From the event announcement:

Did you know that a balance sheet presented under U.S. generally accepted accounting principles can only explain 20% of the value of the average company? The rest is lumped together as “intangible.” Very little is known or understood about this hidden 80% of value, yet this information gap affects the ability of management teams everywhere to make the right decisions and drive growth performance, as well determine the true value of their company.

These intangibles reflect the shift of companies toward greater dependence on knowledge. These “unrecognized” intangibles include a broad range of capabilities and “assets” such as data, networks and processes that together make up the fundamental infrastructure of the modern business.

Management accountants have a unique opportunity to unlock the secrets of this hidden 80% of corporate value. This presentation will explain how you, as a management accountant, can be a valued partner to your fellow managers and peers in identifying, measuring and monetizing these critical intangibles. We will draw from the recent IMA Statement on Management Accounting entitled Unrecognized Intangibles: Identification, Management and Reporting and the book Intangible Capital: Putting Knowledge to Work in the 21st Century Organization, both co-authored by our speakers, Mary Adams and Michael Oleksak.

More information and registration

Last month we attended The Conference Board’s two-day program on Job Growth and Intangibles: New Building Blocks for Jobs and Economic Growth: Intangible Assets as Sources of Increased Productivity and Enterprise Value.  The conference had two themes: policy (the government people) and strategy (the business people).

Fed Chief Ben Bernanke gave the opening address, speaking about intangibles, innovation and job growth.  Bernanke did not bang his shoe on the podium or make any hand gestures

while speaking about this, probably to avoid sending signals to the intangible stock market about his intentions.

He did use the phrase “intangible capital” four times in its proper context, and overall gave a forward looking presentation.  You can read highlights of the speech here.

Many attendees were interviewed during the rest of the conference with the one-to two-minutes posted on YouTube.  Here’s my interview.

People attended from all over the world, which is appropriate because Europe and Asia are far ahead of the US in recognizing the value of intangible capital.  The Brazilian development bank even has an intangible component in its credit ratings for long-term borrowers.  Again, though, the divide was between the government/academic community who want measures for investment and results on research and development and innovation and how to correlate this with job growth and economic growth.

Those of us involved in business recognize the value of government investment and academic research over the years and the job growth that has resulted. (Think of the innovation out of the Defense Department and MIT alone.)   But we are more interested in how this applies to individual companies.

In various forums, we were able to point out that the balance sheet is basically worthless in trying to understand a service company, knowledge-based company or technology company.  You must understand your own firm’s intangible capital to 1) manage it better to increase value and 2) tell the company’s story better to borrow funds, attract investors or get the right price from an acquirer.

Many people at the conference started to understand how investing in and measuring intangible capital can make a difference in individual companies, just as we business-types got some insight about the approaches by the policy types.

The photo was taken earlier this week at the Exit Planning Exchange Summit 2011.  The twist was that the legend for the graphs was hidden by a red pattern that could be filtered out with special glasses.

Everyone at XPX advises private companies and their owners on building and realizing value. OK, so I was nervous about trying this out in this very professional group. But it turned out to be a lot of fun!

The glasses were a great way to engage these professionals in conversations about the fact that 80% of the value of the average company is intangible — but hardly anyone  actually makes the drivers behind this huge value, well, tangible.

Here is one of the handouts we were viewing:

Don’t have red glasses? Want to know more? Check out the slides at www.icvaluedrivers.com and click contact us!

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When there is incomplete information about the details of business, reputation becomes a proxy for its overall success. That’s how small problems can have much greater effect than perhaps they should. If stakeholders do not have a clear picture of what’s going on, they will assume the worst. In the long run, we believe that good intangibles management and transparent communication will diminish the wild swings of reputation that many companies experience today. In the short run, you can make this happen yourself.

1. Do Things Right

It may sound overly simplistic to say it but the principal way that you should manage your reputation is by getting everything else right. That is the essence of the challenge. Reputation is influenced by what you do, how you do it and what you say about it. The best defense is to do it all as well as possible. The best way to do that? Glad you asked. The answer is to build structural capital.

In the first section of this book, you (hopefully) learned that structural capital is a great way to get rich. Good structural capital takes knowledge and turns it into repeatable, scalable processes that have a low marginal cost. Google’s search engine is the best example there is of this kind of structural capital, $22 billion in revenues and counting. But there is another advantage to structural capital: it enshrines “best practices” of your organization in reusable form. There are different levels of structural capital, with varying degrees of power and benefit. As we look at these levels, you will see a repeat of a number of concepts from earlier parts of the book.

If you take what you know and record it, you have yourself a set of policies. Policies are good because they create a standard by which work can be done. They also provide a tool by which work can be audited. And hopefully a set of data that can be used to measure success of the policy.

While policies are good, processes are better. Processes are work patterns that are used over and over again in an organization. They are the operationalization of policies. They put policies to work. The best kind of process is automated. It is integrated with the everyday work or the organization. If it is implemented correctly, this ensures that the policy is also followed. All the time.

The best processes of all are those that are audited. A lot of intangibles management should be incorporated into internal reviews of processes and controls. This ensures that learning will happen over time. And, of course, there is always the command and control aspect. Audits are a good way to enforce standards—I am much more likely to do something if I know that someone is watching.

Many recent problems in global supply chains have been the source of a number of reputational crises in recent memory. Lead paint used on toys supplied to Mattel. Tainted peanut butter supplied to Kellogg for crackers. Contaminated milk in China. These kinds of mistakes obviously indicate a problem somewhere between the policy, the process and the audit. They become reputational crises because they cause sickness and/or endanger the health of large numbers of people.

But the size of the crisis really depends on whether or not the company can pinpoint the problem. The important facts are what happened, how it happened and what the company is doing to ensure that it will not happen again. The size of the crisis grows depending on which of these three questions you can answer. If you are facing a problem, what happened is already obvious. But can you explain—in light of the policy, process and audits that you surely have—how it happened? That will diminish the crisis somewhat. But the most important thing you can do is explain how you have changed your policy, process and audit so it doesn’t happen again. Can you answer these questions?

Seen this way, reputation truly is the bottom line for the quality of your operations, your knowledge factory. Good process and quality control are your best insurance policies for continued reputational success. The quality movement has already moved into more and more knowledge processes. Over time, knowledge processes will be managed with greater and greater rigor. It will be in everyone’s best interest.

2. Be Proactive

The next basic rule for managing your reputation is to be proactive. That means communicating early and often about what you do and how you do it. There are a number of channels of communication with stakeholders—and the number grows every day. Corporate communications, marketing and, really, every client-facing staff person is part of this communication process.

In this discussion, it is important to make a distinction between your reputation and your brand. They are related but have some important differences. Up to this point, we have actually talked a number of times about brand as an asset of your organization. Brands are part of the relationship capital of your organization. Brand is usually associated with a product or service so, by definition, it is something that you create and build. You can actually protect your brand legally. You invest in trying to influence how people understand your brand through activities such as advertising. Ultimately, you have a lot to say about how your brand is defined and how it is perceived in the marketplace.

Your brand can affect your reputation. But reputation encompasses much more than that. As we have said, it is the sum total of your entire organization. While everything you do as an organization influences your reputation, it is ultimately external stakeholders that will give you the thumbs up or down. You should try to help your stakeholders understand the important factors of your operation in order to support your reputation. But there is less room for the kind of artful and creative communication that marks good brand building. With reputation, you need to let the facts speak for themselves. The best protection against unexpected challenges to your reputation is consistent and proactive communication. Build and protect your reputation by providing good information about your operations—tangible and intangible—on an on-going basis.

3. Be Transparent

We recently worked with Nick Shepherd on a paper for the Institute of Management Accounting on intangibles reporting. We undertook this paper together because we shared a belief with Nick that there will be significant changes in the reporting of intangibles in coming years. Nick helped us see the historical context to this trend. The current reporting paradigms were created in the aftermath of the Great Depression. Prior to that time, shareholders in a company did not have access to its financial statements. When new reporting requirements made this mandatory, they were met with all kinds of resistance and fear. Yet, today, we cannot imagine making an investment without this basic information.

We see new changes coming in reporting. The reason why was put very succinctly by former SEC Chairman Cox a few years ago:

At a time when we have 24-hour news—and even 24-hour pizza delivery—why are we still living by the 10-K and the 10-Q? If investors are going to be responsible for the growth of their investments, for picking which funds to put into their 401(k) nest eggs, they’ll need user friendly, responsive numbers that are easily accessible.

What will be the driver of this change? Will it be a top-down imposition of new reporting standards by a governmental agency? We do not believe so. That’s so industrial era. We believe, we hope that it will be a bottom-up movement from stakeholders like investors, analysts, bankers, boards of directors and even managers. Stakeholders that want to understand the full picture of what is really going on in a company. Stakeholders that know that a knowledge-dependent company should be able to describe and measure the knowledge side of its business.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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The first driver is the shift in the control of the means of production. In the industrial era, a company’s profits were driven by what it owned. Workers had to come to the employer to get access to the means of production. It gave companies a greater level of control over its workers. With the rise of the knowledge economy, however, the knowledge held by employees and, indeed, external stakeholders have become an important part of a corporation’s “means of production.” The knowledge factory relies on the unique contribution of human and relationship capital elements. This shift in the balance of power means that companies have to pay more attention to the interests and priorities of their stakeholders as “partners” in the success of the knowledge factory.

The second driver of the increased focus on reputation is the acceleration of communications. If you didn’t understand this before, you certainly do now given the events of wikileaks, Tunisia, and Egypt. Blogs, Twitter, Facebook and other social networks are just the latest developments in a society that had already developed 24-hour news. It is easier than ever before for anyone to get a message out. Sometimes all it takes is a blog post or a YouTube video by one disgruntled customer to go viral and threaten your reputation in an instant.

The third driver is an increased interest in sustainability and corporate social responsibility. Sustainability is an umbrella term for a number of related trends including corporate social responsibility and triple bottom line. CFO magazine defines sustainability as “the practice of publicizing a company’s environmental and social risks, responsibilities and opportunities…it can be thought of as an environmental-impact statement for the entire corporation, with ‘environment’ defined not only in terms of natural resources and climatological effects but also the economic and social impacts of labor practices, charitable endeavors and governance structures.”

The fourth and final driver is the lack of transparency of intangibles. There is a shocking lack of information available to internal and external stakeholders about the knowledge side of business. So when news does get out about a problem or a failure, then the reaction is swift and often very negative. If your stakeholders don’t understand how your business works and don’t receive periodic information beyond just the financials, then bad news is a warning to get out. The less your stakeholders understand about your business and the less you share about non-financial aspects of it, the more vulnerable you are to severe reactions to bad financial news.

You need to consider all four drivers as you think about managing your reputation. But we ask you to pay special attention to the last driver—intangibles reporting. You have a lot of control over your reputation—if you are getting the kind and quality of information to your stakeholders. And very few companies have developed good reporting on intangibles. That means that the 80% of corporate value that is driven by intangibles is invisible. Stakeholders can only guess at it unless you give them the information they need. This is really the goal of Intangible Capital. Helping you see, leverage and communicate about your intangibles. Because it will help you perform better AND because it will help you get the reputation you deserve.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

In thinking about reputation, however, it is important to flip the perspective and see your company through the eyes of your people and your partners. As contributors to the knowledge factory, they are also stakeholders in its success. What do they think of the organization? Does it seem sustainable? Is it a place they want to be or to do business with?

There are countless factors influencing that judgment by your employees and stakeholders. For your employees, it’s about being a good place to work, about compensation and growth. For your customers, it’s about your product, your service, your pricing and how you stand up against the competition. For both, it’s about the quality of your structural capital, the amount of collective knowledge in your system, how you use what you know to create value.

Increasingly, it’s also about how you behave as a corporate citizen. Your environmental footprint, your social contributions, your fairness and transparency. The perspective that’s important here is the perspective of the employee and the stakeholder. It’s about what they think, not what you think. And whether what they think is enough of an incentive to stay connected to you.

There are also new categories of relationship capital that must be mentioned. These include stakeholders such as investors, bankers, neighbors, markets, and even society as a whole. Investors are interested in your financial results and your capacity to continue to produce results in the future. Bankers have a direct interest in the continuing success and viability of your business. Neighbors include the communities that live and work near your facilities or are affected by your product or services. Markets include your competitors and participants in markets related to yours. Society as a whole includes stakeholders that are interested in legal, environmental and systemic consequences of your organization’s actions. Each of these has varied interests. And any one of them can withdraw their support if they believe their interests are not being served.

What holds the whole thing together? Your reputation. Being a good (or good enough) employer. Being a good (or good enough) partner. Your stakeholders collectively create your reputation and they will make their stay-or-leave decisions based on that same reputation. That means that your reputation is your license to earn money in the future. Last year’s earnings tell you the financial bottom line but they don’t tell you whether you are in a good position for a repeat performance. For this, reputation is a much stronger indicator. As the sum total of your company’s value, your reputation will be set through the consensus of your stakeholders. And ultimately, your reputation becomes a leading indicator of your financial earnings. Which is more than enough reason for anyone (even those who view “shareholder value” as measured by short-term stock swings) to pay attention to intangibles and reputation.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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U.S. business culture is very much about results. Two of the ideas that best capture this perspective are the concepts of the “bottom line” and “shareholder value.” The bottom line is a financial calculation. As we have made clear throughout this book, the integrity of financial statements that are used to calculate the profit or loss of an enterprise is seriously compromised by their failure to address knowledge intangibles. Profit and cash flow are still important to the day-to-day survival of a business. But focusing on today’s bottom line without regard to tomorrow’s bottom line can lead you to make bad decisions: To outsource a function that should be a core competency. To fail to invest in an intangible that will preserve and protect a competitive advantage.

Peter Drucker put it this way in the Essential Drucker (p. 111):

Our traditional mind-set…has always somehow perceived business as buying cheap and selling dear. The new approach defines a business as the organization that adds value and creates wealth.

The question of value has actually been at the forefront of American business vocabulary for several decades. The “maximization of shareholder value” is a core doctrine that has rarely been subject to much question. Who could argue? It seems to be the most sensible idea there is; a corporation must measure itself by the value it builds for its shareholders. The problem has come in how this idea has been applied.

The principal metric used for evaluating a public company’s shareholder value is its stock price. Again, seemingly simple on the surface. But stock prices move minute to minute and day to day. This is an even shorter-term measure than is last year’s bottom line. Yet it is regularly used as a justification for strategic decisions, not to mention employee compensation schemes. Seen this way, the concept of shareholder value and the bottom line have been at the root of a lot of dangerous short-term thinking.

Many associate Jack Welch, former CEO of GE, with this concept, citing a speech Welch gave in 1981 entitled, “Growing Fast in a Slow-Growth Economy.” But in March, 2009 he denied that he ever intended to send a message that share price should be of paramount importance. He told the Financial Times that, “The idea that shareholder value is a strategy is insane…Shareholder value is a result, not a strategy…Your main constituencies are your employees, your customers and your products.” 

Then in September, 2009, the Aspen Institute released a paper signed by a group of 28 executives that included Warren Buffet (CEO, Berkshire Hathaway), Lou Gerstner (Retired CEO, IBM) and John Bogle (Founder, The Vanguard Group). The paper, entitled Overcoming Short-termism, opens by saying:

In recent years, boards, managers, shareholders with varying agendas and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation…We believe that short-term objectives have eroded faith in corporations…Restoring that faith critically requires restoring a long-term focus…if not voluntarily, then by appropriate regulation. 

There are those that believe that in the long term, shareholders themselves will force a move away from a short-term perspective. The majority of public stock in the U.S. and the U.K. is now owned by small investors or by pension and investment plans–whose money comes from everyday citizens. In The New Capitalists: How Citizen Investors Are Reshaping the Corporate Agenda, Stephen Davis, Jon Lukomnik and David Pitt-Watson make the case that this change in ownership will drive increased corporate activism. These “citizen investors” are beginning to realize that they have a voice. And the voice is not focused on one company or another maximizing profits to the detriment of the economy as a whole. This voice is concerned with profits but also with long-term value creation and responsible corporate citizenship.

How will it happen? Probably when a lot of threads come together:

• changing business models to meet the new innovation design constraints of the 21st century
• changing attitudes about corporate obligations
• and, (if we have anything to do with it!!) the growing realization that corporate information is leaving out the intangible side of business.

Intangibles represent 80% of the value of the average corporation but these are mistakenly assumed to be non-financial assets without lasting value. The contrary is actually true. The enduring value in an organization is in its knowledge, its brand, its culture, its processes and its people. When we get these assets into the spotlight where they belong, it will change how decisions are made and businesspeople will be in a much better position to think long term.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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But in the knowledge economy, it is no longer enough to just produce a strong bottom line. It may sound a little bold to “replace” the most important metric of business success—profits and cash—with an intangible like reputation. Before you panic and skip this post, remember that we are both former bankers. We are huge believers in financial success. We are not trying to get you to change your mind about the financial bottom line. It is as important as ever. But, as you must have figured out by now, the knowledge era has made business more complicated.

The financial bottom line still tells you whether or not your company made money, but that’s about all. As we have explained in detail in the previous chapters, financials do not report on the intangible production capacity of your business. They don’t capture the operating story as you invest in, operate and monetize your intangible capital through your knowledge factory. And, most importantly for your reputation, very little concrete information on intangibles gets through to your stakeholders.

This lack of good information on intangibles means that for many external partners, your business is a black box. They cannot see inside the black box but will assume it is working well as long as you are making money. When something goes wrong, however, and word gets out, they assume that there is probably more bad news on the way. Your stock price will go down. Your partners will start to worry. Job candidates will think twice about joining you. Existing employees doubt the wisdom of sticking around. Even an isolated problem can quickly damage your overall reputation.

The focus on reputation is also being fueled by a second large-scale trend. There is increased pressure on businesses to not only make money but also to be good citizens of the world. This means that the metrics by which you are measured is changing. Add this to the intangibles information gap, and you have a pretty confusing environment for the average businessperson. To date, most companies are hanging tight, figuring that it is better to not say anything than to say the wrong thing. But your stakeholders are going to make up their minds about you anyway. Wouldn’t you be better off to help them make the best possible decision?

How to do this? We believe that the answer lies in developing robust intangibles measurement systems. You have to be able to describe what you do, how you do it and what kind of results you produce—for your own organization, for your community and for the environment.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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This red band is the reason we focus on “intangibles.” Intangible is the word for the value that is left unaccounted for by accountants and missing in most corporate information. So the red band could be called a cop out. It definitely is a dangerous information gap. An information gap that leaves corporate stakeholders without any hard data on what the true productive capacity of their organization is.

When you think about it, it’s incredible that the intangible information gap still exists. American business culture is supremely focused on getting hard data to make decisions. Yet the business community continues to turn a blind eye to the fact that they lack information on the lion’s share of their corporate value and success. Yes, a good manager has an intuitive feel for the intangible drivers of his or her business. But, if you asked them or their stakeholders whether a business should rely primarily on intuition, they would laugh you out of the board room.

Most people are in a state of denial. Why? We think there are two reasons.

First, no one is asking management teams for this information. Remember that the investment community, corporate managers, boards of directors, bankers, accountants and even regulators all studied in the same schools. They read the same business publications. They all lack the background to ask the right questions and to get accurate answers. So no one asks and no one answers.

Second, as so often happens with change, people think they have a vested interest in the status quo. For example, if you ask an analyst or investor, they will tell you that they already follow intangibles. They spend a lot of time reading about the company and speaking to management in order to identify the critical value drivers and “get behind the numbers” to supplement their own understanding of the company’s results. They are right to a degree. In fact, analysts and investors often develop their own analytical models as a way to make sense of company and industry results. Many are very fond of their way of looking at the world and feel that their analytical approaches represent personal intangible capital, their own unique value, which gives them a leg up on their own competitors. Why would they seek more transparency?

You could say that managers as a group have a particularly strong vested interest in the current system. The importance of a manager increases in situations where there is poor information. In these cases, the manager becomes a critical information source. In fact, communication of information (both up and down the organization) was as important role of managers in the industrial model. Seeking more transparency may diminish this traditional role although there is still plenty for managers to do in the knowledge enterprise.

These barriers are not insurmountable. However, they do exist. And any successful effort to change the status quo must address them directly.

Our book, this blog and our community are all part of our effort to address these barriers. The lack of understanding of intangibles holds back all the stakeholders in our financial system. We hope that improved understanding will lead investors, boards, managers and stakeholders of all kinds to start asking the right questions.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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Triangulation is an approach used in a number of disciplines (including surveying and astronomy) using known points to plot out an unknown distance or space. With intangibles, you can use these three kinds of data—investment, assessment and indicators—to plot out the landscape of your intangibles and get comfortable with the future earnings potential of your business.

In this drawing, the starting point is the investment calculation for intangibles. Since it is a financial measurement, we show it intersecting with the calculation of earnings potential. But assessment and indicators are non-financial metrics. They shed light on the capacity of the intangibles through analysis (assessment) and direct measurement (indicators). That’s why they are shown as defining a different shape, although it is one that overlaps with the earnings potential. Triangulation of intangibles does not add up to an auditable number. But it does shed light on the critical intangible sources of value and future earnings potential of a company. And these measures provide much richer and more accurate information than the gut feel of a manager or an analyst that is in use today.
The exact measurement of intangibles is still in its infancy. Over time, our collective skills in this kind of analysis will improve. But if you use investment, assessment and indicators, you will be able to triangulate, to come up with an understanding of the health and workings of your organization’s intangibles. Most reporting solutions, in fact, use a combination of these metrics to help create a data set about intangibles.

An Example

One of the best generic examples of this approach was suggested by the PwC Corporate Reporting Group. It is a Value Analysis Statement that combines a several measurement approaches. The left-hand column includes 21 value-creating activities divided into six categories of value: innovation, brand, customer, human capital, supply chain and environmental/social. Then for each category, various data columns report:

• Historic cash flow from that activity
• Prospective cash flow indicator (an arrow up, level or down)
• Risk indicators (names the risks but does not measure)
• Non-financial indicators
• Historic trends for the non-financial indicators
• Objective for the non-financial indicators going forward

This is a sound approach from that combines the several kinds of intangibles data—investment, assessment and indicators—with financial results to give a richer picture of the drivers behind the numbers.

We are in the process of creating some scorecards like this for our clients. We’ll try to provide more examples soon.

Adapted from Intangible Capital: Putting Knowledge to Work in the 21st Century Organization by Mary Adams and Michael Oleksak.

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