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Interviews from Juergen Daum's book

"Intangible Assets and Value Creation"

Extract from the interview with Baruch Lev, professor for accounting and finance at the New York University, Stern School of Business. Working closely with such institutions as the U.S. Securities and Exchange Commission and the Financial Accounting Standards Board, OECD, and the European Union, he is one of the world’s leading experts on accounting and disclosure theory and practice related to Intangible Assets:

Juergen Daum: Why is accounting, as it is done traditionally, in our knowledge and information based economy of today an outdated model ?

Baruch Lev: One of the major problems with today’s accounting systems is, that they are still based on transactions, such as sales. In the current, knowledge-based economy much of the value creation or destruction precedes, sometimes by years, the occurrence of transactions. The successful development of a drug, for example, creates considerable value, but actual transactions, such as sales, may take years to materialize. Until then, the accounting system does not register any value created in contrast to the investments made into R&D, which are fully expensed. This difference, between how the accounting system is handling, or better not handling, value created and is handling investments into value creation, is the major reason for the growing disconnect between market values and financial information. Even now, after the stock market declines, the average market value of the S&P 500 companies is six times the value reported on the balance sheet.

Juergen Daum: What is your new accounting model for the new economy ? How should companies report about their intangible assets ?

Baruch Lev: They should report about their innovation process, because this is where economic value is created in today’s knowledge based businesses from nearly all industries. By innovation process, I mean the fundamental economic process of innovation that starts with the discovery of ideas for new products or services or processes, proceeds through the development phase of these discoveries and the implementation stage and establishment of technological feasibility, and culminates in the commercialization of the new products or services. So I recommend as one important complementary element of a new accounting system, a Value Chain Blueprint, a measure based information system for use in both internal decision making and disclosure to investors, that reports about the innovation process. In addition, improved recognition of intangible assets in the accounting system itself is required. The broad denial of intangibles as assets detracts from the quality of information provided in the balances sheet. Even more serious is its adverse effect on the measurement of earnings. The matching of revenues with expenses is distorted by front-loading costs by the immediate expensing of intangibles and recording revenues in subsequent periods unencumbered by those costs. What is required is a significant broadening of the recognition of assets in financial accounting and reporting.

Juergen Daum: What do you recommend to managers concerning intangibles in the actual economic situation ?

Baruch Lev: In today’s slow-growth economy and stagnant capital markets more attention to corporate resource allocation is required from managers. So managers should develop the capability to assess the expected return on investment in R&D, employee training, information technology, brand enhancement, and other intangibles and compare these returns with those of physical investment in an effort to achieve optimal allocation of corporate resources. Today, most business enterprises do not have the information and monitoring tools required for the effective management of intangibles. So investing in these new type of management systems may become an important tasks especially during an economy slowdown. In a challenging business environment I foresee a need for increased, rather than decreased, attention to intangibles – the major driver of corporate value and growth – by both managers and investors. It is now time for the full incorporation of intangible capital in the managerial strategic and control processes as well as investor’s analysis of securities and portfolio performance.

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Extract from the Interview with David P. Norton, co-author of the Balanced Scorecard concept:

Jürgen Daum: I remember your statement at on of your conferences, that the essential difference between a physical assets based company and an enterprise which is based on Intangible Assets is, that the latter is more difficult to manage. You said that Intangible Assets represent only a potential value and only through a strategic management system like the Balanced Scorecard, a company is able to transform this potential into tangible financial value.

David Norton: Yes, exactly. The fundamental difference in this new economy is that there is not a direct one-to-one relationship between an intangible asset, like the knowledge of a worker, and a financial outcome. I cannot show that if I send my workers to training programs for a month, that sales will go up or costs will go down. Instead I have to make the case that training will improve something like quality, and if quality will improve, customer confidence will improve, and if customer confidence improves, then they will buy more.

You cannot isolate the value of a single intangible asset like knowledge. How you create value is like a recipe. You have to put together several ingredients. Training your people is only one ingredient. You also have to give them computer systems. You have to give them incentives. You have to give them leadership.

You have to combine several Intangible Assets to achieve a result. And it is impossible for a financial system to describe this process of value creation. Financial systems are always snapshots: they can’t describe a time-based logic of cause and effect. They look at labor as one category, inventory as another. They can’t integrate different kinds of assets into what I would call a strategic recipe. They can’t integrate different kinds of assets into what I would call a strategic recipe. That’s why the Balanced Scorecard has become so popular with organizations. Just as the economy has moved from tangible to intangible, reporting on the economy will move from the tangible to the intangible. That’s the migration from financial reporting to Balanced Scorecard reporting.

Jürgen Daum: You talk about the „Strategy-focused Organization“. Why is it important that an organization is strategy focused ?

David Norton: Every performance management system has a point of focus. Typically that point of focus is financial performance. What we have learned from working with organizations, is, if you want to execute your strategy – your recipe, how you want to create value for example with your Intangible Assets - , then you have to put the strategy at the center of your management system. You should educate people about the strategy. Their compensation and incentives should be tied to the strategy. When you allocate resources in your budgets, then those should be tied to the strategy. Those things seem to be obvious, but they do not happen in most organizations today. I think that the breakthrough of the Balanced Scorecard is, that for the first time an organization has a way that it can describe its strategy because it allows you to deal with non-financial factors - the intangible assets - and to show how those are being tied to financial outcomes. And once you describe it, you can manage it.

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Extract from the interview with Leif Edvinsson, the father of the concept of Intellectual Capital and the pioneer in implementing it at Skandia in Sweden, a financial services company:

Juergen Daum: Why are companies and shareholders investing more into intangibles today than in the past?

Leif Edvinsson: The reason is, that industrial value chain processes no longer dominate value creation. Today it is innovation, it is seeking new ways of meeting market demands, that is yielding the highest return on investment. And that means that companies have to invest into their Intellectual Capital. They have to invest into knowledge upgrading and into new structures that help them to innovate and to make a difference.

Juergen Daum: What are the components of Intellectual Capital ?

Leif Edvinsson: One is people, human capital. The other is what is surrounding people in an organization, that is what I call structural capital – all those intangibles left behind, when people go home. And in that I include internal processes and structures, databases, customer relationships and things like that. With structural capital you enable organizations to make their human capital more productive. It’s not that people work harder. It’s that people work smarter with structural capital. This is what represents really the value of on organization. Not financial capital, not human capital, but structural capital.

Juergen Daum: You applied these principles at Skandia as the world’s first corporate director of Intellectual Capital during a major strategic transformation of the company, which was very successful. What has changed within the company?

Leif Edvinsson: First of all the thinking. Secondly the reporting system, and third, how we were managing or better cultivating innovation. If you want to change something, you first have to change the thinking of people – their mind set. And if you want to change the thinking, you need to develop another taxonomy, another language. And this language has to be understood by your counterparts. So if you want to communicate with people who are number trained, for example your CFO, you have to develop numbers. That is why we developed at Skandia a number language for Intellectual Capital - the “Navigator”. The “Navigator” is a kind of Balanced Scorecard which we used to report on customer relations, internal processes, human capital and financial results. This numbers represented also the basis for our annual report supplement, to let our investors and stakeholders understand the true value of the company. Then we moved on to introduce a „Future Center“.

Juergen Daum: What is a “Future Center” ?

Leif Edvinsson: The Skandia Future Center is a laboratory for organizational development. It is serving as an arena for knowledge safaris, strategic knowledge meetings and simulations concerts. During the first two years, when I managed it, the center had almost 12000 visitors who have come to, for example, test models of innovative knowledge enterprising in an environment that encourages new ideas and creative processes. The future center is a place, where people from Skandia meet with people they usually do not meet. And it s a place which is much different from the place at which they usually work. It is a prototyping space.

Juergen Daum: What are the major management challenge in “intellectual capitalism” ?

Leif Edvinsson: I think one of the big frontlines for management in the future is knowledge care. And knowledge care is how you focus as a leader on the tacit dimensions of your workforce. Burn-out is the most rapidly growing disease among knowledge workers around the world. And it is counterproductive for the organization as well, not just only for the individual. Burned-out talents are no talents any more and will not be able to contribute in value creating innovations. It is a waste and destruction of capital, of human capital. Companies therefore should focus more on their structural capital. That actually means, that they have to find new work regulations, work environments, and work set-ups where they have knowledge nomads coming into the enterprise for two to four hours a day working with the company’s structural capital. So part time is the work style of the future. This trend will change the way value-creating interactions are done. New organizational rules will emerge, such as much looser organizational structures. So it is a tremendous power shift that will take place, challenging traditional management of both corporations and societies to a transformation policy – to see the options to reshape the existing to something new and better.

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