INTELLECTUAL : MEASUREMENT, RECOGNITION AND REPORTING DR. S.ARAMVALARTHAN MBA, PhD, FCA, ACMA, ACS, 1 INTRODUCTION The present day economy is knowledge based. In a knowledge economy, the drivers of competitive advantage and value creation are knowledge resources such as , organizational processes and external networks. The success of organizations depends more on their ability to exploit and manage their intangible resources than their tangible assets. As intangibles such as knowledge and innovation have become an increasingly important part of corporate value, measurement, recognition and reporting of assumes great significance. MEANING OF INTELLECTUAL CAPITAL Intellectual capital is intellectual material—knowledge, information, intellectual property, experience—that can be put to use to create wealth (Stewart, 1997). A company’s intellectual capital is the sum of its human capital (talent), structural capital (intellectual property, methodologies, software, documents, and other knowledge artifacts), and customer capital (client relationships) (Stewart, 2001). “Intellectual capital is the possession of knowledge and experience, professional knowledge and skill, good relationships, and technological capacities, which whwn applied will give organizations compettive advantage (CIMA, 2001). It is a combination of human capital—the brains, skills, insights, and potential of those in an organization—and structural capital—things like the capital wrapped up in customers, processes, databases, brands, and IT systems. It is the ability to transform knowledge and intangible assets into wealth creating resources, by multiplying human capital with structural capital (Edvinsson, 2002) NEED FOR MEASURING INTELLECTUAL CAPITAL Companies may want to measure intellectual capital for a variety of reasons. Holmen (2005) identified the following five specific main reasons for measuring intellectual capital: • To help organizations formulate their strategy. By identifying and evaluating intellectual capital an organization may gain a competitive advantage. • To assist in diversification and expansion decisions. Intellectual capital may be measured to assist in evaluating mergers and acquisitions, particularly in respect of the purchase price of the acquisition. • To assess strategy execution. Measuring intellectual capital may lead to the development of key performance indicators that will help evaluate the execution of any strategy employed. • For use as a basis for compensation. The measurement of intellectual capital may be linked to an organization’s incentive and compensation plan. • To communicate with external stakeholders. The value of the intellectual capital will communicate to external stakeholders the true value of the organization.

1 Professor , Amrita School of Business, Coimbatore, Tamil Nadu, India NEED FOR REPORTING INTELLECTUAL CAPITAL External reporting of intellectual capital can: (1) close the gap between book value and market value, (2) provide improved inf ormation about the “real value” of the organization, (3) reduce information asymmetry, (4) increase the ability to raise capital by providing a valuation on intangibles, and (5) enhance an organization’s reputation. (Holmen, 2005). INTERNAL REPORTING OF INTELLECTUAL CAPITAL Two important attempts to measure and report intellectual capital internally are Skandia’s Navigator and Kaplan and Norton’s balanced scorecard. Skandia Navigator Skandia documented its approach to measuring intellectual capital supplements to its interim and annual reports (Skandia, 1996). Figure 1 shows the company’s hierarchy of intellectual capital. The overall market value of the firm can be split into two parts: the and intellectual capital. Skandia breaks intellectual capital into several components of human capital and structural capital. Human capital is defined as the knowledge, skills and experience that employees take with them when they leave. Structural capital is defined as the knowledge that stays within the firm. It can be split into customer capital and organizational capital. Customer capital is the value of the organization’s ongoing relationships with the people or organizations to which it sells Organi zational capital can be broken down further into process capital (how things get accomplished) and innovation capital (protected commercial rights and intellectual property). Figure 1 Skandia’s Hierarchy of Intellectual Capital

MARKET VALUE OF FIRM

INTELLECTUAL FINANCIAL CAPITAL CAPITAL

STRUCTURAL HUMAN CAPITAL CAPITAL

ORGANIZATIONAL CUSTOMERCAPITAL CAPITAL

CUSTOMER CUSTOMER INNOVATION CUSTOMER BASE PROCESS CAPITAL RELATIONS [POTENTIAL CAPITAL

Source: Skandia, Intellect ual Capital —Value Creating Processes, a supplement to Skandia’s 1995 Annual Report The Skandia Navigator measurement tool has five main components that are shown in Figure 2: financial, customer, process, human, and renewal and development. At the heart of these is human focus, which drives the whole model. Edvinsson says that navigator can be “viewed as a house. The financial focus is the roof. The customer focus and process focus are the walls. The human focus is the soul of the house. The renewal and development focus is the platform. With such a metaphor, renewal and development become the critical bottom line for sustainability.” (Edvinsson, 2002). Figure 2 Five Components of Skandia’s Intellectual Capital Measurement Methodology

Each of the five components focuses on critical success factors that are quantified to measure change. The indicators used for the financial focus are largely represented in monetary terms. Customer focus concentrates on assessing the value of customer capital to the organization and makes use of both financial and non-financial indicators. The measures used for the process focus emphasize the effective use of technology within the organization. They tend to monitor quality processes and quality management systems but also include some financial ratios. The renewal and development focus attempts to capture the innovative capabilities of the organization, measuring the effectiveness of its investment in training and its expenditure on R&D. Finally, the human focus includes measurements that reflect the human capital of the organization and how the resources are being enhanced and developed. Balanced Scorecard Kaplan and Norton’s balanced score card approach (Figure 3) is similar to Skandia’s Navigator in its use of multiple perspectives (Kaplan and Norton, 1996). The balanced score card uses four perspectives: financial (How do we appear to our stakeholders?), customer (How do we appear to our customers?), internal business process (What business processes must we excel at?), and learning and growth (How will we sustain our ability to change and improve?). The learning and growth perspective includes categories for employee capabilities (human capital), information systems capabilities (information capital), and motivation, empowerment, and alignment (organizational capital). Figure 3: Balanced Scorecard

Source: Robert S. Kaplan and David P. Norton, The Balanced Scorecard: Translating Strategy into Action, Harvard Business School Press, Cambridge, Mass., 1996 In their book Strategy Maps: Converting Intangible Assets into Tangible Outcomes , Kaplan and Norton attempt to demonstrate how the intangible assets of human, information, and organizational capital can be measured. Human capital includes the skills, training, and knowhow of employees. Information capital includes systems, databases, and networks. Organizational capital includes such concepts as culture, leadership, teamwork, and alignment with goals. The value of these assets comes from how well they align with the overall strategic priorities of the organization. Intellectual capital is measured by evaluating how well assets contribute to achieving organizational strategy. (Kaplan and Norton, 2004) A comparison of the meaning of intellectual capital with the four perspectives of the balanced score card highlights how the balanced score card can be used to measure intellectual capital:“Intellectual capital is a combination of human capital—the brains, skills, insights, and potential of those in an organization [learning and growth perspective: human] — and structural capital—things like the capital wrapped up in customers [customer perspective], processes [internal business processes perspective], databases, brands, and IT systems [learning and growth perspective: information capital]. It is the ability to transform knowledge [learning and growth perspective: organizational capital] and intangible assets into wealth creating resources, by multiplying human capital with structural capital. ” ( Edvinsson, 2002) EXTERNAL REPORTING OF INTELLECTUAL CAPITAL INTERNATIONAL FINANCIAL REPRTING STANDARDS Intellectual capital is an intangible asset. IAS 38 Intangible Assets outlines the accounting Requirements for intangible assets (IASB, 2012). It requires an entity to recognize an intangible asset when specified criteria are met. The standard also outlines ways to measure the carrying amount of intangible assets and requires disclosures relating to intangible assets. Critical Attributes of an Intangible Asset The three critical attributes of an intangible asset are: • identifiability • control (power to obtain benefits from the asset) • future economic benefits (such as revenues or reduced future costs Recognition Criteria IAS 38 requires an entity to recognise an intangible asset at cost if, and only if: • it is probable that the future economic benefits that are attributable to the asset will flow to the entity; and • the cost of the asset can be measured reliably. This requirement applies whether an intangible asset is acquired externally or generated internally. IAS 38 includes additional recognition criteria for internally generated intangible assets The probability of future economic benefits must be based on reasonable and supportable assumptions about conditions that will exist over the life of the asset. The probability recognition criterion is always considered to be satisfied for intangible assets that are acquired separately or in a business combination. If an intangible item does not meet both the definition of and the criteria for recognition as an intangible asset, IAS 38 requires the expenditure on this item to be recognised as an expense when it is incurred. Measurement

Initial Measurement Intangible assets are initially measured at cost.

Measurement subsequent to acquisition Cost model and revaluation models are allowed. An entity must choose either the cost model or the revaluation model for each class of intangible asset. Cost model . After initial recognition, intangible assets should be carried at cost less any amortisation and impairment losses. Revaluation model : Intangible assets may be carried at a revalued amount (based on fair value) less any subsequent amortisation and impairment losses only if fair value can be determined by reference to an active market.

Measurement subsequent to acquisition- intangible assets with finite lives The cost less residual value of an intangible asset with a finite useful life should be amortized on a systematic basis over that life. The amortization method should reflect the pattern of benefits. If the pattern cannot be determined reliably, the asset shall be amortized using the straight-line method. The amortization charge is recognized in the statement of comprehensive income, unless another IFRS requires that it be included in the cost of another asset. The amortization period should be reviewed at least annually. The asset should also be assessed for impairment in accordance with IAS 36, Impairment of Assets. If a revalued intangible has a finite life and is, therefore, being amortized, the revalued amount is amortized.

Measurement subsequent to acquisition- intangible assets with indefinite useful lives There is no foreseeable limit to the period over which the asset is expected to generate net cash inflows for the entity. An intangible asset with an indefinite useful life should not be amortized. Its useful life should be reviewed each reporting period to determine whether events and circumstances continue to support an indefinite useful life assessment for that asset. If they do not, the change in the useful life assessment from indefinite to finite should be accounted for as a change in an accounting estimate. The asset should also be assessed for impairment in accordance with IAS 36, Impairment of Assets

Subsequent Expenditure Subsequent expenditure on an intangible asset after its purchase or completion should be recognized as an expense when it is incurred, unless it is probable that this expenditure will enable the asset to generate future economic benefits in excess of its originally assessed standard of performance and the expenditure can be measured and attributed to the asset reliably. Disclosure For each class of intangible asset, distinguishing between internally generated intangible assets and other intangible assets, disclose • Useful life or amortization rate, if finite • Amortization method • Gross carrying amount • Accumulated amortization and impairment losses • Line items in the income statement in which amortization is included • Reconciliation of the carrying amount at the beginning and the end of the period showing o Additions (business combinations separately) o Assets held for sale o Retirements and other disposals o Revaluations o Impairments o Reversals of impairments o Amortization o Foreign exchange differences • Basis for determining that an intangible has an indefinite life • Description and carrying amount of individually material intangible assets • Disclosures about intangible assets acquired by way of government grants • Information about intangible assets whose title is restricted • Commitments to acquire intangible assets

PROBLEMS IN REPORTING INTELLECTUAL CAPTAL An analysis of the requirements of As 39 would reveal that many intellectual capital assets may not meet the criteria for recognition and hence, a significant portion of a company’s assets may not be reported in the financial statements of the company. The non-recognition of such assets as intellectual capital in the financial statements may result in a huge difference between the value of the company as perceived by the investors and the book value of the company as reported in the financial statement. Corporate Annual Reports can be used to fill this gap . Corporate Annual Reports are used as a basic tool for the effective communication of company information and overall performance to stakeholders and other users of company information. As a result of the challenges in respect of disclosing the information on intellectual capital under statutory disclosures, discretionary disclosures should be used to for the purpose.

MEASUREMENT MODELS In order to improve external reporting, information from the management accounting system (such as Skandia Navigator and balanced Scorecard) on intellectual capital may be included in the corporate annual reports. Besides, financial measurement models may also be used. In order to assist organizations to improve their annual reporting and to reap the benefits of reporting on intellectual capital, researchers recommend a number of financial measurement models that may be used to measure intellectual capital. Some of them are: - Discounted cash flow - Relief-from-royalty - Comparable transactions - Avoided cost - Value added - Value chain scoreboard - Market to net book value One of the models, namely, the value chain scorecard is discussed here, VALUE CHAIN SCORECARD Baruch Lev has proposed a scorecard approach to provide investors and external decision makers with information relating to an organization’s utilization of intellectual capital (Lev, 2001). In the present day world, many important business decisions are now made in consultation with partners in the value chain who are outside the organizational boundaries. Lev’s scorecard provides nontransaction and nonfinancial information to support these decisions made with others in the value chain. The scorecard mirrors three portions of the value chain: discovery and learning, implementation, and commercialization. Each of these three can, in turn, be subdivided into three additional categories for a total of nine categories{Table 3]. The first phase of the value chain is the discovery of new products or services. These ideas can be generated internally through R&D efforts or employee networks, they can be acquired from outside the entity, and they can be identified through active and formal networks such as joint ventures, alliances, and supply chain integration. The second major phase of the value chain is the transformation of ideas into working products or services. This can be measured through a variety of milestones: patents, trademarks, or other intellectual property; passing formal feasibility hurdles; and, related to Internet technologies, quantitative measures of activity. The third phase of the value chain is the commercialization of the products or services. Customer measures could include brand value, marketing alliances, and customer churn. Performance indicators could include innovation revenues, market share, economic value added, and knowledge earnings. A final category would provide forward-looking information on the product/ service pipeline. A variety of indicators can be chosen for each of the nine portions of the score card. The indicators should have three attributes: They should be quantifiable, they should be standardized so comparisons can be made across firms, and there should be statistical evidence to link the indicators to corporate value. Table 3 Value Chain Scorecard

Discovery & Learning Implementation Commercialization

Internal renewal Intellectual property Customers • Research and • Patents, trademarks • Marketing alliances development and copyrights • Brand values • Workforce training • Licensing agreements • Customer churn and and development • Coded know-how value • • Organizational capital Technological feasibility Online sales processes • Clinical tests, food and Performance Acquired capabilities drug administration • Revenues, earnings • Technology purchase approvals and market share • Spill over utilization • Beta tests, working • Innovation revenues • Capital expenditures pilots • Patent and know how • First mover royalties Networking • Internet Knowledge earnings • R&D alliances and and assets joint ventures • Threshold traffic • Supplier and • Online purchases Growth prospects customer integration • Major internet alliance • Product pipeline and • Communities of launch dates practice • Expected efficiencies and savings

• Planned initiatives • Expected breakeven and cash burn rate

CONCLUSION With the rise of the “knowledge economy”, intellectual capital is becoming more important. Its measurement and reporting have become important. Mandatory financial reporting does not provide adequate space for reporting information on intellectual capital. So, discretionary disclosure of the information should be made in the corporate annual reports using either the information from the management accounting system or the financial measurement models.

Bibliography Bernard Marr, D. G. (2003, October). Why Do Firms Measure Their Intellectual Capital. Journal of Intellectual Capital , 441-464.

CIMA. (2001). Understanding Corporate Value:Managing and Reprting Intellectual capital. London: Cranfield University School of Management.

Edvinsson, L. (2002). Corporate Longitude: What You Need To Know To Navigate The Knowledge Economy. Upper Saddle River , N.J: Financial Times Prentice Pearson Education, Inc.

Holmen, J. (2005). Intellectual Capital Reporting. Management Accounting Quarterly , 6 (4), 1-9.

IASB. (2012). Retrieved October 5, 2012, from http:/www.ifrs.org/IFRSs/IFRS.htm:

Lev, B. ( 2001). Intangibles: Management, Measurement, and Reporting. Washington, D.C: Brookings Institution Press.

Robert S. Kaplan and David P. Norton. (1996). The Balanced Scorecard : Translating Strategy into Action. Cambridge, Mass: Harvard Business School Press.

Robert S. Kaplan and David P. Norton (2004). Strategy Maps:Converting Intangible Assets into Tangible Outcome. Cambridge, Mass: Harvard Business School Press.

Skandia. (1996). Customer Value, a supplement to Skandia’s 1996 Annual Report.

Stewart, T. (1997). Intellectual Capital: The New Wealth of Organizations. New York, N.Y: Currency Doubleday.

Stewart, T. (2001). The Wealth of Knowledge: Intellectual Capital and the Twenty-First Century Organization. New York, N.Y.: Currency Doubleday.