This thesis examines whether intellectual capital, which represents a firm's human resources and potential to generate future economic benefits, should be identified, measured, and reported in financial statements. It finds that intellectual capital is not currently recognized, despite being a significant driver of firm value and success. This lack of information reduces the usefulness of financial reports and hinders investor decision-making. The thesis analyzes definitions and components of intellectual capital, reviews current financial reporting standards, and proposes methods for measuring and communicating information about a firm's intellectual resources, such as using fair value approaches consistent with recent FASB concepts. It concludes that intellectual capital reporting could provide valuable information to investors if reliable identification, measurement, and disclosure methods can be established.

1. AN ANALYSIS OF A SIGNIFICANT COMPONENT OF THE VALUE CREATING ASSETS OF
AN ENTITY THAT ARE CURRENLTY NOT UNDERSTOOD OR REPORTED:
INTELLECTUAL CAPITAL
by
Louis R. Billmyer
A thesis submitted in partial fulfillment of the requirements for the degree of
Master of Professional Accounting in the Department of Accounting
University of Washington
May 27, 2003

2. Louis R. Billmyer
i
TABLE OF CONTENTS
Section Page
ABSTRACT iii
INTRODUCTION 1
I. DECLINE IN THE USEFULNESS OF ACCOUNTING INFORMATION 3
The Information Gap Between External Investors and Internal Management 3
Problems with Reported Book Value of Equity Numbers 4
Impact on the Residual Income Valuation Model 5
II. THE DEFINITION AND COMPONENTS OF INTELLECUTAL CAPITAL 7
Skandia Insurance Company Defines and Analyzes Its Own Intellectual
Capital 8
Human Capital 8
Organizational Capital 9
Customer Capital 9
III. THE CURRENT FINANCIAL REPORTING ENVIRONMENT 10
The Upton Report on Financial Reporting in the New Economy 10
The Financial Accounting Standards Board (FASB) Statements of
Financial Accounting Concepts (SFAC) and Intellectual Capital 11
FASB SFAC No. 1 – Objectives of Financial Reporting by Business
Enterprises 11
FASB SFAC No. 6 – Elements of Financial Statements 11
FASB SFAC No. 5 – Recognition and Measurement in Financial
Statements of Business Enterprises 12
The FASB Statements of Financial Accounting Standards (SFAS) and
Intellectual Capital 14
FASB SFAS No. 2 – Accounting for Research and Development Costs 14
FASB SFAS No. 86 – Accounting for Costs of Computer Software to
be Sold, Leased or Otherwise Marketed 15
The International Accounting Standards Board (IASB) and Intellectual Capital 16
International Accounting Standard (IAS) No. 38 – Intangible Assets 16
The Link Between Purchased Goodwill and Intellectual Capital 17

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TABLE OF CONTENTS (cont.)
Section Page
The Definition and Components of Goodwill 17
Purchased Intellectual Capital is Recognized via Purchased Goodwill 19
FASB SFAS No. 141 – Business Combinations 20
FASB SFAS No. 142 – Goodwill and Other Intangible Assets 20
FASB SFAC No. 7 – Using Cash Flow Information and Present
Value in Accounting Measurements 21
IV. PROPOSED METHODS FOR MEASURING, VALUING, AND REPORTING
INTELLECTUAL CAPITAL 22
Derive the Value of Intellectual Capital After the Earnings Process is Complete 23
Capitalize Costs That Are Likely To Produce Probable Future Economic Benefits 25
New Accounting Paradigms To Meet Investor Demand for More Relevant
Information 27
Baruch Lev’s Blueprint for New Accounting 27
The Canadian Institute of Chartered Accountants (CICA)
Total Value Creation (TVC) System 29
Intellectual Capital Valuation Techniques Using Modified Finance Concepts of
Fair Value 30
Real Options Valuation Models 30
Valuations Based on SFAC No. 7 and the Present Value of Expected
Cash Flows 31
Reporting and Communicating Non-Financial Information About Intellectual
Capital 32
Current FASB Project Regarding Disclosure of Information About Intangible
Assets Not Recognized in Financial Statements 33
CONCLUSION 34
REFERENCES 35

4. Louis R. Billmyer
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Is the value of a firm’s intellectual capital useful to financial statement users and if so,
can intellectual capital assets be identified, measured and reported reliably in financial
statements?
ABSTRACT
This analysis investigates the issues surrounding intellectual capital and its possible inclusion in
the financial reports of public entities. Intellectual capital should be included because it will
convey important information about the success factors of an enterprise. Without recognition of
intellectual capital, balance sheet information on assets and equity are only marginally useful to
investors. Conservative accounting prevents the recognition of intellectual assets and results in
the improper application of the matching concept. As a result, the Residual Income Valuation
Model produces inaccurate business valuations further impeding the investor decision making
process. Intellectual capital can be decomposed into three primary parts: human capital,
organizational capital and customer capital. The human capital component is the most important
determinant of firm value and is the primary focus of this analysis. Though human capital will
produce future benefits, it is not clear that firms have sufficient control over this asset to allow
for recognition. In addition, reliability issues associated with limitless boundaries, no verifiable
transactions and subjective measurements all have combined to thus far prevent the recognition
of intellectual capital in financial statements.
In February 2000 the FASB published SFAC No. 7 in order to provide a foundation and method
for fair value measurements in financial statements. SFAC No. 7 promulgates the present value
of expected cash flows as an appropriate valuation method and thus could be used to value
intellectual capital. Using SFAC No. 7 valuation techniques, the FASB has already published a
standard (SFAS No. 142) to measure the value of previously purchased goodwill. Intellectual

5. Louis R. Billmyer
iv
capital is a significant component of goodwill; hence, SFAS No. 142 may be a viable precedent
for the FASB to use for inclusion of intellectual capital on financial statements.
In addition to pure fair value measuring of intellectual capital, there are other methods that have
been proposed for communicating information about the intellectual resources of an entity. The
proposals include qualitative metrics, cost capitalization and new accounting paradigms. The
ideal solution includes components from each of these methods combined in one
comprehensive standard on intellectual capital.

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INTRODUCTION
In the broadest view, intellectual capital assets are human beings and their combined potential
to generate future economic benefits for an enterprise. It is difficult to imagine a successful
business that operates without human beings as the primary contributor to its success. Hence,
it can be stated that intellectual capital is the unrecognized foundation of a successful modern
business. Of course, this is not a completely true statement. Successful companies recognize
the value and importance of their intellectual capital assets and invest heavily in developing
those assets. Where intellectual capital goes unrecognized is in the resulting financial reports
that are produced by those companies for their investors and creditors. Thus, investors lack
critical information about a significant component of a firm’s true economic value.
A recent study shows that financial reports are diminishing in perceived value and usefulness to
investors (Lev, 1999). The study empirically associates the lack of accounting information on
the innovative activities of business enterprises with the decrease in the overall usefulness of
the resulting financial information (Lev, 1999). Innovative activities, “…mostly in the form of
investment in intangible assets, such as research and development, information technology,
brands, and human resources, constantly alter firms’ products, operations, economic conditions
and market values”(Lev, 1999, p. 2). Human beings are the drivers of innovative activities and
thus the primary component of intellectual capital. It is obvious that measuring and valuing the
future economic benefits of human beings within an enterprise is a daunting task. However,
there are numerous approaches to this task that companies have embarked on and researchers
have proposed. Finally, accounting regulatory bodies from around the globe have begun to test
the feasibility of implementing various models and standards that might fulfill the information
needs of investors regarding intellectual capital.

7. Louis R. Billmyer
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This analysis begins by examining the information gap between internal managers and external
investors. The information gap has resulted in a decline in the usefulness of financial
information. Information shortfalls include management’s inability to provide data to investors
about its intellectual capital assets. The discussion includes reasons why information about
intellectual capital is missing and what investors are currently doing to make up for the shortfall.
The analysis includes a discussion of the residual income valuation model and how the missing
information reduces the quality of the resulting business valuations.
In the second part of this analysis, intellectual capital is examined in detail and broken down into
its component parts. An attempt is made to identify this elusive asset and provide a foundation
for its valuation and assessment. The discussion includes theories on how intellectual capital is
developed and nurtured within an enterprise. This part concludes by examining how one firm’s
intellectual capital assets can be differentiated from another in terms of quality and value.
The third part of this analysis examines the current financial reporting environment and the
issues related to reporting intellectual capital assets. Topics include intangible assets, research
and development costs, and goodwill. The discussion includes an examination of practices in
the United States and abroad. This section concludes with a detailed analysis of the
relationship between goodwill and intellectual capital. This relationship will shed light on
potential measurement and valuation techniques for intellectual capital.
The fourth and final part of this study discusses several proposals for measuring, valuing and
reporting intellectual capital. The proposals span a wide spectrum of possibilities including new
accounting paradigms, capitalization of certain costs, new qualitative metrics and finance
valuation techniques. The primary goal of these proposals is to provide investors with the
information they need (and are currently lacking) to make quality investment decisions. Many of

8. Louis R. Billmyer
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the proposals depart from historical cost reporting in favor of economic fair value reporting. If
entity wide fair value reporting is the objective, then the valuation and measurement of
intellectual capital will be a significant part of the solution.
I. THE DECLINE IN THE USEFULNESS OF ACCOUNTING INFORMATION
The Information Gap Between External Investors and Internal Management
Broadening asymmetry of information between internal management and external investors has
resulted in a significant decline in the usefulness of published financial reports. In a 1999 study,
Baruch Lev and Paul Zarowin “…use statistical associations between accounting data and
capital market values (stock prices and returns) to assess the usefulness of financial information
to investors”(Lev, 1999, p. 3). Their “…findings indicate that the cross-sectional association
between stock returns and reported earnings, [their] measure of the usefulness of earnings to
investors, has declined over the last 20 years”(Lev, 1999, p. 8). Lev and Zarowin did not stop
there, using empirical data and proxies, they linked the decline in usefulness of accounting
information to the inability of the current accounting system to adequately report the innovative
activities of a firm (Lev, 1999). Human beings drive the innovative activities of an enterprise and
are the primary component of intellectual capital. It is clear from this research that investors are
not receiving the information they need about human (employee) potential and value within a
business.
Most companies do not have a system for identifying and valuing intellectual capital assets. In
other words, most firms have not organized or assimilated their intellectual capital assets into a
usable (and reportable) company-wide format. The limited information they do have is not
required to be reported under United States (U.S.) Generally Accepted Accounting Principles

9. Louis R. Billmyer
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(GAAP). In addition, management is typically hesitant to reveal information that might expose
competitive advantages. Despite the difficulties in quantifying human or intellectual capital,
firms compete for the brightest, most creative and most efficient work force. To be successful,
all firms must effectively manage human capital assets to insure company goals and objectives
are met. In addition, the internal environment companies create to foster innovation and
business success is critical to assessing the total worth of the enterprise. It is obvious that
investors will find this information useful when they compare and value businesses.
Intellectual capital assets are not equal across all firms competing in an industry. Recent
studies have shown investors will drive up the value of firms known (or perceived) to have
superior intellectual capital assets. Though investors attempt to value intellectual capital
through market pricing, the results are unreliable and lack market wide agreement and
confidence. The result is rampant mispricing and stock market volatility. Firms must find a way
to communicate the value of their intellectual capital resources to investors.
Problems with Reported Book Value of Equity Numbers
A firm’s reported book value of equity is not a useful or meaningful number for investors.
Market value of equity to book value of equity analysis reveals a significant amount of a firm’s
worth, as judged by market participants, is not captured in its book value of equity number. An
Arthur Andersen study of 3,500 U.S. firms showed that in 1998, book value of equity was just
28% of market value (Stewart, 2001). This has not always been the case. The same study
showed that in 1978, book value of equity was 95% of market value for the same 3,500 firms
(Stewart, 2001). Market value of equity is a forward-looking number whereas book value of
equity is composed primarily of historical values; hence they will never be equal. However, for
book value of equity to be useful, it should be reasonably close to its market value. This is

10. Louis R. Billmyer
5
currently not the case and thus reflects a significant decline in the usefulness of accounting
information. Former Securities and Exchange Commission (SEC) Chairman Arthur Levitt
identifies the potential problem: “As intangible assets grow in size and scope, more and more
people are questioning whether the true value-and the drivers of that value-are being reflected
in a timely manner in publicly available disclosure”(Stewart, 2001, p. 186). He is alluding to the
expanding importance of intellectual capital in the new economy.
Impact on the Residual Income Valuation Model
The residual income valuation model is the leading mathematical tool used by investors to value
the equity of ongoing business enterprises. It is an accrual accounting model and thus, the
quality of the results are dependent on the proper implementation of the matching principle. A
problem arises when conservative accounting dominates over unbiased accounting as is the
case in the U.S.. Many costs that are expensed in the current period, under GAAP conservative
accounting, will provide future economic benefits. Hence, the unbiased application of the
matching principle of accrual accounting would require those costs to be capitalized and
expensed in the future periods when the benefits are realized. Examples include investments in
intellectual capital, research and development, organizational restructures, information
technology and brands. Conservative accounting results in an understatement of assets, book
value of equity and earnings in the current period. As a result of these understatements, the
valuations produced by the model are unreliable, difficult to compare and generally less useful.
The residual income valuation model can be summarized grammatically as follows:

11. Louis R. Billmyer
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The value of equity now is equal to the book value of equity now plus the residual earnings in
periods 1 through T discounted at the cost of equity plus the forecasted premium at the horizon
period T discounted at the cost of equity.
The model can be summarized mathematically using the following notation:
T
VE o = BVE o + (  (Earn t – Re(BVE t-1)) ) + VE T – BVE T
t=1 (1 + Re)^t (1 + Re)^T
where:
VE = Value of Equity Earn = Earnings
BVE = Book Value of Equity Re = Cost of Equity Capital
Residual income is the excess earnings (also referred to as abnormal earnings) remaining
beyond the minimum amount investors (stockholders) require to be paid for similar risk
investments. This is summarized above as Earn t – Re (BVE t-1) .
Another way of stating residual income is in terms of a return on equity (ROE):
Residual Income = Earn t – Re (BVE t-1) = ( ROE t – Re ) BVE t-1
The above ROE derivation reveals two drivers of residual income. The first driver is abnormal
ROE defined above as ROE t – Re . Conservative accounting practices, such as the
immediate expensing of investments in intellectual capital resources reduces net income in the
current period and thereby lowers ROE and abnormal earnings. Professor Cheng of the
University of Washington Business School explains the problem as follows: “Expensing an
investment with future benefits has a negative impact on abnormal ROE in the investment
period, and a positive impact for the rest of its useful life. If the growth of investments is high,
the negative impact dominates, while if the growth is low, the positive impact dominates”(Cheng,
2001, p. 9). Hence, the model produces different results from one firm to another depending on
the level of non-capitalized long-term investments. The model will consistently undervalue high

12. Louis R. Billmyer
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growth firms that invest significant resources internally thereby discouraging the flow of capital
to those entities that need it most.
The second driver is book value of equity defined above as BVE t-1 . Abnormal ROE is
multiplied by the BVE; hence, the book value of equity increases the magnitude of abnormal
earnings. If the book value of equity is significantly different from the true economic or fair value
of equity, then the model produces materially inaccurate results. As was previously mentioned,
conservative accounting practices contribute to economically inaccurate book value of equity
numbers. Historical cost conventions still dominate the balance sheet under U.S. GAAP. In the
current accounting environment, investments in internally generated intellectual assets and
most intangible assets are always expensed. Therefore, assets and book value of equity
numbers are significantly understated as compared to their fair economic value. Investors are
interested in the economic value of an enterprise, not the conservative accounting value. In
summary, the unbiased application of accrual accounting combined with the balance sheet
restated at fair value would allow investors to generate high quality equity valuations using the
residual income valuation model.
II. THE DEFINITION AND COMPONENTS OF INTELLECTUAL CAPITAL
In recent years there has been an enormous amount of research and writings on the
components of intellectual capital. Assimilating and comparing all of that information is beyond
the scope of this paper. However, most researchers agree that human beings (employees /
management) are the primary component of intellectual capital. Companies invest in people in
order to generate future economic benefits. Management is retained and employees are hired
to facilitate the profit making process. Corporate investment in quality employees is just as
important to success as investment in the best widget-making machine. “One Columbia

13. Louis R. Billmyer
8
University study estimates that spending on intangible assets like research and development
and employee education results in a return eight times greater than an equal investment in new
plants and equipment”(Best Practices, 2002, p. 1). The author goes on to say that “[n]ew
machinery only allows incremental improvements while R&D and education lead to innovations
that create revolutionary advances”(Best Practices, 2002, p. 1). Traditional accounting
capitalizes the machine and therefore it is included in the denominator when calculating return
on investment. However, this is not the case with investment in employees. Modern investors
want to know what a firm’s return on investment in its people is. Internally, companies have a
sense for this, but it is rarely reported in released financial reports.
Skandia Insurance Company Defines and Analyzes Its Own Intellectual Capital
The Swedish insurance company Skandia is a pioneer in assessing, measuring and reporting
intellectual capital. In 1998, Skandia released a supplement to its financial statements entitled
Human Capital in Transformation (Skandia, 1998). Within this report, the company
communicated to investors its understanding of intellectual capital and presented a
comprehensive assessment of its own intellectual capital resources.
Skandia decomposes a firm’s intellectual capital into three primary parts:
Human Capital: Competence, Relationships and Values
Organizational Capital: Processes, Culture and Innovation
Customer Capital: Customer Base, Relationships and Potential
In physical terms, Human Capital is what goes home at night and Structural Capital
(Organizational and Customer) is what remains behind at the firm. Skandia suggests that

14. Louis R. Billmyer
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Human Capital is the most valuable component of intellectual capital because human beings
are the drivers of innovation, customer satisfaction and thus financial success (Skandia, 1998).
In other words, employees are the builders, facilitators and drivers of Structural Intellectual
Capital.
Valuable Structural Intellectual Capital is the direct result of long-term investment in Human
Capital within a firm. In other words, Structural Capital is the physical manifestation of human
innovation into usable processes, systems, products and tools. Structural Capital is composed
of numerous tangible (though usually not capitalized) systems inside a successful enterprise.
For example, Dow Chemical has a powerful and effective system for managing information and
knowledge (Best Practices, 2002). The system allows Dow to share best practices, know-how,
skills, improvements, and innovations efficiently throughout the enterprise. Another example of
Structural Capital is Wal-Mart’s use of cutting edge technology to manage its vendor supply
chain and distribution channels. Through human innovation, Wal-Mart is able to lower its cost of
doing business. This in-turn yields positive future economic benefits for many years to come.
A human focused workplace environment that motivates people and cultivates success is also
part of Structural Capital. The value of a firm’s intellectual capital is dependent upon
management’s ability to foster leadership, teamwork, communication and flexibility among its
employees. Microsoft Corporation is an excellent example of a firm that is committed to a
flexible and team focused workplace. Within this environment, Microsoft has achieved
enormous innovative success in areas such as product development, its own internal
accounting information system and customer relationships. Finally, firms that invest in
employee education and training leading to professional advancement will further expand their
intellectual resources and competitive advantage.

15. Louis R. Billmyer
10
III. THE CURRENT FINANCIAL REPORTING ENVIRONMENT
Intellectual capital can be broadly described as “…the sum of all the intangible factors and
qualities that enable a company to earn a better-than-average return on its GAAP-valued asset
base”(Osterland, 2001, p. 1). The assumption under this definition is that intellectual capital is
not measured or captured in any way under GAAP financial reporting. The vast majority of
intellectual capital is generated internally and thus never capitalized on the financial statements,
hence the previous assumption holds. However, there is an indirect way for intellectual capital
to be GAAP valued and reported in financial statements. A significant component of purchased
goodwill can be attributed to the value of a firm’s intellectual capital assets (Seetharaman,
2002). Purchased goodwill is recognized as an asset under GAAP (Statement of Financial
Accounting Standards (SFAS) No. 141) and is annually valued for possible impairment (SFAS
No. 142). The link between intellectual capital and goodwill will be explored further after a brief
discussion on GAAP reporting of intangible assets that have intellectual capital attributes.
The Upton Report on Financial Reporting in the New Economy
The Financial Accounting Standards Board (FASB) has historically not recognized the
importance of reporting internally generated intangible assets on the financial statements. This
may be changing as the result of a comprehensive 2001 report entitled ‘Business and Financial
Reporting, Challenges from the New Economy’ (Upton, 2001). The highly respected former
FASB member Wayne S. Upton Jr. at the request of the FASB researched and wrote the report.
In Chapter 4 of the report entitled ‘Intangible Assets,’ Upton discusses many issues (pros and
cons) regarding intangible asset reporting, including the possibility of expanding the definition to
include ‘intangible’ intangible assets like intellectual capital. A summary of those issues as they

16. Louis R. Billmyer
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pertain to intellectual capital is incorporated within the following discussion of the current
accounting environment.
The FASB Statements of Financial Accounting Concepts (SFAC) and Intellectual Capital
FASB SFAC No. 1 – Objectives of Financial Reporting by Business Enterprises:
1) Provide information that is useful to investors and creditors.
2) Provide information to help investors and creditors predict future cash flows.
3) Provide information about the economic resources of an enterprise, the claims to
those resources, and the effects of transactions, events, and circumstances that
change its resources and claims to those resources.
Information about intellectual capital clearly meets the three objectives listed above. As
previously discussed in this paper, Human Capital is a valuable economic resource for
businesses.
FASB SFAC No. 6 – Elements of Financial Statements:
Assets Defined:
Assets are probable future economic benefits obtained or controlled by a
particular entity as the result of past transactions or events.
The attributes associated with intellectual capital make it more difficult to definitively meet the
definition of an asset as it is currently postulated. Most scholars agree that human beings
(employees) will generate probable future economic benefits to an enterprise. The FASB
defined ‘probable’ in Footnote 18 of SFAC No. 6 as “…that which can reasonably be expected
or believed on the basis of available evidence or logic but is neither certain or proved”(Upton,

17. Louis R. Billmyer
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2001, p. 62). In addition, investing in human capital clearly meets the past transaction or event
criteria.
The control criterion is a more difficult assertion for firms to meet in regards to intellectual
capital. The FASB defines control as “…both the ability to derive the future benefits and to deny
the ability to others”(Upton, 2001, p. 71). Upton explains the characteristics of control include
the ability of assets to be “…separable from the entity or exist by virtue of contractual or legal
rights”(2001, p. 70). In summary, Upton explains “[w]ith control comes the ability to buy, sell, or
withhold from the market – characteristics of the everyday notion of an asset”(2001, p. 73). The
implication is that assets are owned by entities and are also tradable in a marketplace.
Opponents to capitalization of intellectual capital argue that a firm can not own a human being
and hence the control criterion will never be met (although owners in the professional sports
industry may disagree). Advocates for capitalization argue “…the current definition is
inadequate to the realities of the knowledge economy”(Stewart, 2001, p. 189). Though
employees are generally unrestricted and freely mobile, there are elements of control that apply.
For example, firms can hire and fire employees, they can promote and demote, and can
restructure job requirements. Human Capital transactions within a firm are in a perpetual state
of flux as workers come and go. However, in the aggregate, the economic value of a firm’s
workforce is reasonably stable over time. Though the FASB is considering expanded intangible
asset reporting, altering the definition of an asset is not on the agenda (FASB, 2002, Technical
Project: Disclosure About Intangible Assets).
FASB SFAC No. 5 – Recognition and Measurement in Financial Statements of Business
Enterprises:
Subject to the cost-benefit constraint and a materiality threshold, an item should
be recognized if the following four criteria are met:

18. Louis R. Billmyer
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1) Definitions: The item meets the definition of an element of financial
statements.
2) Measurability: It has a relevant attribute measurable with sufficient
reliability.
3) Relevance: The information about it is capable of making a difference in
user decisions.
4) Reliability: The information is representationally faithful, verifiable, and
neutral.
It has been shown in this analysis that information about intellectual capital is relevant to
investors. Though opponents argue that intellectual capital does not meet the definition of an
asset, many investors, analysts and management teams disagree (see above discussion of
SFAC No. 6). The criteria for measurability and reliability are linked in that non-neutral and
unverifiable measurements are not useful to investors. It is this area that presents the most
significant obstacles to recognition of intellectual capital. “Few would argue that information
about intangible assets is not relevant, but many question whether those items are
measurable”(Upton, 2001, p. 64). There are numerous proposals for measuring intellectual
capital that will be discussed in some detail in section four of this paper. Before doing so, it is
useful to examine the conceptual problems with measuring intellectual capital.
It is nearly impossible to identify the exact boundaries of intellectual capital assets. “Many
authors who comment on the problems of measuring intangible assets are speaking, in part,
about this problem in defining boundaries”(Upton, 2001, p. 73). For example, several middle
managers within a firm may contribute their resources to the success of many different
departments or products. It would be very difficult to allocate the relative value of the middle
managers human capital from one department or product to the next. “Items like workforce or
customer satisfaction are harder to describe and bound in a concise fashion”(Upton, 2001, p.

19. Louis R. Billmyer
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74). Upton also states that “[w]ithout a clear boundary, there is a risk that any measurement will
double count”(2001, p. 74). To prevent this, a strict interpretation of the control criterion for
defining an asset is required. If a company has full control of an asset, then there is little doubt
about its boundaries for measurement purposes. Companies have quasi control over human
capital but they clearly do not have full control. The lack of clear boundaries causes an
additional problem with the reliability criterion. Without clear boundaries it would be nearly
impossible for auditors to identify the assets and even more difficult to verify their values.
Though these problems exist, they are not insurmountable. Innovative firms and groups from
around the world are developing new techniques for reliable identification and measurement of
intellectual capital.
The FASB Statements of Financial Accounting Standards (SFAS) and Intellectual Capital
The FASB has issued several standards that mention intangible assets but there are two that
are of particular interest. Though the FASB has stayed away from the topic of capitalizing
intellectual assets themselves, it has issued standards that cover the byproducts of those
assets. How to account for the innovative activities of human capital within firms is the topic of
the two standards discussed below.
FASB SFAS No. 2 – Accounting for Research and Development Costs:
This 1974 standard requires companies to expense all research and development costs in the
period incurred. In SFAS No. 2’s basis for conclusion, the FASB gives four reasons for this
determination: uncertainty of future benefits, lack of causal relationship to future benefits,
inability to measure future benefits and a lack of usefulness to investors. In his 2001 report to
the FASB, Upton suggests that the time has come to revisit the validity of this standard.

20. Louis R. Billmyer
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Numerous research studies have concluded that there is a causal relationship between
research and development and future benefits (Upton, 2001). In addition, “…academic
research…suggests capital market participants would find considerable relevance from balance
sheets that included R&D efforts”(Upton, 2001, p. 96).
Regarding the uncertainty of future benefits, Upton asserts that “[the] conceptual framework
does not require certainty”(2001, p. 94). It has been observed over time that acquiring firms are
willing to pay for in-process research and development without any guarantee of future success.
Upton proposes a very important shift from conventional views by stating that “[t]he effort in
process is also an asset in its own right”(2001, p. 94). Describing the process further, he
asserts “…research does not suddenly blossom into an asset at a magic moment in
time…[rather]…[i]t is a cumulative and iterative process that builds toward a goal”(Upton, 2001,
p. 80). This is an important shift in views because human beings are the drivers of this process,
hence, they are a significant part of its total value.
FASB SFAS No. 86 – Accounting for the Costs of Computer Software to be Sold, Leased or
Otherwise Marketed:
This 1985 standard requires firms to expense all software development costs as incurred until
technological feasibility is established. Capitalize all remaining development costs after
feasibility has been established. Though this standard only applies to the software industry, it is
important because the FASB departed from its traditional reliance on an exchange transaction
to create a recognition event. Instead, this standard allows for discovery and identification as a
recognition event of an asset (Upton, 2001). In addition, Upton argues that it is consistent with
the FASB’s conceptual framework (2001). Upton proposes that this approach could be used to
recognize all intangible assets (2001). If the FASB expands the discovery and identification

21. Louis R. Billmyer
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approach to recognition of all intangible assets then it bodes well for future inclusion of
intellectual capital in financial statements.
The International Accounting Standard Board (IASB) and Intellectual Capital
Accounting standard setters from around the world have wrestled with recognition issues
associated with intangible assets. The IASB is the primary international arena for harmonization
of accounting standards in all countries. The standards issued by the IASB have been
scrutinized and debated by many countries and interested parties throughout the global
business community. As such, it is important to analyze the breadth and scope of IASB
standards regarding intangible assets.
International Accounting Standard (IAS) No. 38 – Intangible Assets:
This standard is very similar to SFAS No. 86 in the U.S. in that discovery and identification is an
acceptable recognition event for intangible assets. However, a significant difference is that IAS
No. 38 applies to internally generated intangible assets in all industries where SFAS No. 86
applies only to the software development industry. IAS No. 38 states that expenditure on
research should be recognized as an expense when it is incurred. However, an intangible asset
arising from development should be recognized if an enterprise can demonstrate technical
feasibility, its ability to use or sell the intangible asset and its ability to measure it.
Another requirement of IAS No. 38 for capitalization of intangible assets is related to intellectual
capital valuation. That is, the firm must show how the intangible asset will generate probable
future economic benefits. “Among other things, the enterprise should demonstrate the
existence of a market for the output of the intangible asset or the intangible asset itself or, if it is

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to be used internally, the usefulness of the intangible asset”(IAS, 1998). On the face, it appears
IAS No. 38 will allow recognition of intellectual capital assets. However, language further into
the standard specifically disallows capitalization of human capital on the basis of insufficient
control over the asset. “…[U]sually an enterprise has insufficient control over the expected
future economic benefits arising from a team of skilled staff [including management and
technical talent] and from training to consider that these items meet the definition of an
intangible asset”(IAS, 1998, paragraph 15). Though IAS No. 38 specifically disallows
capitalization of a firm’s workforce, the expanded application of this standard to all industries is
a major step toward eventual capitalization of intellectual assets.
The Link Between Purchased Goodwill and Intellectual Capital
Purchased goodwill is an area the FASB has indirectly and inadvertently addressed purchased
intellectual capital. As a result, it may provide a starting point for developing a method for
valuing internally generated intellectual capital. Though the FASB acknowledges the existence
of the asset goodwill, it has never made an attempt to decompose it in economic terms. “This
has been the case for more than 30 years and the accounting community did not make any
serious attempts to really understand what makes up the ‘goodwill’ figure”(Seetharaman, 2002,
p. 132).
The Definition and Components of Goodwill:
The mergers and acquisitions (M&A) market is the only place where goodwill is recognized in
U.S. GAAP. A purchase or acquisition results in a verifiable transaction that unquestionably
satisfies the definition of an asset (SFAC No. 6) and for recognition of that asset (SFAC No. 5).
This is consistent with the FASB’s historically conservative position on recognition of assets in

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financial statements. For several reasons, acquiring firms routinely pay a premium for the target
firm. The premium is purchased goodwill and is defined in GAAP as the price paid for a firm
minus the fair market value of its underlying net identifiable assets (SFAS No. 141). The
reasons acquiring companies pay this premium are similar to the reasons why investors will
price a firm’s stock above its underlying book value. Simply put, there is a significant amount of
value that is not captured by GAAP financial reporting. For example, individual assets are worth
more as a combined unit than they are individually. Wayne Upton Jr., in his report on the New
Economy, suggests the following reasons for the spread between book value and market value
of equity:
1) Assessments of differences between accounting measurement and underlying
value of recognized assets and liabilities. [This is not part of the value of
goodwill. Though investors must make this assessment, acquiring firms are
required to mark all of the underlying identifiable assets and liabilities to fair value
before calculating the value of goodwill. However, the 4 remaining items below
are all components of goodwill.]
2) Assessments of the underlying value of items that meet the definition of assets
and liabilities but are not recognized in financial statements. For example,
patents developed through internal research and development.
3) Assessments of intangible value drivers or value impairers that do not meet the
definition of an assets and liabilities. For example, human capital.
4) Assessments of the entity’s future plans, opportunities, and business risks.
5) Other factors, including puffery, pessimism, and market psychology. (Upton,
2001, p. 2)
An acquiring firm has access to a significant amount of information about the target firm. When
a merger takes place, the acquiring firm can typically, and with some confidence, answer the 5
assessments above. Based on those assessments, companies will pay a premium for a target
firm; thus, the asset goodwill is created and recognized in the ensuing financial statements. In

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the marketplace, investors rarely have access to such inside information and can only guess
what the answers might be.
The link between intellectual capital and goodwill is revealed in Items 2 and 3 above. Acquiring
firms will pay for assets that are not recognized in GAAP financial statements (e.g. internally
developed patents and brands). In addition, acquiring firms will pay for value drivers that do not
meet the definition of an asset (e.g. human capital, organizational capital and customer capital).
“[F]or human capital or customer relationships, there may be no market except M&A”(Stewart,
2001, p. 190). Hence, purchased goodwill is in part, purchased intellectual capital. Further,
many researchers believe intellectual capital is the primary component of goodwill. Two years
ago and after extensive public debate, the FASB published two standards that radically changed
how purchased goodwill is measured and recognized in financial statements. Examining how
the FASB deals with goodwill (and thus by the reasoning above - intellectual capital) will provide
insight on how it could deal with internally generated intellectual capital.
Purchased Intellectual Capital is Recognized via Purchased Goodwill:
The limitation of the transaction requirement for recognition, combined with the lack of markets
for intangible assets, keeps the FASB from allowing firms to recognize internally generated
intangible assets. Though they go unrecognized in the financial statements, these assets exist
and carry substantial value. As an example, in the early 1990’s, a French firm named
Schneider purchased an American firm named Square D for $1.7 billion (Palepu, 2000). The
fair market value of the underlying net identifiable assets was $700 million (Palepu, 2000).
Schneider paid $1 billion for goodwill-more than twice the value of the identifiable net assets. In
contrast to internally generated intangible assets, business combinations involve a purchase
transaction for those same assets (e.g. goodwill) and this occurs in the M&A market. Thus, the

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FASB’s restrictive requirements for recognition of the purchased intangible asset goodwill (and
hence intellectual capital) are satisfied.
FASB SFAS No. 141 – Business Combinations:
This standard addresses financial accounting and reporting for goodwill and other intangible
assets acquired in a business combination. It only covers one point in time – at acquisition. It
defines goodwill as the price paid for a firm minus the fair market value of its underlying net
identifiable assets.
FASB SFAS No. 142 – Goodwill and Other Intangible Assets:
This standard addresses financial accounting and reporting for intangible assets acquired
individually or with a group of other assets (but not those acquired in a business combination) at
acquisition. In addition, it addresses financial accounting and reporting for goodwill and other
intangible assets subsequent to their acquisition. With this standard, the FASB acknowledged
that goodwill is not a wasting asset that should be arbitrarily amortized over certain number of
years. Hence, the standard repealed the previous requirement that goodwill must be amortized
over a finite period, not exceeding 40 years. If goodwill is primarily made up of intellectual
capital, then this reasoning makes sense. The value of a firm’s intellectual capital does not
systematically disappear over time. It more likely will have an ebb and flow pattern of change
but will always be worth something.
The standard requires goodwill to be tested for impairment annually. The FASB kept to its
conservative principles by requiring goodwill to be written down if it is impaired but disallowed
writing it up if it increases in value. The annul impairment test requires firms to measure the

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current fair market value of their goodwill and compare it to its book value for possible
impairment. It is the goodwill valuation component of this standard that is most useful for
developing ideas for valuing internally generated intellectual capital. Firms must allocate their
purchased goodwill to independent reporting sub-units (or divisions) within the acquired entity.
To test for impairment, firms must calculate the fair value of each reporting unit and compare it
with the fair market value of its underlying identifiable net assets (not including goodwill). The
difference is the current value of its goodwill, which is then compared to its book value of
goodwill for possible impairment. This same process could be used to calculate internally
generated goodwill (e.g. intellectual capital). Though the FASB has restricted the scope of this
measurement process to just impairment testing of purchased goodwill, there is no technical
reason why it could not expand it to include measuring non-purchased goodwill. Of course, the
challenge is measuring the fair value of a reporting sub-unit with acceptable reliability. The
FASB turned to SFAC No. 7 for guidance in measuring the fair value of reporting sub-units.
FASB SFAC No. 7 – Using Cash Flow Information and Present Value in Accounting
Measurements:
The FASB published this concept statement in February 2000 and it immediately enlarged the
accountants’ toolbox for estimating fair value of an asset or liability. If there is no market for the
asset or liability that needs to be measured, then this statement allows firms to use proven
finance techniques to calculate fair value. The present value of expected cash flow approach
provides the tools necessary to ascertain the true economic value of assets that lack markets
but do have value. Intellectual capital is an asset that meets this criterion. The measurement
approach involves using estimates for the amount, timing, and uncertainties of future cash flows
rather than arbitrarily assigning a discount rate to capture those components of the estimate. In
other words, the approach focuses on the cash flows, not on the interest rate. The statement
embraces reasonable estimates for uncertain future events. After the cash flow estimates are

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adjusted for all of the possible variables, the risk free interest rate is used to calculate the
present value. SFAS No. 142 requires firms to value reporting sub-units that do not have
readily available markets using the expected cash flow approach. It is reasonable to conclude
that this approach can be used for valuing human capital within an enterprise.
Capitalizing intellectual capital will improve comparability and the usefulness of financial
statements because all firms will now have the assets recorded on their books and be on an
equal playing field. This is in stark contrast to the current system where firms that have
purchased intellectual capital, via goodwill, are the only ones with it capitalized on their books.
Wayne Upton, Jr. summarizes the problem in the following excerpt from Chapter 4 of his report
on the new economy. “Here, many suggest that accounting and accountants have adopted a
pair of irreconcilable positions. Intangible assets acquired from others, including through a
business combination accounted for as a purchase, are recognized in the financial statements.
Intangible assets created with internal resources are not recognized, for the most part”(Upton,
2001, p. 59).
IV. PROPOSED METHODS FOR MEASURING, VALUING AND REPORTING
INTELLECTUAL CAPITAL
Measuring and valuing intellectual capital are not new concepts. The merger and acquisition
(M&A) market values the target firm’s intellectual capital long before the final price is set.
Though acquiring firms value a target firm’s intellectual capital, it is never reported separately
from goodwill. Outside of the M&A market, investors, analysts and other market participants
also attempt to value intellectual capital when they assess the value of an enterprise. This
attempt results in market prices set above book value. As discussed earlier, this market-to-book
spread is not just an assessment of the value of intellectual capital, but several other investor
evaluations as well. The problem is that there is no consistent, reliable method or standard to

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draw upon. As a result, numerous private and public groups from around the world have
proposed solutions to valuing intellectual capital. The proposals cover a broad spectrum of
possibilities ranging from radically different accounting paradigms to simple non-financial
disclosures. The following proposals should be scrutinized within the framework of consistent,
accurate, reliable valuations of intellectual capital. In addition, the cost-benefit constraint should
be considered when determining the feasibility of each proposal. Though the cost-benefit
tradeoff is significant, it is also important to note that any new system for identifying, measuring
and reporting intellectual capital will require a substantial investment by the implementing firm.
However, the payoffs from such an investment will be large in terms of improved investor
relations, modernized human capital management and developing a sustainable competitive
advantage (QPR, 2002).
Derive the Value of Intellectual Capital After the Earnings Process is Complete
New York University Professor Baruch Lev suggests that the value of intellectual capital can be
derived using information already available in published financial statements. Lev proposes that
companies earn a return on three types of assets: financial, physical and intellectual (Stewart,
2001). The return Lev is alluding to is net income or earnings. Hence, without positive
earnings, Lev’s derivation of the value of intellectual capital will not work. In his article entitled
‘Accounting Gets Radical,’ Thomas Stewart summarizes Lev’s approach by stating that “[h]e
starts with performance-company earnings-and then digs inside to identify what assets
produced the earnings. It’s a ‘watch what we do, not what we say’ method”(Stewart, 2001, p.
193).
In simple terms, financial assets include cash and cash equivalents and physical assets include
property, plant, equipment and inventory. Lev uses the ten-year average return on U.S.

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Treasury bonds for the proxy return on financial assets. For physical assets, the proxy return is
the average return on equity for all companies with physical assets and inventories. Finally, Lev
uses the average return on equity for the biotech and software industries for the proxy return on
intellectual assets. Lev chose these two industries because they “…depend on knowledge
assets almost to the exclusion of any others”(Stewart, 2001, p. 190). With this information, the
amount of earnings attributable to intellectual assets can be derived along with the value of
those assets as follows:
Financial Assets (FA) x Required Return on FA = FA Earnings
Physical Assets (PA) x Required Return on PA = PA Earnings
Net Income – FA Earnings – PA Earnings = Intellectual Capital Assets (ICA) Earnings
ICA Earnings / Required Return on ICA = Value of ICA
The advantages of this method are that it is simple, fast and can be applied without the need for
additional information. As part of its ‘Annual Knowledge Capital Scorecard,’ CFO Magazine
uses this methodology to value and rank firms in twenty-two industries based on their
intellectual capital resources (Osterland, 2001). Using empirical data, Lev has validated the
proxy required return rates in several (but not all) industries. However, there is still a significant
amount of subjectivity that is inherent in the proxy returns. A small change in a required return
results in a material difference for derived intellectual capital value. Another disadvantage is
that the method requires positive and stable earnings in order to value intellectual capital. Lev
avoids this problem by averaging three years historical earnings with three years of projected
future earnings. This requires more judgment and worse, it will result in circular or backward
valuations where projected earnings drive the value of intellectual capital. In the real world, the
value of intellectual capital is what drives future earnings, not the other way around. This

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method may be best used as a benchmark or check number for comparison to more
sophisticated direct valuation models.
Capitalize Costs That Are Likely To Produce Probable Future Economic Benefits
The debate over what costs will produce probable future economic benefits has been a hot topic
for many years in the U.S. and abroad. Historically, the primary issue has been whether or not
research and development (R&D) costs incurred by entities should be capitalized as an asset
on the balance sheet. R&D is the physical manifestation of Human Capital and is critical for the
success of firms that are competing to develop the best solution to a problem or need in society.
Hence, R&D costs and activities are a component of intellectual capital.
One approach to capitalizing R&D involves capitalizing all the costs only after the discovery
event occurs. Discovery, in this context, means the point in time when a firm can reasonably
predict that the R&D has evolved to the point where it will produce something that will provide
probable future economic benefit to the firm. Though it is more restrictive, the FASB uses this
methodology in SFAS No. 86. The FASB restricted its application to the software industry and
more specifically to computer software products that will be marketed or sold. Proponents
argue that the FASB should remove SFAS No. 2 (it requires firms to expense 100% of R&D in
the current period) and expand SFAS No. 86 to include all industries and all types of
innovations, whether they are used for internal improvements or external sales. Interestingly,
the International Accounting Standards Board chose this exact method for recognizing R&D and
other internally generated intangible assets (but not Human Capital) when it issued IAS No. 38
in 1998.

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A second approach to capitalizing R&D involves capitalizing all the costs after the discovery
event and retroactively capitalizing all of the previously expensed R&D costs for the now
successful project. Baruch Lev and Paul Zarowin, in their 1999 paper entitled ‘The Boundaries
of Financial Reporting and How to Extend Them,’ describe the value of this proposed method.
“The proposed capitalization allows management to convey important inside information about
the progress and success of the development program. Indiscriminate capitalization [or
expensing as we do under current GAAP] of all past R&D expenditures does not provide such
information”(Lev, 1999, p. 39). Upton, in his 2001 report to the FASB, suggests this method as
a viable reporting alternative consistent with the conceptual framework (Upton, 2001).
There are also proposals for capitalizing Human Capital on the balance sheet. One such
proposal applies leasing models to Human Capital. “[T]here is an effort in the USA to change
the treatment of employees as an ‘asset, which a company has to lease’, (akin to equipment
financial lease) and therefore, the leasing commitment would be capitalized on the balance
sheet similar to ‘debt finance asset’”(Seetharaman, 2002, p. 138). Another idea is to capitalize
employee costs similar to the cost accounting approach of capitalizing direct labor in product
manufacturing. Within this model, firms will look at employee contracts, benefits, wages, perks
and training in a whole new light. The objective is to calculate how much of those costs should
be matched with this period’s revenue and how much should be capitalized and matched with
future revenues. The amount capitalized will vary from one employee to the next and from one
department to another depending on job and department responsibilities. Initially, this process
would be very challenging for firms, subjective and difficult for auditors to validate. However, as
companies gain experience through trial and error, they will better understand what portion of
current Human Capital costs that contributes to future revenues.

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The major advantage of capitalizing R&D and employee costs is that it would work within the
existing accounting system. Auditors will be able to easily and reliably validate incurred costs
because, under this method, transactions are still the basis for measurement. The only new
part is the timing choice for expensing the incurred costs, either this period or a future period.
Though this choice involves judgment, it would not need to be completely subjective. For
example, the FASB could issue a new standard that would provide guidance for determining
when to capitalize and how to allocate those costs in future periods (Similar to IAS No. 38 and
SFAS No. 142). A major disadvantage to cost capitalization methods is that costs are not a
good measure of intellectual capital value (Stewart, 2001). However, the method would be a
start and would provide investors with significantly more information than they currently have
about intellectual resources within an entity.
New Accounting Paradigms To Meet Investor Demand for More Relevant Information
New accounting paradigms have been proposed in an attempt to close the information gap that
exists under the current accounting model. These new models depart from the purely
transaction-based systems in favor of broader event-based systems. In addition, the new
accounting paradigms build on our existing accounting model rather than discard it as
worthless. The following proposals recognize the importance of the transaction-based system
but also recognize the need for more coverage of the true economic activity of a firm.
Baruch Lev’s Blueprint for New Accounting:
After many years of research on the shortfalls of the current accounting model, Baruch Lev, in
his May 2000 paper entitled ‘New Accounting for the New Economy,’ proposes a new
accounting paradigm. Lev’s model has three key components: “…Improved GAAP; Financial-

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Economic Capital—a double-entry system based on the economic definition of an asset; and
Nonfinancial-Path Matrices, an information system aimed at capturing the links between
resources and outcomes”(Lev, 2000, p. 12). Lev suggests that GAAP is an excellent feedback
system that could be even more useful with a few changes. For example, he recommends
“…the capitalization of in-process R&D and the separation of restructuring charges to real
losses from the cost of efficiency-inducing reorganizations”(Lev, 2000, p. 15). Changing GAAP
would require accountants to make some adjustments, though small compared to the
adjustments that would be required to implement Lev’s second component of his plan.
The second part of Lev’s proposed system would require a major shift in how accountants
currently view financial reporting. Lev suggests that economic events should be reported when
they occur rather than when they yield a recordable transaction. To achieve this result, he
proposes a Financial-Economic Capital double-entry accounting system that will augment
conventional GAAP (Lev, 2000). The key driver of this reporting system will be an expanded
economic definition of an asset. Lev achieves a broader definition by removing the restrictive
recognition criteria (from SFAC No. 5) that currently prevents many assets from being recorded.
Simply put, “…[a]n asset is thus a claim by the enterprise (not necessarily in the legal sense) to
an expected benefit…”(Lev, 2000, p. 16). Hence, assets can arise from investments (traditional
GAAP transactions), internally created sources (unique innovations, designs, and human
resource practices) and externally created sources (government and judicial activities,
significant technological changes) (Lev, 2000). Most importantly, this component of the model
will allow recognition of many internally generated intellectual assets.
The third part of Lev’s model attempts to communicate important non-financial information to
investors. Lev’s objective is to provide “…information about innovation capabilities and their
consequences”(Lev, 2000, p. 21). He asserts that “[c]onventional financial information does not

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articulate linkages between capabilities and consequences”(Lev, 2000, p. 21). Non-financial
information will be compiled and presented in path matrices that trace resources to outcomes.
The model will track resource utilization in four major categories: innovation/commercialization
capacity, human resources, customers and networks. For example, inputs for human resources
may be performance-based compensation, employee training and perks with outputs being
employee turnover and workforce quality (Lev, 2000). Unlike parts one and two above, this part
does not require inputs and outputs to be measured in the same units. Finally, all four of these
categories are components of intellectual capital and hence, would provide investors with a
plethora of new and useful information regarding the value of intellectual capital.
The Canadian Institute of Chartered Accountants (CICA) Total Value Creation (TVC) System:
The CICA has been developing and molding the TVC for over nine years. There has been a
significant amount of international interest in the TVC system. The interest was so great that
the CICA, in partnership with a global consortium, applied for a U.S. patent in 2000 (Upton,
2001). Like Lev’s model, the focus is on recording information when an economic event occurs
with or without a related legal transaction. Wayne S. Upton, Jr. summarized the features of the
TVC as follows:
 It is not a substitute for traditional accounting but rather a supplement to it.
 TVC is designed to give insight into pre-transactional value creation by measuring and
reporting on value creation as it occurs.
 It includes a highly sophisticated event-based present value model designed to
capture and report information about an entity’s planned activities.
 TVC is a value-added approach to accounting where value is measured using finance
concepts like the present value of expected future cash flows discounted at the cost of
capital.

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 The system includes real-time, on-line disclosure of changes to the underlying
assumptions (Upton, 2001).
The advantages of the new accounting paradigms discussed above are numerous but not
without cost. Investors still would have traditional GAAP as a feedback tool. In addition, they
would have a vast amount of detailed information about future plans, intellectual resources and
other drivers of economic value. With this information, investors would be well equipped to
calculate the true value of an entity. However, the cost to implement the new accounting
paradigm would be enormous. In addition, a system that attempts to measure value at the
creation point will be inherently complex. Important traditional accounting concepts of
comparability, consistency, understandability, completeness, and existence would all be difficult
to adhere to in the extremely flexible and complex environment of the new systems (Upton,
2001). In conclusion, the new accounting paradigms will provide significant new benefits but not
sufficiently large enough to outweigh the costs of such an expansive undertaking.
Intellectual Capital Valuation Techniques Using Modified Finance Concepts of Fair Value
Real Options Valuation Models:
Applying financial options pricing to real business projects is a method that is spawning interest
throughout the accounting and finance community. Real options valuation models are
“…perhaps the most promising area for valuation of intangible assets…”(Upton, 2001, p. 91).
An option is a right to choose a designated course of action. Option pricing models for financial
assets measure the value of the right to choose. Real options valuation models use similar
inputs to value non-financial assets and liabilities. “Instead of viewing an asset or project as a
single set of expected cash flows, the asset is viewed as a series of compound options that, if
exercised, generate another option and a cash flow”(Upton, 2001, p. 92). This method could be

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used to value numerous projects related to intellectual capital. Candidates for options valuation
include R&D projects, employee training and compensation choices, product development, and
process or systems reengineering projects. Most innovative activities within an enterprise could
be valued using an options model. Upton summarizes the value of in-process innovative
activities by stating that “[a]t any point along the way, the effort to date has value for which
others are willing to pay. The effort may prove unsuccessful, but that doesn’t alter the fact that
the in-process effort is valuable today”(Upton, 2001, p. 80). Though this valuation model
appears promising, there are two problems. First, the model would require subjective inputs
that would be difficult to validate. Second, options valuation models are very complex and
difficult to understand. Notwithstanding these shortcomings, this valuation technique warrants
further examination by accounting standard setters.
Valuations Based on SFAC No. 7 and the Present Value of Expected Cash Flows:
The FASB, via SFAC No. 7, has laid the foundation for measuring intellectual capital. Using fair
value measurement concepts from SFAC No. 7, the FASB recently published a standard that
measures the value of previously purchased goodwill (SFAS No. 142). As discussed earlier in
this analysis, a significant amount of the value of goodwill is attributable to intellectual capital.
Hence, the FASB has indirectly valued purchased intellectual capital. The FASB could simply
extend the application of SFAC No. 7 to internally generated intellectual capital. In addition, the
SFAS No. 142 concept of comparing the fair value of a reporting sub-unit to the fair value of the
underlying net-identifiable assets of that same sub-unit, could be used as the measurement
and/or impairment test for intellectual capital valuations. As Upton clearly points out, the FASB
has a double standard in that firms that purchase intellectual capital (via goodwill) can recognize
the asset but firms that generate it internally can not (Upton, 2001). The FASB has provided

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itself with a means to solve this problem with SFAC No. 7 and universal application of the
procedures it developed in SFAS No. 142.
This valuation method has a few obstacles inherent in many of the proposed methods for
valuing intellectual capital. Estimates of future cash flows are difficult to make, subject to
management manipulation and cannot be validated until the future period unfolds. However,
the lack of reliability of the estimates did not deter the FASB from issuing SFAS No. 142.
Accurately estimating expected cash flows from internally generated intellectual capital is not an
impossible task. The learning curve for management will involve repeat cycles of trial and error
while improving each time. Skandia and many other companies have made significant
advancements in identifying and organizing the intellectual capital assets of their firms.
Applying economic-value-added analysis to identified intellectual assets that are organized by
department, function or sub-unit will provide valuable information to management and assist
them in estimating the fair value of those assets. The FASB has the tools it needs to embark on
a measurement and reporting standard for internally generated intellectual capital.
Reporting and Communicating Non-Financial Information About Intellectual Capital
Non-financial information about intellectual capital assets could be very valuable to investors.
This type of information was the third component of Lev’s new accounting paradigm discussed
earlier. These proposals focus more on qualitative additional disclosure of information and less
on quantitative values. Hence, core GAAP standards and concepts would not need to be
significantly modified.
New metrics that gauge how well a firm is managing its intellectual resources have gained
popularity in the past few years. The type and variety of the metrics used vary widely from one

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firm to another. The results are presented in supplemental reports to the financial statements.
Skandia Insurance Company of Sweden developed the ‘Skandia Navigator’ to use as a future-
oriented business-planning model. “The Skandia Navigator provides a more balanced, overall
picture of operations – a balance between the past (financial focus), the present (customer
focus, process focus and human focus), and the future (renewal and development
focus)”(Skandia, 1998, p. 5). Examples of metrics include training expense per employee,
employee turnover, average years of education per employee and average years of service with
the company. Due to the variety of metrics available, comparability from one firm to another will
be difficult without establishing industry standards and norms. Though this method falls well
short of intellectual capital valuation, it would provide useful information to investors without a
major overhaul of GAAP.
Current FASB Project Regarding Disclosure of Information About Intangible Assets Not
Recognized in Financial Statements
On January 9, 2002, as the result of the 2001 ‘Upton Report on the New Economy,’ the FASB
added to its technical agenda a project entitled ‘Disclosures About Intangible Assets.’ The task
force is looking at both quantitative and qualitative disclosures. The quantitative disclosures are
divided into two types: fair-value-based approaches and cost-based approaches. The task
force concluded that using “[a] fair-value-based approach would provide information that
researchers and exceptionally diligent investors that want it now have to crudely estimate, using
research-generated models and proxies or other limited data”(FASB, 2002, p. 2). Regrettably,
the scope of intangible assets covered by the project does not extend beyond current GAAP
into the area of non-separable and non-contractual intangible assets. The limitation on scope
will prevent internally generated intellectual capital from being considered in this project.

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However, the FASB has initiated the process of discovery and change. This project may create
the possibility and opportunity for future projects on intellectual capital valuation and reporting.
CONCLUSION
The rapid pace of change because of computers, networks, the Internet, technology, and
innovation has created the need for timely, relevant information on the true economic success
factors of an enterprise. The current financial reporting system must adapt to those needs or
the distribution of capital may slow to a snail’s pace while investors attempt to find the
information on their own. In addition, growth companies will find it difficult to compete for
investor dollars if they are unable to communicate the true future economic value of large
current internal investments. Intellectual capital assets are (and always have been) a
substantial part of the success (or failure) of an enterprise. Human beings are the drivers of
financial success. Current GAAP provides very little insight into this important driver of firm
value. Though this is the case, the FASB built sufficient flexibility in the Concept Statements to
allow intellectual capital to be measured and included in financial statements. In particular, the
Concept Statements allow for reasonable judgements, estimates and forward-looking
projections in order to measure the fair value of an asset (SFAC No. 7). Using SFAC No. 7 as
its foundation, the FASB should seriously consider a new project on intellectual capital valuation
and reporting.

40. Louis R. Billmyer
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REFERENCES
Best Practices, LLC. 2002. Intellectual Capital, How Top Performing Companies are
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Financial Accounting Standards Board. January 2002. Technical Project: Disclosure About
Intangible Assets. Norwalk, CT.
Financial Accounting Standards Board. Statement of Financial Accounting Concepts (SFAC)
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Financial Accounting Standards Board. October 1974. Statement of Financial Accounting
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REFERENCES (cont.)
International Accounting Standards Committee. September 1998. International Accounting
Standard (IAS) No. 38. Intangible Assets. http://www.iasc.org.uk
Lev, Baruch and Paul Zarowin. February 1999. The Boundaries of Financial Reporting and
How to Extend Them. Journal of Accounting Research, Autumn 1999, 353-385.
http://pages.stern.nyu.edu/~blev/
Lev, Baruch. May 2000. New Accounting for the New Economy. The Author Has Given Me
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Lev, Baruch. Communicating Knowledge Capabilities. http://pages.stern.nyu.edu/~blev/
Osterland, Andrew. 2001. Grey Matters: CFO’s Third Annual Knowledge Capital Scorecard.
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Palepu, Krishna G., Paul M. Healy and Victor L. Bernard. Business Analysis and
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QPR. 2002. Introduction to Intellectual Capital. QPR Intellectual Capital Online.
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Seetharaman, A., Hadi Helmi Bin Zaini Sooria and A.S. Saravanan. Faculty of Management,
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Upton Jr., Wayne S. 2001. Business and Financial Reporting, Challenges from the New
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Primary Sources of Information:
American Institute of Certified Public Accountants: http://www.aicpa.org
Baruch Lev: http://pages.stern.nyu.edu/~blev/
Financial Accounting Standards Board: http://www.fasb.org

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37
REFERENCES (cont.)
International Accounting Standards Board: http://www.iasc.org.uk/
Journal of Intellectual Capital: http://www.emeraldinsight.com
Knowledge Connections – David Skyrme Associates: http://www.skyrme.com
Paul Strassmann: http://www.strassmann.com
Social Science Research Network: http://papers.ssrn.com
The Montague Institute: http://www.montague.com
The Resource for Information Executives: http://www.cio.com