INTELLECTUAL CAPITAL

Intellectual capital is the term used to describe the intangible assets provided to an entity by its employees' efforts and also knowledge assets such as patents, trademarks, copyrights, and other results of human innovation and thought. Intellectual capital is often disaggregated into four categories:

1. Legally recognized intangible assets such as patents, copyrights, and franchises that are purchased
2. Legally salable and protected intangible assets such as trademarks, brands, customer lists, and customer orders
3. Structural intangible assets such as the systems and databases used within the company; examples of these systems are the information system, accounting system, purchasing system, and sales system
4. Human capital intangible assets such as what is in the minds of the individuals who work for the company; an example is the knowledge that researchers in a pharmaceutical company might have in their minds of past experiments and their results

SIGNIFICANCE IN CONTEMPORARY BUSINESS ORGANIZATIONS

The nature of business activity in the United States changed dramatically during the second half of the twentieth century. Jobs in service-producing industries increased greatly. At the same time, manufacturing, farming, construction, and other goods-producing jobs fell. The U.S. economy underwent a basic change in the ways the labor force is employed. While earlier the most significant businesses were industrial enterprises, with the largest segment of the labor force involved in the production of goods, in the twenty-first century U.S. economy, employment in service businesses exceeds that of employment in the production of goods.

In service businesses, and even in industrial and retail enterprises, there is general recognition that astute knowledge management leads to innovation and value creation, and therefore company success. Within the workforce of a company reside the individuals who have the knowledge that represents intellectual capital.

INADEQUACY OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES

Generally accepted accounting principles (GAAP), which establish what is recorded and reported in an entity's financial statements, ignore an entity's workforce as an asset and also ignore most of the other intangible assets possessed. The stock market analysts, on the other hand, appear to recognize such assets in determining a company's worth, as well as a company's future profit prospects. Companies in which knowledge is important, such as successful companies in the information processing and pharmaceutical fields, sell many times over book value, when purchased by other companies. Even successful industrial companies sell appreciably above book value, though not typically at the levels of companies where knowledge is critical.

The theoretical argument against current accounting is that the current model for reporting does not adequately measure and value the skills, information, and technological capabilities of the individuals in organizations, yet these factors are valuable to the progress of a company. Because of the significance of the unmeasured intellectual capital assets to the future of the entity, and therefore its market capitalization, current financial reporting lacks important informational content, sometimes even to the level of being misleading. Companies have been able to show accounting profits based on their tangible assets following GAAP, while their intellectual capital assets were losing value. Ultimately such companies did very poorly—their profits vanished. Good financial reporting should guide capital to the most promising investments.

An example of the inadequacy of GAAP in relation to recording intellectual capital is in the area of research and development costs of companies. That research improves the knowledge awareness of employees is a prevailing assumption. Intellectual capital would be considered to have been increased because of the learning and understanding gained by means of engaging in research and development. It would then be expected that future revenue would be greater for firms that had significant research and development costs. In some instances research and development results in valuable patents and copyrights. There is evidence that research is strongly associated with earnings, stock prices, and returns.

GAAP, however, mandates the expensing of research and development at the time of the expenditure. (A few exceptions allow for capitalizing some of such expenditures.) Such a ruling reflects the belief that there is no relationship between research and development costs and the future benefits to the firm or that the relationship cannot be established. Another belief is evident: Allowing the capitalization of research and development expenditures introduces the possibility of the manipulation of earnings by companies since establishing objectivity of reasons for amortizing or writing off capitalized costs is difficult to determine.

CURRENT REPORTING STANDARDS

Accounting guidance views intellectual capital as intangible assets and specifies exactly what the term means for accounting recognition. Traditionally such accounts as patents, copyrights, franchises, and goodwill appeared under the intangible assets balance sheet caption, in the instances where the company purchased such assets from other entities. Since internally developed intangible assets, such as patents and copyrights, are generally expensed under current research and development accounting principle, only minimal expenditures, such as the cost of securing a patent may be recorded as an intangible asset. Externally acquired patents and copyrights, however, are recorded at purchase price. Franchises are normally externally acquired and recorded at cost as intangible assets.

The GAAP rules for a purchased subsidiary state goodwill is the excess of the cost of an acquired subsidiary over the sum of the fair values of all identifiable assets that are acquired, less liabilities assumed, that are acquired. Besides tangible assets, identifiable assets include any assets that are intangible assets and meet criteria that make them separable from goodwill such as they can be sold, transferred, licensed, rented, or exchanged or there is a legal-contractual relationship. Examples of identifiable intangible assets separable from goodwill are customer lists, customer orders, brands, and trademarks. If these components of intellectual capital are internally created, there is no means under current GAAP to place their value on the balance sheet. Research and development costs of the acquired subsidiary must be expensed. Goodwill, then, is a residual amount, frequently described as the value of the human capital acquired.

Under current reporting standards the parent company and subsidiary company are required to be reported in the financial statements as if they are a single entity. Therefore, the consolidated financial statements are extremely difficult to understand with the parent's goodwill ignored while the subsidiary's goodwill is shown.

Finally, GAAP does not amortize goodwill because it is considered to have an indefinite useful economic life. Goodwill, however, must be considered annually for impairment. The implied fair value of the reporting unit is compared to its assets including the residual goodwill asset, less liabilities. If the implied current fair value of goodwill is determined to be less than the recorded goodwill, the recorded goodwill must be reduced or entirely eliminated. Because of business economic cycles there are sometimes very large write-offs of goodwill when there is a downturn in the economy and the stock market. It would appear that human capital would not suddenly disappear because of a downturn in the economy.

EFFORTS TO RECOGNIZE AND DISCLOSE INTELLECTUAL CAPITAL INFORMATION

Financial reporting limitations have led to efforts to measure intellectual capital indirectly outside the financial statements. Such measures sometimes accompany the financial statements in reports to stockholders. These nonfinancial measures include information on such items as revenue percentage per employee, employees who have contact with customers, satisfied customers, research and development costs, continuing education and training per employee, employee turnover, and employee satisfaction. One of the best known of the performance measurement strategies that imply the existence of intellectual capital is called the balanced scorecard. It creates measures in the financial, customer, internal business process, and learning and growth areas.

Those who wish to have a more comprehensive, realistic reporting of what provides value to businesses will continue to pay attention to intangible assets.

see also Copyrights; Franchising; Human Resources; Patents; Trademarks

bibliography

Andriassen, D. (2004). Making sense of intellectual capital: Designing a method for the valuation of intangibles. Burlington, MA: Elsevier Butterworth-Heinemann.

Financial Accounting Standards Board (2001). Statement of financial accounting standards no. 141: Business combinations. Norwalk, CT: Author.

Financial Accounting Standards Board (2001). Statement of financial accounting standards no. 142: Goodwill and other intangible assets. Norwalk, CT: Author.

Kaplan, Robert S., and Norton, David P. (1996). The balanced scorecard. Cambridge, MA: Harvard Business School Press.

Lev, B. (1997, Spring). The intangibles research project. Journal of Financial Statement Analysis, 2, 34–36.

Bernard H. Newman