All
About Intellectual Capital
IC
Model | CICM Classification |
Measurement | Sample
Measures | Reporting & Accounting
Thinkers
and economists have been discussing the importance of intangible assets
for the success of organizations for decades. The term intellectual
capital however, was popularized in the 1990s by Skandia, a Swedish
insurance and financial services company, that decided not only to develop
an IC model to manage intellectual capital – the Skandia Navigator
– but also to report on its efforts to stakeholders through the
IC Supplement first published in 1994. This was not the first time that
a company has reported on its intellectual capital. In fact Celemi,
a Swedish educational programs company, has reported on its ‘intangible
assets’ through the Celemi
Monitor since 1995 using Karl Erik Sveiby’s “Intangible
Asset Monitor”. But it wasn’t until Skandia’s work
and the adoption of the IC theory by a number of business leaders that
the IC model was popularized.
The
IC Model
The
IC model, viewing intellectual capital as made of human, customer and
structural capital the interaction of which creates value, has been
developed by Leif Edvinsson (the then Skandia Director of IC), Hubert
St. Onge (of the Canadian Imperial Bank) and Charles Armstrong (President
of Armstrong Inc. – Canada). According to the IC model intellectual
capital is composed of:
Human
capital – includes employee brainpower, competence, skills,
experience and knowledge
Customer
capital – includes relations and networks with partners, suppliers,
distributors, and customers. It also includes the image of the organization
in the market, its social identity, and brand equity
Structural
capital – covers every intellectual capital that can be owned
by the organization including routines, business processes, practices,
databases, systems and intellectual property.
The
IC model is very similar in its classification of intellectual capital
to the earlier classification introduced by Karl Erik Sveiby in a book
by KONRAD- The
Invisible Balance Sheet, in 1989. Svieby explains
that the balance sheet of organizations contains three
invisible types of intellectual capital, or intangible assets, as
he prefers to call it, including:
Internal structure – includes all the systems, databases, processes
and routines that support an organization’s operations and employees
(corresponds to structural capital)
External
structure – includes all external relations and networks that
support the organization’s operations (corresponds to customer
capital)
Competence
- includes individual experience, knowledge, competence, skills and
ideas (corresponds to human capital).
Sveiby
also made a number of distinctions. According to Sveiby only the competence
of the professional employees makes part of the organization’s
competence while that of the support and administrative staff forms
part of the internal structure, since the latter enables the company
to respond to market needs. Sveiby also advances the concept of intangible
revenues to refer to the knowledge and experience that organizations
obtain from their major customers.
Despite
the distinctions that Sveiby makes the two models are similar in that
they classify intellectual capital by grouping similar forms of intellectual
capital together by reference to where they can be found in the organization,
and the level of control that the organization has over them. Thus employee
competence, skills and experience are grouped under human capital by
reference to their connection tp employees, and the fact that an organization
cannot own their brainpower. In sharp contrast is structural capital
which includes everything that the organization can own and are contained
in physical media like a manual or a database or simply in the history
of the organization (i.e. experience and identity). Customer capital
on the other hand refers to such relations and networks that the organization
may have some rights over e.g. contracts, but are to the most part a
result of the organization’s actions in its own environment and
are related to external parties (partners, customers and suppliers)
and factors (market).
The IC model classification though very useful from the conceptual standpoint
provides only general guidance as to the management of intellectual
capital. This is hardly sufficient for management purposes where intellectual
capital not only forms 80 percent of organizational wealth and assets
but also represents the main drivers of value in all industries in the
knowledge-, and innovation-, intensive economy of the 20th century.
More than ever the success of organizations is dependant on their technological
capabilities, pipeline products, strong brands, wide distribution channels
and networks. Though being able to define, recognize and appreciate
intellectual capital is of great value, management needs a comprehensive
guide as to how to develop and leverage intellectual capital.
Furthermore,
the IC model fails to identify the function that the various groups
of intellectual capital has in the business cycle (Al-Ali,
Comprehensive Intellectual Capital Management,
J. Wiley & Sons, 2002). The function that knowledge
and information resources for example play in the business cycle of
production is completely distinct from that of an innovation process
or know-how related to a certain area. As such the way that intellectual
capital can be managed highly depends on the function or role that intellectual
capital plays in the business cycle as a whole. Bundling different forms
of intellectual capital together just because they have a common source
(and a common relation to the organization) as the IC model does, limits
management's ability in setting objectives and defining expected returns
for the management of intellectual capital as a business asset. The
various forms of intellectual capital should be further grouped into
resources, processes, and products where the relation between them is
made clear for the purposes of management, something that the IC model
fails to clarify.
In
contrast to the IC model Andreissen and Tissen, in their book - Weightless
Wealth: find your real value in a future of intangible assets,
Prentice Hall 2001 - explain that to overcome the limitation of
the IC model, intellectual capital should be viewed in the context of
organizational competencies. The authors explain each organization usually
have between 8 to 10 competencies which are supported by its intellectual
capital. As such intellectual capital should be managed in a way to
strengthen the core competencies of the organization as a whole and
not its intellectual capital in general. Despites its attractiveness
this approach runs the risk of hampering the organizational ability
to mine to the full its intellectual capital by developing it only if
it falls in the ambit of its core competencies. In fact that was the
reason behind Xerox's declining to invest in the PC prototype which
was developed in its Palo Alto Research Center leaving it to Steve Jobs
to lead the PC revolution. Xerox focusing on its identified core competencies
at the time failed to leverage its intellectual capital in a new area
of knowledge and as a result lost a once in a lifetime (of an organization)
opportunity.
To
overcome the limitation of the IC model's classification of intellectual
capital, another classification is presented here based on the CICM
model.
The
CICM Classification
The
CICM's classification of intellectual capital is based on the function
that various groups of intellectual capital play in the business cycle
of an enterprise. According to the CICM model intellectual capital are
classified into resources, processes and products as follows:
Knowledge
resources – represent the raw knowledge, whether human
or organizational knowledge, that goes into the making of products/services
of the organization and supports the critical business processes and
operations. The fact that knowledge work forms most of work done in
an organization in the knowledge economy, equates knowledge management
with management of business resources essential for the enterprise
to operate, make effective decisions, and create value. This group
of intellectual capital is mainly composed of human capital and the
organizational knowledge base (a structural asset).
Innovation
processes – represent the various processes and networks
that an organization needs to develop in order to enable its innovation
process and convert ideas and raw knowledge resources into marketable
products. For those organizations that produce no products or services
(ex. the Navy). This group covers critical decision making processes
that enable the organization attain its vision or meet its mission.
This group of intellectual capital is mainly composed of customer
capital and structural capital relating to business processes.
Intellectual
property – represent the various technologies, products,
processes, methods, marks, trade dress, software, publications and
other works that the organization has protected legally and can commercialize
independently as an intellectual product to maximize value. This group
of intellectual capital is mainly composed of structural capital and
customer capital relating to licensing of intellectual property.
Based
on this classification the CICM model manages the various groups of
intellectual capital under three stages of knowledge management, innovation
management and intellectual property management.
IC
Measurement
One very significant aspect of ICM is measurement as without measuring
outcomes, management will have no way of monitoring the success of the
various strategies and initiatives. Measurement is needed not only for
effective control management but also to secure funding for the various
initiatives. Return on investment and other methods based on financial
results are inappropriate in many cases to indicate the success of ICM
efforts in attaining management objectives. ICM practitioners therefore
resorted to the use of performance measures, which have been used since
the start of the 20th century to measure success. The oldest performance
measures were introduced by the manufacturing industry in 1920s to measure
the number of units produced per unit of time, and by the hotel industry
to measure room occupancy rates.
Business
managers however only used performance measures disparately whenever
financial measures proved inadequate to report on the effectiveness
of a certain management practice or program. With the advance of ICM
and the IC theory managers found they needed more performance measures
to monitor the growth of their intellectual capital, and the success
of ICM initiatives and programs. The main goal was to monitor the main
future value drivers. Financial measures were not helpful for this purpose
as they report historical facts and hence failed to reflect the organization’s
potential future performance. Performance measures directed at monitoring
the intellectual drivers of value had the ability to report on the organization’s
future potential, through monitoring a set of identified indicators.
A number of performance measures were developed with the advance of
ICM to measure the different types of intellectual capital. These performance
measures were developed under a number of approaches/frameworks –
mainly: the balanced scorecard method developed by Norton and Kaplan
[The Balanced Scorecard: Translating Strategy into Action,
Harvard Business School Press, Boston 1996] , the Intangible Asset Monitor
developed by Karl Erik Sveiby, and the Skandia Navigator developed by
Skandia AFS [See Edvinsson and M. Malone, Intellectual Capital:
Realizing Your Company’s True Value By Finding Its Hidden Brainpower,
Harper Business 1997].
Each of these models provides a framework for managers to identify certain
strategic goals (e.g. having loyal customers for example) then design
a set of indicators to monitor progress towards the identified goals
(e.g. customer satisfaction rate, response time and the like). Though
the balanced scorecard is not based on the IC model it still addresses
IC aspects under three perspectives in addition to the financial perspective
comprising: customer, internal business process, and learning and growth.
The
Intangible Asset Monitor deigned by Sveiby includes a set of measures
for internal structure, external structure and competence where they
are monitored in relation to three main yardsticks – efficiency,
stability, growth and renewal. The Navigator developed by Skandia presents
a set of indicators under four focuses in addition to the financial
focus: human, customer, process, and renewal and development.
Mainly
used for management internal control, performance measures have become
part of management’s accepted internal accounting practices in
many organizations. This has been further promoted by the balanced scorecard
since it does not require the adoption of the new IC model but merely
a recognition of the intellectual capital drivers of value in a business
and their importance in attaining strategic goals.
Performance
measures for ICM have been used for the following purposes:
* Securing funding for a certain business units, departments or programs.
*
Evaluation and appraisal of the performance of employees for promotion
and reward purposes.
* Evaluation of the performance of business units and departments whenever
financial measures are not adequate. It is worth mentioning here that
the US government enacted the Government Performance and Results Act
in 1993 making it a prerequisite for government agencies to show performance
before they can obtain funding. Since the mission of these agencies
is not to make profit, performance measures play an integral part in
showing progress and securing funding.
* To detect bottlenecks and business problems in certain programs and
departments in reference to a set of expected results before they affect
financial results or the overall performance of the measuring unit.
* Getting a full picture of the performance of certain business units
and the organization as a whole to assess opportunities for future growth.
* In isolated cases – Skandia being the most prominent example
– such measures have been used to report on intellectual capital
to external stakeholders and hence to supplement financial reports.
Sample
IC Measures
A
number of performance measures have emerged under the models mentioned
earlier, and in general. These include:
For
human capital
Level of education of professional employees, rate of turnover, years
in present employment (Sveiby’s rookie ratio), rate of women
employees (statistics indicate that the level of innovation increases
proportionally to the number of women employees in a workplace), employee
satisfaction
For
customer capital:
Customer satisfaction, response time, complaint rate, percentage
of revenue from major customers (Sveiby’s image-enhancing customers)
For
structural capital:
Support staff ratio, number of patents and citation rates,
use of databases (number of hits), brand equity
As
mentioned earlier, measures used to monitor the performance in relation
to intellectual capital have been used by few companies to report on
their intellectual capital to stakeholders. However these are examples
that stand out among a lot of controversy and confusion. The problem
of reporting on intellectual capital is the lack of uniform IC accounting
and reporting standards. Though this is not impossible, the state of
IC reporting and accounting is very muddled to say the least.
IC
Reporting and Accounting
Around
80% of corporate value is made of intellectual capital. Thus a business
intellectual capital is increasingly becoming a prime indicator of its
future performance and hence the ability of management to adequately
manage and capitalize on the intellectual resources of the organization.
Publicly traded companies in the US and many other developed economies
are increasingly reporting on their intellectual capital under voluntary
disclosure guidelines. In Denmark for example, the Danish Ministry of
Tradedeveloped detailed guidelines for businesses to report on their
intellectual capital to stakeholders. Those companies that decide to
report on their efforts to manage intellectual capital can use the guidelines
to report on their formulation and execution of intellectual capital
or a knowledge management strategies. In addition, few companies are
producing intellectual capital reports as supplements to their annual
financial reports. All these attempts however fall short of providing
a standardized way of reporting on intellectual capital.
The
result is that knowledge organizations and stakeholders are left with
the existing financial accounting and reporting system, - a 500 years
old system - under which publicly traded companies report only on 20%
of their value, which pertains to financial and tangible assets. This
leaves much of the valuation of the remaining 80% of the value of the
enterprise to market speculation. For business to realize maximum value
from their intellectual capital, the development of a reporting (external)
model that ensures reliability, and comparability within and across industries,
is a must. Developing intellectual capital reporting is essential for
the creation of the appropriate economic and business environment where
inveting in intellectual capital is not only encouraged, but is also is
subjected to the checks and balances of an open market.
Having
standardized intellectual capital metrics is vital for business decision
making in areas where valuation and alignment of intellectual capital
are essential to the success of the proposed venture, e.g. restructuring,
strategic alliances, outsourcing, mergers, and acquisitions. It is also
essentail for economic development in the knowledge economies.
The
current state (or no state) of intellectual capital reporting is cluttered
by a number of parties that step into the landscape to fix an immediate
problem or respond to certain market needs or pressures, then step out
again. The result is that immediate problems are addressed in partial
haphazard ways jeopardizing the chances later for the development of
a well-thought methodology for dealing with intellectual capital reporting.
In
the U.S. the Fiancnail Accounting Standards Board (FASB) and the SEC
reponded to the pressing needs of reporting on intellectual capital
to external stakeholders by condusitng and commissioning a number of
studies into the need for intellectual capitla reporting and the ways
that industry leaders responded to that need. Both FASB and SEC (dates)
acknolwedged the need for intellectual reporting but that the state-of-art
in measuring and accounting on intellectual capital is still too rudimentarty
for the development of reporting universal standards. FASB did not completely
shy away from the subject and came into the intellectual capitasl radar
again in June 2002 to regulate sime forms of intellectual capital -
resulting in the issuance of Financial Accounting Standards (FAS) #141
and 142. Though FASB's efforts are commendable , the lack of a well-thought
methodology that addresses all forms of intellectual capital (regardless
of being developed internally or acquired from outside) created ample
confusion in the busihness community. Again it provided a quick fix
that would most probably jeopradize future developments in the field.
FAS
141 (Business Combinations) and 142 (Goodwill and Other Intangibles)
refer to intellectual capital that has been acquired, as opposed to
internally developed, by a publicly traded company. The standards eliminated
the amortization of goodwill, requiring its separation from identifiable
intangible assets e.g. brands, patents and contractual agreements. Once
separated goodwill should then be allocated to a reporting unit where
its value is subjected to ‘impairment tests on an annual basis.
Identifiable intangible assets on the other hand are separated and treated
according to their useful lives. Assets with indefinite life e.g. strong
brands, are to be treated similarly to goodwill, while those with a
definite useful life, e.g. patents and copyrights, are to be amortized
over their useful life. Both types should be allocated to a reporting
unit, and in the latter case impairment tests are carried whenever circumstances
warrant, to adjust for changes in the value or the useful life.
Though
the new rules are promising as the accounting community is increasingly
acknowledgeing the need for transparency in relation to merger transactions
and acquisition of intellectual capital. The exclusion of internally
developed intellectual capital from these rules and standards may greviously
misrepresent the value of the intellectual capital base of the enterprise.
Reporting only on acquired items of intellectual capital while failing
to report on similar internally developed items will not only deepen
the disparities between the actual and reported value of the enterprise,
but may also result in an erroneous valuation of the enterprise.
Internally developed intangible assets are treated differently under
accounting rules and standards. Investments in the development of intangible
assets and intellectual capital are generally treated as costs that
should be written off as incurred, a method referred to as expensing.
Seen as business expense rather than investment in assets, expenditure
on developing intangible assets suffer under the constant pressure on
organizations to cut their business expenses and show short-term profits.
If seen as investment then such costs can be accounted as assets on
the basis that they will create future value (generate revenue or save
cost) over their useful lives, a method referred to as capitalizing.
The strong contrast in the accounting principles as they stand now is
that acquired intangibles are capitalized (and hence amortized over
their useful life) while their internally developed counterparts have
to be expensed.
The
rationale of the FASB behind this differential treatment is the uncertainty
involved regarding returns from developing intangible assets. Opinion
No. 17 provides that the cost of developing intangible assets may be
capitalized only if the period of expected future benefits can be determined.
FASB statement No. 2 took the position that research and development
costs should be expensed based on the high degree of uncertainty and
the lack of causal relationship between R&D costs and the benefits
received. FAS No. 86 on the other hand modifies this slightly when it
comes to computer software programs and provides that costs can be capitalized
after the technological feasibility of the software has been established,
and be amortized on a product-by-product basis over the useful life.
It is hard to see why the same standard cannot be applied to development
of other intangibles upon establishing their technological or market
feasibility.
The
latter is the position taken by the International Accounting Standards
Committee (IASC), and a number of European accounting standards boards.
For example the Netherlands allows the capitalization of both research
and development costs while New Zealand allows the capitalization of
development costs only. Germany on the other hand requires the expensing
of both. It is worth noting that both Australia and the U.K. allow for
the capitalization of the costs of brand development, unlike the U.S.
Tackling
the issue of IC reporting should be a concerted effort bringing together
the accounting profession, IC practitioners, business leaders, lawyers
and regulatory bodies. The next step will be working together to develop
a universal model for reporting on intellectual capital. Such a model
should achieve the following main goals:
*Identify
the intellectual capital that drives value within and across industries
and provide common indicators that monitor their progress
*
Create a standardized approach for reporting on intellectual capital
with the end goal of creating a comprehensive IC accounting system
that addresses all types of intellectual capital whether developed
or acquired by the organization.
*
Provide consistent, reliable, and comparanle measures that can be
monitored by a regulatory body .
