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Intellectual Capital

such as successful companies in the information process- under the intangible assets balance sheet caption, in the
ing and pharmaceutical fields, sell many times over book instances where the company purchased such assets from
value, when purchased by other companies. Even success- other entities. Since internally developed intangible assets,
ful industrial companies sell appreciably above book such as patents and copyrights, are generally expensed
value, though not typically at the levels of companies under current research and development accounting prin-
where knowledge is critical. ciple, only minimal expenditures, such as the cost of
The theoretical argument against current accounting securing a patent may be recorded as an intangible asset.
is that the current model for reporting does not ade- Externally acquired patents and copyrights, however, are
quately measure and value the skills, information, and recorded at purchase price. Franchises are normally exter-
technological capabilities of the individuals in organiza- nally acquired and recorded at cost as intangible assets.
tions, yet these factors are valuable to the progress of a The GAAP rules for a purchased subsidiary state
company. Because of the significance of the unmeasured goodwill is the excess of the cost of an acquired subsidiary
intellectual capital assets to the future of the entity, and over the sum of the fair values of all identifiable assets that
therefore its market capitalization, current financial are acquired, less liabilities assumed, that are acquired.
reporting lacks important informational content, some- Besides tangible assets, identifiable assets include any
times even to the level of being misleading. Companies assets that are intangible assets and meet criteria that make
have been able to show accounting profits based on their them separable from goodwill such as they can be sold,
tangible assets following GAAP, while their intellectual transferred, licensed, rented, or exchanged or there is a
capital assets were losing value. Ultimately such compa- legal-contractual relationship. Examples of identifiable
nies did very poorly—their profits vanished. Good finan- intangible assets separable from goodwill are customer
cial reporting should guide capital to the most promising lists, customer orders, brands, and trademarks. If these
investments. components of intellectual capital are internally created,
An example of the inadequacy of GAAP in relation to there is no means under current GAAP to place their value
recording intellectual capital is in the area of research and on the balance sheet. Research and development costs of
development costs of companies. That research improves the acquired subsidiary must be expensed. Goodwill,
the knowledge awareness of employees is a prevailing then, is a residual amount, frequently described as the
assumption. Intellectual capital would be considered to value of the human capital acquired.
have been increased because of the learning and under- Under current reporting standards the parent com-
standing gained by means of engaging in research and pany and subsidiary company are required to be reported
development. It would then be expected that future rev- in the financial statements as if they are a single entity.
enue would be greater for firms that had significant Therefore, the consolidated financial statements are
research and development costs. In some instances extremely difficult to understand with the parent’s good-
research and development results in valuable patents and will ignored while the subsidiary’s goodwill is shown.
copyrights. There is evidence that research is strongly asso- Finally, GAAP does not amortize goodwill because it
ciated with earnings, stock prices, and returns. is considered to have an indefinite useful economic life.
GAAP, however, mandates the expensing of research Goodwill, however, must be considered annually for
and development at the time of the expenditure. (A few impairment. The implied fair value of the reporting unit
exceptions allow for capitalizing some of such expendi- is compared to its assets including the residual goodwill
tures.) Such a ruling reflects the belief that there is no rela- asset, less liabilities. If the implied current fair value of
tionship between research and development costs and the goodwill is determined to be less than the recorded good-
future benefits to the firm or that the relationship cannot will, the recorded goodwill must be reduced or entirely
be established. Another belief is evident: Allowing the eliminated. Because of business economic cycles there are
capitalization of research and development expenditures sometimes very large write-offs of goodwill when there is
introduces the possibility of the manipulation of earnings a downturn in the economy and the stock market. It
by companies since establishing objectivity of reasons for would appear that human capital would not suddenly dis-
amortizing or writing off capitalized costs is difficult to appear because of a downturn in the economy.
determine.
EFFORTS TO RECOGNIZE AND
CURRENT REPORTING STANDARDS DISCLOSE INTELLECTUAL CAPITAL
Accounting guidance views intellectual capital as intangi- INFORMATION
ble assets and specifies exactly what the term means for Financial reporting limitations have led to efforts to meas-
accounting recognition. Traditionally such accounts as ure intellectual capital indirectly outside the financial
patents, copyrights, franchises, and goodwill appeared statements. Such measures sometimes accompany the

398 ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION