Importance of Intellectual Capital in the Modern Economy

Executive Summary

The report discusses the relative importance of the Intellectual Capital in the present economy due to the revolution that fosters the propagation of the value creation. The Intellectual Assets of an organisation play a vital role in improving its value and maintaining the competitive advantage. However, these intellectual assets are not capitalised in the financial statements as they are unable to determine their historic costs and their future benefits are sometimes uncertain.

Despite of this a lot of companies have discovered ways that facilitate the valuation , measurement and reporting of their intellectual assets i.e companies like Coca Cola , Marks & Spencer and Kingston Hull Plc have reflected their intangible assets such as brands separately from the goodwill on their company balance sheets as some guidance is provided by the International Accounting Standard in the disclosure of the intangible assets. The report also presents some theories that are aimed at eliminating the confusions created about the Accounting Profession.

As the Accounting Profession and the Accountants cannot be blamed as conservatives in not providing space for the Intellectual Assets in the financial statements because in doing so , the financial statements will loose their relevance , reliability and neutrality. The report further throws some light on the issues that are related to the field of Intellectual Capital that include that there is no uniformity in the relative theory as there is no such definition and the Intellectual Capital model that is accepted generally.

In the end the report concludes by suggesting that the under the supervision of the International Accounting Standard researchers, consultants, scholars and the accountants have to find a common way such that the value relevance of the Intellectual Capital and the principles of accounting are preserved.

Aims and Objectives

The aim of this study is to discuss that whether the exclusion of the Intellectual Assets of an organisation in the balance is realistic and pragmatic. As the Intellectual Capital is considered a value driver for the modern economy and a lot of organisations are focusing on their intellectual assets as compared to the intangible assets.

Objectives

The objectives of this study include:

• To assess the importance of the Intangible assets as compared to the tangible assets of an organisation.

• To provide some evidences about the organisations attitudes and the awareness about their intellectual assets.

• Finally, to conclude that whether the eviction of the Intellectual assets is pragmatic or not.

Rationale

The Current Gobal economies are now facing a new revolution that brings them to a new form of business environment. This major change in the world economies is due to the fact that there has been a disproportion observed between the Book Value and the Market Value of a firm. Because , in the past the Balance Sheet and the Income statement were the only tools used by the Shareholders ,managers and the executives to make strategic decisions and monitoring the performance of the company.

However, it can be argued that things have changed now. As one of the important concern for the companies is the Value Creation.

The expansion of the markets in the product or a service sector has been possible with the aid of the internet , high- technology and the innovation ,information , market chains and globalisation. This in turn has created a global competition among the firms that are now striving to acquire knowledge. Furthermore, the acquisition of the knowledge brings some vital concerns of its use, management and the improvement.

This has changed the operations of the the organizations that used to emphasize on the production capability ,now focus on the creative operational structure. The organisations are now using the special tools for acquisition, management and the protection of knowledge such as Research & Development , Patents , trademarks , copyrights , databases , customer and supplier relationships and Human Resources are known as the intellectual assets of the organization and constitute the Intellectual Capital.

The relative importance and the expected returns of the Intellectual Capital has convinced the organisations to think and work in a new innovative way to achieve dominance over the competitors in the market. However , inspite of this the Intellectual Capital has not been considered in the performance appraisals and not included in the financial statements under the heading of assets.

The organisations are spending a lot on the Intellectual Capital as compared to their tangible assets so therefore it is not wise to go against the flow of current market trends by focusing more on the tangible assets. This would lead to the creation of inaccurate procedures, policies and the decisions. Hence reducing the value in front of the investors and the customers.

Cowey (1999), approves the conception of a “New Economy “ and the “ Knowledge Company ” and insists that this concept accepted world-wide. He demonstrates that the opinions of “ what we own ” to “ what we Know ” have changed and know it depends upon the companies to apprehend the value creation by putting stakes in the training technology , staff retention and knowledge otherwise the efforts will not be productive.

The Organisation for Economic Co-operation and development (OECD , 2005) reports that the investments in the Intellectual Capital has grown faster than the investments on machinery and equipment few years back. It is further revealed that the spending on the Research & Development , software and the higher education was higher than the spending on the Machinery and the equipment in USA and Finland notebaly in 2002 and increased in greater proportions between 1994 & 2002 among the OECD countries as well.

Arora(2000) purports that the the edge on the competitors in the challenging business environment can only be achieved by the proper administration of the Intellectual Capital which is another name of the Knowledge management.

Kaplan & Norton(2001) suggest that the company’s market value includes only 10-15% of the company’s book value of the assets. Furthermore, the possibilities of producing a value are risen through the the activities whose foundation is the knowledge that is enforced on the intangible assets of an organisation as compared to tangible assets.

A Convention held under the OECD(1999) , concludes that a prominent set of information is required on the Intellectual Capital in its association with the tangible assets in the determination of value. Traditional Financial Reporting does not provide the necessary information to pursue the value creation process.

Due to the availability of the information via internet technologies there is a need of a new reporting model that accommodates the information pertaining the Intellectual Capital that creates the value for customers and suppliers.

Bradley(1997) discovered that the predicaments that were involved in the traditional financial accounting were due to the emergence of value. He explained the problem by arguing that the balance sheets and the income statements were the benchmarks in delivering the financial information to the shareholders. However, the significance of these financial statements in propagating the value has decreased due to the emerging trend of investments in the intangible assets.

It is stated that the value of the brands was not reflected in the financial statements and in the equity values .This has led to the reconsideration of the intangible assets and the brands specifically. This fostered the proposition of of including such assets in the financial statements. However , the accounting profession does not fully supports the the idea that the intangible assets are the main factors in creating the value.

On the contrary the investors and the trade leaders have acknowledged this truth. Furthermore, it is also quoted that 72% of the value was not reflected in the balance sheets of the companies surveyed in United Kingdom. Brands form the major part of the unexplained value that is not part of the balance sheet (Brand Finance plc , 2000).

The Figure 1 shows the Gap between the market capitalisation and the net asset value.

Why Intellectual Capital

Upton(2001) reports that the companies under the scrutiny of the FASB Business Reporting Research Project provide considerable non- monetary information. Therefore it can be argued that the AICPA and FASB have been analysing the Intellectual Capital since 1991.The Intellectual Capital is considered endangered when the information of a company becomes obsolete when the competitor increases its information.

Therefore the preservation of the Intellectual Capital is crucial for maintaining the competitive edge. However,the companies that are knowledge intensive are prone to risks of losing their market shares(MacDougall & Hurst,2005).Guthrie(2000) suggests that “Accountants must find a to incorporate measures of Intellectual Capital or they will become irrelevant “.

Statement of Methodology

The method used in the report is the study of the literature that is already present in the field of Intellectual Capital and the Accounting to support the arguments.After, the study necessary facts and evidences are combined to form the Literature Review of this report. This report does includes the collection of the primary data and its analysis. A case study is added to further enhance the understanding of the applications of IC in firms.

Research Question

The research question is “ Is the exclusion of Intellectual Assets from accounting statements realistics?”

The research question of this report is basically a debate that is going on in the academic, industrial and the business sector. This topic demands study to be commenced taking in account both the views of the implications of including or excluding the intellectual assets in the financial statements.

Literature Review

Definition of the Intellectual Capital

The Organisation for Economic Co-operation and development (OECD , 1999) illustrated that the Intellectual Capital was the composition of the financial value of two classes of the intangible assets i.e

• Structural Capital

• Human Capital

The structural Capital includes the organisational resources like the softwares, databases etc. The Human Capital however, contains the human resources employees (internally) , customers and suppliers(externally).

The term Intellectual Capital is presumed as having the same meaning as the Intangible Asset. In contrast , the definition that is provided by the OECD(1999) puts the Intellect Capital as a subset of the intangible assets of an organisation.

Because there are certain intangible assets that do not fall under the category of the Intellectual Capital. The repute of a firm is not considered as a part of the Intellectual Capital(Guthrie & Petty , 2000).

Stewart(1997) defines the Intellectual Capital as a “ Intellectual Material “ that Includes the knowledge , information , intellectual property , experience that can be used to generate wealth. Furthermore , Stewart (1997) categorises the intellectual capital in to structural , customer and the human capital. He argues that the human capital is the generator of the innovation and the improvement.

The structural capital includes the tools and the facilities that are used the human capital to form value. Customer Capital includes the value that is produced as a consequence of the organisations relations with which performs the business transactions(Stewart , 1997).

Intellectual Capital can also be defined as the combination of the human capital and the structural capital. The human capital includes the knowledge , skills and the experience of the employees. It is further argued that the human capital is not in the possession of the organisation as compared to the structural capital (Edvinsson & Malone , 1997).

Elements of the Intellectual

Structural Capital

Structural Capital is what is left behind in the organisation when the employees go home. The Structural Capital arises from the those organisational processes that are focusing on the improvement and the establishment of the organisation. (Roos et al , 1997).

Bontis et al (1999) suggests that the structural capital includes the organisational resources that encompass the knowledge that is not actually stored in the human brains and whose value is greater than its physical value.These assets include databases , softwares , manuals , trademarks , leaseholds , franchises , patents , licenses , employee training , employee contracts etc.

The structural capital plays an important role in the creation of the value. As it helps the human capital to explore new ideas , learn from the past experience and protects the knowledge and the new inventions by providing the technology and the legal aid.

Customer Capital

Kohli & jaworski(2000) defined the customer capital as the organisations ability to evolve the knowledge about market that is focusing on the cutomer desires and perceptions.

This acquired knowledge is used by the organisations in response to the changing attitudes of the customers and the market. Organisations use this knowledge to have a contingency plan to tackle the threats produced from changing market trends.

The definition provided by Bontis(1999) suggests the customer capital should be iterated as the relational capital that includes the relationships with the suppliers, partners and the investors in addition to the relationship with the customers.

Human Capital

Hudson(1993) defined the human capital as the composition of the inheritance, qualifications , experience with the opinions about life and business.

It is further argued that the organisational employees are the key architects of the Intellectual Capital through their proficiency , opinions and expertise. The competence of the employees includes skills and qualifications and their opinions come under their behaviour and perceptions about work. The expertise is important in devising the innovative solutions to the problems. Furthermore, employees are an important asset for an organisation but they are not owned assets(Roos et al , 1997).

Exploitation Of Intellectual Capital (Economical Perspective)

It is suggested that the critical factor in the improvement of the economy is the proper utilization of the Intellectual capital .It is further noted that by increasing the tricks of Intellectual Capital will provide a competitive edge and the value of the firm will be augmented and specifically business will bring financial benefits. It is not a new thing that the intangible assets like brands, intellectual property , relationships are considered as a unprocessed input for the organization that increases the worth by the application of intelligence in possession of the organization.

(Watters et al 2006 , Intellectual Assets Center , Glasgow, Uk).

The research on the recognition and reporting of the intangible assets and the intellectual capital has brought them to the acute attention.The research believes that the intangible assets play a significant role in the creation of endurable competitive advantage with in the advanced organsations.Due to the expansion of the modern knowledge based economy it has become transparent that the intangible assets and the Intellectual Capital of an organization have become a platform in accomplishing the competitive advantage as compared to the hi-tech tangible assets(Drew , 1999).

Tayles et al (2005) have described two doctrines in the realization of the intangible assets that provide the assistance in the achievement of the competitive superiorty. The research is continuously striving to find the authentic procedures to measure the intangible assets and the indices that provide a forecast of the future economical benefits based upon the doctrines that are prescribed by Tayles et al (2005).Firstly , the expanding financial statements of the companies is the idiosyncracy of its Intellectual Capital that give the edge on the market competitors. Secondly, is the inefficient justification of the Intellectual

Capital in the expansion of the economy(Tayles et al , 2005).

Skinner (1986) purported that with the utilization of the technology, manufacturing productivity can be achieved by the intangible assets of the company which are the authentic reagents of the prosperity and that justify the monetary investment.

How the Companies Exploit the Intellectual Capital

Case Study

Kingston Communications(Hull) Plc is group of companies based in Hull,United Kingdom. The groups is presently offering the services related to information, communication technology and the telecommunications to the consumer markets in UK. The groups Brands include Affiniti,Smart 421,Jam IP(Integration and management services),Karoo, Eclipse, Mistral (Internet and Telecommunication services) and Hull Color pages and Know( Information Services).

The group is Ammortising the its Intangible Assets that aquired in the Acquisitions.In 2007,the ammortisation on intangibles was ₤8 million(from Total depreciation and ammortisation).The group also has purchased the tangible and the Intangible assets worth ₤30.2 million.The Groups Controlled measures include, measuring the learning and development(p9),Customer Satisfaction.

KM also believes that Human Resources when managed through and effective Policy can bring the Tangible effect on the companys performance. KM is running a development program to enhance the Knowledge and

Intelligence of the employees.The company also manages the Relational (Custmer) Capital by arranging the meetings of the Directors on the Investor relations and the shareholders concerns specifically.

The Company’s publishes its Financial Reports complying with the IFRS,however, the company also provides additional disclosures if compliance with the IFRS does not fullfil the requirements of the users(i.e External Stakeholders,External investors,Suppliers and the Customers) to understand the impact of certain transactions that have an effect on the financial performance of the company.

Relational Capital Management and Policies

Arranaging meetings with the shareholders time to time to discuss the company’s strategies and performance.Maintaining a investors relations function to encourage and improve the communication with the investors.

The Goodwill of the Company in 2007 was worth ₤192.754 million(2006:₤155.551 million) and the Intangible Assets had the value of ₤48.511 million (2006 : ₤39.450) according to the Balance Sheet on 31^st march,2007.

The Cash Flow Statement of the Company for the year ended 31^st march,2007 also explicitly show the Amounts of the Ammortisation of Intangibles as compared to the tangible fixed assets.The Cash Flow statement also show the companys procurement of the Intangible assets ₤6.495 illion in 2007.

The financial statements of the Company are prepared according to the principles prescribed by IFRS and IFRIC.These financial statements are based on the concept of historical Cost accounting.However, the statements are modified due to the revaluation of the financial assets to a fair value by using the income statement.

Intangible Assets Identified by Kingston Communications

The Intangible Assets of the Kingston Communication include:

1.) Goodwill

2.) Customer and Supplier Relationships

3.) Technology and Brands

4.) Software

5.) Development

Goodwill

The Groups Goodwill is reported in the acquisitions of the subsidiaries and it is the difference between the Cost of Acquisition and the Net Assets. The Goodwill is tested for impairment annually.

Development

The company’s intangibe asset that is developed through the research and development activities only when it fulfils the criteria of Intangible Asset Recognition prescribed by IAS 38 i.e the asset is identifiable,impact on future cash flows and the developmental costs of the assets are measured reliably.The estimated life of the internally developed intangible asset is 1 year and is also ammortised on a straight line basis.

Valuation of the Intangible Assets in Kingston Commnuications

The intangible assets that are acquired through the acquisitions are valued on the basis of their time value and the future impact of on the performance of the companies.

Appraisal of Intellectual Capital in Kingston Communications

The Kingston Communication is exploiting,managing and reporting its Intellectual Capital as tool necessary for the competitive advantage and for improving the future performance of the company. According to the companies policy the Intangibles Assets are included in the Balance Sheets in order to satisfy its investors and guarantee the future investments in the company.

However, there are no benchmarks for the management and the evaluation of the these Intangible assets.Also, the company is not using the models for the

Classification of these Intangible assets as suggested by (Kingston Hull plc , 2008) Measuring the IC (Performance)through strategies(Management Accounting)

Simons(1999) suggests that the by measuring the performance of a company is basically the comparison of the outcomes of the business activities with the critical business targets.

The traditional financial accounting utilizes two techniques to measure the Performance .These are Return on Capital Employed(ROCE) and Return on Assets (ROA). However , these techniques are condemned due to the fact that they are old fashioned , unable measure the intangible assets and are unable to appraise the stakes in the technology which is essential for the firm to compete in the global market(Bourne et al , 2000; Amir & Lev , 1996).

Valuation Methodologies(Performance Measures as well)

The economic measure of the Profit yields the same result as the traditional accounting during the matching phase of costs and revenues by preserving the value significance. This is done by improving the financial reports with the disclosure of the concealed assets like the intangible assets and the investments in the long run(Simons , 1990).

(It includes the tools and various methodologies ) Watters et al(2006) have discussed the application of a Scorecard assessment tool in the Scottish SME that provides a review that how efficiently companies are exploiting their Intellectual assets.The tool helps the SMEs to manage three areas of operations i.e Sales and Marketing , Research and Development and Human Resources. It assign the scores to activities that come under the three operational areas according to their effectiveness and links them to the strategic objectives of the firms.

(Appendix 1)

Brand Finance plc(2000) suggests that there are a lot of methods present for the valuation of the Brands, however there is a need to find an optimal one. Cost based methods of brand valuations show a disparity from its market valuation.

The Market Comparison method is not efficient as it is difficult to obtain the comparison data. Royalty Relief method determines the royalty rate on the estimates of the income generated from brands. However , this method does not clearly states that how a brand is going to create value. The Economic Use method combines the consumer and the competitor to entitle the value to the brand.The last method is the most optimal method which is the Brand Finance that uses the Discounted Cash Flow (DCF) analysis in concluding the value for a brand.As the Discounted Cash Flow method valuation complies with the valuations performed by the financial analysts , accountants to check for the impairment of the intangible assets.

Measurement of Intellectual Capital

Why there is a need for the companies to measure the intellectual capital

This is a very long debate that why companies need to measure the intellectual capital.There are several advantages of doing that. The term intellectual capital can be said to be “expandable” in terms of the Value and rewards. The greater the effort of a company the greater is a competitive advantage and greater is sustainability of the company.

Nowadays companies and the firms have become Knowledge aware i.e they have now recognized the importance of the of the knowledge that creates value and sustainability. The Companies working in the Telecommunication, Pharmaceutical and the research technology sector specifically have to invest a lot in the Research and Development to compete and develop the innovative solutions to avail the opportunities in the market.Therefore, there is a strong need for these companies to devote themselves to measure and manage their intellectual capital effectively.

However, it is very difficult to justify the investments in digging out the knowledge that creates value .These investments are rather very complex and unpredictable even if they are tested and analysed by the efficient tools for their proficiency.

Some Organisations that are knowledge based are sometimes not sure about the amount of the Knowledge they have and the amount of knowledge they need tocarry out their functions internally and externally. That is the reason, these organizations loose the interest of the investors and therefore the investment.

Balanced Scorecard (An Alternative to Balance Sheets)

Kaplan & Norton(1992) , presented the theory of the Balanced Scorecard for improving and tracking down the performance of an organisation. The authors suggest four dimensions such as Financial , Customer , internal business process and learning and growth. These dimensions are believed to provide a insight in to the current performance and identify the factors that can improve the future performance.

A combination of the non-financial and financial measures are insufficient in determining the performance of an organisation. The main problem is that its just like a Wild Goose Chase as this amalgam of the performance indicators are not pursuing a specific business objective.

Kaplan & Norton(1996) believe that the both the financial and the non- financial measures must have a focus on a goal that has to be achieved in maintaining the sustainability. The authors further argue that the various measures provided by the balanced scorecard can help the organisation to plan a particular strategy and then can implement it across its subsidiaries, departments to share a common motive with trasnparency. A well planned BSC can hep the organisation to learn from the short-term reports that are generated and scrutinized through various perspectives.

Andriessen(2004) suggests that the predicament of measuring the Intellectual Capital can be resolved by applying the balanced scorecard. It has been advised that the specified strategy plans can be created that guide the organisations to confidently invest in the human resources, technology and the structural capital. It is further revealed that by measuring and administering the intellectual capital can also help the organisation to convert its non-monetary achievements in to monetary achievements(Kaplan & Norton , 2004).

A study conducted by Hagood & Friedman(2002) devised a way for the implementation of the balanced scorecard to measure the accomplishments of the human resource information system of a company. They have developed a system that uses the balanced scorecard as its foundation to improve the human resource information system in association with highlighting the goals and objectives of the organisation.

Despite of its usefulness the Balanced Scorecard has some limitations. In this context Voelpel et al (2006) has identified five limitations of the balanced scorecard in its application in the modern economy. First being its inflexibility that is, it measures the performance of a company only in four perspectives by leaving behind some other perspectives out of attention. Voelpel et al(2006 ) explain the second limitation which is that the BSC is less efficient in accommodating the changes in the changing economy.

The BSC a defines a strategy for a company and its subsidiaries to achieve a goal by neglecting the individual goals of a subsidiary as a consequence a company is unable to use its potential properly. The third one is that BSC focuses more on improving the internal performance of an organisation therefore by losing a link with the external world to exploit the innovation.The forth limitation of a BSC is that it focuses on the organisation in itself and provides no information about the actions of competitors. The fifth problem with the balance scorecard is that it goes straight in measuring the performance in a rational way .As a consequence the more complex predicaments are difficult to apprehend(Voelpel et al , 2006).

A Comparison between the benefits that arise from intangible and tangible assets

There are risks involved with the investment in the intangible assets like R&D. Kothari et al(1998) have conducted a research by comparing the uncertainty of benefits associated with the tangibles and the intangibles assets.

The methodology used for this research was the regression analysis of the future earnings variability involved with the expenditure in Research and Development and the tangible assets .Furthermore , the variables like firm size and the leverage are also used to define the boundary of a research.It has been illustrated by Kothari et al (1998) that the future benefits of R&D investment are more uncertain than the tangible assets. Shi(2003) has analysed and studied the relationship of bond prices and the measures of R&D expenditures and suggest that there is a fair risk involved with the spending of the R&D projects that increases risk factor with the bondholders claims and hence are more riskier than the other projects.

Issues in Intellectual Capital(Flaws in the IC Concepts)

Bontis (2001) discovered a predicament with the intangibles assets is that there is no unique conception that is accepted by everyone. Every investigator or a consultant who contributes to the debate expects the approval and recommends his own jargon.

Various other researchers have pointed out flaws in the definitions of the Intellectual Capital. According to Edvinsson and Malone(1997) the intellectual capital was the difference of Market value and the Book value. In contrast Upton(2001) recommends that the intellectual capital cannot be absolutely characterized by simply calculating the difference of market and book value.

Following that Habersam and Piber(2003) advocate that the term intellectual capital cannot be determined by the difference of market value and the book value. Pragmatically, the difference can be influenced by some other elements that are not associated with the intangibles.Further research enumerates five components that can realize a change in the the stock prices which incorporates the recognised assets , company liabilities , legal events , shareholders equity and the timing issues(Garcia-Ayuso 2003).

The benefits received by a firm cannot be attributed to the individual intangible Assets as such benefits are a result from the inter-cooperation of more than one Intangible asset. Therefore, it could be wise to value the intangible assets all together. It is further argued that the market value of a firm cannot be ascribed to the intangible asset