The need for IC Reporting

Change has been a way of life for mankind, yet change has always been difficult. Throughout history, man has constantly been faced with the opportunity of doing something in a new way, a better way – but that has always met with resistance. To give just one example, do you recall the invention of the personal computer by IBM in the 1940s and the subsequent (by now infamous) remark of IBM Chairman Thomas Watson “I think there is a world market for five personal computers”. In hindsight, we can now say that the personal computer has been largely responsible for the rapid modernization of our society during the last thirty years. So rapid and massive has been this modernization that as a society we have become used to embracing change more and more rapidly – remember ATMs did not exist thirty years ago, the World Wide Web did not exist twenty years ago and mass mobile telephony as we have accustomed to today did not exist even just ten years ago!

Yet today, we are at the crossroads of one more change – this time in the field of accounting and reporting of company performance. Unlike tangible changes outlined in the examples above, this is a softer change. It has to do with the way business accounts are recorded and presented to stakeholders. But why do we need a change in our accounting system, you might ask? What is wrong with it? It isn’t broke, right? So why fix it? The reasons however are many.

Firstly, the present system of accounting is old, very old. The double-entry bookkeeping system of accounting that is in use today was popularized by the Italian monk Luca Pacioli more than 500 years ago! This system relies on recording each business transaction using balancing credit and debit entries in two different ledgers. It is a system that is well understood and it has served us well throughout the industrial era, yet it has one critical shortcoming. The system works by matching revenues to expenses accurately in order to determine income. But it cannot handle value creating transactions that happen much before revenues have been realized. For instance, when the R&D efforts of a pharmaceutical company culminate in the passing of regulatory clinical tests, enormous value is created. Yet the accounting system does not recognize any of it.

The loss would have been limited had it been restricted to the failure to recognize value. But present accounting policies in fact do more damage by mandating the immediate expensing of R&D costs that go into the drug discovery process instead of capitalizing them, thereby recognizing such costs as an asset. The net effect of this policy is a reduction in net income in the year that R&D costs are incurred at the cost of protecting future income. This is a double whammy.

Finally, the accounting system is in total disconnect with the way companies operate in the knowledge economy. We know for certain by now that intangible assets are the primary driver of growth in the knowledge economy. Yet the accounting system is blissfully ignorant to this situation. For example, we all know that the value of Apple is linked closely to the ability of Steve Jobs to lead the company on the path of continuous innovation. Yet, the book value of Apple did not change when Steve Jobs rejoined Apple and it will definitely not change if Steve Jobs were to quit Apple all of a sudden!

Professional accounting bodies the world over have been trying their best to make the accounting system adapt to the knowledge economy. But changing a system that is carved in the hearts and minds of accountants over the last 500 years is easier said than done. In the meantime, investors are getting highly impatient. Genuine investors already know that published income statements and balance sheets are not reliable instruments for making investment decisions. They rely instead on other sources of information such as analysts, insiders, research, tips, etc. Some of these sources are genuine yet others exist only for making a quick buck from gullible investors. Such is our plight today.

But the situation can be remedied and quite easily too. This is where the need for IC Reporting comes in. All that needs to be done is that the annual report (or even quarterly income disclosures) needs to be supplemented by a statement of change in the Intellectual Capital of the company. This way, investors will be able to see not only the financial performance of the business but they will be able to correlate that performance with the investments in intangible assets of the business. They will be able to verify the sustainability of the performance. This in turn will drive down the cost of capital for the business which in turn will make the business more efficient. In short, IC Reporting will enable an unending positive feedback cycle for the business.

Change seems radical whenever it is first proposed. But in hindsight it always seems a no-brainer. IC Reporting is a change whose time has come. We will see this change implemented much sooner than later. And it will be for the good of all of us.

An asset that appreciates with time

We live in very interesting times. The economic transformations that are changing the fundamental s of our social behavior and the very fabric of our life are tremendous. For instance, email was unknown in the corporate world prior to 1990. Today in a span of just under 20 years email has become so pervasive that, most if not all, businesses would be unable to function efficiently without email communications. Mobile phones were largely unknown prior to 1994. Today, in a span of 15 years the mobile phone has become so ubiquitous that it has rapidly shed its image of a luxury item and now become a necessity. In the Indian context, ATM banking was largely unknown in the country prior to 2000. Today in a span of just 10 years ATMS have proliferated so fast and so much that some banks have actually started limiting the number of teller assisted cash withdrawals that customers can make each month.
Economic change is not only happening, it is happening more and more rapidly. Consider this. Until the 1800s, farming was the main occupation of people. The primary requirement for farming is land - the more the better. Unfortunately, the land that we have inherited is not only limited but with time the increasing population has only hastened to increase the per capita demand on it. In the 19th and 20th centuries the focus shifted from farming to manufacturing, driven to a large extent by the industrial revolution. The spotlight during this time was on increasing productivity, using machines in place of human labor. Machines had a huge advantage over humans – they could work faster, they produced output of consistent quality, they did not get tired and they could work all three shifts if needed. During these two centuries machines came to dominate our lives like never before – their acceptance eased by their promise of freeing us from drudgery and making more free time available for our creative use. While machines changed our lives forever during the industrial era, it took many centuries for the focus to shift from farming to manufacturing.
Yet the next change happened within the next 200 years, when we crossed over from the industrial era into the knowledge era. Today machines are no longer a source of competitive advantage. If I can buy a machine so can the competition. The increased productivity that both of us have is not enough of an advantage anymore. To sell our goods, we both need to add value. There are various ways of adding value – but all of them require leveraging the intellectual capital of the organization to provide a product or a service that is superior to what the competition can provide. This in turn requires the systematic management of Intellectual Capital, since that is the very source of competitive advantage in the knowledge era. In fact, unlike physical assets like machines and land which get depreciated over time and financial assets which get depleted with time, intellectual capital is the only asset that appreciates with time. Doesn’t this sound a bit like having your cake and eating it too? Yet it is true. Very few businesses have realized this truth since we are still in the formative years of the knowledge era. But those that have will surely survive and even thrive in this era and survive into the next.