Intellectual Capital Reporting- Why, What & How

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By CA Deepak Rajdev

CA Deepak RajdevToday’s Economic environment is changing so rapidly.

In view of Liberalisation, Globalisation and  Privatisation, Business Organisation are more towards following the systems which not only cater to national standards but also fulfill the requirement of International business environment.

Knowledge being the new engine of corporate development has become one of the great clichés of recent years, but there is no doubt that successful companies tend to be those that continually innovate, relying on new technologies and the skills and knowledge of their employees rather than traditional assets such as plants or machinery.

Value can also be generated by intangibles (those assets not always reflected in financial statements) and forward-looking companies have realised that these are an integral part of fully understanding the performance of their business.

Looking towards all the major stock exchanges of the globe, Companies with almost no fixed assets in the traditional sense of the word were having their stocks more highly rated than many of the other companies. Much of the discussion about intangibles thus grew out of early attempts to account for the sometimes staggering difference between the so-too-say book and market values of companies.

Since then we have had the crisis in United States having an impact on the overall globe, Investors understand about the possibility of inflated earnings or inflated reported figures. More so, incidents like Enron or WorldCom or Satyam have created pressure on companies to report all the value drivers of their performance and that includes non-financial drivers also.

But it is not only investor pressure that is forcing companies to accept that managing intangibles is no longer an option available to them. Now a days, forthcoming legislation and standards also warrant the inclusion of: “How intangible assets contribute to overall value generation by the Company?”

This briefing is an attempt to raise awareness of the need for companies of all sizes to manage and communicate the value of their business beyond that captured by financial numbers alone. Some companies, usually large, have already implemented various Intellectual Capital (IC) measurement tools and techniques.

However, IC management and reporting is not an attempt to criticise or devalue the traditional model of financial reporting. Some intangibles are already included in balance sheets while others are not included for a reason.

What is Intellectual Capital

“Intellectual Capital is like a newly discovered, still uncharted ocean, and few business executives understand its dimensions as to how to navigate it.”

Under mentioned definitions can be analysed in detail to understand the term in a thorough way -

“Intellectual capital includes Intellectual material – knowledge, information, intellectual property and experience – that can be put to use to create wealth.”

In other words, it can be said that ‘Intellectual capital is the group of knowledge assets that are attributed to an organization and most significantly contribute to an improved competitive position of the said organisation by adding value to defined key stakeholders’. Further can be interpreted as “Representation of the financial value that human innovations, inventions, and intelligence bring to a business enterprise.”

Why Report Intellectual Capital
Although Traditional reporting has served its purpose well, but till now forms only a part of the jigsaw of how value is created and communicated.  All the Economists and the Consultants across the Globe are of the view that the traditional financial reporting system is incapable of explaining resources like internally generated knowledge and employees capabilities and strengths.

Disclosing information on such factors is likely to lower the cost of equities because it decreases uncertainty about the future prospects of the company and facilitates more precise valuation of the company. Further, It will increase liquidity of the capital market and enhance the demand of the company’s securities also.

Many Economists and the Accountants suggest that it will result into the under mentioned disadvantages if the information on Intellectual Capital is not reported:
(1) Insider trading may happen as it is always possible that mangers exploit the internally produced information on Intellectual Capital coz general public will not be aware about the same.
(2) Increased volatility and the danger of incorrect valuation of the firms, which leads to the investors and bankers placing a higher risk level to the organizations.
(3) Increased Cost of Capital.

Despite regulators being in the process of establishing mandatory standards for reporting financial and non-financial information, the corporate are voluntarily reporting such information in their Annual Reports as they recognize that they will derive economic benefits from an effectively managed disclosure policy.

Benefits of an Intellectual Capital (IC) Reporting
(1) Companies could use an Intellectual Capital Report to measure the effectiveness of their Corporate Strategy and fine tune it
(2) Investors and Lenders could use it to understand the Company’s value creation processes and the basis for sustainability of the same in the future
(3) Prospective Customers could use it to understand whether the Company has strengths in the areas it desires from its suppliers
(4) Potential employees could use it for selecting the right Company where they can hope to make a career for themselves
(5) Investment Bankers could use an Intellectual Capital Report for matching potential suitors
(6) Bankers could use it to better quantify the risk of lending to the company
(7) Fund Managers and Retail Investors could use it for discovering under and overvalued stocks, provided valuation information is published along with the IC Report
(8) Finally, Society at large will benefit since the combination of the above benefits will result in efficient utilization of Capital

Thus, the wide benefit of Intellectual Capital Reports to a diverse set of stakeholder makes it an invaluable tool for communicating value.

Conclusion
Intellectual capital is important to both society and organisations. It can be a source of competitive advantage for businesses and stimulate innovation that leads to wealth generation. Technological revolutions, the rise to pre-eminence of the knowledge-based economy and the networked society have all led to the realisation that successful companies excel at fostering creativity and perpetually creating new knowledge.

Companies depend on being able to measure, manage and develop this knowledge. Management efforts therefore have to focus on the knowledge resources and their use.

Intangibles and how they contribute to value creation have to be appreciated so that the appropriate decisions can be made to protect and enhance them. There must also be a credible way of reporting those intangibles to the market to give the investment community comprehensive information to assist in valuing the company more accurately Huge investment flows in intangibles do not appear as positive asset values on financial statements, so the traditional accounting model does not represent them in a meaningful format. But financial statements should be seen as only a part of the jigsaw in how companies assess and communicate value.

The finance function has a key role to play in managing knowlege assets and  understanding and communicating sources of enterprise value. It may take a while to reach a consensus on what constitutes the best model for managing and reporting intangible value drivers. But experimentation is invaluable if we are to agree on best practice and arrive at a point of convergence between the disparate approaches.

About CA Deepak Rajdev
Deepak Rajdev is a Commerce Graduate and an Associate Member of the Institute of Chartered Accountant of India and has secured 33rd Position in India in CA Final Examinations of ICAI. He is also an Associate Member of the Institute of Cost and Works Accountant of India. In addition, he has done Diploma in Risk Management. He is presently working with India’s biggest Telecom Company as Business Analyst for Madhya Pradesh and Chhattisgarh.  He is presently the Visiting Faculty of known Management Colleges of Indore.

Also, he is associated in teaching CA and CWA students at Indore.  He is the Chief Editor of the Monthly Newsletter of Indore Branch of CIRC of ICAI and representing the CA Members in Industry for Indore. He has given Presentations and contributed papers at various Conferences and Seminars organized by ICAI and other organization.  In addition to above, he has authored and presented several articles and papers on various topics of professional interest. Mr Deepak Rajdev can be reached at rajdevdeepak@gmail.com

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Posted by on Nov 30 2010. Filed under Columnists, Latest News. You can follow any responses to this entry through the RSS 2.0. Both comments and pings are currently closed.

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