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Understanding corporate value: managing and reporting intellectual capital

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Page 1: Understanding corporate value: managing and reporting ...valuebasedmanagement.net/articles_cima_understanding.pdf · Understanding corporate value: managing and reporting intellectual

Understanding corporate value: managing and reporting intellectual capital

Page 2: Understanding corporate value: managing and reporting ...valuebasedmanagement.net/articles_cima_understanding.pdf · Understanding corporate value: managing and reporting intellectual
Page 3: Understanding corporate value: managing and reporting ...valuebasedmanagement.net/articles_cima_understanding.pdf · Understanding corporate value: managing and reporting intellectual

3

1 Introduction 4

2 Definitions of intellectual capital 62.1 Classifications of intellectual capital2.2 Why is intellectual capital so difficult to measure?

3 IC measurement 8Generic models3.1 Balanced scorecard3.2 Performance prism3.3 Knowledge assets map approachIndividual company models3.4 The Skandia navigator3.5 Ericsson’s cockpit communicator3.6 Celemi’s intangible assets monitor3.7 Ramboll’s holistic company model3.8 Bates Gruppen CompanyIQ measurement system

IC valuation 143.9 The value-added approach3.10 The value creation index3.11 Market or value-based approach3.12 Tobin’s q3.13 Calculated intangible value3.14 Matching assets to earnings – the Baruch Lev method3.15 Human resource accounting3.16 Value-added intellectual capital coefficient

4 Knowledge management 194.1 Knowledge process wheel4.2 Knowledge management and the accounting profession

5 Reporting intellectual capital 235.1 Accounting standards5.2 Operating and financial review5.3 Intellectual capital reports

6 Conclusion 26

Writers: Danka Starovic, project manager, technical issues, CIMA, and Bernard Marr, research fellow in the Centre for Business Performance at Cranfield School of ManagementProduction editor: Sarah Vaux Designer: Adrian TaylorPublisher: Chartered Institute of Management Accountants Inquiries: [email protected] (tel: 020 8849 2275)

Intellectual capital Contents

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Knowledge being the new engine ofcorporate development has become oneof the great clichés of recent years, butthere is no doubt that successfulcompanies tend to be those thatcontinually innovate, relying on newtechnologies and the skills andknowledge of their employees ratherthan assets such as plants or machinery.

Value can be generated by intangiblesnot always reflected in financialstatements and forward-lookingcompanies have realised that these arean integral part of fully understandingthe performance of their business.

At the height of the dotcom boom,companies with almost no assets in thetraditional sense of the word werehaving their stocks more highly ratedthan many of the stalwarts of Britishand global industry. Much of thediscussion about intangibles thus grewout of early attempts to account for thesometimes staggering differencebetween the so-called book and marketvalues of companies.

Since then we have had the UScompany collapses, followed by a bearmarket that continues to shrink thevalue of equities around the world.Intangibles still matter, but the keydriver for measuring and reportingthem has become transparency.Investors – understandably wary about the possibility of inflated earnings after Enron or WorldCom – areputting pressure on companies to reportall the value drivers of theirperformance and that unavoidablyincludes non-financial ones.

But it is not only investor pressure thatis forcing companies to accept thatmanaging intangibles is no longer anoptional extra. Forthcoming legislationon issues such as the operating andfinancial review, due to be included inthe Companies Act 2003, requires largepublic and very large private companiesto provide a “qualitative as well asfinancial evaluation of performance,trends and intentions”. In other words,companies will have to produce anaccount of how their intangible assetscontribute to overall value generation.

This briefing is an attempt to raiseawareness of the need for companies ofall sizes to manage and communicatethe value of their business beyond thatcaptured by numbers alone. Somecompanies, usually large, have alreadyimplemented various intellectual capital(IC) measurement tools and techniques.The rest see themselves as being toobusy simply surviving to worry aboutwhat seems like an unnecessary luxury.

Also included is a summary of someof the current approaches and modelsused for valuation and measurement. Allhave limitations and many suffer from alack of practical testing. But this is still adeveloping field, with contributions frommany disciplines, so the lack ofconsensus is not surprising. Moreexperimentation and convergence interminology and tools will eventually be

necessary if the concept of intellectualcapital is to become widely acceptedand put into practice.

This is not an attempt to criticise ordevalue the traditional model offinancial reporting. Some intangibles are already included on balance sheets;others are not, for a reason. Traditionalreporting has served its purpose well, but now forms only a part of the jigsaw of how value is created and communicated.

Intellectual capital andaccountants in businessIn a recent KPMG survey of non-executive directors (Neds), more than 60 per cent of the sample said theydidn’t consider themselves to be veryknowledgeable about non-financialperformance indicators. In fact, it camelast on the list of suggested topics. Notsurprisingly, financial performance wasat the top, with 94 per cent saying thiswas an area where they were mostknowledgeable. As many Neds aresenior managers or executiveselsewhere, it is safe to assume this isfairly representative.

It is not simply that directors are notup to speed on intangibles, althoughsome of them may well not know muchabout the subject. The main reason citedfor this worrying shortfall is that“information provided by executives ismainly financial”. Comments like thisclearly spell out the challenge ahead foraccountants. As the main custodians ofperformance data in companies, theyneed to ensure that the rightinformation is communicated to the

1 Introduction

4

Intellectual capital

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right people. Effective strategic andoperational decision-making hinges onthat information being relevant, timelyand robust – and that means it has toconsist of more than just numbers.

This briefing is therefore primarilyaimed at finance professionals andaccountants in business who would liketo implement or improve themeasurement and management ofintellectual capital in their ownorganisations. It will also be useful toanyone looking for a generalintroduction and an overview of the keyconcepts of intellectual capital andknowledge management.

Why should you manageintellectual capital?Traditionally, the only intangible assetsrecognised in financial reportingstatements were intellectual property,such as patents and trademarks, andacquired items such as goodwill.Although it is still not possible to assignmonetary values to most internallygenerated intangible assets, theynevertheless need to be considered ifthe process of value creation is to beproperly understood.

Failure to do so can have damagingconsequences at all levels. For an

individual firm, not understanding howvalue is generated can lead to inefficientresource allocation. It means thecompany does not fully understand itsbusiness model and may therefore beunable to assess the value of futurebusiness opportunities. On a wider scale,it can lead to anomalous marketbehaviour: if the markets don’t get theinformation they need through “official”channels they may resort to rumoursand speculation, which could lead tovolatility. There may also be amisallocation of resources on a macrolevel in terms of market investments.

Some go as far as to say that the lackof understanding of intellectual capitalby market participants contributed tosome of the spectacular market failuresin the past few years (Holland, 2002).Marconi in the UK and Enron in the USare both examples of how rapid changein the company value-creation processescreated systemic problems in the marketfor information. In both cases, thecompany value-creation processesswitched out of heavy use of tangibles(Enron in physical energy production,Marconi in electrical goods and defence)

Intellectual capital

into a perceived increased use ofintangibles (energy-trading skills,provision of high-tech services). Thissudden switch may have contributed toconfusion among analysts and investors.

Companies that measure and reportintangibles may experience substantialgains. For example, Leif Edvinsson,former corporate director for intellectual capital at Swedish financial servicescompany Skandia AFS, claims that areduction in the cost of capital of 1 percent was directly attributable to the company’s ability to measure andreport its intangibles.

As long as it is relevant and timely,additional information helps investors toassess a company’s potential for futureearnings, so helping to keep share pricesstable. This in turn reduces the risksassociated with a company and resultsin a lower cost of capital.

There can be little doubt that lookingbeyond the assets reported in financialstatements should be a critical exercisefor every organisation wholly or partlydependent on intangibles for its valuecreation. Finance professionals should beat the forefront of this process, usingtheir skills and expertise in measurementand control to develop systems capableof accommodating intellectual capital. ■

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While there are plenty of genericdefinitions of intellectual capital, manyorganisations develop their ownidiosyncratic definitions. For example,Skandia defines it as “the possession ofknowledge, applied experience,organisational technology, customerrelationships and professional skills thatprovide Skandia with a competitive edgein the market”.

There is some confusion over howintellectual capital differs fromintangibles, intangible assets orintellectual property. This briefing willfollow the approach adopted by theMeritum guidelines for managing andreporting on intangibles and will useintangibles and intellectual capitalinterchangeably. There is no commonlyagreed definition of intangibles – theword is often used as a noun to meanbroadly the same as intellectual capital.Intangible assets, on the other hand, areonly those that financial standardswould recognise as assets and allow onbalance sheets.

Intellectual property can be defined asintangible assets, such as patents,trademarks and copyrights, that can beincluded in traditional financialstatements. Measuring intellectualproperty is important so an organisationknows what it owns but it does not

capture the processes required to reachthat stage. Intellectual capital can beboth the end result of a knowledgetransformation process or theknowledge that is transformed intointellectual property.

1 Classifications ofintellectual capital

IC is a broad concept which is often split into different categories – mostcommonly human, relational andstructural capital.

According to guidelines produced byresearchers from universities acrossEurope, collectively known as theMeritum Project, human capital isdefined as the knowledge, skills andexperience that employees take withthem when they leave. Some of thisknowledge is unique to the individual;some may be generic. Examples areinnovation capacity, creativity, know-how and previous experience, teamworkcapacity, employee flexibility, tolerancefor ambiguity, motivation, satisfaction,learning capacity, loyalty, formal trainingand education.

Relational capital is defined as allresources linked to the externalrelationships of the firm – withcustomers, suppliers or partners inresearch and development. It comprisesthat part of human and structuralcapital involved with the company’srelations with stakeholders (investors,creditors, customers, suppliers), plus theperceptions that they hold about thecompany. Examples of this are image,customer loyalty, customer satisfaction,links with suppliers, commercial power,negotiating capacity with financialentities and environmental activities.

Structural capital is defined as theknowledge that stays within the firm. Itcomprises organisational routines,procedures, systems, cultures anddatabases. Examples are organisationalflexibility, a documentation service, theexistence of a knowledge centre, thegeneral use of information technologiesand organisational learning capacity.Some of them may be legally protectedand become intellectual property rights,legally owned by the firm underseparate title. The InternationalFederation of Accountants (IFAC) offersa slightly different classification (seetable opposite).

Intellectual capital

2 Definitions of intellectual capital

6

‘Intellectual capital is the group of knowledgeassets that are attributed to an organisationand most significantly contribute to animproved competitive position of this organisation by adding value to defined key stakeholders’

Marr and Schiuma (2001)

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2 Why is intellectual capitalso hard to measure?

The first reason is historical. Accountingrules, although revised on a regularbasis, were initially designed for assetssuch as plant or machinery – tangiblethings that represented a source ofwealth during the industrial age. Second,some intangibles are hard to measure.Creativity, for example, is at the heart ofa knowledge-generation process yet isessentially an unpredictable process with unpredictable outcomes. It canmanifest itself in many ways. Forcompanies such as Sony and 3M,product and process innovation play akey role in market differentiation.

This leads us to the third problem: theidiosyncratic nature of IC. What isvaluable for one company may beworthless for another. This has resultedin diverse measuring systems that makecomparability across companies andsectors difficult.

Finally, intellectual capital can havetwo dimensions. The Meritum guidelinesdistinguish between intangible resources and intangible activities as away of highlighting IC’s static ordynamic character:

“The intangible resources of acompany, a static notion, can bemeasured at any given time. Thusworker competencies (human capital),intellectual property rights (structuralcapital), customer satisfaction oragreements with suppliers (relationalcapital) would be considered under this category.

Intangible resources can also beanalysed in a dynamic sense. Companies

are undertaking activities to acquire orinternally produce intangible resources, tosustain and improve existing ones and tomeasure and monitor them. Thesedynamic activities thus imply an allocationand use of resources that are sometimesnot expressed in financial terms and,consequently, may or may not appear inthe corporate financial reports.”

This dynamic nature of IC means thatits individual components are often not

valuable by themselves but work only asa system. In other words, it is theintellectual capital elements interactingthat generates value for companies. Forexample, a company may have goodprogramming skills that enable it tobuild software. However, they might beworth little unless accompanied by astrong distribution network, loyalty andcommitment from its employees and apowerful brand name. This dynamiccombination of intangibles is often therecipe for success in companies such asMicrosoft, where the value of itsintellectual capital is more than the sumof its individual parts. ■

Intellectual capital

7

Human capital Relational (customer) capital

● know-how ● brands● education ● customers● vocational qualification ● customer loyalty● work-related knowledge ● company names● occupational assessments ● backlog orders● psychometric assessments ● distribution channels● work-related competencies ● business collaborations● entrepreneurial elan, ● licensing agreements

innovativeness, proactive andreactive abilities, changeability

● favourable contracts● franchising agreements

Organisational (structural) capital

Intellectual property Infrastructure assets● patents ● management philosophy● copyrights ● corporate culture● design rights ● management processes● trade secrets ● information systems● trademarks ● networking systems● service marks ● financial relations

Classification of intellectual capital, IFAC (1998)

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Performance management andvaluation frameworks have traditionallypaid little attention to assessingknowledge, concentrating almostexclusively on financial results.

When influential authors such asKaplan and Johnson argued during the1980s that the finance-dominatedperformance-management systems werefailing to meet the needs of moderncompanies, a number of seemingly morecomprehensive approaches, such as theSmart pyramid or performancemeasurement matrix, were proposed.Although these represented a step inthe right direction, they fell short ofexplicitly addressing the issue of IC.

The total quality management (TQM)movement with its associated initiatives,such as the EQFM excellence model orthe Malcolm Baldridge award,encouraged organisations to examinethe “softer” dimensions of theirperformance such as leadership,employees and impact on society.Business results – expressed in financialterms – still mattered but were to beconsidered in a wider context ofinteraction with various stakeholders.However, TQM was primarily developed as a philosophy of businessbehaviour and has limited use inperformance measurement.

Since then there has been aproliferation of models, none of whichhas been put into widespread useexcept the balanced scorecard.

Measurement approaches (outlined below) are mainly about howcompanies measure and reportperformance internally in order to gainmanagement insights that can helpthem to run their business. Valuationapproaches, on the other hand, areprimarily concerned with placing aneconomic value on firms and theirintangibles. They generally take anexternal view and are designed to helpanalysts or investors assess the financialvalue of an organisation.

IC measurementGeneric models

1 Balanced scorecardIn 1992, Robert Kaplan and DavidNorton pioneered their balancedscorecard (BSC). Since then, it hasbecome a model for many of thereporting systems that include non-financial measures.

Over the past decade, the balancedscorecard has evolved from being ameasurement framework to being astrategy implementation tool. Itrepresents a set of cause-and-effectrelationships among output measures and performance drivers in the four perspectives: ● financial measures: how do we look to

shareholders, for example, cash flowand profitability;

● customer measures: how do ourcustomers see us, for example, priceas compared with competitors andproduct ratings;

● internal process measures: what mustwe excel at, for example, length ofcycle times and level of waste;

● learning and growth measures: canwe improve and create value, forexample, percentage of sales derivedfrom new products.Today, Kaplan and Norton stress the

importance of visualising causalrelationships of measures and objectivesin so-called strategy maps. These areessentially communication tools thatvisualise an organisation’s strategy andthe processes and systems needed toimplement it.

Although Kaplan and Norton insistedthat companies should select their ownmeasures, many have criticised the BSCmodel for being too limited. For

3 IC measurement and valuation

Intellectual capital

● Corporate● Business unit● Brands/products/

services● Operating

Stakeholder satisfaction

Stakeholder contribution

● Develop products andservices

● Generate demand● Fulfil demand● Plan and manage enterprise

● People● Practices● Technology● Infrastructure

InvestorsCustomers andintermediaries

EmployeesRegulators and

communitiesSuppliers

Figure 1: performance prism

StrategiesProcesses

Capabilities

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example, the perspectives fail to addressthe needs of all an organisation’sstakeholders and the execution may betoo driven from the top for it to beeffective. It has also been said that someof the relationships between the fourperspectives are more logical thancausal. PricewaterhouseCoopers, in therecent book Building Public Trust, hasdisclosed the findings of an unpublishedsurvey in which 69 per cent ofexecutives reported “that they hadattempted to demonstrate empiricalcause-and-effect relationship betweendifferent categories of value drivers andboth value creation and future financialresults. Less than one-third of these feltthey had truly completed the task; thissuggests its difficulty”.

2 Performance prism The performance prism (see figure 1) isa second-generation performancemeasurement and managementapproach developed by Cranfield Schoolof Management in collaboration withconsultancy Accenture.

It recognises the importance ofcompanies taking a holistic approach tostakeholder management in today’sculture of involvement. Its advantagesare that it addresses all stakeholders –not only investors but customers andintermediaries, employees, suppliers,regulators and communities. It does thisin two ways: by considering therequirements of those stakeholders and,uniquely, what the organisation wantsand needs from its stakeholders. In thisway, the reciprocal relationship and theexchange process with each stakeholderis examined. The performance prismaddresses the strategies, processes and,importantly, the capabilities that areneeded to satisfy these two critical setsof wants and needs.

The flexibility of the performanceprism allows it to be applied to anyorganisation or organisationalcomponent. The focus on intangibleperformance drivers makes the

framework useful for companiesattempting to measure their intellectualcapital. Also, it creates a visual map ofhow the different areas of performanceinterrelate. It explicitly acknowledgesthat all five facets of the performanceprism should be covered in a so-calledsuccess map. This way, it avoids theoften-criticised narrowness of thebalanced scorecard.

A more detailed description of theperformance prism model can be foundin CIMA’s technical briefing, “Latesttrends in corporate performancemeasurement” at www.cimaglobal.com/downloads/tech_brief_perf_man_160702.pdf. CIMA will soon publish anexecutive guide on performancereporting to boards which will include acase study showing how Shellimplemented the performance prism.

3 Knowledge assets map approach

The knowledge assets approach takes aknowledge-based view of a firm. It wasspecifically designed to help companiesidentify and measure their knowledge-

based assets and their contribution tovalue. Having identified the criticalknowledge assets, they can easily beintegrated into broader frameworkssuch as the performance prism.

Knowledge assets are identified as thesum of two organisational resources:stakeholder and structural. Thisdistinction reflects the two keycomponents of any enterprise: its actors, who can be internal or external,and its constituent parts, or theelements at the basis of anorganisation’s processes (see figure 2).

Stakeholder resources are divided intostakeholder relationships and humanresources – the external and internalactors of a company. Structuralresources are split into physical andvirtual infrastructure, which refers totheir tangible and intangible nature.Finally, the virtual infrastructure isfurther divided into culture, routines andpractices, and intellectual property.

Stakeholder relationships include allforms of relationships established by thecompany with its stakeholders. Theserelationships could be licensingagreements, financial relationships, orcontracts and arrangements aboutdistribution channels. It could also be

Physicalinfrastructure

Routine andpractices

Stakeholderresources

Structuralresources

Knowledge asset

Virtualinfrastructure

CultureIntellectualproperty

Humanresources

Stakeholderrelationship

Intellectual capital

Figure 2: hierarchy of knowledge assets

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customer loyalty, which represents afundamental link between the companyand one of its key stakeholders.

Human resources contains knowledge provided by employees informs of competencies, commitment,motivation and loyalty as well as advice. Key components are also know-how, technical expertise, problem-solving capacity, creativity, educationand attitude.

Physical infrastructure comprises all infrastructure assets, such asstructural layout and IT equipment suchas computers, servers and physicalnetworks. This category is oftenoverlooked as a knowledge asset but plays a key role in how knowledge is shared.

Culture embraces corporate cultureand management philosophies. Someimportant components are theorganisation’s values, mission and vision.Culture is of fundamental importancefor organisational effectiveness andefficiency, since it provides a framework,sometimes implied, through which tointerpret events.

Routines and practices coverinternal practices and virtual networksand routines. These routines couldinclude tacit rules and procedures, suchas manuals with codified procedures andrules, databases and tacit rules ofbehaviour or management style. They determine how processes arehandled and how work flows throughthe organisation.

Intellectual property is the sum ofpatents, copyrights, trademarks, brands,registered designs, trade secrets andprocesses whose ownership is grantedto the company by law. These are thetools and enablers that allow thecompany to perform its daily processesto produce results.

This framework can be used to helpidentify knowledge assets, which can

then be the basis for visualisation ofhow these assets are interrelated andtransformed to satisfy stakeholderneeds. Such a visualisation is called avalue creation map (see figure 3) and itshows the pathways of how value iscreated in organisations. Knowledgeassets are represented in bubbles linkedwith arrows. The size of individualbubbles represents stocks of particularknowledge assets in terms of strategicimportance and arrows of differentthickness show the transformations andrelationships between knowledge assetsand stakeholder needs (based on aconcept by G Roos (1997)). A map canbe used to visualise the static anddynamic nature of IC and how it addsvalue to different stakeholders.

It is possible to provide a wide rangeof indicators for each of the categorieslisted: it is up to the management teamto identify the most meaningful ones.

Care needs to be taken whenselecting the metrics. Many of thoseproposed in accounting literature tend

to be general and fail to address thetypes of knowledge that play a criticalrole in value delivery for individualcompanies. Managers need to start byrecognising that knowledge assets areunique to each company and themetrics selected should therefore reflectthis (see figure 4).

Individual company modelsSome companies, notably fromScandinavia, have developed their own measurement models. It should be pointed out that all those mentioned derive at least a part of theirincome from consultancy and thereforehave a commercial interest in promotingtheir models. Elsewhere thedevelopment and use of IC models ispatchy. Mainland Europe is probably theleast advanced, with the UK and US alittle further ahead. Pacific Rim countries such as Australia and Japan,on the other hand, have recently madestrong advances.

4 Skandia navigatorOf all the systems for measuring ICSkandia’s navigator model, developed in1994, is probably the best known, eventhough it is only implemented in theSwedish part of the organisation.

Intellectual capital IC measurement and valuation

Culture

Physicalinfrastructure

Stakeholderrelationships

Human resource

Financial success

Intellectual property

Practices and routines

Figure 3: value creation map (source: Marr 2003)

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It reflects four key dimensions of itsbusiness: financial focus; customerfocus; process focus; and renewal anddevelopment focus. At the heart ofthese is human focus, which drives thewhole model.

The similarity with the balancedscorecard is immediately apparent.Indeed, Sveiby (1998) sees the navigatoras a combination of the BSC andCelemi’s intangible assets monitor.

Edvinsson says that navigator can be“viewed as a house. The financial focusis the roof. The customer focus andprocess focus are the walls. The humanfocus is the soul of the house. Therenewal and development focus is theplatform. With such a metaphor,renewal and development become thecritical bottom line for sustainability.”(See figure 5.)

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Intellectual capital

Stakeholder relationships ● Number/quality of partnering agreements; number/quality of distribution agreements;number/quality of licensing agreements; public opinion survey; market share; length ofrelationship; partner satisfaction index; customer retention.

Human resources ● Demographics indicators, for example, number of employees; number of employees in alliances;average years of service with company; average age of employees; full-time permanent employeesas percentage of total employment; employees working at home/total employees; number ofwomen managers.

● Competence indicators, for example, employees with high qualifications; people with PhD and/ormasters degree/total employees; average years of service with the company; number of years inspecific professions; definition of a competence map.

● Attitude indicators, for example, average level of happiness (measured with Likert-type scale);savings from implemented suggestions from employees; number of new solutions, products andprocesses suggested; qualitative descriptions of employees (commitment, loyalty, entrepreneurialspirit, enthusiasm); motivation and behaviour indicators.

● Human resource management practices indicators, for example, training expenses/employees;employee turnover; time in training; expenses for employee-development activities (social andpersonal); indicators about activities to motivate employees; indicators about recruitment practices.

Physical infrastructure ● Scalability/capacity measures; facilities/equipment versus plan; time to execute server updates;system integration; use of knowledge-sharing facilities.

Culture ● Management philosophy; number of internal disputes and complaints; qualitative measures about employee satisfaction; feedback; values; behaviour; motivation; commitment; loyalty; opinion survey.

Practices and routines ● Process quality; number of codified processes; networking practices; norms; database availability;intranet use.

Intellectual property ● Revenues from patents; number of patents and registered designs; value of copyrights; value ofpatents versus R&D spend; trademarks; brand recognition survey.

Financial focus

Customer focus

Operating environment

IC

Renewal and development focus

Process focus

History

Today

Tomorrow Humanfocus

Figure 5: Skandia navigator (source: L Edvinsson and M S Malone, 1997)

Figure 4: knowledge assets indicators

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Each of the five focuses has criticalsuccess factors that are quantified tomeasure change. The indicators used forthe financial focus are largelyrepresented in monetary terms.Customer focus concentrates onassessing the value of customer capitalto the organisation and makes use ofboth financial and non-financialindicators. The measures used for theprocess focus emphasise the effectiveuse of technology within theorganisation. They tend to monitorquality processes and qualitymanagement systems but also includesome financial ratios.

The renewal and development focusattempts to capture the innovativecapabilities of the organisation,measuring the effectiveness of itsinvestment in training and itsexpenditure on R&D. Finally, the humanfocus includes measurements that reflectthe human capital of the organisationand how the resources are beingenhanced and developed.Measurements from the five focuses canthen be recorded and compared fromyear to year.

5 Ericsson’s cockpitcommunicator

Ericsson, the Swedishtelecommunications company, hasdeveloped a commercial product calledthe cockpit communicator, again basedon the balanced scorecard and with fivevery similar perspectives: innovation,employee, process, customer andfinancial. Each is represented as the dialsin an aircraft cockpit and each has itsown indicators. Following inputsrelevant to each indicator, thecommunicator suggests the actions thatwill match the organisation’s strategies.The dials will subsequently show if thecompany is on target in eachperspective. According to Ericsson, theaims of this product are:● a vision-driven organisation,

where priority is given to actions

that are compatible with thecompany’s strategies;

● a communicated strategy linked toindicators and actions;

● a balanced focus on past, present andfuture performance;

● a balance between short-term resultsand long-term strategy;

● the ability to evaluate and changeorganisational strategy rapidly in linewith performance and changingbusiness conditions;

● the ability to manage, measure andcommunicate future values.

6 Celemi’s intangible assets monitor

International training consultancy Celemimonitors three overall categories:customers (external structure); people(competence); and organisation (internalstructure). Under each of theseinterdependent categories, the three keyareas of growth/renewal, efficiency andstability are tracked, each with its ownperformance indicators (see figure 6).

Celemi also produces a managementtraining game called Tango which uses intangible assets monitor thinkingand accounting.

12

(source: “Uncovering Hidden Assets”, Celemi Annual Report, 1999)

Our customers Our structure Our people(external structure) (internal structure) (competence)

Growth/renewal Growth/renewal Growth/renewalRevenue growth Organisation-enhancing Average

customers professionalcompetence years

Image-enhancing customers Revenues from new Competence-products enhancing

customersR&D revenues Growth in

professionalcompetence

Intangible investments Experts with post-(% value added) secondary degree

Efficiency Efficiency EfficiencyRevenues per customer Proportion of Value added per

admin staff expertRevenues per Value added peradmin staff employee

Stability Stability StabilityCustomer satisfaction index Admin staff turnover People satisfaction

indexRepeat orders Admin staff seniority Median age of all

(years) employees (years)Five largest customers Rookie ratio Expert seniority

(years)Expert turnover

Intellectual capital IC measurement and valuation

Figure 6: Celemi’s intangible assets monitor (Karl-Erik Sveiby)

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7 Ramboll’s holistic company model

As with other Nordic models, Ramboll’s holistic company model (see figure 7) consists of key areaswithin which certain performanceindicators are managed.

These key areas lead to three sets ofresults – customer, employee andsocietal – and all three combine toproduce the financial results. The key areas are values and management, strategic processes,human resources, structural resourcesand consulting services.

For example, the performanceindicators for human resources are staff composition, staff turnover andcompetence building.

These key performance indicators(KPIs) are then further subdivided. The ones for competence building, for example, are supplementary training expenses excluding salary, the amount spent per course participant and the hours offcontributed by employees.

The table (see figure 8) provides a list of possible human, organisationaland customer capital indicators, but measurements will always becompany-specific.

Financial

Humanresources

Customerresults

Employeeresults

Societalresults

Consultancy

Structuralresources

Strategicprocesses

Values andmanagement

Intellectual capital

Figure 7: Ramboll’s holistic company model

8 Bates GruppenCompanyIQ measurementsystem

Bates Gruppen is the Norwegian arm ofBates Worldwide and part of theCordiant Communications Group. It hasrecently proposed a method thatconsists entirely of non-financialmeasures. The CompanyIQ allows acompany to score its knowledge assetsagainst those of a similar organisation. ● Stage one

Identify why customers buy from yourcompany as opposed to a rival. This isbest done in a day workshop in whichmanagement select between eightand 12 attributes – for example, rapidresponse or good design. The final listis sent to customers and employeeswho rate each attribute twice, oncefor its value to customers and then forits uniqueness. A scale of one toseven is used. The results are plottedon to a two-by-two matrix. Anyattributes that make it into the topupper-right quadrant – ie are high onvalue and uniqueness – will beexplored further.

● Stage two Identify the intellectual assets thatproduce star attributes – BatesGruppen has identified 100. Ideally,

these should be divided as equally aspossible between human, customerand structural IC assets. All of theseassets must either be measurable inabsolute terms, for example, trainingexpenses, or capable of measurementusing scales, for example, customersatisfaction. At least 60 per cent ofthe assets identified should becomparable to data from reputablebenchmarking studies or from thePIMS database – a huge repositorycontaining data on items such asquality for thousands of companies.

● Stage threeIt is now possible to calculate yourCompanyIQ. Scores on the 100selected assets must first be weightedfor relative impact on profitability(available from PIMS) then comparedwith similar companies on the chosendatabase. Bates Gruppen has selecteda median score of 100.The process does not stop at stage

three. As with any measurement systemsome form of feedback has to be builtinto the system for a company to remaincompetitive. The strength of assetswithin the 100 can be identified andweaker ones improved.

This method is more than just ameasurement system. It requires anorganisation to identify its highlyvaluable, unique capabilities and theintellectual capital assets behind them.

While calculating its IQ, a companymay find it is producing goods orproviding services that are similar tothose of a competitor or containfeatures that add little value tocustomers. This will leave the company with a ready-made list ofindicators, so allowing it to take actionthat has a direct impact on its profit-maximising capabilities.

This system requires a great deal ofwork initially, including gathering datafrom employees and customers who maybe unwilling to participate or who mayprovide hastily compiled information of

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little use. It may also be difficult for acompany to divide its knowledge assetsequally between the three types ofintellectual capital, meaning that someare incorporated to make up thenumbers while others are excluded. Thesuggestion that at least 60 per cent ofthe indicators are comparable to thosefrom other companies still leaves a lotopen to subjectivity.

Valuation of ICValuation approaches were developed toallow external parties or stakeholders toput an economic value on an

organisation. They are usually based onpublicly available data and are mostlyused by finance professionals.

It is a challenging area and it isdifficult to see how some of the modelscan be meaningfully applied in practicein their current state.

9 Value added approachThis measurement and valuationtechnique was proposed by Robinsonand Kleiner (1996) and comprises aframework of two parts.

The first part uses Porter’s value chainconcept. The basic premise, from an

industrial perspective, is that rawmaterials enter from one end of thechain and, as they go through theprocesses that will eventually convertthem into finished goods, value is addedto them. Production is not the onlyfunction involved as the raw materialshave to be procured and the finishedgoods marketed and sold.

The whole procedure also has to beadministered and managed. The keypoint is that all of these internalfunctions should serve the overallpurpose of the organisation, which is tocreate value for its customers.

Intellectual capital IC measurement and valuation

Human capital indicators Organisational capital indicators Customer capital indicators

Revenue generated per employee Income per R&D expense Growth in sales volumeNumber of senior positions filled Individual computer links to database Revenues per customerby junior staffRecruitment, development and Number of times database has Proportion of sales to repeattraining spend per employee been consulted customersEmployee satisfaction Upgrades of database Customer satisfactionAverage length of service of staff Contributions to database Effectiveness of ad campaignStaff turnover Upgrades of SOPs Brand loyaltyEducational level of staff Value of new ideas Brand imageStaff with professional qualifications Ratio of new ideas generated to new Product returns as a

ideas implemented proportion of salesNew ideas generated by staff Number of new product introductions Customer complaintsValue added per employee New product introductions per employee Reputation of companyPost-training evaluation exercise – Proportion of income from new Proportion of customer’s businessbenefits accrued product introductions that your product or service

representsProportion of revenue-generating Number of patentsstaff to otherImage of company from employee’s Average length of time for product designperspective and development

Changes implemented due to employee or customer satisfaction surveysIT expenditure as a percentage of administration spend

All of the above indicators are either numerical or can be represented numerically, for example, company image can be rated from 1, for poor, to10, for excellent. Therefore indicators provide figures that can be compared from year to year. Where the indicators give a financial figure theyrepresent a link between the non-financial and financial dimensions. For example, the innovative capabilities of staff (new ideas) can be measuredby assessing the value of new ideas to the organisation (money saved or money earned). Skandia Banken (part of the Skandia Group) makes aninteresting measure – an expense ratio that compares the cost of knowledge transfer to overall operating expense (Lynn, 1998). The key is inidentifying appropriate measurement techniques and indicators that show how value has been created.

Figure 8: Ramboll’s holistic company model list of indicators

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The second part of the framework isborrowed from the economic valueadded (EVA) theory, which has its rootsin corporate finance and was developedby Stern Stewart, a New York-basedconsultancy. If the return on capital forany project is greater than the cost ofcapital then the company shouldproceed with it. The basic objective ofEVA is to develop a performancemeasure that accounts for all the waysin which organisational value can beadded or lost.

Robinson and Kleiner proposedcombining Porter’s concept and EVA sothat the “financial project evaluationapproach, which relies on value creation,should be applied to all of the internalprocesses of the value chain. Theunfortunate difficulty is that many of theinternal processes are in the form ofintellectual capital and are not readilymeasurable.” To overcome this barrierRobinson and Kleiner have come upwith several suggestions, including:● measuring intellectual property

(patents, licences) at their currentmarket value;

● using the Hay method (named afterthe Hay Group, a global personnelconsultancy) to measure humancapital, whereby job categories andtheir related salaries are evaluated bymeasuring know-how, problem-solving and accountability;

● the use of ratios such as training peremployee, number of ideas peremployee and other productivity/employee ratios;

● measuring the ability of anorganisation to learn and adapt tochanges in the environment.Porter’s value chain concept and EVA

are both well established and combining

them to assess how key activities createvalue within an organisation has clearbenefits. It should eliminate anywasteful activities and lead to themaximum amount of value being addedto a product or service.

The difficulty arises when it comes tothe measurement of value, especiallywhen the activity is “soft”. Clearly theprompt answering of a customer queryadds value, but it would be difficult toput a monetary value on it. Robinson’sand Kleiner’s suggestions to overcomethis fall short of providing clearvaluations for all “soft” assets, so theirproposal should be seen as more of aframework to be used if and when areliable method of measuring intellectualcapital is agreed.

10 Value creation indexThe value creation index attempts tomeasure the importance of differentnon-financial metrics in explaining themarket value of companies.

It followed a survey of readers ofForbes ASAP, the technologysupplement of US business journalForbes, in which they were asked torank the key drivers of corporate valuein their industries. Publicly availableinformation was then used to develop aseries of metrics associated with thosevalue drivers and the correlationbetween the metrics and share priceswas tested. The aim was to discoverwhat factors the market considersimportant rather than just whatmanagers say is important.

The survey revealed the following key findings:

● Key drivers of corporate value (in rank order):1 Customer satisfaction.2 Ability to attract talented employees.3 Innovation.4 Brand investment.5 Technology.6 Alliances.7 Quality of major processes, products

or services.8 Environmental performance.The authors compared these findings

with those of their own research.● Key drivers of corporate value in

durable manufacturing (in rank order):1 Innovation.2 Ability to attract talented employees.3 Alliances.4 Quality of major processes, products

or services.5 Environmental performance.6 Brand investment.7 Technology.8 Customer satisfaction.This kind of rigorous analysis,

especially the attempt to correlatemetrics with capital markets, is in starkcontrast to simpler measurementtechniques. However, the statistical anddata-gathering techniques required aredaunting and few corporate teams havethe time, skill or inclination to incur thenecessary costs. Nevertheless, it offerstwo important insights:● What management (and perhaps

users) consider important may notcoincide with marketplace behaviour.

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Intellectual capital

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For example, customer satisfactiondoes not have the impact in themarketplace that managers tend toassume it has.

● The value creation index attempts todevelop different indices for differentindustries. This is consistent with the view now widely held in IC circles that non-financialperformance metrics must becompany- or industry-specific.Details of another market-driven

reporting framework, developed byPricewaterhouseCoopers, can be foundin CIMA’s executive briefing “BusinessTransparency in a Post-Enron World”.ValueReporting was developedspecifically to try and close the gapbetween what companies currentlyreport and what the markets want. It isbased on extensive research in thecapital markets and tailored to matchthe performance dimensions of specificindustries. Go to www.cimaglobal.com/downloads/enron.pdf

11 Market or value-basedapproach

A simple way of calculating the value ofan organisation’s intellectual capital is totake the difference between its marketvalue – the number of shares in issuemultiplied by the market value of theshare – and the net value of its assets.This can be done with a minimum ofinformation and the gap between thetwo figures, the market-to-book ratio, isoften used as an indication that acompany has many intellectual capitalassets that are not reflected in itsfinancial statements.

There are several drawbacks to thismethod. The most obvious flaw is thatthis method values IC as one asset andmakes no attempt to separate the itemsthat might comprise it.

Intellectual capital IC measurement and valuation

In addition, the market value of acompany is subject to a number ofexternal variables, includingderegulation, media and politicalinfluences and rumours. You only haveto look at the overvaluation of some ofthe earliest dotcoms to go public andthe subsequent dramatic drop in theirshare values. In the case oflastminute.com, the share price fell by90 per cent in less than 18 months, yetthere was little change in the company’sintellectual assets.

The current financial accountingmodel also does not attempt to valuethe firm in its entirety. Instead, it recordseach of its severable assets at anamount in accordance with currentlegislation and the financial accountingstandards. The market, however, would value the company in its entirety as a going concern. This means the figure for intellectual capitalwould differ simply by the adoption ofdifferent accounting policies acrossnational boundaries.

12 Tobin’s qThe “q” developed by economist James Tobin stands for the ratio of themarket value of the firm to thereplacement cost of its assets. If thelatter is lower than the former, then the company is making a higher thannormal return on its investment.Technology and human capital assets were traditionally associated withhigh q values.

It could be argued that Tobin’s q ismore accurate than the market-to-bookmethod because it uses replacement,rather than historic, costs. However,finding these replacement costs is more

difficult than simply referring to abalance sheet. The model is also subjectto the same drawbacks as previousones, since it uses the market value asone of its key measures.

Tobin’s q cannot provide an accuratefigure for individual intellectual assets.Its real value lies in trend analysis: if theq is falling, either the company is notmanaging its intellectual assetseffectively or investor sentiment hasmoved against it.

13 Calculated intangiblevalue

Calculated intangible value (CIV) issimilar to the super-profits method ofvaluing a company – the differencebetween the maintainable profit and theexpected return on the tangible assetsemployed. Stewart (1995) illustrates themethod by using data from USpharmaceutical company Merck:● Stage one

Calculate average pre-tax earnings forthree years – $3.694 billion.

● Stage twoGo to the balance sheet and get theaverage year-end tangible assets forthree years – $12.953 billion.

● Stage threeDivide earnings by assets to get thereturn on assets (ROA) – 29 per cent.

● Stage fourFor the same three years, find theindustry’s average ROA. Forpharmaceuticals the average is 10 percent (this method will not work if theROA is below average).

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Intellectual capital

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● Stage fiveCalculate the “excess return”.Multiply the industry average ROA bythe company’s average tangible assets– 10 per cent x $12.953 billion. This iswhat the average drug companywould earn from that amount oftangible assets. Subtract that from the company’s pre-tax earnings, which in the case of Merck wouldgive an excess of $2.39 billion. This is how much more that companyearns from its assets than the averagedrug manufacturer.

● Stage sixCalculate the three-year-averageincome tax rate and multiply this bythe excess return. Subtract the resultfrom the excess return to get an after-tax figure. This is the premiumattributable to intangible assets. ForMerck, with an average tax rate of 31 per cent, this is $1.65 billion.

● Stage sevenCalculate the net present value (NPV)of the premium. This is done bydividing the premium by anappropriate percentage, such as thecompany’s cost of capital. Using anarbitrarily chosen 15 per cent rate,this yields Merck $11 billion. This isthe CIV of Merck’s intangible assets.This final figure is not the amount left

were you to subtract the tangible assetsfrom the market value of Merck, whichat the time of calculation would havebeen $45.6 billion. Rather, the $11 billion reflects a measure of thecompany’s ability to use its intangibleassets to outperform other companies inits industry. A rising CIV indicates that abusiness is generating the capacity to

produce future wealth – even if themarket hasn’t recognised it yet. A weakor falling CIV may point to the fact thata company’s investments in intangiblesaren’t paying off or that too much is stillbeing spent on tangible fixed assets.

A major benefit of CIV is that it allowsinter- and intra-industry comparisons onthe basis of audited financial results. Aswith other methods that provide ratios,there is also the potential for settingbenchmarks and spotting trends.

But there are problems. First, it adoptsthe industry ROA as a basis fordetermining excess returns and, asaverages tend to suffer from outlierproblems, there could be excessivelyhigh or low ROAs. Second, thecompany’s cost of capital will determinethe NPV of intangible assets. Calculatingthe industry average to counter this willresult in the same problems as theadoption of an average industry ROA. Itis also impossible to separate IC fromgoodwill using the resulting value, sothe method fails to evaluate theindividual components of IC.

14 Matching assets toearnings – the BaruchLev method

Baruch Lev, professor at Stern School ofBusiness, New York University, hasproposed a method of matchingearnings with assets that generate them.The calculation uses expected after-taxreturns on assets – two are averagesand one (for IC assets) is formulatedusing correlations between return onequity and cash flow, traditionalearnings or knowledge earnings. ● Stage one

Take average annual earnings for acompany. Lev suggests using threeyears of past earnings and three

years of earnings provided by theconsensus forecasts of analysts. Forthe sake of this example, assume theyare $1 billion.

● Stage twoSee what the balance sheet has in theway of financial assets. Assume theyare $5 billion. Then take the expectedafter-tax return on financial assets,which is approximately 4.5 per cent.Therefore the $5 billion worth offinancial assets explains $225 millionof the earnings.

● Stage threeNow turn to the physical assets of thecompany and again assume they areworth $5 billion. Using the averageafter-tax return for physical assets,which is approximately 7 per cent,$350 million of earnings can becredited to them.

● Stage fourThis leaves a balance of $425 millionthat must have been produced byassets not on the balance sheet,which Lev calls knowledge-capitalearnings. These earnings are thendivided by an expected rate of returnon knowledge assets, which has beenworked out at 10.5 per cent (seenotes below).

● Stage fiveUsing the formula:

Knowledge capital earningsKnowledge capital discount rate

it can now be assessed that, toproduce $425 million in earnings, thisimaginary company would need$4.06 billion of intangible assets.In order to calculate the intellectual

asset discount rate, Lev looked at

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Intellectual capital IC measurement and valuation

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whether cash flow, traditional earningsor knowledge earnings most correlateswith return on equity. He found only a0.11 correlation between strong returnson equity and cash flows, a 0.29correlation with traditional earnings anda strong 0.53 correlation withknowledge earnings. This would seemto justify a rate of 10.5 per cent thatcompares with 4.5 per cent for financialassets and 7 per cent for physical assets.

Like CIV, Baruch Lev’s method usesboth earnings and assets as data sourcesrather than relying purely on assets. Bymatching assets to earnings,organisations would be left with a figurethey can use for comparisons with othercompanies, or for indicating that theirown earnings from IC are going up ordown. However, like some of the othermethods, this one results in a singlefigure for IC while not attaching valuesto individual components. The figure of 10.5 per cent representing theexpected rate of return on knowledgeassets could be challenged. The method has also been criticised as beingtoo complex.

15 Human resourceaccounting (HRA)

The aim of human resource accounting(HRA) is not simply to describe thefinancial accounting aspect ofcapitalising expenditure on recruitment,

training and development. It is alsodesigned to quantify the economic valueof people to the organisation in order tocontribute to decision-making, planningand control processes.

As a result, various models have beenproposed, all with the underlyingrationale of attempting to calculate thecontribution each employee makes tothe organisation.

According to Bontis et al (1999), HRAcan provide external information toaccounts users but also has otherassociated benefits. It allows for internalfeedback to the members of theorganisation on the accomplishment ofstrategic goals. It also acts as a startingpoint to develop future plans andstrategies by recognising the corecompetencies inherent in a company’sunique IC.

However, HRA again relies on humancapital alone and, although salaries,wages and the costs of recruitment andtraining are simple enough to measure,putting value on the growth andaccumulation of employee knowledgecan prove a lot more difficult.

16 Value-added intellectualcapital coefficient

This method calculates the differencebetween sales and all inputs (exceptlabour expenses), divided by intellectualcapital, which is estimated by totallabour expenses. The higher the ratio,the more efficient the company is atusing IC assets.

The main advantage of this approachis simplicity. The figures are easy toobtain from any annual report and, oncecalculated for a year, can be used forinter- or intra-company comparisons.However, this straightforwardness hasmany disadvantages. Comparing anorganisation’s labour expenses to its ICwould appear to undervalue IC whencompared with other methods such asthe market-based approach. Also, acompany could be using its labourresources inefficiently, but this could bemasked by a more efficient use of otherinputs leading to a similar ratio.

The approaches outlined give a goodidea of the range of methods, disciplinesand functional specialisms employed inmeasuring and valuing intellectualcapital. Only one of these – thebalanced scorecard – is in widespreaduse, while the rest remain tootheoretical, too flawed or simply tooundeveloped to be accepted universally.

Eventually, it may be a combination ofthese ideas that provides the mostpractical solution. ■

This section is based on two CIMA-sponsored research projects, “Measuringthe immeasurable” by Wall, Kirk andMartin of the University of Ulster, and“Measuring and managing knowledge”by Marr, Neely and Schiuma of CranfieldSchool of Management.

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Intellectual capital

4 Knowledge management

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Intellectual capital and knowledgemanagement (KM) should not beconfused. It is essential for all companiesto maintain and grow their IC stocks –rather than simply measure them – andknowledge management is one way of helping them to do this. But the two are quite distinct: KM is a processwithin a company, whereas IC covers itswhole operations.

As with many of the concepts in thisarea, there is no universal definition ofknowledge management. The GartnerGroup defines it as “a discipline thatpromotes an integrated approach toidentifying, managing and sharing all ofan enterprise’s information assets. Theseinformation assets may includedatabases, documents, policies andprocedures, as well as previouslyinarticulated expertise and experienceresident in individual workers.

KPMG came up with a morecommonly used definition in 2001:“Knowledge management is a collectivephrase for a group of processes andpractices used by organisations toincrease their value by improving theeffectiveness of the generation andapplication of intellectual capital.”

The term “knowledge worker” wasfirst used by management guru PeterDrucker in the 1960s. He rightlypredicted that knowledge wouldbecome the key economic resource and even called knowledge workers thenew capitalists.

But it wasn’t until the late 1990s thatthe craze for all things knowledgemanagement really began. Traditionalcompetitive advantage based oneconomies of scale was eroded bysmaller, nimbler and more ingeniouscompetitors. As the market cap of start-ups soared, companies around the worldsuspected that their potential for successmay reside in the knowledge, expertiseand creativity of their employees.

Yet few knew how to use thisknowledge in a systematic way in order to gain real business benefits. This created a huge demand forproducts and services about knowledge management – books,conferences and consultancies weresuddenly everywhere.

After the boom came the bust andmuch of the market cap created in thelate 1990s had been wiped out evenbefore Enron and the geopoliticaldevelopments sent the world stockmarkets into turmoil. But knowledgemanagement remains an importantconcept in an economy dominated byintangibles and there are now signs thatit is becoming a part of everydaybusiness infrastructure. Rescued frombeing a consultant-driven fad, it is nolonger seen as an end it itself –something companies could implement

as a one-off initiative or purchase withan expensive piece of software.

The misconception that there was afinite stock of knowledge to be“managed”, almost always with anexpensive IT system, meant that manycompanies initially overlooked theoverall business purpose. In fact, manyembarked on knowledge-managementinitiatives without a clear idea of whatbusiness benefits they could expect andwhat else might have to be changed tomake them work.

Instead, companies should start offwith a clear value proposition that isthen driven through every part of thesystem, including organisational culture.

It has been said that you can’tmanage knowledge; you can manageonly the culture that leads to thatknowledge being shared – and mostwould agree that managing culture isn’teasy. This is especially true for so-calledtacit knowledge (see table below) whichcannot be codified or stored. How thatknowledge is used and shared will

Some knowledge can be codified through a set of management and technologicalprocedures and put into repositories such as databases or presented on intranets.Some, on the other hand, exists only in the heads of the employees or in therelationships that exist between them. Sidney Winter presents a classification of knowledge dimensions as a continuumbetween the two sides of the table below.

Tacit Explicit

● not teachable ● articulable● not articulated ● teachable● not observable in use ● articulated● complex ● observable in use● an element of a system ● simple/independent

(Dimensions of knowledge assets, based on Winter, 1987)

Managing tacit knowledge is usually seen as the more difficult part but manycompanies also struggle with explicit knowledge. A simple example is intranets,which so many have got wrong. As an internal knowledge-sharing tool, theirpotential is phenomenal, yet many intranets lie unused, with staff relying insteadon traditional ways of obtaining information such as social networks or using thephone. This shows the importance of addressing cultural as well as structural issuessurrounding knowledge management.

Tacit explicit knowledge

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Knowledge generation includes aset of processes executed in order toincrease the stock of corporateknowledge assets. There are two main sub-processes of knowledgegeneration: knowledge acquisition andknowledge creation.

Knowledge acquisition is a process ofcapturing and bringing knowledge fromthe external environment into the company. The simplest way of doing this is to buy it, but knowledgeassets can also be rented (for example,paying consultants to resolve specificproblems or building relationshipsthrough alliances). Some companies,known as knowledge brokers, specialise in providing support forknowledge acquisition.

Knowledge creation is the process ofdeveloping new knowledge assetswithin the company. As it’s linked toindividual learning processes, it can be

the result of either fortuitous individualactivity or planned organisational policy. The most effective way ofcreating knowledge internally is toencourage employees to be creative andkeen to learn by devoting specificresources to these processes. A commonway of doing this is to establish units designed for this purpose, such asR&D departments.

Knowledge mapping is the process of identifying knowledge assetswithin an organisation and definingways of accessing them. Enablingeveryone to access existing knowledgemakes it easier to create newknowledge assets. Knowledge mapping

Intellectual capital Knowledge management

Culture andvalues

Strategy andgoals

Vision

Vision

Marketplace

Marketplace

Processes andsystems

Relationships and structure

Resources

20

depend on the unspoken norms ofbehaviour that constitute organisationalculture. It is these, rather than formalsystems, that guide many employees’interactions with customers, colleaguesand other stakeholders.

The way in which an organisation isstructured – its myriad formal andinformal relationships, the processes andsystems used, and the resources at itsdisposal – will have a major influence onits culture. This can constrain strategyand goals and, consequently, theorganisation’s vision.

The elements of the globe expressedin figure 9 combine to create anorganisation that is aligned to achieveits vision which is, in turn, appropriatefor its marketplace and externalenvironment. The interconnectednessserves to emphasise the importance oflooking outside as well as inside. Youmay have a sophisticated knowledge-management system, but if yourstrategy is wide of the mark or you havefailed to assess your risks properly,knowledge management by itself willnot give you a competitive advantage.

1 Knowledge process wheelThe knowledge process wheel, (seefigure 10) developed by Cranfield Schoolof Management’s Centre for BusinessPerformance, summarises a set ofknowledge management processes thatcan be used to grow and maintain IC.

Figure 9: KPMG organisation system model (M Jeans, 1998)

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Knowledgeapplication

Knowledgemapping

Knowledgesharing

Knowledgetransfer

Knowledgegeneration

Knowledgecodification

Knowledge

Knowledgestoring

is usually supported by knowledge-storing technologies.

Knowledge sharing is a process thatallows knowledge to be disseminatedacross an organisation. Many companiesadmit that “if they knew what theyknew” the benefits would beconsiderable. There would be lessduplication of effort and informationused for decision-making would bemore accurate. The main obstacle toknowledge sharing is that knowledgeoften represents a source of power tobe guarded jealously. This is especiallytrue in economic downturns, whenhaving unique knowledge can make you indispensable.

Knowledge sharing can be donethrough either formal or informalprocesses. The former includesmeetings, seminars and workshops,knowledge databases or internaldocuments. Informal processes include casual discussions betweenindividuals. Companies shouldencourage such knowledge sharing byproviding time, space and socialactivities for this purpose.

Sharing can also be supported by theright IT infrastructure, such as on-linedatabases, data warehouses/knowledgerepositories, intranets, decision-supporttools and shared drives. Companies thathave implemented these shouldremember that their success depends onpeople actually using them and that ITcan only ever be a facilitator or a toolthat brings scaleability to the process.

Knowledge transferring is theprocess of passing on knowledgebetween cognitive systems. A distinctionis often made between intra- and inter-organisational knowledge transfer.When it takes place within a firm,among different units, groups orindividuals, it overlaps with knowledgesharing. When it involves severalcompanies, it shares characteristics with

many knowledge-acquisition processes.The main difference is the disparity ofuse. The former is intended to turnindividual/team knowledge intoorganisational knowledge. The latterworks towards creating a channel and acontext that enables an organisation toacquire the knowledge from the outside.

Knowledge codification is theprocess aimed at formalising knowledgeinto appropriate codes such as words,pictures or film. It involves:● capturing knowledge – identifying

knowledge related to an activityneeded to achieve a specific business goal;

● externalisation – changing the natureof knowledge from a tacit to a moreexplicit one;

● representation – a description of theexplicit knowledge with anappropriate set of information codes. Knowledge storing is the process of

saving knowledge within theorganisation, thus making it availableanywhere at any time. This process is atthe heart of knowledge mapping andcan take the form of either knowledgedatabases or directories. In the former,codified knowledge is stored inappropriate information codes. Thismethod is used by many consultancies,such as Accenture and Ernst & Young,which have developed best-practicedatabases to support their consultantsthroughout the world.

Directories, on the other hand,provide links to people with specificknow-how and the only informationstored is that required for identifyingpeople and places where knowledgeresides. For example, pharmaceuticalcompany Hoffman-LaRoche, as a part ofits overall drug approval processknowledge map, has a catalogue of

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Intellectual capital

Figure 10: Knowledge process wheel

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relevant experts, arranged according toknow-how, questions and issues.

Knowledge application is theprocess of applying knowledge withinthe organisation. Knowledge becomes a value-added resource only if it isapplied to improve businessperformance. Translating knowledgeinto action can mean a difference inorganisational performance.

Combining the classification ofknowledge assets within a companywith the analysis of appropriateknowledge processes allows managersto identify and understand the leversthey need to pull in order to managetheir companies’ capabilities.

Even if they are reluctant to instigatea comprehensive knowledge-management system, companies shouldstill consider how individual elementsmay be applied. The knowledge processwheel could be used to identify anyobvious gaps in their systems.

2 KM and the accountingprofession

The move to a knowledge-basedeconomy has had a direct effect on theaccountancy profession. Information oncerepresented power and accountants hadaccess to data that few othersunderstood or knew how to get hold of.

Advances in technology mean thatinformation is more widely available andaccessible, and much of routineprocessing and analysis can now be leftto IT. There are also more people, suchas those with MBAs, who are trained to

understand and use financialinformation. The importance of non-financial information has also increased.

As for accountants’ skills, a recentpublication by FMAC (the Financial andManagement Accounting Committee ofthe International Federation of Accountants) says: “Local knowledgeand technical competence will beinsufficient; instead a premium will be placed on value-adding contributionsto management.”

If they are to add value, in otherwords, accountants will have tocombine the knowledge andunderstanding of “traditional” financialinformation within their control withmore sophisticated interpretationtechniques. This means ensuring theydevelop greater commercial awareness,including fostering better links withother departments and appreciatinghow their role contributes to thestrategic direction of their companies.Accountants in business will increasinglyhave to position themselves not asnumber crunchers but as strategicadvisers who can help companies tounderstand and evaluate their financialand competitive position.

A recent CIMA-sponsored report,“Management accounting andknowledge management”, based onworkshops in 10 companies, concludedthat, while they were getting prettygood at acquiring and sharinginformation about competitors,customers and suppliers, they often didnothing with it. In each of theworkshops, participants found it muchharder to identify processes for retainingand using knowledge than those foracquiring and sharing it.

The report concluded thatmanagement accountants shouldcontract rather than expand their viewof strategic management accountingand that the onus should shift tomanaging the knowledge resourcesalready held within the organisation.Because their skills are based onmeasurement and control, managementaccountants are also best placed tobecome the champions of cross-functional knowledge-managementactivities in organisations, possibly inpartnership with HR professionals.

The research also found that thebusiness case for knowledgemanagement tends to be obscuredbecause of a lack of understanding oflinks between knowledge managementand financial results. Accountants’involvement in this area could make theinterdependencies much more visible bydeveloping appropriate performancemanagement and reward systems. ■

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1 Accounting standards Some intangibles are already included intraditional financial statements. In fact,the accounting rules for reportingintangible assets have been evolvingover the past 20 years or so.

By the early 1990s, SSAP22(Accounting for goodwill) and SSAP13(Accounting for R&D) were wellestablished, but there were no specificguidelines for dealing with items such asbrands, despite the fact that theyaccounted for much of the market valueof some companies.

As a consequence, the AccountingStandards Board introduced FRS10, themain standard for reporting intangiblesand goodwill. It came into force foraccounting periods ending on or after23 December 1998 and replacedSSAP22. Intangibles are defined as“non-financial fixed assets that do nothave physical substance but areidentifiable and controlled by the entitythrough custody and legal rights”.According to UK Gaap the objectives ofFRS10 are to ensure that:● capitalised goodwill and intangible

assets are charged in the profit andloss account in the periods in whichthey are depleted;

● sufficient information is disclosed inthe financial statements to enableusers to determine the potentialimpact of goodwill and intangibleassets on the financial position andperformance of the reporting entity.

In 2005, when the internationalreporting standards are due to replacenational rules for companies listed onregulated markets within the EU, IAS38will supersede FRS10.

IAS38 grew out of an early attempt todevise an accounting treatment for R&Dcosts and was finalised in July 1999. Itsdefinition of intangible assets is similarto that in FRS10, except it adds thatintangible assets are held for use “in theproduction or supply of goods andservices, for rental to others or foradministrative purposes”.

IAS38 specifies that a company canonly recognise an asset if:● it is identifiable;● it is controlled;● it is probable that future benefits

specifically attributable to the assetwill flow to the enterprise;

● its cost can be reliably measured. These criteria apply to both purchased

and self-created assets. In fact, IAS38does not specify that internallygenerated intangibles can never berecognised as assets. It is laid out in sucha way, however, that it is difficult toimagine items meeting the recognitioncriteria (see UK and international Gaap,Tolley/Ernst & Young).

If the item does not meet the abovecriteria, IAS38 requires the expenditureon it to be recognised as expense whenit is incurred. This also applies to thefollowing items at all times:● internally generated goodwill;● start-up, pre-opening and

pre-operating costs;● training costs;● advertising costs;● relocation costs.

According to the InternationalAccounting Standards website,www.iasplus.com, examples of possibleassets as defined by IAS38 include:● Computer software.● Patents.● Copyrights.● Movies.● Customer lists.● Mortgage servicing rights.● Licences.● Import quotas.● Franchises.● Customer and supplier relationships.● Marketing rights.

It is clear from this list that much ofwhat is commonly regarded asintellectual capital would not in factpass the recognition test. The mainreason for this is that many intangiblescannot be controlled. Both FRS10 andIAS38 mention control as being centralto the definition of an asset. As the UKand international Gaap says: “Thenotion of maintaining custody oversomething that has no physicalsubstance may seem rather strange but FRS10 explains that it means suchthings as keeping technical orintellectual knowledge secret. Therequirement for this to be throughcustody or legal rights means thatpseudo-assets, such as portfolios ofclients or a team of skilled staff, couldnot be recognised as assets, as there isinsufficient control.”

IAS38 defines control as the ability toobtain future economic benefits

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5 Reporting intellectual capital

Intellectual capital

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generated by the resource and theability to deny those benefits to others.This normally means legal rights, as inFRS10, but control can also bedemonstrated “in the absence of legalenforceability by factors such as marketand technical knowledge. However,skilled staff, customer portfolios ormarket share are unlikely to becontrolled in such a way to meet thedefinition of intangible assets.”

Customer satisfaction is a case inpoint. As Wayne Upton says in his 2001Financial Accounting Standards Board(FASB) paper, Business and FinancialReporting, Challenges for the NewEconomy : “While the entity may reapeconomic benefits from happycustomers and workers, it cannot denyothers the ability to entice awaycustomers and employees. The controlcriterion allows accountants and others to draw boundaries aroundparticular things that may be recognised as assets.”

He goes on to say that we shouldconsider the possibility that certain itemsshouldn’t be included in financialstatements because they lack theessential characteristics of assets, ratherthan because the financial statementscannot accommodate them. This is the

opposite of the now almost universalview that financial reporting is out ofdate and unable to cope with thedemands of the new economy.

Upton quotes a merchant banker whosays: “Balance sheets are for stuff, notpeople or ideas. People aren’t assetsbecause you can’t own them, at leastnot in this country (I’m neglectingalimony here); you can only rent them.Ideas are not assets because, partly dueto the fact that people who generatethem can’t be owned, you can’t keepthem bottled up for very long. If youwant to measure the value of peopleand their ideas, you need to look atcash flows, not assets. Balance sheetsmeasure the value of stuff you own,cash flows measure the value of thingsyou rent.”

A similar argument is put forward inAndrew Lennard’s essay for theAccounting Standards Board (ASB),Liabilities and how to account for them.He says that it is impossible to imaginehow the true value of a company couldbe calculated with a reasonable degreeof credibility and objectivity. Also, thedesire to approximate the total of thebalance sheet with the market value ofthe company belies a misunderstandingof the information needs of investors.Analysts, for example, do not want tobe told what the value of a company is– it is their job to work it out from thefinancial statements and other sources.

In other words, information providedin financial reporting is only the starting

point, a part of the bigger picture.Investment decisions, as Lennard says,are about what is going to happen inthe future, and financial statements canonly contribute to that understanding.

2 Operating and financialreview

Although it seems unlikely that manyintangibles will soon appear on financialstatements, the operating and financialreview (OFR) could be a suitable form of narrative reporting for identifyingtheir importance.

The recent company law review, likelyto be included in the updatedCompanies Act 2003, requires all publicand large private companies to producean OFR. Besides traditional financialmeasures, the OFR requires companiesto include an account of how intangibleassets contribute to its overall valuegeneration and how the conflictingstakeholder interests are balanced.

The key area to be covered from theIC reporting point of view is the“dynamics of the business” – in otherwords, known trends, events,uncertainties and other factors that may substantially affect futureperformance, including investmentprogrammes. The report specifies someof the areas that companies may berequired to address – for example, risksand opportunities and related responsesin connection with:● competition and changes in

market conditions;● customer/supplier dependencies;● technological change;● financial risks;● health and safety;

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● environmental costs and liabilities;● projects and programmes to maintain

and enhance tangible and intellectualcapital, brands, R&D and training.The ASB guidance on OFR published

in January this year says that it shouldgive a commentary on the strengths andresources of the business that will help itin the pursuit of its objectives and, inparticular, on those items that are notreflected in the balance sheet. Suchitems might include:● corporate reputation and brand equity;● intellectual capital;● licences, patents, copyrights and

trademarks;● R&D;● customer/supplier relationships;● proprietary business processes;● websites and databases;● market position/dominance.

The ASB adds: “The use of relevantfinancial and non-financial measures willoften assist the user’s understanding ofthe potential value of such items.However, it is not intended that anoverall valuation of the business must begiven, nor, in the case of listedcompanies, for net asset value to bereconciled to market capitalisation.”

Some of the areas mentionedcorrespond loosely to IC components. Itis questionable, however, how manycompanies will complete their OFRs inthe spirit of the ASB guidance. A recentreport shows that the more innovativedisclosures in the ASB proposal – such as

the dynamics of the business, forward-looking disclosures, revenue investmentand soft assets – are generally beingresisted by companies, including someof the biggest (“Half the story”,Association of Chartered CertifiedAccountants, 2003).

The OFR is a “through the eyes ofmanagement” statement which relies ondirectors’ judgment of materiality. It maytherefore lack comparability, bothbetween companies/sectors and year onyear. There is also a danger that materialdisclosed will be too vague and difficultto understand. On the other hand, it isprecisely this judgment of what ismaterial for individual businesses thatcould accommodate the idiosyncraticnature of many intangibles. In any case,whichever method companies choose toadopt, it will need to have credibilitywith the stock market.

3 Intellectual capital reportsIf we accept that, for the time being,intangibles are unlikely to appear inpublished balance sheets, we are still leftwith a problem of how to account for,measure and manage what areundoubtedly important value drivers inmany of today’s businesses. Investorsneed this information if they are tovalue companies with a greater degreeof accuracy.

Some research (Holland, 2002) pointsto the fact that much of this informationdoes in fact get communicated, albeit inprivate meetings between companiesand investors. Although this canfunction relatively well, clearly it is notan ideal situation for the investmentcommunity as a whole, as it is biasedtowards the big institutional investors.

In Europe, there have been variousinitiatives to address the reporting ofintellectual capital, most notably theMeritum guidelines and its follow-upproject E*Know Net (both sponsored bythe EU and the Organisation forEconomic Co-operation andDevelopment) and a Danish initiative onintellectual capital statements sponsoredby the Danish government.

As a way of overcoming theinformation imbalance, these researchprojects suggest that companies startpublishing a supplement to the annual report – a so-called intellectualcapital statement.

Based on best practices observed inmore than 100 European companies,the projects have resulted in guidelineson how to report intellectual capital.Although the guidelines vary slightly incontent and terminology, the underlyingideas are the same. Organisations areencouraged to produce reports thatcontain the following three elements:● narratives about the company vision;● management challenges and actions;● a set of indicators.

The narratives give organisations thespace to explore their strategicobjectives, the products they sell andtheir customer approach. It alsoidentifies the critical intangibles anddescribes how they drive performanceand deliver value to stakeholders.

With management challenges andactions, an organisation can explainwhich IC assets need to be strengthenedor acquired in order to achieve itsstrategic objectives. It allows firms toreport on activities, initiatives and

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Intellectual capital

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processes, either already in place orplanned for the future. Activities andmanagerial actions can also be prioritised.

Organisations can create a set ofindicators that visualise theirperformance in terms of intellectualcapital management. Users ofintellectual capital statements should beable to look at these and assess howwell the company is fulfilling itsobjectives. There is no predefined set ofmeasures and the set chosen caninclude indicators that measure effects,activities or the resource mix.

Many firms across Europe alreadypublish IC statements on a voluntarybasis. They see it as a way of increasingtransparency and explaining their viewof the company’s business model to the market. But, while separateintellectual capital statements may beappealing to users of information,especially individual shareholders, theymay place an unwelcome burden oncompanies already facing greaterdemands for transparency.

There is also a danger of informationoverload – many companies alreadyproduce corporate social responsibilityreports. At this stage, it is not yet clearwhether there will be a consensus about the advantages of producingthese kinds of statements, or whether such reporting will one daybecome mandatory.

Intellectual capital is important toboth society and organisations. It can bea source of competitive advantage forbusinesses and stimulate innovation thatleads to wealth generation.Technological revolutions, the rise topre-eminence of the knowledge-basedeconomy and the networked societyhave all led to the realisation thatsuccessful companies excel at fostering creativity and perpetuallycreating new knowledge.

Companies depend on being able tomeasure, manage and develop thisknowledge. Management effortstherefore have to focus on theknowledge resources and their use.Intangibles and how they contribute to value creation have to be appreciated so that the appropriatedecisions can be made to protect andenhance them. There must also be acredible way of reporting thoseintangibles to the market to give the

investment community comprehensiveinformation to assist in valuing thecompany more accurately

Huge investment flows in intangiblesdo not appear as positive asset valueson financial statements, so the traditional accounting model does not represent them in a meaningfulformat. But financial statements shouldbe seen as only a part of the jigsaw inhow companies assess andcommunicate value. The financefunction has a key role to play inmanaging knowlege assets andunderstanding and communicatingsources of enterprise value. It may take a while to reach a consensus onwhat constitutes the best model formanaging and reporting intangible value drivers. But experimentation isinvaluable if we are to agree on best practice and arrive at a point of convergence between the disparate approaches. ■

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Intellectual capital Reporting intellectual capital

6 Conclusion

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A Profession Transforming: From Accountingto Management, IFAC, 2001

“Assessing strategic knowledge assets ineBusiness”, B Marr, G Schiuma and A Neely,International Journal of Business PerformanceManagement, Vol 4 Nos 2-4, 2002

“Bridging the S-curve gap”, M Jeans, inSuccess in Sight: Visioning, A Kakabadse(ed), Thomson, 1998

Building Public Trust, S Dipiazza Jr and R Eccles, John Wiley & Sons, New York, 2002

Business and Financial Reporting: Challengesfor the New Economy, W Upton, FASB, No219-A, April 2001

“Creating a knowledge culture”, S Hauschild, T Licht and W Stein, TheMcKinsey Quarterly, No 1, 2001

“Efficiency through knowledge”, I Windle,FT, 21/02/01

Financial Institutions and CorporateGovernance, J Holland, CIMA, 2002

“From the ancient Greeks to the moderndatabases”, R Newing, FT survey –Knowledge Management, 28/04/1999

Guidelines for Managing and Reporting onIntangibles, Project Meritum, January 2002

Human Capital and Corporate Reputation,ICAEW, June 2000

“How to measure an organisation’sintellectual capital”, G Robinson and B Kleiner, Managerial Auditing Journal, Vol 11, No 8, 1996

“Intellectual capital: defining keyperformance indicators for organisationalknowledge assets”, B Marr, G Schiuma andA Neely, Business Process ManagementJournal, Vol 10, No 4, 2003

Intellectual Capital – Issues and Practice,ICAEW, June 2001

Intellectual Capital: Navigating the NewBusiness Landscape, G Roos et al,Macmillan, London, 1997

“Knowlege and competence as a strategicasset”, S Winter, The Competitive Challenge,D Teece, Ballinger, Cambridge, 1987

Knowledge Management – A State of theArt Guide, P Gamble and J Blackwell, KoganPage, 2001

“Known quantities”, B Marr, FinancialManagement, CIMA, April 2003

Liabilities and How to Account for Them, A Lennard, ASB, 2002

MA and Strategic Human ResourceManagement, J Innes, R Kouhy and R Vedd, CIMA, 2001

Management Accounting and KnowledgeManagement, J Edwards, P Collier and D Shaw, CIMA research report

Measurement and Management ofIntellectual Capital, IFAC, 1998

“Measuring and managing intellectual capitaland knowledge assets in new economyorganisations”, B Marr and G Schiuma, inHandbook of Performance Measurement, M Bourne (ed), Gee, London, 2001

“Measuring intellectual capital – theinternal and external drivers for measuringand reporting intellectual capital,” B Marr, D Gray, paper presented at “The transparententerprise, the value of intangibles”conference, November 2002

Measuring the Immeasurable, A Wall, R Kirkand G Martin, CIMA research report

“Measuring the worth of human capital”, R Donkin, FT, 07/11/02

New Measures for the New Economy, C Leadbetter, ICAEW, 2000

Non-executive directors’ survey 2002-03,KPMG, 2003

“Performance evaluation in the neweconomy”, International Journal ofTechnology Management, Vol 16, Nos 1-3

“The knowledge tool box”, N Bontis et al,European Management Journal, Vol 17, No 4, 1999

“The metric system for performance”, S Overell, FT report – Understanding HumanCapital, 31/10/02

“The next society”, P Drucker, TheEconomist, 1/11/2001

The New CFO of the Future: FinanceFunction in the 21st Century, Institute ofChartered Accountants of Australia andKPMG Consulting, 2001

The Performance Prism: The Scorecard for Measuring and Managing BusinessSuccess, A Neely, C Adams and MKennerley, Financial Times Prentice Hall,London 2002

“Trying to grasp the intangible”, T Stewart,Fortune, Vol 132, No 7, 1995

UK and International Gaap,Tolley/Ernst&Young, 2001

“Value relevant information on corporateintangibles”, J Holland, University ofGlasgow, paper presented at “Thetransparent enterprise, the value ofintangibles” conference, November 2002

Valuing Intangibles, C Vance, ICAEW, 2001

Useful websitesCIMAwww.cimaglobal.comCranfield University Centre for BusinessPerformancewww.cranfield.ac.uk/som/cbp/E*KNOW-NETwww.eu-know.netInternational accounting standardswww.iasplus.comSkandiawww.skandia.se/hem/hem.jspEricssonwww.ericsson.com/cockpit/Celemiwww.celemi.comRambollwww.ramboll.dk/dan/default.aspBates Gruppenwww.bates.no/flash.htmlBaruch Levhttp://pages.stern.nyu.edu/~blev/ Company law reviewwww.dti.gov.uk/cld/review.htm

References and further reading

Intellectual capital

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Understanding corporate value: managing and reporting intellectual capital

The Chartered Institute of Management Accountants (CIMA) represents financial managers and accountants working in industry, commerce, not-for-profitand public-sector organisations. Its key activities relate to business strategy, information strategy and financial strategy. CIMA is the voice of more than 77,000students and 59,000 members in 154 countries. Its focus is to qualify students, to support both members and employers and to protect the public interest.

The Chartered Institute of Management Accountants, 26 Chapter Street, London SW1P 4NP +44 (0)20 7663 5441 www.cimaglobal.com

Cranfield School of Management is a world-class university business school based in the UK. Renowned for its strong links with industry and business, it iscommitted to providing practical management solutions through a range of activities, including postgraduate degree programmes, management development,research and consultancy. The Centre for Business Performance is a research centre dedicated to performance measurement and management. The work of thecentre revolves around the design, implementation, operation and evolution of performance measurement systems. Its website is www.cranfield.ac.uk/som/cbp