For this assignment, research two contemporary accounting topics, such as valuing intellectual capital and International Financial Reporting Standards (IFRS), and how thes

Did you know that assets comprising 86% of the market value of Dow Jones Industrial Average compa-

nies are not reported in financial statements? Perhaps not, if you think of company value strictly from an accounting standpoint. ¶As the late Roger Sinclair forcefully argued in three articles on CFO.com, it seems crazy that accounting

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PENSIONS

an idea that has two main components: (1) key talent is the only thing that drives the creation of intellectual capi- tal; and (2) because internally created intellectual capital isn’t in the financial statements (only acquired intellectual capital is, in the form of goodwill), executives don’t pay enough attention to developing key talent.

So, CEOs and CFOs don’t under- stand that critical roles—like product development talent at pharmaceutical and technology companies or market- ing talent at consumer products com- panies—are enormously valuable?

“I think that intuitively they do,” says McGuire. “But because those

rules still prohibit companies from in- cluding the value of internally created intangible assets alongside tangible assets in their financial statements. After all, there’s no debate that today, a majority of most companies’ market value derives from brands, patents, technologies, and other intellectual capital. That wasn’t the case when the process of standardizing accounting practices began hundreds of years ago. It wasn’t even the case, for the most part, 30 years ago.

Sinclair was a brand valuation expert who largely spent his later years beating this drum. Put simply, he wanted the value of brands to be more visible to investors.

Another party beating the drum these days, but with a somewhat different purpose, is a firm called Talent Growth Advisors. The firm specializes in helping companies build talent strategies that link to business value. Its co-founders and managing directors are Tom McGuire, a former CFO of Revlon who also worked at Coca-Cola in finance, marketing, and talent acquisition, and Linda Brenner, a former human resources executive who also is CEO of HR technology solutions firm Skillsify.

Brenner and McGuire are pushing

values aren’t on the balance sheet, because they don’t put dollar signs beside those assets, they don’t have a metric that drives the right behaviors.” McGuire and Brenner have created a metric that, they say, achieves that end.

“The cost of developing and main- taining intellectual capital assets,” McGuire continues, “is recorded as an expense on the income statement— along with all other people costs like those for ‘HR director’ and ‘accounts payable clerk,’ which truly are ex- penses—rather than as an investment in those critical assets.”

For decades, says Brenner, compa- nies have been failing at understand- ing the important difference between key talent and everyone else.

For example, a large company typically has a recruiting department that may be responsible for filling thousands of jobs per year. “There is typically no framework for saying, ‘Let’s fill this job differently than that one,’ or ‘Let’s put our best recruiter on this one,’” says Brenner.

“The same is true for performance management: it’s the same process for everyone,” she adds. “But no game will be won in this knowledge economy by spreading limited resources as thinly and evenly as possible in this way.”

Quantifying Intangibles Given the failure of accounting rules to account for the value of intellectual cap- ital, McGuire and Brenner have created what they call a “workaround” metric.

The metric is calculated first by coming up with a company’s “enter- prise value”—market capitalization,

Intellectual Capital: The Hidden Talent Metric Talent is what drives intellectual capital, but neither are well-reflected in corporate books. By David McCann

18 CFO | December 2016 | cfo.com

HUMAN CAPITAL

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those companies are undervalued?” says McGuire. “I don’t want to say that. It can be one conclusion.”

Among the 25 companies evaluated, the average ICI was 0.86. The lowest ICI was registered by Caterpillar, at 0.48, followed by American Express (0.52), Wal-Mart (0.57), and Cisco (0.64). (See the complete list, left.)

However, McGuire cautioned that a company with a higher ICI than one in another industry is not necessarily a “better” company. Rather, companies should only be compared with others in their industry.

“For a company with a high ICI, its worth certainly depends more on intellectual capital and thus on its talent,” he says. “But every company should take the numbers in its indus- try and use them to develop talent strategies that maximize the value they get from talent.”

McGuire expects that when he performs calculations for the entire Fortune 500, those in the Dow 30 will tend to be the leaders in their respec- tive industries. “In each industry there will be a range,” he says. “If you’re at the bottom of the range, it will tell you where you could be and point you to- ward strategies that could let you get the most out of your position.”

Talent Growth Advisors also listed the 25 companies according to intel- lectual capital value per employee. In that category, one company, Visa, was an extreme outlier at more than $14 million per employee. Next was Apple, at just under $4.5 million.

Visa had relatively low head- count—about 11,000 employees for a $14 billion business—and very little investment in tangible assets, Mc- Guire notes. Apple, by comparison, had about 10 times as many employees but 16 times greater revenue and far greater tangible assets. “We will see others with similar characteristics as Visa in the Fortune 500, but I have a feeling Visa will still be at the top of the heap,” says McGuire. CFO

plus outstanding debt and market- able securities, minus cash and cash equivalents.

From that value, the adjusted book value—for purposes of this calculation, total shareholders’ equity, again ad- justed by adding debt and subtracting cash and cash equivalents—is subtract- ed. The resulting value thus consists purely of internally created intellectual capital that’s not on the books.

To that resulting value, the calcu- lation adds in the value of intangible assets that are recorded on the books, including goodwill (i.e., the value of acquired companies’ intangible assets) and trademarks. The result is called the “intellectual capital value.”

Finally, an “intellectual capital index” (ICI) is calculated by dividing the intellectual capital value by the enterprise value. The index shows how much of the company’s value is in its intellectual capital.

McGuire hopes to position the ICI as a tool that companies will actually use. “The ICI will help companies man- age the development of those internal assets and value them, even though they are not on the books,” he says.

Calculating ICI So far, while McGuire intends to cal- culate an ICI for all Fortune 500 com- panies, he’s done so for only the Dow 30 companies—as of the end of their 2015 fiscal years—except for the five that are in either the financial services or petroleum industries.

Four of the 25 companies—Boeing, Pfizer, Apple, and United Technolo- gies—had an ICI of greater than 1.0, meaning that the value of their intel- lectual capital was actually greater than their enterprise value. Their ICIs were 1.04, 1.04, 1.04, and 1.01, respec- tively. Each company has made acqui- sitions that provided enough goodwill that, when added to their internally developed intellectual capital, the com- bination outweighed their net equity.

“Some have asked, does that mean

19cfo.com | December 2016 | CFO

ICI*Company

Measuring Intellectual Capital The higher a company’s Intellectual Capital Index (ICI), the more its enterprise value comes from its brands, patents, technologies, and key talent.

*The ICI is calculated by dividing a company’s intellectual capital value by its enterprise value. The intellectual capital value is calcu- lated by subtracting adjusted book value from enterprise value and then adding the value of goodwill and trademarks.

Source: Talent Growth Advisors

Boeing 1.04

Pfizer 1.04

Apple 1.04

United Technologies 1.01

United Health 0.98

Visa 0.98

Johnson & Johnson 0.98

Procter & Gamble 0.97

Microsoft 0.93

Dupont 0.93

3M 0.91

Nike 0.91

Merck 0.89

Home Depot 0.86

IBM 0.86

Coca-Cola 0.85

Disney 0.83

McDonald’s 0.83

Intel 0.72

General Electric 0.71

Verizon 0.70

Cisco 0.64

Wal-Mart 0.57

American Express 0.52

Caterpillar 0.48

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