Slip of the tongue

Fitting the intangible pieces together: a call to arms

most do not understand intangibles. This is If intangibles are ever to achieve the a problem because knowledge intangibles prominence they should in business, are the key to the future of our firms, our a common language that describes communities and our national , what they are and how they are as well as the general one. Each kind of intangibles specialist has something to deployed needs to be developed bring to the table. But we must all come together and create a holistic view that By Mary Adams and Michael Oleksak makes sense of the confusing picture facing businesspeople when they try to figure out If you are reading this magazine, then at one what we are talking about. time or another your interest in intangibles This article describes the perspective of will have put you in the following situation. five of the principal kinds of professional that You are at a business event and make a new influence how intangibles are understood acquaintance. The two of you start chatting today: accountants, , investors, risk about intangibles. The other person tells managers and business managers. Each you enthusiastically that, yes, they work perspective is examined individually and then with intangibles too. But within a few a suggestion is outlined of how to pull them minutes, you realise that they have a all together. The goal is to develop a holistic completely different perspective. They don’t view of intangibles management that can see the field in the same way that you do. show a mainstream businessperson how to You have completely different philosophies. manage the growing intangible side of their You don’t share a common definition of business and take advantage of the expertise even the simplest terms (starting with the of each of these professions. IAFS very word “intangible”). You walk away This article is sponsored by the Intangible unsure of whether you will ever speak the How intangibles are seen today Asset Society’s Member News same language. We live at the intersection of the industrial Committee. The objectives of the Society Put yourself in the shoes of the average and knowledge economies. Yet most of our (www.iafinance.org) are to increase the businessperson. It’s the same for them. ideas about business and management are visibility, transparency, and value of Every time someone talks to them about legacies of the industrial era. This is intangible assets through education, intangibles, they get completely different especially evident when you look at the advocacy and the promulgation of information. The definitions, the details different views of intangibles held by each of standards. The Member News Committee and the vocabulary vary. The priorities the featured perspectives featured in Table 1. spearheads the Society’s education efforts appear different, almost contradictory. It’s None of the professions described in this through the Mission:Intangible Monthly no wonder that most businesspeople ignore article sees its jobs as intangibles Briefings, a conference call on the first Friday the trend of the booming importance of management. Intangibles have just crept into of each month featuring a moderated intangibles that we in the field see with the job description thanks to the shift from conversation with two or more authorities. such great clarity. Each of us is providing the industrial to the knowledge era. Table 1 IAM magazine, a Globe White Page Ltd just a piece of the puzzle. Very few of us are makes clear that each of these perspectives is publication, is the media partner of the trying to fit these pieces together. a consequence of the job that the respective Society. In each issue, IAM magazine This problem of vocabulary and professional has to do. Accountants focus on publishes a contribution from the Society on perspective ends up hurting your business intangible assets because that is what they a noteworthy intangible asset finance matter. and your clients’ businesses. Clients don’t are equipped to identify. Lawyers focus on buy things that they don’t understand. And intellectual property because they are experts www.iam-magazine.com Intellectual Asset Management November/December 2010 63 Slip of the tongue

Table 1. Differing perspectives on intangibles

Accountant Investor Risk manager Manager

Core concern How to represent How to comply with How to make How to identify How to leverage the performance the law and use it to money trading and mitigate risk all resources for the greatest and capacity of protect and leverage this stock profits and long-term value the firm assets and/or relationships

Systemic view Financial statements Document/contract log Financial Enterprise risk Financial statements, statements + management multiplicity of information management sources on individual discussion intangibles

Intangibles Only deal with intangibles Tend to think of Primary focus is Focus generally With the exception of the perspective when they are part of a intellectual property as financial and on individual risks, occasional balanced financial transaction. dominant intangible. intellectual capital although reputational scorecards or intellectual Must conform with Actually involved in all is seen as a risk helping to move capital report, most standards (GAAP, three intangibles non-financial focus towards more businesses do not focus on FASB, IASB) categories asset holistic view of intangibles as a separate intangibles asset class or management challenge

Favourite “Intangible value can “If you can’t protect it “We have “To zero in on “That’s interesting but what comment disappear in a minute” legally, it’s not worth proprietary ways intangible risks, does it have to do with my anything” of analysing we ask our clients business?” companies” what keeps them up at night” in the laws that create this special class of limiting their definition to those assets that intangibles. Investors don’t really focus on can be capitalised following a financial intangibles, except as intellectual capital transaction. Of course, the great majority of – an undefined, non-financial element of intangibles are not acquired from outside value and competitive advantage. Risk the organisation, but are rather built managers focus on specific intangible risks internally. These are not capitalised. The and sometimes on corporate . net effect of this approach is the huge gap Business managers focus on intangibles as that exists today between the total value of part of their job, but lack a clear vision of the a corporation and the book value on its importance of intangibles to their success. balance sheet. Today, the balance sheet The end result of these differing explains only 20% of the value of the perspectives is five completely different average company on the S&P 500. The inventories of corporate intangibles, as the remaining 80% is off balance sheet, following discussions bear out. intangible and poorly understood by most accountants. Our favourite comment by an Accountants accountant is that intangible value is Accountants are charged with measuring ephemeral and can “disappear in a minute”. the financial performance and capacity of a The contrast between the intangibles firm. Their models and standards generally recognised in the normal course of business do not recognise investments in intangibles and in a third-party transaction is very clear as capital spending, meaning that most in Table 2. Here you see that accountants investments in intangibles are expensed in recognise almost no internally developed the year in which they are made. This has intangibles. But they do allow for many kinds two consequences: it lowers current of intangibles acquired in a third-party earnings and it fails to create a record of the transaction to be eligible for capitalisation on accumulated investment in intangibles. the balance sheet. This table summarises this The only exception to this rule is when broad array of intangibles. These extensive intangibles are acquired in a third-party lists and the accounting profession’s transaction, such as an asset purchase or a documentation of how to identify and treat corporate acquisition. When accountants everything from assembled workforce to talk about intangible assets, they are backlog and technology constitute a

64 Intellectual Asset Management November/December 2010 www.iam-magazine.com Slip of the tongue

Table 2. The accountant’s perspective

Accountant Recognised intangibles

Human capital Internally generated: • None Acquired: • Assembled workforce • Non-compete agreements

Relationship capital Internally generated: • None Acquired: • Customer lists • and brands • Contracted revenues • Backlog • Off-market agreements • Government licences and rights • Goodwill*

Structural capital Internally generated: • IFRS allows capitalisation of some R&D Acquired: • Technology • Patents • Software • Databases • Catalogues of works/copyrights • Domain names

Fudge factor * Goodwill (excess of purchase price over acquired tangible and intangible assets)

wonderful primer on the variety of knowledge infrastructure, no one is sure how all this assets held by today’s companies. breaks down. At the time of an acquisition, But even though accountants are open to only the obvious assets get valued and capitalising a diverse array of investments, in capitalised. Until accountants can provide a practice very few intangibles end up being more accurate description of the intangible identified and booked in the average merger. infrastructure developed within companies, In Ernst & Young’s Acquisition Accounting: the intangible information gap will continue What’s Next for You?, data was summarised to plague businesses every day, not only for 700-plus acquisitions around the world when they undertake an acquisition. in 2007. Overall, an average of 30% of the purchase price for an acquisition was booked Lawyers to tangible assets, with 23% booked to Lawyers are charged with helping specific intangibles and a whopping 47% corporations to comply with the law and booked to goodwill. use the legal system to protect and leverage Does this mean that half of the value of corporate assets. This mandate has the average deal is truly dependent on the implications for all kinds of intangibles, as company’s reputation and the goodwill of seen in Table 3. However, when you ask the its stakeholders? Probably not. It is more average lawyer about intangibles, they will likely that this is related to the 80% gap invariably talk about intellectual property. seen in the US stock markets and is a Intellectual property is the most tangible of consequence of the failure to understand corporate intangibles because there are intangibles investment over time. These specific bodies of law associated with it investments built an intangible, operational and, in some cases, registration systems to infrastructure that includes systems, establish corporate ownership and rights to processes, competencies, networks and the asset. This special legal status also . But since there is no record of makes it possible to buy and sell individual the financial existence of this IP rights, a strategy that has become www.iam-magazine.com Intellectual Asset Management November/December 2010 65 Slip of the tongue

Table 3. The lawyer's perspective

Lawyer Recognised intangibles

Human capital • Employment contracts • Employment practices • Non-compete agreements

Relationship capital • Customer contracts • Supplier contracts • Licensing agreements • Trademarks (part of IP as listed below)

Structural capital Intellectual property: • Patents • Copyrights • Trade secrets • Know-how

Fudge factor Know-how increasingly common in recent years. corporate value decades ago, when book However, this legal status can also blind value and corporate value began to diverge. lawyers to the power and value of other A lack of useful operational information on classes of intangibles. Our favourite the balance sheet has driven investors to comment from an IP lawyer is: “The only rely heavily on the income statement to intangibles that have any value are those understand how the company works. Most that are protected under IP regulations and do not understand how intangibles systems.” investment distorts the income statement. Nevertheless, much of an organisation’s They do, however, understand how acquired knowledge lies outside the formal IP intangibles distort the balance sheet and systems, as trade secrets and know-how. they don’t like it; as seen above, half of the Trade secrets can be as critical as IP. Lawyers value of the average acquisition ends up can play an important role in determining being booked as goodwill. This large the right strategy for IP – to draw the line rounding error adds to the mystery and between the knowledge that a company confusion of intangibles. should treat as trade secrets (which can One dangerous consequence of this remain a secret) and that which should be focus on the income statement is a short- disclosed and protected as IP (which, by term view of operations rather than a view definition, requires disclosure). But the vast of the capacity and outlook of the majority of knowledge in an organisation is organisation that would be afforded by a neither IP nor trade secrets. The catch-all complete balance sheet. For example, as term used by lawyers for this knowledge is seen in Table 4, the investor’s main way of know-how. Lawyers play an important role in understanding human capital is as wages helping companies to protect and leverage a and salaries – that is, as an expense rather broad variety of know-how. Contracts are than as a resource. If you see human capital one of the most important ways of only as an expense and have no information protecting these kinds of intangibles, about the competencies and experience of including employee knowledge, customer staff, then all layoffs are good. and vendor relationships and acquired Investors get most of their information knowledge in the form of software and data. about intangibles from management discussion of and footnotes to financial Investors statements. In fact, many investors insist Investors provide capital and liquidity for that they have a special approach to corporations. The average investor is aware analysing the extra-financial information. of the gap between corporate value and net Our favourite comment from an investor is: book value, but most are surprised by the “We have unique and proprietary ways of size of this gap if you show it to them. But analysing companies; we don’t need they don’t spend a lot of time worrying intangibles information.” about it. Most investors gave up using a This is, in fact, a very telling statement. balance sheet as a way of measuring Most investors are vaguely aware that some

66 Intellectual Asset Management November/December 2010 www.iam-magazine.com Slip of the tongue

Table 4. The investor perspective

Investor Recognised intangibles

Human capital Corporate: • Wage and salary expenses • Management discussion of workforce and management

Relationship capital Corporate: • Management discussion of customer and other relationships • Goodwill in acquired companies (goodwill generally not viewed favourably)

Individual assets: (see Accounting M&A)

Structural capital Corporate: • Management discussion of technologies, intellectual property • General perception of unidentified “intellectual capital” or knowledge

Individual assets: (see Accounting: acquired assets)

Fudge factor Market premium (excess of corporate value over tangible net worth)

extra value is emerging in companies due to important, but it has increased in importance the shift to the knowledge era. They with the rise of hyper-connected media, frequently use the phrase “intellectual capital” where problems and mistakes are telegraphed to name this phenomenon. But they see in real time. intellectual capital not as a financial asset, but The work of risk managers overlaps in rather as an extra financial, intangible many ways with intangibles. However, most advantage that one company may have over risk managers do not have a conceptual another (a view that has also been advocated understanding of intangibles. In fact, our by many within the intellectual capital favourite comment from a risk management community). If intellectual capital is really so consultant is: “We understand tangible risk hard to see and measure, an investor’s ability really well, but for intangible risk, our to analyse it becomes a unique competitive starting point is usually to ask what keeps advantage for the investor – one to be the manager up at night” (not a particularly protected and preserved. In a strange way, this scientific approach). attitude and/or lack of understanding has kept Table 5 gives a good sense of the investors from calling for improved intersection between intangibles and risk. intangibles reporting. The main manifestation of risk management is policies and processes that describe the Risk managers way that employees in particular, and the Risk managers are charged with identifying organisation in general, should do their work. and mitigating the risks facing their The job of the risk manager is to identify, organisations. This is an even more diverse define, monitor and troubleshoot compliance set of professionals than the accountants, with these systems. The goal is to prevent a lawyers and investors described above. An crisis from happening. Thus, risk managers emerging umbrella concept of enterprise risk have a hand in many aspects of intangibles management has been adopted by some firms, management. However, today’s risk but practice varies greatly around the globe. managers do not usually use an intangibles Areas which get special focus vary by firm and management perspective in defining the include ethics, compliance, governance, focus of their work. assurance, operational risks and security. Another comprehensive way of looking at risk Business managers is through the lens of reputation. Reputation Managers have the job of leveraging their is the sum of how corporate stakeholders view organisations’ resources for profits in the the organisation. Reputation has always been short term and value in the long term. Most www.iam-magazine.com Intellectual Asset Management November/December 2010 67 Slip of the tongue

Table 5. The risk manager’s perspective

Risk manager Recognised intangibles

Human capital • Key man life • Employee conduct, ethics • Professional liability • Directors’ and officers’ liability • Policy and procedure compliance • Errors and omissions

Relationship capital • Reputational risk • Product liability • Regulatory liability • Libel

Structural capital Policies and processes, such as: • Employment/HR • Regulatory compliance • Safety • Facilities management • Quality control • Ethics • IP risk (both offensive and defensive) • Data/tech risk

Fudge factor General liability managers today are unfamiliar with the portfolio. In Europe and Asia, there is greater statistics about the growth in intangibles and use of specific intellectual capital reports do not really understand how this trend which aim to be more comprehensive. affects their own businesses. Of course, However, neither of these approaches has managers are influenced by the work of their achieved mainstream practice. Today, no accountants, lawyers, investors and risk has a mainstream reporting managers. As seen above, this work provides approach for intangibles. a varied and fragmented view of intangibles. This means that while managers Nor has there been a consensus from the understand the importance of each of the business schools. In the United States, the individual intangibles in Table 6, few think only mainstream intangibles management of them as being part of a cohesive system. tool is the Balanced Scorecard, which Thus, it is unsurprising that a common highlights a few key intangibles such as comment from managers is: “That’s really employees, processes and customers, but interesting, but what does it have to do with does not inventory the full intangibles my business?” This is the question that

Businesses need accountants, lawyers, investors and risk managers. But each provides an incomplete view of the total knowledge intangibles of a company. No one is looking at the big picture. And decisions of all kinds are hampered by bad information

68 Intellectual Asset Management November/December 2010 www.iam-magazine.com Slip of the tongue

Table 6. The manager’s perspective

Manager Recognised intangibles

Human capital • Competencies • Experience • Attitude • Management skills

Relationship capital • Customers • Vendors • Partners • Government licences, clearances • Unions • Press • Financing sources • Brands

Structural capital • Databases • Systems and processes • Intellectual property (patents, trademarks, copyrights, trade secrets) • Culture

Fudge factor Intangibles

everyone in the field of intangibles must continue to get little mainstream attention. answer – hopefully with a single voice. Yet the data is overwhelming. In the space of just a few decades, there has been a Why these diverse views are a problem fundamental shift in our economy, fuelled Each point of view described above is by the rise of information technology. necessary and valid. Businesses need While the industrial era was marked by accountants, lawyers, investors and risk technology that multiplied the output and managers. But each provides an incomplete capability of the human body, the view of the total knowledge intangibles of knowledge era is marked by technology that a company. No one is looking at the big multiplies the output and capability of the picture. And decisions of all kinds are human mind. This means that knowledge, in hampered by bad information. This leaves its many forms, is a key driver of businesspeople in a tough spot. productivity and growth. All professionals Basically, the stock market tells them that and managers need to incorporate this there is an intangibles information gap, but change into their thinking and their work. these same investors don’t demand better information to fill in the gap. Accountants Towards a holistic view (who should be able to fill in the gap) continue The challenge is how to integrate the to insist that this value is nothing more than approaches of each of the professions with the goodwill of a company’s stakeholders. the goals of the enterprise. The answer is to Lawyers focus on individual transactions, but learn to start with an enterprise view. What are not in a position to provide a global are the most important intangibles of the analysis of intangibles. And risk managers are enterprise? How do these intangibles work also hard pressed to provide a global view. together to create competitive advantage? What are the consequences of this situation? Intangibles professionals need to develop a • Specific intangibles go unrecognised. shared view of the basic intangibles structure • Companies do not get valued accurately. of a company – one that supersedes the • Mergers fail. perspectives of individual professions and • Managers miss key risks, creating gets at the unique and important intangibles reputational crises. in an individual company. How to do this? • Decisions about specific intangibles are The starting point for identifying the made in isolation. most important intangibles is the company’s • Innovation comes too slowly. revenue and business model. What does it do for its clients? Sell a product or a service? Are Despite these problems, intangibles there unpaid aspects of its offerings that are www.iam-magazine.com Intellectual Asset Management November/December 2010 69 Slip of the tongue

nonetheless critical to the paid offering? The next step is to identify the Action plan A knowledge infrastructure in place to support this business model. This includes Like all businesspeople, today’s intangibles intangibles professional, you have greater the human, relationship and structural professional is working within systems that knowledge than just how to follow today’s knowledge that enables the company to were optimised for the industrial era. But the rules. You have options to educate and create customer value and get paid. For economy continues its breakneck transition assist that go beyond the constraints of simplicity’s sake, don’t inventory skills for to the knowledge era. While all our systems today’s incomplete standards. typical support activities such as marketing, and professions catch up, we need to be finance or IT. Focus here on the intangibles proactive in helping companies and clients Filling in the gaps is not as radical an that support the business model: deal with the very real knowledge-era option as it may sound. For accountants, it • Structural capital – what are the key challenges that they face today. Intangibles may mean developing intangibles information processes, knowledge and IP that are at the top of this list of challenges. inside a management accounting system (as support the business model? The starting point for every professional opposed to its statutory system). • Human capital – what employee needs to be a holistic view. It’s not enough to Management accounting is a mainstream competencies are needed to support cite the rulebook when the rules ignore 80% of activity; it just hasn’t been used as these processes and the business model? the value of the average company. We all need aggressively as it might for reporting • Relationship capital – what are the key to learn how to fill in the gaps where today’s intangibles. For lawyers, filling in the gaps relationships that support these rules fall short – not by breaking the rules, but may mean advising clients on how to protect processes and the business model? by taking a bigger-picture view. non-IP assets – also a mainstream activity. Your personal holistic action plan should For investors, it may mean asking a new set If you were to create such an inventory look like this: of questions of management teams, pushing for the Google search engine business, it • Inventory key intangibles – when you for new information types. For risk managers, would look something like this: begin working with a new company or it may just mean giving more attention to the • Value creation – the business model is client, start with an inventory of key growing intangible side of business. free search subsidised by keyword intangibles such as that described above. The truth is that most managers are not yet advertising. With existing situations, don’t be afraid to doing this on their own. It is rare to see • Structural capital – the organisation’s take a step back and do the same. managers provide even a simple inventory or key processes and/or IP that support • Identify highest priorities – the management plan for intangibles. So it is in the the business model: the search engine intangibles on this list are critical to the interest of the intangibles professionals that itself and the advertising algorithms to current and future strength of the support management teams to help them get match it. organisation. Talk about how best to started. A small investment in creating a holistic • Human capital – the employee core measure them, protect them and action plan for all key intangibles in an competencies that support the existing leverage them. organisation will make it easier for you to target business and fuel continuous innovation • Create a plan within current guidelines the right areas of focus for your work. And it will and learning: high-level maths and – do the best job under current guidelines make it easier to try to coordinate with other computing. of your profession. For accountants, this intangibles professionals. Taking leadership of • Relationship capital – the relationships means that a lot of the items on the list this process also positions you as a strategic that make it all happen: searchers, won’t be in the statutory financials. That’s intangibles partner – one that is helping advertisers and partners that embed OK. But it’s not a reason to stop there. companies to adapt to the changing world, not Google search in their sites. • Strategise how to fill in the gaps – as an trying to tie them to the past.

Most companies’ intangibles inventories are more complex than this Google example, could move beyond the current standards for even though it summarises a US$20 billion- statutory reporting and develop management plus business. But it is a good illustration of reports that track investment in these key the power of a simple tool. This inventory intangibles. Lawyers could advise how to makes it clear where the company’s protect the most critical core assets legally, priorities should lie for its existing business. regardless of their potential as IP. Risk It also helps to highlight the key assets that managers could focus on the aspects of could be the platform for future innovations. operations that are most sensitive from a For example, Google’s experience with revenue and/or expense perspective. Finally, keyword advertising has helped it to create armed with this better information, investors significant growth by generating advertising could make a more accurate decision about on the YouTube platform which the the outlook and value of the company. company acquired in 2006. The advantage of starting with an Mary Adams and Michael Oleksak are the inventory is that everyone starts off by co-authors of Intangible Capital: Putting focusing on what is important in the Knowledge to Work in the 21st Century company and then moves onto the Organization perspective of individual professions. With [email protected] this kind of inventory at hand, accountants [email protected]

70 Intellectual Asset Management November/December 2010 www.iam-magazine.com