As a high-tech journalist, I’ve spent my career charting the development of revolutionary ideas as they emerge from the minds of a few creative individuals (often in the most unlikely places), spend several years in the wilderness of experimentation and debate, then suddenly sweep across the landscape, flaring up in the public’s imagination as if from thin air.
That is precisely what is happening right now with a new/old idea called intellectual capital. If you listen closely to the words of our business leaders, read between the lines of industry journals, and watch the behavior of the best corporations, you can feel the distant rumblings of a great change approaching: The intellectual capital movement, often disguised with other names, is bursting out everywhere.
But appearances aside, movements never arise spontaneously. Rather, they are born from a deep, but unspoken, dissatisfaction with the status quo.
The balance sheet has been the sacred text of the industrial world now for four centuries. But in the last thirty years, as one by one each sector of modern life has been transformed by technology, there has been a growing sense that our measurement systems—not the least of which are the balance sheet and the rules of accounting that stand behind it—no longer serve their appointed task. And that task is to determine the real value of an enterprise.
 Illustration by Taylor Jones |
During these times of rapid, unremitting change, new factors and forces within companies have taken on a vital role in creating success. And none of these critical factors fits into the old categories of assets and liabilities, revenues and expenditures, profit and loss. They are too evanescent, too intangible, too subjective—too embedded in transience of time—to fit the timelessness of the rules of accounting. Yet such characteristics do not make these factors less important, but more, because they accurately reflect the complexity and the continuous change of modern life. Unlike traditional accounting, these new measures look forward instead of backward toward qualities that create future competitiveness, not transactions that created past profitability. Needless to say, in the fast-moving world of a modern, global, Internet-based commercial world, so do we.
Still, knowing the existence of these other factors doesn’t automatically mandate their use. There are some good reasons for not attempting to measure the intangible assets, the intellectual capital, of companies and other organizations. Such a measurement will be difficult, imprecise, and it will open the Pandora’s box of politicization and hype, fad and fraud.
THE NEED TO MEASURE INTELLECTUAL CAPITAL
There is also one compelling reason for attempting to measure intellectual capital: We have no choice. For that reason, we must move forward . . . but carefully, lest we do as much damage as good.
Anyone who follows the stock market—and these days that’s everyone—knows that there is a widening gap between the value of a company’s balance sheet and the value bestowed on that company by the market. Even if we strip away the distortions of a bull market, those differences are still there, and they are decisive. The average value of companies today on the world’s stock exchanges is two times book value. In the United States, especially among knowledge-based companies, that multiple can be as great as nine.
Clearly, this represents a serious problem. Traditional accounting gives us half or less of the information we need to make an intelligent judgment about corporate value. As for the rest, we are on our own. We don’t even have a language to describe the rest, much less a yardstick. Instead, we rely on rumor, inside information, auguries, and gut instincts.
And that is both unfair and dangerous. Unfair because it distorts the free flow of capital and tilts the field against the small investor. Even the best analysts are still half blind to the firms in which they are making buy and sell recommendations. And they have almost unlimited access. The small private investor, with a pension and a few shares, is left to divine a company’s real value from the obscure footnotes in the back of the annual report and from rewritten press releases in daily newspapers. The result is not only an extraordinary volatility in valuations, driven by the unexpected eruptions of hidden strengths and weaknesses, but also a massive inefficiency of investment, as good money flows into bad companies that possess great media savvy, while good but less-noticed companies pay more for the capital they rightly deserve. Even more serious for the long-term strength of our economy is that we reward companies with good balance sheets but no future and punish companies that are compromising their balance sheets now for what would have been a bright future.
As I said, this blindness is also dangerous because it is the business equivalent of driving looking only in the rearview mirror. And these days we are all driving at breakneck speeds. Traditional accounting is brilliant at telling us where we’ve just been and pretty good at telling us where we are right now, but it does a miserable job of telling us where we are going. That kind of static measurement was efficient enough in 1876 or even 1976. But, thanks to the technological revolution, we now live in a world in which perpetual, revolutionary change is the status quo and in which tomorrow is often more present than today. It is the rare company that can operate the same way it did a decade ago or build a business strategy based on incremental change. More often, the best we can do is try to build an organization with enough resilience, with enough openness to new ideas, and, most of all, with enough intelligence to react swiftly and decisively to radical change coming from unexpected directions.
Traditional accounting gives us half or less of the information we need. As for the rest, we’re forced to rely on rumor, inside information, auguries, and gut instincts.
You won’t find the capacity to cope with profound change on the traditional balance sheet or in inventories or accounts receivable or equipment. Instead it lies within that odd little catchall category of traditional accounting called intangible assets. Today we call it intellectual capital, and it includes everything from intellectual property to customer satisfaction to employee training to corporate information systems. Our challenge is how to identify intellectual capital, codify it, and measure it—in other words, to make it as accurate and informative as the balance sheet itself.
In the old economy one didn’t need to worry about these intangible assets until the day the company was sold. Now CEOs worry about them from the moment they awaken in the morning until the moment they fitfully fall asleep at night. Is my company prepared for what’s coming? Do we have enough information, and are we distributing it properly? Are my people smart enough? Am I smart enough? Should we be training more? And if so, what should we be learning? What is the intellectual capital of my company, and how can I increase it?
DEVELOPING THE TOOLS
More than a decade ago, Walter Wriston in his book The Twilight of Sovereignty set into motion the intellectual capital debate by stating, “The new source of wealth is not material, it is information, knowledge applied to work to create value.”
Five years ago, the consensus was that intellectual capital had indeed become the decisive factor in the long-term success of a growing number of companies, but that as an asset it was so ineffable—indeed, so intangible—that it could never be truly identified, much less measured.
But, during the past few years, as the role of intangibles has grown evermore dominant in modern economic life, several companies have made pioneering efforts to make intellectual capital an empirical discipline. The first of these, by Leif Edvinsson of Sweden’s Skandia, broke new ground in 1995 with the publication of the world’s first intellectual capital annual report. Others have followed, such as Gordon Petrash of Dow Chemical, currently preparing the first IC report by a U.S. company. Dozens, perhaps hundreds, of projects of similar or lesser scale are in the works throughout the world. The number of IC web sites grows by the week. And, in that barometer of hot business trends, most of the top consulting firms, such as Andersen Consulting and Ernst & Young, have started up their own IC practices. Clearly, we are at a turning point.
The ultimate test, of course, is the accounting profession. But even here we are beginning to see thoughtful accounting firms coming to recognize that intellectual capital measurement and reporting is not a threat to traditional accounting but an adjunct to it. IC measurement, done right, is the leading indicator of tomorrow’s earnings statement.
What is likely to come out of all this activity is both a philosophy of intellectual capital and a body of metrics that will slowly codify into a standard IC reporting format comparable to that used by traditional accounting. It is no longer outrageous to predict that, by the early years of the twenty-first century, intellectual capital annual reports will be as common as traditional annual reports and that, indeed, today’s balance sheet may in time be an appendix to a larger body of IC measures.
It is a thrilling idea, but a disconcerting one too. One of the best ways to win any game is to write the rules. And with intellectual capital we are entering an era in which the most fundamental financial rules are about to be up for grabs. Already we are seeing the first signs of two extreme and opposing camps emerging to define just what metrics we shall use.
On one hand there are those who believe that intellectual capital is the best way to sneak into the back door of the modern corporation. That camp would love to see the IC reporting metrics weighted toward measures of diversity, community outreach, and all of the isms that hold sway over modern life. They believe intellectual capital will finally bring justice and enlightenment to the corporate world. This is IC as PC, as a tool for social activism.
The second camp believes that IC should only measure the most tangible of the intangibles—that is, systems, the ability of the company to process and use information. This is intellectual capital as diagnostic software. That camp, understandably, fears opening the doors to wild-eyed activists. And, to keep those doors tightly shut, that group is willing to destroy intellectual capital by reducing it to a meter on the front of a computer.
But there is a third approach—one to which most of us will eventually belong and from which the real IC revolution will spring: intellectual capital as a dynamic filter. Let’s take all the metrics devised by the many different camps, from the number of nodes in the client-server system to the number of minority women in executive positions, and test for their true contribution to a company’s value. Let’s see which actually converts over time to dollars and cents on the balance sheet.
Each of us has our own opinion about what makes a company successful, as does every politician, stock analyst, union organizer, and corporate executive. Now is that once in a half-millennium opportunity to put them all on the table and see which really do matter. Let’s begin that process right here, today.
We have time. It took four hundred years to perfect double-entry bookkeeping and the principles of modern accounting. We don’t have that long, but a few years of serious debate won’t cost us much and may ultimately save us. We now have the best minds at work on intellectual capital and the experiences of a growing number of companies.
If we do this right, we can construct a value system that will make companies more efficient, more competitive, and ultimately more valuable. Even more than that—because intellectual capital measurement is not confined to business but is likely to be the first universal measurement tool for all human institutions—we will be able to construct a more valuable society.
That, of course, is the hope that emerged last out of Pandora’s box. Intellectual capital is indeed our best hope for continued prosperity into the twenty-first century. And learning how to measure it is the only path for getting there.
