Is there a case for Intangible Expense Reporting?

I had recently blogged about the need for publicly listed firms to embrace IC Reporting as a tool for providing their current and prospective investors with more incisive information about their business. A handful of businesses around the world have already adopted this practice but the vast majority is yet to start, perhaps they are awaiting industry or regulatory guidance in this matter. Meanwhile there is another school of thought among the IC community that suggests that a more practical and less stringent approach would be to have businesses report their expenses incurred on developing intangible assets along with their statement of accounts. The logic behind this suggestion is that businesses already keep track of their operating expenses and capital expenditures. Hence it should not be too difficult to keep track of specific expenses incurred on developing intangible assets. Let’s try and dissect this approach and try to understand its pros and cons.

Let’s set the ground rules first. Let us agree that we are only considering the interest of investors here. There are other stakeholders that could also benefit from an Intangible report on the firm such as employees, suppliers and partners, yet we are not addressing their concerns here because these stakeholders have a direct access to the business through which they can get reliable information about the business that is useful to them. Investors however do not have access to any such direct channels and have to rely solely on the formal communication from the business as the only authoritative source of reliable information about the business.

Next, let us think about what investors are interested in. Very simply they are interested in Return on their Investment or ROI. ROI is the bottom-line interest of every investor. Yet it is not enough for the management to commit a particular ROI to investors which they will accept at face value. Investors also need to see the proof of why their investment in the business will be a multi-bagger.

An astute investor will choose to invest in those industries whose products and services will be in great demand in the coming years. Within that industry, the investor will then choose to invest in that specific firm which is best geared up for catering to the forecasted demand of the industry. Choosing the industry whose products and services will be in demand in the future requires a thorough understanding of the macro-economic environment of the geography where the industry is located. Investors rely on a variety of research reports and other inputs for deciding the industry of their choice. But once an investor has decided on the industry that he wants to invest in, all that remains to be done is choosing the firm that is best equipped to meet the demand for products and services of that industry.

At this point investors will start looking at performance of the various firms in the industry, one at a time. And all they will have for doing so is the published financials of the business. Since investors know that more than 70% of the value of any business is generated by intangible assets, this is what they will try to figure out from the financial statements, but will fall woefully short. Let us assume here for the sake of argument that the published financials for the business also include the expenses specifically made for developing intangible assets. Is this a good assumption? Will this really work in practice? Technically it is very easy for accountants to ‘group’ intangible expenses and publish the same along with their financials. However, let us look this situation from the point of view of the company’s managers, the people who will be responsible for publishing this information in the first place. What is their objective? Clearly they are motivated by making the most amount of operating profit for the business, since that will fetch them the maximum compensation (assuming their compensation is linked to operating profits). And how is operating profit calculated – simply by deducting all operating expenses from all operating income. If managers now have an avenue of categorizing some operating expenses as capital expenses, what do you think they are going to do? They will clearly reduce operating expenses and increase capital expenses, which in turn will directly inflate profits in the current period at the cost of deflating profit in future periods since all capital expenses need to be depreciated in the future. This will directly benefit managers when their performance is reviewed for the current period but it will hurt investors who will be left with reduced profits in the future. A discounted cash flow analysis of the business will show that the value of the business is less now. Therefore what is good for managers will turn out to be not so good for investors. It is exactly this behavior of managers that is curbed by accounting guidelines that have strict rules for determining the expenses that can be capitalized in the statement of accounts.

The above argument against reporting of expenses incurred on intangibles is in the best case – that is when all such expenses are actually incurred on developing intangible assets. However, since accounting principles in this matter are not yet evolved, frivolous practices may soon kick in around expenses that center on the ‘grey’ area. For instance, all or part of employee wages may be shown as expenses incurred on developing human capital. Expenses incurred on annual maintenance of information technology assets such as computers, video conferencing equipment, etc. may be shown as expenses incurred on developing structural capital. And routine expenses incurred by salespeople for soliciting customers may be shown as expenses on developing customer capital. These and other such ‘creative’ accounting practices will flourish to the point where operating expenses will be negligible. Is this a desirable state? You may say it is desirable for managers but investors will be worse off than they are now.

The conclusion I am arriving at therefore is that whereas the suggestion for reporting of intangible expenses is a noble thought, in practice it will only lead to obfuscation, deceit and chicanery. Instead what we need is an Intellectual Capital Report of the business that is drafted by an independent IC professional. This report should be published along with the statement of accounts and it should be audited by external IC professionals in the same manner that the accounting statements are audited by external accounting professionals.

I invite fellow IC professionals to submit their own point of view to this discussion.

Packaging – Relational Capital in action

Of the three components of Intellectual Capital - Human, Structural and Relational – it is most difficult perhaps to understand the contribution and value of Relational Capital in real life. I decided therefore to focus this week on the one industry that contributes immensely, entirely and solely to the Relational Capital of its Customers. I am referring here to the multi-billion dollar packaging industry dominated by players such as Tetra Pak, Alcan Packaging, Crown Holdings, Alcoa, Amcor, Rexam, etc. 

The importance of packaging is critical to the successful selling of any product, especially in the Retail sector. New product launches especially benefit from an attractively designed package that clearly engraves the value of the product in the minds of the consumer. Initial sales of such products are driven by the attractiveness of the package (and also the price) while repeat sales depend on other product attributes such as quality, durability, reliability, satisfaction, etc. Next time you visit your local grocery store or a nearby shopping mall, try and find new product launches and then take a probing look at the packaging around the product. Compare that package to that of existing products in the same category and you will soon realize what I am talking about.

Packaging is an art, although over the years savvy marketing professionals have detailed it down to a science. Many a time, the package has nothing inherently to do with the product per se, but is designed solely to convey a positive impression and familiarity on the mind of the buyer. For e.g. have you ever wondered why products targeted for kids invariably have cartoon characters depicted on the package? I am quite sure that Mickey, Mini and Goofy have sold more toys, school supplies and snack items than Walt Disney could have ever imagined in his wildest dreams! Yet there is rationale behind this approach. Since the product package is a very tangible item, marketers leverage the physical properties of the package in order to draw the attention of buyers. These include color, shape, size and convenience among other things. Many different rules have evolved in this regard based on the conditioning of the human psyche. For instance, black implies luxury, brown conveys an earthy feel, green projects nature and freshness, sky blue implies purity, etc. The size of the package is determined by consumption patterns – this explains why cola cans have a capacity of 355 ml, a very odd number. The shape of the package is often dictated by optimum storage criteria – this is the reason why even cylindrical or spherical packages like cans and playing balls are aggregated together in rectangular shaped boxes. Finally, the package is often designed to enhance consumer convenience for e.g. fruit drinks packed in tetra-packs have a straw attached to the package and creamy cheese and yogurt packs come with a handy plastic spoon attached to the top.

Lest you get the impression that packaging is relevant only for the retail sector, let me dispel that notion by telling you that nothing could be further from the truth. Packaging is highly important not only to other products but in fact also to services. Consider a software product such as Windows, the Operating System that runs most personal computers on this planet. Microsoft, the maker of Windows, has a virtual monopoly in this category, yet Microsoft invests heavily into improving the User Interface of Windows and releases a newer version of the product every three years or so. The User Interface is the packaging of Windows – it is how you see the product and how you use it and get used to it. Improving it is the only way by which Microsoft can attract you to upgrade your operating system to a newer version every three years and thereby generate new sales on essentially the same product! If Microsoft did not improve the User Interface of Windows, you would have no need to upgrading your operating system, would you? Moving on to services now – let’s take the example of Banking. All banks essentially do the same thing – borrow money at the lowest possible rates, lend it at the highest possible rates and make money on the spread. All banking services therefore fulfill either the borrowing need or the lending need of the bank. Looked at this way, banking is really a commodity service isn’t it? Yet have you noticed how some savvy banks package their services differently. In their bid to attract you (the customer), they pamper you with special privileges such as free debit cards, no annual fee credit cards, gifts at the time of account opening, cash delivered to your home, etc. not to mention exclusive privileges such as private banking and wealth management that are offered only to the choicest few. Similarly airlines, that essentially offer the commodity service of transporting you from point A to point B, ensure your loyalty and your business by packing their service with a loyalty program into which you are enrolled free of cost!

There is no doubt about the huge value that the packaging industry creates. Yet it is a surrogate industry – the tangible packages that the industry develops fulfill the intangible needs of the product manufacturers. The product manufacturer focuses on developing the best quality product at the lowest possible cost whereas the packaging supplier focuses on developing and delivering the packaging concept for the product. This is a great example of how product manufacturers leverage the Relational Capital of their package solution suppliers. The deep relationship between two enables them to work jointly together on the best package for the product. Packaging solution providers are so glued-in on their Customers and their target markets that they themselves invest heavily into developing newer packaging materials such as recyclable and biodegradable materials that are in demand by end consumers. In the process they generate a steady quantum of value add for their Customers which looked at from the perspective of the product manufacturers is really nothing but Relational Capital.

The need for IC Reporting

Change has been a way of life for mankind, yet change has always been difficult. Throughout history, man has constantly been faced with the opportunity of doing something in a new way, a better way – but that has always met with resistance. To give just one example, do you recall the invention of the personal computer by IBM in the 1940s and the subsequent (by now infamous) remark of IBM Chairman Thomas Watson “I think there is a world market for five personal computers”. In hindsight, we can now say that the personal computer has been largely responsible for the rapid modernization of our society during the last thirty years. So rapid and massive has been this modernization that as a society we have become used to embracing change more and more rapidly – remember ATMs did not exist thirty years ago, the World Wide Web did not exist twenty years ago and mass mobile telephony as we have accustomed to today did not exist even just ten years ago!

Yet today, we are at the crossroads of one more change – this time in the field of accounting and reporting of company performance. Unlike tangible changes outlined in the examples above, this is a softer change. It has to do with the way business accounts are recorded and presented to stakeholders. But why do we need a change in our accounting system, you might ask? What is wrong with it? It isn’t broke, right? So why fix it? The reasons however are many.

Firstly, the present system of accounting is old, very old. The double-entry bookkeeping system of accounting that is in use today was popularized by the Italian monk Luca Pacioli more than 500 years ago! This system relies on recording each business transaction using balancing credit and debit entries in two different ledgers. It is a system that is well understood and it has served us well throughout the industrial era, yet it has one critical shortcoming. The system works by matching revenues to expenses accurately in order to determine income. But it cannot handle value creating transactions that happen much before revenues have been realized. For instance, when the R&D efforts of a pharmaceutical company culminate in the passing of regulatory clinical tests, enormous value is created. Yet the accounting system does not recognize any of it.

The loss would have been limited had it been restricted to the failure to recognize value. But present accounting policies in fact do more damage by mandating the immediate expensing of R&D costs that go into the drug discovery process instead of capitalizing them, thereby recognizing such costs as an asset. The net effect of this policy is a reduction in net income in the year that R&D costs are incurred at the cost of protecting future income. This is a double whammy.

Finally, the accounting system is in total disconnect with the way companies operate in the knowledge economy. We know for certain by now that intangible assets are the primary driver of growth in the knowledge economy. Yet the accounting system is blissfully ignorant to this situation. For example, we all know that the value of Apple is linked closely to the ability of Steve Jobs to lead the company on the path of continuous innovation. Yet, the book value of Apple did not change when Steve Jobs rejoined Apple and it will definitely not change if Steve Jobs were to quit Apple all of a sudden!

Professional accounting bodies the world over have been trying their best to make the accounting system adapt to the knowledge economy. But changing a system that is carved in the hearts and minds of accountants over the last 500 years is easier said than done. In the meantime, investors are getting highly impatient. Genuine investors already know that published income statements and balance sheets are not reliable instruments for making investment decisions. They rely instead on other sources of information such as analysts, insiders, research, tips, etc. Some of these sources are genuine yet others exist only for making a quick buck from gullible investors. Such is our plight today.

But the situation can be remedied and quite easily too. This is where the need for IC Reporting comes in. All that needs to be done is that the annual report (or even quarterly income disclosures) needs to be supplemented by a statement of change in the Intellectual Capital of the company. This way, investors will be able to see not only the financial performance of the business but they will be able to correlate that performance with the investments in intangible assets of the business. They will be able to verify the sustainability of the performance. This in turn will drive down the cost of capital for the business which in turn will make the business more efficient. In short, IC Reporting will enable an unending positive feedback cycle for the business.

Change seems radical whenever it is first proposed. But in hindsight it always seems a no-brainer. IC Reporting is a change whose time has come. We will see this change implemented much sooner than later. And it will be for the good of all of us.

Have we realized the importance of Core Competencies yet?

The world of strategy professionals suffered an irreplaceable loss last Friday with the passing away of Dr C K Prahalad, who was the Paul and Ruth McCracken Distinguished University Professor of Strategy at the University of Michigan’s Ross school of Business. One of the foremost contemporary business thinkers and management gurus of our time, Dr Prahalad is credited with introducing the world to concepts such as Core Competency, Reinvention, Continuous Innovation, Next practices and to the immensely popular byline “Think Global, Act Local”. The last decade of his life was spent on prodding corporate houses and big businesses to focus on the world’s poor, thereby targeting both sustainable development and inclusive growth.

Like many other students of Business Strategy, I never had the opportunity to meet the great man. I only read his articles and his ideas. I was particularly enamored with his concept of Core Competence in the Corporation, published way back in 1990 along with Professor Gary Hamel of the London Business School. In this 16 page ground breaking article, they wrote 

“The diversified corporation is a large tree. The trunk and major limbs are core products, the smaller branches are business units; the leaves, flowers and fruits are end products. The root system that provides nourishment, sustenance and stability is the core competence. You can miss the strength of competitors by looking only at their end products”. 

Much before the computer became omnipresent in corporate offices, much even before email became the norm for corporate communications and definitely much before the proliferation of mobile telephony, Professor Prahalad had the clairvoyance to get to the core of the basis for a corporation’s competitive advantage in the market place and expressing it in a metaphor that could be understood by all. By equating core competencies in the corporate to the root system of a tree, he achieved in sending out many clear messages in one single shot, some of them being:

  1.     Core Competencies are the basis of long term corporate sustainability.

  2.     Core Competencies are corporate resources and they cut across business units

  3.     New products and services can be created if core competencies are in place

  4.     Employees who embody the core competencies of the corporation often get a free hand over others.

In so dearly portraying the importance of core competencies, he also succeeded in elevating the prominence of intangible assets in the enterprise, a concept with which we are still grappling a full twenty years after Dr Prahalad first introduced it to the world. Such was the insightful genius of the man. He constantly exhorted corporate leaders to think outside the box, to ‘see’ opportunities lurking right in front of them, to look beyond existing markets, to always question the assumptions behind price and performance, to constantly search for and build innovative products and to lead customers to such products. He often gave the example of Steve Jobs of Apple and Ratan Tata of Tata Motors in this regard.

Just this month, he summarized his article on “Best practices get you only so far” in the Harvard Business Review by writing “Executives are constrained not by resources but by their imagination”. Memorizing this byline and trying to put it to practice could perhaps be the best tribute to Dr C K Prahalad.

Intellectual Capital – What’s in it for me?

“What’s in it for me?” IC practitioners, the world over, have probably heard this question more often than not. Answering it, I am quite sure, is not so easy since the answer fluctuates greatly depending on both the background of the person asking the question and his or her specific interest in the field of Intellectual Capital. Nonetheless, let me take a stab at answering this question as generically as possible, using illustrations along the way to convey a larger point.

Intellectual Capital, we know, is a set of intangibles that coalesce to give an individual or a firm a distinct competitive advantage in the marketplace. Want to see the proof? Ask yourself why you prefer to drive an extra mile to do your weekly grocery shopping at a store which looks much cleaner, is well lighted, has spacious aisles, offers free parking and always has all your items in stock. Wait, don’t bother - the answer is in the question itself. However did you ever stop to wonder whether the factors that made you go out of your way and ‘prefer’ a specific grocery store were purely a matter of chance or could it be that someone deliberately crafted these things just to attract and retain demanding customers such as yourself? Intellectual Capital, like most other good things in life, does not happen on its own – it has to be made to happen. The promoters of the grocery store you prefer probably surveyed customers like you on the various factors that would attract you to their store week after week, on the items that are most consumed by you, on the type of store layout you prefer, etc. before even putting a business plan together. The success of that plan was ensured from day one because by responding to the survey, you ensured that the grocery shop owner could fabricate a store that had a competitive advantage and by visiting it regularly you ensure that he can perennially raid your wallet every single week!

Still need more proof? Let me ask you – have you ever changed your dentist, your insurance agent, your tax advisor, your stock broker, your travel agent or even your barber? If you answered yes to any of these, just think of the reason for the change. Was it because the service that you were receiving had become routine? Was there a lack of personal touch? Were you getting herded in along with others? Were you missing individual attention? All in all, was that extra something missing in the service? Yes? You bet. That extra something is called ‘value-add’ in management jargon. Value addition happens when your service professional goes beyond the boundaries of performing the routine transaction and does something exclusively for you. For instance, your dentist could offer you an annual free check-up, your insurance agent could review your existing cover and suggest changes to suit your lifestyle, your stock broker could offer buying and selling tips and your barber could just subscribe to that latest fashion magazine that you could read while you are waiting your turn. Come to think of it, these value additions do not cost much – in most cases they are offered free – but they are the difference between why you stick with your current service professional or decide to take your business elsewhere. These value additions are a part of the Intellectual Capital of the Service Professional and they can literally be the difference between bloom and gloom (not to mention doom) for him or her.

Are you starting to get the point? Intellectual Capital may sound a mouthful, but it is present everywhere if you only care to see. In today’s knowledge era, it has come to be the difference between growth and stagnancy, between prosperity and paucity, between success and failure and even between survival and extinction. The days of plain old order taking are over. Insurance agents, travel agents, stock brokers and other professionals made money hand over fist in the last few decades only because they were in the agency business. If you needed an air ticket you had to buy it through your travel agent. If you needed to invest in stocks you had to talk to a stock broker. Likewise, if you needed an insurance policy you had to solicit an insurance agent. Order taking is best done by computers in the Information era. Computers are far cheaper than humans, can work 24 hrs a day, do not get tired, do not need supervision or food and do not make mistakes. All forms of agency businesses have already been replaced by Internet portals that are housed in giant data centers running multiple computers in redundant fashion. Those agencies that have not yet been hit with this reality are only counting their last days.

So how does this affect me, you say? I am a manager inside a big firm and am therefore insulated from all this change. Do you believe so? Nothing could be further from the truth. What is true for self employed professionals and businesses is true for corporate professionals as well. Look closely at what your job function is, once again. Is your department providing HR support services? Are you the training manager in your firm? Or are you a line manager in charge of production scheduling? Are you? Then you have reason to worry. Know this. HR support services are being increasingly provided by self supporting HR portals from vendors such as SAP and Oracle. Training, or more importantly learning, is increasingly assuming the form of CBT (Computer Based Training) that is delivered to the trainee on his computer in a digital format at the time of his choice. And production schedules in manufacturing shops are being increasingly generated by ERP (Enterprise Resource Planning) software installed in-house. In short then, is your job function one step closer to being taken over by a computer? Is it a candidate for automation? If it is possible, it will happen. Obtaining competitive advantage through ruthless cost cutting is one of the most common outcomes of the Information era and it is bound to affect you as well. The only question is when.

What then should I do, you ask? The answer is strikingly simple too. Have you seen that poster of man rising from the posture of an ape many eons ago first to stand erect on his own two feet, then to walk, run and then use his hands for making tools for hunting? You couldn’t have missed it. That picture just got updated with an additional image towards the end – man using his brain. And that is what you need to do. I know by now, that you need proof. This time proof is easier. The Information era rewards those who use their brains much more than those who use their hands. I am not referring to the class distinction between white collar and blue collar workers here, although that would have been sufficient to make my point. But I ask you instead to follow the money trail. Tell me, which are some of the best paid professions? Go ahead name a few. Here, let me help you out. Investment Bankers, Surgeons, Fashion Designers and Lawyers who are at the top of their field are still people who are making money by the fistful. I am sure you wouldn’t grudge a New York lawyer his hourly rate of $400 – he is worth it you say. Similarly you wouldn’t stoop to bargain the price of a Louis Vuitton handbag would you? The name itself is worth more you say. Or would you negotiate the fees of the heart surgeon who is scheduled to perform a bypass surgery on your spouse next week? Definitely not, right? Well then ask yourself, why you would be willing to pay exorbitant sums to these people? The answer is because they have spent their lifetime in gathering specific knowledge and know how it can be used for your benefit. That is their Intellectual Capital. They are specialists. The Information era punishes generalists by replacing them with computers and rewards specialists with fame and fortune. The message is clear now - develop your own Intellectual Capital and become a specialist.