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July 5, 2004

Assessment and Disclosure of Intellectual Assets Needed

Masahiro OKUNO (Professor, University of Tokyo)

Keita NISHIYAMA (Director, Research and Analysis Division, Ministry of Economy, Trade and Industry)

The importance of intellectual assets in business management is increasing, but for productive utilization these assets need appropriate means of assessment. In order to have long-range investments aimed at enhancing intellectual assets evaluated properly, Japanese companies should participate actively in the discussion on methods of evaluation carried out internationally.

Significant influence on the performance of corporations

The importance of intellectual assets in business management is increasing. Intellectual assets is a much broader concept than intellectual property rights, and it encompasses areas such as human capital, organizational process, brand control, leadership, and customer/supplier relations. Terms such as intellectual capital and intangible assets are also used often to represent the same idea.

The reason such a concept gained importance lately is a change in the competitive environment. In a world where capital can flow freely, owning financial assets or manufacturing facilities will not necessarily constitute a source of competitiveness. In addition, the price competition of standardized products has intensified and the pricing powers of goods providers of the has declined. Advancement of informatization has enabled suppliers to cope with detailed demands of customers, and to develop products with distinct characteristics. But the "freshness date", or period of time a founder's profit can be enjoyed for each product, is not long. Intellectual assets support corporations in a competitive environment where the strategy of individualization and constant technical innovation are essential.

A number of recent positive analyses have shown the increasing importance of intellectual assets. Not just limited to areas of R&D or patent acquisitions, facets of intellectual assets such as organizational processes and human resources have significant relevance on business performance. Professor Rev of New York University analyzed 250 US companies and calculated the share of sales increase that are not attributable to any of the three elements, i.e. capital, labor, or R&D. The result was that 43% of sales increase was caused by components other than these three factors, and this portion was in high correlation with investments in areas of organizational processes such as information technology, and enhancement of human resources.

In Japan, the Ministry of Economy, Trade and Industry (METI) used a similar method to estimate the corresponding figure using data from 402 manufacturing companies. The result showed that 67% of increases of sales was attributable to elements other than capital, labor, or R&D.

The recent trend of penetration by independent labels into the CD industry also illustrates the significance of intellectual assets. The traditional industry structure centered around manufacturers equipped with CD stampers and recording studios is changing with the emergence of those with in-depth knowledge of specific types of music.

Enhancement of intellectual assets also affects the structure of international division of labor. There are already a number of coalitions being established in East Asia where various stages of production -- R&D, product planning, test production, part manufacturing, and assembly -- are separately dealt with in different parts of the region. The trend is observed not only in the manufacturing industry but also in the service sector, as in the case of designing and laying out convenience stores across the region. It is within such a new framework of division of labor that Japan should seek to conserve innovative functions within its perimeters, and the foundation on which to realize the goal is intellectual assets.

On the other hand, unlike tangible assets such as machinery and equipment, intellectual assets are difficult to quantify, and there is an urgent need to establish a viable means to evaluate them. There already exists a number of methods being developed to assess intellectual assets for a certain business entity, but the matter involves issues beyond management of individual companies, and the implementation of following infrastructural elements is also required.

First, there is the issue of exchange of information between corporations and the financial market. While the importance of intellectual assets in business management is growing, there is an increasing frustration among investors that traditional-style financial statements do not sufficiently disclose relevant information. In Denmark, the rules on financial reports were amended in 2000 to encourage businesses to prepare and disclose a report on intellectual assets. In the UK, a requirement for certain companies to include their future strategies and risk assessments in publicized financial statements is being discussed.

Issues abundant in quantification attempts

There are two major approaches in evaluation and disclosure of intellectual assets. One is to break up intellectual assets into separate elements such as brand equity and human capital, and quantify each of their values. The other is to first state management objectives in the aim of enhancing intellectual assets in a qualitative form, and then indicate certain quantitative indexes which would enable investors to gauge progress. Currently the former approach still is considered impractical, and both Denmark and the UK have adopted the latter approach. In addition, neither country has set rigid disclosure rules and have left it to the originality and ingenuity of individual companies for better methods to gradually evolve.

The issue of disclosure has close relation with the basic subject of what the purpose of a corporation is. The UK is planning to revise its corporate law to require directors to not only seek short-term profits but also to become responsible for the company's long-term growth. The new financial statement mentioned above is expected to function as a means to verify whether such obligations by the directors are met.

There is a need for financial institutions to improve the abilities of assessing intellectual assets. The core factor in providing financial facilities to business such as ventures, small companies, and rejuvenating entities is the proper evaluation of intellectual assets. The skill of evaluating such assets is essentially a competitive edge of individual financial institutions, but the evolution of the methodology and the dissemination of a certain level of skill among financial institutions should improve the quality of venture business financing.

The second point is that the issue of intellectual lending relates to the discussion of corporate social responsibility (CSR). Enhancement of CSR does not necessarily conflict with profit growth. Investing in human resources in a company or building a customer network is indeed attending to social responsibilities by serving stakeholders. Enhancing CSR by, for example, establishing an effective risk management system and thus improving corporate image would certainly contribute to long-term growth.

Financial statements of UK companies consider CSR evaluations contiguous to intellectual asset evaluations, and both are included in the items to be reported. As the volume of social responsibility investments (SRI) increases substantially, inclusion of new items such as human capital investment and knowledge building--in addition to the traditional focus of attitudes toward environment--is being suggested.

The issue of intellectual asset evaluation has affected a fundamental characteristic of the current economic framework. The 20th century system relied on the ability to forecast the future, such as in the case of demand action, to supply goods of unilateral character through mass production. On the other hand, in the 21st century system, with informatization and globalization in the setting and various groups of values intermixing in a disorderly manner, the general direction would emerge only as a result of turmoil. A reflection of the transformation can be seen in the recent spotlight on modules instead of hierarchy in the discussions of organizational forms.

However, as modules require architecture to function, the 21st century economic system needs some sort of intermediary function to connect the diverse elements. An important function of newly established funds to support ventures, small companies, and rejuvenating entities is to evaluate companies based on the notion of value creation.

Evaluation specialists necessary

Business entities need to create value by constantly reassembling their intellectual assets, while assessing demand actions and being evaluated through various criteria. In the same way that 21-century businesses need professional appraisers in addition to professional managers, it may be dubbed as the era of "separation of management and appraisers".

Establishment of infrastructure is an international issue. At the Ministerial Meeting of the OECD held in May, six countries including Japan and the UK suggested to initiate a project on "value creation and intellectual assets". In recognizing the way companies' value creation is changing, it proposed as follows: (1) study and analysis of the evaluation method of intellectual assets, (2) investigation into a proper method of corporate disclosure including intellectual assets, and (3) presentation of broad policy issues related to small business financing and human capital policy. The work is to begin this fall by members from both government and private sectors. Productive developments from such international efforts are expected.

Long-term foresight and emphasis on human capital has been said to be the characteristic of Japanese corporate management. As the discussion on rules for doing business and accounting procedures continue in international forums, Japan should participate in the discussions to voice inclusion of a system to value long-term investments aimed at sustaining and enhancing intellectual assets, and promoting the companies' relationship with stakeholders.

In addition, as new accounting rules are expected to include requirements to disclose commitment on the strategy and risks of a company, it could induce Japan's corporate managers to adopt new strategic planning methods beyond traditional on-site ones. In order to contribute to these international discussions by way of providing views and opinions from real business experience, not only the government but also active participation of the private sector is expected.

(The original Japanese article appeared in the June 21, 2004 issue of Nihon Keizai Shimbun.)

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