Recognition and Measurement of Intellectual Resources: the accounting-related challenges of Intellectual Capital Dave O’Donnell Philip O’Regan Veronica O’Regan Chief Knowledge Officer Lecturer in Accounting Lecturer in German Intelllectualcapitalireland.com University of Limerick University of Limerick Ireland Ireland Ireland dolan.odonnell@oceanfree.net philiporegan@eircom.net veronica.oregan@ul.ie Abstract Those charged with the financial management of commercial resources concur. The International The key to competitive success is likely to Federation of Accountants (1998), for instance, notes be the ability to create, leverage, and that knowledge is the primary competitive factor in develop specialised knowledge and business; that it is a non-traditional intangible resource; and that the accumulation, transformation, creation and intellectual resources. This new reality valuation of this resource lies at the heart of intellectual presents both challenges and opportunities capital management (IFAC, 1998). for accounting, a discipline which has However, industrial era managerial paradigms, traditionally found it difficult to deal with based on the tangible sources of value (land, labour and the recognition and measurement issues financial-capital) and the predict-direct-exploit-control bureaucratic machine metaphor are proving surrounding intangible assets. This paper increasingly incapable of dealing with the emergent makes two contributions to the emerging complexities of visualising, creating and leveraging this literature on intellectual capital. Firstly, it resource. Furthermore, little is known about how these offers some preliminary results of a study intellectual resources, structures, institutions, processes of the drivers and generators of intellectual or dynamics actually develop, or how they should be managed, utilised, valued or accounted for. A concept capital. Secondly, it posits a theoretical/ such as intellectual capital, even with the accumulated methodological approach to intellectual tools of the philosophy of consciousness and the recent capital based upon Habermas’ concept of move to the philosophy of language, cannot be communicative action, a concept that precisely defined. This should not, however, prevent us from using it at a time when the intangible is rapidly allows the premium attaching to the gaining economic and social supremacy over the human and dynamic elements of tangible (O'Regan & O'Donnell, 2000). organisations to be accentuated. This paper proceeds in six sections as follows: Section 1 briefly summarises the emerging literature on Intellectual Capital. Section 2 identifies a number of the Introduction issues of relevance to financial and management Drucker’s (1994) claim that knowledge is becoming the accounting raised by the emergence of an intangible only meaningful economic resource is complemented asset such as ‘intellectual capital’ as a primary driver of by Quinn’s (1992) assertion that the ability to manage corporate wealth. Section 3 introduces a conceptual this resource is the critical skill of the modern era. framework within which this dynamic can be imagined. Adopting the Habermasian (1984) notion of The copyright of this paper belongs to the paper’s authors. Permission to copy ‘communicative action’, an action-theory allowing for without fee all or part of this material is granted provided that the copies are the exploration of the role and nature of relationships not made or distributed for direct commercial advantage. amongst employees as the main drivers and repositories Proc. of the Third Int. Conf. on Practical Aspects of of corporate wealth, this section challenges a literature Knowledge Management (PAKM2000) which already leans heavily towards systems-theoretic Basel, Switzerland, 30-31 Oct. 2000, (U. Reimer, ed.) approaches which facilitate the colonisation of this http://sunsite.informatik.rwth-aachen.de/Publications/CEUR- space by the owners of capital. Section 4 outlines a very WS/Vol-34/ preliminary analysis of data collected in a survey of O’Regan, O’Donnell and O’Regan 17-1 CEOs of thirty indigenous, knowledge-intensive firms per employee functional Customers operating in the IT sector in Ireland, and presents some teams Index of the accounting issues which this raises. Section 5 Rookie ratio Database use Frequency of discusses some of these issues in the context of frequency repeat orders Habermas’ theory of communicative action. Section 6 Level of Investment in Brand loyalty offers some indications of future research possibilities. education IT Training and Proportion of Customer 1. Current Approaches to Recognising and Education cost support staff complaints Measuring Intellectual Capital Years of R&D expense Customer experience satisfaction In the absence of any accounting-specific methods to Reputation Age of Profitability recognise and measure intellectual capital, various with agencies organisation per customer templates have been developed by others to facilitate its Sources: Dzinkowski 2000; Sveiby 1997. identification and management. Although there is substantial variation as to how each dimension is These approaches are supplemented by various conceptualised, theorised or measured, and a glaring methods developed to enable inter-firm comparison. dearth of good empirical studies, a broad consensus is Among the more common approaches facilitating this now emerging in which most intellectual capital models relative assessment of the existence and valuation of assume a three way distinction between People, intellectual capital are: External, and Internal dimensions (Bontis,1998; Edvinsson & Sullivan, 1996; Roos et al., 1997; von 1. Market-to-book ratios: the simplest of the Grogh & Roos, 1996; St. Onge, 1996; Stewart, 1997; calculations, this takes the difference between the Sveiby, 1997; Kaplan and Norton, 1997). This is book value of a company as represented by its indicated in Table 1 which provides an outline of three balance sheet and the market value, whether from of the more developed intellectual capital models. stock exchange or internal market to be equal to the level of intellectual capital in the business; Table 1: Emerging Intellectual Capital Templates 2. Tobin’s ‘q’: ‘q’ is the ratio of market value to replacement cost of a company’s assets and can be People Internal External used as a comparative base between firms; Sveiby People’s Internal External 3. Calculated Intangible Value (CIV): using industry Competence Structures Structures norms to establish rates of return for tangible Kaplan Learning Internal Customer and growth processes perspective assets, this measure calculates the level of and perspective perspective intellectual capital by attributing to it any return in Norton excess of the industry norm. Edvinsson Human Organisat- Customer capital ional capital capital 4. ‘Colorised’ reporting: proposed by SEC Source: Sveiby http://www.sveiby.com.au commissioner Steven Wallman, this approach places the emphasis on additional narrative reports In this scheme the ‘People’ dimension refers to people (the ‘colour’) which supplement the more competencies, knowledge, know-how and experience - traditional (the ‘black and white’) financial the ‘traditional human resource’. The ‘Internal’ refers to statements, with information which helps to the set of inner organisational structures, routines, identify and classify intellectual capital in a relative processes, management systems and so on. The context. ‘External’, often referred to as ‘customer capital’ refers to external constituencies and structures such as links to While all of these can be faulted on a number of customers, suppliers, and various other external grounds, their primary usefulness is that they provide a networks. common measure allowing firm performance to be Common measures or indicators of these benchmarked, thus enabling comparative measures of dimensions have been identified and developed intellectual capital to be established (Dzinkowski, Examples are listed in Table 2. Significantly, several of 2000). these are already produced by accounting-based internal 2. Accounting for Intellectual Capital management and information systems (IFAC, 1998; Roslender, 2000). Accounting has traditionally focused its attention on capturing and representing items which can be fully Table 2: Intellectual Capital Indicators objectified. Underpinned by a system of historical cost accounting which ascribes ‘value’ to transactions People Internal External involving tangible entities, generally accepted Employee Number of Sales per accounting practices (GAAP) have been developed satisfaction patents customer which reflect accounting’s fundamental stewardship Value Added No of multi- Satisfied role, that is, of accounting for and informing company O’Regan, O’Donnell and O’Regan 17-2 management and its various stakeholders of the In recent years some attempts have been made existence and progress of its resources, activities and by accounting regulators to redress this deficiency. investments (Power and Laughlin, 1996; Lodh and Accounting standard setters, for example, have begun to Gaffikin, 1997; O’Regan and O’Donnell, 2000). review the conceptual scaffolding that has seemed to Reflecting this historical emphasis upon its preclude the discipline from addressing issues of stewardship role in relation to tangible items, relevance in the modern commercial milieu. accounting has found it much more difficult to deal with Hermannson (1964) and Brummet et al. (1968) were items which its limited conceptual framework neither seminal figures in the attempt to advance the recognises nor values. In fact, since such intangible recognition and measurement of human resource costs resources can never be fully objectified, accounting’s under the term Human Resource Accounting cognitivist paradigm is incapable of embracing them (Flamholtz, 1985). The accounting profession has, within its worldview. One of the principal catalysts in however, largely ignored HRA, citing the traditional causing the efficacy of current financial reporting and objections put forward by those aware of the challenges management accounting concepts and procedures to be posed by accounting for such resources (Grojer and revisited has been the gradual realisation that intangible Johanson, 1998; Guerrero, 1998). Furthermore, while assets can no longer be dismissed as the incidental and there have been efforts to address some of the more troublesome offspring of activities undertaken by troublesome intangible assets such as goodwill and relatively few, albeit large, entities. The dawning brands, the solutions proposed have disappointed, awareness that intellectual capital in its various guises particularly in failing to deal at a fundamental level with now forms a major part of the resource base of not only the conceptual and epistemological challenges posed. In individual firms, but also entire industries, has essence, while some progress has been made, the challenged accounting regulators to review the manner opportunity to critically reconsider the nature and role in which these are treated. In an environment in which of accounting in this context has been largely eschewed. international trade in the knowledge sector is growing five times faster than in natural resource-intensive 3. Communicative Action industries, where the costs of information long ago surpassed the costs of equity (Strassman 1996), and The traditional accounting model is one which views an where tangible assets often represent less than one-third individual being as capable of gaining knowledge about of corporate value (Van Buren, 1999), an accounting a contingent environment and using this knowledge system designed to satisfy the needs of ‘financial’ effectively by intelligently adapting to and manipulating capital is incapable of embracing the measurement and that environment (O’Donnell, 1999a). This perspective reporting needs of knowledge-based entities (IFAC, assumes that this world is pre-given and that the goal of 1998). As Lev (1997, p.35) puts it: any cognitive system is to create the most accurate representation of this world. Representations can be ‘In recent decades the usefulness of financial stored in and retrieved from individual schemata, and if reports of public companies has steadily the events represented occur frequently they can be declined, despite their increased gloss and stored in scripts; these schemata and scripts are often girth. One indicator: In the 1960s and 1970s, referred to as knowledge structures (von Krogh and about 25% of the differences in stock price Roos, 1996). At a general level, most contributions in changes could be attributed to differences in this vein assume that managers and organisations create reported earnings. But by the 1980s and early representations of their environments through 1990s, this figure had dropped to less than processing information available to them in this 10%. That's a lot of lost relevance. Everybody external environment (see Lyles and Schwenk, 1992 for in this economy ought to be concerned. a seminal example). The phenomena in need of Reliable financial reporting guides capital to explication in intellectual capital research, however, the most promising investments. But bad or may not be simple facets of objective nature but the outdated information can lead to an inefficient inter-subjective dynamic processes of understanding allocation. This leads to volatile markets and and agreement at both the interpersonal and intra- investors who demand higher-risk premiums to psychic levels. Processes of knowing grow when they cover the increased uncertainty. That's why, are shared (Baumard, 1999; Bontis, 1998; Nonaka, for capital markets to function best, financial 1994; von Krogh and Roos, 1995; Spender, 1998; statements need to be as informative as Sveiby, 1997), whether these be individual or possible. Conventional accounting performs collective, tacit or explicit. Knowledge workers are idea poorly with internally generated intangibles and revenue creators, not mere reified cost factors of such as R&D, brands, and employee talent— production. the very items considered the engines of We claim that a more suitable point of departure modern economic growth’. for exploring this emergent dynamic, with implications for people management and accounting professionals, is the set of symmetric and reciprocal relations O’Regan, O’Donnell and O’Regan 17-3 presupposed in Jürgen Habermas’ (1984, 1987a, people element) is such that it can never be completely 1987b) Theory of Communicative Action (O'Donnell, observed by either participants or observers: intellectual 1999a, 1999b; O'Donnell et al., 2000; O’Regan and capital embraces not only what is known or stocks, but O’Donnell, 2000). Communicative action theory also the processes of knowing, or flows. (Bontis, 1998; provides an ontological and epistemological foundation Nahapiet and Ghoshal, 1998; Roos et al., 1997; Sveiby, that has yet to be adequately developed in intellectual 1994; Van Buren, 1999). capital research. The dynamic intellectual capital- In this worldview, the nexus of intellectual creating process of knowing that can be leveraged into capital creation may be viewed as residing in the set of market value can be viewed as existing in the interactional social relations that exist between people communicative relation between human beings. whose ‘value’ is greater than the sum of their individual Through communicative processes people continuously parts. Moving beyond traditional concepts of human learn, develop, unlearn, relearn and apply common capital (Becker, 1964), which refer to an individual’s understandings by which to exchange, combine, create, acquired knowledge, skills and abilities, intellectual renew and transfer tacit, implicit, explicit and codified capital refers to the knowledge and knowing capability processes of knowing from blueprints, ideas, emotional of a social collectivity (Nahapiet and Ghoshal, 1998). states and fuzzy hunches into problem definitions, This collective phenomenon represents both a key solutions, added value and markets (O'Donnell et al., resource and a capability for action based on knowledge 2000). The universal communicative relation between and knowing that can be leveraged into value. People human beings, which satisfies the scientific and action are given some priority over system and requirements of objectivity in a specific sense structure as it is people through the process of (Habermas, 1984, p137), is suggested here as the germ- communicative interaction who define situations, define cell of intellectual capital creation. Nahapiet and problems, capture know-how, share insights, and Ghoshal (1998) cite Edith Penrose’s (1959, p.53) innovate. Intangible values are created by people; observation that the communicative experience: money and technology are merely the tools that people use and are themselves expressions of knowledge. The ... develops an increasing knowledge of the emerging system dynamic is based more on possibilities for action and the ways in which informational and telecommunications structures with action can be taken by ... the firm. This increase probable new lifeworld-system relationships in knowledge not only causes the productive experiencing their genesis at the moment. We know opportunity of a firm to change... but also very little about what an economy and society based on contributes to the ‘uniqueness’ of the the economics of intangible values would look like, or opportunity of each individual firm. how those aware of the shifting sands could possibly attempt to steer it. Roos and his colleagues (1997) note that most strategic contributions on knowledge focus on two main issues; 4. Research the way knowledge is created and the way it is leveraged into value, although there is no definitive One of the persistent obstacles confronting managers boundary between the two. As customer relations in and, indeed, accountants as they struggle to develop knowledge-intensive businesses are no longer seen as measurement and management techniques appropriate one-way driven, but, rather, partnerships in which to the dynamics of the knowledge economy is the lack solutions are co-created and knowledge flows both of empirical data. Thus, while considerable work has ways (Sveiby, 1997), both internal architecture and been done by individual companies such as Skandia and external architecture should be considered in any Dow Chemicals to develop indicators of intellectual comprehensive analysis. We are dealing with people capital, little is known about the changing internal and/or systems, with action theory and/or systems dynamics within firms and, indeed, economies, that theory. parallel the knowledge era. A joint research programme Kogut and Zander (1993) argue that the firm undertaken by the University of Limerick, the Irish may be viewed as a social community that specialises in Management Institute and the University of Maryland the creation and internal transfer of knowledge, and that involving the collection of detailed and extensive this productive knowledge defines the firm’s perceptual data from Chief Executive Officers, Top competitive advantage. From this perspective, which Management Team members and Core Employees in complements Edith Penrose's (1959) seminal work on indigenous Irish firms operating in the knowledge the growth of the firm, competitive advantage may be economy is, however, yielding considerable insights viewed as a sufficient condition governing firm trade, into these dynamics. Supplemented by internal and direct investment, and growth, and it is probable that external data on the financial performance of these the ability to both create and leverage intellectual firms this research may provide some early indicators of capital is becoming its primary source. Nevertheless, the extent of the challenges posed for managers, the partly tacit and socially unconscious nature of accountants and national planners by the ‘new intellectual capital embedded in various lifeworlds (the O’Regan, O’Donnell and O’Regan 17-4 1 this corporate value not only commonly remains off the economy’. More specifically the perceptual data derived to date from interviews with CEOs of thirty of balance sheet, but is absent from internal management these indigenous Irish firms provides empirical reporting processes intended to facilitate decision- evidence of the significance of intellectual capital in making. It is imperative, therefore, if it is to retain its terms of company value, the principal drivers of that traditional information supplying role, that accounting value, and the extent of the challenge facing develops new internal and external measurement accountancy as it attempts to grapple with the concepts and reporting methodologies that recognise recognition and measurement issues associated with the central role of knowledge as a source of wealth. intellectual capital. These will need to be supplemented by new financial The Irish software/telecoms sector provides an management techniques that incorporate information ideal research framework for any such investigation. In resources and knowledge into investment appraisal recent years it has established itself as the largest techniques. This can only be achieved initially by software exporter in the world and been one of the focusing on relative, indicative disclosures rather than primary engines of growth in an economy that has on the development of objective recognition criteria and experienced real growth of 37% in 5 years, a rate measurement techniques. Such an approach allows the unparalleled in the developed world. It also provides a possibility of building upon existing techniques such as ‘new economy’ environment in which the scope to those management accounting approaches that already develop new managerial practices is greater than in recognise quality and strategic management issues or traditional industries. Within this sector indigenous reporting practices which recognise the usefulness of Irish firms play an increasingly significant role, ‘softer’ disclosures in narrative form (Roslender, 2000). employing over 20,000 people in more than 900 firms The interviews are also significant in (OECD, 1999). confirming that the greater part of this intellectual As one part of the interview process CEOs capital can be traced to the people element in these were asked to provide perceptual data as to the extent businesses. CEOs perceive that almost fifty per cent of of intellectual capital as a source of corporate wealth. this intangible value links directly to the people This involved indicating the percentage of company employed in these knowledge-intensive firms. This value deemed to derive from ‘intellectual capital’. In challenges the traditional accounting model which line with existing typologies, intellectual capital was classifies labour as an expense. The knowledge presented as consisting of people, internal structure and economy views employees as assets whose primary external structure and CEOs were also asked to indicate function is to generate revenue by converting the degree to which the drivers of this wealth can be knowledge into a marketable form. The extent to which traced to these factors by distributing 100 points people are perceived as assets rather than costs suggests between them. Finally they were asked to estimate any that one way in which intellectual capital may be better increase or decrease in company value over the course accommodated is by revisiting the whole concept of of the preceding twelve months. Table 3 provides a Human Asset Accounting and developing templates and summary of this feedback. new conceptual approaches which will result in the recognition of employees as the principal asset of a Table 3: Results of CEO Interviews business. It should also lead to the development of new tools to better assist in the management of, and % % IC % IC in % IC in investment in, people (O’Donnell et al, 2000; Van value in Internal External Buren, 1999). in IC People Structures Structures This links to another related consequence of Average the new dynamics of the knowledge economy – the (n=30) 66.07 49.80 18.68 31.52 changes being induced in corporate governance models. The existing corporate model strongly favours the The most striking finding is that Chief providers of financial capital. However, in an Executive Officers in the fastest growing sector of the environment in which the primary resource is seen as fastest growing economy in Europe believe that, on knowledge embedded in people, together with their average, almost two-thirds of their company value is relationships both to one another and to knowledge and attributable to intellectual capital. This crystallises the ways of knowing, then the existing governance model extent of the challenge for accounting in that currently will be challenged to embrace a stakeholder approach which recognises the claims of employees to a share of 1 The data set developed here forms part of the joint ownership reflecting the fact that they provide the Irish Management Institute-University of Limerick primary value creating resource. Nor is this likely to be research programme on knowledge-intensive Irish satisfied by stock option schemes which are predicated companies. A collaborative arrangement is in place with upon notions of reward. A governance model which has the University of Maryland at College Park in the USA. traditionally linked ownership to provision of capital This programme is directed by IMI-UL Professor may be forced to recognise the consequences of this Patrick Flood and Tony Dromgoole of the IMI. paradigm in an economy in which intellectual capital is O’Regan, O’Donnell and O’Regan 17-5 provided by other than financial capitalists. It is also However, the real significance of Habermas’ likely that as part of this process the attempts of notion of communicative action lies in the fact that at a financial capitalists to capture and establish ownership time when accounting is being forced by commercial by means of patents or its physical expression in the realities to reconsider its ontological and form of recipes and manuals will be resisted by epistemological framework, it offers a theoretical, employees. The nature of relationships internally will substantive and real platform on which a paradigm also be affected with power correlating more closely to shift, as called for by Spender (1998), might be knowledge and knowledge networks than to hierarchy explored (O’Donnell, 1999b). We claim that applying within a traditional organisation structure. Habermasian theory from a lifeworld perspective has Furthermore, in an economy in which the the potential to facilitate a broadening in the conceptual importance of teams, knowledge flows, processes and discipline of accounting, a broadening which is capable collegiality are commonly seen as facilitators of value of providing insight into the intangible nature of creation, the traditional predict-direct-exploit-reward intellectual capital. It may offer the means by which the paradigm which underpins the agency view of firm colonisation by the system of accounting technology organisation may be increasingly challenged by models and regulatory bodies of the accounting ‘lifeworld’, that which emphasise notions of trust, empowerment, is the social, cultural and communication context within alliance and transformation. These will require the which the accounting system is located, may be development of internal management techniques which renegotiated (Burrell, 1994; Laughlin, 1987; O'Regan recognise and encourage the accommodation of these & O'Donnell, 2000; Power and Laughlin, 1996). concepts as well as reporting methodologies which distinguish between entities in which these traits are 6. Conclusion increasing and those in which they are decreasing. These techniques will also need to recognise the often As confirmed by this research, by creating competitive chaotic and intuitive process of creativity and advantage intangible assets such as intellectual capital ‘knowing’. are playing an increasingly important role in the wealth- creating dynamic of the knowledge economy. If it is to be properly managed, however, information systems 5. Discussion appropriate to intangible resources and to the needs of The challenge for accounting therefore becomes one of an increasing range of users and stakeholders will need a fundamentally ontological nature: continue with and to be satisfied. Accounting has traditionally been the modify a positivist model which has traditionally had principal supplier of such information, gathering and difficulty with either recognising or measuring assets presenting it in a manner such as to allow timely and which cannot be fully objectified, or contemplate a new informed decision-making by management and model in which the insights provided by Habermasian stakeholders. But accounting’s capacity to continue to theory, or others, could inform the nature of the new function as a primary information provider has been paradigm. compromised by its inability to respond more rapidly to In fact, there has been a willingness on the part the demands of a new economy in which intangible of some accounting academics to consider the relevance resources have emerged as the principal catalysts for of Habermas to managerial accounting practices and growth, with consequent radical changes in financial statements that are proving increasingly organisational structure and knowledge flows. incapable of meeting the requirements of their principal The information revolution, therefore, offers a users (O’Regan and O’Donnell, 2000). Thus, Laughlin number of challenges for accounting, and this research (1987), Arrington and Puxty (1991), Broadbent and project is being extended to investigate ways in which Laughlin (1994) and Power and Laughlin (1996), have existing accounting methodologies and paradigms are attempted applications of Habermas’ notion of being adapted by firms operating in this new economy. communicative action within accounting and have Significantly, these challenges may be best met by those sought to extend beyond the traditional who learn to apply traditional collection, valuation, technical/objectivist paradigm to include both reporting and auditing skills in developing new ways of interpersonal and subjectivist dimensions (Power and facilitating the creation, integration and management of Laughlin, 1996). However, their main focus has been knowledge in a transparent manner. 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