Ask VeraSage: Accounting for Intellectual Capital?

I've been having a dialogue with a consultant for the last two years, and we recently had a very interesting discussion on intellectual capital (IC).I thought you might find it of interest, since IC is what the professional knowledge firm is all about.Our exchange focused on whether or not it is possible—or even desirable—to attempt to value IC, and perhaps placing that value on the financial statements, or a set of parallel statements.Doug was not advocating this approach, just questioning the validity of doing it, and what the impact would be. I've had many other discussions with consultants and CPAs about, for instance, placing the value of a company's brand on its balance sheet.Should we account for IC, like GAAP accounts for transactions? Should IC be on the financial statements?We both conclude no. Here's why.

Hi Doug,We do use IC as an integral part of a professional firm's business model, which is why we refer to them as Professional Knowledge, not Service, Firms. PKFs sell IC, not time.As for measuring IC, I find the work of others in that area interesting, and have met my share of firms that offer formulas and frameworks to value IC. All fascinating, but I'm still trying to answer, "What's the point?"Some insist they want IC to be put on the firm's financial statements, which will and can never happen, since accounting is designed to capture value after a transaction, not value it before hand.You certainly could devise parallel financials for IC, but again, what's the point? The argument is to force managers to think about it, value it, etc.But it seems to me that this is the "What you can measure you can manage mentality," and with IC, effectiveness is always and everywhere more important than efficiency (the latter of which is always a measurement, where the former is always a judgment).Since value is subjective, any formula or model for IC will be flawed from the get go. Not that it's not a worthwhile exercise, such as how Interbrand values the world's leading brands, but it's the illusion of accuracy and precision. I've seen companies pay well over IC value calculations because value is subjective.So, I come back to what's the point of this? What's the service being offering by valuing IC? What's the value of doing so? I don't think it's as obvious as IC folks make it out to be. As you know, I wrote an entire book, Mind Over Matter, on this topic, but didn't try to value IC—it can't be done with any reliability.Thanks Doug, look forward to your thoughts.Ron

Thanks very much, Ron.This is exactly the kind of response I was hoping for—informed and critical. I'm slowly committing Mind Over Matter to memory, so I have deep respect for your opinions.I have a lot of skepticism myself. I take your point about accounting being the trail of the past. I have heard the argument that by putting NPVs on assets, is bringing the future into the present, and isn't it true that IC is exactly about the future, and that is why [we need] a breakthrough in accounting? It is supported by IASB standards on intangible assets and impairment, which also track with FASB standards 38 & 38.But the IC side intrigues me, because so many people believe there is such a need to recognize (and quantify and monetize) your subtitle (intellectual capital is the chief source of wealth). I think this belief is even more strongly held in the wake of the debacle over people pumping up risky underpinnings (lousy mortgages, among others) into highly leveraged clouds of crap. A wealth creation engine based on human knowledge, experience, relationships, performance, and results seems like a more positive economic foundation. But how to capture, how to harness?Thanks again for your quick and thoughtful response. One of these days I'll buy you a beer, or a glass of your favorite wineCheers, and great thanks,Doug

Hi Doug,I understand the argument, my problem is knowledge is also a social construct—it simply cannot be quantified, tracked, and put into a formula.There is certainly value in valuing IC for a business sale, and indeed that is what happens. This is why accountants call the sales price over the book value "goodwill"—just a word that describes their ignorance, i.e., their inability to value an enterprise, only capture it after a transaction takes place.But even formulas for IC won't capture the subjective value of an enterprise. How many times have you seen a company pay way above a company's value, as assessed and computed by business valuators? It happens a lot, and that's because value is subjective.And no, I do not think putting NPVs on assets is bringing the future into the present. Accounting can't do that, and even if there existed formulas, they would be full of errors and inaccuracies.Here's another reason: knowledge is actually about the past, whereas entrepreneurism is about the future, and you can't capture the Black Swans of entrepreneurialism by formulas. No amount of sophisticated IC formula could have predicted, captured, or harnessed eBay or Google. It takes therisk-taking of entrepreneurs to create new wealth. Anything we can capture, measure and harness is almost by definition about the past that is already dying.I've come to the conclusion that we'll never be able to measure IC. So what?We know it's there—like dark matter in the universe—but there are too many variables. It's spiritual, not material—meaning you can't measure it.To believe otherwise is the materialist fallacy—that everything needs to be measured to be understood. It doesn't work—see the USSR, Cuba, North Korea and any other communist country.This doesn't mean we should ignore IC, only that trying to measure and value it is futile—like plunging a ruler into an oven to determine its temperature. It's the wrong device.There's lots more to say on this topic, but it does make my brain hurt.Ron

Doug made the final salient point about IC, what Joseph Schumpeter called the Creative Destruction of capitalism:

The key point is that the value does not arise from the accounting of it, however elaborate the accounting scheme might be, but rather in the context of a marketplace that is focused on performance and results, enhanced by a skunkworks generator, etc.

Would love to hear your opinions on this topic.