Management of Intangible Assets A Value Enhancing Strategy in Knowledge Economy

 

Ramin Nejati

 

ABSTRACT:

Intangibles are the main performance drivers in the present transition from a traditional to a knowledge-based economy and are responsible for enterprise value creation. The paper explains key components of intangible assets viz. human capital, structural capital and relational capital; drivers for the growth of intangibles and also highlights cost associated with disclosure of intangibles. This paper underlines the positive correlation between disclosure and corporate valuation and highlights role of intangible assets as a driver of competitive differentiation and explains how intangible assets enhance corporate valuation.

 

 

INTRODUCTION:

More than a half century after the birth of modern financial reporting, it is becoming increasingly clear that incremental changes in corporate reporting the work of national and international financial accounting boards  is in sufficient to correct the systemic weaknesses that persist in current era of knowledge economy. The corporate business world has changed notably over the past decade.Unfortunately, many management strategies and approaches have not changed with this transformation, as traditional management systems were designed for an erawhen tangible assets were dominant. Current accounting systems appear to ignore most intangible and knowledge based assets. Measuring and managing intangible assets as key determinants of competitive advantage is the new critical management skill. In today’s knowledge based economy, many industries operate without a traditional capital base, and without traditional observable assets. Yet these companiesare increasingly the main contributors of value to the economy. It is nothing less than the ability to increase the value of a company by converting intangible assets into financial returns for the organization[1].

 

Meaning of Intangible Assets:

Intangible assets have been broadly defined as non-physical resources of value (claimsto future benefits) generated by innovation (discovery), unique organizational designs, or human resource practices. Different professional groups use different terminology to represent non financial measures, such as intangible assets.” The terms, intangible assets, knowledge assets and intellectual capital can be used interchangeably, based on the fact that they differ only in their discipline of origin.

 

 

The term intangible assetis most widely used among accountant community, while economists use the termknowledge assets, and management and lawyers use the term intellectual capi[2].

 

How Intangibles Differ from Tangibles:?

Some of the business rules that have been present over the past century are changingvery fast. Take for example the law of diminishing returns the more you use fixed assets such as building and machineries, the smaller is the marginal return. However, for intangibles such as knowledge this does not apply in the same way. It is often argued to be the opposite, the more we use our knowledge, the higher the return i.e, law of increased return. In addition, unlike physical resources that can only be used for one activity at one point in time intangible assets can be deployed at the sametime in multiple uses at different locations let us take the example of the knowledge to produce a specific drug, the programming of software application, a brand or even the corporate culture³. After all, such intangibles assets, unlike machinery and inventory,are not something a manager can kick, move and count. Nor do intangibles show upin any systematic way on the balance sheet, the profit-loss statement or cash flows. Intangibles, in other words, are not only intangible; they are largely invisible in relationto standard business management tools and disclosures.

 

Classification of Intangibles:

The intangible terminology is widely spread. There exist numerous classifications for intangible assets. The classification most widely used was the one that distinguishes and divides an organization’s resources into three different classes, viz. Human Capital, Structural Capital and Relational Capital. Most firms could clearly distinguish these three groups of variables. These three components of intangibles are interactive The Human Capital raises the Structural Capital; bothtogether generate the Relational Capital.

 

Human Capital:

Comprising the knowledge, education, experience, leadership, competence, skills, and intellectual agility of the individual employees.

 

Structural Capital:

Including processes, systems, structures, brands, patents, innovations, intellectual property and other intangibles that are owned by the firm, but do not appear on its balance sheet.

Relational Capital:

Which represents alliances and networks, valuablerelationships with customers, suppliers and other relevant stakeholders.

 

Human capital is defined as the knowledge that the employee takes with him when he leaves the firm at the end of the day. That is, for example, his/her knowledge expertise, job skills, educational level, etc. As opposed to this, Structural capital is defined as the pool of knowledge that stays at the firm at the end of the working day, as for example, the firm’s rules, operating procedures, routines, culture, databases, patents etc. Finally, the Relational capital is defined as all the intellectual capital linked with the external relationships of the firm, as, for example, customer satisfaction, supplier’s relationship and marketing procedures. Intangibles are the “hidden capabilities” of an organization and they derive from three key sources human capital; customer or relational capital; and structural or organizational capital.

 

Factors Driving Growth of Intangibles:

Following are growth drivers for surge in intangibles after 1990:

·      Globalization of economy;

·      Deregulation of

ü Telecommunications,

ü Transportation,

ü Financial services;

·      Increased business competition; and

·      Advances in IT[4].

 

 

Today’s era has various titles such as the Information Economy, New Economy,Service Economy, Knowledge Economy or the Knowledge Society, which are common lyshowing different market prerequisites than those traditional industries dealt earlier.It also reflects the continuing ascendance of intangibles as key value drivers in themodern corporation. The knowledge economy requires new management methods.Managers need techniques to identify the intangibles, including approaches for visualizing how these resources drive performance and tools to measure and valuethe stocks and flows of these assets. Coping with these changed business conditions, mostly indicated by globalisation, the sharpening of competition and increasing customer demands, some companies began attempts to capture the value of the irorganisational in tangible resources. In many areas, intangible resources have become more valuable than the physical evidence that carries it.

 

Why Firms Disclose Intangibles?

In today’s business environment, intangible assets such as knowledge, skills, relationships, processes, brands, or culture are, more than ever, a vital strategic resource. It is intangible factors people, ideas, and reputation which underpin the best performing businesses. For investors, current financial reporting simply does not deliver information on the intangible assets that today account for well over half the market’s capitalization. Quality of management, brands and reputation, knowledge systems, governance, social and environmental risks and opportunities the whole gamut ofintangibles are yet to appear in a consistent and reliable fashion in company reports. For companies failing to grasp the reporting transformation, disquiet among corporate stake holders over time will intensify with each reporting cycle, whose contentsseem increasingly detached from the realities of 21st century sources of value, risks and opportunities. Successful companies recognize that investing in these intangible aspects of their business is essential to their ability to create world-class high value added products and services. For companies as well as investors, it is there fore essential to understand those intangible drivers of corporate value growth for leveraging and converting intangibles into a basis for competitive advantage and economic profit. Disclosure of intangibles as a non-financial measures offer three clear advantages over traditional measurement systems based on financial data. There are three main reasons why organizations are seeking to measure and disclose intangibles:

 

1. To help organizations formulate their strategy and assess strategy execution;

2. Assist in diversification and expansion decisions;

3. To communicate measures to external        stakeholders [5].

 

1.To help organizations formulate their strategy and assess strategy execution:

Traditional financial measurement and evaluation systems generally focus onannual or short-term performance against accounting yardsticks and standards. They do not deal with progress, relative to customer requirements or competitors, or other non-financial objectives that may be important in achieving long term profitability, competitive strength and other strategic goals.For example, new product or market development, or transforming organizational capabilities may be important strategic goals, but may hindershort-term accounting performance. By supplementing accounting measures with non-financial data about strategic performance and implementation ofstrategic plans, companies can communicate objectives and provide incentives for managers to address long-term strategy. Disclosure also provides closerlink to long-term organizational strategies[6].

 

2. Assist in diversification and expansion decisions:

Drivers of success in manyindustries are “intangible assets” such as intellectual capital and customer loyalty,rather than the “hard assets” such as building and plant machinery, allowed on to balance sheets. Although it is difficult to quantify intangible assets infinancial terms, reporting and disclosure of intangibles can provide indirect, quantitative indicators of a firm’s intangible assets base. One research study examined the ability of “intangible assets” to explain differences in US companies’ stock market values. It found that measures related to innovation, management capability, employee relations, quality and brand value explained a significant proportion of a company’s value, even allowing for accounting assets and liabilities. By excluding these intangible assets, financially oriented measurement can encourage managers to make poor, even harmful, decisions.

 

3. To communicate measures to external stakeholders:

Non financial measures suchas intangibles can be better indicators of future financial performance. Even when the ultimate goal is maximizing financial performance, current financial measures may not capture long-term benefits from decisions made now.Consider, for example, investments in research and development or customer satisfaction programs. Under current GAAP accounting rules, research and development expenditures and marketing costs must be charged for in the period they are incurred, so reducing profits. But successful research improves future profits, if it can be brought to market. Similarly, investments in customer satisfaction can improve subsequent economic performance by increasing revenues and loyalty of existing customers, attracting new customers and reducing transaction costs. Non-financial datacan provide the missing link between these beneficial activities and financial results by providing forward-looking information on accounting or stock performance. For example, interim research results or customer indices may offer an indication of future cash flows that would not be captured other wise[7].

Intangibles as a Driver of Competitive Differentiation:

Wealth and growth in today’s economy are driven primarily by intangible assets.Global business is now primarily intangible, its value based primarily on future potential. But the future is created by doing the right things today – exploiting brands and relationships, ideas and talent. Indeed, the intangible businesses must bemanaged differently. 62% of the world’s business is now intangible. ($19.5 trillion of $31.6 trillion global market value). While technology is the most intangible sector (91%), USA’s technology sector is 98% intangible. Intangible assets are levers for competitive advantage and sustainable performance,so businesses should be finding ways to identify and manage their key intangible assets and disclose this to their stakeholders, in order for them to be able to better understand and value the organization. Business firms possess a number of different types of knowledge including scientific knowledge, knowledge of their markets and customer base, knowledge of sources of supply of materials and components, the knowledge and skills of its employees, etc. Some of this knowledge can be purchased in the market place or byinvesting in activities such as R&D. This knowledge is often codified, i.e., it canbe written down and easily absorbed by someone with the necessary expertise. Ifnot protected by some form of intellectual property rights or by secrecy, it can bereadily acquired by competitors.In contrast, other types of knowledge are only acquired through experience of thebusiness concerned, through learning curve and learning by doing. Such knowledgeis often tacit, not easily written down or communicated except by direct human experience, and is not easily acquired by business competitors who must create such knowledge for them selves to acquire it. Much organizational knowledge is of this kind. Tacit knowledge is a major source of competitive advantage for firms. They are main drivers of intangible assets. It is easy to show the role knowledge now plays inthe competitiveness of firms. Many firms, particularly in high technology and high value added sectors,  show a very large gap between the stock market value of the company and the book value of its tangible assets. This reflects the value of firms’intangible assets, most of which consist of the stocks of knowledge which the firmhas built up or acquired.Good practice enterprises are well aware of the importance of intangibles for the success of the firm. These firms measure, report, communicate and evaluate important intangibles in the management control process. Intangible resources arelikely to increase the future value of the company, in general, and its innovation capacity in particular. Intangible assets drive economic performance[8]. They do not show up on a balancesheet or an income statement yet, they are the manageable and usually quantifiable drivers of corporate-value creation. The importance of knowledge in firms competitiveness and profitability is not new. The increasing importance of knowledgeis shown by the fact that in many sectors investments in intangible assets are nowmuch greater than those in fixed capital equipment. Few years ago, advanced industrial economies were dominated by sectors such as steel, bulk chemicals and power generation which invested large amounts in plant and machinery. By contrast, the rapidly growing sectors of the current economy such as electronics, e-commerce, pharmaceuticals and telecommunications invest mainly in R&D, software and information technology, advertising and training. Some emerging sectors, such asthose associated with the Internet, hardly invest in fixed assets at all. Many firms andorganizations are directing a lot of effort towards improving the measurement, bothof intangible assets and of the returns to investments in knowledge acquisition and creation such as R&D and training. Some firms are now appointing senior executives with responsibility for managing knowledge assets or intangible assets. Companies that generate greater profits from fewer tangible assets will obviously possess more in the way of intangible assets such as brands, patents, customer loyalty and reputation etc. These, and many other types of intangible assets, are difficult forrivals to replicate. They generally lead to more durable competitive advantages andenhanced pricing power. To enable organizations to start measuring and gaining value from their intangibles,it is vital to identify and pinpoint the key resources held by the organization that drive value creation. These may include:

·      Human resources (e.g. skills, know-how, experience)

·      Stakeholder relationships (e.g. partner, customer or supplier relations)

·      Culture (values and management philosophies)

·      Routines (e.g. procedures, processes, and tacit rules)

·      Intellectual property (e.g. patents, trade secrets, brands).

 

In this knowledge economy, investment in intangibles (e.g. brand, training and R&D) exceeded investment in traditional tangibles (e.g. property, plant, equipment). One need only observe the price-to-earnings and/or market-to-book ratios ofcompanies like Microsoft, Oracle, Yahoo, Google and Starbucks to see dominationof intangibles in contributing to standard measure of value creation. And companieslike Dell and Wal-Mart are sector leaders not because of scale per se, but because oftheir superior capacities to innovate in the areas of process improvements and logistics. Capacity to innovate among the most potent of all intangibles enables growth, not vice versa. The factors that have become most important to business success and economic growth in developed economies in the twenty-first century are ‘intangible’ ornonphysical. Intangibles are equivalent terms for the non-accountable assets of anorganization. In 1980, the value of tangible assets, reported on the balance sheet ofStandard & Poor 500 companies in the US on average, made up still most of themarket value of these companies. 80% of the market value of S&P 500 companies inthe US in 1980 was covered by the value of tangible assets. In 2002, this ratio hasbeen totally turned around only 25% of the market value of S&P 500 companies was represented through the value of their tangible assets, 75% was the portion ofthe market value that was assigned to intangible assets. (Accenture 2004 research study Annexure I). Comparison of intangibles assets across the globe is given asAnnexure II.The change from the agrarian economy to the knowledge society has led to thesituation, that the unreported or intangible assets in a balance sheet are on averageseveral times those of the tangible assets. This provokes increasing criticism of traditional accounting methods—“they look backwards and at physical assets only”. Intangible resources are widely recognized to be an important innovation driver and a key resourcefor each type of organization. Stakeholders (especially investors) ask in these days for Intangible Disclosures Statements, in addition to the conventional financial reports[9].

 

Role of Intangibles: Finding of Capgemini Ernst & YoungResearch Study:

Many studies show that it is the intangible assets that provide competitive advantagesand above normal financial returns for organizations. Businesses have always hadintangible assets management talent, organizational capability, and intellectual capital but these are now being valued as never before.Following is finding of Capgemini Ernst & Young research study on intangibles.

 

1) Intangibles matter to investors. Intangible assets can provide leading indicatorsfor what the market values most predictable future earnings. A study conducted by Capgemini Ernst & Young found that 70 percent of buy-side investors used nonfinancial measures to determine share prices and company valuations andthat nonfinancial data drove at least 30 percent of their investment decisions.

 

2) Intangibles have been shown to be correlated with earnings. The investors seek for growth and profitability of their investment. As it is under current accounting practices, intangibles are supposed to have value, but their value stems from investor’s estimations. One of the reasons behind the promoted disclosure of additional, intangibles-related information is to give the investors a reliable pictureof the firm’s future performance. In this way, the market gets to know more thanit has to guess, which should have a further impact on the expected returns[7].

 

Intangibles: Measurement and Reporting Challenges:

Measuring and managing are essential for a firm to be able to successfully control,maintain and further develop its intangibles. Most managers agree that intangiblesare their most important value drivers, the difficulty, however, is how to manage, measure, and report these important assets. Economist Intelligence Unit survey revealsthat even though most executives around the world recognize that intangibles arecritical for the future success of their businesses, most admitted that their approachesof managing, measuring, and reporting intangibles were poor or non-existent. Anyorganization has countless intangible and knowledge-based resources that can becombined in limitless ways to create value. The question is, which of these assets aremost critical to achieving the strategic objectives and how can they be combined toproduce the ever more important, sustainable, competitive advantage. Although there are many advantages to non-financial performance measures and intangible reporting, they are not without drawbacks. Research has identified fiveprimary limitations.

 

1. Time and cost has been a problem for some companies. They have found the costsof a system that tracks a large number of financial and non-financial measures canbe very significant. A greater number of sundry performance measures frequently require significant investment in information systems to draw information frommultiple (and often incompatible) databases. Evaluating performance using multipleand diverse measures that can conflict in the short term can also be time-consuming. Bureaucracies can cause the measurement process to degenerate into rigidmechanistic exercises that add little to reaching strategic goals.

 

2. Unlike accounting measures, non-financial data are measured in many ways,as there is no common denominator for measurement. Evaluating performance or making trade-offs between attributes is difficult when some are denominatedin time, some in quantities or percentages and some in arbitrary ways. Manycompanies attempt to overcome this by rating each performance measure interms of its strategic importance (from say on the scale of not important toextremely important) and then evaluating overall performance based on aweighted average of the measures. Others assign arbitrary weightings to thevarious goals. One major car manufacturer, for example, structures executivebonuses so 40% based on warranty repairs per 100 vehicles sold; 20% oncustomer satisfaction surveys; 20% on market share; and 20% on accounting performance (pre-tax earnings). However, like all subjective assessments, these methods can lead to considerable error[4].

 

3. Lack of causal links is a major challenge in intangible measurement and reporting. Many companies adopt non-financial measures without articulating the cause effect relations between the measures or verifying that they have abearing on accounting and stock price performance. Unverified causal linkscreate two problems while evaluating performance:

 

a) Incorrect measures focus attention on the wrong objectives, and

 

b) Improvements cannot be linked to later outcomes.

Xerox, for example, spent millions of dollars on customer surveys, under theassumption that improvements in satisfaction translated into better financialperformance. Later analysis found no such association. As a result, Xerox shiftedto a customer loyalty measure that was found to be a leading indicator offinancial performance.The lack of an explicit casual model of the relations between measures alsocontributes to difficulties in evaluating their relative importance. Without knowing the size and timing of associations among measures, companies find it difficult to make decisions or measure success based on them.

 

4. Another problem with non-financial measures is lack of statisticalreliability whether a measure actually represents what it purports torepresent, rather than random “measurement error”. Many non-financialdata, such as measurement of satisfaction level, are based on surveys with limited primary data. These measures generally exhibit poor statistical reliability, reducing their ability to discriminate superior performance orpredict future financial results.

 

5. Finally, although financial measures are unlikely to capture fully the many dimensions of organizational performance, implementing an evaluation system with too many diverse performance measures can lead to “measurement disintegration”. This occurs when an over abundance of measures dilutes the effect of the measurement process. Managers chase a variety of measures simultaneously, while achieving little gain in the main drivers of success[10].

 

CONCLUSION:

In today’s business environment, intangibles such as knowledge, skills, brands, patents, copyrights, relationships, culture, processes and routines, expenditures for researchand development, human resources, or intellectual property are, more than ever,vital strategic resources and are the critical sources of competitive advantage. The competitive advantage of firms lies in those business activities which the firm knowshow to do well. The knowledge which the firm possesses its knowledge pool, thusplays a key role in the survival, profitability and growth of the firm. As intangibles are critical for the future success of businesses and sustainable performance, there is need to disclose this to stakeholders in order for them to beable to better understand and value the organization. For such organizations, capital costs and the volatility of their share prices should decline as investors gain greatercertainty about the values of the companies.

(Pankaj M Madhani is an Assistant Professor at Icfai Business School, Ahmedabad. He can be reached at pankaj.madhani@gmail.com).

 

REFERENCES:

1.     Litan, Robert and Wallison, Peter. “The GAAP Gap: Corporate Disclosure in the Internet Age”, Working Paper, AEI-Brookings joint centre for regulatory studies.

2.     Ballow, John, et. al. “Enhanced Business Reporting”, A formal joint proposal to the AICPA from Accenture LLP & Asset Economics, Inc., October, 2004.

3.     “Final Report of a Feasibility Study concerning a programme for research into the measurement and valuation of intangible assets” Carried out for the Department of Tradeand Industry, University of Manchester, April 2000.

4.     “Made to measure: Corporate performance management in the financial services industry”, An Oracle White paper with the Economist Intelligence Unit, March 2004.

5.     “Intangible assets and future value”, An Accenture Survey Conducted by the EconomistIntelligence Unit (EIU), 2003.

6.     Jürgen H. Daum. “Intangible Assets and Value Based Network Control in the Automotive Industry. Part 1”, A research report on the role of a intangibles based analysis of the value creation system  the example of Toyota.

7.     “The Role of Intangible Assets In The New Economy”, A Product White Paper by Dennemeyer & Company, www.ipfrontline.com.

8.     White, Allen L. “Business Brief: Intangibles and CSR”, Business for Social Responsibility, www.bsr.com, February 2006.

9.     Oehlcke, Fatma, et. al. “Do voluntary intellectual capital disclosures provide information about firms’ intangible assets?” Working Paper, Cass Business School, London UK, 2005.

10.   Eronen, Anne. Classification of intangibles – some comments, Helsinki: ETLA, The Research institute of the Finnish Economy, www.fek.su.se