Visualising intangibles as company drivers of innovation and growth: some recent European developments

1. Visualising intangibles as company drivers of innovation and growth:some recent European developments • Stefano Zambon • University of Ferrara – Italy • zambon@economia.unife.it Presentation delivered at the National Centre for Research on Europe, University of Canterbury, Christchurch (New Zealand), 22 July 2005

2. “The substantial foundation of the industrial corporation is its immaterial assets” “There may be peculiar difficulties in the way of reducing this goodwill to the form of a fund, expressing it in terms of a standard unit” Thorstein Veblen, 1904

3. The Lisbon objective for the EU “to become by 2010 the most competitive and dynamic knowledge based economy in the world, capable of sustainable economic growth with more and better jobs and greater social cohesion”

4. The Agenda A) The today’s rise of intangibles B) Consequences of the mis-treatment of intangibles C) Initiatives and actions undertaken (by companies/academics, and institutions) D) Policy indications E) Some open problems and conclusions

5. A) The Rise of an Interest in Intangibles • Change in the bases of creation of firm value - from industrial to post-(post-)industrial economy (e.g. advanced service firms) - post-fordist, interactive mode of production - decentralization/diffusion of knowledge • From unidimensional to multidimensional performance of an organisation • Obsolescence of traditional accounting systems (2004: Market-to-Book ratio  3) • Scarcity of data on intangibles in National Accounts

6. A) The New Value Creation Process and Its Implications • Change in production processes: strategic phases are research, marketing and know-how, and not so much manufacturing  phases where intangible assets are key • Today main determinants of growth at firm (micro) and country (macro) levels are therefore intangible assets

7. A) Problems encountered by firms capturing benefits from intangible investment… Economic attributes of intangible assets make it: • Difficult to exclude other users (public good problem) so firms cannot appropriate the full benefits from the investment (Geroski 1995) • Difficult to estimate ex ante the precise use of intangible inputs, potential products, and timing and magnitude of benefits • Difficult to write contracts for transfer or exchange of intangibles unembodied in a physical asset

8. A) Effect of uncertainty • Investment in intangibles is also associated with high levels of uncertainty • While there is evidence that investment in intangibles leads to tangible investment, there is a lag between intangible investments and economic benefits (intangible investment occurs early in the life cycle) • To overcome problem associated with this risk, most accounting standards require expenditure on (particularly internally generated) intangible assets to be expensed  considered more reliable

9. A) The Logic of Traditional Accounting • ECONOMIC TRANSACTION AS THE “ENGINE” • OF TRADITIONAL ACCOUNTING • ECONOMIC TRANSACTION SETS ACCOUNTING • VALUE  PRICE  HISTORIC COST/FAIR VALUE • MEASUREMENT CATEGORIES LINKED • MAINLY TO “FORDIST” INDUSTRIAL ACTIVITY • MEASUREMENT OF PERFORMANCE & • SURPLUS IN A SHAREHOLDER PERSPECTIVE

10. B) Traditional Accounting for Intangibles (e.g. International Accounting Standard 38) • General suspicion • Recognition issues (R&D, Brands, Training) • Conservative measurement criteria: - General principle: Immediately expensed as a period cost - If recognised as an asset, then valued at Cost or Revalued Cost (not value) - Amortisation over a short period of time • No attention to the intangible drivers of value

11. B) In company reporting, once upon a time there was Goodwill... Purchase price – Fair value of net assets = Goodwill - Poor (synthetic) representation in cognitive terms of the intangibles possessed by an organisation - Residual value used to represent all the “unidentifiable”/“unseparable” intangibles of the acquiree - Managerial and users’ need for a more analytical knowledge, control, and representation of intangible elements of a firm’s wealth (brands, organisational capabilities, IPR, etc.) and of its drivers

12. B) Unmeasured intangible inputs and outputs in the economy • Problem: Changing composition of investment is not reflected in financial reporting • Problem: Accountability of management for actions/decisions in managing the firm’s resources • Problem: Lack of data for analysis and rational resource allocation  info. asymmetry

13. B) Micro-Economic consequences • Serious economic consequences for the firm from • the poor accounting treatment of intangibles • The mismeasurement of intangibles at the • company level has adverse economic • effects in terms of: - Investment decisions - Level of information asymmetry concerning a firm (volatility of share prices & insider trading) - Internal/management information systems

14. B) Intangibles at a macro level • Intangibles as connecting tissue, the “glue” that • allows the homeostasis of the economic system • We need to better understand how tangibles and • intangibles combine to create collective value • Intangibles are mismeasured – more often • undermeasured – at a macro level • Potentially serious consequences at a policy level •  wrong indicators  wrong diagnosis of a • country performance and policy recipe

15. B) Costs of Mismeasurement - Firm level: risk of wrong strategies - Industry level: misallocation of resources within and between industries; skill bias - Capital market level: under- or over-valuation of companies; misallocation of resources; volatility - Country and European level: policy making based on imperfect set of indicators may result in inappropriate policies

16. C) A series of initiatives: company and academic reactions • In 1992 Kaplan and Norton propose the Balanced Scorecard  non-financial measures break in • In 1994 Skandia starts the production of an Intellectual Capital Statement • Many measurement and reporting models are put forward by practioners, academics, companies

17. C) A framework of analysis

18. Balanced Scorecard, Norton & Kaplan 1992 Financial Perspective (goals and measures) Internal business perspective (goals and measures) Customer perspective (goals and measures) Innovation and learning perspective (goals and measures)

19. Skandia Navigator, Edvinsson & Malone 1998 OPERATIVE ENVIRONMENT FINANCIALFOCUS HUMAN RESOURCE FOCUS CUSTOMER FOCUS PROCESSES FOCUS INNOVATION AND DEVELOPMENT FOCUS

20. Intangible Assets Monitor, Sveiby 1997 INTANGIBLE ASSETS

21. Value Chain Scoreboard, Lev 2001

22. C) A series of initiatives at an institutional level • Half ’90s: OECD Studies • 1999: International Conference in Amsterdam (OECD + Dutch and Danish Governments) • 2000: European Commission’s High Level Expert Group on the Intangible Economy • 2001-2003: Research projects Prism and Meritum/E*Know-net funded by the Commission  Meritum Guidelines on ICR

23. C) A series of initiatives at an institutional level (cont’d) • 2002: International Conference in Madrid (Autonomous University Madrid + Spanish Government + OECD + European Commission) • 2002-2003: Official Study for the European Commission on the measurement of intangible assets (Ferrara+New York+Melbourne) • 2004: International Conference in Helsinki (Sept.) + OECD Forum in Paris (Oct.)

24. C) A series of initiatives at an institutional level (cont’d) • 1997-2003: Danish Guidelines on IC Reporting as a result of a Government-driven project • 2004: German Guidelines on IC Reporting by the Ministry of Labour • 2002-04: Various documents on intangibles by the UK Department of Trade and Industry • 2003: Letter on Intangible Economy signed by the UK, German and French Governments

25. C) A series of initiatives at an institutional level (cont’d) • June 2004: The Japanese Government issues a White Paper about making economic policy in the knowledge era  strong emphasis on intangibles and intellectual capital reporting • April 2005: A new policy by the city's Pudong New Area  recognition of human resources as capital contribution up to a maximum of 35% of the enterprise's registered capital, and a report and filing system for enterprise annual reviews (for both domestic and foreign co’s)

26. C) A series of initiatives at an institutional level (cont’d) • 2004-05: High Level Expert Group set up by the DG Research of the European Commission with the task of producing an official report on Intellectual Capital Reporting especially for research-based SMEs • 2005: Action Plan of the European Commission on business-related services  strong recommendation to these co’s to prepare an intangibles-based report

27. C) A series of initiatives at an institutional level (cont’d) • June 2005: World Bank has organized a Conference on “Intellectual Capital for Communities in the Knowledge Economy: Nations, Regions and Cities” held in Paris • 20-22 Oct. 2005: OECD will hold an International Policy Conference on Intellectual Assets in conjunction with the University of Ferrara (www.ferraraonintangibles.net)

28. C) Official Study for the European Commission A 2003 STUDY ON “THE MEASUREMENT OF INTANGIBLES” MADE BY THE UNIVERSITIES OF FERRARA, NEW YORK AND MELBOURNE FOR THE DG ENTERPRISE. Available at: http://europa.eu.int/comm/enterprise/services/ business_services/index.htm

29. C) Definitions of Intangibles • Far too many definitions & different classifications • and taxonomies of intangibles (micro & macro) • Need for reducing them through consensus • In the Study intangible assets defined as a source of • futurebenefitsthatiswithoutaphysicalembodiment: • Intellectual property is an intangible asset with legal rights • Includesinnovation-relatedintangibles(patents), but also market-related (brands), human resource (compensation systems, training policies), and organizational intangibles (internalstructures, systems and processes) • “Hard” intangibles (tradable) vs. “Soft” intangibles

30. C) New measurement & reporting models for Intangibles • Various innovative methods for the recognition, measurement, and disclosure of intangibles and intellectual capital (IC) have been analysed • A taxonomy of the different new methodologies (holistic vs. atomistic; monetary vs. non-monetary) • The rise in company practice of IC statements • Analysis and comparison of the four main Guidelines on IC statements proposed so far (Meritum, Nordika, IFAC, and DATI) • Exploration of the relations between IC statements • & Corporate Social Responsibility (CSR)(e.g. GRI)

31. C) A working definition of IC Intellectual Capital – IC – is the internal(competencies, skills, capabilities, etc.)and external(imagine, brands, customer satisfaction, etc.) stock of intangibles of an organisation, which allows the latter to transform a bundle of material, financial and human resources in a system capable of creating stakeholder value through the pursuit of sustainable competitive advantages (Zambon, 2000) Organisational knowledge becomes IC only when it is durably and effectively internalised or appropriated by an organisation

32. IC as New Concept for Representing & Managing Intangibles A concept that encompasses the various types of intangibles, including social and environmental intangibles - a “new” notion of the wealth of an organisation - thrust towards information relevance instead of reliability in reporting - a concept in evolution  different accents - a concept on whose basis company reporting might be reformed?

33. C) Towards a New Reporting Tool Intellectual Capital (IC) Statements or Report on Intangibles Based on indicators  many without a financial nature • The partitioning of IC into three interrelated sections is quite widely accepted: Human Capital, Organizational Capital (including Innovation Capital), Relational Capital visualised/measured through indicators and parameters

34. C) Guidelines on IC statements: some emerging convergences and differences - International Federation of Accountants (IFAC) – Study no. 7 (1998) - Danish Agency for Trade and Industry (DATI) Guidelines (2000, but new edition 2003) - Nordika Project Guidelines (2001) - Meritum Project Guidelines (2002) - “Intellectus Model” (Spain) (2003) - German Guidelines (2004) - Japanese Guidelines (2005) Other documents deal with some aspects of IC reports, but without focussing on them (e.g., GRI, EFQM, ISO)

35. C) INTANGIBLES AND INFO. USERS: THE CASE OF FINANCIAL ANALYSTS • In 2001 the Italian Association of Financial Analysts (AIAF) set up a study group on Intangibles • In January 2002 a model has been developed – in collaboration with the University of Ferrara – to measure the level of disclosure on intangibles by companies in their external reports • This model has now been refined/extended in order to represent/rank European companies on the basis of their level of disclosure on intangibles

36. C) The Basic Framework for Ranking the Level of Disclosure on Intangibles(AIAF 2002) LEVELS OF COMMUNICATION ON INTANGIBLES Level 3 Extended information FIVE DIMENSIONS OF COMMUNICATION Level 2 “Reasoned” information Organisation Innovation & IPR Human resources Level 1 “Minimum” information Customers & Market Strategy NATURE OF INFORMATION Actual Forecast

37. IC Statements and Environmental and Social Reports: The case of GRI • The Global Reporting Initiative (2002) is: - a reporting framework for non-financial aspects - based on the three-dimensional concept of “sustainability” (economic, environmental and social)  so called triple bottom line - evidence of an overlapping between IC statements and social & environmental reports (e.g., indicators on employees’ training and education, supply chain management, quality of management, investment in R&D, stakeholder engagement)

38. An Intangible Perspective on CSR and Stakeholder Value THE BASIC IDEA  SOCIAL CAPITAL & ENVIRONMENTAL CAPITAL AS PARTICULAR INTANGIBLES TO BE MANAGED BY COMPANIES (AND PUBLIC SECTOR ENTITIES)

39. The Integrated Reporting System Intangibles / Intellectual Capital Reporting ENVIRON- MENTAL REPORTING SOCIAL REPORTING Collectivity Society TRADITIONAL FINANCIAL REPORTING Investors/Auditors/Financial Analysts

40. D) Main Policy Implication • Urgent to better measure intangibles both at micro and macro level • Priority: better measurement at firm level because good indicators at micro level allow also to build better indicators at macro level

41. D) Intangibles Reporting: policy recommendations • Policy aim: Develop and promote a new, integrated, reliable and verifiable company disclosure system which is based on intangibles • What is needed is CONVERGENCE between existing methods and reports

42. D) Intangibles Reporting: policy recommendations (cont’d) • Identify a standardised set of intangibles indicators serving as minimum common information denominator • Consistent data at micro level as foundation for more aggregated analyses  in this respect we need rather detailed categories in the prospective intangibles taxonomy

43. D) Intangibles Reporting: policy recommendations • Provide incentives to firms to adopt a new reporting system based on intangibles, as well as to use and reveal that information • Favor the emergence of a generally agreed taxonomy and definition of intangibles • Encourage voluntary experimentations & exchange of best practices  good IC reporting guidelines are already in place

44. D) Intangibles Reporting: policy recommendations (cont’d) • Induce information system/software providers to develop the collection of data on intangibles  e.g. XBRL • Promote the gathering of the reported information on intangibles in a systematic and coherent way (cf. US Edgar) • Support ad hoc research

45. D) Intangibles reporting:policy recommendations (cont’d) • Convergence to be searched for with statistical offices, but starting point of intangibles information should be corporate reporting  a delta, not a substitute • Drawing on other forms of voluntary/ supplementary reporting (such as social, environmental, sustainability reports etc.) for inducing companies to produce information on intangibles • Looking for synergies in the efforts  e.g. OECD + European Commission + US Institutions + Japanese Institutions

46. E) Some questions on IC Reports Despite their value and innovativeness, IC reports face some criticisms concerning their: - consistency - reliability/subjectivity - thoroughness - meaningfulness: a) high subjectivity in the choice of the useful indicators b) indicators do not possess additive properties c) high specificity of indicators

47. E) Some questions… (cont’d) However, some open problems: - Value in absence of a market price (value in use vs in exchange) (i.e., credibility and meaningfulness) - Specificity vs Generalisability (i.e., consistency & comprehensiveness problems) - Regulation vs Voluntary Compliance - Atomistic vs Holistic measurement approach - Common vs Different Measurement Units - Relevance vs Reliability - Users  stakeholders?

48. Final consideration • We face a major PARADOX: - The more the system is based on intangible assets, the stronger it is (because intangibles are major determinants of growth and value creation). - However, at the same time: the more the system is based on intangibles, the more vulnerable it becomes. The challenge we all face is to learn how to measure and report in this intangibles environment