INTELLECTUAL CAPITAL: MEASUREMENT,

RECOGNITION AND REPORTING

DR. S.ARAMVALARTHAN MBA, PhD, FCA, ACMA, ACS, 1

INTRODUCTION
The present day economy is knowledge based. In a knowledge economy, the drivers of
competitive advantage and value creation are knowledge resources such as human capital,
organizational processes and external networks. The success of organizations depends more on
their ability to exploit and manage their intangible resources than their tangible assets. As
intangibles such as knowledge and innovation have become an increasingly important part of
corporate value, measurement, recognition and reporting of intellectual capital assumes great
significance.

MEANING OF INTELLECTUAL CAPITAL

Intellectual capital is intellectual materialknowledge, information, intellectual property,
experiencethat can be put to use to create wealth (Stewart, 1997). A companys intellectual
capital is the sum of its human capital (talent), structural capital (intellectual property,
methodologies, software, documents, and other knowledge artifacts), and customer capital (client
relationships) (Stewart, 2001). Intellectual capital is the possession of knowledge and
experience, professional knowledge and skill, good relationships, and technological capacities,
which whwn applied will give organizations compettive advantage (CIMA, 2001). It is a
combination of human capitalthe brains, skills, insights, and potential of those in an
organizationand structural capitalthings like the capital wrapped up in customers, processes,
databases, brands, and IT systems. It is the ability to transform knowledge and intangible assets
into wealth creating resources, by multiplying human capital with structural capital (Edvinsson,
2002)

NEED FOR MEASURING INTELLECTUAL CAPITAL

Companies may want to measure intellectual capital for a variety of reasons. Holmen (2005)
identified the following five specific main reasons for measuring intellectual capital:

To help organizations formulate their strategy. By identifying and evaluating intellectual

capital an organization may gain a competitive advantage.
To assist in diversification and expansion decisions. Intellectual capital may be measured to
assist in evaluating mergers and acquisitions, particularly in respect of the purchase price of
the acquisition.
To assess strategy execution. Measuring intellectual capital may lead to the development of
key performance indicators that will help evaluate the execution of any strategy employed.
For use as a basis for compensation. The measurement of intellectual capital may be linked
to an organizations incentive and compensation plan.
To communicate with external stakeholders. The value of the intellectual capital will
communicate to external stakeholders the true value of the organization.
Professor , Amrita School of Business, Coimbatore, Tamil Nadu, India

NEED FOR REPORTING INTELLECTUAL CAPITAL

External reporting of intellectual capital can: (1) close the gap between book value and market
value, (2) provide improved information
ormation about the real value of the organization, (3) reduce
information asymmetry, (4) increase the ability to raise capital by providing a valuation on
intangibles, and (5) enhance an organizations reputation. (Holmen, 2005).

INTERNAL REPORTING OF INTELLECTUAL CAPITAL

Two important attempts to measure and report intellectual capital internally are Skandias
Navigator and Kaplan and Nortons balanced scorecard.

Skandia Navigator
Skandia documented its approach to measuring intellectual capital supplements to its interim and
annual reports (Skandia, 1996). Figure 1 shows the companys hierarchy of intellectual capital.
The overall market value of the firm can be split into two parts: the financial capital and
intellectual capital. Skandia breaks intellectual capital into several components of human capital
and structural capital.
Human capital is defined as the knowledge, skills and experience that employees take with them
when they leave. Structural capital is defined as the knowledge that stays within the firm. It can
be split into customer capital and organizational capital. Customer capital is the value of the
organizations ongoing relationships with the people or organizations to which it sells
Organizational
zational capital can be broken down further into process capital (how things get
accomplished) and innovation capital (protected commercial rights and intellectual property).
Figure 1
Skandias Hierarchy of Intellectual Capital
MARKET VALUE OF
FIRM

FINANCIAL CAPITAL

INTELLECTUAL
CAPITAL

HUMAN CAPITAL

STRUCTURAL
CAPITAL

ORGANIZATIONAL
CAPITAL

CUSTOMERCAPITAL

CUSTOMER BASE

CUSTOMER
RELATIONS

CUSTOMER
[POTENTIAL

INNOVATION
CAPITAL

PROCESS CAPITAL

Source: Skandia, Intellectual

ual Capital
CapitalValue
Value Creating Processes, a supplement to Skandias
1995 Annual Report

The Skandia Navigator measurement tool has five main components that are shown in Figure 2:
financial, customer, process, human, and renewal and development. At the heart of these is
human focus, which drives the whole model. Edvinsson says that navigator can be viewed as a
house. The financial focus is the roof. The customer focus and process focus are the walls. The
human focus is the soul of the house. The renewal and development focus is the platform. With
such a metaphor, renewal and development become the critical bottom line for sustainability.
(Edvinsson, 2002).
Figure 2
Five Components of Skandias Intellectual Capital Measurement Methodology

Each of the five components focuses on critical success factors that are quantified to measure
change. The indicators used for the financial focus are largely represented in monetary terms.
Customer focus concentrates on assessing the value of customer capital to the organization and
makes use of both financial and non-financial indicators. The measures used for the process
focus emphasize the effective use of technology within the organization. They tend to monitor
quality processes and quality management systems but also include some financial ratios. The
renewal and development focus attempts to capture the innovative capabilities of the
organization, measuring the effectiveness of its investment in training and its expenditure on
R&D. Finally, the human focus includes measurements that reflect the human capital of the
organization and how the resources are being enhanced and developed.

Balanced Scorecard
Kaplan and Nortons balanced score card approach (Figure 3) is similar to Skandias Navigator
in its use of multiple perspectives (Kaplan and Norton, 1996).
The balanced score card uses four perspectives: financial (How do we appear to our
stakeholders?), customer (How do we appear to our customers?), internal business process (What
business processes must we excel at?), and learning and growth (How will we sustain our ability
to change and improve?). The learning and growth perspective includes categories for employee
capabilities (human capital), information systems capabilities (information capital), and
motivation, empowerment, and alignment (organizational capital).

Figure 3: Balanced Scorecard

Source: Robert S. Kaplan and David P. Norton, The Balanced Scorecard: Translating Strategy
into Action, Harvard Business School Press, Cambridge, Mass., 1996
In their book Strategy Maps: Converting Intangible Assets into Tangible Outcomes, Kaplan and
Norton attempt to demonstrate how the intangible assets of human, information, and
organizational capital can be measured. Human capital includes the skills, training, and
knowhow of employees. Information capital includes systems, databases, and networks.
Organizational capital includes such concepts as culture, leadership, teamwork, and alignment
with goals. The value of these assets comes from how well they align with the overall strategic
priorities of the organization. Intellectual capital is measured by evaluating how well assets
contribute to achieving organizational strategy. (Kaplan and Norton, 2004)
A comparison of the meaning of intellectual capital with the four perspectives of the balanced
score card highlights how the balanced score card can be used to measure intellectual
capital:Intellectual capital is a combination of human capitalthe brains, skills, insights, and
potential of those in an organization [learning and growth perspective: human] and structural
capitalthings like the capital wrapped up in customers [customer perspective], processes
[internal business processes perspective], databases, brands, and IT systems [learning and growth
perspective: information capital]. It is the ability to transform knowledge [learning and growth
perspective: organizational capital] and intangible assets into wealth creating resources, by
multiplying human capital with structural capital. ( Edvinsson, 2002)

EXTERNAL REPORTING OF INTELLECTUAL CAPITAL

INTERNATIONAL FINANCIAL REPRTING STANDARDS
Intellectual capital is an intangible asset. IAS 38 Intangible Assets outlines the accounting
Requirements for intangible assets (IASB, 2012). It requires an entity to recognize an intangible
asset when specified criteria are met. The standard also outlines ways to measure the carrying
amount of intangible assets and requires disclosures relating to intangible assets.

Critical Attributes of an Intangible Asset

The three critical attributes of an intangible asset are:

identifiability
control (power to obtain benefits from the asset)
future economic benefits (such as revenues or reduced future costs

Recognition Criteria

IAS 38 requires an entity to recognise an intangible asset at cost if, and only if:

it is probable that the future economic benefits that are attributable to the asset will flow
to the entity; and

the cost of the asset can be measured reliably.

This requirement applies whether an intangible asset is acquired externally or generated

internally. IAS 38 includes additional recognition criteria for internally generated intangible
assets
The probability of future economic benefits must be based on reasonable and supportable
assumptions about conditions that will exist over the life of the asset. The probability recognition
criterion is always considered to be satisfied for intangible assets that are acquired separately or
in a business combination.
If an intangible item does not meet both the definition of and the criteria for recognition as an
intangible asset, IAS 38 requires the expenditure on this item to be recognised as an expense
when it is incurred.
Measurement
Initial Measurement

Intangible assets are initially measured at cost.

Measurement subsequent to acquisition

Cost model and revaluation models are allowed. An entity must choose either the cost model or
the revaluation model for each class of intangible asset.
Cost model. After initial recognition, intangible assets should be carried at cost less any
amortisation and impairment losses.
Revaluation model : Intangible assets may be carried at a revalued amount (based on fair value)
less any subsequent amortisation and impairment losses only if fair value can be determined by
reference to an active market.
Measurement subsequent to acquisition- intangible assets with finite lives

The cost less residual value of an intangible asset with a finite useful life should be amortized on
a systematic basis over that life. The amortization method should reflect the pattern of benefits.
If the pattern cannot be determined reliably, the asset shall be amortized using the straight-line
method. The amortization charge is recognized in the statement of comprehensive income, unless
another IFRS requires that it be included in the cost of another asset. The amortization period

should be reviewed at least annually. The asset should also be assessed for impairment in
accordance with IAS 36, Impairment of Assets. If a revalued intangible has a finite life and is,
therefore, being amortized, the revalued amount is amortized.
Measurement subsequent to acquisition- intangible assets with indefinite useful lives

There is no foreseeable limit to the period over which the asset is expected to generate net cash
inflows for the entity. An intangible asset with an indefinite useful life should not be amortized.
Its useful life should be reviewed each reporting period to determine whether events and
circumstances continue to support an indefinite useful life assessment for that asset. If they do
not, the change in the useful life assessment from indefinite to finite should be accounted for as a
change in an accounting estimate. The asset should also be assessed for impairment in
accordance with IAS 36, Impairment of Assets
Subsequent Expenditure

Subsequent expenditure on an intangible asset after its purchase or completion should be

recognized as an expense when it is incurred, unless it is probable that this expenditure will
enable the asset to generate future economic benefits in excess of its originally assessed standard
of performance and the expenditure can be measured and attributed to the asset reliably.
Disclosure

For each class of intangible asset, distinguishing between internally generated intangible assets
and other intangible assets, disclose
Useful life or amortization rate, if finite
Amortization method
Gross carrying amount
Accumulated amortization and impairment losses
Line items in the income statement in which amortization is included
Reconciliation of the carrying amount at the beginning and the end of the period showing
o Additions (business combinations separately)
o Assets held for sale
o Retirements and other disposals
o Revaluations
o Impairments
o Reversals of impairments
o Amortization
o Foreign exchange differences
Basis for determining that an intangible has an indefinite life
Description and carrying amount of individually material intangible assets
Disclosures about intangible assets acquired by way of government grants
Information about intangible assets whose title is restricted
Commitments to acquire intangible assets

PROBLEMS IN REPORTING INTELLECTUAL CAPTAL

An analysis of the requirements of As 39 would reveal that many intellectual capital assets may
not meet the criteria for recognition and hence, a significant portion of a companys assets may
not be reported in the financial statements of the company. The non-recognition of such assets as

intellectual capital in the financial statements may result in a huge difference between the value of the
company as perceived by the investors and the book value of the company as reported in the financial
statement. Corporate Annual Reports can be used to fill this gap. Corporate Annual Reports are

used as a basic tool for the effective communication of company information and overall
performance to stakeholders and other users of company information. As a result of the
challenges in respect of disclosing the information on intellectual capital under statutory
disclosures, discretionary disclosures should be used to for the purpose.

MEASUREMENT MODELS
In order to improve external reporting, information from the management accounting system
(such as Skandia Navigator and balanced Scorecard) on intellectual capital may be included in
the corporate annual reports. Besides, financial measurement models may also be used. In order
to assist organizations to improve their annual reporting and to reap the benefits of reporting on
intellectual capital, researchers recommend a number of financial measurement models that may
be used to measure intellectual capital. Some of them are:
-

Discounted cash flow

Relief-from-royalty
Comparable transactions
Avoided cost
Value added
Value chain scoreboard
Market to net book value

One of the models, namely, the value chain scorecard is discussed here,

VALUE CHAIN SCORECARD

Baruch Lev has proposed a scorecard approach to provide investors and external decision makers
with information relating to an organizations utilization of intellectual capital (Lev, 2001). In
the present day world, many important business decisions are now made in consultation with
partners in the value chain who are outside the organizational boundaries. Levs scorecard
provides nontransaction and nonfinancial information to support these decisions made with
others in the value chain.
The scorecard mirrors three portions of the value chain: discovery and learning, implementation,
and commercialization. Each of these three can, in turn, be subdivided into three additional
categories for a total of nine categories{Table 3].
The first phase of the value chain is the discovery of new products or services. These ideas can
be generated internally through R&D efforts or employee networks, they can be acquired from
outside the entity, and they can be identified through active and formal networks such as joint
ventures, alliances, and supply chain integration. The second major phase of the value chain is
the transformation of ideas into working products or services. This can be measured through a
variety of milestones: patents, trademarks, or other intellectual property; passing formal
feasibility hurdles; and, related to Internet technologies, quantitative measures of activity. The
third phase of the value chain is the commercialization of the products or services. Customer

measures could include brand value, marketing alliances, and customer churn. Performance
indicators could include innovation revenues, market share, economic value added, and
knowledge earnings. A final category would provide forward-looking information on the
product/ service pipeline. A variety of indicators can be chosen for each of the nine portions of
the score card. The indicators should have three attributes: They should be quantifiable, they
should be standardized so comparisons can be made across firms, and there should be statistical
evidence to link the indicators to corporate value.
Table 3
Value Chain Scorecard

Discovery & Learning

Implementation

Commercialization

Internal renewal

Intellectual property

Customers

Research and
development
Workforce training
and development
Organizational capital
processes

Acquired capabilities

Technology purchase
Spill over utilization
Capital expenditures

Networking

R&D alliances and

joint ventures
Supplier and
customer integration
Communities of
practice

Patents, trademarks
and copyrights
Licensing agreements
Coded know-how

Technological feasibility

Clinical tests, food and

drug administration
approvals
Beta tests, working
pilots
First mover

Internet

Threshold traffic
Online purchases
Major internet alliance

Marketing alliances
Brand values
Customer churn and
value
Online sales

Performance

Revenues, earnings
and market share
Innovation revenues
Patent and know how
royalties
Knowledge earnings
and assets

Growth prospects

Product pipeline and

launch dates
Expected efficiencies
and savings
Planned initiatives
Expected breakeven
and cash burn rate

CONCLUSION
With the rise of the knowledge economy, intellectual capital is becoming more important. Its
measurement and reporting have become important. Mandatory financial reporting does not
provide adequate space for reporting information on intellectual capital. So, discretionary

disclosure of the information should be made in the corporate annual reports using either the
information from the management accounting system or the financial measurement models.
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