Report highlights benefits of intellectual capital reporting for SMEs

September 6, 2006

Brussels, 05 Sep 2006

Reporting intellectual capital in annual reports can help research-intensive small and medium enterprises (SMEs) secure financial investment, and should become an integral part of companies' reporting, according to a report by a European Commission high-level expert group. The report, 'Reporting intellectual capital to augment research, development and innovation in SMEs (RICARDIS)', is the result of an expert group, set up by the Commission to define intellectual capital (IC), and the reasons why it is important to research-intensive SMEs. The report also makes recommendations on how the Commission can help Member States develop guidelines for and stimulate reporting of this type of information by SMEs.

The report defines Intellectual Capital (IC) as 'the combination of an organisation's human, organisational, and relation resources and activities. It includes knowledge, skills, experiences and abilities of the employees, its research and development (R&D) activities, organisational routines, procedures, systems, databases and it intellectual property rights, as well as all the resources linked to external relationships; such as customers, suppliers and R&D partners'.
This definition is particularly relevant to research-intensive SMEs, whose activities may not just include R&D, but cut across many other types of intellectual capital.

However, when making assessments for funding, SMEs often fail to articulate these 'intangible' resources and capabilities, which drive value creation. Instead, information tends to dwell solely on financial accounts, not including innovation projects or management methods. The report argues that this failure to provide a full picture of business value is one reason why SMEs find it difficult to raise finance or equity from banks or investors.

The report recommends including an intellectual capital statement in addition to the more traditional financial statements. The statement would have two functions. First, it can act as an internal navigation tool to help develop and allocate resources - define strategy, prioritise objectives, monitor the development of the SMEs results and thus facilitate decision-making. Second, the statement can enable SMEs to better communicate with stakeholders and thereby attract financial and human resources, and develop relationships.

These benefits are illustrated in a series of case studies that accompany the report. In one study, investors were asked to generate forecasts for revenues and earnings for an SME, and provide their recommendations on the company's stock. The investors were divided into two groups. One group was given the company's full annual report, including the intellectual capital statement, while the other group was provided with a version of the report that excluded all of the quantified non-financial information.

The study found that those analysts given the full report gave a lower forecast than those given only the financial results. However, those analysts given the full report were also far more likely to buy, rather than sell stock. This is because the more information let the analysts develop a fuller picture, giving them more confidence to invest, despite lower forecasts. This can benefit the company not only through investment, but also recruitment.

Additional anecdotal evident from the SME found that fund managers and analysts were reluctant to take intellectual capital information seriously. However in meetings with fund managers and analysts, the SME found that the fund managers started to ask new questions, often requesting information that was already available in the intellectual capital statement.

However, despite the evidence of the benefits of intellectual capital reporting, companies have been slow to take it up. The report suggests that this may be due to a lack of awareness of these benefits, as well as a lack of guidelines available on how to write an intellectual capital statement. Although some guidelines do exist, the report argues that they are generally adapted to local circumstances and business culture and differ greatly from one to another in their terminology and methodology.

Similarly, only a few countries in Europe have sought to make this type of information a standard part of companies' annual reporting. In Germany, the accounting standard recommends companies report their intellectual capital in the management report, although this is not an obligation. Denmark requires companies to disclose information about their human capital, if relevant to the economic activity, while in Austria reporting of this capital is now mandatory for all universities.

The report points to Australia and Japan, where both governments have sought to develop a common set of guidelines and standards for intellectual capital reporting. In Australia, the government set up a Society for Knowledge Economics, which includes the Institute of Actuaries of Australia and Microsoft Australia. The first task of the society was to develop guiding principles on 'Extended Performance Management', aimed at the management and reporting of intellectual capital. In Japan, the government proposed a new model for the voluntary reporting of intellectual assets. The decision to publish a Japanese model was motivated by the expectation that this '[...] will have a big impact in the worldwide trend. Also it may be possible to set a de facto standard.'

In light of the developments in Japan and Australia, and in order to maintain its leadership in the field, The RICARDIS report urges Europe to take prompt action to stimulate the uptake of intellectual capital reporting by SMEs, and develop global standardisation for this type of information. The report looks to the European Commission, which it says should take a leading role in developing common guidelines that may be adopted by Member States at different speeds and levels.

The expert group makes the following policy recommendations to the Commission to improve identification, measuring and reporting of intellectual capital:

- establish a European Adoption Task Force that oversees and facilitates the development of intellectual capital reporting and management in research intensive SMEs and acts as a learning platform;
- produce a practical guide on intellectual capital reporting for research intensive SMEs, banks, investors and infomediaries;
- use intellectual capital reporting as a criterion for public support;
- apply intellectual capital reporting as a tool for government agencies;
- conduct further research on new business models' dynamics and the importance of intellectual capital;
- set up an international standardisation steering group to facilitate the development of consensus-based standardisation of taxonomies, indicators, and intellectual capital statements for research-intensive SMEs and help develop standards;
- encourage banks to develop new forms of finance for research based SMEs.
//CPA Further information:
http://ec.europa.eu/invest-in-research/policy/capital_report_en.htm

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