Intellectual capital audit

An Intellectual Capital Audit is an audit of a company’s Intellectual capital for monitoring and overseeing the intellectual capital of a firm for the purposes of capitalizing on Intellectual capital already within the company, and identifying opportunities for increasing the Intellectual capital of the company. .

Übersicht

Until recently few firms have attempted to measure and assess the new intangible, knowledge . At least one study has found that key components of intellectual capital are poorly understood, inadequately identified, inefficiently managed and inconsistently reported. The firms did not have a consistent framework to report on intellectual capital As a response, the frameworks to audit Intellectual capital have emerged from a recent branch of research in Intellectual capital. The rationale is that both financial and non-financial data on Intellectual capital should be consistently gathered using a cohesive framework.

The worth or value of an organization cannot be given by the values in the balance sheet alone. Just as the use of discounted cash-flow analysis is being accepted as a more reliable measure of value and will eventually replace other accounting-based valuations, the value of intellectual capital will need to be measured and determined.

An Intellectual Capital Audit is important for the following reasons :

• it is a rich source of data that helps to fill the gaps in the strategy to make it successful.
• it helps to evaluate and design R&D programs.
• it provides knowledge in re-engineering a firm to retain valuable capability and know-how.
• it helps plan education and training programs mutually beneficial to the employees and organization.
• it provides information on assets not recorded in traditional accounting to ascertain the value of the enterprise .
• it enables to ascertain organizational memory and expand it so that organization does not have to reinvent the wheel.

There are several steps to follow when undertaking an intellectual audit. The firm should:

• determine the purpose of the audit whether to quantify results monetarily, to set comparatives, or benchmarks.
• identify the problem space so that audit provide focus and is manageable.
• determine the aspect of the asset to be investigated (for example on customer base; it could be size, repeat business, customer profile or brand loyalty).
• assign high values as a benchmark to the asset aspect been investigated (ex. Repeat business, the high value is 100%),
• choose the audit method.

An audit can be carried out on individual intellectual items or on all intellectual items using a framework. points to appraising the firm on the perceived awareness and importance of intellectual capital, through ‘an information and self-evaluation kit’ before carrying out an intellectual audit. The ‘kit’ asks questions in broader areas such as; “What is intellectual capital?” ; “Why is it important?”. Perceived status of intellectual capital in the firm in relation to other firms; measuring of intellectual capital, and matter relating to reporting of intellectual capital. This is because anecdotal evidence suggests that measuring, reporting and managing of intellectual capital happens in an individualistic and ad-hoc manner. The ‘information and self-evaluation kit’ is still at an early development stage and can be viewed as a precursor to an internal intellectual capital audit.

Types of Audits

There are two major types of audits. One is to audit by core competencies, and the other is to audit either individual or a spectrum of audit items.

Auditing core competencies

Auditing by core competencies is one way to audit intangible assets .

The steps are:

• define the intangible assets in relation to core competencies of the firm. Each core competence is a combination of intangible assets such as knowledge and skills, standards and values, explicit know-how and technology, management processes and assets, and endowments such as image, relationships, and networks. Knowledge creation is the core competence of any firm .
• estimate the strength of each core competence with the aid of a checklist using five criteria. The checklist provides a score from 0-5. These criteria are:
  • customer benefit,
  • better than competition,
  • future potential,
  • difficult to imitate, and
  • solidly embedded.
  • determine the value of each core competence in relation to five value drivers:
  • added value,
  • competitive advantage,
  • potential,
  • sustainability and
  • robustness.

• monitor them.

Once the value of intangible assets is determined for a number of years they can be converted to an index and changes can be explained in qualitative terms. This method of auditing core competencies has certain limitations. The management time and commitment is a pre-condition. The firm should have a clear strategy to increase the value of intangibles. The thinking in terms of core competencies is easier for some organisations only .

Auditing individual or a spectrum of items

The second way involves auditing individual or a spectrum of items. Some authors have attempted to assign a monetary value to individual intellectual capital items. Measuring the monetary value of customers and contract rights (Reilly and Dandekar, 1997) are examples. The monetary measurement methods are suggested on several intellectual capital items. The measurement method can be market approach, replacement cost approach, or income approach (based on income producing capability of the asset) (Brooking, 1996, pp181-182) depends on quantity and quality of data available, purpose and objective of the exercise, and experience and judgement of the accountant . In this respect, auditing patents seems to be an established area . It could be because patents are the most tangible intellectual property that has the strongest legal protection and has the greatest effect on commercial success for certain organizations. They help protect core technologies and business methods, boost R&D, increase branding effectiveness, improve financial performance and enhance competitiveness .

To assess the financial value, many companies assign a portion of market capitalization as a proxy of their intellectual property as an alternative to individual patent measurement. Another method is to use knowledge scorecard. Knowledge scorecard is the capitalized difference (net present value) between annual normalized earnings and earnings from financial and physical assets . A primary consideration in the valuation is the strength of protection . The business and commercial value of patents is ascertained by mapping patents as growth rate in the vertical axis and their current and future use in the horizontal axis . Another way is visualize the firm’s patents along with any or all competitor patents and evaluate such things as dominance, breadth of coverage, blocking and opportunity openings . Intellectual Asset Managers through their Intellectual Asset Management Teams are responsible to develop and maintain an intellectual asset plan to align with the business strategy, and review intellectual asset portfolio at least once a year. They are also responsible to identify key intellectual assets, classify them by utilization, manage portfolio costs, where appropriate do a competitive technology and portfolio assessment, and create and staff intellectual assets team and facilitate meetings. Further, they provide leadership and support to the intellectual asset management vision and process implementation, and recommend for licensing, abandonment, donation and utilization of intellectual assets . Some companies tend to adopt measuring individual intellectual capital items as a basis to develop a comprehensive capital measurement system. For example, Dow Chemicals was developing its ‘patent tree’ into ‘knowledge tree’ to carry out an intellectual asset audit that includes their biggest intellectual asset, know how .

Brooking (1996) proposed a framework with intellectual capital items to be used as a basis to audit a spectrum of intellectual capital items. The framework was expanded by later by other authors (Australian Society of CPAs and The Society of Management Accountants of Canada, 1999, pp14; International Federation of Accountants, 1998, pp7; Dzinkowski, 1999 (b); Dzinkowski, 2000). Guthrie et.al (1999) further modified that framework to ascertain the status of intellectual capital reporting in Australia. The framework was expanded further for a more detailed analysis of human assets (Abeysekera, 2001)

Research Methods

There are several methods to carry out an internal intellectual capital audit. Different research methods may be more suitable for different intellectual capital items. Market assets are evaluated using market research, customer interviews, survey, competitive analysis, return on investment, sales and payment analysis. Intellectual property assets are audited using surveys on market pull and know-how, analysis of payments and competitors, return on investments, and auditing agreements. Infrastructure assets are audited using, interviews, return on investments, and assessing standards. Human centred assets are audited using interviews, tests and assessments, reviews, knowledge elicitation and review of records .

An external intellectual capital audit can be carried out using interview, surveys, content analysis, focus groups and case studies are the most popular method . This can be because case studies help managers to generate actionable knowledge and they are very strong lessons for the company . Description of knowledge is similar to description of story suggesting there is a meaningful link between the two. By encoding knowledge in stories, little of the leveraged value of knowledge is lost in communication . Interviews and questionnaires are used to supplement each other and used usually for larger sample sizes (Petty and Guthrie, 2000 (b)).

Most of the examples cited in the knowledge management and intellectual capital literature are based on case studies. Although case studies are one of the best ways to understand and disseminate knowledge because narratives and story telling is a very effective way to convey knowledge . However, case studies are one of the weakest empirical research methods in terms of validity and reliability (CASL, http://iisd.ca/casl/CASL Guide/ParticipantObserver.htm, 1998).

Since knowledge management and intellectual capital are about intellectual assets and liabilities, accurately measuring them in verifiable manner has not been perfected yet. It is also difficult to carry out quantitative research such as laboratory-based experiments to establish relationships of individual intellectual capital variables to results since there are other intervening and moderating variables that confound the results. The relationship of those other variables is also not established. One way to restore the empirical validity and reliability is to carry out carefully planned qualitative research. There are several established instruments such as content analysis, field studies, focus groups and case study interviews. It is necessary to reinforce these single methods with one or more other methods to enhance validity and reliability. Such empirical research approach is necessary to restore credibility and verifiability of results in the minds of the educated reader.

Audit Objects

The object to be audited can be broadly classified into an examination of documentary evidence in both written and other forms, the processes and values of the firm, and aspects of employees and their relations with others (both people and institutions). The object used to audit intellectual capital determines the research methods to be employed (refer to Figure 1) and some research methods are more suitable to examine a given audit object than others. The documentary evidence of intellectual property is legally binding, and minutes of management and board meetings reveal the status and strategic direction the firm. Company annual reports are also useful audit objects as they enable organizations to construct relationships with others to create and maintain conditions for their continued profitability and growth . It is not the only weapon available to do that. Advertising, sales promotion, public relations campaigns, political lobbying, charitable contributions and support for scientific research and so forth are more important weapons. However, annual report represents the corporate concern in a comprehensive and compact manner. Further they are regularly produced and offer a summary of management’s thoughts in each period . The purpose of annual reports can be defined as ‘demonstrating present and future performance’. Annual reports is a special communication opportunity to go beyond reporting simply financials and is a chance to show leadership and vision to reflect organisation’s value and its position . Annual reports are a good proxy to audit comparative position and trends of intellectual capital between firms, industry and countries. Several published research have used annual reports as audit objects to ascertain the status of intellectual capital of firms in Australia Australia , and between countries .

Fazit

The type of audit to be carried out is governed by factors such as time and commitment of the management to the audit. Although there are several research methods available to audit intellectual capital items, some methods are better than others for auditing a given intellectual capital item. It also depends on the level of validity of the findings required and the purpose of the audit. If the purpose is to quantify them, then a high internal validity method may be more suitable, and if the purpose is to set benchmarks then a high external validity method may be more suitable. The type of audit object to be examined is determined by the access to information, time available for the audit, and the level of validity required from the audit. A better way to approach the audit is to combine two or more methods of auditing and audit objects so that any limitation imposed by one method and object are compensated by the other. However, any audit on intellectual capital of a firm is better than no audit since it is one of the most important assets that needs to be managed consistently and efficiently to harness its value to increase the bottom line.