How does a Chief Executive Officer (CEO) make a strategic business decision?
How does an executive form an opinion on the balance between a return on an allocation of resources and the potential risk involved?
How do bankers or investors decide to invest their capital and how do they weigh up the balance between the hoped for Return On Investment (ROI) and the possible loss of their capital?
How do they ‘see’ a business? On what basis is their ‘perception’ of the business formed? How do they get a map of a business?
Medieval Measurement
Amazingly, most of today’s investment and business decisions are still based on an invention that has not yet been updated for over 500 years!
In Venice in 1494, a Franciscan monk and collaborator of Leonardo Da Vinci, Fra Luca Pacioli, invented double-entry bookkeeping and published the world’s first textbook on accounting principles and practice. Ever since, this has been the basis of investment decisions. Double-entry bookkeeping shows a map of how money and goods flow through a business.
This allowed investors and business people to ‘see’ a business, evaluate risk and return and then form an opinion on whether or not to make an investment.
In those days and even on through the industrial revolution, a business consisted of things. Things are tangibles like property, buildings, inventories, cash in the bank and so on. So the double-entry bookkeeping system seemed like a useful way of organising one’s view of the ebb and flow of these tangibles and one simply accepted this way of looking at things and then went on to make one’s investment decision.
That was then, this is now. Since the knowledge and information revolutions, it’s hard to imagine how young business people could be misled more than to be given the impression that this is what today’s businesses are still made up of – tangibles. Yet we find that in business colleges and MBA programs around the world the medieval measurement, the ‘double-entry’ view of a business, is still being taught as though it were enough.
In the 2000s we already have computers that can do more than 100 billion computations a second and we are still using pre-Newtonian physics to make our business decisions. In the next few years, this will have to change.
Knowledge-Based Companies
In knowledge-based companies like Microsoft and Google what does the traditional accounting system capture? Hardly anything.
The old accounting system is blind to knowledge-based assets and is often limited to just considering labour and material costs. In today’s fastest-growing, market-responsive businesses the cost components of many products are intellectual capital like R&D and customer-service.
As clever companies increasingly recognise their intellectual assets, they will increasingly direct their attention to developing those assets. When it comes to productivity, two heads are always better than one and that means networking – intranets, extranets and the Internet.
Intellectual Capital (IC)
These ‘far-seeing enterprises’ will be exploiting, managing and measuring the primary ingredient of their economic performance, their intellectual capital or IC as it is now being called. The intangible IC assets of information, knowledge and skill will be formalised, captured and leveraged to produce higher-valued assets, higher performance and a more profitable enterprise.
Also, hi-tech manufacturing companies of today and tomorrow will derive most of their value-added from knowledge and skill. This will have to be accountable. Those businesses that are not accounting for their IC assets will be under-valued and left behind. Those that do will more than double their assets and move ahead.
ICD and Investing in People
In business, people are now becoming more important than money. IC is becoming the most valuable asset of many corporations. IC accounting is how a modern business gets a more accurate view of its people assets when knowledge is its chief resource.
Suppose you are an investor. You can form a more useful and realistic perception of companies like Google by accounting for their ‘soft’ IC assets than you can by merely accounting for their ‘hard’ assets like their office buildings, cash and equipment.
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FACT: The value of the tangible (money) assets on today’s balance sheet is exceeded many times by the value of the IC (people) assets of the enterprise.
FACT: The intellectual capital of the enterprise is the raw material from which all financial results are derived.
FACT: The intellectual capital owned by the enterprise can be measured, managed and developed along with the financial capital and tangible assets currently recorded on the balance sheet of the enterprise.
It depends on (among other tgihns), your asset allocation which will, in turn, depend on factors such as age/proximity to retirement, number of dependants etc.A person with a high amount of net worth tied up in their home may well find that fluctuations in the value of that home will have a significant influence on total return. However, the influence of the home should decline over time as more money is diverted to other investments. Likewise, a person who has acheived their financial goals may well choose to shift to lower risk assets with lower expected returns – in effect prioritising wealth preservation over wealth creation.As a benchmark, you should be aiming to produce returns on your investments (net of tax) which are at least:1. higher than the after tax cost of any debt you may have (including home mortgage). If yoru returns are lower than this, then you are better off paying down the debt (possibly subject to diversification issues and, if your circumstances so require, an emergency fund);2. higher than the after tax return on long term government bonds of a highly rated country/government (generally being the lowest credit risk available).The other way of looking at it is to work backwards and ask: what rate of return do you need to earn in order to acheive your financial objectives within the desired time frame? You should take into account furture savings expectations, taxes etc etc. Once you know the answer to this question, you can allocate your wealth to a portfolio of assets which collectively has at least the potential to meet your objectives. As a further part of this process, you should sk how realistic your assumptions are and how much risk you are assuming with yor asset allocation – in effect are you being realistic or have you spent too much time listening to the promotors of shoddy investment products?When I last did this exercise two years ago, I cam up with a number of 6.7% pa (after tax) which I thought would be quite easy – until last year when I suffered large losses in the equities market and the real estate market.
I ‘m not sure how to start with this . I understand the concept but how do I measure the true value of IC? Is it a purely subjective value?
Real capital value of any asset depends on beneficial outcomes it can generate – accounting uses the purchase price or replacement cost values as a guide because it is easily identifiable and provides a framework to prevent fraud and other forms of defaulcation.
IC values will become part of the balance sheet when there is a need for it. Perhaps climate change accounting when it evolves will lead to development of techniques that can be more readily applied to IC. In the meantime don’t hold your breath. I have tracked this since 1985, having written a mini-thesis on this:)