Understanding Intellectual Capital beyond IAS 38

For the next 2 to 3 articles we are going to introduce and discuss intellectual capital (IC) and knowledge management. For you readers that continue to be excited about discussing financial accounting standards, don’t worry we will get back to them with IAS 23. But on a serious note, as you will read in these 2 to 3 articles, financial accounting standards do not by definition recognize all true assets. Yes, intangible assets are recognized but only to a limited extent. Read the comments below by Mr. Hans Hoogervorst, Chairman of the International Accounting Standards Board (IASB), the shortfall becomes very apparent. In these articles you will also observe that IC includes “human capital” i.e. employees, not ordinarily recognized under financial accounting standards. Thus IC embraces a broader scope of what are intangibles compared to what are considered to be traditional intangible assets under IAS 38.

Throughout these articles we have stressed repeatedly that accounting, assets and liabilities, must adhere to the Framework. We have also discussed that by definition an asset must have derived future economic value i.e. revenue. Intellectual capital does not violate the Framework as we will discuss. IC very simply recognizes what was previously off the books. As you will learn eventually there is a parallel with special-purpose entities that at one point were also never recognized.

“The lack of measurement of intangibles at micro-level (i.e. company) is another recurrent policy priority which underlies many of the above issues. Shared methods for valuation and accounting are a relevant basic issue which may explain the difficulty to see intangibles in company annual financial statements and disclosures. This issue is particularly true for internally generated intangibles, such are – in many cases – the IPRs. As Mr. Hans Hoogervorst, Chairman of the International Accounting Standards Board (IASB), pointed out recently “Intangible assets go unrecorded (or under-recorded) on the balance sheet…. we know that the [accounting] standard [IAS 38] is rudimentary because it is based on historical cost, which may not reflect the true value of the intangible asset” (June 2012).”

Again, despite what may appear to be a digression from the previous articles, accounting for IC does in fact create a supplementary balance sheet also based on the debit and credit system in the same way as financial accounting standards. Thus IC accounting creates a recognition of otherwise not-reported or off-balance sheet assets. The charts below should be studied carefully.

 

The above Financial balance sheet is exactly what we have been covering thus far in these articles. The only difference is now the introduction of an IC financial statement assets and liabilities using the same principles of debits and credits i.e. the accounting model.

 

 

 

 

 

 

 

 

 

 

 

 

 

We’ve a lot more to discuss, next week onwards, including definitions

Next week, relative to IC, we’ll start addressing:

Differentiation ~ businesses must differentiate themselves from the competition to stand out to potential customers. 

#1 reason why managers fail: inability or inaptitude in retaining top talent. Many bosses have this attitude that anyone is replaceable easily like gloves, that they can hire someone even better. They are fooling themselves, and do disservice to their company and they may lose their own future. A good employee has knowledge of systems, products and processes. They have trust relationships with clients and co-workers that takes years to build.

Think about this simple statement, is it better, from a marketability and fund-raising perspective, to have more high quality assets being reported than less! Being a no-brainer I suspect the answer is intuitively obvious and thus why is IC not being embraced. Difficulties of measurement is not a response!! Consider Skandia!

In 1991, Skandia AFS formally established an Intellectual Capital function headed by a Director of Intellectual Capital-the first ever in the world. Oh, if 1991 seems ‘dated’, consider the history of lease accounting:

1949: The Committee on Accounting Procedure determined that operating lease accounting shouldn’t be used for long term leases. They issued the bulletin, Disclosure of Long-Term Leases in Financial Statements of Lessors, which required finance leases to be recorded as a leased asset and long-term liability. However, since capitalization was not required by GAAP, most lessees still used off-balance lease reporting. (https://explore.leaseaccelerator.com/history-lease-accounting/ )

“W HEN YOU BUY A COMPANY, what do you buy? The fixed assets? Or do you look for some more sustainable assets? What do you measure? The number of customers? The number of nodes in the network of the virtual corporation? What do you value? The number of working hours? The number of good ideas? The reason why Skandia started to focus on intellectual capital was, among other things, a need for a new logic regarding the development of knowledge intensive services. This is based on the very simple metaphor of a tree with fruit as well as roots. For the long-term sustainability of an organization it is much more important to focus on nurturing the roots than harvesting the fruit. The long-term idea might even be to get a new balance with a leadership focus on how the tree is flourishing. A focus on intellectual capital provides an effective instrument to manage and develop the company. It will also serve as a useful indicator when benchmarking the company against other companies. It will stimulate renewal and development. It is also a better tool for evaluating the soft assets of the organization. Therefore, in the final analysis, intellectual capital becomes at least as important as financial capital in providing truly sustainable earnings.” End quote. Long Range Planning, Vol. 30, No. 3, pp. 366 to 373,1997 (Leif Edvinsson)

Now consider these ‘Google’ definitions relative to Skandia and the concept of IC.

Differentiation ~ businesses must differentiate themselves from the competition to stand out to potential customers. 

Commoditized ~ it is the movement of a market from differentiated to undifferentiated price competition. 

Holistic ~ characterized by the belief that the parts of something are intimately interconnected and explicable only by reference to the whole.

Competitive advantage ~ in business, a competitive advantage is the attribute that allows an organization to outperform its competitors. A competitive advantage may include access to highly skilled labour, geographic location, high entry barriers, and access to new technology.

#1 reason why managers fail: inability or inaptitude in retaining top talent. Many bosses have this attitude that anyone is replaceable easily like gloves, that they can hire someone even better. They are fooling themselves, and do disservice to their company. A good employee has knowledge of systems, products and processes. They have trust relationships with clients and co-workers that takes years to build. When you lose a good employee, you lose part of your culture. You lose part of your company and they may lose their own future.

Thus with IC, we’re looking at:

o  Human Capital

o  Customer Capital

o  Structural Capital (Organizational Capital)

Last week we said, accounting for IC does in fact create a supplementary balance sheet also based on the debit and credit system in the same way as financial accounting standards.

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Now, let’s try and put this into perspective. Let’s say we have two small entities one on the East Coast and one on the West. Both entities start off with the same capital, rent an office, purchase furniture and equipment and hire employees. Let us also assume that both businesses are attempting to find a cure for the common cold, certainly most desirable. Based on this information, the financial statements i.e. particularly the balance sheet would pretty much look identical. We’ll also make an assumption that the costs of setting up business were also very similar.

Having dropped a hint above, the founder, on the East Coast, is both a researcher and a doctor and has hired other doctors, researchers, to assist in the work. The entity however on the West Coast has a founder both a doctor and researcher but also a PhD. On the West Coast as well, the founder has hired a similar number of employees to assist in the work but besides being researchers and doctors, they are all PhD’s as well.

Understand though that this additional information is still not disclosed in the financial statements, and at surface level their financial statements are still very similar. It would be reasonable to assume that the providers of capital would consider that these entities have an equal opportunity to succeed. Let’s add a caveat that in both entities irrespective of qualifications the payroll is quite similar. At this juncture all the expertise and knowledge can be classified as tacit.

Now let’s start mixing things up a bit. On the East Coast the founder though very well-qualified and experienced has a certain disdain and indifference towards accountants and infrastructures. His/her time they believe, is better spent

focused on the mission of the entity, that is to produce a cure for the common cold. This attitude effectively creates the corporate, politically orientated culture such that the accounting (bean-counter) personnel are pretty much isolated to do their work and instructed not to interfere nor disturb the researching function.

On the contrary, the West Coast founder believes in a very participative style of management with all functions cooperating to help each other. (continued)

IC and knowledge management is accounting absent IFRS accounting standards. Such contrasting internal information is critically valuable.

More next week.

To all the diehard fans out there, seriously, that are all anxiously waiting for the next IAS article understand where IC and knowledge management fits in. These three articles discussing IC highlights a gap in completeness of financial information. If you go back to our earlier articles one of the objectives of the framework was to enable investors and stakeholders to effectively predict future cash flows and income growth. It is readily apparent now that financial statements in their present state of compliance lack that ability. Effectively IC brings to the surface information that greatly enhances the ability of stakeholders to predict as well as make buy and sell decisions. Consider, for example, the complexities of revenue and lease accounting (IFRS15 and 16), as well as financial instruments and derivatives. And let us not forget the upcoming insurance accounting standard IFRS17. Relatively speaking therefore, it is a reasonable probability that, with efforts, IC building blocks currently off-balance sheet, would arrive at a valuation model capable of analysis and financial interpretation providing credibility. Accounting has always been an art not a science and under accounting standards judgment is often called for where precision and perfection (however defined) is just not attainable.

Continuing from last week: On the contrary, the West Coast founder believes in a very participative style of management with all functions cooperating to help each other. Each week all functions gather together to update how things are coming along. The West Coast founder was very concerned that should one of his staff, a PhD researcher, leave the firm that all critically valuable researching information to date would effectively walk out the door and be lost (a noncompete clause wouldn’t necessarily be too helpful). Fortunately, with his son being a CPA (ok, ok called poetic licence), he respected the role of accountants, understood the importance of process flows and infrastructure and especially after long discussions with his son, happens occasionally, recognized the importance of documentation, critical in auditing of course. He also understood that without an advanced electronic e-filing and document recovery system little would necessarily be gained by old-fashioned paper documentation and filing cabinets. Thus he required, before the end of each day, for all researchers to dictate the days efforts, what had been achieved, any breakthroughs, and if any bottlenecks were being experienced. But most importantly and very shortly after the entity opened its doors, even before research had begun, he requested that each researcher take whatever time that was needed to dictate their thinking. What was the approach

they were planning to use, and what problems they were anticipating could arise and what steps could be put in place. Thus before even a day’s work had been completed the expertise and PhD’s experience was now explicit and safely part of the entity.

So therefore, given our two hypothetical scenarios, East and West Coast, if our IC balance sheet were developed, which entity would greatly enhance their asset base and by definition use that leverage to gain additional much-needed funding. Funds, which otherwise, would probably not be forthcoming. Often times, small micro-entities (SMEs) given the scant nature of their balance sheets struggle to obtain the necessary funding for research.

Now let’s revisit these concepts pertinent to IC.

·      Differentiation

·       Commoditized

·      Holistic

·       Competitive advantage

·      #1 reason why managers fail

Were both East and West entities to have the same culture, same type of founder, researchers that had the same background and qualifications etc. then commoditized would be an apt description? Furthermore, applying IC and knowledge management would probably add very little value. However on the contrary with the very deliberate stark differences (in my story) it is very apparent that the West Coast entity has significant assets that need to be brought to the surface on an IC balance sheet, supplementing the official financial statements.

So what are they, what are the undisclosed differences?

Human Capital:

1.    Know how

2.    education

3.    work related knowledge

4.    work-related competences

Structural Capital:

1.    management philosophy

2.    corporate culture (participative management)

3.    management processes (documentation)

4.    information systems (e-filing, capturing and recording know how)

Certainly there is no question that implementing an IC system (supplementary balance sheet) is no easy task and many organizations will struggle with applying the concepts. It is also very likely that employees may be very reluctant to document/record their expertise and knowledge (explicit information). That expertise and knowledge could well be construed as providing leverage for both promotions and salary increases. And employees may see it as a loss of identity and marketability. Employers may see it as strengthening their market position, their external reputation and enhancing their brand name. As an IC balance sheet is venturing into unknown territory, the possibility of gaining additional funding, leveraging these IC assets, initially requires full implementation. Banks are highly unlikely to document their position until a legitimate and credible IC balance sheet is presented to them. Thus there is a dichotomy as employees potentially see it as a threat and employer’s, i.e. , management, consider IC balance sheet as supporting additional funding opportunities.

In conclusion, a supplementary IC balance sheet can provide significant value to both sides of the coin. Any entity, for example a small researching SME (our East and West entities), clearly needs additional leverage to obtain additional funding over and above that supported by typical financial statements. If funding is simply supported by an official financial accounting standard, a set of IFRS financial statements, from a collateral perspective along with 3 to 5 year business projections may be insufficient. From the bank’s/lenders viewpoint such small entities start-up position may be classified in a high risk category, which is totally understandable. Now introduce beneath the surface high quality IC assets, our West entity.

Don’t forget risk from a bank point of view is based upon the probability of success and a very minimal potential for losses or debt default. If a financial lender, i.e. a bank and others, now realize this researching entity is supported by PhD’s, a well organized and structured organization, a participative culture with captured explicit information documented, the picture will suddenly change. And, very important, additional funding provides employees with a stronger future, remuneration incentives and career opportunities.

For the paper including images, contact Peter Welch ([email protected]) This was published in Lucubrate weekly magazine. Peter Welch publishes weekly accounting articles, having submitted 29 articles to date since March 2018.