Intellectual Capital Is Generally Insubstantial In Nature Accounting Essay

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

In an Information age the , knowledge has become the key resource, which will require being continually acquired and up-dated. Edvinsson (1997) defines intellectual capital as the 'possession of knowledge, applied experience, organizational technology, customer relationships and professional skills'. Recent social scientists account Human capital as 'One component of intellectual capital'. According to Bontis et al. (2001), quite simply, human capital represents the individual knowledge stock of an organization as represented by its employees. Roos etal. (1998) argue that employees generate intellectual capital through their competence, their attitude and their intellectual agility. Thomas T. Stewart, (1997) defines "Intellectual capital is intellectual material - knowledge, information, intellectual property, experience - that can be put to create wealth". Intellectual capital is "A dynamic nexus of a company's human capital, social capital and knowledge management" (Rastogi, 2003).

The term "intellectual Capital (IC)," was first introduced by Kenneth Galbraith in 1969 (Bontis, 1998) who believed that there was more to the definition of corporate intelligence than dry skills-that it also requires intellectual action. IC, as he introduced it, is the move from "having" knowledge and skills to "using" the knowledge and skills that are scripted, often circuitously, in literature. The active use of knowledge is the transformation of information known to the individual into a product or service that is of value to a firm and its stakeholders. In short intellectual capital is defined "A dynamic nexus of a company's human capital, social capital and knowledge management" (Rastogi, 2003). Edvinsson (2000) views IC as the future earning potential derived from the combination of human capital and the potential of workers within an organization.

Ulrich (1996) argues that intellectual capital exists when skilled employees are committed to business goals. That is, IC equals competence time's commitment. Others view this asset as functioning at the collective level and regard it as a meta-competence. Rastogi (2002), for instance, views IC as a firm's holistic capacity or meta-capacity to meet the challenges and exploit opportunities in its continual support of and search for value creation.

While intellectual capital is generally insubstantial in nature, it is becoming widely accepted as a most important corporate strategic asset proficient of generating sustainable competitive advantage and superior financial performance (Barney, 1991). Edvinssonand Malone (1997) define the difference between a firm's market value and book value as the value of intellectual capital. A firm's intellectual capital, in a broad sense, is comprised of human capital and structural capital (Bontis, 1996). Human capital is employee-dependent, such as employees' competence, commitment, motivation and loyalty, etc. Although human capital is recognized as being the heart of creating intellectual capital, a distinctive feature of human capital is that it may disappear as employees exit (Bontis, 1999). In contrast, structural capital belongs to firms, including innovative capital, relational capital, and organisational infrastructure, etc. Recognizing the value of intellectual capital is reliable with the theory of stakeholder view (Donaldson and Preston, 1995), which maintains that stakeholder relationships include all forms of relationship of the company with its stakeholders, e.g. employees, customers, suppliers, and residents of the community.

In 1991, Barney, in his seminal study "Firm Resources and Competitive Advantage", expanded Werner Felt's 1984 model with concepts from organisational economics and strategic management literature to demonstrate that firms can gain and maintain competitive advantage. Barney coined the phrase "Resource- based view of the Firm" to describe this new model. He argued that firms' sustained competitive advantage derives from resources and capabilities that are rare valuable, imperfectly imitable, and not substitutable. Moreover in the context of the firm, these resources and capabilities are viewed as bundles of tangible and intangible assets that include management skills, organisational processes and routines, and information and knowledge.

Resource - Based View (here after quoted as (RBV) links a firm's internal capability (what it does best) to its external Industry environment (what market demands and what competitors offer).Capabilities have proven more difficult to delineate and are often termed as intangible assets (Hall, 1992) or intermediate goods (Amit and Schoemaker, 1993). Essentially capabilities refer to the firm's capacity to deploy resources, usually in combination using the skills of individuals or group as well as organizational routines and interactions to affect a desired end. Academicians and practicing managers alike however were not aware of the argument, regarding the resource - based view until recently. Resource - based view gained attention of strategic thinkers only after the contribution by prominent authors such as Barney, (1986), Wernerfelt (1984); Dierick & Cool in 1989. Dierick & Cool's paper is a fundamentally important literature in the theory of Resource - based view, because it clearly explains the kind of resources and capabilities that are of central concern.

A number of scholars have expressed the concern that much of the strategy literature was narrowly focused on product market position as a basis for competitive advantage and above normal return. This approach has created an analytical problem: if a product's market position is achieved or otherwise protected by the deployment of scarce assets, it is necessary to account for the opportunity cost of those assets. The measured returns of the products market activities under normal circumstances will be inflated if the opportunity cost is not properly appropriated. Dierick & Cool (1989) offered a unique perspective on the topic of limits to imitation of valuable, but non tradable asset stocks. They suggested that the degree to which an asset is imitable depends upon the characteristics of the process used to accumulate the particular asset. Time compression diseconomies, asset mass efficiencies, interconnectedness of asset stocks, asset erosion and causal ambiguity are the dimensions associated with the value of an imitable asset.

Acknowledging the growing gap between the market and book values of firms, investigation into how to measure firms' intellectual capital and whether capital market is efficient with intellectual capital has been drawing broad research interest. Lev and Radhakrishnan (2003) By modeling sales as a function of a firm's organisational capital, net fixed assets, number of employees, and R&D capital, developed a firm-specific measure of organisational capital. Using a sample of approximately 250 companies they showed that organisational capital estimate contributes significantly to the explanation of the market values of firms, beyond assets in place and growth potential.

A path breaking research by Pulic(1998) in parallel to the concept of Skandia Navigator (see Bontis et al., 1999), Pulic (2000a, b)depicted firms' market value as created by capital employed and intellectual capital, which consists of human capital and structural capital. Applying VAICas a measurement of the overall intellectual ability of a company, the author conducted a study of the IC efficiency of Croatian banks from 1996-2000 (Pulic, 2002c), and suggested that the banks surveyed exhibited varying degrees of efficiency in IC and overall value creation, as measured by VAIC. The study may be viewed as an attempt to apply the methodology as a tool for benchmarking banks operating in the region. A similar study was also conducted at the national level to examine the Croatian national economy, where 400 companies in Croatia were analysed by sector, industry, region of the country and number of employees (Bornemann, 1999; Pulic, 2002b). However, it is Pulic's empirical work on the London and Vienna Stock Exchanges to which this study makes immediate reference. Pulic (2000a) tested the relationship between VAIC and the market value of 30 randomly selected companies on the London FTSE 250 from 1992 to 1998. Furthermore, 70 companies listed on the Vienna Stock Exchange from 1994 to 1997 were examined in a separate study. These studies found a high degree of correspondence between VAIC and the market value of companies.

The study

The study of the field of intellectual capital deals with elusive intangibles. The problem, as briefly anticipated above, lies in its measurement. Unfortunately, an invisible conceptualization, regardless of its underlying simplicity, becomes an abyss for the academic researcher. According to Bontis (2001) Intellectual capital is conceptualized from numerous disciplines, lending the field an assortment of interpretations. Accountants are interested in how to measure it to show up on balance sheets, information technologists want to codify it on systems, sociologists want to balance power with it, psychologists want to develop minds that best utilize it, human resource managers want to calculate an ROI (return on investment) on it, and training and development officers want to make sure that they can build it. This field may be growing at an unbelievable rate, and the market has long recognized the value of knowledge and other invisible factors in the value-creating process (Bontis, Dragonetti, Jacobsen, and Roos, 1999).As argued in the introductory part of the paper this study is different from prior studies as it measures efficiency utilization of intellectual capital . The Intellectual capital is having a key role from the production oriented era where Conventional companies' objective was to increase production, and everything was contingent upon production.but in contradiction to this modern companies' which is based on knowledge objective is, however, to produce commodities by using more information as much as possible. Today, business success rests upon the ability and efficiency of companies to utilize information. The value-based management approach pushes the managers so as to maximize the economic value of the assets by using them efficiently

The Intellectual capital studies in India are still in infancy studies and this paper an attempt is made to try to measure the Intellectual capital efficiency of Indian firms. For this study the firms were selected from the Information Technology service sector representing Non financial services and banking Service representing financial service vertical,. which plays a crucial role in the economy of India , its innovation in products and services, and driving factor for competition is mainly accounted for by intellectual capital. Pharma Sector is also considered as it is a sector where knowledge of workers in research and treatment is considered as important, another factor which motivated considering health care is the recent growth in this sector .

In this study, we present the results of the investigations conducted over a period of seven years (2003-2009) on a total sample of analysis covering firms. In particular, we have analyzed 16 banks which constitute Bankex in the Bombay stock Exchange (BSE). Banks which had been having Commercial banking experience of more than seven years were only considered for the study. Bankex is representing organizations reflecting sensex movement in banking sector market, a sample of 13 firms comprising information technology index of Bombay stock Exchange( BSE) to represent Information Technology sector .Seventeen firms of the Health care index of Bombay stock exchange to represent pharma sector was included for the study . Following Firer and Williams (2003) and Shiu (2006), companies with negative book value of equity, or companies with negative Human capital HC or Structural Capital values were excluded from the sample.

The data is obtained from Prowess Data Base. Prowess provides detailed information on each company. This includes a normalized database of the financials covering 1,500 data items and ratios per company.

This part of the study provides the theoretical framework designed to push the measurement and investigation of intellectual capital into a more rigorous and comprehensive domain. The Value Added Intellectual Coefficient, will be introduced and explained in the following section of the investigation

Researchers, such as Edvinsson, Malon Sveib and Stewart maintain that traditional accounting is inapplicable to modern companies for it cannot appropriately measure and indicate their natural dynamics. However, only using intellectual brainpower intensely in the production process can now increase the value of commodities. To accomplish this, a company should and may rely on its skilled workers.

This empirical study applies a new accounting tool of VAIC(TM) or the Value Added Intellectual Coefficient, developed by Ante Pulic (1998) as his trade mark- and his colleagues at the Austrian IC Research Centre (Pulic 2000; Borhemann 1999) which is designed to help managers leverage their company's potential. The key contribution of VAIC is to provide a standardized and consistent measure that can be used to conduct comparative analyses across various sectors locally and internationally.

This potential of VAIC is motivated by growing evidence in the literature, much of the research stemming from the work of Pulic (1998). Bornemann (1999) found a correlation between intelligent potential and economic performance.

The method of Value Added Intellectual Coefficient (VAICTM) was first made public by Pulic (1998) and further developed by Manfred Boremann (1999). It gives a new insight to measures of value creation and monitors the value creation efficiency in companies using basic accounting figures. VAIC is designed to effectively monitor and evaluate the 'efficiency' in adding value (VA) to a firm's total resources and each major resource component, focusing on value addition in an organization and not on cost control (Pulic 2000, Boremann 1999).

VAICTM method assumes that company is a dynamic and ever-changing system, and a company's workers are viewed as the primary asset for success. VAICTM method is based upon physical, financial and intellectual capital. This method measures the performance of both physical and intellectual capital in value-adding process. The coefficient of VAICTM is the efficiency of all resources and exhibits the value-adding ability of a company or an economy. The larger the coefficient, the more efficiently used physical, financial and intellectual capital turn out to be.

VAICTM numerically shows the total efficiency of physical, financial and intellectual capitals in value-adding process. Pulic's methodology focuses on value-adding, value-adders, and value-adding procedures. VAICTM considers the entire company as a dynamic system.

Ante Pulic proposed in 1998 a coefficient to provide information about the value creation efficiency approach when determining tangible and intangible assets within a company. The model proposed is an analytical procedure that can be easily used by the relevant stakeholders of a company to effectively monitor and evaluate the efficiency of value added (VA) according to a firm's total resources (including intellectual resources) and each major component of these resources.

An economic system becomes more efficient if it can provide more goods and services to society without expending more resources. But in order to analyze efficiency at an enterprise level, we must also consider it an economic category that defines a system's capacity to turn tangible and intangible input into output.

The ultimate purpose of an enterprise is its yield of profit. But does making profit make an enterprise to have a sustainable competitive edge? Modern indicators for quantifying performance at a macro-economic level are built on the concept of value creation. It is through this concept that it can best determine the level of efficiency within a given enterprise, and it often underlines a surplus value, which appears after the cost of the invested capital is covered by the operation results. In economic terms, this surplus value is called "value added" or "value created". As long as an enterprise does not generate a profit higher than the cost of capital employed, it registers a loss.

The enterprise thus yields less output to the economic environment than the input it uses as resources. In this case it could be stated that it does not create wealth (value), but rather wastes it. The value created (and also value added) indicator acknowledges that the use of any sort of capital implies the existence of costs that have to be paid. Irrespective of the origin of capital and of the form in which it is supplied, it can never be used for free. The earnings that add value to a company can be recorded only after all costs have been covered (Gigare 2009).



VA= Value Added

OUT= Output

INP= Input

The value added indicator is measured in monetary units (units of value): Money earned by an enterprise is what provides this enterprise with value. The indicator is simple, and intellectual Capital is one of its central contributing factors. Each and every employee takes part in the process of value creation, as well as company stockholders, suppliers and clients.

The VAICTM as defined is a composite sum of three separate indicators:

(1) Capital employed efficiency (CEE): indicator of VA efficiency of capital employed.

(2) Human capital efficiency (HCE): indicator of VA efficiency of human capital.

(3) Structural capital efficiency (SCE): indicator of VA efficiency of structural capital.


For a better understanding of the study the following explanations will help

Human Capital: As the Human Capital is not only one of the most important components of intellectual capital, it is also the ability source of intellectual capital. Stewart suggests that the workers in a company from bottom to top must be seen not as assets, but investment. Human capital can be defined as health, knowledge, motivation and skills, the attainment of which is regarded as an end in itself (irrespective of their income potential) because they yield fulfillment and satisfaction to the possessor. It is also referred to the employee competence in creating both tangible and intangible assets by contributing in the continuous generation of knowledge and ideas. Unlike structural capital, human capital is always owned by the individuals who have it, unless it is recorded in a tangible form or is incorporated in the organization's procedures and structures ( In essence, continuous strengthening of intellectual resources and capabilities must be made to create a larger pool of talents and high caliber professionals in the banking and finance industry (Zeti, 2005). Financial sector in particular, needs a new generation of professional executives who are more customer-centric, technology-savvy, more highly qualified, flexible and agile with skill sets that are now more comprehensive than previously. In the context of globalization, high class human capital today has become a necessity and not merely opulence.

Structural Capital: Structural capital encompasses the enabling structures that allow the organization to exploit the intellectual capital. The structures ranges from tangible items offered by an organization such as patents, trademarks and databases, to complete intangible success such as culture, transparency and trust among employees (Seetharaman, Low, and Saravanan, 2004). This capital is resulted from the products or systems that firm has created over time and will stay remains with the enterprise when people leave (Nik Muhammad and Aida, 2007). Thus, organizations that possess strong structural capital will have a supportive culture that permits their employees to try new things, to learn and to practice those (Bontis et al., 2000).

Structural capital can further be divided into relational capital (regarding external actors such as suppliers, customers, allies, local communities, government, shareholders, etc.), organization (including structure, culture, routines and processes) and renewal and development (all the projects for the future: New plants, new products, BPR, etc.).

In particular, relational capital is defined as all resources linked to a firm's external relationships. These relationships may be with customers, suppliers or R&D partners. Relational capital comprises that part of human and structural capital involved with the company's relations with stakeholders (investors, creditors, customers, suppliers, etc.), plus the perceptions that they hold about the company. Examples of this sort of capital are popular image, customer loyalty, customer satisfaction, links to suppliers, commercial power, negotiating capacity with financial entities and environmental activities.

Capital Employed: Capital employed refers to physical capital employed for attaining business goals.

The VAIC approach can be explained further as follows"

Firstly, to find out the competence of a company in 'creating' or value added (VA) the difference between output and input should first be calculated.

OUT - IN = VA------------------------------------------------------------(3.1)

where OUT (output) includes the overall income from all products and services sold on market, IN (input) contains all expenses for operating the company, exclusive of labour expenses, which is not regarded as a cost. VA (value added) results from how current business and related resources, capital employed, human and structural, are used or employed

Then, it is necessary to determine how much new value has been created by one unit of investment capital employed, with the second step being the calculation of the relation of value added and capital employed (including physical and financial capital)

VA/CA = VACA ------------------------------------------------------------(3.2)

where VACA is the Value Added Capital Coefficient.

The third step is to assess the relation between value added and human capital employed, to indicate how much value added has been created by one financial unit invested in employees.

VA/HC = VAHC---------------------------------------------------------------(3.3)

where VAHC is the Value Added Human Capital Coefficient.

In Pulic's (1998) paper, structural capital (SC) is obtained when human capital (HC) is deducted from value added; with HC and SC being in reverse proportion. The fourth step is to find the relation between VA and SC, indicating the share of SC in created value.

SC/VA = STVA ------------------------------------------------------------------(3.4)

where STVA is the Value Added Structural Capital Coefficient

The fifth step is to assess each resource that helps to create or produce VA.

VAIC(TM) = VACA+ VAHC +STVA ------------------------------------------------(3.5)

where VAIC, the Value Added Intelligent Coefficient, indicates corporate value creation efficiency.

In a later research from Firer and William (2003), they define VAIC as a composite sum of three separate indicators:

(1) Capital employed efficiency (CEE): indicator of the VA efficiency of capital employed.

(2) Human capital efficiency (HCE): indicator of the VA efficiency of human capital.

(3) Structural capital efficiency (SCE): indicator of the VA efficiency of structural capital.


In accordance with the VAIC equation of Firer and Williams (2003), the study uses the natural log of CEE so as to achieve equivalence in value with HCE and SCE and sets the minimum value of VAIC as zero. In practice, efficiency is not will not be given treated negative values, to make it possible to investigate the correlation between VAIC and measures of corporate performance. The VAIC and its components was used as the input measure and financial parmeters such as ROAA,EPS and ROCE which is elaborated further in the following paragraph. A Novel and Pragmatic tool Malmquist DEA was deployed to measure intellectual capital efficiency

The Malmquist Dea approach

The efficiency performance of corporate has been discussed for years. Recently, due to rapid growth of financial markets and technological innovations, it has become more important to measure the efficiency of Corporate. If the institutions operate more efficiently, they might expect an improved profitability and a higher value to the stakeholder.

A lot of studies have been conducted in service industry; especially on banking sector by many renowned scholars. A host of studies have focused on estimating characteristics of the cost function and measuring economies of scale and scope by assuming that all banks were operating efficiently; These studies include Bell and Murphy (1967), Longbrake and Johnson (1975), and Kolari and Zardkoohi (1987) Banker and Maindiratla (1988) argued that the estimated cost function represented the average behaviors of banks in the sample, and the regression procedures could be modified to orient the estimates toward frontier

The Malmquest DEA Analysis is a method that uses the firm's efficiency frontier to construct measures of overall, technical, and scale efficiency. It uses a non-parametric programming approach and investigates inefficiencies among the sampled firms . This approach estimates how much total productivity in a particular sector can be improved and ranks the efficiency scores of individual firms. Notable among studies using this method include those by Berg et al. (1991) for Norwegian banks, Grifell-Tatje and Lovell (1996) for Spanish banks, Lang and Welzel (1996)for German banks, Resti (1997) for Italian banks, Leightner and Lovell (1998) for Thai banks, Gilbert and Wilson (1998) for Korean banks, Altunbus et al. (1999) and Drake and Hall (2000)for Japanese banks, Rebelo and Mendes (2000) for Portugese banks, and Sathye (2001) for Australian banks. The study of Berg et al. (1993) showed that the mean productivity index was1.09 between Finland and Norway, 1.52 between Finland and Sweden, and 1.40 between Norway and Sweden. Sathye (2001) studied the productivity changes in the Australian banking over the period 1995-1999 by using the Malmquist index, and found that the mean total factor productivity in Australian banking was 1.013.

The data envelopment analysis (DEA) approach was pioneered by Charnes, Cooper, and Rhodes (or CCR) (1978) and later extended by Banker, Charnes, and Cooper (or BCC) (1984). The Malmquist index is commonly used to assess firms' productivity changes. In order to identify the possible causes behind productivity changes, the Malmquist index is usually decomposed into technical efficiency and technological progress changes. The Malmquist DEA technique was applied to find out the sector that utilizes their intellectual capital efficiency to the maximum level.

The Malmquist total factor productivity (TFP) index measures the TFP change between two data points by calculating the ratio of the distances of each data point relative to a common technology. Following Färe et al. (1985), the Malmquist TFP change index between period s (the base period) and the period t is given by:

mo (ys, xs, yt, xt) = [ds

o (yt, xt)* dt

o(yt, xt)/ ds

1(ys, xs)*dt

1(ys, xs)]1/2, ……………………………….(3.10)

where the notation ds

o (yt, xt) represents the distance from the period t observation to the period s technology. A value of mo greater than one indicates a positive TFP growth from period s to period t, while a value less than one indicates a TFP decline. The decomposition of the above can be done as follows:

Efficiency change = dt

1 (yt, xt)/ ds

o(ys, xs)…………………. (3.11)

Technological change = [ds

o (yt, xt)* ds

1(ys, xs)/ ds

o(yt, xt)*dt

1(ys, xs)]1/2………………….. (3.12)

In empirical applications, the four distance measures that appear in (1) are calculated for each firm in each pair of adjacent time periods using a mathematical programming technique described by Coelli et al. (1998) and Coelli (1996) for the computer program DEAP Version 2.1.As previously stated, technical efficiency can be decomposed into pure technical efficiency and scale efficiency. Likewise, the change in technical efficiency can be partitioned into a change in pure technical efficiency (PE) and a change in scale efficiency (SE).

In the DEA methodology, formally the CCR model, efficiency is defined as a weighted sum of outputs to a weighted sum of inputs, where the weights structure is calculated by means of mathematical programming and constant returns to scale (CRS) are assumed. In1984, Banker, Charnes and Cooper developed a model with variable returns to scale (VRS).Both the models are applied for the study. Generally speaking, the product of inputs and outputs in a DEA application should optimally be less than the sample size in order to distinguish the firms effectively.

Therefore the variables used for the study comprises of four inputs (Human capital, structural capital, physical capital and VAIC, and three outputs measures considered are identified as follows :

ROCE: Ratio of the operating income divided by net assets , used as a proxy for economic performance (Lev and Sougiannis, 1996; Nakamura, 2001; Lev, 2004).

ROAA: Ratio of the earnings before interest and taxes divided by book value of total assets, used as a proxy for financial performance (Firer and Williams, 2003;Chen et al., 2005; Shiu, 2006).

EPS: Earnings per share (EPS) is a commonly used measure by analysts in the valuation of companies in the financial market in intellectual capital studies (Hong Pew Tan, David Plowman and Phil Hancock 2007).

The Discussion above has provided a plausibility of research assertions about t as well as the measures assessing them. Analytical procedures and tools for testing the efficiency was also presented, both input and output parameters for measuring intellectual capital efficiency have been operationalised. With these we will extent the study into the next section which presents the results of analysis carried out for the study.

Results and Discussion