Stakeholder agency theory intellectual capital definition

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The current chapter reviews the following literature: stakeholder-agency theory, intellectual capital definition, intellectual capital disclosure in prospectuses, components of IC and relationship between IC with firm characteristics and board structure.

2.1 Underlying Theories

2.1.1 Stakeholder-Agency Theory

In agency theory, principals hire agents to perform some service on their behalf. Thus, the assumption of a typical agency theory framework is that there is a conflict between the interest of the shareholders, who are the owners, and the management, who run the corporation, on behalf of the shareholders (Zahra and Pearce, 1989). In order to monitor the managers more effectively, shareholders appoint board of directors who act as a link between shareholders and managers. Thus, the board bears the responsibility to oversee the management.

As such, the agency theory assumes that the corporate board is an essential internal governance mechanism. However, the board's capacity to monitor is jeopardised if internal members (executives of the corporation or others affiliated with management) make up the majority of the board. Thus, agency theory argues that agency relationship has become the principal focus in analysing and studying corporate governance. Zahra and Pearce (1989) explain that the boards are said to perform the critical function of monitoring and rewarding top executives to ensure shareholders' wealth is maximised.

Hill and Jones (1992) argued that other contracts should be considered within an agency framework, which includes those between managers and the different primary interest groups of the firm or stakeholder. Stakeholders refer to the groups of constituents who possess a legitimate claim on the firm. They consist of stockholders, creditors, managers, employees, customers, suppliers, local communities and the general public. Hill and Jones (1992) also explained that the managers are the only group of stakeholders who enter into a contractual relationship with all other stakeholders and have direct control over the decision-making device of the firm. Therefore, the unique role of managers suggests that they can be considered to play the role as the agents of other stakeholders; hence the term stakeholder-agency theory. Other stakeholder groups also place claims on the firm that is, if satisfied, reduce the amount of resources that management can direct towards the pursuit of growth through diversification (Hill and Jones, 1992). For instance, meeting employees' claims for higher wages and customers' demands for greater quality/lower prices both involve the use of resources that might otherwise be invested by managers to maximise the growth rate of the firm. Hence, with higher wages, better knowledge and conducive working conditions, the employees' productivity may improve and thus provide management with more resources i.e. voluntary disclosures.

2.1.2. Information Asymmetry Theory

In information asymmetry, the firms try to disclose additional information in order to increase and attract shareholders or investors. By disclosing more information, the investors and capital lenders will be confident with the current firm's performance in handling physical assets. Under the information asymmetry, the firm ensures it has better and more voluntary disclosure compared to its competitor. It is often argued that firms might find it advantageous to provide additional pieces of information (i.e., voluntary disclosure) to investors and analysts through the financial reporting (Petersen & Plenborg, 200). Information asymmetry between firms and (potential) investors, due to a low level of disclosure, increases cost of capital by introducing 'adverse selection' between buyers and sellers of the firm's shares. In order to avoid that, the firm will disclose more information, thus reducing information asymmetry and, hence, attract extended interests (liquidity) in the firms' shares, which lead to lower cost of capital (Diamond & Verrecchia, 1991).

Existing literature suggests that a firm's asymmetric information environment has a great impact on governance mechanisms. Cai et al. (2009) explained that large and older firms may face less information asymmetry because the firms tend to be more mature, have established and time-tested disclosure policies and practices, and receive more attention from the market and regulators. Schrand and Verrecchia (2004) found that greater disclosure frequency in the pre-IPO period is associated with lower under pricing. Botosan (1997) argues that firms that are not closely followed by financial analysts experience lower cost of capital with increases in disclosure.

According to Leuz and Verrecchia (2000), firms that switched from German to an international accounting regime (IAS or US GAAP) commit themselves to increased levels of disclosure. They also found that firms that switched to an international accounting regime in general, experience lower cost of capital and higher trading volume. In Malaysia, Foo and Mat Zain (2010)found that firms with bumiputra dominated boards and boards with an independent chairman are significantly and negatively associated with information asymmetry. The reason is due to the unique Malaysian environment where organisations tend to be secretive in nature.

2.2 Definition of Intellectual Capital

The terms intellectual capital, intangibles, and knowledge assets are popular topics of research and are frequently used interchangeably. Many researchers, however, notice that there is no consensus on the precise definition of these terms (Beattie &Thomson, 2007 and Marr et al., 2004). This idea is backed by Lev (2001) and Abdul Rashid et al. (2009) who claim that the terms are widely used - intangibles in the accounting literature, knowledge assets by economists, and intellectual capital in management and legal literature. However, these terms refer essentially to the same thing: a non physical claim to future benefits.

Williams (2000) defined IC as the enhanced value of a firm attributable to assets. It is generally of an intangible nature, resulting from the company's organisational function, processes and information technology networks, the competency and efficiency of its employees and relationship with its customers. Intellectual capital assets are developed from (a) the creation of new knowledge and innovation; (b) application of present knowledge to current issues and concerns that enhance employees and customers; (c) packaging, processing and transmission of knowledge; and (d) the acquisition of present knowledge created through research and learning. In accounting terms, intellectual assets (IA) are "debits", individual assets such as patents or intellectual property. On the other hand, intellectual capital (IC) is a 'credit' balance or total organisational wealth (equity) invested in all intellectual assets.

Webster Dictionary defines 'capital' as anything which can be used to increase one's power of influence. The Oxford English Dictionary defines 'capital' as 'that which confers wealth, profit, advantage or power' and defines 'capital' as the entries of balance sheet showing all properties, both tangible and intangible which includes cash, stock, inventories, property rights and goodwill. The International Accounting Standard Committee (IAS 38, 1998) defines intellectual capital or intangible asset as, "an identifiable non monetary asset without physical substance held for use in the production or supply of goods or services, for rental to others or for administrative purposes. An asset is a resource, (a) controlled by an enterprise as a result of past events, and (b) from which future economic benefits are expected to flow to the enterprise". Klein (1998) suggests that intellectual capital is knowledge, experience, expertise, and associated with soft assets, rather than their hard physical and financial capital. In most cases, intangible assets are defined as (capital) assets that do not have physical substance but are likely to provide future benefits (Canibano et al., 2000). This study therefore uses the terms intangibles, intellectual capital, and knowledge assets synonymously.

2.3 Components/Types of Intellectual Capital

Several researchers have provided classification schemes to describe the major components of IC. Contemporary classification schemes divide intellectual capital into three categories: 1) external (customer-related) capital, 2) internal (structural) capital and 3) employee competence/human capital (e.g. Sveiby, 1997; Roos et al., 1997, Stewart, 1997; Edvinson & Mallone, 1997; Petty &Guthrie, 2000; Goh & Lim, 2004). They are shown in Figure 2.1.

Figure 2.1 Components of Intellectual Capital

Intellectual Capital

Internal (structural) capital

External (customer related) capital

Employee Competence (Human Capital)

2.3.1 Employee Competence (Human Capital)

In all three components shown in Figure 2.1, employee competence is usually distinguished as the most important driver of IC value creation. This is because the crucial strategy in developing a firm's IC base revolves around the effective arrangement of its structural capital and human resources (A Danish Trade and Industry Development Council Taskforce, 1996). Cuganesan et al. (2006) mentioned that employee competence (human capital) specifically refers to the skill, training and education, and experience as well as value characteristics of an organisation's workforce. In the process of creating value from IC, the role of human capital is paramount. Skilled and engaged employees are required to propel innovation and both create and subsequently realise the benefits of favourable customers, suppliers and broader external relations. It is for these reasons that the management of human capital has been quoted as critical for businesses if they are to compete effectively (Sveiby, 1997). Bontis et al. (2000) referred to employee competence as the individual-level knowledge that is possessed by every employee. Pulic (1998) stated that in the knowledge-based economy the responsible party for the achieved market results are definitely the employees; they are the cohesion factor of the core structure of a company through which products and services are created. Brooking (1996) wrote that human-centred assets are the vital components of employee competence which comprise expertise, creative and problem solving capability, leadership, entrepreneurial and managerial skills embodied by employees. Employee competence consists of know-how, education, vocational qualification, work related knowledge, work-related competency and entrepreneurial spirit.

2.3.2 External Structure (Relational Capital)

External structure refers to the firm's relationships and communication channels that connect it with its competitors, customers, suppliers, lenders, investors, and other stakeholders outside  its physical boundaries. In the context of intellectual capital, external structure is the organisational value obtained from reliable, quality-driven supplies and from loyal, satisfied customers (Lynn, 2000). Bontis et al. (2000) defined external structure as customer capital, the sole feature of the knowledge embedded in the marketing channels and customer relationship that an organisation develops through the course of carrying out business. Brooking (1996) stated that market assets are the potential an organisation has due to the market-related intangibles. External structure is made up of brand recognition, customer, customer loyalty, companies' name, distribution channel, business collaboration, licensing agreement, favourable contract and franchising agreements.

2.3.3 Internal Structure/Organisational Capital

Internal structure is the supportive infrastructure that enables employees to perform competently; it is owned by an organisation and remains with an organisation even when people leave. Brooking (1996) pointed out that internal structure can be divided into two components, namely intellectual property and infrastructure assets. According to Bontis et al. (2000), internal structures encompasses all non-human storehouses of knowledge in organisations which include databases, organisational charts, process manuals, strategies, and routines; it includes anything whose value to the company is higher than its material value. Internal structure consists of intellectual property such as patent, copyright and trademark. It also covers infrastructure assets such as management philosophy, corporate culture, management process, information system, networking system and financial relations (Goh & Lim, 2004; Abdul Rashid et al., 2009).

2.4 Intellectual capital disclosure in prospectuses

The Malaysian Securities Commission (2005) explained that it is mandatory for the prospectus to include all such information that investors and their professional advisers would reasonably require and expect to find in the prospectus. This information enables all the interested parties to make an informed assessment of the assets, liabilities, financial position, profits and losses, prospects, and rights attached to the securities; it also gives them an opportunity to evaluate the merits of investing in the securities and to assess the extent of risk involved in doing so. Some examples of the information include a company's pre-listing performances (earning per share), forecast earnings, potential and risk of the respective markets. The study done by Abdul Rashid et al. (2009) shows that more intellectual capital information is disclosed in prospectuses than annual reports. This is because prospectuses offer additional information on the companies' long term strategy, company risk and future profitability; they are generally more forward looking than annual reports. Annual reports focus on historical performance while prospectuses provide information which pertains to companies' future prospects (Abdul Rashid et al., 2009).

Previous literature provides examples where researchers (e.g. Bukh et al., 2005; Cordazzo, 2007; Singh and Van der Zahn, 2007) have looked at some initial public offering (IPO) prospectuses which were employed by management to describe the shares the companies are offering to potential investors. It is pertinent to note that prospectuses and annual reports are tailored to specific needs of different users. Unlike annual reports that focus on historical performance, prospectuses provide information that focus on companies' future prospects. Cordazzo (2007) asserts that prospectuses offer additional information on companies' long term strategy, business risk and future profitability; it is generally more future oriented than annual reports. These differences are likely to be reflected in the disclosure practices of the two documents.

2.5 Intellectual capital disclosure and firm characteristics

The extent of intellectual capital disclosure in Malaysia IPO prospectuses can be explained by three firm specific variables - Company age, company size and industry differences.

2.5.1 Company Age

Company age has often been seen as a proxy for risk, in the sense that the more established companies are generally less risky. From this perspective, the extent of a company's disclosure is expected to be related to how long it has been in business. For example, a study done by Jaggi (1997) on Hong Kong listed firms consists of 161 samples; it was concluded that there were some positive associations between intellectual capital disclosure and company age, i.e. the number of years the company has been in business. A study by Rimmel et al. (2009) on120 Japan IPO firms also found a positive relationship between firm age and intellectual capital disclosure. The mature companies, i.e. companies which have been in existence for comparatively a longer period of time, are likely to disclose more information (Jaggi, 1997). This is because the older firms naturally have more resources such as number of employees compared to the younger firms to ensure better disclosure in intellectual capital information.

2.5.2 Firm Size

Firm sizes are also likely to influence disclosure. The study of Robb et al. (2001) consists of 192 US, Canada and Australia samples. It was found that large firms tend to disclose more information on intellectual capital than smaller firms. This shows that company size is related to the amount of voluntary disclosure. Another example, Anton (1954) concluded that one-third of large American and Canadian companies regularly present results to stockholders while the corresponding figure for small companies is one out of 20. Among the explanations are that large companies are more likely to have a larger ownership base, and that the costs of providing information are more prohibitive for small companies. The latter problem tends to grow with increased disclosure. A study done by Cordazzo (2007) consisting of 86 IPOs from Nuovo Mercato and Borsa Italiana listings in the period of 1999-2002 also found that a firm's age has positive association with its level of intellectual capital disclosure.

However, another factor to be considered is that larger companies, when compared to smaller ones, seem less risky to investors and have better access to resources. Therefore, small companies have greater incentives to reduce uncertainty by providing more disclosure. This argument presumes that a small company - all other things being equal - should disclose more information and details on competitors than is the case for a large company. These implications have been supported in studies by, for example, Ahmed and Courtis (1999). However, not all studies conclude that the size of the company is a significant factor in explaining voluntary publication of information. For instance, Wallace (1988) and Stanga (1976) concluded that size is not a significant factor in explaining differences in companies' reporting between Nigeria and the USA. Bukh et al. (2005) also stated that company size does not affect the intellectual capital disclosure in Danish IPO prospectus consisting of 68 firms. The reason is the cost of disclosure theory does not have significant importance in the present era of more advanced accounting systems and instant reporting. Hence, firm size is not an important influence over a firm's level of intellectual capital disclosure.

2.5.3 Industry differences

Industry differences, has previously been used to explain differences in disclosure in annual reports by Bukh et al (2005), Cordazzo (2007) and Rimmel et al. (2009) because there are differences in industry disclosure norms. Bukh et al. (2005) explained that as intellectual capital is regarded as being especially important in high-tech industries, it is anticipated that IT and biotechnology companies will disclose more information than traditional manufacturing and commercial companies. Furthermore, since the market-to-book values of IT and biotechnology companies are generally higher, the disclosure of intellectual capital is relatively important. These results are similar to the findings of Cooke (1989) which stated that industry differences have significant effects on intellectual capital disclosure; companies which are categorised as 'trading', disclosed less intellectual capital information than other industry types.

2.6 Intellectual Capital Disclosure and CG mechanism

The relationship between intellectual capital disclosures in Malaysia IPO prospectuses with CG mechanism can be explained by four variables - Ethnic diversity on board, chairman duality role, board size and audit committee size.

2.6.1 Ethnic Diversity on Board of Directors

Based on the current literature available, a variety of reasons can be highlighted to support how ethnic diversity can increase a board's influence on a firm's performance with respect to IC. Concerning IC disclosure, Williams (2000) argued that the board diversity in terms of ethnic background are characteristics of diversity that may have placed South Africa publicly listed companies in a better position to oppose the nation's business environment during the 1990s. A diversified board of directors enables a firm to create alliances and coalitions with a broader range of human resources. Thus, a greater variety of knowledge, skills and capabilities can be accumulated and exploited, thereby increasing a firm's IC disclosure.

Williams (2000) conducted a study from a sample of 84 publicly listed companies in South Africa. The aim was to investigate the relationship between board structure characteristics and intellectual capital performance which is measured based on the VAICTM. Empirical findings from the study support the proposition that there is a significant positive link between greater diversity across a board of directors in terms of race and organisation's intellectual capital disclosure.

A study by Coffey and Wang (1998) on 98 Fortune 500 companies touched on the subjects of the present dynamic nature of the world's business environment and emergence of greater power to a wider set of stakeholder groups. It was observed that increased diversity on boards of directors would improve decision making. Overall, empirical findings support the general tenants of resource dependence theory that view human resources as the most vital firm level resource required in establishing competitive advantage.

In Malaysia, studies which explore the connection between board diversity and intellectual capital disclosure is scarce. The study by Haniffa and Cooke (2000) covers 167 non-unit trust and non-financial companies. The study shows there is a significant relationship between the ratios of bumiputra directors on the board and voluntary disclosure. The result of their study seems to be in tandem the belief that Islamic values encourage transparency in business. Malays, who are generally Muslims, are expected to be less secretive in terms of disclosure as compared to Chinese.

2.6.2 Chairman Duality

According to the Malaysian Code of Corporate Governance (MCCG, 2000), there is a requirement for balance of power and authority between the CEO and Chairman so that no single individual has uncontrolled power of decision-making. Even though there is no restriction for Malaysian PLCs to separate or combine the CEO-Chairman position in the firm, the MCCG emphasises that there should be a clearly acceptable division of responsibilities between both positions. As stated in the MCCG (2000), if the roles of the board's chairman and the CEO are combined, the board should have astrong independent element in order to avoid the board from being dominated by a single person. The Chairman has to be independent so as to monitor the effectiveness of the board over the management and support the separation of the role of the CEO and Chairman (MCCG, 2000).

Similarly, Dimma (2002) explains that a widely held company will perform excellently for its shareholders if the roles of chairman and CEO are separated. The two reasons are: 1) separation allows the chairman to focus on the board and its members and on sound corporate governance. 2) The corporation will perform best if power is distributed between the board and the management. Williams (2000) also supports the separation of roles of chairman and CEO because it will enable the board of directors to implement their decisions related to intellectual capital disclosure in a more effective manner. Lack of duality will also allow the board to develop a greater affinity with a more diverse set of stakeholders, such as employees and customers who will increase the firm's overall IC disclosure (Williams, 2000).

A study done by Liang and Li (1999) on 228 China private firms and Abdul Rahman and Mohd Haniffa (2002), found that duality roles of chairman and CEO did not seem to perform as well as their counterparts with separate board leadership based on accounting performance measurement, Return on Total Equity (ROE) and Return on Total Asset (ROA).

However, duality role may enhance board effectiveness when stewardship theory is applied to support their cases. It can be argued that managers will act in the best interests of the shareholders as their compensation is dependent on the firm's performance.

2.6.3 Audit Committee Size

Audit committee was first introduced in the United States as an internal control mechanism to reduce corporate fraudulent practices. In Malaysia, the Audit committee formation is mandatory for all Bursa Malaysia listed companies with effect from 1 August 1994, in compliance to Bursa Malaysia Listing Requirements. The revised MCCG (2007) proposed that the establishment of Audit Committees should comprise at least three non-executive directors.In addition, all of the members should be independent and led by an independent non-executive director. The rationale of having the non-executive directors in the Audit Committee is that these persons have vested interests in ensuring that the financial affairs of the company are handled appropriately (Revised MCCG, 2007). It also notes that having such persons in the Audit Committee ensure that the interests of management are always aligned with those of the owners.

In a study done in South Africa by Williams (2000), they found no association between the size of Audit Committee and firm's intellectual capital disclosure. In Malaysia, a study done by Abdullah (2001) showed that the Malaysian companies which complied with the KLSE requirement of Audit Committee have at least three members. Similarly, in another study done by Muhammad Sori et al. (2001) on the compliance of Audit Committee requirement of the main and second board firms, it was found that most of Malaysian Audit Committee fulfilled the minimum number of members required, which is three people.

2.6.4 Board Size

The size of the board is different across geographical borders. Rebeiz and Salameh (2006) studied 100 US firms and pointed out that the average board size in Australia, the United States, and the United Kingdom is around 10 members. In contrast, a board size of 40 members is quite normal for Japanese firms. In Malaysia, the average number of board of directors is 8 people. Jensen (1993) pointed out that in cases where the number of board members exceeds seven or eight, it weakens the function of the board and allows the CEO to easily gain control of the board. When the number of board members is small, the board's communication improves and the board members are more likely to reach consensus.

On the subject IC disclosure, Abeysekera (2010) studied 52 top Kenyan listed firms. It was mentioned that Board size can be a "resource" to companies that inform investors about future earnings through intellectual capital. Such disclosures can help firms to improve their share price by informing investors about resources not disclosed in financial statements. In a study done on Kenyan listed companies, firms that disclose more human capital resources have larger boards. Larger boards attempt to demonstrate that they maintain future earnings from intellectual capital resources by codifying strategic human capital that is tacit in nature with tactical internal capital; the boards disclose to investors that tacit knowledge is made explicit in firms to sustain future earnings from intellectual capital resources (Abeysekera, 2010).

2.7 Theoretical framework

The theoretical framework of this study is to determine the amount of intellectual capital disclosed in the IPO and also to examine the association between intellectual capital disclosure and industry differences, firm age and firm size, which can be stated as firm characteristics. This study also examines the relationship between intellectual capital disclosure and board structure focusing on board size, chairman duality role, board ethnicity and audit committee size.

It is also noted from previous literature that there are few factors that are found to influence the level of intellectual capital disclosure. In order to avoid any influence by these factors/variables on the results being generated, these variables are thus controlled. The control variables in this study are under pricing and auditor's reputation.

The theoretical framework also touches on the relationship between Intellectual Capital Disclosures, Firm Characteristics and Board Structure.

Independent Variable

Industry Differences

Firm Age

Firm Size

Dependent Variable

Intellectual capital level of disclosure

Control Variable

Under pricing and auditor's reputation

Audit Committee Size

Chairman Duality Role

Board Ethnicity

Board Size