Importance of Intellectual Capital in the Modern Economy
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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.
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.
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.
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.
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 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.
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.
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
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 â‚¤8 million(from Total depreciation and ammortisation).The group also has purchased the tangible and the Intangible assets worth â‚¤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 â‚¤192.754 million(2006:â‚¤155.551 million) and the Intangible Assets had the value of â‚¤48.511 million (2006 : â‚¤39.450) according to the Balance Sheet on 31st march,2007.
The Cash Flow Statement of the Company for the year ended 31st 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 â‚¤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:
2.) Customer and Supplier Relationships
3.) Technology and Brands
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.
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.
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 assets as there exists some contribution of the tangible assets.
In addition , the market value does not retains its position due to the variation in the equity prices and the market value for some private owned companies are not accessible and also a firm having the subordinate companies do not enjoy the freedom of individual market value. (Tayles et al , 2005).
Barsky & Bremser(1999) discover the dubiety in the intangibles and the long-term ventures by quoting the examples of the recognition and the amortization phases of R&D, acquiring market and other vital investments whose returns are distributed among different accounting periods.
Why Intangibles should be included in the Balance Sheet:It has been suggested by Berry(1993) that the debate on the intangible assets due to the decision of some major companies for instance Coca Cola of including their Brand value in the balance sheet as an asset . This step forced the accounting profession to provide some guidelines and framework for the intangibles.
Brands are a major tool in maintaining the competitive advantage therefore the companies must monitor the performance of the brand in the market as their success can provide the economic benefits to the company. Furthermore, the brands also provide assistance in the management decisions when they are included in the balance sheets,purported by Elliot & Elliot(2008).
A Special Committee under the American Institute of Certified Public Accountants AICPA (1994) , observes the due to the sheer competition and the swift improvement in the technology has brought striking changes in the business environment. As a consequence the companies have responded to the changes and have re- organised their operations. Companies are now focusing on improving customer and supplier relationships , increased high value activities and improved decision capability by adding the non-financial information in decision making.
Asset Recognition in Financial Statements
Exposure Draft 52 (1990) Accounting for Intangible Fixed Assets provided three conditions for the recognition of the intangible assets. These conditions were focusing on the characteristics of intangible assets like the identifiable historic costs , separable from goodwill on the basis of cost and the identity.
Balance Sheet Overview
The Balance sheets have been of prime importance to investors, lenders and trade creditors due to the fact that it provided an overview of a company’s ability to efficiently convert its assets in to cash, to pay its debts and meet the expenses occurring for growth and expansion.
The balance sheet has its base on the concept of Historical Cost Convention the Accounting that is any event or a transaction is recorded after it takes place.
The historical cost convention has been criticised from inside and outside the accounting profession. There are some analysts that recommend to modify the foundation of financial accounting from historical cost convention to Value Accounting paradigm. However , some analysts suggest that the optional Methods in the traditional financial accounting should not be practiced(Gellein & Newman , 1973).
Despite of its usefulness the Historical Cost pose serious accounting problem of valuation . As when a long-term resource is entered or recorded at the actual cost of acquisition but as the time passes the value of the resource may increase or decrease. Considering the example of the real estate market , whose prices have gone up due to the inflation and other factors but yet the historical cost cannot facilitate the increase in the value of the resource. Even with the problems it serves as a major instrument of valuation in accounting and is based on the principle of objectivity , highlighted by Solomon et al (1995).
Elliot & Elliot(2008) argue that the financial statements that are prepared under the historical cost convention are objective and factual as they are supported by the facts and evidences that makes them verifiable and unchallenged. However, they need to be modified due to the revaluation of some fixed assets.
According to Berry(1993) , intangible assets like reputation, knowledge, skill, etc could be rejected by the historical cost accounting from being treated as an asset on the basis of the uncertainty in future benefits , prudence concept and the unidentified costs of these assets.
Intangible Assets and the Balance Sheet
It is reported by Hussey & Bishop(1992) , the assets like the Brands and the Publication titles are seen on the Balance Sheets of the some renowned Companys under the heading of the intangible assets , separated from the Goodwill as they do not fall under the requirements of SSAP 22 .These intangible assets remain on the Balance Sheets indefinitely unless there is no impairment in their value observed.
Are traditional Accounting methods relevant in reflecting value
The traditional accounting methods are losing the importance the value creation is attributed to the intangible assets of firms whose focus is towards the knowledge based economy(James ,1999). Davies and Waddington(1999) assert that the traditional accounting gives less attention to the generation of value.It is argued that the Profit and Loss account and the balance sheet are unable to pilot the expected succeeding earnings.The accounting profession is now initiating to realize the importance of the intangible assets as the authentic enhancers of the investors value. In addition , the arrangements made by the GAAP in this context are less satisfactory.
Research and Development Costs
SSAP 13(1987) Accounting for Research and development classifies the research in to Pure and Applied Research and then amortizes the costs related to the research that is incurred in the same year.
The disclosure of Research and Development in the Balance sheets are done in two parts . The fixed assets that are either acquired or constructed to facilitate the Research and Development that spans many accounting periods should be included in the Balance Sheet and written-off using the profit and loss account over their useful service lifetime.
However , the other development expenditure should be written-off in the year of occurrence except for the special circumstances .These special circumstances defined by SSAP 13 with the conditions such as a well defined project with an identifiable expense , certainty of success with the availability of the required resources.Such development costs are shown on the Balance Sheet under the intangible fixed assets and is amortised accordingly(Hussey & Bishop,1992).
A study by Elliot & Elliot(2008) outlines two constraints or thoughts that oppose the recognition of the Research & Development expenditure as an asset.The first being is that the company with an efficient R&D may be acquired by the other company who is less committed to R&D and wants to increase its earnings.Secondly ,it is the uncertainty of the benefits that are expected to be received from the R&D expenditure .Therefore , the accounting profession following the principle of prudence places the Research as an expense.
IASC(1999) suggested that if the development costs fulfill the conditions for the recognition as an asset than they must be treated as intangible assets and amortized.
An accountants who are involved in financial reporting of companies based in UK are more concerned about the disclosure of R&D rather than thinking about the accounting treatment of R&D and they would not presume that the financial statements are the communication channels that broadcast the valuable information on R&D, suggests Nixon(1997).
The IASB’s framework for the preparation and the presentation of financial statements(2001) provides two conditions for the capitalization of the development expenditure in the balance sheet that includes the increased certainty of the future benefits and the costs that can be determined.
The costs that are incurred in the development of an intangible asset can be determined by the help of the accounting system of a company that can trace back the cost of every component of a cost. However ,the difficulty is the uncertainty of the flow of the future benefits to the company.Because , if an pragmatic approach is applied to this scenario it will further reveal that that the complexities and the cost involved in the development phase is much greater than expected. This uncertainty can be seen practically in the Sales of new product that is launched in the market. So, this uncertainty of future benefits cannot fulfill the condition specified by the IASB ,so therefore on this basis the development expenditure cannot recognized in the balance sheet outlined by Elliot &Elliot(2008).
It is argued that the returns on the equity are governed by the extent to which a firm is indulged in the R&D.The investors are biased towards the R&D expenditure and are unable assess the future benefits that are expected from the R&D. Investors therefore undervalue the R&D. It is indeed perceived by the researchers that the R&D is free from risky, but in reality it does not happen. Market returns prove the proposition of the underestimation of benefits and the risks involved with R&D(Lev and Sougiannis 1996 ; Chan et al 2001).
However, Boone and Raman(2001) , suggest that the companies that are involved extensively in R&D have an edge of knowledge which their bidders don’t posses.So, as a consequence they can demand a high ask price for their knowledge assets from their potential bidders. This in turn increases the liquidity of their assets when they are disclosed properly.
Human Resources(Human Capital)
OECD(2007), while explaining the eminent impact of Human Capital on the Financial performance of an organisation highlights five characteristics of the workers such as educational levels , skills and experience , age and the gender when considered changes the arrangement of the labour which has proved to play a crucial role in the expansion of the production capacity.
The idea for putting people on the balance sheets was first introduced by Hermanson(1963) when he suggested formulate the framework of Human Asset Accounting that treats the organisational employees as assets.
Hermanson(1964) further conceded that the employees are the operational assets of an organisation that do not fall under the category of those assets that are controlled by the organisation. He also admitted that the there will be a discomfort in recognising the employees in the balance sheets as there was no historical cost associated with these assets , which was a usual practice in the accounting profession.
Kinman(2007) suggests that the hesitation of the accountants in including the intangible assets in the financial statements is not their mistake but on the contrary the accountants according to their professional requirements prepare the financial reports that contain the information that is objective,relevant , reliable, neutral and that is concerned by fulfilling the information needs of the stakeholders.
Flamholtz is considered one of the prominent figures in the context of the Human Assets Accounting. Flamholtz(1985) discovered five aims of the human asset Accounting that include: to provide a platform on making the decisions on the Human assets , to provide information that quantifies the costs and the monetary value associated with the employees as organisational assets and the managers should embrace the human resource procedures in their inferences.
Lambert(1998) has identified two problems with the disclosure of the intangible assets while his study on the Customer Satisfaction as an indicator of financial performance. Lambert(1998) argues that the advantages of the intangible assets like Customer Satisfaction are less apparent and hence is difficult to make standards for their disclosure .The reason for that is the methods involved for measuring Customer satisfaction embeds complexity and are biased .Secondly , Lambert(1998) ,suggests that the disclosure standard for the Customer Satisfaction must provide guidance on the measurement , presentation and the Geographical boundaries of the data.
Concessions, Patents, licenses, trademarks and similar rights and assets
The assets that fall under these categories are recognized in the Balance Sheets when they have and create a value and they can be separated from the goodwill or they have been created by the company itself. Such assets help the company to create a product or a service and provide the legal aid to protect the companies ideas and innovations, purported by Hussey & Bishop(1993).
The study of the patents conducted by Solomon et al (1995) reveals that the patents play an important role in a new product creation and development as they provide the exclusive rights for the use and exploitation of the product to its owners.Patents can be purchased from its owners and can be generated by the company itself through the development of a new product by conducting the research and development.
However , the costs of a purchased and internally generated patent are seen differently. Moreover , the intangible assets when purchased are treated as an asset but at the same time the research and development costs pertaining a particular patent are expensed in the profit and loss account. It is further argued that due to the practical problems and the larger amount of uncertainty involved in the development of a product and then a patent the research and development costs are expensed due to the unpredictable results.
It has been found that the stakes in the software has a vital effect on the organisational performance in the recently passed years.The countries like France , Netherlands , Sweden and the United States the investments in the software has contributed in one-third portion of ICT( Information and Communication Technology) Capital to GDP increase in the years between 1995 and 2003(OECD, 2007)
Software Publishers Association(1996) suggested that there the software development costs should be included in the R&D expenditure. The reason behind that was the the vividness of the industry and high risks involved in thedevelopment phase of a software. Therefore, it was very difficult to ascertain the the practicability of a software and hence it was regarded as an R&D expense upon which most of the software development companies agree.
Aboody & Lev(1998) explain the this attitude of the software development companies is due to the elasticity in the policy of SFAS 86, that allows the companies to either recognise the software developmet as an asset or as an expense.
Thomas(1996) purported that the well-known brands are assets that can be further enhanced in the market. He also argues that the organisation owns the structural capital that includes the organisational skills and the market intelligence that enables it introduce the novel resources in the market. In addition the brand capital and the structural capital both when combined can enhance the organisations capability to expand in the market.
Berry(1993) discussed the proposition of Accounting Standard Board of not treating the brands as the intangible assets as they were not separable from the goodwill hence should be valued under goodwill. The reason behind this is the unknown historic cost in the development and the management of the brand that includes the advertisement and marketing expenses.
In contrast the companies that included brands as assets in their balance sheets have determined the value of their brand.But as a matter of fact the value is not always accepted in most of the situations so therefore the historic costs have to be used instead of value for the intangible assets.
Why Intangibles are not included in the Balance Sheet(ISSUE)
Arnold et el(1994) explained a conflict which arises in the accrual accounting framework and the prudence concept ,when the intangible assets are treated as expenditure and matched with the revenues .This treatment implies that the benefits received from the intangible assets span many accounting periods and then they should be treated as the fixed assets in the Balance sheet on the other hand.
Two more problems exist with the intangible assets. At first there some intangibles in R&D and goodwill that create a greater uncertainty in their value if separated from the organization who owns them. Secondly ,the problems arise when the intangible assets need to be amortized. Complications occur in the identification of costs when acquired and created internally i.e patents , expertise.
Furthermore , it is very difficult to determine the time period during which and asset produces the benefits,Arnold et al(1994). Solomon et al(1995) have argued that the Intangible Assets have the ability to provide benefits to the business and can exploit the firms financial resources.
Despite that many financial statement users support the proposition of not including these assets on the balance sheet due to the fact that the benefits received from these assets are less apparent and uncertain as compared to the benefits received from tangible assets like plant , machinery and equipment etc.
Rutledge(1997) supports the argument that by including the Intellectual Capital in the Balance Sheets will reduce the efficiency of the Balance Sheets. He explains the idea by saying that the companies who include their bright workers in the balance sheet look more more profitable to the stakeholders even if they are not making the profit.He further opposes the proposition of including some characteristics of the workforce like gender , ideas in the balance sheet is pragmatically not suitable.
He adds more by saying that the people are not the assets for the organisation as they cannot be owned , so how the ideas from the people can be treated as assets? If the value of the workforce has to be calibrated than it should be done by the Cash Flows as they measure the services used by the organisation. On the other hand the balance sheets provide a picture of the assets owned by the organisation.
However this is not true in the production or the labour intensive organisations the workers that have been trained and those who acquire skills possess an implicit knowledge of doing something in an efficient manner even if they have not verbalised and passed that knowledge to other workers.
Mclean(1995) , reports that the importance of the non-financial performance measures that need to be accompanied by the traditional Accounting Model is appreciated by many researchers , professionals , consultants and the Managers. Companies are now examining the performance norms that are foucused on their cognitive activities.It is further argued that some business administrators believe that the traditional accounting system does not provides the reality of economic benefits received from the knowledge intensive activities.In addition there is an immense need for a new accounting model that incorporates the human resources, skills and the knowledge.
Contradictions on the Value relevance of Regression Models and the Financial statements
The regression analysis of the stock prices and the independent variables like the financial statement measures and the book value reveals that the power of the financial statements has become less relevant in explaining the market value of shares. Furthermore , it is also agreed that the relative importance of the balance sheets as compared to the income statement has increased with the passage of time. Aslo , value relevance is given more importance in the high-technology firms with a large amount of intangible assets as compared to the firms involved in the other industry sector, Francis and Schipper(1999).
Core et al(2003) , differ from the argument provided by the Francis and Schipper(1999) by their study of the regression model of equity values and the traditional financial variables by reporting that the explanatory power of the regression model declines with the passage of time in all the industry sector. However , the relevance of the traditional financial variables for equity variables remain stable with the passage of time.
Are the investors satisfied with the provided information about the intangibles:
Lev and Sougiannis(1996) founded that the upon reflecting the Research and Development expenditures ,recognized and amortized were relevant to the interests of the investors by adding them to the value relevance of the book values and the earnings of the US companies. Further, study of the value of the brands value in the market concluded that the brand values were statistically significant with respect to the value relevance .However , it was difficult decide that either the market prices are governed by the brand value or the value of the brand should be estimated by the market prices, Barth et al(1998).
Amir and Lev(1996) , purported that the there are some intangible assets that are unrecorded are value relevant and play a role in the growth and development of a firm that is specifically working in the cellular phone industry. Although the Customers are a non-financial measure but when added to the traditional financial measurement tools , they increase the reliability and the estimation power. In contrast Aboody and Lev(1998) , concluded that the traditional recognized assets i.e stock returns and the stock prices were more relevant to value for the investors as compared to the intangibles like the development costs of a software.
It has been demonstrated by Holthausen and Watts(2001) that research in this area may have limited implications for setting the standards on the intangibles assets because the research has been able to find the associations of these intangible assets with the stock prices and the value relevance to investors. However, the fails to find the actual reason that why these intangible assets are treated in associations. The authors further argue that the financial statements provide useful information other than valuation of equity.Therefore , it is not reasonable to use the association with the equity prices and the value relevance to the investors as a standard for valuation , disclosure and the recognition of intangibles assets in the balance sheets.
Need for Alternative treatment(accounting) for Intellectual Capital:
It is noted that new procedures are required to appraise and control the intellectual capital of the company.On the basis this , it can be asserted that the intangible assets of a company now justify the need of particular accounting manipulation. The basic theme for that is that some components of the intellectual capital do not acknowledge the elevations of the traditional financial accounting( Roos, 1997 ; Rennie, 1999).
Batchelor(1999), reports that the old fashioned accounting procedures are Creating a misunderstanding of the assets and making the erroneous decisions based on the net value of the tangible assets in the balance sheets.
The Intellectual Capital Accounting (ICA) provides the information on the business activities that are aimed at expanding its intellectual capital for value creation. The reporting of the intellectual capital is aimed at acquiring the information that gives an insight in to the performance of the business(Mouritsen et al ,2001b).
Booth(1998) suggests that the measurement of Intellectual Capital is not enigmatic and the accounting skills are capable of measuring it. He argues that there are some accounting methods with little refinement are ready to use for this purpose. The complications exist at the managerial level in the apprehension of the Intellectual Capital and utilizing it improve business activities.He asserts by saying that every thing is clear as the simulation tools already exist and the calculations are difficult to perform.
Bartram(2000) explains that the a step to accounting for the intellectual capital can be explained by a chance to increase the value.
Leadbeater(2000), identified three alternative suggestions for Intangible assets related to their measurement and market which he named Incremental, Radical and Hybrid. The incremental technique leaves the traditional accounting procedures as they are but some additional information that is pertinent and important for the intangible assets is added. The intangible assets are valued using the methods commonly used in the acquisitions and the quasi- market valuations(reduced valuation errors) are obtained using the real options approach.
The radical approach suggests totally a new balance sheet i.e Intellectual Capital Balance Sheets that emphasize more on the intangible assets. The financial information is included only to keep the track of the monetary investments and their returns. Intangible Assets Monitor by Sveiby( ) can quoted as an example. Last but not the least is the hybrid approach involves the whole society in devising the valuation of the intangible assets in addition to the valuation perceptions of the managers and the accountants.
The valuation of the intangible assets demands a new rectification that resolves their valuation issues. The accountants have to play a vital role by designing and implementing a new balance sheet that accommodate the intangible assets.
It is apparent that global economy is working under a new doctrine of driving the value. All the monetary returns are associated with exploitation of the value. This value propagation has dictated a change that is observed when the organisations value their assets on the historical cost convention (a price on which an asset is
acquired) and then compare this with greater value of the same asset that is offered by the current market. It can be argued that if the organisations are treating their assets in a traditional way than they are underestimating the worth of that asset. The acquisition of a land is a simple example of explaining the argument whose value change with the ups and downs of the real estate market.
The knowledge is considered to be a key factor in the creation of value and maintaining the competitive advantage in the market. Now the organisations have become knowledge aware and they are striving to achieve the competency which takes them to the lead in the market. Intellectual Capital by definition is a knowledge acquisition paradigm . Actually, it can be said that the Intellectual Capital itself is a knowledge that provides the benefits of innovative strategies that allow the companies to stand more liquid and solvent.
However, the market value of a company cannot be totally attributed to the intangible assets of a firm there is an influencing role of the tangible assets in the market value. These prominent assets include the assets on the balance sheets, company liabilities, share holders equity. Practically it is seen that the liabilities of a company when increase from its net tangible assets, as a consequence company is unable to carry on its routine procedures. The shareholders are concerned about their share of money not the company’s worse position.
It is now generally accepted that the investments in the tangible assets such as plant and machinery has decreased .The companies are now spending a lot on the Research and development and the processes that support the latter in the acquisition of the knowledge which they use as a tool survive in the market. As it is the investment in the intangible assets. Despite the acceptance of the Intellectual Capital as the driver of a value, its has not received the proper recognition in the financial statements.
In contrast it is found that although the investments in the tangibles assets have reduced due to the change in the economy. However, it can be justified that the investments in the intangible assets is risky. As there are a lot of risks involved in R&D like the failure of the project , the companies can acquire those companies involved in the R&D.
Similarly, the development and the marketing of the software poses a lot of risks i.e a software may fail to exist, software can contain bugs that decrease its market. Also, the investments in the brands also carry risks like the strong brands in the market become hurdles for the weak or new brands to come in the market , a strong and the original brand can loose its effectiveness when a lot of other small brands are associated with that brand causing the Brand Dilution.
The fame of the traditional financial statements is now reduced because they are not able to accommodate the drivers of the value i.e Intellectual assets of an organisation. The current revolution in the modern economy demands a new change in the layout or a new model that is flexible enough to recognise the Intellectual Capital. As, it is perceived and admitted that the Intellectual Capital is going t loose its potential if it is not given the relative importance in the financial statements and the companies are going to loose edge over the competitors.
The accounting profession cannot be blamed for not accommodating the intangible assets as the accountants job is to fulfil the information needs of the mangers and most prominently the shareholders. It is the users need that dominates the reports produced by the accountants. Also, the Accountants fulfil their duty by providing the appropriate , reliable , unbiased , and fact-based information.
The techniques that have been applied in measuring the performance of an organisation i.e Return on Investment(ROI) and Return on assets have now become obsolete in the context of measuring the Intellectual Capital. However,
Discounted Cash Flow (DCF) analysis is used in the valuation of the intangible assets like brands together with the framework that assigns values to the brands according to the current market demands.
The definitions that are discussed in the literature above suggest that there is no uniform definition of the intellectual capital which is generally accepted. Every researcher provides his/her own ideas and perceptions in defining the intellectual capital. However, most of the definitions support the notion that intellectual capital is prominently used to create value.
Also , the division of the intellectual capital is observed in to customer , human and the structural capital in order to fully apprehend the role of the intellectual capital in its management and the development of value.
The traditional financial statements are based on the Historical Cost Convention. The historical cost has witnessed criticism as it is unable to provide the information about the value. Also, the historical cost convention can reject the idea of treating the intangible assets like skills, Knowledge (Intellectual Capital) on the basis of the uncertainty in future benefits , propagation of the Prudence concept of Accounting, and the costs that are also uncertain.
However, the Historical Cost and the financial statements if tend to follow prudence and is based on the objectivity provides the benefits of being unchallenged on the information they provide as they are accompanied by actual facts.
In practice the Research is not treated as an expense. However, the development expenditure is treated as an asset on two conditions of certainty of success and the costs that can be traced purported by SSAP13 , IASC and IASB.In contrast the proposition of not including the R&D expenditure in the balance sheets can be followed due to uncertainty and the complexities like the failure of a new product in the market. Also , the patents are not recognised in the balance sheets when generated internally and due to unpredictable results.
Human assets are the important assets of an organisations.They are the brains of the organisation as organisations don’t think, humans thin
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