capital at the Swedish corporation Skandia and co-author of Intellectual Capital: Realizing Your Company’s True Value by Finding its Hidden Brainpower) equates intellectual capital with the sum of human capital and structural capital (i.e., customer relationships, information technology networks and management.)10:
Intellectual Capital = Human Capital + Structural Capital
Thomas Stewart (editor of Fortune magazine and author of Intellectual Capital: The New Wealth of Organizations) says that intellectual capital is simply “packaged useful information.” He also quotes the following definition of intellectual capital by professor David Klein and consultant Laurence Prusak: “Intellectual material that has been formalized, captured, and leveraged to produce a higher-valued asset.”11
Identifying Intellectual Capital
Building on these basic definitions, experts have identified areas of an enterprise where intellectual capital can be found. There is general agreement that intellectual capital comprises all the following:
Human Capital: The capabilities of the company’s employees necessary to provide solutions to customers, to innovate and to renew. In addition to individual capabilities, human capital includes the dynamics of an intelligent (learning) organization in a changing competitive environment, its creativity, and innovativeness. Structural Capital<: The infrastructure of human capital, including the organizational capabilities to meet market requirements. Infrastructure includes the quality and reach of information technology systems, company images, databases, organizational concept and documentation. Customer Capital: The relationships with people with whom a company does business. Although this usually means clients and customers, it can also mean suppliers. It has also been referred to as relationship capital. |
It is the interplay among human, structural and customer capital that helps determine the true value of a company’s overall intellectual capital. A closer look at each of these three components of intellectual capital can help to identify the problems and opportunities associated with measuring and managing them.
Human Capital
Human capital is the lifeblood of intellectual capital. It is the source of innovation and improvement, but it is also the hardest component to measure. Moreover, human capital cannot be owned by a company, it can only be “rented” (i.e., in the form of employees). When companies invest in human capital, value increases. There are many examples of individual companies, large and small, that have thrived because of their investments in people. Taken together, the picture is dramatic.
In 1995, for example, the National Center on the Educational Quality of the Workforce (EQW) released a report about the relationship between education and productivity at more than 3,100 U.S. workplaces. The findings showed that, on average, a 10-percent increase in the educational level of employees led to an 8.6-percent gain in total productivity. By contrast, a 10-percent rise in the value of equipment (capital stock) increased productivity by only 3.4 percent. These figures suggest that the marginal value of investing in people is about three times greater than that of investing in equipment!12
Knowledge That Adds Value
Of course, what people know is not the whole story. The raw material of knowledge is not to be mistaken for intellectual capital: It’s only intellectual material until it is harnessed into something that adds value to the company. For knowledge to be put to work and then valued, it must be identified and made accessible.
There are two basic kinds of knowledge in a corporation: tacit knowledge and explicit knowledge. Tacit knowledge is extremely difficult to explain or write down; it is often knowledge that people do not even realize they have. Tacit knowledge is what a retail buyer has when she “just knows” that happy faces will be hot this year, or when a machinist instinctively feels that something’s not right with the equipment. It’s that sixth sense about how to sell an idea to the boss or simply knowing how to touch-type without thinking about it.
Explicit knowledge, on the other hand, is what can be captured, explained in words, traded, or sold — for example, a corporate mission statement, an operations manual, a sales script or a manufacturing procedure. This knowledge remains with the company after an employee leaves. Companies have to make tacit knowledge explicit if it is to be formalized, examined, improved or shared — and thus turned into an asset with added value.
Human capital grows when a corporation uses more of employees’ knowledge or when more employees gain more useful knowledge. Therefore, a company’s ability to capitalize on its employees’ ideas and know-how, and its commitment to training and education, can enhance productivity and add value. For example, to use more of what their employees know, GE created its “Work-Out” program, a perpetual series of “town meetings” at which employees present ideas for improvement and managers are required to evaluate those ideas. It’s a proven way of getting ideas out in an environment safe from personal rejection, politics and bureaucracy.13
“Owning” Brainpower
Companies need to find ways to “own” brainpower even though they can’t actually own people. Ironically, many high-tech, knowledge-intensive companies find that by giving employees ownership in their companies, they are more likely to win the employees’ loyalty and to create a stable knowledge environment.
Microsoft, for example, incorporated in 1981 not only to raise capital but (at least in part) to share ownership of the company with the employees — their key asset. And when Microsoft went public in 1986, it was not to raise proceeds to build factories but to give an objective monetary value to employees’ shares, thus giving them a financial incentive to remain at Microsoft rather than to take their knowledge elsewhere.14
Making Human Capital Measurable
To manage human capital, it must be measurable. If companies want to maximize their use of knowledge, they need to know who has it, what they know, how much they know and how to use it. But how do you measure the hearts and minds of human beings? And how do you do it if they’re telecommuters, on the road 80 percent of the time, or simply subcontractors? How do you do it if you’re a virtual corporation?
Certainly some basic characteristics can be measured, including:
Quantifying these facets of human capital, identifying other meaningful measures, and then assessing them within the context of the company’s strategy are the first steps toward valuing human capital. Understanding the infrastructure that supports them is another important step, as explained below.
Structural Capital
Structural capital is the skeleton and glue of an organization. Its value depends on how well it enables a company to package, move, and use human capital — the company’s knowledge — in service to corporate goals.
Structural capital is not to be confused with (for instance) computer hardware or equipment, which are already on the books as assets. Rather, structural capital is a company’s capability to use these tools to contribute to profitability.
Brookings identifies six key components to structural capital (or infrastructure assets, as she calls them):
The combined value of these components depends on how well they work together to achieve the company’s goals.
Knowledge Managers
Structural capital is where knowledge managers come in. In fact, the emergence of the knowledge management field demonstrates the positive effect that improving structural capital value can have on corporate profitability. Certainly, the way in which a company uses its information technology and networking systems can have a profound effect on its ability to do business on a global level, to assure uniform standards of quality in different locations, and to share important information about customers or about production innovations.
The need for knowledge management has spurred the development of software, systems and consulting services. Knowledge databases are becoming more common. The big consulting firms have introduced numerous related services. In recent years, for example, Arthur Andersen has created its Knowledge Xchange, Booz Allen & Hamilton has developed Knowledge On-Line (KOL), Ernst & Young has launched a Center for Business Knowledge, KPMG Peat Marwick has introduced its Knowledge Manager and Price Waterhouse has promoted its Knowledge View.16
Companies are now recognizing the need to manage their knowledge resources and many have created knowledge management positions. For example, Andersen Consulting has “knowledge integrators” who interface with manufacturers but also perform the multiple functions of librarian, intellectual entrepreneur and program director. They are responsible for maintaining databases and documents, motivating consultants to use their system, and identifying areas of potential knowledge creation that would be useful to the firm and its clients. Each knowledge integrator is associated with a business activity rather than being quarantined in the library.17
Affecting the Bottom Line
Evidence that knowledge management can positively affect the bottom line is plentiful. For example, Andersen Consulting’s knowledge database (Knowledge Xchange) not only helps provide information to whoever needs it, but it saves the firm millions of dollars annually in FedEx charges alone. The financial value of a well-executed networking system is also demonstrated by a 1994 study of 64 companies that used Lotus Notes, which found that companies earned an average three-year return on investment of 179 percent, primarily because of savings in the cost and time of internal communication.18
Another example of how structural capital can help create a comparative advantage can be seen in how Skandia quickly managed to take advantage of the worldwide trend toward deregulation of insurance and other financial services. By efficiently sharing, moving and creating information and ideas through its systems, Skandia identified techniques and technology that could be transplanted anywhere. As a result, the company cut the time required to open an office in a new country from seven years to seven months. It then took this finding and created a prototype concept — all the software, manuals, and other knowledge required to open an office.19
Tying Structural Capital to Corporate Goals
The challenge in valuing structural capital is in measuring how well it serves a company’s goals. Structural capital can be either a liability (an outmoded corporate culture, for example) or an asset (Lotus Notes used effectively, for example). Investing in a computer network does not necessarily increase the value of structural capital. How the network is used to increase profitability does.
Technology in particular can present pitfalls to corporations, and it definitely affects how structural capital is measured. The wrong technology might be employed, for example, or the wrong vendor selected, thus making a company vulnerable if its equipment becomes obsolescent. Even the right technology can be misused. GM is the classic example with its robotics fiasco of the 1980s. Desiring to automate the production floor, GM invested an estimated $40 billion on robotic equipment that caused smashed cars, injured workers, and serious damage to the company’s bottom line.
Finding the Right Measures
One solution is to develop measures that can help avoid mistakes while also valuing improvements. Edvinsson proposes the following:
Ultimately, both human and structural capital are assessed in how they affect profitability, and profitability relies in large part on how well clients and customers are reached and retained. Therefore, the third key component of intellectual capital (identified by Hubert St. Onge of the Canadian Imperial Bank of Commerce and sometimes lumped in with structural capital) is companies’ relationships with customers, as explained below.
Customer Capital
Customer capital is the most obviously valuable component of intellectual capital. In some ways, it is also the easiest to measure, because revenues come from customers. Thus, companies can track market share, price sensitivity, market size, seasonality and so on. And the information is illustrative. For example, Ford Motor knows that an increase of one percentage point in customer loyalty represents a $100 million increase in profits.21
But products are changing, and so are consumers. The information age has created smarter products, but also smarter, more demanding consumers. Many companies now equate their competitive advantage with their ability to deliver complete customer satisfaction. To this end, Edvinsson suggests that companies can evaluate how well they are doing — i.e., assess their customer capital — in part by measuring the following:
Information Is Power
Since technology has made information more accessible to both consumers and companies, consumers have become more powerful. They know more about what companies can and should deliver, how to obtain products at lower prices, what to watch out for and what to insist on.
As power shifts downstream, so does the potential for value. For example, now that customers are self-diagnosing more frequently because of the availability of information, they are making more decisions about their own health and the medications they might need. As a result, pharmaceutical companies increasingly use direct-to-consumer advertising even for prescription drugs.
The value chain is a way to help understand the increase of value along the chain of activities involve in bringing a final offering to consumers. Value-chain analysis looks at each link in the chain to see where value is added and how it might be increased. The idea is for companies to maximize value at minimum cost and to allocate resources to those activities that generate the most value — thereby maximizing profitability.
Information systems (structural capital) can enable companies to capitalize on customer capital and deliver value where there is greatest profitability. Enterprises capitalizing on the strengths of modern resources to add value to their customers have experienced dramatic improvements in their financial performance. Sometimes this leads to equally dramatic changes in a company’s valuation; at other times, it leads to fundamental changes in the how the company operates.
How To Add Value
For example, MicroAge (an authorized computer reseller) began by adding value in the traditional wholesaler way — by buying in bulk, holding inventory, and providing delivery and installation services. Through knowledge of its customer base, however, MicroAge learned that as customers became more sophisticated and equipment more diverse, they wanted a fully integrated system, not just computers.
MicroAge “saw value shifting from physical attributes to information attributes” — that is, knowing how to customize systems for clients. The result? The company moved its business focus to where the value was — assembling systems. Information about customers helped MicroAge identify where they needed to be on the value chain. The most valuable links on this chain belong to those with knowledge — the companies that know what drives their business.23
Annie Brooking calls customer capital market assets, which she includes with intellectual property, such as trademarks and brands. Brands can be valued by assessing their leadership, stability, trends, marketing support, protection and the extent to which their market is international. Measurement of repeat business, backlog and customer loyalty is more straightforward, because all are based on sales projections. The key is to find a way to value the commitment of customers to a company as technology makes it possible to forge stronger links with customers.
Implications for Accountants
Where to from here? In intellectual capital, the accounting profession has an exciting opportunity to bring its talent and experience to bear on an issue that will affect business fundamentally from now on. The urgency of the problem seems to have taken hold, as a recent article on the editorial page of the The Wall Street Journal shows:
| “…we have no accounting methodology for recognizing the value of investments in intangible assets. As companies accelerate spending on intangibles to capture global opportunities, ‘earnings’ are being understated while returns on book equity and market-to-book and price/earnings ratios are being overstated. In other words, current stock market valuations are more reasonable than they appear.24” |
Progress has been made in developing measures for specific elements of intellectual capital. In Britain, for example, some companies have shown a separate value for brand names in their balance sheets, though this practice has been highly controversial.25 So far, however, efforts to measure the value of intellectual capital have not stood the test of time, nor are they comprehensive.
New performance measures are needed, and new valuation methods will have to be devised. Annie Brookings hangs her hat on the strategic value of an intellectual capital audit. Who better to refine that process than accountants?
But making sure that businesses recognize the value of intellectual capital is not a job only for auditors. Instead, CPAs in business and industry, along with accounting educators, consultants, and regulators, will all have to collaborate on establishing criteria for recognizing and measuring intellectual capital, implementing appropriate controls and developing information systems.
Leif Edvinsson sees four important new roles for accountants:
Beyond the obvious need for accountants to become involved in an area that needs them and that will affect their future, accountants can apply the concepts of intellectual capital management to self-management.
The first step is to share and use existing information. How does your organization define and measure intellectual capital? What valuation challenges have you experienced, and how have you dealt with them? If the accounting profession is to play an important role in defining and assessing intellectual capital, it must begin to hone its vision of this critical issue today.
Expertise in intellectual capital valuation and management can become a core competency for any accounting firm. Further, accounting firms can perform internal audits of intellectual capital to assess where their own firms’ hidden assets lie and where they themselves might move along the value chain. Opportunities abound.
Notes:
1 Lester C. Thurow, The Future of Capitalism, (New York: William Morrow and Company, Inc.), 1996.
2 Lowell L. Bryan, "Stocks Overvalued? Not in the New Economy," in the column Manager’s Journal, The Wall Street Journal, November 3, 1997, p. A24.
3 Leif Edvinsson and Michael S. Malone, Intellectual Capital, (New York: HarperCollins), 1997, p.5 .
4 Edvinsson 1997: 8.
5 Edvinsson 1997: 19.
6 Edvinsson 1997: 8.
7 Edvinsson 1997: 167.
8 Annie Brooking, Intellectual Capital, (London: International Thomson Business Press), 1997, p.8.
9 Thomas A. Stewart, Intellectual Capital , (New York: Doubleday Currency), 1997, pp. 62-63.
10 Edvinsson 1997: 3.
11 Brooking 1997: 12.
12 Edvinsson 1997: 11.
13 Stewart 1997: 67.
14 Stewart 1997: 85.
15 Stewart 1997: 92.
16 Stewart 1997: 105.
17 Brooking 1997: 62.
18 Stewart 1997: 112.
19 Stewart 1997: 126.
20 Stewart 1997: 113.
21 Stewart 1997: 77.
22 Edvinsson 1997:108.
23 Stewart 1997: 144.
24 Edvinsson 1997: 94-95.
25 Stewart 1997: 154.
26 Lowell L. Bryan, "Stocks Overvalued? Not in the New Economy," in the column Manager’s Journal, The Wall Street Journal, November 3, 1997, p. A24