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To all the diehard fans out there, seriously, that are all anxiously waiting for the next IAS article understand where IC and knowledge management fits in. These three articles discussing IC highlights a gap in the completeness of financial information. If you go back to our earlier articles one of the objectives of the framework was to enable investors and stakeholders to effectively predict future cash flows and income growth.
Accounting Has Always Been an Art
It is readily apparent now that financial statements in their present state of compliance lack that ability. Effectively IC brings to the surface information that greatly enhances the ability of stakeholders to predict as well as make buy and sell decisions. Consider, for example, the complexities of revenue and lease accounting (IFRS15 and 16), as well as financial instruments and derivatives. And let us not forget the upcoming insurance accounting standard IFRS17. Relatively speaking, therefore, it is a reasonable probability that, with efforts, IC building blocks currently off-balance sheet, would arrive at a valuation model capable of analysis and financial interpretation providing credibility. Accounting has always been an art, not a science and under accounting standards, judgment is often called for where precision and perfection (however defined) is just not attainable.
Picture: rawpixel.com
The Importance of Documentation
Continuing from last week: On the contrary, the West Coast founder believes in a very participative style of management with all functions cooperating to help each other. Each week all functions gather together to update how things are coming along. The West Coast founder was very concerned that should one of his staff, a Ph.D. researcher, leave the firm that all critically valuable researching information to date would effectively walk out the door and be lost (a noncompete clause wouldn’t necessarily be too helpful). Fortunately, with his son being a CPA (ok, ok called poetic license), he respected the role of accountants, understood the importance of process flows and infrastructure and especially after long discussions with his son, happens occasionally, recognized the importance of documentation, critical in auditing of course. He also understood that without an advanced electronic e-filing and document recovery system little would necessarily be gained by old-fashioned paper documentation and filing cabinets. Thus he required, before the end of each day, for all researchers to dictate the days’ efforts, what had been achieved, any breakthroughs, and if any bottlenecks were being experienced. But most importantly and very shortly after the entity opened its doors, even before research had begun, he requested that each researcher take whatever time that was needed to dictate their thinking. What was the approach they were planning to use, and what problems they were anticipating could arise and what steps could be put in place? Thus before even a day’s work had been completed the expertise and Ph.D.’s experience was now explicit and safely part of the entity.
So, therefore, given our two hypothetical scenarios, East and West Coast, if our IC balance sheet were developed, which entity would greatly enhance their asset base and by definition use that leverage to gain additional much-needed funding. Funds, which otherwise, would probably not be forthcoming. Often times, small micro-entities (SMEs) given the scant nature of their balance sheets struggle to obtain the necessary funding for research.
The Concept of Intellectual Capital
Now let’s revisit these concepts pertinent to Intellectual Capital (IC).
- Differentiation
- Commoditized
- Holistic
- Competitive advantage
- #1 reason why managers fail
Were both East and West entities to have the same culture, same type of founder, researchers that had the same background and qualifications etc. then commoditized would be an apt description? Furthermore, applying IC and knowledge management would probably add very little value. However on the contrary with the very deliberate stark differences (in my story) it is very apparent that the West Coast entity has significant assets that need to be brought to the surface on an IC balance sheet, supplementing the official financial statements.
So what are they, what are the undisclosed differences?
Human Capital:
- Know how
- education
- work related knowledge
- work-related competencies
Structural Capital:
- management philosophy
- corporate culture (participative management)
- management processes (documentation)
- information systems (e-filing, capturing and recording know how)
Certainly, there is no question that implementing an IC system (supplementary balance sheet) is no easy task and many organizations will struggle with applying the concepts. It is also very likely that employees may be very reluctant to document/record their expertise and knowledge (explicit information). That expertise and knowledge could well be construed as providing leverage for both promotions and salary increases. And employees may see it as a loss of identity and marketability. Employers may see it as strengthening their market position, their external reputation and enhancing their brand name. As an IC balance sheet is venturing into unknown territory, the possibility of gaining additional funding, leveraging these IC assets, initially requires full implementation. Banks are highly unlikely to document their position until a legitimate and credible IC balance sheet is presented to them. Thus there is a dichotomy as employees potentially see it as a threat and employer’s, i.e., management, consider IC balance sheet as supporting additional funding opportunities.
A Supplementary Intellectual Capital Balance Sheet
In conclusion, a supplementary IC balance sheet can provide significant value to both sides of the coin. Any entity, for example, a small researching SME (our East and West entities), clearly needs additional leverage to obtain additional funding over and above that supported by typical financial statements. If funding is simply supported by an official financial accounting standard, a set of IFRS financial statements, from a collateral perspective along with 3 to 5-year business projections may be insufficient. From the bank’s/lenders viewpoint such small entities start-up position may be classified in a high-risk category, which is totally understandable. Now introduce beneath the surface high-quality IC assets, our West entity.
Don’t forget risk from a bank point of view is based upon the probability of success and a very minimal potential for losses or debt default. If a financial lender, i.e. a bank and others, now realize this researching entity is supported by Ph.D.’s, a well organized and structured organization, a participative culture with captured explicit information documented, the picture will suddenly change. And, very important, additional funding provides employees with a stronger future, remuneration incentives, and career opportunities.
Lucubrate Magazine, Issue 44, October 26th, 2018
The photo on top: Christina Morillo
Photo: Bruce Mars
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