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I was at the FMA-NH meeting on Tuesday night talking about, what else?, intangibles.

Here's an expanded version of the deck I used and thought I would share:

The long-discussed and reviewed merger of American Airlines and USAir has finally gone through. It is the latest in a series of bankruptcies and mergers that have turned twelve airlines into four .

Mergers have a very bad record in general because more often than not, they fail to deliver achieve expected benefits. Airline mergers have an even tougher time because the industry struggles to make a profit. So there should be interest in using information that would improve the chance of the success of mergers and acquisitions. But there’s enormous momentum in our financial and accounting systems even though they miss a lot of the story in today’s businesses.

The Accounting for the American transaction hasn’t been disclosed yet (although here’s a long but interesting discussion of how the accounting might look) but there eventually will be a consolidated balance sheet of the combined entities.

Of course, the GAAP balance sheet won’t include many of the most important assets of the two organizations. Things like:

• Human Capital – Unionized workers, unionized pilots, training systems, core competencies
• Structural Capital – Systems to support reservations, route management, maintenance. Rights for routes and landing slots in airports.
• Relationship Capital – Customer relationships. Relationships with suppliers and regulators. Brands and reputations.
• Strategic Capital – Business models, culture and external market opportunities.

What if there were a consolidating and consolidated inventory of these “intangible” aspects of the two organizations? It would tell us a lot more about the prospects for success of the transaction than any of the raw numbers would.
Even better, what if there were an objective evaluation of the relative strength of each of these assets in the two organizations as a guide to how the consolidation should be handled? It would provide greater transparency among management, employees, customers, partners and regulators. And, based on our experience, lead to better decisions and, who knows, maybe even a profit for the combined airlines!

If you look at the reporting about this deal, most of it is about the intangible capital of the two airlines. However, since there is no ICounting available, the best we get is isolated pieces of a jigsaw puzzle. Here’s hoping that businesses catch on and start pulling the full puzzle together before the deal closes…

The Polish Wikipedia (pl.wikipedia.org) is the Polish-language edition of Wikipedia, it now has around 1,023,000 articles, making it the ninth-largest Wikipedia edition overall, the largest for a language which is official in only one country. It is also probably the first edition of Wikipedia with articles about postindustrial accounting and finance.

This is my translation of a part of the entry for „Financial accounting” (in polish: „Rachunkowość finansowa”):

Accounting for competence assets and intelellctual capital 

(in polish: Rachunkowość aktywów kompetencyjnych i kapitału intelektualnego)

The traditional financial accounting records of material wealth is not able to provide an image of intangible factors of production typical of the knowledge-based economy. This gap in the accounting system complements a new branch of accounting, namely financial accounting for competence assets and intellectual capital. Accounting for competence assets and intellectual capital allows you to enter into the books of the entity the knowledge worker competencies valued in the monetary terms and indicate their sources, then is possible to show in financial statments a true and fair view of knowledge-based enterprise. At the current stage of development of accounting it is not sanctioned legally mandatory part of the accounting system. However, its use provides a complete picture of the enterprise according to the principle of substance over form.

My english is far from an excellence, but I hope that reader is able to understand it. Is not? :-)

Source:

pl.wikipedia.org/wiki/Rachunkowość_finansowa

Most organizations today are highly dependent on the strength of their people, systems, processes, relationships and strategy for success. Yet these intangibles are invisible and rarely managed in a systemic or holistic way.

This is a problem because, for better or worse, people tend to pay more attention to things they can measure. Measures help frame thinking and help create a feedback loop for learning and improvement.

One of the most established measurement systems in our economy is Accounting. This is a system that has roots in 15th century Venice. It is a well-balanced system that worked well through the industrial era. These Accounting systems have taught us to manage business by the numbers. It’s all built on the foundation of “accounts,” sorting financial transactions into categories labeled as income, expenses, capital, assets, inventory, property, plant and equipment. These “accounts” are reported on financial statements as measures of performance of the organization on a monthly basis and such measures have been hallmarks of corporate performance standards for decades.

For a lot of good reasons, Accounting will never be able to address all the intangibles in a company. At Smarter-Companies, we are promoting the concept of ICounting as a complement to Accounting to fill in that gap. It is based on the concept of ICounts, which are “accounts” categorized by the type of intangibles within your organization. ICounts provide the foundation for ongoing measures of the performance and influence of intangibles on overall organizational results.

The ICounts process involves the creation of an intangible capital inventory which is then mapped out on to an intangible capital map and/or canvas. Then these elements are measured using intangible capital graphs. This approach creates a custom-designed system that describes and measures the unique intangibles of an organization—something most companies have never seen before.

The graph report uses stakeholder feedback and ratings to score the strength of an organization’s intangible capital. Yes, I said stakeholder feedback. Therein lies an important distinction from Accounting. ICounts are not developed and measured by external standards. They are developed by a team with and for their stakeholders. And the stakeholders are the judges of how well things work.

This is why we see ICounts as the ultimate leading indicator of growth, performance, valuation and reputation. It’s the net promoter score on steroids. If you have the right people, processes, partners, culture and business model in place to create value for your stakeholders, you will be successful and profitable. If you want to know how you're doing, ask your stakeholders. You’re already managing these things. Why not measure them in a holistic, systematic way? ICounts make it simple.

In recent weeks I’ve been getting ready for an exciting session on Accounting for Intangible Assets at SIBOS 2013 in Dubai next month. Working with the team for the Innotribe track has been amazing. They are helping me fine tune our ICounts open source exercises in a way that will help the bankers in the room understand the intangibles that are so critical to smarter companies.

These intangibles are mostly invisible today. That’s because the dominant information sources used today are the financial statements which were optimized for the tangible world. Financials are still important. But because they barely get at the intangibles, there is a need for a new information set. Our term for this new approach is ICounting.

The basic steps are the same in both systems: inventory, classify, measure and consolidate. But the focus is very different. Here are the basic steps in the two systems:

Everyone in business has a basic understanding of the accounting steps outlined here. But very few have translated them to the intangibles side of business. There are lots of smart companies around today. But they are figuring this stuff out on their own using gut feel and intuition. Given the fact that up to 80% of the corporate value is intangible in economies like the U.S., it creates a lot of unnecessary risk and blinds people to greater possibilities. Is that the best we can do?

We think we can do better. That’s what we’re up to at Smarter-Companies. And that’s what I’ll keep talking about at tomorrow at IPR Plaza and at Sibos. I’ll share more in the coming weeks but the best way to experience these ideas is to be there live. Hope you can make it!

There’s a new report out summarized under the headline Goodwill Impairment Holds Steady this week on the Business Finance site.

The article is full of data on things like total impairments, goodwill as a percentage of total assets, total reported versus total impaired goodwill, percentage of companies reporting impairment. All this data seems to indicate that there must be something important going on. I’m here to tell you it’s not.

What’s wrong with this picture? Instead of analyzing trends on the total amount of goodwill, someone needs to say STOP and ask why all this goodwill is there in the first place?

Because basically, goodwill is a plug number that gets booked when one company buys another. The accountants identify assets of the acquired company that can be added to the balance sheet of the acquiring company. According to an E&Y study right before the Great Recession, the acquirers' accountants can, on average, they account for 50% of the purchase price.  The rest goes into goodwill.

The reason for this is that most of the value in business today is in knowledge assets that are not eligible to be put on the balance sheet. Investments in intangibles wash through the income statement with current year operating expenses. Intangible infrastructure gets built but no one tracks it.

But when there is an acquisition, the imbalance of this approach quickly becomes apparent. Accountants have to account for the full purchase price but they don’t have any way of determining where most of the intangible value is (they usually can identify a few things like customer lists and trademarks). So they put the unidentified portion on the balance sheet and basically say that 50% of the value purchased is derived from a feeling of your customers—the “good will” that they hold for you in their hearts.

Then the charade continues as the accountants and valuators periodically recalculate the value of the business. Using fancy spreadsheets and projections, they determine if this “good will” has decreased which is then booked as a financial loss. Then, with studies like this one, the whole system just keeps rolling on. The conversation looks at all the factors that the accountants look at but nothing about the fundamentals of the underlying acquisitions.

Do you want to break away from this charade? I wish I could tell you to fire your accountants but you can’t—they have to play this game and will continue to play this game for years until accounting standards catch up with the shift away from the Industrial Era (yes, that’s where this problem started. But 10-15% goodwill back then was a logical concept. 50% is getting surreal….)

But you can develop ICounting expertise and hire an ICountant. They will help you identify all the “intangible” but very real assets you have built through years of investments in information technology, processes, data, networks, relationships, competencies (all of which are knowledge assets of one form or another). An ICountant can also help you measure these assets using both quantitative and qualitative means.

Just because the accountants call it goodwill doesn’t mean that’s what it is. Goodwill is an accounting construct. The reality is that there is a core of knowledge assets that drive the performance of a company. Don’t make another acquisition without looking beyond this artificial construct and identifying what you are really buying. 

One of the very basic tenets of accounting is that you only show as assets those things that you own. It’s completely obvious and sensible. That tenet will never change. Nor should it.

But this is one of the tenets that makes it hard to rely on accounting alone to understand how organizations work in today’s world. Because what defines a company or an organization today is not really what you own. It’s about what you attract. Can you attract the right people, the right partners, the right customers to collaborate and contribute to your mission and your business model? Will these people contribute their ideas and knowledge to support that mission? Are they engaged and do they trust you enough to share their best ideas? Will they help you build a better organization going into the future?

These relationships are assets but not the kind you own. That’s where ICounting comes in. ICounting identifies the key assets (both owned and volunteered) that an organization can count on to fulfill its mission. How does an ICountant know that an intangible is an asset that the organization can count on? By measuring them in the right way—going right to the source and asking the stakeholders themselves. If you identify all the key intangible capital assets connected to an organization and if the stakeholders say that those assets are a positive contribution to meeting their needs, then you have one of the best measures you can get. Stakeholder satisfaction today tells you much more about next year’s profits than last year’s profits do.

Figure out all the intangibles you need to keep your stakeholders satisfied and you’ll have the best kind of asset inventory. You’ll understand which assets are driving your results.

For more on this idea, check out our new paper, Do You Know Which Intangibles Drive Your Organization’s Results?

In my post last week about ICountants versus Accountants, I talked about the critical role that accountants play in conforming to accounting and reporting standards. These standards are critical to the functioning of our economy—they ensure that readers can understand and trust the information in the financials.

Beyond statutory reporting, financial accounting is still the best way to understand historical financial flows and profitability. Accounting is set up to track cash and it does a great job at it. The problem is that a lot of the value creation in today’s world is hiding in cash items that serve a different purpose today.

In traditional accounting, human capital is an expense. The money you spend to build connections with your partners and clients is an expense. The money you spend to develop data or processes is an expense. The money you spend on research and innovation is an expense. The money you spend to create a productive, trusting culture that attracts employees and customers and partners to your company is an expense. In the tangible industrial era, these items really were current-year expenses. But today, there’s something more going on.

Today, these “intangible” expenses are investments in the future of your company with value lasting well beyond the current year. Competencies and knowledge and connections. There are many good reasons why accounting has to expense the money you spend to build this intangible capital infrastructure. And I don’t advocate changing accounting (at least not yet). But I do advocate thinking differently—and more strategically. That’s where ICountants come in.

ICountants help you see the lasting infrastructure you build with all the money that gets expensed in traditional accounting. Rather than talking to you about last year’s cash, ICountants talk to you about your value creation capability for tomorrow. That’s a lot more strategic and much more proactive if you want to generate cash in the coming months and years.

ICountants and ICounting help you build records of your intangible capital infrastructure. Having good information and measures of the people, knowledge, connections and innovation capacity you rely on will help you think more strategically about the future. We offer our introductory tools in an open source form (please help yourself!). And we train and are building a global network of ICountants who can help you on the journey.

If you are serious about growth and innovation for tomorrow, you’ll want to get started with ICounting today.

Accounting has roots that go back 500 years to Columbus-era Venice when local  merchants built global businesses and needed ways of keeping track of their financial transactions. This system worked well over the following centuries even as the global economy changed dramatically through industrialization. That’s because it is a system to track financial transactions. The system works really well for arms-length purchase and sale of tangible assets.

This system helped measure the financial health and success of an organization. But in today’s economy, accounting is facing some real challenges. A lot of the value created in and by an organization happens outside the view of the accounting system. In order to understand the health and success of an organization today, you need to look beyond the assets captured in the accounting system.

Workers thinking, processes improved, problems solved, lines of code written, designs drawn, relationships created, worker motivated—all of these exist in the accounting system only as operating expenses, here today and gone tomorrow. That’s the problem. Because what’s happening inside companies today leaves behind a footprint, a lasting value, a renewable and, most importantly a re-usable resource. Human capital, relationship capital, structural capital (knowledge, processes, designs, etc) and strategic capital are all long-lived assets that are the infrastructure driving the financial success of companies today.

ICounting is based on the principle that the knowledge and data and processes and relationships you form in your work have a lasting value. Rather than relying on financial transactions, ICounting looks at the value created by the exchange of knowledge and solutions. And the long-term infrastructure that gets left behind in the form of competencies, processes, data, networks, designs and trust. If you want to understand the health and success of an organization, you’ll need to understand these “intangibles.” And to do that, you’ll need to find an ICountant. Or to become an ICountant. For more information, visit the ICounts section of our website.

I had a lot of fun on the IC for IP panel this week at the Intellectual Property Business Congress in Boston. The level of appreciation for the links between IP and IC weren’t too surprising. What was surprising to me was how much we ended up talking about accounting.

There are many cases of millions and billions worth of patents that had literally no value in the accounting until they are sold and suddenly, voila, there’s new value on the balance sheet that wasn't there before. One woman told the story of an acquisition that involved literally billions in patents and only 12 people. The financial people struggled to show why the value made sense. These huge shifts lead to greater and greater distrust of accounting.

But the most powerful discussions were about how the patents aren’t really the source of the value—it’s the knowledge and intangibles behind them. IP is a protection that facilitates the identification and the trading of value but you have to look beyond the IP to see (and ultimately monetize) that value.

One of my co-presenters explained it by contrasting two recent acquisitions by the same buyer, a mid-sized robotics technology company. Both came with a handful of good patents. Both sets of patents added to the company’s protective legal “moat” in their core technology areas. But one deal earned a very small price and the other a very high price. The Chief Legal Officer explained that the difference in price was due to the intangible capital that came with the intellectual property. The IC in this case was the team (human capital) and the systems (structural capital) and the connections (relationship capital) that came with the acquisition. The only element they didn’t “buy” was the strategic capital. In fact, he discussed at length the need for implanting the company’s culture into the team from the acquired company. Pure knowledge has a much more limited value than knowledge put to work. These differences were mostly booked to goodwill.

Discussions like these make it more clear to me than ever that we need to continue to create an alternate system. Not to replace accounting. But to complement it. And to get managers the information they need to manage their business and, ultimately, to manage their finances. Because companies spend a lot of money on intangibles. And they need ways to measure the effectiveness of that investment.

All this is why we started a movement for ICounting, to empower teams to create their own information sets about their intangibles. The main principles are the same: inventory and measure your assets. The difference is that we are inventorying intangibles and measuring them through stakeholder ratings. When you think about it, stakeholder usefulness is the ultimate leading indicator of profitability and the direct tie back to Accounting.

Ask your Accountant if they are learning ICounting. Hire an ICountant to help you. Learn the principles yourself with our open source tools. Some day, you’ll do all three. But don’t sit and wait for the system to change. Create a system that works for you today.

How much do you spend every year on accounting? It’s probably a lot. And at the end of the day, you get a balance sheet that explains just 20% of your total corporate value. You get very little information about your capacity to generate future growth, earnings and value.

That’s because the source of competitive advantage for every company has shifted. It used to come from hard assets you could see on the balance sheet. Today it’s about the quality of your people, processes, networks and knowledge. All of these are invisible in accounting even though they are economic assets that you spend a lot of money and time to develop and maintain.

How can you get information on these things? By improving your ICounting. Even if you don’t call it that, you probably spend time measuring different aspects of your intangibles. I don’t know if it works out exactly like this but in my experience, most companies spend 80% of their measurement budget on the accounting that only supplies information on 20% of their asset value.

Now I know that you can’t stop spending on accounting. And there are lots of other good reasons to use it. But none of them cancel out the fact that you aren’t getting critical information about the viability of your company.

The good news? You can make a very small amount of money go a long way with ICounting. It’s a system you can design yourself or with the help of an ICountant. The steps are simple:

• Identify – Just as with accounting, you have to start with an inventory (we offer an open source inventory tool to help you with this)
• Visualize – Think of this as the modern equivalent of a balance sheet. How do you present a single, high-level view of all your intangibles? (we also offer open source visualization tools for this step)
• Measure – There are lots of options here (here’s an article in our library on the ABC’s of Intangibles Assessment)
• Optimize – With a succinct statement of which intangibles are driving your results and how they measure up, you can’t help but take action.

Our goal with ICounting is that you spend 20% of your measurement budget to cover 80% of your value. Not a bad deal.