Dr. Kretov Kirill - Basic classification of corporate assets. Introduction to Various types of Intangibles.

Making the invisible visible is the CEOs job (John Hagel, The McKinsey Quarterly)

1.0 Introduction Amid the many complicated and creative models encountered over the last decade, it has become evident for most companies that the valuation of Intangible Assets and Intellectual Capital has proven to be more theoretical than practical. Although a number of studies have been carried out on the valuation of Intellectual Capital, most of the findings seem more theoretical than practical. The concept of intellectual capital has already been researched by many elite scholars, who have created many interesting theories. However, most of their work is purely theoretical, and their concepts and theories are not widely accepted. Very few of them have been actually applied. For example, many papers have been written about intellectual capital and its importance to a companys performance; quantitative analyses and reports show that intellectual capital is an emerging competitive advantage that results in long-term profits and greatly increases the value of the company. However, current accounting practices recognize only a very limited number of intangible asset types (in terms of intellectual capital). From the accounting perspective, the choice is very limited: there are R&D and Goodwill (the second being inapplicable to most companies). Only if the company is aware of the existence of some particular type of asset may it decide to estimate its value using a given valuation method (if one is applicable). The problem is that the final value is not a guarantee of the real value of an asset. Another practitioner may not agree with the valuation principle applied and may propose another that he finds more appropriate, or someone might apply a number of theories to the Intellectual Capital of a company and come up with a list of indicators that might not be accepted or understood by others who prefer other concepts. Thus, it seems that the root of the problem is not the lack of evaluation methods but the lack of widely accepted standards for these methods and for the reporting of the results. Moreover, there are issues involving patents, trademarks, copyrights, and other forms of know-how: exclusive rights, the most profitable kind, are given only to patent holders. An accountant recognizes only those assets recognized by current accounting practices (as regulated by the IFRS). Since reporting unrecognized assets is only optional, an accountant may decide not to spend time reporting them, especially if his motivation is not very high, and he wants to spare himself the work. Knowledge management scholars know that it is possible to identify where knowledge comes from and classify it using various theories and taxonomies. This can be helpful for companies that apply KM principles to create value through the continuous identification of the pieces of intellectual capital they create. The foregoing has described only a few of the perspectives from which the field of intangibles can be considered.
Basic Classification of Corporate Capital by Dr.Kretov Kirill Geneva, Switzerland on 2009 December

1.1 Historical Overview Intangible assets are not a modern invention or a phenomenon of the 21st century. Indeed, contrary to popular misconceptions, this type of asset has existed for a long time. Throughout human history, knowledge and information have remained two of the most precious commodities. The caveman who discovered the secret of manufacturing and used a spear to kill a mammoth faster and with less risk to himself possessed an

intangible asset that meant the difference between life and death not only for the hunter-gatherer but also for his community. Similarly, the inventors of the alphabet, calendar, and mathematics possessed equally important intangible knowledge assets. In contemporary society, knowledge has become far more complicated, specialized, and technical. Mistakes made in the operation of a nuclear plant, space shuttle, or biological weapons research facility can mean the deaths of millions. Much like in prehistoric times, knowledge, and expertise have remained assets that can mean the difference between the life and death of the tribe. Now, particularly in the developed world, businesses are increasingly reinventing themselves as service-oriented operations. Manufacturing tangible commodities that consumers can touch, smell, or taste is rapidly becoming a thing of the past. These transformations have become increasingly frequent across a wide spectrum of organizations. Many companies rely almost entirely on intangible assets and consider them one of their core competitive advantages. This was accurately described in the Harvard Business Review: Employees skills, IT systems, and organizational cultures are worth far more to many companies than their tangible assets. Unlike financial and physical ones, intangible assets are hard for competitors to imitate, which makes them a powerful source of sustainable competitive advantage.( Robert S. Kaplan and David P. Norton, Measuring the Strategic Readiness of Intangible Assets). It is well known that most of the business resources in developed countries are intangible: in 1982, the material assets of American companies constituted 62% of their marketable value (Stewart T.A. Intellectual Capital. The New Wealth of Organizations.); after 10 years, that share fell to 38%, and current research (R.S., and Norton D.P. Die strategiefokussierte Organisation: Fuhren mit der Balanced Scorecard.) estimates it at only between 10% and 15%. By the end of 1999, the value of the property reflected in the balance sheet constituted only 6.2% of Microsofts market price, 4.6% of SAPs, and 6.6% of Coca-Colas (Daum J.H. Intangible Assets). In 1982, the share of the non-material resources in added value creation for the 500 largest American companies was 38%, and by 1998 it was 85% (Du Voitel, R.D., Roventa, P. Mit Wissen wachsenStrategisches Management von intellektuellem Kapital, in.: Perspektiven der Strategischen Unternehmensfuehrung.). The current investments structure strengthens the prevalence of non-material resources: in the early 80s, 62% of investments in the American industry were acquisitions of material assets; by 1992, that share dropped to 38% and was only 16% in 1999 . Since 1991, US enterprises have been spending more money on information processing equipment than on other equipment; information is replacing material merchandise stock, and knowledge is pushing out tangible fixed assets. Prominent economist Leonard Nakamura estimates that the United States invests at least $1 trillion per year in intangibles (Leonard Nakamura, A Trillion Dollars a Year in Intangible Investment and the New Economy, in John Hand and Baruch Lev, eds., Intangible Assets: Values, Measures, and Risks.), a figure derived from the fact that about 6 to 10 percent of the US GDP is spent on intangible assets. Investments in R&D and software have increased significantly over the last 40 years. Simultaneously, the average cost of goods sold has fallen by more than 10 percent since 1980. Services, which are counted as intangibles, rose from 22% of GDP in 1950 to 39% in 1999. These dramatic changes (Margaret Blair, and Steven Wallman, The Growing Intangibles Reporting Discrepancy, Unseen Wealth: Report of the Brookings Task Force and Intangibles.) not only document a clear increase in investments in intangible assets but also underscore the growing value of intangibles as an important element of contemporary business.

2.0 Basic classification of corporate assets Every organization possesses multiple types of assets, which it combines to produce goods and services. The objective of this section is to classify these assets based on their common attributes. All assets can be divided into two major types. The first type incorporates conventional assets that can be touched, sensed, and felt: these are known as tangible assets. Any asset that does not fit the above description can be categorized as intangible. According to IFRS (IAS-38 Intangible Assets, Issued in September 1998, revised in January 2008.), an Intangible Asset is an identifiable non-monetary asset that does not have physical substance. An intangible asset must be identifiable, a requirement that distinguishes it from goodwill. Tangible assets are usually associated with intangible assets, as represented in the diagram by the overlap between the two major categories. For instance, when an organization produces physical commodities, it will usually have some form of intellectual property (IP) associated with and involved in the manufacturing process. Most physical products, however, cannot be patented in their entirety. For example, a notebook computer manufactured by Sony may include not only a patented CPU cooling technology, the Sony brand name, and the VAIO trademark but also a Blue-ray player, which relies on technology developed and patented by the Blue-Ray Disk Association (BDA). Similarly, automobile industry giants like BMW incorporate components, such as GPS systems and MP3 players, that are patented by other organizations. On the other hand, an organization can also possess intellectual property that has not yet been employed in any manufacturing or production process. For example, General Motors maintains an extensive portfolio of inventions and licensed intellectual property in addition to its vast array of trademarks and patents used in current product offerings. Thus, an overlap between tangible and intangible assets does exist but is only partial. Furthermore, the diagram also includes financial assets, which are intangible by definition. Cash and its equivalents are not real property, because cash needs no valuation; however, it can still be secured by physical assets. For this reason, the diagram illustrates a partial overlap between financial and tangible assets. J. Cohen proposes that Intangible assets can be categorized into two distinct groups, identifiable and unidentifiable. In addition, intangibles (or proto-assets) share some of the attributes of identifiable and unidentifiable assets but do not fit neatly into either of these two categories. Here we see the difference in opinion about the essence of Intangible Assets. From an accounting standpoint (i.e., for the IFRS), an IA is an identifiable non-monetary asset, but J. Cohen states that the IA may be further split into identifiable, unidentifiable, and proto categories. Those who begin to explore this field farther will see more serious disagreements among researchers regarding terminology and concepts. In my opinion, an asset should be called by a name recognized by accounting practices: if it is not recognized but is clearly identified and valuated, then it is an asset.
2010 December, Geneva, Switzerland Dr. Kirill Kretov Introduction to various types of Intellectual Capital

2.1 Identifiable Intangible Assets (Recognized in Accounting) Intellectual property is most commonly associated with the concept of identifiable intangible assets and includes patents, copyrights, trademarks and trade secrets. These elements all share one salient commonality they are accorded special legal protection or recognition and are deemed property as a matter of law. Recognition and protection of intellectual property is not a development of modern times. The Copyright Act was enacted in the United States in 1790, while President Jeffersons Patent Act of 1793 codified the concept of patents. Legislation, however, has occasionally proven to be inadequate, raising the possibility of benefits derived from the ownership of intellectual property being removed. For example, in 2003 alone, 308 out 526 patent infringement suits filed in the United States were deemed invalid or unenforceable. Aside from temporary monopolies, the major benefit of intellectual property ownership is its potential marketability. Patents are routinely sold, licensed and bought. IP assets are identifiable, separable and are often purchased or assigned to someone other than the inventor or creator. Research and Development It is probably a good idea to begin the discussion about types of Identifiable intangibles with Research and Development (R&D). Historically there were only two intangible items reported in public company financial statements: R&D and Goodwill. For this reason R&D expense records of public firms have been the topic of widespread academic research. R&D is defined as an identifiable intangible asset because it may result in the creation of intellectual property. For example a companys research may lead to patents that can be bought and sold separately. Marketable patents, however, are not the only purpose of R&D investments - they often lead to improved manufacturing techniques, trade secrets and other types of intellectual property that will never be patented, but will nonetheless improve the companys competitiveness. Consequently R&D has the potential for the creation of other assets, some of which are discussed below. Patents There are three basic types of patents, which include utility, design, and plant patents. (See U.S. Code Title 35 Patents1, for a full description of patents and patent laws.) For the patent to become enforceable it should be listed in at least one registry of intellectual property, some of which can include The United States Patent and Trademark Office (USPTO), the European Patent Office, the Japanese Patent Office, and World Intellectual Property Organization (WIPO). The core purpose of all of these offices is to act as the registry of patent information. These organizations check whether a patent application meets various criteria (must be novel, non-obvious, and useful) and if so, records the invention as having been created and owned by patentee. The application process is not rapid and the cost to obtain a patent is not nominal. The author of this paper (Dr.Kretov Kirill) resides in Switzerland and has recently sent a patent application for a method of password protection against various types of key-logging techniques to the European Patent Office (EPO). Besides attorney costs to help draft the application, simply starting the process costs CHF 3,600 and the first results are expected to arrive no earlier than six months after the date of application. Normally it takes two to three years to win patent approval. After a successful application, the patent holder has the right to exclude others from making, using, or selling its invention for a period of 20 years (which is why patents are often described as temporarily granted monopolies). Perhaps most interesting is a subset of utility patents knows as process or method patents. During the internet boom of the late 1990s, many start-up technological firms have filed for process patents that described
1

U.S. Code Title 35, http://www.law.cornell.edu/uscode/html/uscode35/.

methods that could be useful to everyone. For instance, there is a patent filed on the process of using modem to connect to the Internet. Most famous are probably Amazons 1-Click buying feature and Microsofts double-click patent. Some critics of the USPTO allege that during 1990s, patent reviews have failed to take into account the test of non-obviousness. Many suggested that the life of Internet-related process patents should be reduced to under 20 years. However, in spite of the fact that many Internet-related process patents were approved only a few resulted in economic benefit to their inventors. It is probably logical to ask: Why grant patents at all? There is a simple economic rationale: if inventors cannot protect their work and make some money of it, they have little motivation to create the invention in the first place. The right to exclude others from using the invention is a kind of reward for investing the efforts to develop a patentable idea or technology. Patent law generally supports the notion of monopolies being oftentimes good for customers. The enforced expiration of patents supposedly creates the right balance: enough protection to encourage innovation, but not so much as to encourage abuse. Copyright U.S. copyright law was established in 1790, during the Second Session of Congress, convened on January 4th and the bill was signed into law on May 31st by George Washington. However the initial idea of copyright goes back to the late fifteenth-century England when the printing press was introduced. Copyright is usually made for written material or creative works, such as books, photographs, music, video records, and software code. The process of applying for copyright is relatively straight forward the creator of work owns the copyright as soon as the work is created. Unlike patents, filing for copyright registration simply gives notice that the creator is claiming copyright to the work, but it does not conclusively establish ownership. Furthermore, the copyright office does not screen submission for possible conflicts with existing copyrighted materials. Up until 1980s, owners of copyrighted materials, such as books or audio and video records were not faced with mass copying of their works. But lately, due to the rapid development of technology (especially the Internet) enormous quantities of copyrighted material were digitalized. At this point it might be interesting to note copyright issues related to digital media and to mention the concept of fair use. Fair use is any use of copyrighted material that does not infringe copyright even though it is done without the authorization of the copyright holder and without an explicit exemption from infringement under copyright law.2 However, fair use is widely misinterpreted. For example if someone buys a computer game for about EUR 100, it is logical to expect that the buyer will not be happy to lose it due to accidental scratching or other physical damage caused to the disk. DVD copying software can be used to make a backup copy, so that if the original disc stops working, the buyer does not lose their money. However, there is no guarantee that the buyer will not decide to share this backup with other people. Uploading the image file (exact copy of the disc) to a file-swapping peer-to-peer network may expose it to millions of people, potential buyers who will not pay for game, but use its pirated copy instead. Some companies are integrating anti-copying techniques that complicate the copying process, but at the cost of the buyers ability to create a backup copy. In other words DVD-ripping and peer-to-peer networking software itself can be very helpful, and may have socially valuable legal uses, even if it often is used for illegal ones. Copyright holders struggle to find a solution that will help to prevent unauthorized use of their work, but with minimal success so far.

Congressional Budget Office, Copyright Issues in Digital Media, http://www.cbo.gov/ftpdocs/57xx/doc5738/08-09-Copyright.pdf (August 2004) p.X.

Trademarks Websters dictionary3 defines trademark as a distinctive name, phrase, symbol, design, picture, or style used by a business to identify itself to consumers. Just like copyright, trademarks can be established through common-law usage. The registration process is somewhere between copyrighting and patenting in terms of the amount of review conducted and legal assistance required. There are legal advantages to registration, but trademark search is not necessary. An attorney normally conducts one search only to determine what other trademarks exist that could be confused with the one under consideration. It is even possible for two very similar trademarks to coexist, provided that they are not likely to be confused. For example it is possible that some plastic-window manufacturer will apply for the trademark called Windows, even if a very similar trademark is registered by Microsoft. However if a start-up software developer company will create its web browser and apply for the Internet Explorer trademark they most likely will not obtain it, simply because the product classes are very similar and likely to cause confusion. Trade Secrets Trade secrets are types of assets that result from a certain way of doing business or proprietary technology that provides competitive advantage to its holder. It is something that is used in ongoing business, like a unique compilation process or data mining system. According to the Uniform Trade Secret Act (UTSA): "Trade secret" means information, including a formula, pattern, compilation, program device, method, technique, or process, that: (1) derives independent economic value, actual or potential, from not being generally known to, and not being readily ascertainable by proper means by, other persons who can obtain economic value from its disclosure or use, and (2) is the subject of efforts that are reasonable under the circumstances to maintain its secrecy.4 Simply speaking, trade secrets are something that provides economic value because they remain unknown to the competition. For example one company may abandon e-mail protocol as the communication channel between workers and switch to an instant messaging service. Derived economic value could be the lack of spam, instant message delivery, and improved security. In the meantime, its competitors will still using slow and unsecure e-mails, waste 90% of their traffic on spam, and wonder why messages have been sent, but not received. Unlike patents, owning a trade secret does not prevent others from using it. Two firms can independently and simultaneously hold the same information as the trade secret, but they cannot hold two separate patents on exactly the same invention. There is no way someone can prevent another company from using instant messaging service as the internal channel of communication, except if the company is unaware of this possibility. Brands Brands are often confused with trademarks in fact, the author (Dr. Kirill Kretov) of this paper was surprised to find that Websters Merriam dictionary defines brand as synonym to trademark. It is not - brands are much more than simply names or trademarks. A brand is an economic asset, because it adds value by

3 4

Merriam-Websters Collegiate Dictionary, 11th ed. (Springfield, MA: Merriam- Webster, 2003). National Conference of Commissioners on Uniform State Laws, Uniform Trade Secrets Act, http://nsi.org/Library/Espionage/usta.htm (Minneapolis, MN: NCCUSL, August 2-9, 1985), $1.4.

conveying information about a product. According to Tom Blackett 5, brands that keep their promise are business assets. They attract loyal buyers who regularly return to them, making it possible for the brand owner to forecast cash flows and to plan and manage the development of the business with greater confidence. Because of the brands ability to secure income it can be classified as a productive asset in the same way as any other, more traditional business assets like equipment, cash, investments, and so on. At the same time brand owners have the incentive to keep their promise. If eventually the market discovers fraud the company risks to lose a significant number of its clients. The author of this paper is a great fan of all Sony products - he believes that this company produces beautiful, innovative and durable products and, as a result, he is willing to pay more for their quality. But there are many other Japanese brands available on the market and if suddenly Sony decides to cut corners and trade low quality products under its good name, the author will simply switch to available alternatives. Software Code Software code is said to be one of the most complicated intellectual properties to codify. It is possible to obtain a patent for the business process that the code enables or trademark certain features of the software. In fact, even some part of the code can be kept as a trade secret while the code itself can be simply copyrighted. However, this is complicated by different accounting treatments which largely depend on whether the software regarded as an input to the organizations manufacturing process, or whether the software is the firms product is and of itself. In other words the firm may use and/or sell software code. For example Microsoft Office is a very useful application that organizations might use for word processing or spreadsheet calculation. However the cost of license for a given number of workplaces may not be treated as valuable intangible property. At the same time MS Office is an extremely valuable intangible property to its creator Microsoft. Note that only Microsoft holds the source code, while those who buy licenses are only given its compiled version.

Tom Blackett, What is Brand? in Brands and Branding, Rita Clifton and John Simmons, eds. (Princeton, NJ: Bloomberg Press, 2003) 18-9.

2.2 Questionable Recognition Accounting standards normally have high requirements regarding disclosure of information about nonmaterial (intangible) assets. For example, IFRS-38 requires that financial reports should include the following information for each type (class) of assets: methods of amortization, results of re-evaluations, estimated life periods (asset remains useful), and other explanations of significant changes in total value of non-material assets. Reporting should also include the total cost of R&D, which is considered as spending for the current period. However, it is the specific company that develops a classification of non-material assets, normally based on some principle of their homogeneity. In other words, IFRS recommends disclosure of information about valuable intangible (non-material) assets that are owned by a company but not recognized by current accounting practices (CAP). At the same time, the report format can be defined by a company. As a result, we have a lack of standardization and a nightmare for investors, who have to compare parameters that are very often of different natures and incomparable. Some reports with information about particular assets may be not incomparable just with other companies but even with reports from the same company for different time periods. Some researchers 6 have already identified this negative side of flexibility and freedom in reporting and classification allowed by IFRS. 7 As can be seen, then, current accounting practices only recognize R&D (primarily replacement cost). It is possible to calculate the total cost of Human Resources. But there are no practical and widely accepted tools or techniques for evaluation of intangible assets separately, at least from the accounting perspective. In the table below (table 2.1) there is a list of intangible assets classified as recognized and not recognized by CAP (recommendations from IFRS).
Recognized in accounting (mainly in IAS-38) Trade marks Software Licenses and Franchises Patents Copyrights Service and exploitation rights Recipes, formulas, models, projects and concepts Source Codes and documented algorithms Acquired Goodwill (IAS-3) Not recognized in accounting Expenses on training and education Advertizing Expenses Reorganizational Expenses Research expenses Stuff (Personnel) skills and abilities Technical knowledge Market share List of clients Brand names Other intangible assets, regulated by various Internal Goodwill

standards8
Classification of assets by their recognition in IFRS.

Also, from an accounting standpoint there are unidentifiable intangible assets. These assets are special in the sense that they remain hidden (at least in the accounting sense) until a transaction like a merger or

Wayne, S.U., Challenges from the New Economy. Business and Financial Reporting, SPECIAL REPORT/Financial Accounting Standards Board, April 2001. www.fasb.com 7 At this point the idea of need of universal taxonomy model and superior reporting standard came to the authors mind. 8 Discussed in IAS 12, 17, 19, 27, 28, 31, 32, 39, etc.

acquisition gives rise to their identification. Goodwill is such a type of an asset that is only valuated under certain circumstances and may have significantly different value depending on those circumstances. There are other unidentifiable intangibles (that may not be present in the above lists), but conventional accounting rules do not provide much insight into valuating them. Between two very similar (in terms of identifiable assets) companies, one might be more profitable than another. Various unidentified factors account for one company being more efficient than another. Consider two very similar high-tech companies, both doing business by developing software and selling it on the Internet. All visible characteristics of both companies are very similar but one, lets call it Company A, generates 10% more sales each month than Company B. If a bigger holding company decides to acquire a high-tech firm, it might be willing to pay more for company A than for company B, simply because A is more profitable. This difference may appear as Goodwill on the financial statement. But why is A more efficient? It could be because company B was focused on designing their portal by using nice graphics and animated menus to make their site look more attractive than that of company A. At the same time, company A paid more attention to cross-browser compatibility, so that the page correctly displays in all browsers. Thus some potential buyers with very specific web browsers are simply unable to execute the shopping cart script on the companys B portal, while everything runs smoothly on their competitors (company A) portal. It is possible that those users of specific browsers account for the percent difference in the amount of sales generated by both companies. If company A identifies that it is more efficient because of its portals compatibility, it may wish to keep this fact secret, thus the reason for its efficiency will become a trade secret. In other words, when the source of efficiency is identified, the subject asset becomes an identifiable one. The cross-compatibility module will become a trade secret or know-how. However, often that efficiency remains unidentified and in many cases the management is unable to pinpoint the reason for it. Goodwill Goodwill is probably the most commonly discussed unidentifiable asset. It has already been mentioned that goodwill is one of two intangible items that were routinely reported in public company financial statements (another one is R&D). Goodwill shows up on a company's books when it acquires another company, and the buyer naturally has to pay more for it than the fair value of the net identifiable assets, both tangible and intangible. Numerous goodwill definitions can be found in various documents and standards regulating the business accounting and estimate activities (IFRS, USA GAAP). Note that given definitions are paraphrased and not exact citations from sources. IFRS 3 "Companies merger" (International Financial Reporting Standards) By IASB (International Accounting Standards Board)
Goodwill arising from merger of the companies is the sum paid by the buyer over the purchase marketable value in expectation of future economic gains. The future economic gains can result from the synergy effect of the acquired identified non-material assets or assets which separately are not subject to acknowledgement in the financial reporting but which are a part of the purchase cost. Goodwill is the excess of a purchase cost over the acquired share in fair value of the identified acquired assets, which are inseparable from the target company. Actual goodwill cost is the purchase cost minus the difference of fair value of identified assets, obligations and contingent obligations.

SFAS 142 "Goodwill and other intangible assets"(Financial Accounting Standards) By USGAAP (US Generally Accepted Accounting Principles)

Goodwill is the cost excess of an acquired company over the cost of its identified assets minus obligations. Goodwill reflects such factors as customer demand satisfaction, good management, production efficiency, successful location, etc.

EVS 2000 (European Valuation Standards) (latest 2009) By TEGOVA (The European Group of Valuers Associations)
There are three categories of non-material assets subject to evaluation: business goodwill (unallotted non-material assets), personal goodwill, and identified non-material assets. Business goodwill is inseparable from the company and can be considered in the balance sheet after company sale, according to IFRS. Personal goodwill is not transferred under sale and is not considered at company cost calculation.

As can be seen from the given definitions, in various business accounting standards, there are practically no discrepancies concerning the essence of goodwill. Thus, most of the time, goodwill value appears if company acquisition takes place, and the difference between the purchase cost and the fair value of identified assets is calculated. In other words, the traditional understanding of goodwill origins lies in the following: Goodwill arises when a business is acquired at a price exceeding its assets marketable values sum. In turn, this excess can be explained this way: The business market price as a whole is comprised of the cost of all assets, including the ones not reflected in the balance sheet. As it is known that in the balance sheet un-identifiable9 assets cannot (should not) be reflected, their cost is embodied in goodwill. The residual method of goodwill calculation is based on it. However goodwill takes place not only when the company possesses unrecorded intangible assets. We can give examples of some factors irrelevant to the value of intangible company assets that influence goodwill value and are subject to be reflected in the company-buyer balance sheet:
Cost of the identified assets (the more non-material assets are capitalized, the less remain for goodwill);10 Sales price of an acquired enterprise depending on a seller's ability to prove the high price or on the buyer's ability to beat down the price, on commission intermediaries, etc.; Identifiable assets evaluation errors (cost calculation is based on taken balance, not marketable value of net assets); Award paid at acquisition (excess of purchasing price over market capitalization at the moment of purchasing); A value of all company obligations (more obligations lower the value of goodwill); Goodwill allowances methods (in different national accounting standards, allowance during the permitted by accounting standards period; immediate allowance of this value at the expense of equity capital or absence of the allowance in general is accepted); External environment influence: favorable location, favorable conjuncture, new preferences of consumers, special taxation rates, etc.; Identified assets depreciation methods;

In this context we also assume all identifiable intangible assets that are not recognized by current accounting practices (see previous section). 10 Ideally, if all assets are identified and properly valued, goodwill should be equal to zero. But that is impossible, since many assets just cannot be fairly valued, and some of them are even hard to identify.

The marketable value of both assets and the business as a whole is determined for cases of probable most effective utilization.11 It is obvious that the most effective methods of use for separate assets and business as a whole cannot coincide: The asset markets develop under the influence of different factors than the business markets. In other words, a business cost is determined by money flows from sale of the goods or services produced by the business and the cost of separate assets necessary for production by money flows from sale of these assets. Thus, efficient use of the business as a whole and of separate assets are non-comparable, which means that the business as a whole and separate assets marketable values are also non-comparable. Completeness of company asset representation in the balance sheet does not matter: If the cost of all assets is entered into the balance sheet, even those not identified by standards of the business accounting, the sum of the assets marketable values basically will not coincide with business cost as a whole. If cost in these assets use within this business is higher than cost at average market alternative method of use, the goodwill will be positive, if not negative. Still, negative goodwill does not testify to inefficient activities within the business if we understand an effective business as the one which has assets return at an average branch level. Incomparability valuations of business as a whole and of separate assets is caused by the fact that the business valuation as a whole is made with a view of business continuation, and evaluation of each asset is made proceeding from the assumption of its independent sale (separately from the property complex included in the business). To confirm the above we will present the following provisions. Goodwill evaluation is always attached to the value assessment of a business as a whole, which non-material assets and intellectual property valuation specialists specify. Business cost calculation methods are based on revealing forecast data concerning company activities, on assets creation costs measurement or on comparison of activity indicators with the comparable companies from an objective database. From the market point of view a business cost shall not depend on the cost of its elements, as business is an "ongoing concern", and its partition into elements shall happen only with a view of real or fictitious liquidation. Acting business is always considered as a single complex which will continue to act in the foreseeable future (IFRS, Principles).12 Most material and non-material assets, at their merge in business, lose their liquidity because of their greater specificity and sometimes complete inseparability from the business. These are assets which are created specifically for this business and have no other application, as owing to technological specificity and to attachment to a business site. (Tangible examples are various constructions like bridges and pipelines; an intangible example could be a value associated with personal ties of ex-owners with clients and suppliers.) Besides, sometimes there are restrictions in their use: long-term obligations, contracts, government requirements (for example, ecological regulations), or social responsibility of the business. It is also impossible to dismiss management and personnel errors. Under these conditions, market evaluations of assets are difficult and can be replaced with substitution costs. Thus, assets often lose their independent marketable value; it remains only as a historic fact of investments realization into these assets in the past. This cost is also necessary to investors as a reference point for risk identification of present and future investments. Bringing it all together, we can conclude that the goodwill concept can be used in a narrow and a wide sense. In a narrow sense, goodwill is understood as the accounting assets meeting the financial reporting standards criteria. Only acquired goodwill is acknowledged; internally created goodwill is forbidden to reflect in the balance sheet. The goodwill size is determined as a difference between the acquisition value of the company and the book value of its material, non-material and cash assets and obligations. In a wide sense, goodwill is a complex of all intangible company assets. Hence, we can speak of the goodwill of an operating
11 12

IVS 2007 (International Valuation Standards), published by International Valuation Standards Council. Roslender R. and R. Fincham, Thinking critically about intellectual capital accounting, Accounting, Auditing & Accountability Journal, 2001, vol. 14, no. 4, pp.383-99.

company only in the meaning different from accounting sense. The approximate sense of this meaning is expressed by the terms reputation, business standing, or/and company brand. But such goodwill (in a wide sense) is not shown in the balance sheet. Some authors, speaking about goodwill, prefer to call it "the company price" or "business reputation", keeping the same sense. When investor makes a decision to invest money (or buy some company) he normally wants to know exactly what he is buying (or simply speaking, what he gets in exchange for his money). If it is a service company (an IT company that operates in the field of software development or web applications), then most likely the sum total of all of its intangible assets is much smaller than the overall company value. This value will most likely appear in some form of goodwill, but what makes these numbers? With current accounting practices, in many cases we deal with an expensive black box. This is a reason why a prospective buyer will perform a due-diligence of the company. It will help to evaluate the intangible assets owned by this company. Human Capital The term human capital came into the business lexicon after Gary Becker (University of Chicago economist and Nobel Prize-winner) published a book titled Human Capital in 1964. Becker (along with Jacob Mincer, Milton Friedman, Sherwin Rosen, and Ted Schultz) created the economic concept of human capital as distinct from typical financial or physical assets, because of its difference from them in the sense that human capital cannot be separated from the humans who possess it. It is fully in keeping with the capital concept as traditionally defined to say that expenditures on education, training, medical care, etc., are all investments in capital.13 Soon after Becker developed the concept of human capital, economists and consultants began to subdivide and classify it. Simply speaking, it means both physical and intellectual ability. Many researchers state that human resources are the most valuable assets of an organization. But how can the capital value of human resources be found using current accounting practices? For the intellectual organization that focuses on creation of various types of intellectual capital (not speculation, but real innovative development) and that has the biggest portion of its value allocated to intangible assets, people are everything. The company can be evaluated by calculating the amount of all the HR spending (salaries, payments to outsourced workers, training programs, various incentives, etc.). Someone may say that this is precisely what is done to calculate the cost, but cost is not a value the capital represents. It is more of a cost as capital value concept. It may sound nonsensical, but it basically means that if someone incurs cost it assumes that something was bought (money was changed to something). No matter whether that something was tangible or intangible in nature, it has a value and a price. More important is whenever that something is, it is useful to others (how many people would love to have it). If there were many of them, what would be their price, and how would this price be determined? Also, if that something was bought on the market, for many buyers the cost would be similar (this product or service has a fixed price). Thus it can be said that it is a sort of valuation using the market approach. However, the value really depends on the type of asset you hold and the supply/demand curves for it. If the new owner obtained it for a lower price than others, it means he has good contacts (refers to relational capital in IC concept). In relation to HR, if you have a project where you need professionals to do work for you, you dont simply spend money, but you get some quality work and even if it doesnt have a material form it still has value. For example, it could be consultation with a lawyer in Switzerland; project duration is 4-6 hours and an hourly rate would be between 300 and 1000 Swiss francs. Depending on your contacts (RC) the cost of project (outsource) will be between 1500 and 5000Chf. But after the projects completion and payment, you begin to

13

Becker, Gary, Human Capital: A Theoretical and Empirical Analysis, with Special Reference to Education (Chicago: University of Chicago Press, 1993) 15-6.

own something - it could be answers to questions asked during consultation hours or some other piece of knowledge from the lawyer consulting with you. In other words, you become the owner of some piece of intellectual capital. If it is not very specific to your needs, probably there are many others who are willing to pay a similar price for that kind of information. Thus it is really an intangible asset, which can be valued using at least the cost and market approaches (more about evaluation will be discussed in later sections of this thesis). However, the salary is a very average reflection of the real creativity of a given person and value generated (profit associated) from it. Also, there are industry leaders and lagers industry leaders are those who pay above the average salary set by industry in order to acquire the best people. Industry lagers normally pay below average, but it is not that their human resources are worse in terms of creativity, skills, knowledge or experience than those in big companies. Consider all the possible areas of expertise that are available to the modern IT companies: There are big companies that are best in providing their particular products and services on the market, but they cant be best in all possible market niches. It makes possible the situation when a little group of experts in particular field are a lot more productive in a certain task (Activity) than a research center of some big company. Also, worth mentioning is that it seems like in todays economy companies no longer compete in terms of best technology; it is the competition of patented technologies and various licenses. Research and development, including creativity, are tied by various legal barriers (patent sharks), so that many professionals are not allowed to enter a particular field of technology.

2.3 Intellectual Capital Modern lines of world economy development, strengthening of a role of intellectual and information resources for production of competitive products have led to occurrence of one of the most scaled financial problems. Its essence can be described as follows: as methods of a product creation have changed, and knowledge has turned to one of major factors of new cost creation, it is necessary to reconstruct in appropriate way the content of the public reporting of the companies before their proprietors and other investors. The reporting shall contain the information on cost major factors: company strategy, future monetary flows, non-financial activities, intangible company assets, including business standing. Of course, the public reporting is not limited to only the financial statements. As it was mentioned before, IFRS recommends publication of information about intangible assets not-recognizable by CAP. For instance, there are various notes and discussions reported in annual reports (like K-10). However, this field requires farther standardization otherwise it has little practical value. In this paper, Kretov Kirill applies some concepts of intellectual capital in order to develop a reporting model for the complete capital structure. Initially the problem of evaluation of intangible factors has arisen in information-saturated companies where the amount of material assets is insignificant, and the mental potential is high. Investors were not inclined to invest to such companies, and in front of the managers there was a task of calculation of their intangible assets value and of informing investors to create more adequate picture about the company activities of the and its prospects. Modern idea about intangible factors of new cost production are embodied in concept "intellectual capital". The managers managing companies cost are almost single in the opinion concerning the name of this phenomenon, its content, and also that modern accounting cant consider these new assets (employees competence, customers relations, computer and administrative systems, databases, etc.) 14. Some researchers even state that for intellectual capital accounting it is required new financial and administrative concept15 . Financiers discuss whether it is necessary to change traditional accounting terms (non-material assets, business standing), and also about possibility of cost evaluation of a new indicator, its accounting and showing in the reporting. Three Major Elements of Intellectual Capital Various models and theories of intellectual capital represent generalization of value factors management practice in the specific companies, and now it is admitted by both researchers and experts. For this reason each model is unique and reflects specificity of the company. At the same time, accumulating of experience and knowledge of an intellectual capital by the beginning of current decade has allowed to determine general approaches, to develop more or less single structure of companies knowledge assets. Almost all this problem researchers and managers allocate three components of intellectual capital: 1) human capital (HC); 2) structural, or organizational, capital (SC); 3) customer capital (CC).

14

Richard Petty, James Guthrie. Intellectual Capital Literature Review. Measurement, reporting and management. Journal of Intellectual Capital. Vol. 1, Number 2, 2000, pp. 15576. 15 Dzinkowski, R. The measurement and management of intellectual capital. Management Accounting (UK), Vol. 78, Number 2, p. 326.

In some models16, the client capital is called the capital of relations, or connections (relational capital), but it is understood also as loyalty and customer satisfaction. Generally speaking, it is possible to estimate the human capital volume through the number of intellectual workers and the amount of information, knowledge and skills which they own, through the quantity of leaders, idea men, "revolutionaries". The value of personnel knowledge and abilities is characterized by specialists' capability to solve difficult, non-standard, unexpected problems; employees' independence and trainability; the capability of managers to deal with transformations; creative activity; tendency to partner interaction; etc. We can estimate development of the human capital through proportion of the types of activity "inspiring" on search of new solutions forcing company's employees to learn something new. At last, degree of human capital binding is estimated through personnel adherence to company's insight and values, employees' satisfaction by work and industrial relations, personnel loyalty to the company and retention of leading workers, company's reputation on the labor market, etc. (Later in the work, the Human Resources will be discussed more into details.) Organization structural capital is reflected by the number and quality of business partners; degree of business partner retention to the enterprise; integration of the value chain and an company's role in it; availability of a flexible and effective business network (on a global scale, as well); information system quality; early detection system quality; involving of pressure groups into decision making; procedures of transformation of implicit knowledge into explicit one; partnership level in the organization; quality of network interaction; completeness and quality of databases; trademarks and patents; codified knowledge of technical processes (the degree of completeness and clearness of documentation reflecting consumer value creation in the organization); collection of prototypes for economic problem solution; intellectual property; backlogs on new products; corporate culture market orientation; territorial arrangement advantages; unique technical libraries and databases, customer databases; logistic, sales, advertising, cartel contracts; overcome starting difficulties; licenses. The organization customer capital is reflected, by the following characteristics: expected discounted income from available consumers; number of regular company's customers, their share in sales amounts, average cooperation experience; customer growth quality and prospects; customers' satisfaction; company's "ownership" of the industry standard; competitive advantage with new production launch; the volume of the concluded contracts; the degree of customer retention to the organization. So, it is possible to tell that in the provided models there is more common than distinctions. The overwhelming majority of authors recognize presence of intellectual capital independent elements human, organizational, client, however they are called. At the same time, now there are a lot of terms anyhow connected with intangible assets: brand, business standing (goodwill), intellectual property, non-material assets, expenses on researches and developments. What is relation of these terms with concept of an intellectual capital? It is not quite obvious why the general name "intellectual capital" is used to combine such essentially different and frequently not having the direct relation to the intelligence phenomenon as employees' value system, enterprise image, brands, customers' loyalty. In our opinion, the uniting basis here can be the idea of intellectual capital circulation: employees' knowledge and capabilities are embodied in organizational processes and relationship with business partners that, in turn, create the base for steady relations with customers; cooperation with customers and partners leads to experience accumulating, development of enterprise employees' knowledge and capabilities.

16

Sanchez P., Chaminade C., Olea M.. Management of intangibles - An attempt to build a theory. Journal of Intellectual Capital, Vol. 1, Number 4, pp. 312327.

Ordering and systematization of existing terminology becomes pressing question on which, in particular, the method of intangible assets reporting, accepted and recognized by the accounting organizations will depend.

About the author Present article is a part of Doctorate Thesis written by Dr. Kretov Kirill (Master of Arts in Human Resource Management and Doctor of Business Administration) December 2009, Geneva, Switzerland. The author invites everyone to participate in his ongoing survey on the site http://www.kretov.ch