Stefano Zambon and Giuseppe Marzo

VISUALISING INTANGIBLES:
MEASURING AND REPORTING IN THE

KNOWLEDGE ECONOMY
Visualising Intangibles:
Measuring and Reporting in the
Knowledge Economy
Edited by
STEFANO ZAMBON and GIUSEPPE MARZO

University of Ferrara, Italy
© Stefano Zambon and Giuseppe Marzo 2007
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system
or transmitted in any form or by any means, electronic, mechanical, photocopying, recording
or otherwise without the prior permission of the publisher.
Stefano Zambon and Giuseppe Marzo have asserted their moral right under the Copyright,
Designs and Patents Act, 1988, to be identified as the editors of this work.
Published by
Ashgate Publishing Limited Ashgate Publishing Company
Gower House Suite 420
Croft Road 101 Cherry Street
Aldershot Burlington, VT 05401-4405
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Ashgate website: http://www.ashgate.com
British Library Cataloguing in Publication Data

Visualising intangibles: measuring and reporting in the
knowledge economy
1. Intangible property - Valuation 2. Intangible property -
Accounting 3. Corporations - Valuation
I. Zambon, Stefano II. Marzo, Giuseppe
657.7
Library of Congress Cataloging-in-Publication Data

Visualising intangibles: measuring and reporting in the knowledge economy / edited by
Stefano Zambon and Giuseppe Marzo.
p. cm.
Includes index.
ISBN: 978-0-7546-4628-0 1. Intangible property--Accounting. 2.
Intellectual capital. I. Zambon, Stefano. II. Marzo, Giuseppe.
HF5681.I558V57 2006
657'.73--dc22
2006031453
ISBN: 978 0 7546 4628 0
Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire.
Contents
List of Figures vii

List of Tables ix
List of Appendices xi
List of Contributors xiii
Introduction: Visualising the Invisible: Measuring and Reporting on Intangibles

and Intellectual Capital 1
Stefano Zambon and Giuseppe Marzo
PART 1 MEASUREMENT AND REPORTING ISSUES
1 Regulatory Changes in Accounting for Goodwill and Intangible

Assets: A Study of Their First Impact on
European Companies Listed on US Markets 9
Stefano Zambon and Vania Crosara
2 Intangibles and Real Options Theory: A Real Measurement

Alternative? 31
Giuseppe Marzo
3 Intangible Assets:The Next Accounting Frontier 49

David W. Young
4 IC Statement vs. Environmental and Social Reports: An

Empirical Analysis of their Convergences in the
Italian Context 67
Michela Cordazzo
PART 2 DISCLOSURE ON INTANGIBLES:

VALUE RELEVANCE, SCORING AND RATING
5 On the Informational Usefulness of R&D Capitalization and

Amortization 97
Baruch Lev, Doron Nissim and Jacob Thomas
vi Visualising Intangibles
6 Scoring Company Disclosure on Intangibles: An Application
of an Innovative Methodology in a European Perspective 129
Stefano Zambon and Ilaria Bergamini
7 Credit Rating and Intangible Assets: A Preliminary

Inquiry into Current Practices 165
Adele Del Bello
PART 3 NEW PERSPECTIVES ON THE MEASUREMENT

AND REPORTING OF INTANGIBLES
8 XBRL as a new Language for Business and Intangibles

Reporting 193
Kurt P. Ramin
9 The Neglected Intangible Asset: Organizational Power

in the Knowledge Economy 207
Giovanni Masino
10 Intangibles and Performance Measurement Systems

in Opera Houses: Case Studies from Italy and the
United Kingdom 221
Fabio Donato
11 Macro Indicators of Intangible Assets and

Economic Policy 241
Patrizio Bianchi and Sandrine Labory
Index 263
List of Figures
2.1 Investment life cycle, real options and intangible assets. 38

2.2. Some classifications of risk and their overlapping areas. 41
2.3 How existing IAs influence on an ROA-based valuation of
a new IA investment 44
3.1 Differences in return on assets across selected industries 62
4.1 The value platform 70
4.2 Skandia Business Navigator 72
4.3 Publication period of Italian environmental and social reports 77
4.4 The theoretical relationship between IC, social, and environmental reports 85
4.5 The empirical relationship between IC, social, and environmental
reports in Italy 86
5.1 Year-by-year 1-year ahead raw and abnormal returns (adjusted for
size and B/M) for the high BVDIST portfolio 122
5.2. Cumulative abnormal returns (CAR) for BVDIST quintiles over the
three years following 124
6.1 AIAF-University of Ferrara’s original model 132
6.2 Radar diagram 132
6.3 Levels of information in 2001 fiscal year 141
6.4 Levels of information in 2002 fiscal year 141
6.5 European best practices on intangibles communication in 2001
fiscal year 147
6.6 European best practices on intangibles communication in 2001
fiscal year 147
8.1 The corporate reporting supply chain 194
8.2 The three-tier model of corporate transparency 195
8.3 Example of XBRL IFRS tag reuse 196
8.4 How XBRL changes the consumption of corporate reports 197
10.1 ROH organisational structure 224
10.2 TOR organisational structure 226
10.3 The overall performance measurement system 236
11.1 Firm creation in the bio-region (numbers of firms) 284
11.2 Dimensions of development according to the socio-demographic
typology (per capita value, Tuscany = 100) 296
This page intentionally left blank
List of Tables
1.1 Alternative accounting behaviours of the analysed companies 18

3.1 categories of intangible assets proposed by the financial
Accounting standards board 53
3.2 Relationship between categories of intangible assets and
Ease of measurement 54
3.3 Examples of the relationship between intangible assets and
Strategic considerations 58
4.1 Celemi intangible asset monitor 71
4.2 Models of Italian environmental and social reports 79
5.1 Descriptive statistics for samples 102
5.2 Analysis of the impact of capitalizing and amortizing R&D on the
association of earnings and book value with stock price 106
5.3 The impact of capitalizing and amortizing R&D on the association
of earnings and book value with future earnings (before R&D) 109
5.4 Annual buy-and-hold portfolio returns and other characteristics
for quintiles of BVDIST and EARDIST 113
5.5 Monthly cross-sectional Fama-MacBeth (1973) regressions of firm
returns on BVDIST, EARDIST and risk factors 116
5.6 Time-series regressions of monthly excess returns for BVDIST
portfolios on the three Fama and French (1993) factors (market
return, size, and B/M) 118
5.7 time-series regressions of monthly excess portfolio returns on
The fama and French (1993) factors 120
5.8 Cross-sectional Fama-MacBeth (1973) monthly regressions for
January returns 125
6.1 AIAF’s scale for ranking company disclosure on intangibles 136
6.2 Information on intangibles detected in company annual reports 139
6.3 Average and standard deviation for the six communication dimensions 143
6.4 Statistical data about the type/scope of information 145
6.5 Statistical data about the number of information 146
6.6 Hexagons’ areas 147
6.7 Highest scores per communication dimension on intangibles
representing the European best practices 148
7.1 Rating scales for mid-long term bonds (due beyond 12 months) 168
7.2 Main results emerging from the content analysis regarding the
intangible resources considered in the credit rating process 181
7.3 Main results emerging from the interviews with the analysts
regarding the intangible aspects considered in the credit rating process 186
11.1 Measurable elements of human capital 254
11.2 Characteristics of development (Tuscany average = 1) 257
List of Appendices
Appendix 1.A
a) Companies analysed by European country 28
b) Companies excluded from the analysis 29
Appendix 1.B
a) Global comparability indexes 30
b) Partial comparability indexes referring to goodwill 30
Appendix 4.A
The More Frequent Information in Italian Environmental Report 90
Appendix 4.B
The more frequent information in Italian social report 92
Appendix 4.C
Elements of an IC statement in Italian environmental and social reports 94
Appendix 6.A
List of Indicators proposed by AIAF 152
Appendix 6.B
Sample 155
Appendix 6.C
Results 159
Appendix 6.D
Mandatory and voluntary disclosure 161
List of Contributors
Ilaria Bergamini She worked as a research assistant at the Faculty of

Economics of the University of Ferrara. Currently she is
a financial analyst at an Italian bank
Patrizio Bianchi Rector of the University of Ferrara
Michela Cordazzo Assistant researcher, Free University of Bolzano
Vania Crosara She worked as a research assistant at the Faculty of
Economics of the University of Ferrara. Currently she is
working as an Italian CPA in Ferrara.
Adele Del Bello Post-doctoral fellow, Faculty of Economics, University
of Ferrara.
Fabio Donato Associate Professor of Business Economics and
Management, Faculty of Economics, University of
Ferrara
Sandrine Labory Assistant professor, Faculty of Economics, University of
Ferrara.
Baruch Lev Philip Bardes Professor of Accounting and Finance, Stern
School of Business, New York University and Director
of the Vincent C. Ross Institute of Accounting Research,
New York University.
Giuseppe Marzo Lecturer of Business Strategy and Business Valuation,
Faculty of Economics, University of Ferrara
Giovanni Masino Associate Professor of Organization Theory, Faculty of
Economics, University of Ferrara.
Doron Nissim Gary Winnick and Martin Granoff Associate Professor,
Columbia Business School.
Kurt P. Ramin Chairman, XBRL International Steering Committee
at the International Accounting Standards Committee
Foundation, London.
Jacob K. Thomas Williams Brothers Professor of Accounting and Finance,
School of Management - Yale University.
xiv Visualising Intangibles
David W. Young Professor of Management at Boston University’s School
of Management.
Stefano Zambon Full Professor of Business Economics and Management,
Faculty of Economics, University of Ferrara
Introduction
Visualising the Invisible: Measuring and

Reporting on Intangibles and Intellectual
Capital
Stefano Zambon and Giuseppe Marzo
University of Ferrara
In recent years, one of the most important emerging features of economic systems
and organisations is the role of intangibles in wealth creation, which are for this
reason often comprehensively referred to as Intellectual Capital.
Even though intangibles have always been important for running economic
activity, they are nowadays at the centre of an increasing interest by the scientific
community and the practice world. The attention devoted to this subject area is
becoming very substantial when considering the large number of articles and books
published in the last decade or so, as well as the major events and projects promoted
by numerous national and international institutions (European Commission; OECD;
United Nations; various country governments such as Denmark, Japan, Germany;
Brookings Institution, and so on).
The underlying reason is that intangibles are strongly considered as today’s major
value drivers of firms, industries and regions, and therefore to measure, analyse and
manage them is a crucial effort in the direction of comprehending and improving
value creation with reference to the different economic levels and sectors.
However, despite their widely accepted relevance, intangibles still appear to be
poorly understood and not sufficiently investigated and analysed both by academics
and practitioners. What seems to be increasingly recognised is indeed the necessity
for adopting fresh approaches to the measurement and management of intangibles.
Although some steps have been made towards a better visualisation of these resources,
a clear knowledge gap continues to exist in this field, calling for new models, tools
and methodologies significant to the realms of theory and practice.
Meanwhile, recent events and phenomena have further increased the importance
of intangibles to managers, infomediaries and investors. In this perspective,
the accounting standards revolution in Europe requiring the implementation of
International Accounting Standards/ International Financial Reporting Standards
(IAS/IFRS) has emphasised the measurement and reporting of intangibles in
European companies’ financial statements. IFRS 3 on Business Combinations and
IAS 38 on Intangible Assets in particular, are at the centre of a lively debate on the
2 Visualising Intangibles
contents these rules should have for improving annual report information and its
usefulness for economic decision-making. A comparison between IAS/IFRS and the
U.S. Financial Accounting Standards (U.S. GAAP) reveals also some differences
in the treatment and capitalisation of intangible assets, and potentially a different
degree of disclosure between the two sets of rules, with consequences in terms of
appreciation of these resources.
Moreover, the interest to make company information available in a widespread
and timely fashion, and the need for a detailed and rapid benchmarking between
business reports of different entities, are paving the way for new technological tools
such as the eXtensible Business Reporting Language (XBRL), which can be usefully
applied also to information on intangibles.
A further emerging trend is that many firms, which are dissatisfied with the current
accounting treatment of intangibles, have begun to produce and often publish ad hoc
reports for better representing these key-resources. Different contents and forms of
statements have been used for this purpose in recent years, and therefore an analysis
of their contribution to effectively manage and disclose intangibles/intellectual
capital to various audiences appears to be potentially of great interest.
The importance of intangibles is also witnessed by the largely adopted focus
on knowledge management in company practices globally. Indeed, how individual
knowledge can be transferred to and operates at an organisational level, and how such
knowledge can be retained and renewed by firms, are two topics inherent to the field
of intangibles. All types of knowledge are in fact intangible assets of an organisation,
and hence the sustained attention on knowledge management is another distinctive
way to emphasize the important role of these resources in value creation.
Also policy makers are increasingly recognising the crucial role of intangibles
for the competitive advantage of both nations and regions, and are supporting
research programmes on the subject area. Traditionally, the weight of investments
on GNP and the quality level of workforce have been at the centre of policy makers’
decisions. Nowadays, nations and regions are increasingly competitive in relation to
the knowledge capital they possess, but economic theory and statistical indicators
are still unable to capture the value and complexity of intangibles. Thus, the quest for
a new approach to measuring, analysing and valuing intangibles is fastly emerging
also at a meso and macro level.
The awareness of the need for new research on intangibles is the fundamental
drive that stimulated this book. It derives from a two-year interdisciplinary project,
funded by the Directorate General “Information Society Technologies (IST)” of the
European Commission, and named PRISM (“Policy making, Reporting and measuring
Intangibles, Skills development, and Management” – http://www.euintangibles.net).
In particular, the research presented in this book essentially collects the revised
version of the studies developed within the Ferrara University’s research unit on
“Accounting, financial analysis and audit in the intangible economy” led by Prof.
Stefano Zambon. The research outcomes of this unit have been integrated into this
publication accompanied by other works of distinguished scholars dealing with
important and emerging topics in the field1.
1 In 2004 Ashgate published a book titled “The Economic Importance of

Visualising the Invisible 3
The book aims to offer new insights into the measuring, reporting, evaluation,
and management of intangibles, and the use of associate information in a variety of
contexts and settings, not only linked to profit-making entities and the micro level.
Chapter 1 by Stefano Zambon and Vania Crosara analyses the effect that the new
U.S. accounting rules on business combinations (SFAS 141 and SFAS 142) have
initially produced on net income and shareholders’ equity of European companies
listed on the American stock exchanges (Nyse and Nasdaq). For the first time, in
2002 these companies had to prepare their consolidated accounts according to these
U.S. standards. In this way, the chapter aims also to estimate the income and equity
effects of the rules set by the International Accounting Standards Board (IASB) in
this area – i.e. IFRS 3 – which closely reflect SFAS 141 and SFAS 142. Indeed, as
a consequence of the E.U. regulation requiring the use of International Accounting
Standards/International Financial Reporting Standards (IAS/IFRS) by listed
European companies for their consolidated accounts from 2005 onwards, the above
U.S. rules on business combinations have become de facto extended also to the
European context. A further aim of the chapter is to assess the amount of disclosure
originally released by European companies to the U.S. market in respect to the new
accounting treatment of goodwill and its component parts.
In Chapter 2, Giuseppe Marzo provides an evaluation of the real options theory
in analysing and measuring intangible assets. This seems to be a promising approach
for valuing intangible assets. Nevertheless, a deeper understanding of how it can
be effectively employed requires an accurate analysis of both the reasons and the
scope of such a use. This chapter firstly highlights how a real options lens can be
utilised for interpreting some characteristics of intangible assets, hence delineating
the theoretical foundations to the adoption of such an approach for valuing these
resources. Secondly, it focuses on the relationships between intangible assets and
real options’ value. Furthermore, a conceptual model addressing intangible assets’
risk is framed in the light of the real options theory.
In Chapter 3, David Young focuses his attention on the evolution of accounting
from the point of view of the development of Generally Accepted Accounting
Principles (GAAP), highlighting that the major thrust has essentially been so far
to make the financial reports of all organizations reflect these principles more
accurately. In many respects, the quest has been for an appropriate combination
of relevance and reliability. GAAP had defined what was relevant, and over time
accounting standards were developed in an effort to improve reliability. For several
reasons, however, and most notably the growing significance of intangible assets,
GAAP no longer is sufficiently relevant for the financial community. The purpose
of the chapter is to discuss why this is so, and to propose a set of principles to
Intangible Assets” edited by Patrizio Bianchi and Sandrine Labory, which collects
the research outcomes of the other PRISM project’s research unit based at the Uni-
versity of Ferrara and led by Patrizio Bianchi. This unit was devoted to the study of
the “Policy implications of the intangible economy”. The interactions between the
two Ferrara research teams within PRISM have been rich and mutually beneficial,
and they are witnessed, inter alia, by the chapters that each of the two units’ lead-
ers have contributed to the Ashgate book edited by the other.
supplement GAAP, called Generally Accepted Intangibles Principles or GAIP. Like
the GAAP, the proposed GAIP are at a very general level. Once they or a modified
set are deemed relevant, efforts can take place to improve the way data are measured
and reported, i.e. reliability. These efforts would likely be the responsibility of a
standard-setting body, comparable to the Financial Accounting Standards Board
(FASB) in the United States.
The increasing importance of intangible assets as the fundamental value drivers
has brought about some criticism to the traditional financial statements, since their
inadequacy in addressing the issue of intangibles, and has stimulated the emergence
of an alternative intangibles-oriented form of corporate reporting, i.e. the Intellectual
Capital (IC) statement. However, in the recent past other innovative reports are being
more and more frequently produced by companies, such as environmental and social
reports. Michela Cordazzo, in Chapter 4, addresses whether IC statements have
some points of contact with those reports, or whether they should be considered as a
brand new reporting model, independent of and completely detached from the other
two. Through an empirical analysis with specific reference to the Italian context, the
study reveals that there is a high level of dispersion in the information composing
of environmental and social reports; that a significant overlapping of data between
these two sets of documents exists; and more importantly that a quite relevant set of
information is in common between the environmental and social reports on the one
hand, and IC statements on the other hand.
The usefulness of disclosure on intangibles displayed by traditional financial
statements is at the core of Chapter 5 by Baruch Lev, Doron Nissim and Jacob
Thomas, who investigate as to whether capitalisation and subsequent amortization of
R&D expenditures improve the information conveyed by earnings and equity book
value about intrinsic equity value. Indeed, under U.S. GAAP reported balance sheets
and income statements are based on immediate expensing of R&D expenditures.
These authors proceed to capitalise those expenditures, and derive adjusted equity
book values and earnings using simple amortization techniques (straight-line over
assumed industry-specific useful lives). After confirming that such adjustments
increase the association of book values/earnings with contemporaneous stock prices
(and future earnings), Lev, Nissim and Thomas examine the relationship between
those adjustments and future returns. Despite the approximate nature of those
adjustments, they are able to predict stock price movements over the next 20 months.
Apparently, capitalization and amortization of R&D provides information not fully
reflected in stock prices.
In Chapter 6, Stefano Zambon and Ilaria Bergamini investigate and rank the
level of publicly available disclosure on intangibles provided by Italian, French,
German and U.K. listed companies, using a model jointly developed in 2002 by the
University of Ferrara and the Italian Association of Financial Analysts (AIAF). The
basic framework of this model is three-dimensional: it divides information between
forecast and actual; it distinguishes six communication dimensions for intangibles
(strategy and business model; innovation & IPRs; human resources; organisation;
customers and market; corporate governance); and it catalogues companies according
to diversified communication levels depending on the completeness and depth of
information provided (“minimum” information, “reasoned” information, extended
Visualising the Invisible 5
information). The results seem to outline quite distinctive patterns of intangibles
disclosure in the examined national contexts, which are somewhat surprising with
reference to the standard views elaborated by the international accounting theory on
the general disclosure level of those countries’ companies.
Chapter 7 by Adele Del Bello addresses a rather unexplored but significant issue,
i.e. the attitude and methodologies of credit rating agencies vis-à-vis intangible
assets during their rating process. The paper probes into the methods utilised in
this area by the three most important international rating agencies: Standard and
Poor’s, Moody’s, and Fitch Ratings. As a result of an analysis of these agencies’
rating methodologies and some semi-structured interviews, it emerges that for all
three entities ratings are essentially based on financial data. Despite the frequent
reference to specific intangibles in the internal manuals, it appears that there is no
official structured algorithm or procedure followed by these agencies to track down
in an organic and formalised way the role of intangibles in their evaluation process.
Nevertheless, the presence of these assets, and in particular of qualified human
capital, company reputation and branding, and good management credibility and
track record, seems often to be related to the granting of higher level ratings. Hence,
some common informal guidelines aiming at valuing intangibles appear to emerge,
even though the rating of these resources is still largely based upon individual
analysts’ experience.
Chapter 8 by Kurt Ramin focuses on eXtensible Business Reporting Language
(XBRL), a dialect of the internet language XML (eXtensible Mark-up Language),
which applies specifically to business reporting with a particular focus on financial
reporting. XBRL enables both preparers and users of accounting information to
process, publish and exchange information more efficiently, and to analyse data
more quickly. XBRL aims to bring standardization to the business information
supply chain, thus improving the efficiency of communications to investors,
financial markets, and other stakeholders. In the context of Intellectual Capital, this
technology introduces an efficient way to understand the treatment of intangibles
and related information from entity to entity and from country to country. Finally,
XBRL enables the consumer of the information to distinguish different forms of
“capital” in company reporting. Monetary, financial, and intellectual capital can then
be disclosed in a coherent manner by sharing a common set of definitions and tags.
In Chapter 9, Giovanni Masino addresses the necessity of building a better
“intangible assets-based theory of the firm”. He focuses his attention on the role
of power, pointing out the lack of attention to power issues by the intangibles
scientific community, while examining some reasons for their importance. The
chapter explores why power is a very relevant intangible in itself, and analyses its
relationships with other intangible resources. It finally highlights the benefits of
exploring different epistemological directions from the standpoint of such a central
but neglected intangible.
Fabio Donato in Chapter 10 opens up a new, fresh perspective, dealing with
the management and reporting of intangible assets in non-profit entities, and in
particular cultural organisations. Through the analysis of two case studies (the
Royal Opera House in Covent Garden, London, U.K.; and the Teatro dell’Opera in
Rome, Italy) and their performance measurement systems, the chapter underlines
the “ontological” importance of these resources for cultural organisations, their
objectives, and day-by-day operations. It also suggests an innovative categorization
of intangibles suitable for opera houses, which can be fruitfully used either on a
quantitative or a qualitative/descriptive basis.
In Chapter 11, Patrizio Bianchi and Sandrine Labory argue that there are four
main policy indicators of intangible assets at macro level, corresponding to four main
intangible assets: human capital, innovation and knowledge base, organisational
capital, and social capital. Existing indicators of such assets are imperfect, so
that these resources result in either being badly measured or not measured at all.
Therefore, policy prescriptions based on such indicators cannot be optimal. As a
consequence, in order for policy to be effective in the intangible economy, a first step
is to improve macro indicators. Authors suggest a number of ways to ameliorate the
measurement of such indicators, which include the use of surveys, the stress on the
local level relative to the global one, and the emphasis on the need to take account
of complementarities.
Acknowledgements
In passing this work for printing, we would like to express and recognise our debt
towards the people who in various ways have supported our effort in editing a book
which aims to offer new insights on intangibles.
In particular, we would like to thank all contributors for the valuable work
they provided, and for their willingness to promptly review earlier drafts of their
chapters.
We are indebted to the Directorate General “Information Society Technologies
(IST)” of the European Commission, which funded the above mentioned Ferrara
University’s research unit within the PRISM Project, thus making possible the
development of the ideas upon which some chapters of the book are based.
We are thankful to Prof. Lucie Courteau and Dr Michela Cordazzo, both from
the Free University of Bolzano, for helping us with the review process of some
chapters.
We also would like to thank Ms. Brenda Ogilvie for her contribution towards
improving the English style of a significant number of book chapters.
Finally, we are also grateful to Ashgate for its continuous support during our
lengthy, but rewarding editorial process.
Stefano Zambon
Giuseppe Marzo
March 2007
PART 1
MEASUREMENT AND
REPORTING ISSUES
Chapter 1
Regulatory Changes in Accounting for

Goodwill and Intangible Assets:
A Study of Their First Impact on
European Companies Listed on US
Markets
Stefano Zambon and Vania Crosara
Introduction: SFAS 141 and 142 as the Culmination of the FASB Business
Combination Project
In recent years, the importance of intangible assets within companies has notably
increased and this has produced the need for a better disclosure about this type of
resources. At the same time, last few years have been characterised by a strong
wave of mergers and acquisitions that has sharpened the problem of accounting for
intangibles, which constitutes an increasing portion of the assets acquired in this
kind of transactions.
Several institutions raised the problem of changing the accounting rules in this
field. Definitively, the issuance in July 2001 by the US Financial Accounting Standards
Board (FASB) of the Statements of Financial Accounting Standard (SFAS) 141
“Business Combinations” and 142 “Goodwill and Other Intangible Assets” marked an
important step in this direction. After, several other accounting institutions followed
FASB’s example. These Statements are among the most significant pronouncements
issued by the FASB in many years and reflect the culmination of a project, which has
begun in the second half of the ‘90s, aiming at reforming the accounting treatment of
business combinations (Mard et al. 2002).
The purpose of the FASB’s work was to increase reliability of financial data and
comparability of annual reports released by companies. The starting point was the
possibility to account for business combinations using one of the two then allowed
methods: the purchase method or the pooling-of-interests method (even though the
use of the second was permitted only when certain criteria were met). Consequently,
similar transactions might have been recorded in two different ways, reducing the
comparability of financial statements. Therefore, the first aim was the abolition of
one of the two methods: in this respect, FASB decided that business combination had
to be accounted for using only the purchase method, thus prohibiting the adoption
of the pooling-of-interests. Another important step was to revise the requirements
contained in APB Opinions no. 16 and 17 about the identification and the recognition
of intangible assets and their accounting treatment, so to enhance consistency in the
application of these standards. Finally, FASB decided that useful lives of certain
intangible assets could be indefinite and that amortisation of those assets would not
be representationally faithful.
These were the three main points with which the Exposure Draft issued by the
FASB in February 2001 for illustrating the new accounting model dealt. In response,
FASB received several comment letters, which brought some changes about:
• the reporting level at which to measure goodwill impairment. The FASB

revised the definition of “reporting unit” (the level within the consolidated
business at which goodwill impairment is measured) to a higher level, which
reduced the potential number of reporting units and the extent of goodwill
impairment testing;
• the timing and the mechanism of the impairment test. SFAS 142 requires an
at least annually impairment test instead of the application of the indicator-
based approach proposed in February 2001 Exposure Draft. Furthermore, for
goodwill a two-step impairment test approach has been introduced; and
• effective date. The ED required the immediate adoption of both SFAS after
their final issuing. Instead, general rules are that SFAS 141 is effective for
business combination initiated on or after July 1, 2001 and SFAS 142 for
years beginning after December 15, 2001.
In July 2001, with an unanimous approval, FASB issued the above mentioned
SFAS 141 “Business Combinations” and SFAS 142 “Goodwill and Other Intangible
Assets”, which superseded APB Opinions no. 16 and 17, respectively. The extent
of the consequences of these two accounting standards is wide, as they brought
about strong innovation in accounting for intangibles (especially goodwill) acquired
individually, in group or in a business combination. They aim to represent an updated
answer to the need for a better disclosure about these resources and an increased
comparability of accounting documents. Through their application, the representation
of the investments made in an acquired entity has improved, since purchase method
records transactions on the basis of exchange value, and disclosure about the
operation carried out has increased, this potentially helping to better understand
the economic effect of the event and to better assess company future profitability
and cash flows. More in general, SFAS 141 and 142 intended to produce a greater
reliability of the financial results, in compliance with the concept of representation
faithfulness contained in the FASB’s Statement of Financial Accounting Concepts
no. 2 on “Qualitative Characteristics of Accounting Information”.
In the light of the above regulatory changes, the aim of this study is to analyse
the way European companies listed on US financial markets (Nyse and Nasdaq)
reacted to the issuing of SFAS 141 and 142 and, when they had already adopted
these standards, to measure the impact of their application on company net income
and shareholders’ equity.
Regulatory Changes in Accounting for Goodwill and Intangible Assets 11
The importance of this topic is linked to the relevance of US GAAP for European
companies. Actually, these companies listed in the USA have to compulsory prepare
their consolidated accounts in compliance with US GAAP or, alternatively, to present
a reconciliation statement (contained in the so-called Form 20-F) between American
accounting principles and their domestic GAAP, as requested by the US Securities
and Exchange Commission (SEC) to foreign registrants listing their securities on
Nyse and Nasdaq. Thus, in 2002-03 European companies had to face for the first
time the application of the two new American SFAS. Moreover, the importance
of this issue is linked to the change in EU regulatory framework (EU Regulation
no. 1606/2002), which prescribes European listed companies to prepare their
consolidated accounts in accordance to International Financial Reporting Standards
(IFRS) from 2005 onwards. As in last few years a progressive alignment between
US GAAP and IFRS has begun, European companies have now to deal with IFRS 3
on business combinations, which closely resembles to the US standards. Indeed, it
can then be said that the US rules have subtly influenced accounting for intangible
assets also vis-à-vis the other European companies (see Zambon and Dick 1998).
The paper is articulated as follows. In the following section, an analysis of the two
SFAS will be proposed. A rather detailed overview of their content will be provided
and their major innovations highlighted, also in comparison with the principles they
supersede. Then, the empirical analysis will be presented. It is based on Forms 20-F
released by European companies: at first, a qualitative study will be conducted in
order to assess the behaviour of the analysed companies in respect of SFAS 141
and 142. After, both global and partial comparability indexes will be calculated to
measure the quantitative effect of the two SFAS on net income and shareholders’
equity of European companies listed on US markets. The last section will be
dedicated to drawing some conclusions. Findings about the examined issues will be
discussed, offering a few interpretations and comments. Some further suggestions
for a future development of this study will be provided.
A Presentation of SFAS 141 and 142
An overview of SFAS 141 and SFAS 142
SFAS 141 on “Business Combinations” Statement 141 has been issued by the
FASB in order to produce relevant changes in the method of accounting for business
combinations as well as in the classification of intangibles and in their recognition
apart from goodwill. On the one hand, it prescribes this type of transactions to be
accounted for only by using the purchase method; on the other hand, it sets criteria
that intangibles must respect for their recognition apart from goodwill.
This statement supersedes APB Opinion no. 16 on “Business Combination”
issued in 1970 and amends or supersedes a number of its subsequent interpretations.
APB Opinion no. 16 allowed companies to record business combinations using
one of the two methods: the purchase method or the pooling-of-interests method.
Even though the use of the pooling-of-interests method was permitted only if certain
criteria were satisfied, the possibility to account for identical transactions in different
manner reduced the comparability of company financial statements.
In spite of the important changes introduced, it has to be noted that many of
the previous prescriptions remained the same, like the criteria to be followed by
companies to determine the cost of the acquired entity and to allocate it to assets
acquired and liabilities assumed, as well as accounting for contingent considerations
and pre-acquisition contingencies.
The FASB choice to account for all business combinations according the purchase
method, determines the need to always treat this kind of transactions as acquisitions,
and then to identify an acquirer entity and to calculate a goodwill as the excess of the
cost over the net amounts of assets acquired and liabilities assumed.
Another important innovation introduced by SFAS 141 regards the separate
recognition of intangible assets apart from goodwill. This is the most important
change in the allocation of the business combination cost. It is prescribed that
intangible assets have to meet one of the two criteria set for their separate recognition,
otherwise their value must be included in goodwill. These criteria are:
• the contractual-legal criterion. The intangible asset has to arise from a contract
or a legal right, regardless if that contract or that right can be transferred
separately from the entity acquired or from other rights and obligations;
• the separability criterion. If the intangible assets does not arise from a contract
or from a legal right, it can be recognised apart from goodwill only if it is
separable. This means that it can be divided or separated by the acquired entity
and can be sold, exchanged, transferred or rented. Even when an intangible
asset cannot be sold, transferred, exchanged, rented individually, it is to be
considered separable if it can be part of a transaction together with a related
contract, asset or liability.
To help companies to better allocate the cost of the business combination, SFAS
141 provides a list of examples of intangible asset that meet these two criteria and are
therefore to be accounted for as assets apart from goodwill. This guidance identifies
five categories of intangible assets:
• Market-related intangible assets;

• Customer-related intangible assets;
• Artistic-related intangible assets;
• Contract-related intangible assets; and
• Technology-related intangible assets.
This is not an exhaustive classification and inside each category various

intangibles can be included. As for the amortisation of these intangibles and the
impairment methods, rules are given in SFAS 142.
It is interesting to point out that the value of the assembled workforce of “at-will”1
employees acquired in a business combination does not meet the two prescribed
criteria for the separate recognition and should therefore be included in the amount
recorded as goodwill. This is based on the FASB’s view of the need to limit the
appreciation of the intellectual capital that underlies the value of an assembled
workforce.2
Finally, SFAS 141 requires companies to produce a more complete disclosure on
the resulting business combination. Instructions regard both information to include
in the annual financial statements and disclosure to be produced in the interim
reports. In addition to the information that a company has to produce in the period in
which a material business combination is carried out (general information about the
operation), other several cases are indicated:
• when the amounts assigned to goodwill or other intangible assets are relevant
in relation to the total cost of the operation during the period in which a
material business combination is completed: SFAS 141 requires then specific
information for goodwill, intangible assets subject to amortisation, and
intangible assets not subject to amortisation (this information, together with
general information about the business combination, is to be disclosed also
when the operation is completed during the current year up to the date of the
presentation of the nearest interim report);
• when a series of intangibles is not individually immaterial but material in the
aggregate;
• when the company is a public business enterprise, supplemental information
is to be disclosed in the notes to the financial statements on a pro-forma basis
for the period in which a material business combination occurs;
• when an extraordinary gain due to the business combination occurs,
information required by APB Opinion 30 is to be produced;
• when the allocation of the purchase price is preliminary and when contingent
consideration is based on future earnings, companies have to produce the
information required by the SEC.
Regarding to the information to be disclosed in the interim report, companies

must provide it when the business combination is completed during the year up to
the date of the nearest interim report.
As pointed out early, provisions of SFAS 141 apply to all business combinations
initiated after June 30, 2001 and to all business combinations accounted for by the
purchase method, whose acquisition date is July 1, 2001 or later (these provisions do
not apply to business combinations between two or more mutual enterprises). It is
therefore important to give a clear definition to the term “initiated”: SFAS refers to
the definition provided by APB Opinion no. 16, for which a business combination is
1 “At will” employees refers to those employees that are not subject to a contractual
employment agreement.
2 As it will be shown by the empirical analysis presented in the third section, the
workforce is the most retreated/reclassified item after the application of SFAS 141 and 142.
considered initiated at the date when the main terms of the plan are publicly released
or at the date when stockholders are notified in writing with the exchange offer.
Moreover, some transitional provisions have been given for the accounting of
business combinations by the purchase method when the acquisition date is before
July 1, 2001. In this case, the carrying amount of acquired intangible assets that
do not meet the criteria for the separate recognition apart from goodwill must be
reclassified and included in the goodwill value as of the date in which SFAS 142
is applied in its entirety. Furthermore, the carrying value of intangibles meeting the
contractual-legal or the separability criteria that were included in goodwill must be
reclassified as of the date in which SFAS 142 is applied in its entirety.
SFAS 142 on “Goodwill and Other Intangible Assets” Statement 142 has been
issued together with SFAS 141 in July 2001 in order to introduce some changes
in the treatment of goodwill and other intangible assets. These changes affect the
accounting for these resources also when they are acquired for effect of a business
combinations. The innovations introduced regard especially the amortisation of
goodwill and the accounting for other intangible assets, for which SFAS introduces
a division between intangibles with finite and indefinite life.
SFAS 142 supersedes APB Opinion no. 17 “Intangible Assets” issued in 1970,
with the exclusion of the accounting method for intangibles internally developed
and of the requirement to expense research and development costs at the date
of acquisition.
The approach introduced by SFAS 142 is profoundly different from the one
previously adopted, as goodwill and some intangible assets (with indefinite
useful life) will cease to be amortised, and will be tested for impairment at least
annually at the reporting unit level. The immediate consequence of this treatment
will be that their values will not decrease constantly. This may produce a greater
volatility in the net income, as impairment losses might occur irregularly and for
differentiated amounts.
Operationally, it is first of all necessary to define what is a reporting unit. Then,
it is necessary to define the procedure used for the impairment test. According to the
definition contained in SFAS 131 on “Disclosure about Segment of an Enterprise
and Related Information”, a reporting unit is the same level as, or one level below,
an operating segment.3 Thus, the goodwill allocation to each reporting unit at the
acquisition date is an procedure that will become very important for testing goodwill
for impairment. Goodwill must be assigned to the reporting unit that may benefit of
the synergies deriving from the aggregation. If it has to be allocated to more than one
reporting units, then the allocation must be reasonable, supportable and consistent,
as required by the Statement.
As for the mechanism of this test, SFAS prescribes a two-steps approach. The
first step consists of comparing the carrying amount of the reporting unit including
goodwill to its fair value to assess whether there is a need for impairment. It is
3 SFAS 131 defines an operating segment as a component of an enterprise about which

separate financial information is available that is evaluated regularly by the chief operating
decision maker in deciding how to allocate resources and in assessing performance.
then important to give a clear definition of “fair value”, that is the value at which
a reporting unit can be exchanged4 .If the fair value exceeds the carrying amount,
goodwill is considered not impaired and the second step is unnecessary.
If the fair value is lower than the carrying value, then the second step of the test
shall be performed for measuring the amount of goodwill impairment. The second
step consists of comparing the implied fair value of goodwill of one reporting unit
to its carrying value. The former value is calculated deducting from the reporting
unit’s fair value the fair value of all assets (both tangible and intangible) assigned
to the reporting unit. If it emerges that the carrying value of goodwill is higher than
the implied fair value, then an impairment loss should be recognised of an amount
equal to that difference (the impairment loss cannot exceed the carrying value of
goodwill). After its recognition, the adjusted carrying value of goodwill represents
its new accounting base. Moreover, subsequent reversal of a previously recognised
goodwill impairment loss is prohibited once the measurement is completed. With
regard to its presentation in the financial statement, impairment loss should appear
as a separate line in the operating section of the income statement.
As pointed out before, companies shall perform the impairment test of goodwill
at least annually, or whenever circumstances or events occur and indicate that
an impairment of the fair value of the reporting unit is more likely than not. The
measurement test can be performed at any time during the year, provided that it is
performed around at the same time every year.
Another innovation introduced by SFAS 142 regards the different treatment
of intangibles with a finite life and those with an indefinite life. Considering that
the useful life corresponds to the period in which an asset contributes directly or
indirectly to future cash flows, intangibles with a finite useful life will continue to
be amortised over their useful life in a manner that reflects the pattern in which
economic benefits are consumed. When the pattern cannot be reliably determined,
a straight-line amortisation shall be used. An important innovation introduced by
this Statement in respect of APB no. 17 is that it does not impose a temporal limit to
the amortisation: APB no. 17 prescribed that intangibles had to be amortised up to
40 years, while SFAS 142 indicates that amortisation must continue for the whole
useful life of the intangible asset.
Regarding to the treatment of intangibles with indefinite useful life, it is similar
to the treatment of goodwill. Also this kind of intangible assets will no longer be
amortised but subject to an impairment test, but performed in a different manner
from the goodwill. In this case, it consists in comparing the fair value of the asset to
its carrying value. If the carrying amount is higher than the fair value, the company
must recognise an impairment loss equal to this excess.
Likewise SFAS 141, Statement 142 requires a wider disclosure to be provided on
goodwill and intangible assets. It gives guidance about information that companies
has to disclose. There is some information that has to be presented on every period
for which financial statements are prepared, and regards intangibles subject to
4 Statement of Financial Accounting Concepts (SFAC) no. 7 defines the fair value as the
amount at which that asset (or liability) could be bought (or incurred) or sold (or settled) in a
current transaction between willing parties, that is, other than in a forced or liquidation sale.
amortisation, intangibles not subject to amortisation, and changes in the carrying value
of goodwill. Other information has to be disclosed when only a portion of goodwill
is allocated to the reporting unit, and also when there is a recognised impairment
loss that also includes intangibles not subject to amortisation. Finally, companies are
required to disclose particular information in the acquisition period on intangibles
acquired either individually or in group that do not constitute a business.
As pointed out early, all provisions of SFAS 142 will be effective for fiscal
years beginning on or after December 15, 2001. An early application is allowed for
companies whose fiscal year begins after March 15, 2001, provided that the first
interim report has not been previously issued. Some provisions already apply to
goodwill and other intangible assets acquired after June 30, 2001, even though the
Statement has not been applied in its entirety.
FASB also prescribes some transitional provisions for goodwill and other
intangibles acquired in a business combination whose acquisition date is before
July 1, 2001, and that were accounted for by the purchase method: these provisions
deal with the need to reclassify as of the date in which SFAS 142 is applied in its
entirety, the carrying value of intangibles that cannot be recognised as assets apart
from goodwill, the carrying amount of recognised intangibles meeting the criteria
prescribed by SFAS 141, as well as the carrying amount of recognised unidentified
intangibles that were included in goodwill.
Finally, some particular provisions for goodwill and intangible assets acquired
after June 30, 2001, for goodwill and intangible assets previously recognised, and
for the equity method goodwill, are provided.
Research and Methodology
The Sample
An opportunity to compare US financial results to financial results obtained by

applying domestic accounting principles is offered by those companies which are
obliged by the US Securities and Exchange Commission to present the Form 20-F.
Indeed, as aforementioned, the SEC requires non-US companies listing their stocks
on US stock exchanges to present their consolidated accounts complying with US
GAAP or, alternatively, to prepare a reconciliation between US GAAP and national
accounting principles. The reconciliation statement can therefore be used to test the
distance between the two sets of accounting rules.
The analysis carried out in this chapter takes into consideration all European
companies that were listed on US Stock Exchanges at 1st January 2003 for the fiscal
year 2002.5
Data have been directly collected consulting web sites of Nyse and Nasdaq, and
the initial sample was composed of 292 European companies listed at the date of
1st January 2003, 186 listed on Nyse and 109 listed on Nasdaq (Alcatel, Carlton
5 The expression “year 2002” refers here to fiscal periods ending between July 1, 2002
and June 30, 2003.
Communication and Elan Corporation were listed on both stock exchanges). Of
these companies some have been excluded from the analysis because at a closer look
they did not meet the prescribed criteria (of being a European company and of being
listed as at 1st January 2003), or because it has not been possible to get the Form 20-
F. The final sample is therefore composed by 262 companies (see Appendix 1.A).
Alternative Accounting Behaviours of the Analysed Companies
In analysing the accounting behaviour of the companies composing the sample

of this study, it has been found that they comply with the SEC requirements in a
different manner (see Table 1.1).
Companies have been divided into three categories:
1. Fully compatible accounts: these companies prepare their consolidated

accounts in accordance with US GAAP, which fully comply also with the
national accounting rules. This is the case of one Swiss company analysed.
2. Only non-national accounts: these companies do not prepare their consolidate
accounts in accordance with their domestic accounting standards but produce
them in compliance with US GAAP. In this category also companies preparing
Forms 10-K and 10-Q have been included. In this case it is of course not
possible to assess the qualitative differences and the distance between the
results expressed according to national and non-national accounting rules.
3. Reconciliation provided: companies belonging to this group provide a
reconciliation between the results expressed according to their national
accounting standards and those complying with US GAAP. Only for this
companies it is therefore possible to measure the distance between domestic-
and American-based accounting results by calculating the comparability
indexes.
As noted above, only for companies classified in the latter category global and
partial comparability indexes have been calculated. Nevertheless, all companies
have been used for the qualitative analysis.
Methodology
The stated aim of the chapter is the analysis of the implementation impact of SFAS
141 and 142 on European companies’ accounts. When these companies applied these
Statements, the distance between the accounting results obtained using domestic
accounting principles and US GAAP, will be measured.
Initially, a qualitative analysis has been carried out. Forms 20-F referred to fiscal
year 2002 have been analysed with reference to their section dedicated to accounting
policy or to the notes to the accounts, in order to verify which principles companies
have adopted to account for business combinations, goodwill and intangible assets.
This allowed to check whether companies were effectively adopting the new
standards and the manner they were applying them. Further, also a check on what
categories of information companies disclosed on intangibles was also carried out.
Table 1.1 Alternative accounting behaviours of the analysed companies
COMPANIES
U.S. GAAP
Fully compatible
Logitech (Switzerland)
accounts
Total = 1
Only non-national Telekom Austria (Austria); ICOS Vision Systems (Belgium); Eurotrust
accounts (Denmark); Activcard, Business Objects, EDAP TMS, Flamel Technologies,
Genesys, Havas, Ilog, Infovista, SCOR Group, Transgene, Wavecom
(France); Altana, Celanese, Daimler Chrysler, Deutsche Bank, Digitale
Telekabel, E.ON, Epcos, Fresenius Medical Care, Infineon Technologies,
INTERSHOP Communications, iXOS Software, Lion Bioscience,
Pfeiffer Vacuum Technology, SAP, Siemens (Germany); Antenna TV,
Coca-Cola Hellenic Bottling Company, Hellenic Telecommunications
Organization, National Bank Greece, Stelmar Shipping, STET Hellas
Telecommunications, Tsakos Energy Navigation (Greece), Hibernia
Foods, ICON, IONA Technologies, Skillsoft, Trintech Group (Ireland);
Luxottica Group (Italy); SBS Broadcasting, Stolt-Nielsen, Stolt-Offshore,
The Cronos Group (Luxembourg); ASM International, ASML Holding,
BE Semiconductor Industries, Chicago Bridge & Iron Company, CNH
Global, Core Laboratories, Crucell, Head, ICTS International, James Hardie
Industries, Metron Technology, New Skies Satellites, Orthofix International,
Qiagen, Sapiens, STMicroelectronics, Triple, Van der Moolen Holding (The
Netherlands); Statoil (Norway); A.O. Tatneft, Mobile TeleSystems, Vimpel
Communications, Wimm-Bill-Dann Foods (Russia); Autoliv (Sweden); ABB,
Adecco, Alcon, Ciba Specialty Chemicals Holding, Connverium Holding,
INFICON Holding, Mettler Toledo International (Switzerland); Turkcell
Iletisim Hizmetleri (Turkey); ARM Holding, Autonomy Corporation, Danka
Business Systems, Denison International, Dialog Semiconductor, Ebookers,
Futuremedia, Galen Holdings, Insignia Solutions, Ispat International,
Professional Staff, Senetek, Shire Pharmaceuticals Group, Telewest
Communications (UK)
Total = 92
Table 1.1 continued

Reconciliation Delhaize Group (Belgium); Aktieselskabet Dampskibsselskabet Torm, Novo
provided Nordisk, TDC (Denmark); Instrumentarium, Metso, Nokia, Stora Enso, UPM-
Kymmene (Finland); Alcatel, Alstom, Aventis, AXA, Companie Générale de
Geophysique, Dassault Systemes, France Telecom, Groupe Danone, Lafarge,
Pechiney, Publicis Groupe, Rhodia, Sanofi-Synthélabo, Sodexho Alliance,
Suez, Technip.Coflexip, Thomson, TotalFinaElf, Vivendi Environment,
Vivendi Universal (France); Allianz, BASF, Bayer, Deutsche Telekom,
Schering, SGL Carbon (Germany); Allied Irish Bank, CRH, Elan Corporation,
Ryanair Holdings, The Governor and the Company of the Bank of Ireland,
Trinity Biotech, Waterford Wedgwood (Ireland); Benetton Group, DeRigo,
Ducati Motor Holding, Enel, ENI, Fiat, Fila Holding, Natuzzi, SAES Getters,
Sanpaolo IMI, Telecom Italia (Italy); Randgold Resources (Jersey); Espirito
Santo Financial Group, Gemplus International, Metro International, Millicom
International Cellular, Tenaris (Luxembourg); ABN Amro Holding, AEGON,
Akzo Nobel, Arcadis, Buhrmann, Equant, Gucci Group, ING Group, KLM
Royal Dutch Airlines, Oce, Reed Elsevier, Royal Ahold, Royal KPN, Royal
Philips Electronics, TPG (The Netherlands); Eksportfinans, Norsk Hydro,
Smedvig, Telenor (Norway); Banco Comercial Portuguese, Electricidade de
Portugal, Portugal Telecom SGPS (Portugal); Rostelecom (Russia); Banco
Bilbao Viscaya Argentaria, Banco Santander Central Hispano, Endesa,
Repsol YPF, Telefonica, Telefonica Mòviles, Terra Networks (Spain); Biacore
International, Electrolux, Ericsson Telephone Company, Modern Times
Group, Skf, Swedish Match, Tele2, Volvo (Sweden); Centerpulse, Credit
Suisse Group, Novartis, Serono, Swisscom, Syngenta, UBS (Switzerland);
Abbey National, Acambis, Allied Domecq, Amarin Corporation, Amersham,
Amvescap, AstraZeneca Group, Barclays Bank, BG Group, Bookham
Technology, BP, British Airways, British Biotech, British Sky Broadcasting
Group, BT Group, Bunzl, Cable & Wireless, Cadbury Schweppes, C.A.T.G.,
Carlton Communications, Celltech, Colt Telecom Group, Cordiant
Communications, Corus Group, Diageo, Eidos, Enodis, Gallaher Group,
Hanson, HSBC Holding, Imperial Chemical Industries, Imperial Tobacco
Group, International Power, Lastminute.com, Lloyds TBS Group, Merant,
mmO2, National Westminster Bank, NDS Group, P&O Princes Cruises,
Pearson, Premier Farnell, Provalis, Prudential, Reed Elsevier, Reuters, Rio
Tinto, Royal & Sun Alliance Insurance Group, Scottish Power, Signet Group,
Six Continents, SkyePharma, Smith & Nephew, Spirent, The Boc Group, The
Rank Group, The Royal Bank of Scotland Group, Tomkins, Unilever, United
Business Media, United Utilities, Vodafone Group, Wolseley, WPP, Xenova
Group (UK)
Total = 169
TOTAL U.S. GAAP Total = 262
Source: writers’ elaboration

After the qualitative analysis, companies have been divided into groups in
respect of the accounting standards adopted in preparing their consolidated financial
statements. For each group global and partial comparability indexes have been
calculated in order to measure the distance between the domestic vs. US-expressed
main financial results and, hence, between the two sets of accounting principles.6
Firstly, the overall distance between national and US-based results has been
measured through the global comparability index (Gray 1980), that is:
1 – US value – non-US value

|US value|
When the index assumes values greater than 1, the accounting result deriving by the
application of national principles is higher than the one calculated in compliance with
US GAAP. Vice versa, when the index assumes values lower than 1, the application
of national GAAP leads to results lower than those calculated by applying US
accounting principles. If the index is equal to 1, this means that generally there is
full compatibility between the two sets of accounting rules.
Even though this index has been widely used in literature (e.g., Ashbaugh and
Davis-Friday 2002; Crosara 2002; Gray 1980; Johnson 1996; Lagerström 1997;
Radebaugh and Gray 1997; Street et al. 2000; Weetman and Gray 1990 and 1991),
it is not without some methodological limits. For instance, it has been pointed out
that it tends to indeterminism when the non-national value (the US value in this case)
gets close to zero.
In order to quantify the impact of the adjustments related to goodwill on financial
results, a partial comparability index has also been calculated, that is:
1 – partial adjustment value

|US value|
This index expresses the explanatory weight of the adjustments related to an

accounting variable (here goodwill) vis-à-vis the total amount of a set financial result
(net income or shareholders’ equity).
Likewise its global version, the partial comparability index revolves around the
value of 1. If it assumes values greater than 1, this means that the national-based
value investigated is higher than the American-based and vice versa.
In both cases, outlier values have been excluded from the analysis, as their
inclusion could have produced misleading results. Outliers have been assumed to
occur when the index values are higher than +4 or lower than –2, which corresponds
to a difference, in absolute value, of ±300%.
Comparability indexes have been calculated for the main financial results (net
income and shareholders’ equity) and, with regard to the global index, have also
been computed for ROE. This measure, in fact, sums up the two main financial
results, as it is the outcome of their ratio (net income/shareholders’ equity). For its
6 As above mentioned, only companies producing a reconciliation between local and

US GAAP have been considered here.
very nature it plays a sort of stabilisation role, in that the indexes calculated using
such a variable express a balanced overall measure of the comparability between two
different sets of accounting principles.
Findings
The application of SFAS 141 and 142: the state of the art
The qualitative analysis carried out in this chapter shows that most companies of
our sample apply (or they provide some information about) both standards issued
by FASB in 2001.
Results show that only 4% of the total companies do not mention any of the two
new principles. By analysing their accounting documents, it emerges that there is
no disclosure on the treatment of goodwill: therefore in these cases it is not possible
to ascertain whether SFAS 141 and 142 have been adopted, even though 7 of these
10 companies prepare their consolidated financial statements under US GAAP (the
remaining three companies use IFRS, Swedish and UK GAAP), hence we expect the
two new standards to be used.
The other 252 companies provide instead some information on SFAS 141 and
142. However, whilst there are no companies showing information only about
SFAS 141 on accounting for business combinations (this may depend on the fact
that companies have not been involved in this kind of operation in the fiscal year
considered), approximately 20% (58 companies on 252) disclose only on SFAS
142.
It emerges that some companies had business combinations in 2002, and that these
transactions, according to the provisions of SFAS 141, have been recorded using the
purchase method, by virtue of which a value for goodwill has to be recognised.
Furthermore, by implementing this new standard, companies had to reclassify
their intangible assets in respect of the criteria prescribed by the Statement for
their separate recognition apart from goodwill or the inclusion of their value in the
goodwill. The analysis evidences that few companies reclassified their intangibles
according to the provisions of the new standard: the most recurring reclassification
regarded the workforce, whose previous accounting value has to be included in the
goodwill.
With reference to SFAS 142 and its implementation, companies ceased to
amortise goodwill and conducted a goodwill impairment test as set by the standard:
therefore, they used a two-step approach at the reporting unit level. The primary
effect of the application of this Statement is a reduction in the amortisation allowance
(and thus an increase in the net income), in connection with the recognition of an
impairment when fair value of goodwill is lower than its carrying amount. Moreover,
as prescribed by SFAS 142, companies had to change the treatment also of other
intangible assets, distinguishing between such assets with indefinite useful life, that
have not to be amortised but subject to an annual impairment test, and intangibles
with a finite useful life, that continue to be amortised but without a temporal limit.
Companies had to assess the impact of the application of these two new
Statements, that in most cases resulted to be not relevant.
The analysis also revealed that, according to the disclosure requirements of
SFAS 141 and SFAS 142, companies provided detailed information on the manner
the purchase price was allocated amongst the assets and the liabilities acquired in
business combinations, as well as on the state of the impairment test and the way
they carried it out for reporting units constituting the business.
The global distance between domestic accounting principles and US GAAP7
The calculation of the global comparability index allows to measure the distance
between the main financial results obtained through the application of domestic
accounting standards (or IFRS) and those reconciled to US GAAP.
This index has been calculated for net income, shareholders’ equity and ROE,
excluding outliers as defined above.
As for net income, the analysis shows that there is an especially significant
difference between Portuguese GAAP and US GAAP: the application of this local
set of accounting principles leads to an income result that is 68.4% higher than
the US-based one, whilst this difference is limited in the case of Spanish GAAP:
the index assumes in fact the value of 0.987. Also the difference between UK and
US GAAP is not relevant: the global index is 1.027, that means that UK-based net
income is on average higher than the US one by only 2.7%. As for the other sets
of accounting rules considered, the application of IFRS leads to a net income that
is 8.3% higher than that obtained with the application of US GAAP. Moreover,
companies using Belgian, Danish, Finnish, German, Irish, Italian and Norwegian
GAAP reveal lower results after the reconciliation, whilst companies adopting
Dutch, French, Swedish and Swiss GAAP obtain higher results when they express
their performance according to US GAAP. In general, the quantitative divergences
are quite wide with large swings in both ways.
As for shareholder equity, results appear to be more aligned, and there are less
significant differences vis-à-vis net income comparability indexes. In this case,
only the application of Dutch GAAP produces a largely different result: the index
is 0.656, this implying that the shareholders’ equity in accordance with US GAAP
is on average 34.4% higher than that shown in the domestic consolidated financial
statements. On the contrary, the difference between US and Belgian-based equity
is minimal, it being only of 0.7% (with US results being higher). Regarding to
other accounting principles, comparability indexes are higher than 1 in the case of
Danish, French, Irish and Italian GAAP, and lower than 1 for the companies of other
countries.
Finally, as for ROE, results show on average a larger difference between the US-
based results and the domestic-based ones. In most cases ROE obtained applying US
GAAP is lower than that calculated applying national accounting rules. In particular,
it can be noted a difference of 43.1% (the index is equal to 1.431) between Portuguese
and US GAAP (this reflects the significant difference in the respective net incomes),
7 See Appendix 1.B for details on the global comparability indexes.

and a difference of 37.8% between Dutch and US GAAP (the index is equal to 1.378).
The less significant differences emerged in comparison to Norwegian, Swedish and
Spanish GAAP (indexes are equal, respectively, to 1.060, 1.085 and 1.088).
The findings of this study seem to be in line with those of previous studies. As
regards UK GAAP, the net income global index (1.027) confirms that UK-based
results are on average higher than those US-based, as it has already been pointed out
by Weetman and Gray (1990 and 1991), Zambon (1998), and Adams et al. (1998).
As for shareholders’ equity, the analysis shows that UK amounts are generally
lower than US ones (the index is 0.921), thus confirming the sign of the results
obtained in the above mentioned studies, where the same global comparability
index ranged between 0.765 (Weetman et al. 1993) and 0.81 (Zambon 1998). It is
interesting to note a tendency of this index to move upwards during the years with
reference to the UK-US equity comparison, which can be a signal of the ongoing
convergence between the two sets of national rules.
As regards Spanish GAAP, the results obtained here confirm the findings of Ucieda
(2002) only with reference to net income: he found that net income was lower when
applying Spanish GAAP vis-à-vis US GAAP, and that Spanish-based shareholders’
equity was higher; this study shows instead that both net income and shareholders’
equity are on average lower (0.987 and 0.961, respectively) in comparison to the US
GAAP-denominated results, even though both indexes are very close to 1.
The partial distance between domestic accounting principles and US GAAP8
Since global comparability indexes do not permit to value in detail the contribution
of each reconciliation adjustment, a partial comparability index for net income and
shareholders’ equity has also been calculated in order to measure the impact of the
goodwill-related adjustments on company financial results.
In this respect, the adjustments producing an effect on net income and
shareholders’ equity and deriving from the differentiated treatment of goodwill in
the various national accounting systems, have been considered. These adjustments
relate essentially to both the non-amortisation of goodwill (and related impairment
test) according to the Statement 142, and the different way of accounting for business
combinations and intangible assets according to Statement 141 (i.e. purchase method
accounting). For this reason, a partial comparability index for net income and one for
shareholders’ equity have been calculated referring to goodwill.9
The results of the analysis show that, in respect to the net income partial index,
the extent of the adjustment relating to goodwill is in most cases significant. In fact,
excluding the case of German, Italian and Spanish GAAP (for which differences
are, respectively, of –2.6%, +8.1%, and +2.3%), with reference to the other sets
of accounting standards considered, differences are larger than ±10%. Further,
when the partial comparability index assumes values in line with the measure of
8 See Appendix 1.B for details on the partial comparability indexes.

9 The partial comparability index considers then all the individual adjustments producing
an effect on the expression of goodwill in the balance sheet, and on its amortisation allowance
in the profit and loss account.
the correspondent global comparability index, one can infer that the adjustments
relating to goodwill have a significant impact on the financial results calculated
applying the two sets of standards. For example, this is the case of the Finnish
GAAP, where the global index is 0.788 and the partial index for goodwill is 0.756;
in the remaining cases there are other factors that are more influential in explaining
the difference between national and US-based results (e.g., the treatment of financial
instruments).
As regards to the shareholders’ equity partial index, the differences are in general
more limited. Excluding the case of the Irish and Portuguese GAAP, it can be
observed that the greatest difference is equal to –22.6% (Dutch GAAP), whilst in
the case of Belgian, Finnish and Norwegian GAAP the difference is lower than 1%.
Also for shareholders’ equity, a similarity in the values of global and partial indexes
implies that goodwill adjustments have a significant weight on the total adjustment
(and, then, on determining the overall distance between local and US accounting
standards): this is the case of IFRS, Belgian, French and Spanish GAAP.
It emerged (even though rarely) that some business combinations have been
accounted for by the European companies considered using the pooling-of-interests
method, whilst – as aforementioned – this is not anymore possible accordingly to
the new US GAAP, with obvious consequences on the amounts of goodwill and the
other assets acquired.
Conclusions
The chapter is concerned with the application of the SFAS 141 on “Business
Combination” and 142 on “Goodwill and Other Intangible Assets” by European
companies listed on Nyse and Nasdaq, which have faced the first application of
the new rules in preparing 2002-03 accounting documents in compliance with US
GAAP, as requested by the Securities and Exchange Commission.
The primary aim of the study was to evaluate the impact of this newly devised
accounting treatment of business combinations, goodwill and other intangible
assets on the main financial results of European companies. This is to be seen as an
important case study on the effect of a major regulatory change on the representation
of company performance and wealth. To pursue such an aim, the way European
companies listed on US financial markets reacted to the issuing of SFAS 141 and 142
has been qualitatively and quantitatively analysed on empirical grounds. The intent
was also that of predicting the financial consequences for European companies of the
implementation of the new IASB’s standard on business combination and goodwill
(IFRS 3) that compulsorily applies to the consolidated accounts of listed European
companies with reference to the 2005 financial year, and that is very similar to the
US standards here examined.
The study was articulated in four main steps:
1. A rather detailed examination of the US SFAS 141 and 142 and their elements
of discontinuity.
2. The selection of the sample drawn from the European companies listed on US
financial markets as at 1st January 2003.
3. A double empirical analysis: a qualitative investigation has first been
conducted to assess whether the selected companies effectively accounted for
their intangibles in accordance with the new US provisions. In the case of a
positive answer, the quantitative impact of these US standards on companies’
main financial results (net income and shareholders’ equity) has been measured
through both the global and the partial comparability indexes.
4. A commentary on the results emerging from the empirical analysis.
Findings show that there has been a general application by the analysed European
companies of the two US Statements in question. In fact, after the application of
the transitional provisions of the two standards, their application has become
systematic.
It has also been found that many of these European companies prepared the
consolidated financial statements included in their Forms 20-F by directly applying
US GAAP, and therefore in this case it has not been possible to calculate the
quantitative impact of the implementation of the two Statements. On the contrary,
for companies using IFRS or domestic accounting rules (and hence producing a
reconciliation of their net income and shareholders’ equity to US GAAP in the
Forms 20-F) it has been possible to appreciate the quantitative impact of SFAS 141
and 142 through the calculation of the comparability indexes in both their global and
partial versions.
Results show that the impact of the examined US regulatory changes on the
consolidated financial statements of European companies listed on American
markets, has not been trivial. Quite wide divergences reaching often 20-30%, and in
some cases even 40-50%, in net income, shareholders’ equity and ROE of European
companies have been found as a consequence of the new US treatment of business
combinations, and in particular of goodwill and other intangible assets. It is then
reasonable to expect a similar large effect when European companies listed on EU
markets will have to compulsorily apply IASB’s IFRS 3 on business combinations
and goodwill from 2005 financial year (which means 2006 in most circumstances),
given the close resemblance of this standard to the US counterparts.
Even though the price to pay in terms of accounting impact to the alignment of
the European legislation in this field (through the IFRS 3) to the US standards is
likely to be rather high, a positive aspect could also be seen, in that the smaller are
the differences between the accounting principles on business combinations applied
in the two sides of the Atlantic, the smaller will also be the adjustment costs of
operational and technical nature that companies will have to bear when deciding to
list their stock on US financial markets and carry out this type of operations. After all,
accounting standardisation is an important, though not-for-free, intangible asset.
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with IASC Standards, The International Journal of Accounting, Vol. 35, No. 1,
pp. 27-63.
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Appendix 1.A
a) Companies Analysed by European Country
Countries Companies
Austria Telekom Austria

Belgium Delhaize Group, ICOS Vision Systems
Denmark Aktieselskabet Dampskibsselskabet Torm, Eurotrust, Novo Nordisk, TDC
Finland Instrumentarium, Metso, Nokia, Stora Enso, UPM-Kymmene
France Activcard, Alcatel, Alstom, Aventis, AXA, Business Objects, Compagnie
Générale de Geophysique, Dassault Systemes, EDAP TMS, Flamel Technologies,
France Telecom, Genesys, Groupe Danone, Havas, Ilog, Infovista, Lafarge,
Pechiney, Publicis Groupe, Rhodia, Sanofi-Synthélabo, SCOR Group, Sodexho
Alliance, Suez, Technip-Coflexip, Thomson, TotalFinaElf, Transgene, Vivendi
Environment, Vivendi Universal, Wavecom
Germany Allianz, Altana, BASF, Bayer, Celanese, Daimler Chrysler, Deutsche Bank,
Deutsche Telekom, Digitale Telekabel, E.ON, Epcos, Fresenius Medical Care,
Infineon Technologies, INTERSHOP Communications, iXOS Software, Lion
Bioscience, Pfeiffer Vacuum Technlogy, SAP, Schering, SGL Carbon, Siemens
Greece Antenna TV, Coca-Cola Hellenic Bottling Company, Hellenic
Telecommunications Organization, National Bank Greece, Stelmar Shipping,
STET Hellas Telecommunications, Tsakos Energy Navigation
Ireland Allied Irish Bank, CRH, Elan Corporation, Hibernia Foods, ICON, IONA
Technologies, Ryanair Holdings, Skillsoft, The Governor and the Company of the
Bank of Ireland, Trinity Biotech, Trintech Group, Waterford Wedgwood
Italy Benetton Group, DeRigo, Ducati Motor Holding, Enel, ENI, Fiat, Fila Holding,
Luxottica Group, Natuzzi, SAES Getters, Sanpaolo IMI
Jersey Randgold Resources
Luxembourg Espirito Santo Financial Group, Gemplus International, Metro International,
Millicom International Cellular, SBS Broadcasting, Stolt-Nielsen, Stolt-Offshore,
Tenaris, The Cronos Group
Netherlands ABN AMRO Holding, AEGON, Akzo Nobel, Arcadis, ASM International, ASML
Holding, BE Semiconductor Industries, Buhrmann, Chicago Bridge & Iron
Company, CNH Global, Core Laboratories, Crucell, Head, Equant, Gucci Group,
ICTS International, ING Group, James Hardie Industries, KLM Royal Dutch
Airlines, Metron Technology, New Skies Satellites, Oce, Orthofix International,
Qiagen, Reed Elsevier, Royal Ahold, Royal KPN, Royal Philips Electronics,
Sapiens, STMicroelectronics, TPG, Triple, Van der Moolen Holding
Norway Eksportfinans, Norsk Hydro, Smedvig, Statoil, Telenor
Portugal Banco Comercial Portuguese, Electricidade de Portugal, Portugal Telecom SGPS
Russia A.O. Tatneft, Mobile TeleSystems, Rostelecom, Vimpel Communications, Wimm-
Bill-Dann Foods
Spain Banco Bilbao Viscaya Argentaria, Banco Santander Central Hispano, Endesa,
Repson YPF, Telefonica, Telefonica Mòviles, Terra Networks
Sweden Autoliv, Biacore International, Electrolux, Ericsson Telephone Company, Modern
Times Group, Skf, Swedish Match, Tele2, Volvo
Switzerland ABB, Adecco, Alcon, Centerpulse, Ciba Specialty Chemicals Holding,

Connverium Holding, Credit Suisse Group, INFICON Holding, Logitech, Mettler
Toledo International, Novartis, Serono, Swisscom, Syngenta, UBS
Turkey Turkcell Iletisim Hizmetleri
UK Abbey National, Acambis, Allied Domecq, Amarin Corporation, Amersham,
Amvescap, ARM Holding, Autonomy Corporation, AstraZeneca Group, Barclays
Bank, BG Group, Bookham Technology, BP, British Airways, British Biotech,
British Sky Broadcasting Group, BT Group, Bunzl, Cable & Wireless, Cadbury
Schweppes, C.A.T.G., Carlton Communications, Celltech, Colt Telecom
Group, Cordiant Communications, Corus Group, Danka Business Systems,
Denison International, Diageo, Dialog Semiconductor, Ebookers, Eidos, Enodis,
Futuremedia, Galen Holdings, Gallaher Group, Hanson, HSBC Holding, Imperial
Chemical Industries, Imperial Tobacco Group, Insignia Solutions, International
Power, Ispat International, Lastminute.com, Lloyds TBS Group, Merant, mmO2,
National Westminster Bank, NDS Group, P&O Princess Cruises, Pearson, Premier
Farnell, Professional Staff, Provalis, Prudential, Reed Elsevier, Reuters, Rio
Tinto, Royal & Sun Alliance Insurance Group, Scottish Power, Senetek, Shire
Pharmaceuticals Group, Signet Group, Six Continents, SkyePharma, Smith &
Nephew, Spirent, Telewest Communications, The BOC Group, The Rank Group,
The Royal Bank of Scotland, Tomkins, Unilever, United Business Media, United
Utilities, Vodafone Group, Wolseley, WPP, Xenova Group
b) Companies Excluded from the Analysis
Company Reason for exclusion

1) Amdocs US company
2) BBVA Preferred Capital Cayman resident company
3) BBVA Privanza International Cayman resident company
4) BCH Capital N.a.
5) British Energy N.a.
6) CP Ships Canadian company
7) Daimler Benz N.a.
8) GlaxoSmithKline N.a.
9) Incam N.a.
10) Industriforvaltnings AB Kinnevik N.a.
11) International Corporation N.a.
12) Madge Networks N.a.
13) Matav Israelian company
14) National Grid Transco N.a.
15) Octel Corporation US company
16) Oxford GlycoSciences N.a.
17) Petroleum Geo-Services N.a.
18) QXL Ricardo Delisted
19) Rexam N.a.
20) Rhone Poulenc Business combination with Aventis
21) Royal Dutch Petroleum Company N.a.
22) Scania N.a.
23) Shell Trans & Trading N.a.
24) Svensk Exportkredit N.a.
25) TeliaSonera N.a.
26) Transcom Worldwide Delisted
27) Trikon Technologies US company
28) Unilever N.a.
29) Velcro Industries N.a.
30) Willis Group US company
Appendix 1.B
a) Global Comparability Indexes
Set of Net income Shareholders’ equity ROE global index

accounting standards global index global index
IFRS 1.083 0.961 1.106
Belgian Gaap 0.620 0.993 0.625
Danish Gaap 0.800 1.140 0.806
Dutch Gaap 1.312 0.656 1.378
Finnish Gaap 0.788 0.972 0.811
French Gaap 1.074 1.050 1.277
German Gaap 0.882 0.863 0.751
Irish Gaap 0.913 1.035 1.117
Italian Gaap 0.900 1.100 0.880
Norwegian Gaap 0.923 0.940 1.060
Portuguese Gaap 1.684 0.827 1.431
Spanish Gaap 0.987 0.961 1.088
Swedish Gaap 1.062 0.950 1.085
Swiss Gaap 1.198 0.842 1.167
UK Gaap 1.027 0.921 1.198
b) Partial Comparability Indexes Referring to Goodwill
Set of Net income Shareholders’ equity

accounting principles partial index partial index
IFRS 0.794 0.969
Belgian Gaap 0.705 0.994
Danish Gaap 0.890 0.979
Dutch Gaap 1.177 0.774
Finnish Gaap 0.756 0.995
French Gaap 0.859 1.053
German Gaap 0.974 1.030
Irish Gaap 0.794 0.542
Italian Gaap 1.081 1.076
Norwegian Gaap 0.894 0.993
Portuguese Gaap 1.366 0.506
Spanish Gaap 1.023 0.953
Swedish Gaap 0.779 0.930
Swiss Gaap - -
UK Gaap 0.892 0.820
Chapter 2
Intangibles and Real Options Theory:

A Real Measurement Alternative?
Giuseppe Marzo
Introduction
The possibility to employ Real Options Theory (ROT) for intangible assets’ valuation
seems to be very promising. Nevertheless, the ROT attitude for valuing “fluid”
situations, where a pre-ordinate path to follow does not exist, can easily disguise the
complexity of intangible assets’ valuation.
This chapter addresses the problem of a balanced assessment of the usefulness
of ROT for valuing IAs, analysing the pros and the cons of ROT. Firstly, it tries
to underline the reasons that can justify a real options approach to the problem of
IAs’ valuation. Other papers (e.g., Bouteiller 2002; Bose and Oh 2003) have already
proposed ROT for IAs’ valuation, but they offer reasons too generalised for a ROT-
based valuation. On the contrary, this chapter aims to demonstrate that a real options
lens can be fruitfully employed for capturing the economic substance of IAs, so
making ROT effective in their valuation.
Moreover, the chapter recognises that a ROT-based valuation of IAs cannot leave
out neither the relationship between existing IAs and the one to be valued, nor the
analysis of how such existing assets influence the ROT-based value of an on going
IAs investment. To reach these points, the chapter presents the investment life-cycle
model, where each single phase can be analysed in terms of real options that become
available and the role of IAs in providing support to their value.
The second goal of the chapter is to present some criticisms to ROT, especially
when applied for valuing IAs. As for this point, the chapter analyses the problems
arising from the relationship between value and uncertainty1 of a real option, and the
techniques used for calculating the value of a real option.
Throughout the chapter, a distinction is made between existing IAs and investment
creating (or able to create) new IAs. Such a distinction can be sometimes very clear,
but other times it can be fuzzy. To better clarify it and in order to facilitate the
reading of the chapter, it should be noted that an investment creating new IAs can
sometimes consist in putting existing IAs at work but in new forms. The possibility
1 Being conscious of the theoretical difference between risk and uncertainty, the two
terms will be nevertheless used interchangeably along the chapter.
to employ a patented technology in other business and the opportunity to extend a
firm’s brand are example of such situations.
For avoiding any confusion, the chapter will deal with the example of a research
project, giving so the possibility to unambiguously appreciate the different role of
existing IAs with respect to the investment to be valued.
The points above presented correspond each one to a specific section of the
chapter. After a short presentation of ROT, which next section is devoted to, section
3 will analyse how to use real options lens for re-interpreting IAs’ features. Section
4 will present the investment life-cycle, also discussing the role of IAs in enhancing
real options value. Section 5 is devoted to examine the criticisms of a ROT-based
valuation. Section 6 concludes.
Some Basic Concepts on Real Options Theory
In 1977 Stewart Myers discovered the strong analogy between financial options and
some of “real” projects and assets belonging to a firm, and he called real options
such situations, so giving the start for the development of valuation models based on
financial options theory.2
A real option is the right – and not the obligation – to make a potentially
value–accretive decision if – and only if – the market conditions are or will become
favourable. A very useful example is that of an R&D project. A firm valuing such a
project knows that the uncertainty it must face with relates not only to the R&D in se,
but to the market conditions also. At the moment of valuation, market conditions are
usually very uncertain. Nevertheless such an uncertainty is not necessary detrimental
for the value of the R&D project. Indeed, the firm will not be forced to undertake
the investment for marketing the new product, if market conditions prevailing at
the end of R&D will be unprofitable. On the contrary, the firm will have managerial
flexibility consisting in the opportunity to avoid any further investment, so limiting
its losses to the R&D’s costs.
When an investment creates or embeds real options, it must be valuated comparing
the cost for creating real options with their value. The R&D project presented above
can be thought of as the cost of the created real option. At the light of ROT, this cost
enables the firm to exercise an investment option in the case of a positive evolution
of the market. Since striking an option requires a new investment, such a decision
will be made only if the present value (PV) of the expected cash flows arising from
this investment is likely to be greater than strike costs. Such a PV is equivalent to the
underlying asset of a financial option. The valuation of the overall project (e.g. R&D
project and the investment for building the plant) should be comprehensive enough
to include the NPV of the R&D project and the value of the real options available to
the firm. The sum of the two components is called the Expanded NPV.
Literature on ROT (Amram and Kulatilaka 1999; Copeland and Antikarov 2003)
points out that the value of a real option depends on the degree of managerial flexibility
2 The analogy with financial options is also responsible for some limits of ROT models
(Lander and Pinches 1998; Marzo 2005).
Intangibles and Real Options Theory: A Real Measurement Alternative? 33
available to the firm and on the risk of the project. For investment projects featuring
high risk and high flexibility, the option value is at the maximum. The rationale for
this is that managerial flexibility can protect the firm against negative evolution of
market conditions without weakening the possibility to take advantage of the positive
evolutions. In the ROT context, uncertainty is essential for a real option to have
value. Indeed, in a certain world no option could have value: a decision-maker could
be able to rightly plan the future since the beginning of a project. The combination
of uncertainty with flexibility determines the asymmetry of a real options payoff. At
the time the real option could be struck, the probability distribution of value is cut at
the level of the exercise price. In fact, for values lower than the strike price (e.g. the
cost for building the plant) the option will not be exercised. The faculty to exercise
the option only if profitability limits the losses but not the gains, so translating into
a hockey stick profile.
Even though literature on ROT focuses mainly on uncertainty and managerial
flexibility, an additional two conditions are essential for a real option to have value:
irreversibility and the arrival of new information at the time of option exercise.
Irreversibility is strongly correlated to sunk costs (Dixit and Pindyck 1994).
Furthermore, the more an investment is firm-specific, the less it can be recovered.
In fact, because its firm-specificity, it cannot be conveniently sold to another firm.
Even if an investment is not firm-specific, the secondary market could price it non-
correctly (Akerlof 1970). Irreversibility is important when coupled with the concept
of path-dependency. Because of irreversibility, the future is dependent on present
and (forward) path-dependency arises (Kogut and Kulatilaka 2001).
Irreversibility is also related to scarcity (Kogut and Kulatilaka 2001). If an asset
can be replicated in the future, the problem of irreversibility is not important, and the
firm can make a decision without consideration of future path-dependency. But if the
asset cannot be replicated in the future – then the asset is scarce and irreversibility
must be taken into account.
The fourth important condition for a real option to have value is that information
must flow to the firm at a rate useful to make the right decision, that is to strike or
not the real option. Coming back to the R&D example above proposed, it is possible
to clarify this point. As said before, if the R&D project turns out successfully, the
firm has the real option to make an investment for marketing the new product. At
the moment the R&D project must be valued, nevertheless, the firm does not know
if the market conditions will be profitable enough to compensate for the cost of
the investment. The basic assumption of ROT is that during the R&D project, new
information will flow to the firm, useful to enable the right decision.3
Giving the four conditions on the ground, the calculation of real options value
can be performed through two different approaches: Contingent Claims Analysis
(CCA) and Dynamic Programming (DP). The former is the same approach employed
for valuing financial options, and it is based on the assumption that the real options
payoffs can be replicated through a traded security (or a portfolio of securities)
already existing. If such a security, called twin security, does not exist, a Marketed
3 For some critical considerations on the relation between value and risk of real options,
see Coff and Laverty (2001), and Marzo (2005).
Asset Disclaimer approach (Teisberg 1995; Copeland and Antikarov 2003) can be
followed, where the twin security is the project itself, valued by discounting its
expected cash flow.4
Dynamic Programming calculates the value of a real option through the application
of Bellman principle and the decision-maker’s utility function. As Dixit and Pindyck
(1994) point out, the two approaches collapse when DP is applied within the risk-
neutral framework (DPRN). The risk-neutral framework is a way to put into DP the
replication of real options payoffs. In fact, if the payoffs can be replicated by existing
securities, the real option holder position can be perfectly hedged, so cancelling
away any form of risk she/he bears.
A strong condition for applying CCA and DPRN is the market completeness5,
which make it possible to perfectly replicate the real options payoffs. Nevertheless,
as Smith and Nau (1995) and Smith and McCardle, (1998 and 1999) have pointed
out, the market completeness cannot be taken for granted. In this later case, the real
option valuation should combine CCA and decision analysis. Anyway, if the market
is not complete, the value coming out from CCA is only the upper limit of the real
value of the option.
Even though the problem of valuation is undoubtedly the most investigated
topic in the field of real options, in the last decade some interesting articles address
the usefulness of the real options thinking or reasoning (Faulkner 1996; Morris,
Teisberg and Kolbe 1991; McGrath 1997 and 1999; McGrath and MacMillan 2000;
McGrath and Nerkar 2004). The conceptual framework of real options theory is
applied in order to analyse and interpret economic phenomena, leaving on the ground
the problem of valuation. This way, Bowman and Hurry (1993) have used the real
options lens for discussing some interesting topics related to the strategy and the
organisational processes of a firm.
Using Real Options Lens with Intangible Assets
A large part of literature on IAs (Dosi 1988; Lev 2000 and 2001; Wyatt 2002;
Zambon 2003) highlights some characteristics that can be framed through the real
options lens:
• Non-rivalry, since an intangible asset can be at the same time exploited in

multiple activities, in contrast with tangible assets;
• Increasing returns, due to the fact that knowledge (and other intangibles) is
cumulative, and its use enlarges its benefits;
4 Authors proposing Market Disclaimer Approach assume that the project can be given
the same value it would have if it was traded on financial market. Nevertheless, introducing
a new asset in a non-complete market can modify the structure of equilibrium returns, so it
is not possible to be sure that the calculated value corresponds to the market value of the
project.
5 In general terms, a market can be defined complete if linear combination of traded
securities can replicate any new investment opportunity.
• Firm specificity, since IAs’ value is dependent on the specific characteristics
of the firm;
• Path dependency, since IAs are grounded on the history and on decisions the
firm made in the past;
• Scarcity, in the sense that because of specificity of IAs, they are hardly
replicable by other companies
• High level of risk, particularly if compared to tangible assets.
Giving the remarks on real options’ value and what just introduced about IAs’
features, it is now possible to use real options lens for giving an interpretation of
IAs’ characteristics.
Non-rivalry, increasing returns and the portfolio of real options The possibly to
employ IAs in multiple activities is tightly relating to flexible decision-making. The
Hamel and Prahalad’s concept of portfolio of technologies (1990) is a good example
of this point. Flexibility means that a firm is not obliged to employ IAs in many
different contexts, but it has the opportunity to do it. In particular, the non-rivalry
of IAs translates into the creation of a portfolio of real options, the strike of which
depends on the market conditions (Kogut and Kulatilaka 2001). The real options
lens can account for such a situation.
Path-dependency and the real options value Literature on capabilities, core

competencies and IAs shows that the firm’s future actions are conditioned by its past
decisions. Capabilities, core-competencies and IAs in general, accumulate during
the firm’s history (Abernethy and Wyatt 2003). IAs feature path-dependency, which
in turn creates irreversibility, a condition of paramount importance for the value of
a real option.
Path-dependency, irreversibility, specialisation and competitive positioning Since

future decisions are influenced by past decisions, a firm cannot easily modify its
strategy to react to competitors. The higher the specialisation, the higher will be the
inertia of a firm. Specialisation is a way to make stronger the weight of the history,
e.g. irreversibility and path-dependency. In the perspective of ROT, specialisation is
the result of a stream of struck real options, each one being the possibility to expand
or to contract the modules of knowledge and the capabilities of the firm. Indeed, an
available real option confers to the firm the opportunity to postpone a decision in
the future. Until decision is not made, the future paths are not pre-determined, and
the flexibility a firm has is very high. When an option is struck, the firm decide for a
specified course of action, so reducing availability of other different paths. This is a
way to say that specialisation can be framed in term of strike decisions: the larger is
the number of real options a firm decides to strike, the less is flexibility it is saving
for the future. From a rational perspective, real options lens can account for the
intentional strategy of limiting future path-dependency, through the creation of (a
large number of) real options giving the firm the opportunity to postpone irreversible
decisions.
Furthermore, the great the specialisation, the high the possibility of phenomena of
escalation of commitment (Coff and Laverty 2001; Marzo 2005), with the possibility
of producing effects detrimental of the value of the firm.
Value and firm-specificity Real options on one hand and IAs on the other hand are
anchored to firm-specificity. Indeed, firm-specificity contributes to determine the
value of IAs and, on the other hand, generates irreversibility in decision-making,
therefore influencing the value of a real option. For example, a lower degree of
specificity increases the value of the exit option; while on the contrary a higher
degree of specificity can produce inertia (Dixit 1992; Dixit and Pindyck 1994) by
raising barriers to exit.
Value and uncertainty As known, the value of an option increases, ceteris paribus,
with uncertainty, but only if managerial flexibility is available to the firm. IAs’
investments can be carried on in order to reduce the firm’s business risk (Abernethy
and Wyatt 2003). Event though there are several ways to obtain this effect, the
creation of managerial flexibility (e.g. real options) seems to be of interest. Upton
(2001) notes that this could really justify the adoption of ROT for IAs’ valuation.
IAs, real options and risk Berk, Green and Naik (1998 and 1999) show that
R&D projects and new ventures display high level of systematic risk, and Ho, Xu
and Yap (2004) empirically demonstrate that R&D investment increase a firm’s
systematic risk. Wyatt (2002) remarks that the risk associated to IAs is higher than
risk associated to tangible assets, since generally IAs precede investment in tangible
assets. So, IAs pay for a greater uncertainty. As pointed out by Lev (2001), the
risk progressively reduces during the investment, since it is at its maximum at the
moment of the research project, while it reaches a lower level at the moment of the
marketing phase. The rationale for the higher uncertainty of IAs can be analysed in
the ROT perspective. An R&D project, for example, is riskier than the following
tangible investment because of the technical risk and the uncertainty about the market
evolution. Investment in tangible asset (the building of the plant, for example) is not
more subject to the same relevant technical uncertainty, and the market risk is also
lower. Indeed such an investment will be carried on only if market conditions are
positive enough to make the investment profitable. Thus, it is the arrival of new
information and knowledge that make it possible the reduction of the risk during the
life of the investment. Such a phenomenon can be also interpreted at the light of real
options lens reminding that the arrival of new information and knowledge is one of
the four conditions giving economic value to a real option.6
Following the analogy with financial options, it can be shown that the systematic
risk of an option is greater than the risk of the underlying asset (Gemmil 1993).
Chung and Charoenwong (1991) decompose a firm’s systematic risk into the risk
6 See section 2 for a discussion on this point.

associated with asset in place and the risk arising from future growth opportunities,
demonstrating that the latter is higher than the former.
The two effects just discussed can jointly explain the riskiness of IAs. Section 5
will come back to this point.
Intangible Asset and Real Options Along an Investment Life-Cycle
This section deepens the analysis of the relationships between IAs and real options
highlighting the mutual influence along a generic Investment Life-Cycle (ILC).7
Following such a conceptual model, one can understand how IAs’ and real options
value influence each other.
Figure 2.1 and the following analysis present the main phases of the ILC, the real
options available in each phase and the relationships with IAs.
The ILC approach developed in this section requires a distinction between
existing IAs and on going IAs investments. Such a distinction makes it possible to
analyse the impact of existing IAs on the new investment value, identified as the
prerequisite investment.
1. Prerequisite investment. Prerequisite investment is the condition enabling the

portfolio of real options along the ILC. Following the analogy with financial
options, such an investment can be though as the premium to be paid in order
to obtain the right to strike (if convenient) the option(s) in the future. For the
carrying on of a prerequisite investment, IAs a firm holds are of paramount
importance. An R&D project is a typical prerequisite investment, since it gives
to the firm the opportunity to market the new product without obligation to do
it. The success of an R&D project is mainly dependent on the available skills,
capabilities and competencies. In some circumstances, the property of patents of
such similar rights can contribute to carry on the R&D project in a faster way or
with more profitable results. From the ROT standpoint, the IAs role is twofold.
They influence both on the technical success R&D project and on the time and
the costs of the project.
2. Recognition of the investment opportunity. With the success of the research
project, the new product can be marketed. Obviously, this is a faculty for the firm,
and in fact it will go ahead with the building of the plant only if profit is expected.
This is the first real option available: the faculty to continue by building the plant
or to stop in case of negative scenarios.
Another type of real option can be available during this phase: a deferring
option. A firm indeed can decide not only about the possibility to invest or to
stop its activity, but also about the possibility to defer the investment in tangible
assets. Traditional DCF-based capital budgeting systems are not able to value
correctly such a situation, while ROT can do it (Dixit and Pindyck 1994; Amram
and Kulatilaka 1999). In particular, investment in tangible asset can be deferred
7 The ILC is adapted from Benaroch (2001).

Figure 2.1 Investment life cycle, real options and intangible assets
even if the immediate investment seems to be profitable but the expected growth
of the future price can generate a higher profit for a wait-and-see strategy.
The value of a deferring option is influenced by several conditions. First
of all, if the firm decides to defer the investment, it will lose, at least, a part
of value of the cash flows that will be generated during the waiting period.8
Indeed, the possibility to defer the investment determines a reduction in the
value of cash flows since they must be discounted for a longer period. Secondly,
the waiting period can reduce the value of the project because the firm cannot
completely exploit the advantages related to the legal protection of a patent or
a similar right.9 In such a situation, the value reduction is not only related to the
discounting problems, but also to the loss of some of those cash flows. Finally,
8 The cash flow lost during the waiting period is embedded in the ROT model by the
same way than the dividend in financial options models.
9 A simple model proposed by Damodaran (s.d.) models such a situation assuming that
the value of underlying asset reduces 1/N per year, where N is the n umber of the year of
validity of patent or similar right.
the waiting period can permita new competitor to enter the market, so acquiring
the advantages of the first mover.10
Relationships of IAs with real options are, in this case, of two types. Deferring
option is a learning option (Dimpfel and Algesheimer 2002) because it gives the
firm the opportunity to acquire or to develop its knowledge about the market
conditions. It originates a knowledge-based intangible asset.
On the other hand, IAs affect the value of the real option, through the influence
on the condition characterising its life and its exercise. For example, the existent
IAs can protect the firm from the entrance of a new competitor. Patents and
other legal rights, customer relationships and the firm’s core competencies can
represent effective protection of the value of the project.11
3. Building. The investment decision is generally implemented through the building
of a tangible asset. Such a decision can be structured as a staged investment
decision: the plant can be built according to a modular approach or following a
path of increasing commitment. The staged development is a learning option, since
it confers to the firm, the opportunity to acquire new knowledge. Despite the case
of the deferring option, the staged development option can strongly contribute to
offer to the firm new information not only on the external conditions, but also on
the internal conditions. After each stage, the firm can indeed verify the way its
plans are carrying on, and in case of necessity can assume appropriate correcting
actions. This option can permit a reduction of some type of endogenous12
uncertainty relating, for example, to the capabilities of building the plant.
Often, the staged development requires organisational competencies. For
example, the decision to enter foreign markets (Pellicelli 1992; Hurry 1993)
is developed through subsequent stages, where each stage represents an option
to carry on the internationalisation, and features a higher commitment than the
previous one.
Also technological competencies can be of paramount importance. The
competencies relating to scaling up in the downstream investments influence the
way a firm can develop a full-size plant starting from a prototype plant.
4. Operations. During this phase various options can became available. One of
these is the suspend option, consisting in the possibility to temporarily suspend
the project in the case the prices of the product are not sufficient to recover the
production costs.13 Another type of option is that of switch: a firm can change the
mix of either the inputs or the outputs of its production. In more general terms,
the switching between different knowledge modules is also possible (Levinthal
10 Such situations can be modelled by means of a Poisson process which accounts for the
probability of the entering of a new competitor or technology. More complex models can be
based on Game Theory (Grenadier 2000a, 2000b e 2000c; Smit and Trigeorgis 1999).
11 Patents, legal right, trademarks and others, can influence the cost competitors must
support for copying an invention (Levin, Klevorick, Nelson and Winter 1987). So, they can
be accounted for by correcting both the useful life of a real option and the exercise costs.
12 A definition of endogenous uncertainty is provided in the next section.
13 In order to value a suspend option, costs arising from such a decision must be
carefully estimated. Examples of such costs are those relating to mothballing of the plant or to
its restart.
and March 1993; Kogut and Kulatilaka 2001). In the latter case, the role of IAs is
twofold: they can enable the switching between different modules of knowledge;
or, if firm features high specialisation, they can increase the cost of switching.
Then the cost of switching reflects the degree of operational flexibility of a firm.
5. Abandonment. When the market conditions become structurally unfavourable,
the firm has the opportunity to completely abandon the investment. Such an
option is very similar to a financial put option, if the firm receives some amounts
from the divestment. As said in section 3, the more specific is the asset to be sold,
the higher the exit barriers and the lower the real option’s value.
6. Growth opportunities. The firm can expand by entering new businesses. This
is the essence of the growth option. Such options are rooted, for example, in
technological capabilities and competencies. Prahalad and Hamel (1990) showed
that Canon founded on the imaging technologies the diversification of its
product: scanners, printers, cameras, all share the same portfolio of technological
competencies, and this is the basis for exploiting such growth options.
Another example relating to such types of real options can be that of strategies
of brand extension, by which a firm enter new (related) businesses. In the fashion
sector, for example, the total-look strategy is based on such an approach.
7. Obsolescence. This phase represents the end of the project.
Figure 2.1 shows the phases of a generic ILC and the real options available along each
phase. Outside the broken circle, the figure also shows the relationships between IAs
and real options. The arrows highlight the influence of IAs on real options (arrows
externally-oriented) and the fact that learning options can create knowledge assets
(arrows internally-oriented).
Intangible Assets and Real Options Theory: Some Criticisms
The two previous sections have used the real options lens to analyse the economic
characteristics of IAs. Real options lens is a very fruitful tool for that purpose.
Nevertheless, in order to appreciate the usefulness of adopting ROT for IAs
valuation, a deeper analysis should be carried out in order to identify pros and cons.
The advantages of using ROT for analysing IAs have been already discussed in the
previous sections. This section is devoted to highlight some criticisms to the use of
ROT for valuing IAs. The first criticism comes out from the way ROT is usually
implemented. Here the problem is the assumption that a greater uncertainty is always
positive for the value of a real option. Nevertheless, existing IAs can reduce the risk
of the new IAs. Thus, the effect of IAs on the risk of the firm should be carefully
appreciated.
The second criticism relates to the methodologies employed for calculating the
real options value. In particular, the assumption that the real options payoffs can
be perfectly replicated by existing securities or through the MAD approach. This
section will discuss these two issues.
A good point for starting with the analysis is the relationship between the value
and the risk of a project embedding real options.
Below a fruitful, even if not exhaustive, classification of different types of risk
is provided:
• Diversifiable and systematic risk;

• Endogenous and exogenous risk;
• Technical, market and economic risk;
• Replicating and private risk.
Figure 2.2 shows the four different classifications and their relationships. The
oblique borders demarcating the classes testify the fact that the distinctions are not
usually completely dichotomous but fuzzy, then some overlapping areas emerge. For
example, market risk can be in part diversifiable when it refers to industry risk, but
it is in part systematic.
The classification based on the distinction between diversifiable and systematic
risk is at the core of traditional financial theory. On financial markets, only systematic
Figure 2.2 Some classifications of risk and their overlapping areas

risk requires for an excess return with respect to risk-free investments. Models
such CAPM are based on such a distinction. Cash flows featuring systematic risk
should be discounted using a risk-adjusted interest rate, while cash flows with no
systematic risk should be discounted using the risk-free interest rate. Examples of
the first types are cash flows coming from revenues, while cash outflow relating to
R&D investment, tangible investment and fixed costs are generally characterised by
diversifiable risk.
Endogenous and exogenous risks qualify for the origins of the risk. In particular,
endogenous risk is relating to the time for carrying on the project, (Bräutigam, Esche
and Mehler-Bicher 2003), its complexity and its costs. Exogenous risk arises from
the market and the whole economy.
The distinction between technical, market (Dixit and Pindyck 1994; Amran and
Kulatilaka 1999; Copeland and Antikarov 2003) and economic risk (Miller and
Park 2003) breaks down the previously analysed category. Technical risk relates
to time, cost and success of an investment activity, while market risk is firmly
relating to the dynamics of demand and competition, and economic risk is shaped
by forces influencing the whole market. Then technical risk is mainly diversifiable,
while systematic and economic risks are more systematic. The latter is prevalently
systematic. Market risk, in fact, can be reduced by mean of an inter-sectors
diversification.
Figure 2.2 also shows that the different types of risk affect different components
of the value of a real option. In fact, endogenous, technical, and diversifiable risk
affect the cost of the prerequisite investment and/or the cost of striking the real
option. On the contrary, exogenous, market, economic and systematic risk affect the
present value of the project underlying the real option.
The latter classification, e.g. replicating and private risk, is proper to ROT, and
will be explored in detail further. Here it suffices to say that, according to remarks
in Section 2.2, the major proportion of private risk with respect to public risk, affect
the usability of CCA (or DPRN).
Once the categories of risk has been presented, it is possible to note that the
assumed positive influence of the risk on the value of a real option should be better
investigated, also at the light of existing IAs and of their effect on the risk. In
particular at least two effect can be found:
1. A reduction of technical/diversifiable risk relating to the cost, time and

probability of success of project. For example, a firm’s competencies can
permit to increase the probability of a research project’s success;
2. A reduction in market/systematic risk. For example, a high quality of IAs can
protect firm against competition or demand weakness. A deeper understanding
of the effect of exiting IAs on the systematic risk can be obtained by
decomposing the overall systematic risk (identified by the beta index) into
a three-factor model. Such a mode, for example, (Chung Charoenwrong
1991; Hamada 1972; Rubinstein 1973; Lev 1974; Mandelker ─ Rhee 1984;
Miles 1986; Hawawini ─ Viallet 1999; Griffin ─ Dugan 2003), could relate
the systematic risk to: a) the expected revenues; b) the variable/fixed costs
structure (the so called operating leverage); c) the financial leverage. As for
the first point, it could be though of that IAs can reduce the revenues volatility
and/or increase the expected average revenues. As for the operating leverage,
the IAs have a dual effect, since they can increase the level of fixed cost, due
to the amount of their investment cost, while at the same time reducing the
variable unit cost, because of the improvement of the firm efficiency. As for
the financial leverage, Ho, Xu and Yap (2004) found that firms with more
growth opportunity have a lower debt/equity ratio. Recalling that such growth
options can arise from IAs, it could be thought of that company with more IAs
have a lower financial leverage degree.
The first effect determines, ceteris paribus, an increase in the project’s Expanded
NPV, and this for two reasons. Firstly, it can improve the probability of success
of the prerequisite investment. For example if the IAs level of a firm can increase
the probability of success from 50% to 60%, the Expanded NPV will increase
proportionally. Secondly, the reduction of technical risk can become evident during
the investment in tangible asset, so reducing the cost for exercising the available real
options. It should be noted that the analogy with financial options has often led to
mis-consider the problems associated to the cost for striking a real options. A large
number of ROT models, indeed, do not consider explicitly the possibility that the
strike costs can increase so reducing the value of the option. Such an approach has
also led to neglect the importance of the ability of a firm to strictly control time and
cost of striking investment.14
The effect of the reduction of systematic risk is more difficult to analyse. On one
hand, it reduces the risk-premium required by investors, so increasing the present
value of the underlying asset. This effect translates into a greater value of the real
option. On the other hand, if the reduction of systematic risk implies a reduction of
the overall risk of the project, a reduction of the value of the real option can also be
possible:; indeed, ceteris paribus, the value of the real option is positively correlated
to the overall risk (variance) of the underlying asset value.
Figure 2.3 shows a qualitative model embedding the remarks just presented. The
signs “+” and “-” near to the arrowhead mean that the two linked variables change
in the same or, respectively, in the opposite direction. The Figure shows how the
existing IAs impacts on the value of available real options and on the Expanded
NPV of the project, through their influence on the risk of the project. The Figure also
shows that existing IAs can enhance expected cash flows from new investment, so
increasing the value of underlying asset. Effects of a variation in economic risk are
intended to be completely exogenous so they are not affected by IAs.
The model just presented is a first attempt to discuss the relations between risk
and the value of a real option. A simple simulation model (Marzo 2005) can be run
in order to demonstrate that in some circumstances, an increase in the uncertainty of
cash flow expected from entering a new business can be make a growth option more
valuable for a firm with IAs of less quality with respect to another firm whose IAs
are characterised by a higher quality level.
14 See Marzo (2005) for a critical analysis on this point.

Figure 2.3 How existing IAs influence on an ROA-based valuation of a new

IA investment
As for the second criticism, related to the replicability of the real option’s
payoffs, the distinction between private and public risk is important. As said before,
Contingent Claims Analysis, or alternatively DPRN, is usually employed for valuing
the real options.15 The existence of a twin security is of paramount importance for
applying both CCA and DPRN.
Referring to the distinction between public and private risk, the more the project
features public risk, the more easy is the applying the CCA. A problem arises,
however, from the fact that the importance of IAs derives from their specificity for
a firm. IAs are specific in the sense that they are difficultly replicable by other firms.
Moreover, their specificity is of paramount importance for generating economic
value through the strategy they permit to implement.
Due to the specificity of IAs, it could be thought the they display mainly private
risk, so making ineffective the use of CCA for their valuation.
The consideration just exposed is also supported by the fact that assuming the
completeness of the markets indirectly means that any new venture can be perfectly
replicated by existing securities. This way, there is no justification for any process
of economic innovation.
15 Dynamic Programming (DP) can also be employed for valuing real options. When DP
is employed jointly with the risk-neutral approach the results are consistent with those coming
from CCA. The risk-neutral approach can be though of as a way for considering the fact that,
if twin security exists, investors are fully diversified and do not ask for risk premium.
Since the existence of private risk, the value of IAs calculated by applying CCA
(or the DPRN) can be thought of at least as the upper limit of their value. Without
introducing the utility function of the decision-maker, the value of IAs is therefore
indeterminate.
Conclusions
This chapter has proposed a balanced valuation of the usefulness of ROT for
valuing IAs. In doing this, the chapter has presented the pros and the cons of such
an approach.
The advantages with using ROT for valuing IAs are related to the opportunity
to interpret some characteristics of IAs through the real options lens. This way, it is
possible to appreciate, in a qualitative form, the value of an IA. Moreover, the real
options lens can be used to identify different real options along a generic investment
cycle in IAs. Such a portfolio of real options and its relationships with existing IAs
is potentially a useful tool for appreciating the role of IAs in the value-creation
process.
On the other side, ROT is also characterised by techniques for performing the
calculation of the value of a real options. In particular CCA and DPRN are the
two major techniques employed in literature. Such techniques, however, are based
on assumptions that do not match with the reality especially for the case of IAs.
This represents the major criticism to the ROT-based valuation of IAs. Due to the
unrealism of the assumptions, the value of IAs calculated through ROT does not
seem to be reliable.
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Chapter 3
Intangible Assets:
The Next Accounting Frontier
David W. Young
Boston University School of Management
Introduction
The growing significance of intangible assets has rendered Generally Accepted

Accounting Principles (GAAP) insufficient for the financial community. GAAP
needs to be supplemented by a set of Generally Accepted Intangible Principles,
or GAIP. GAIP should begin at a very general level, and a body, comparable to
the Financial Accounting Standards Board (FASB) in the U.S., should use these
principles to guide the development of standards that govern the way publicly-traded
companies measure and report on their intangible assets.1
Why GAIP? Why Now?
The need to report on intangibles is not due to a dissatisfaction with GAAP, per se.
Rather, it comes from a realization that, with the structural changes that have taken
place in the U.S. economy (as well as in most other economies of the industrialized
world), GAAP does not provide the financial community with enough relevant
information. Three limitations in GAAP create a need for GAIP.
Limitation #1. A lack of focus on knowledge-based firms
The transition from a product-based to a service- and knowledge-based economy

means that many of an organization’s crucial resources are not measured and
reported under GAAP. These resources comprise such difficult-to-measure items as
internally developed patents, special formulas, sophisticated inventory management
and information systems, and networks of supplier and buyer relationships. They
also can include a cadre of smart people engaged in clever activities, such as writing
software code, devising new product ideas, or working to assure customer satisfaction.
1 Although much of GAAP is universal, the principles developed by the FASB are
specific to the U.S. As international accounting standards evolve, they almost certainly
will differ from those in the U.S. Indeed, from all available evidence, it would appear that
the rest of the world is far ahead of the U.S. in developing ways to measure and report on
intangible assets.
It sometimes is said that at companies such as Microsoft, 3M, and perhaps even
Starbucks, most of the assets walk out the door at the end of each day.
These resources do not fit into GAAP’s structure because, for the most part,
they are non-monetary, whereas GAAP’s money measurement concept requires
information to be reflected in monetary amounts. In an economy where many of
a firm’s “assets” consist of human, legal, informational, and similar resources that
assist it to gain and preserve market share, GAAP is inadequate. It does not measure
these resources, and never intended to.2
Limitation #2. A restricted view of intangibles
Although GAAP attempts to measure and record some intangible assets, its focus is
extremely limited. For example, debates have taken place in the past, and continue
to this day, concerning the best way to compute and amortize goodwill.3 Similarly,
when a firm purchases a patent, it capitalizes it and amortizes it over a prescribed time
period. However, these debates ignore the “goodwill” that exists even if a company
is not sold, as well as the value of patents that were developed internally rather
than purchased. This is because the combination of GAAP’s money-measurement
and historical-cost principles, requires that patents, goodwill, and similar intangible
assets be measured and recorded based on market transactions that permit the
establishment of a reliable cost. Nevertheless, even the most strident supporters of
GAAP would freely acknowledge that many firms have intangible resources that
GAAP does not now, nor likely ever will, attempt to measure.
Limitation #3. An historical view of performance
A set of financial statements always reflects past performance rather than future
potential. Again, this is fundamental to GAAP. Much debate has taken place over
the past 40 years or so about ways to shift from the historical cost of assets to their
“fair market value,” but to date, the historical-cost proponents have prevailed.
GAAP has moved slightly in the non-cost direction by measuring the present value
of several liabilities (such as pensions), and reporting some assets at lower of
cost or market value, but it nevertheless remains a system that reports on a firm’s
historical performance rather than its potential. GAIP, while also historical, would
give the financial community a much better ability to assess a company’s future
profit potential.
2 Of course, just because an asset has a monetary measure does not mean that the
amount shown on the balance sheet is useful. There are many assets (such as inventory,
buildings, patents, and others) where the monetary amount shown on the balance sheet differs
considerably from the asset’s market value.
3 See, for example, FASB (2001a and 2001 b).
Intangible Assets: The Next Accounting Frontier 51
Background on Intangibles
Despite GAAP’s focus, intangible assets of one sort or another have always been
relevant considerations for the financial community. Reports by rating agencies, such
as Standard & Poor’s and Moody’s generally contain a discussion of a company’s
potential to sustain its earnings. So, too, does a stock- or bond-offering prospectus.
Likewise, commercial bankers juxtapose a loan applicant’s financial risk (the amount
of debt on its balance sheet) with their assessment of its business risk (the degree of
uncertainty about future cash flows). Similarly, fund managers and financial analysts
regularly interview senior managers of a firm in which they are investing a portion
of their clients’ portfolios in an effort to determine whether the firm’s strategy and
organizational capability portend successful financial performance. More recently,
the balanced scorecard has attempted to link future financial performance to the
three performance drivers of customers, internal processes, and employee learning
and growth. All of these perspectives rely on assessing a firm’s intangible assets.4
Accounting myopia
The accounting profession’s view of intangibles has suffered from three limitations.
First, until recently, most discussions about intangible assets have concerned a small
subset of what now is considered to be a vast array of resources in many firms. As
discussed above, intangibles currently are defined as those assets that one cannot see
or touch, such as patents and goodwill, but that become relevant when they are the
subject of a market transaction.
Second, once the accounting profession recognized the need to address a more
broadly defined set of intangible assets, it failed to look outside its rather narrowly
defined arena to develop a set of building blocks. Instead, in a movement resonant
of the land rushes of the 19th century, each proponent staked out his or her territory
in this newly emerging field. The result is a bizarre combination of a land rush, the
seven blind men and the elephant, and the Tower of Babel.
Finally, the profession has made little effort to develop a set of principles.
Instead, the discussion of intangibles to date has focused on one of two matters: (1)
a description of the problem, frequently illustrated with examples or anecdotes, but
without much in the way of a conceptual framework to structure it, or (2) a handbook
for executives who wish to manage their intangible assets more effectively. Notably
lacking is a focus on either the principles that should govern the measurement of
intangible assets, or the way that information on intangible asset reports should be
structured so as to best inform the financial community of a firm’s capabilities and
limitations.
A framework for intangibles
Although no agreed-upon framework has been developed, the financial community

has been implicitly gravitating toward one. Of the several frameworks that have been
4 See, for example, FASB (2001a and 2001 b)

proposed, the most comprehensive is that of the Financial Accounting Standards
Board. The FASB has suggested that there are seven categories of intangible assets:
statutory-based, contract-based, technology-based, workforce-based, organization-
based, customer-based, and market-based. These categories are shown in Table 3.1,
along with the contents of each and some illustrative examples.
Some of these categories are more easily described than others. For example,
despite the heterogeneity of the organization-based category, some of its elements
are nevertheless relatively easy to document. An organization’s structure and
internal processes can be described even if they cannot be seen or touched. In
contrast, technical expertise, talent, and creativity, which are part of the workforce-
based category, are very hard to describe in any objective way. At the other end of
the spectrum are contract-based intangibles, which not only can be described, but
frequently can be assigned a monetary value.
These distinctions give rise to the classification of intangibles in Table 3.2, which
can help guide the development of intangible reporting measures. As one goes from
the top to the bottom row on this Table, the ability to quantify an organization’s
intangible assets diminishes, suggesting that an intangible reporting effort should
begin with the top row and move downward.
Despite difficulties in measuring intangibles in the bottom two rows of Table
3.2, this analysis portrays an optimistic scenario. In five of the seven categories, it is
possible to assign some sort of monetary value to an intangible asset. In four of the
seven, although it would be difficult or impossible to assign a monetary value, the
intangible asset nevertheless can be described in fairly objective terms. Non-compete
contracts can be listed, for example. Information systems, procedure manuals,
software programs, and the like can be identified and described without divulging
trade secrets. So, too, can organizational policies, board member affiliations,
customer lists, and so on. Indeed, there are only a few instances where an intangible
asset that might be of considerable value to a firm could not at least be listed or
described in fairly objective terms.
The Contribution of the Field of Corporate Strategy
The examples in Table 3.2 are only part of the story. Strikingly absent from most
of the discussion on intangibles to date, is the perspective of the field of corporate
strategy. Yet, for well over 60 years, researchers and practitioners in this field have
been developing frameworks for assessing a firm’s competitive position and the
sustainability of its profits. While not using the term “intangible assets,” per se, this
field nevertheless has focused on those activities that are not reported on a firm’s
financial statements but that assist it to select and maintain a competitive position in
an industry, or, at the corporate level, to decide which industries to enter and exit. It
is these activities and their results that comprise many of a firm’s intangible assets.
Indeed, as the discussion below indicates, the approaches a firm takes to address
Porter’s “five forces” of buyer power, supplier power, substitutes, rivalry, and threats
of new entrants requires (Porter 1980), among other activities, identifying a firm’s
intangible assets.
Table 3.1 Categories of intangible assets proposed by the financial accounting standards board
Category
Statutory-based Contract-based Technology- Workforce-based Organization- Customer-based Market-based

based based
Contents Patents, Licensing Information Technical Organization Customer Brand names
copyrights, trade agreements, systems, secret expertise, talent, structure and lists, delivery or logos, retail
names royalty formulas, creativity, processes, board routes, customer shelf-space
arrangements, procedural recruiting members and histories, credit arrangements,
landing rights, manuals, and training affiliations, records. distribution
alliance software programs, financial channels.
agreements, FCC programs, incentive arrangements
licenses. blueprints, compensation with board
laboratory plans. of directors,
notebooks, financial policies
recipes. and cultural
norms.
Examples Segway’s McGraw Hill’s American GE’s training Toyota’s AARP’s mailing Macintosh’s
patent, Disney’s author contracts Airlines institute, production system, list. Federal apple, Proctor
Micky Mouse Microsoft’s SABRE system, Squibb’s MacDonald’s Express pickup and and Gamble’s
copyright,Amazon. software WalMart’s scientists franchise system, delivery routes, a distribution
com’s trade name licensing inventory Microsoft’s WalMart’s product hospital’s medical channels.
agreements system, recruiting distribution system records
Coca Cola’s program 3M’s GE’s learning
concentrate compensation culture.
formula system
Source: FASB (2001).
Table 3.2 Relationship between categories of intangible assets and ease of measurement
CATEGORY
Government- Contractual Technological Employee-Related Organizational Customer-Related Market-Related

Protected
Can see and/or
touch
Possible to assign a Patents, copyrights, Licensing Technical expertise, Financial Retail shelf-space
monetary value trade names. agreements, royalty recruiting and arrangements with agreements.
arrangements, training programs, board of directors.
landing rights, incentive
alliance compensation
agreements, FCC plans.
licenses.
Difficult or Non-compete Information Organization Customer lists,
impossible to contracts. systems, secret structure and delivery routes,
assign a monetary formulas, processes, board customer histories,
value procedural members and credit records.
manuals, software affiliations,
programs, financial policies
blueprints, and Cultural norms.
laboratory
notebooks, recipes.
Cannot see or
touch
Easy to describe Technical expertise, Brand names or
recruiting and logos, distribution
training programs. channels.
Difficult to describe Talent, creativity. Cultural norms.

Buyer power
A firm can mitigate the power of its buyers in several ways. Like Federal Express,
it can demonstrate to them that its products or services save more money than they
cost, hence lessening the buyer’s price sensitivity. Or, like Mont Blanc Pens or the
American Express Black Card, a firm can differentiate its products or services in
such a way that the quality and features required by the buyer are not available
from other suppliers. Similarly, a firm can attempt to raise its customers’ switching
costs, such that even if a comparable product or service were available for less, the
customer’s cost to convert to a new supplier would be sufficiently high to act as a
deterrent. Many Internet service providers do this by creating non-portable history
files and address books. A firm also may enter into a strategic relationship with
its customers, such that the two combine their efforts, thereby creating a mutual
dependency. Finally, a firm can make sure it has a broad customer base, thereby
minimizing the power of any given customer.
Supplier power
In general, mitigating the power of suppliers means minimizing the ability of a

single supplier to “hold up” the firm from conducting business as usual. In effect, if a
supplier has something the firm needs and can’t get elsewhere, the firm is vulnerable
to hold up. Hold-up is especially threatening when both parties in a relationship have
invested in assets that are specific to that relationship, thus making it hard to walk
away. A contract negotiation between a health maintenance organization and a large,
important provider, such as a prestigious teaching hospital, is an example of such a
relationship.
A firm can mitigate supplier power in several ways. To the extent that its
purchasing policies direct a large volume of business to a particular supplier without
the presence of high switching costs, as WalMart does, it will have considerable
power over that supplier. By contrast, if it is purchasing in a market where there is
high rivalry, such as in a commodity market, it also can seek to keep its switching
costs low, thereby maintaining the real or implied threat of changing suppliers. Or,
if there is not sufficient competition in its supplier market, it can attempt to develop
substitute inputs, such that it can shift inputs if a particular supplier’s price becomes
too high. Many beverage producers, for example, can move rather easily among
cans, bottles, and plastic containers for their products. Finally, maintaining an option
to backward integrate and supply its own inputs also is a possible strategy to mitigate
the power of some suppliers. Coors actually exercised this option some years ago
when it began to manufacture its own cans.
Substitutes
Many firms face the threat of substitute products or services being developed by
competitors. Substitutes can either threaten a firm’s market share or, if functionally
equivalent, can create a cap on the firm’s prices. To counteract this threat, some firms
attempt to raise their customers’ switching costs. Others will incorporate the benefit
of a substitute into their own products.
Rivalry
The need to mitigate the power of rivals depends to a great extent on a firm’s
industry, and the size, nature and market share of its competitors. In general,
however, the power of a rival depends on the nature of its products and services, and
how differentiated or similar they are from others in the industry. By differentiating
the rapid-delivery product from overnight to 2-days, for example, Airborne Express
became a significant rival of Federal Express and United Parcel Service.
New entrants
In part, the threat of new entrants depends on the scale and learning economics of the
industry, which will dictate the minimum economic size needed to enter the industry
and hence the up front capital requirements. This threat also depends on factors such
as access to distribution channels, knowledge of governmental regulatory policies,
the expenditures needed to create a brand image, and any ongoing requirements to
remain in the industry, such as advertising. To gain even a small percentage share of
market in the cola industry, for example, a firm must be prepared to spend millions
of dollars each year in an effort to overcome the force of Coke’s and Pepsi’s massive
advertising campaigns. Similarly, after obtaining a 20 percent share in the high-end
segment of the disposable diaper market, Johnson & Johnson was forced to exit
this segment when it found that it was unable to afford the frequent manufacturing
changeovers needed to keep pace with the constant feature modifications initiated
by the industry leaders.
Relationship to GAIP
The above discussion raises the question of how intangible reporting under GAIP
can help the financial community to identify the ways that a firm has raised buyer
switching costs, addressed potential sources of market and technological disruption,
minimized the potential for supplier hold up, responded to the threat of substitutes,
positioned itself against its rivals, and raised barriers to entry. Table 3.3 contains
some examples of how intangibles in each of the seven categories shown in
Table 3.1 can be applied to these five forces.
An approach such as this is decidedly different from proposals to date concerning
reporting on intangible assets. These proposals have focused on the resources that
a firm has available—such as the knowledge possessed by its work force—rather
than on the way that a firm has used those resources to address the five forces. This
distinction is decidedly non-trivial. If a set of intangible reports had been prepared
for Xerox some years ago, for example, it likely would have included the company’s
superior service network as an asset not reported under GAAP. However, Xerox’s
service network was of little value when Canon developed a copier that required
infrequent servicing, and that could be repaired by the customer. The real question
was what Xerox was doing to mitigate the threat of its rivals, or to raise its customers’
switching costs so they would not be tempted to purchase a competitor’s copier.
Issues in Developing GAIP
Assigning a monetary value to some intangibles, and listing or describing most of

the others, while encouraging, is only a first step. Even incorporating Porter’s five
forces into a set of intangible reports does not consider several important issues that
need to be addressed in the effort to develop a set of generally accepted intangible
principles. There are ten such issues.
Issue #1. Market value versus book value
The argument has been made that the “true value” of a company’s intangibles can
be determined by comparing the market value of its stock to its accounting book
value (Hall 2000; Lev 2001). The difference between the two can be attributed to
such intangibles as human capital, R&D spending, and education and training of the
workforce, among others Hall 2000; Bresnahan, Brynjolfsson, and. Hitt 2000; Lev
and Sougiannis 1999).
There are three problems with using this approach to value a firm’s intangible
assets. First, can it really be true that the dramatic declines in market caps of most
publicly-traded companies during the first few years of the 21st century came about
because these companies lost some of their human capital, reduced their spending
on R&D, cut back on workforce training, and the like? If not, then something else
is at work, and the gap between market value and book value ceases to be as good
a measure of the true value of a company’s intangibles as has been suggested.
Indeed, as discussed elsewhere in this book, many companies have a vast array of
intangibles that are unknown to most members of the investment community, and
hence cannot be expected to influence share prices in any significant way. At the
same time, share prices can be affected by a variety of economic, political, and
environmental factors, many, if not most, of which have nothing to do with a given
company’s intangibles. In short, while the gap between market and book values
perhaps provides a rough approximation of the totality of a company’s intangibles,
it is at best a blunt instrument.5
Second, even if such a blunt-instrument approach were valid, it would measure
intangible assets at the most macro level, without providing any of the underlying
detail. As a result, investors and others would have a great deal of difficulty addressing
the sustainability or durability of the value of a firm’s intangible assets. This point is
developed more fully later in the chapter.
Finally, and perhaps more important, since there is no standardized measurement
or reporting of a company’s intangible assets, the market valuation is based on
imperfect information, or, at best, asymmetrical information. Because of this, two
important goals of a system to measure and report on intangibles are (a) to improve
5 For additional discussion of this point, see Upton (2001).

Table 3.3 Examples of the relationship between intangible assets and strategic considerations
CATEGORY
Strategic Government- Contractual Technological Employee-related Organizational Customer-related Market-related
consideration rotected
Threat of buyer An annual contract Expedia.com’s Nordstrom’s By having Amazon.com’s Proctor and
switching between a customer on-line reservation employee established customer history Gamble’s retail
and a fitness center system containing compensation Word, Excel, and allows it to direct shelf space
mitigates the threat each customer’s system encourages PowerPoint as repeat buyers to agreements with
of switching for at flying preferences salespeople to industry standards, books and products supermarkets make
least one year. and credit card create satisfied, Microsoft has of potential interest its products highly
information deters repetitive deterred the threat to them. visible to buyers.
customers from customers. of buyer switching.
using other on-line
systems.
Threat of supplier Disney’s contract General Electric’s WalMart’s spartan meeting rooms and Coors backward
holdup with Pixar deters stock option policy volume purchases from multiple vendors integration into
Pixar from holding makes it difficult deter supplier holdup. can production
up Disney. for employees to eliminated the
leave GE. threat of holdup
by some of its
suppliers.
Threat of substitutes Adobe’s licensing Microsoft’s Adobe’s policy
agreement with constant revision of providing its
users of Acrobat and improvements “Reader” free
makes it difficult in its operating of charge deters
for substitutes to system and office substitutes.
enter the market. software deters
substitutes
Threat of new Schering-Plough’s Amazon.com’s Adobe’s policy Coca Cola’s and
entrants patent on Allegra and Barnes and of providing its Pepsi Cola’s
deterred new Noble.com’s order “Reader” free of multi-million dollar
entrants for many processing systems charge also deters annual advertising
years. are complex new entrants. expense makes it
technological difficult for a new
systems that new entrant to compete
entrants may effectively.
have difficulty
developing.
Threat of rivals Disney’s copyrights Southwest’s landing Fedex’s on-line General Electric’s Coca Cola’s and
on its characters rights in small tracking system new employee Pepsi Cola’s brand
(e.g., Mickey airports make it and computerized training program names make it
Mouse) makes it difficult for rivals ordering system gives it a recruiting difficult for rival
difficult for rivals to establish a makes it difficult edge over its rivals. colas to compete.
to copy its theme presence. for rivals to
parks. compete
Threat of slack WalMart’s Walmart’s policies
inventory system of shared hotel
helps it maintain a rooms and walking
very high inventory rather than using
turnover. taxis creates a
culture that eschews
slack.
the quality of the available information and (b) to reduce existing information
asymmetries. Indeed, by reporting on intangibles, companies will provide the
investment community with considerably more information than it now has on the
elements that constitute “value.” Moreover, by making this information available
to the entire investment community, intangible reporting will help to reduce the
advantages that large investors have over smaller ones.
Issue #2. Full disclosure versus trade secrets
Clearly, reporting on intangibles should not require a firm to divulge trade secrets or
other matters that would give its competitors an advantage in the marketplace. Yet,
if the financial community is to be adequately informed about a firm’s intangible
assets, some of what a company traditionally has considered proprietary may need
to be disclosed. Drawing the line appropriately will be fraught with controversy, and
will require an entity akin to the FASB that has an open discussion process prior to
adopting a reporting standard. Amazon.com’s resistance a few years ago to divulge
information on something as seemingly innocuous as its number of customers,6
suggests that there will be considerable controversy about the level of disclosure.
Issue #3. Historical versus forecasted performance
This issue is not unlike the debate that has taken place in financial reporting for
several decades, where, to date, historical-cost proponents have triumphed over
proponents of market value or inflation-adjusted value. The argument has centered
on reliability, with the underlying idea being that anything requiring an adjustment
is inherently suspect. The same issue will need to be addressed for reporting on
intangible assets, where any requirement for a forecast no doubt will create the
potential for considerable optimism.
Issue #4. Cost versus value
This issue focuses on the availability of data for computing the cost of an intangible
asset. Consider, for example, the internal development of a patent. With appropriate
cost accounting techniques, an organization should be able to determine the R&D
expenses that were incurred in creating the idea or product that subsequently was
granted a patent. It would be a relatively simple matter to report this cost—and
others like it—as part of a firm’s intangible assets, even though the R&D effort
had been expensed previously on the company’s income statements. Of course, this
cost says nothing about the patent’s value to the company. Its value would be the
discounted cash flows from the incremental earnings that would take place due to its
presence, which can extend up to 17 years into the future. Clearly, the present value
of most internally developed patents greatly exceeds their full R&D costs.
6 Kaufman (1999) for a discussion of Amazon.com’s resistance to reporting this kind of

information.
Should a company’s intangibles report show just the number of patents and the
full cost of developing each, or should it forecast the earnings for each patent and
compute its present value? As with any estimate of this sort, the forecasted earnings
would be subject to error, sometimes of a significant magnitude. Many questions
would need to be answered before such a report could be considered reliable.7
Issue #5. Industry-specific versus general reporting
There is some support in the accounting community for the development of separate
types of intangible reporting for each industry. However, since many reporting items
would be the same for a wide variety of industries, there is no need to be industry
specific at the outset. Certainly the seven categories shown in Table 3.1 are relevant
for almost any industry. Patents obtained, growth in customers, development of
software, and the like, while not appropriate for all industries, would have a broad
enough applicability that work on industry-specific intangibles could, as a minimum,
be postponed for several years.
Although industry-specific reporting is not be needed, a firm’s chosen industry
is important. As Figure 3.1 indicates, profitability, as measured by return on assets,
differs considerably across industries. If readers of intangible reporting statements
are to fully understand a firm’s profit potential, they will need information about the
overall attractiveness of its industry. But this is quite different from industry-specific
reporting on intangibles.
Issue #6. Status versus flows
Financial accounting statements contain one report that shows a company’s status (the
balance sheet) and three (the income statement, the statement of cash flows, and the
reconciliation of retained earnings) that show flows to explain the changes in status
during the reporting period. One issue to be resolved in reporting on intangibles is
whether comparable statements are needed, and, if so, what their elements might be.
For example, are we interested in the number of customers that a company has as of
the end of a year, the number of new and lost customers during the year, or both? Just
as financial accounting would be of little use if the only statement were the balance
sheet, the same is true for intangibles. Thus, it seem clear that both status and flow
reports will be needed.
Issue #7. Absolute versus relative
Other than one or two ratios (such as earnings per share), financial accounting presents
only absolute figures, leaving financial statement readers with the task of computing
whatever ratios or percentages they feel are needed to improve their understanding
of the statements’ contents. An important question for intangible reporting is whether
a similar approach should be used. For example, if a firm reports both new and lost
7 For additional discussion on this point, see Blair and Wallman (2001).
Figure 3.1 Differences in return on assets across selected industries

Source: Pankaj Ghemawat and Jan W. Rivkin, Creating Competitive Advantage
customers as well as a beginning and ending customer totals, analysts can compute
whatever percentages they desire.
On the other hand, it may be the case that some intangible assets have little
information value as absolutes. Employees trained, for example, would be of little
value unless readers knew what percentage they comprised of the total work force.
Thus, if relative figures are not to be reported, an intangible reporting system will
need to contain sufficient raw data to allow an analyst to compute a variety of useful
or potentially useful ratios or percentages.
Issue #8. Results measures versus process measures
This is a particularly tricky issue, in part because the line between results and
processes is occasionally fuzzy. The issue is complicated by the fact that, in many
respects, the ultimate result measure is a financial one—a satisfactory return
investment. However, in the arena of intangibles, there are certain measures that
can be considered “results,” and others that are clearly “processes.” Customer
satisfaction, for example, is a results measure, whereas the associated processes
might be improved technical support, more generous product exchange policies,
faster response time to complaints, and so on.
It would appear that reporting on intangibles should focus on results rather than
processes. Not only could a company’s list of processes be quite lengthy, but they
most likely would mean very little to readers of the reports. Results, on the other
hand, are much clearer and relatively unambiguous in terms of their ultimate impact
on the firm’s profitability.
Issue #9. Quantitative reporting versus narrative reporting
As Table 3.2 suggests, some intangible assets do not lend themselves to quantitative
measurement, and even those that do may be limited to simple counts: number of
customers, number of copyrights, and so forth. Yet, it is clear that, say, Disney’s
copyright on Mickey Mouse has considerably more market value than McGraw
Hill’s copyright on an out-of-print book. Again, however, any attempt to assign
value to an item such as a copyright (or many other intangible assets) would be
highly subjective.
This dilemma suggests that some combination of quantitative and narrative
reporting may be appropriate. Just as a set of financial statements is accompanied
by an explanatory set of footnotes, so too could a set of reports on intangible assets.
The narrative explanations would allow readers to gain an appreciation for the
significance of the numerical indicator.
Issue #10. Required reporting versus optional reporting
Once an intangible reporting framework is established, most firms will not want to
reveal sensitive information. Other firms no doubt will believe that the prescribed
reporting formats do not provide a sufficiently robust description of their intangible
assets, and hence may wish to supplement the required reports with additional ones
that provide readers with greater detail.
The solution to this issue would seem to lie in a modest beginning, followed by
an evolutionary process as the field of intangible reporting evolves. Thus, while it
may be possible to identify a set of principles that constitutes GAIP, the reporting
requirements most likely should be minimal in the first few years. This will allow
the standard setting body to learn about problem areas, and to develop new standards
to address them.
Generally Accepted Intangible Principles: A Proposal
The framework on intangibles shown in Table 3.2, combined with Porter’s five forces,
and the ten above issues, gives rise to seven principles to govern the measurement
and reporting of intangible assets. These proposed Generally Accepted Intangible
Principles are presented at a sufficiently high conceptual level that they can remain
in place for some time. As with GAAP, various standards will need to be developed
over time to improve the reliability of the information being measured and reported,
but the principles themselves should remain unchanged.
Principle #1. Position
This principle is similar to GAAP’s “entity” principle. It requires a firm to define

both its industry and the competitive position it occupies, or aims to occupy, in it.
If a firm is operating in multiple industries, it would need to identify its competitive
position in each. It also would need to compare its return on assets with the industry
average, which will serve to link intangible reporting with financial reporting. This
principle will allow readers of intangible statements to have a basis for assessing
how the firm’s intangible assets can assist it to maintain or improve its profitability.
Principle #2. Evolution
This principle recognizes that some intangible assets require several years to reach
maturity, and requires a firm to report on the status and flows of its intangible assets
over a period of several years. Such a report will allow readers to see both the current
status of an intangible asset and how it has evolved over time.
Principle #3. Cost
This principle recognizes that some intangibles can be given a monetary value, but
lessens the potential problem of a company overestimating the value of its intangible
assets. Thus, for example, a patent would be reported at the full cost of developing it,
but no attempt would be made to estimate the present value of its future cash flows.
Principle #4. Tactility
This principle recognizes the somewhat oxymoronic fact that some intangible assets
can be seen or touched, and therefore described, even if it is not possible for the entity
to ascribe a cost to them. Non-compete contracts, information systems, procedural
manuals, the organizational structure, and customer histories are all examples of
“tactile intangibles.”
Principle #5. Results
This principle requires the entity to report on results, rather than processes, for those
intangibles that cannot be ascribed a cost. For example, the entity would report the
number of employees trained as a percent of total workforce rather than number of
training programs it ran.
Principle #6. Category
This principle stipulates that there are seven categories of intangible assets (shown in
Table 3.1), and requires the entity to describe its intangibles in each.
Principle #7. Sustainability
This principle requires the entity to assess the sustainability of its profitability in
terms of five threats: loss of customers, supplier hold-up, substitutes, new entrants,
and the actions of rivals. For each area the entity would need to describe how its
intangible assets help to raise buyer-switching costs, avoid supplier hold-up, mitigate
the effect of substitutes, prevent the entry of new competitors, and deter the actions
of rivals.
The Intangible Reports
These seven principles give rise to a need for two reports on intangible assets: the
Status and Flow Report and the Sustainability Report. The Status and Flow Report
would show the entity’s intangible assets classified into the framework of Table 3.2,
and it would show the changes that occurred to them each year over a period of
several years.
The Sustainability Report would be in the format of Table 3.3. It would show
how the entity’s intangibles assist it to sustain its profitability by helping to mitigate
the threats of buyer switching, supplier holdup, substitutes, new entrants, and rivals.
The purpose of this report is to recognize that an intangible asset is of little value
unless it assists a firm to improve its position relative to one or more of these threats
to the sustainability of its profits.
Report contents
The actual content of these reports would evolve over time, as the standard-setting
board responded to requests from the financial community for new standards,
promulgated proposed changes, and ultimately issued new standards. Nevertheless,
by focusing on the items contained in Table 3.2, the initial content of the Status and
Flow Report would be relatively easy to develop. The Sustainability Report would
be more problematic. Companies might report initially on those items they consider
important, and the board might then develop reporting standards in each category as
various items emerged as important for readers.
Limitations and Prospects
No form of intangible reporting, however robust and detailed, will allow the financial
community to attain complete certainty about a company’s makeup or future
prospects. The goal of reporting on intangible assets, therefore, is not to eliminate the
difficult job that financial analysts, bankers, investors, and others have in attempting
to forecast a company’s future profitability and cash flows. Rather, it is to facilitate
the job, and to minimize the information asymmetries among the various groups.
By providing information that goes beyond the traditional financial reporting of
GAAP, intangible reporting can help to improve the information that is available to
the financial community and reduce these information asymmetries. As with GAAP,
however, GAIP will never be perfect, and efforts to improve its reliability no doubt
will need to continue indefinitely. Nevertheless, by providing investors, bankers, and
other members of the financial community with increasingly relevant information on
intangible assets, GAIP reporting can help to improve the functioning of America’s
financial markets.
References
Blair, M. M. and Kochan, T. A. (eds.) (2000), The New Relationship: Human Capital
in the American Corporation, The Brookings Institution Press, Washington,
D.C.
Blair, M. M. and Wallman, S. M. H. (2001), Unseen Wealth: Report of the Brookings
Task Force on Intangibles, Brookings Institution Press, Washington, D.C..
Bresnahan, T. F., Brynjolfsson, E. and Hitt, L.M. (2000), ‘Technology, Organization,
and the Demand for Skilled Labor’, in Blair M., M. and Kochan ,T. A. (eds.).
Financial Accounting Standards Board (FASB) (2001a), SFAS no. 141, Business
Combinations, Norwalk CT, Financial Accounting Series, No 221-B, June.
Financial Accounting Standards Board (FASB) (2001b), SFAS no. 142, Goodwill
and Other Intangible Assets, Norwalk CT, Financial Accounting Series, No 221-
C, June.
Hall, B. H. ‘Innovation and Market Value’ in Ray Barrel, in Mason, G. and
O’Mahoney, M. (eds.).
Hall, R. E. (2000), ‘E-Capital: The Link between the Stock Market and the Labor
Market in the 1990s’, Brookings Papers on Economic Activity, 2.
Kaufman, L. (1999), ‘Cutting through the Fog of Growth for Net Retailers’, New
York Times, September 1.
Lev, B. (2001), Intangibles: Management, Measurement, and Reporting, Brookings
Institution Press, Washington, D.C.
Lev, B. and Sougiannis, T. (1999), ‘Penetrating the Book-to-Market Black Box: The
R&D Effect’, Journal of Business Finance and Accounting, 26, April-May.
Mason, G. and O’Mahoney, M. (eds.) (2000), Productivity, Innovation, and Economic
Performance, Cambridge University Press, Cambridge.
Porter, M. E. (1980), Competitive Strategy, The Free Press, New York.
Upton, W. (2001), Business and Financial Reporting, Challenges from the New
Economy, FAS Special Report.
Chapter 4
IC Statement vs. Environmental and

Social Reports:
An Empirical Analysis of their
Convergences in the Italian Context1
Michela Cordazzo
University of Bolzano
Introduction
In recent years one of the main features of accounting and management studies
has been the widespread search for appropriate measures in order to capture firm
value and its new sources. There is indeed a vast agreement in the scholarly and
professional community that the value of a firm performance is not adequately
portrayed by the traditional financial measurement tools, which appear to many as
incapable of representing the multidimensional nature of that performance.
On the other hand, it is more and more recognised that the process of value
creation in companies is also changing. New macro and micro events such as the
dematerialization of economic activity, the knowledge society, the service-based
economy, the technological advances have profoundly undermined the bases on
which the traditional systems of value calculation rest. In particular, these systems
seem to be highly inadequate when addressing the valuation of intangibles. As well
known, some of them find a representation in the financial statements (purchased
brands, intellectual property, consolidation goodwill), but the large majority of them
remain outside the boundaries of a proper accounting detection.
On the basis of the joint consideration of the above two phenomena – the
awareness of the multidimensional nature of firm performance and the inadequacy
of traditional accounting systems – a new concept has been recently proposed
aiming to cope with the issues posed by the different economic and technological
environment. The concept is that of Intellectual Capital (IC), which has started to
receive a growing international attention in these very years.
From a conceptual and scholarly point of view, already many interpretations and
connotations of IC have been pointed out in the literature, while at a corporate level
an increasing number of firms are supplying information on IC and its components.
1 This chapter has already appeared in the Journal of Intellectual Capital, Vol. 6, No. 3,
2005, pp. 441-464.
Some companies prepare already an IC report, which is autonomous and separate
from the traditional annual financial report. The interest in the IC is also rising at
an institutional level, as it is witnessed by recent initiatives of the EU Commission
(Eustace 2000; Zambon 2003) and the Danish Agency for Trade and Industry (1998
and 2001).
However, one delicate point – which could condition the future spreading of the IC
report among European companies – is the degree of “newness” of such reports, as well
as the magnitude of the effort to produce them. From the first point of view, it is well
known that other innovative forms of corporate reporting, such as the environmental
and social reports, have started to be adopted by European companies in the recent
past, also as a consequence of statutory or professional requirements. It is therefore
reasonable to arise the question whether with IC statement we are facing a complete
new reporting model, which is different in conceptual terms from the environmental
and social reports that are more established and recognised in the business, institutional,
and academic context. In this respect, can the social and environmental reports be seen
as expressions of a wider and growing concern with IC “ingredients”? In other words,
could the social and environmental performance of a company be also interpreted as
part of the wider IC performance of an organisation?
A second element, which may limit the adoption of IC statement, is the associated
technical need for accounting for new information and phenomena that are generally
disregarded by the information systems of companies. In this respect, if some
convergences could exist between the information required for the production of IC
statement and social and environmental reports, then some form of “informational
economies of scope” could be envisaged. The underlying assumption here is that
these common elements from an information point of view, if existent, could favour
the spreading of those innovative forms of company reporting.
The aim of the chapter is to explore empirically these issues, and in particular
whether IC statement presents some elements of commonality in conceptual and
informational terms with the social and environmental reports. To this end, a detailed
content analysis of the social and environmental reports published by companies has
been carried out. This analysis has been primarily referred to the Italian context.
The work will unfold as follows. In the next section a short outline of the aims and
main contents of IC statement will be made. After an introduction to the regulatory
framework and models of environmental and social reporting will be proposed.
Then, the nature, methods and contents of the social and environmental reports will
be empirically explored. Their linkages with IC report will be later presented and
discussed. Some final observations will bring the chapter to an end.
The “Rise” of Intangibles and the Main Features of IC Statement
The debate on intangibles has begun with parallel developments in practice and in
theory in the last twenty years. Among the developments in the realm of practice we
could single out the following: knowledge as a sustainable competitive advantage,
importance of intangibles, relevance of service and intangible components of
a product (customer satisfaction), and increase expenses in R&D. Among the
IC Statement vs. Environmental and Social Reports 69
developments in the realm of theory (especially strategy studies, theory of the firm,
and management accounting) we could single out the following: competence-based
view of the firm; resource-based view of the firm; management of intangibles as a
source of competitive advantage, and multidimensional frameworks for capturing
the different aspects of a firm performance (cf. the balanced scorecard by Kaplan
and Norton 1992).
These developments have fostered practical and scholarly attention to the
intangible determinants of an organisation success. In this respect, the value creation
of firm activity have recently found new interpretations and definitions owing to
the importance that scholars and practitioners have attached to intangibles and
knowledge (cf. Itami 1987; Nonaka and Takeuchi 1995).
On the other hand, accounting systems and traditional measurement tools have
revealed to be insufficient in their traditional underlying rules and principles, because
of their reliance on the historical cost principle and the transaction-based values, as
well as their “unstable” distinction between an asset and a period cost. But also
the overall logic of the traditional accounting system and concepts have started to
look inadequate for the emerging different firm model, which responds now more
and more to post-industrial organisational and management criteria (service-based,
immaterial, low workforce rate, network-shaped). A clear empirical evidence of the
problems that accounting systems face in the contemporary economy is given by the
well known gap between book value and market value of a firm, because the firm
value is a high percentage of intangible resources (Lev 2001).
As a response to the above issues, several companies, mainly based in northern
European countries, have focussed on the concept of Intellectual Capital (IC), and
adopted new tools for classifications and identification of drivers for value creation.
An important precedent of the 70s, which bears some resemblance with the IC
concept and measures, is HRA – Human Resource Accounting (Flamholtz 1999).
There have been many theoretical proposals to develop such as a measurement
model, but those scholarly proposals appear to have had virtually no impact on
company practice, apart from football industry.
Another relevant precedent of IC report is the so-called “value added statement”,
which has been produced by some UK and continental European companies during
the 70s. Also in Italy this approach attracted the attention of some scholars (Ardemani,
Catturi). This practice, though, was dismissed after a few years.
However, over the 90s new IC frameworks have been developed and applied,
such as the “value platform” by Dow Chemical, the application of “intangible assets
monitor” by Celemi, and the “value scheme” by Skandia.
The value platform has been proposed in 1996 by Edvinsson (Skandia), Onge
(The Mutual Group) and Petrash (Dow Chemical). The framework states that IC
components are human capital, organisational capital, and customer capital (see
Figure 4.1). The firm value creation is within the triangle, and the objective of the
framework is to maximise the value space through the three components of IC.
Dow Chemical has helped the improvement of the value platform developing an
intellectual asset management model with the function to integrate the intellectual
assets into business strategic programs. The company started the implementation of
the intellectual asset management with patents (Petrash 1996).
Figure 4.1 The value platform

Source: Petrash, 1996.
Sveiby proposed the intangible asset monitor in 1997 (Sveiby 1997). The assets
of a firm are classified into tangible and intangible resources, and the intangible
capital is divided into three categories: internal structure, external structure, and
individual competences. Three classes of indicators are identified within each
category: growth/renewal, efficiency, and stability/risk. Such a framework has been
implemented in the consulting Celemi, which recognized three areas as being the
fundamental factors of success: “our customers” (external structure), “our people”
(competence), and “our organisation” (internal structure). The company have
developed in each area a system of indicators, which measure its knowledge-focused
strategy (see Table 4.1).
The Skandia value scheme has been developed by Edvinsson in 1993. According
to his approach, the firm’s market value is created by IC and financial capital. The IC
is divided into structural capital (including customer and organisational capital) and
human capital. Organisational capital consists of innovation (intellectual assets and
intellectual property) and process capital. Such a framework is innovative, because
in the traditional economic models only the financial capital was considered in the
calculation of the market value (Edvinsson and Malone 1997). In coherence with the
value scheme, Skandia has then developed the “business navigator” (see Figure 4.2),
and has prepared its IC report. The business navigator is a tool for a better monitoring
of firm performance and creation of value. Such a framework links together past
(financial focus), present (customer focus, human focus, and process focus), and
future (renewal and developments focus) aspects of firm’s activity. The customer,
Table 4.1 Celemi intangible asset monitor
Intangible Assets
Our Customers Our Organisation Our People

(External Structure) 1997 (Internal Structure) 1997 (Competence) 1997
Growth/Renewal Growth/Renewal Growth/Renewal
Revenue growth 22% Organisation-enhancing 49% Average professional 8
Image-enhancing customers 71% competence 65%
customers 70% Revenues from new Competence-enhancing 47%
products 27% customers 68%
Intangible investments % Growth in professional
value added competence
Experts with post-
secondary degree
Efficiency Efficiency Efficiency

Revenues per 269 Proportion of 21% Value added per expert 753
customer administrative staff 8,5 Value added per employee 620
Revenues per
administrative staff
Stability Stability Stability

Repeat orders 54% Administrative staff 0% Expert turnover 6%
Five largest 40% turnover 2 Expert seniority 3
customers Administrative staff 55% Median age all employees 35
seniority
Rookie ratio
Source: Celemi, 1997
process and human focus are referable through the calculation of performance
indicators to IC components. Interestingly enough, a comparison between the
business navigator and balanced scorecard model shows that there is a substantial
overlapping between them. However, there is also an important difference, which is
the diverse relevance accorded by the business navigator to the human factor, that in
the latter case is explicitly placed at the centre of the value creation of a firm.
Another important initiative has been carried out by the Danish Trade and Industry
Development Council, which has developed the Project Intellectual Report in 1997,
then re-proposed in 2000. The Council has analysed the IC accounts provided by
ten Scandinavian companies in 1997, and then has identified four categories of
indicators for the measurement of IC: human resources, customers, technology, and
processes. According to such categories, the main objectives of IC accounts are to
reveal firstly the factors that create growth, and then the areas that drive the growth
of a company.
In Italy there are only three companies (Brembo, Plastal, and Eptaconsors) so
far that have produced an IC report. One of these companies also publishes such a
report. Both cases have been largely inspired by the above mentioned “intangibles
asset monitor” by Sveiby, which has been adapted to the specific company
characteristics.
Figure 4.2 Skandia business navigator

Source: Intellectual Capital Report, Skandia 1994
What can be inferred from the above short presentation is that there is a substantial
convergence between the different models for representing IC. More specifically, the
IC wealth appears to have been segmented into three main components, which could
be labelled in dissimilar ways: the human capital and the related competences, the
organisational-internal capital (which is articulated also in organisational capital and
technological capital), and the external-relational-customer capital. However, the
basic aims pursued seem to be largely shared by the different models.
Environmental and Social Reporting: The Regulatory Framework and

Proposed Models in Italy
A new principle of “corporate social responsibility” is emerging among companies.

As a response of environmental, social and economic pressures, the responsibility
of a firm is now being enriched with the voluntary management of impact of its
activity on both the environment and society. Such new social aims are not intended
to interfere with the economic goals, but to imbue financial decisions with an
ethical content, that contributes to the environmental protection and a better society
(European Commission 2001).
In environmental and social accounting literature, several studies has identified
and measured the interactions between the economic firms’ activity and the
environment, and in particular the research in corporate social reporting has
valued the environmental and social actions of companies through the analysis of
information disclosure (Gray 1990; Guthrie and Parker 1989 1990; Roberts 1992;
Gray, Bebbington and Walters 1993 and 1995; Deegan and Rankin 1997; Mathews
1997). Within such analysis, some works have emphasised that the environmental
and social corporate reporting is not systematic, because of the absence of regulation,
and depends on the interest of stakeholders in the environmental and social behaviour
of a company. Thus, on the basis of such joint considerations, the companies produce
environmental and social information in the form of voluntary documents (FEE
1993 1995 and 1996; Gray, Bebbington and Walters 1995).
The need for integrating environmental and social together with the economic
profile in Italian companies finds its quantitative expression in ad hoc corporate
environmental and social reports. Those documents are voluntarily prepared by the
companies in order to communicate to users their environmental and social goals, as
well as the decisions, programs and procedures realized for pursuing such goals.
Environmental report
The rules for the preparation of environmental reports have different sources: the
Community standards, the national law and the proposals of organisations and
institutions (Bartolomeo, Malaman, Pavan and Sammarco 1995; CNR 1997; Frey
1997; Molina 1997).
The EU standards, whose influence is more and more relevant and are directly
applied within the States members of the EU, are the following:
• 92/880/EEC regulation includes the discipline referring to the Community

assignment of a ecological quality label, i.e. Ecolabel;
• BS 7750 standard, issued by the British Standard Institution in 1992, contains
a specification for the adoption of the Environmental Management System.
Such a specification provides to assure and supply a documentation on the
level of conformity of the company’s actions to environmental policy and
objectives. The standard has been the draft of EMAS regulation in 1992, and
has replaced by the ISO 14000 standards (Tencati 2002);
• 95/1836/EEC regulation is relevant within the Community legislation,
because it defines the rules regarding the voluntary joining of companies to
the Community system of Eco-Management and Audit Scheme (EMAS).
The regulation provides that companies adopt in their production sites an
Environmental Management System based on policy, programs, procedures,
and objectives of environmental improvement, and publish an environmental
report;
• ISO – International Standard Organisation, and in particular the ISO 14000
standards, issued in 1996, have been prepared to promote a common
approach to the environmental management, and to increase the capacity of
companies in obtaining and measuring their improvements in environmental
performances;
• 01/761/EU regulation allows voluntary participation by organisations in a
Community eco-management and audit scheme, i.e. EMAS 2, a new version
of EMAS. The main changes introduced by this regulation are: it is open to
the participation of any organisation (company, corporation, firm, enterprise,
authority or institution, or part or combination thereof, whether incorporated
or not, public or private, that has its own functions and administrations), in
the previous version it was applicable only to companies’ production site;
the Environmental Management System shall be implemented according to
the requirements of ISO 14001, that reduces the differences between the ISO
14001 and EMAS, and makes the latter more operational in the companies;
and the promotion of small and medium-sized enterprises’ participation in
EMAS (Troina 2001, Tencati 2002);
• on 30 May 2001 the European Commission has approved the “Recommendation
on the recognition, measurement and disclosure of environmental issues in
the annual accounts and annual reports of companies”. Such a provision will
be adopted by companies covered by the Fourth and Seventh Accounting
Directives, banks, other financial institutions and insurance companies
covered by the 86/635/EEC and 91/674/EEC Accounting Directives. The
disclosure of such a information would assure that accounts and management
report include environmental data, beyond the information voluntary provided
in the environmental reports.
As regards to Italian national law, which is particularly fragmented in this subject

area and refers to provisions of subsequent realisation, the unique relevant normative
disposition is the Law of 25th January 1994, no. 70. The law includes the rules for
the simplification of executions relating to environment, health, and public safety, as
well as the realization of Eco-Management and Audit Scheme.
The standards of FEEM –Fondazione Eni Enrico Mattei (ENI Enrico Mattei
Foundation) are instead an alternative source to the statutory one. The Foundation
has created a working group for the research of environmental indicators and
environmental accounting principles (FEEM 1994). The studies of the group are
focused on the EMAS regulation, environmental accounting, and the preparation
of environmental report. Regarding the latter point, some guidelines have been
identified for the form of this report, which is composed of two parts: qualitative,
such as commentaries, and quantitative, such as presentations of the main variables
describing the relation between the company and environment. For each of the two
sections some areas have been developed: as to the qualitative information, the
company’s description, environmental policy, environmental management systems,
risk management, relation with the legislation, product policy, conservation of
natural resources, relation with external subjects, and certification; while referring to
the quantitative information, the environmental expenses, emissions, consumptions
of raw materials and products, and indicators of environmental performance.
Moreover, for each of these areas the working group has recognised some minimal
and recommended specifications: the first should be included for a reliable and fair
report, while the exclusion of the others does not compromise the total value of
report (Siniscalco 1997; Dezzani 1999a and 1999b).
Social report A legal rule codifying form and contents of the social report does not
actually exist neither at the community level nor at a national one.
As regards to the EU initiatives, a first proposal, that tended to make homogeneous
the information and consultation of the employees in the companies, is the “Vredeling
project” presented on 24 October 1980 at the EU Council; while a second proposal,
relating to the form of the social report, came from the IX Strasbourg Congress in
1983.
At an international level, the main reference models for the preparation of “social
accountability” are:
• Global Reporting Initiative – GRI project, set up in 1997 by some European

institutions and supported by companies, agencies and non-government
organisations, which is directed towards the creation of a “sustainability
reporting” system for the companies producing voluntarily environmental and
social reports;
• Social Accountability 8000 – SA8000 standard, published in 1998 by CEPAA
– Council for Economic Priorities Accreditation Agency, which refers to
the certification of “social accountability”, i.e. the ethical level and social
responsibility attained by a company;
• AccountAbility 1000 – AA1000 standard, developed in 1999 by the ISEA –
Institute of Social and Ethical Accountability, which aims to improve the social
accountability and performance through the dialogue with and integration of
stakeholders.
In Italy, from the beginning of the ‘80s to date, the regulation dealing with social
accountability presented at the Senate has been the bill of 22 July 1981, no. 1517,
including rules on social report and the setting up of Security Councils. Such a law
has not had a sequel (Beica 1999; Chiesi, Martinelli and Pellegatta 2000).
A model of social report has also been proposed in 1990 by the IBS – Istituto
Europeo per il Bilancio Sociale (European Institute of Social Report). The innovative
aspects introduced with this model, vis-à-vis the Bilan Social in France and the
Sozialbilanz-Praxis in Germany, are: the chart of company values, composed of a
list of principles/values that a company should try to attain; and the form of social
report, that is articulated into four sections, i.e. the company identity, value added,
social relation, and social accounting (Marziantonio and Mari 1999).
The form of IBS model has been also expanded by Strategia d’Immagine,
company developing social report models, in collaboration with the Istituto Europeo
per il Bilancio Sociale. In comparison with the previous IBS model two sections
are added: the contents, included in the introduction, for a deeper description of
principles and objectives of social report; and the methodological note, reported
in the conclusions, for the description of the recognition principles and methods
adopted.
In 1998 the GBS – Gruppo di studio per la statuizione dei princìpi di redazione
del Bilancio Sociale (Working group on issuing of social report preparation
principles), composed of academics, professionals and associations (Assolombarda)
has been set up. The GBS intends to prepare a standard model of social report with
the support and collaborations of scholars and professionals. As in the IBS model,
the fundamental element of a social report is the company (ethical) values and their
alignment with management decisions (GBS 2001).
In 2000 the ABI – Associazione Bancaria Italiana (Italian Banking Association)
has created a working group on the definition of social report guidelines. Such a
document, together with the traditional financial statements, has a double purpose: to
offer qualitative and quantitative data on the banks’ social operations, and to provide
information for the valuation of social performance (ABI 2000). The “social report
model for the credit sector”, elaborated by the working group according to the IBS
model and GBS standards in 2001, is composed of five sections: 1) Descriptive
introduction of company identity; 2) Account (production and distribution of value
added); 3) Social relation; 4) Surveying system; 5) Improvement proposal (guideline
for the future management). These sections are preceded by a Methodological
introduction (Preparation principles of social report), and followed by a Procedural
conformity declaration (Statement on social report). From 2001 several Italian banks
have started to produce social reports using these guidelines.
Another relevant aspect is, for the first time in Italy, the inclusion of the Audit of
the Social Report in the social report of ACEA (a public utilities company). Other
companies have included subsequently this enclosure, which is composed of the
auditor’s report and the audit principles. To date, indeed, the audit report had been
included only in the environmental report by a large number of companies.
The change introduced by the company ACEA underlines two important aspects
linked to the preparation of the Audit of the Social Report: on the one hand, the
problem of the lack of audit principles for the auditing of environmental and
social reports. The auditor’s report is included to increase the reliability of such
documents, which are voluntary and not regulated, so the lack of auditing guidelines
and principles may determine the situation that the auditor’s reports do not achieve
completely their objectives. The differences on the auditing methods, form and
contents of auditor’ s report, and the lack of codified procedures have induced the
Fondazione Eni Enrico Mattei and Ernst & Young Auditing and Environmental
Studies to promote the “Forum on auditing of environmental report”. The purpose
of forum is to define some guidelines as clearness-drivers of environmental report
auditing (Dezzani 1999). FEE has dealt in such debate underlining that the increase
in the production of environmental information and reports has resulted in the need
for the provision of independent assurance of such reports (FEE 2000a).
On the other hand, the reference in the auditor’s report to the GRI principles,
SA8000, and IBS, GBS, ABI standards seems to suggest that the auditing of
social report is based on the conformity to those non-statutory guidelines. Such
standards have therefore the potential to become a set of criteria for the auditing
of environmental and social reports. Regarding the initiatives of GRI, CEPAA and
ISEA on the promotion of standards for the environmental and social auditing, some
authors observe that the issue of standardised auditing procedures is not only relating
to the “auditing best practices”, but also to who are the environmental and social
auditors (Owen, Swift, Humphrey and Bowerman 2000).
Italian environmental and Social Reports: An Empirical Analysis
Methodology
The empirical analysis of Italian environmental and social reporting has been
articulated into three phases: the first phase of the research has required the
identification of the companies, which prepare social and environmental reports.
Subsequently, the whole social and environmental report series prepared by Italian
entities is examined, and their contents and methods standardised and compared.
The layouts of reports have been classified into report models (see Table 4.1),
while the information contained in the reports have been allocated into general
subject areas: six for environmental reports, and five for social ones (Appendices 4.A
and 4.B). Each subject area has then been divided into general qualitative classes,
i.e. variables, and some quantitative or qualitative indicators could correspond to
every class. The number of variables and indicators depend on the characteristics of
data in the reports.
The main subject areas are prepared considering the information present in both
reports, and are as follows: human resources, audit and supplementary information,
processes, financial variables, customers, environmental respect, and technology.
Even though the overall purpose of these social and environmental documents is
different, the first four areas are common to both reports, while the others are specific
to one of the two sets of documents: environmental respect and technology to the
environmental report, customers to the social one. The presence of many overlapping
information suggests that the distinction between social and environmental reports is
weak (for example environmental impact in social reports and human resources in
the environmental ones).
In the analysis, information is shown in a decreasing frequency order with regard
to each variable and within every variable to each indicator (Appendices 4.A and
4.B). The peculiarity and the discontinuity of information have produced a large
dispersion of variables and indicators in the reports examined. For this reason a
variable is considered only when it shows up with a frequency more than, or equal
to, three times. Despite this preliminary selection of data, the total number of
frequencies of variables for both reports is around 2,400.
Figure 4.3 Publication period of Italian environmental and social reports

Sample
As to this preliminary phase of the research, it is necessary to underline that it has

been difficult to identify the companies, which prepare environmental and social
reports in Italy, because on the one hand the production of such documents is done
on a voluntary basis, and on the other hand it is often done for internal purposes.
Only recently, indeed, Italian companies have begun to signal the production of such
documents also via Internet. As a matter of fact, 36 and 58 companies, which prepare
respectively the environmental and social report, have been identified.
The sample is composed by public utilities, banks, co-operative organisations,
and former state owned companies. Public administrations, such as local healthcare
units and local authorities, have not been considered.
The publication period considered for the environmental and social reports is
respectively 1991-2001 and 1990-2001 (see Figure 4.3), and for a large number of
companies this phenomenon is quite recent and is concentrated in 1996-1999. Some
companies produce occasionally the social and environmental reports, and for this
reason there are 33 and 50 companies, instead of 36 and 58 entities, at the end of
such a period in the Figure 4.3. Given that the vast majority of the companies has
started this informational practice fairly recently (in the second half of the 90s), this
seems to suggest that an increasing number of companies could choose in the next
few years to evaluate the results of their activity also in an environmental and social
perspective and to give account publicly.
The reports are produced by two categories of companies:
• individual report, the companies classified in this section prepare only one
type of corporate social reporting: environmental or social;
• two sets of accounts, the companies prepare both environmental and social
report: separately, two documents; or together, only one document.
As regards the production of environmental report, such documents could

be classified into environmental report of production site, whether the data and
information refer to specific plants or factories, and corporate environmental report,
when they relate to a multi-sites company. The investigated companies have a multi-
site nature.
Layouts
The companies publish environmental and social information both in their or

consolidated financial statements, where some sections are included to describe
human resources or environmental impact, and in specific documents.
As regards the production of specific reports, the disclosure of environmental
and social aspects of firm activity depend on the environmental and social report.
The companies preparing such documents do not use only one term to define the
production of the information relating to the environmental and social management,
but they adopt definitions ad hoc (see Table 4.1). Some companies have changed
one or more times the definition of their environmental and social report during
the publication period. The analysis considers the definition adopted in 2001.
Furthermore, there is not frequently financial information, and sometimes the
section “environmental and social accounting/statements” include only information
referring to the environmental respect and relationship with stakeholders.
In this sense the environmental and social reports do not correspond to the
traditional financial statements composed of Balance Sheet, Profit and Loss Statement,
and Notes to the Accounts. On the contrary, even if they have some links with the
accounting of financial statements, these documents adopt calculation patterns and
methods, which change the accounts of financial statements, such as “environmental
performance indicators” (in environmental report) or “production and distribution of
value added” (in social report).
Environmental report The definitions, forms, and contents terms adopted for
the preparation of the investigated environmental reports are the following (see
Table 4.2).
Table 4.2 Models of Italian environmental and social reports
ENVIRONMENTAL REPORT
Financial Number of
Report models
information companies
1. Environmental/health, safety and environmental statement Yes/No 19
2. Environmental account Yes/No 4
3. Environmental report Yes/No 7
4. Socio-environmental statement/report Yes/No 5
5. Environmental declaration Yes 1
SOCIAL REPORT
Financial Number of
Report models
information companies
1. Social report Yes 43
2. Social statement Yes/No 4
3. Social co-operative report Yes 3
4. Socio-environmental statement/report Yes/No 5
5. Social declaration Yes 1
(1) The environmental/health, safety and environmental statement includes

environmental and financial information collected in nine sections:
(a) company identity: presentation of company, included frequently in the

description of its activity or chairman’s message;
(b) environmental policy: description of tools for the environmental protection,
and introduction of environmental strategies and objectives;
(c) environmental management and security: illustration of environmental
management, environmental risk management, and conformity to national
legislation;
(d) product policy: characteristics of products (or services) and productive
processes; some information on human resources are sometimes supplied;
(e) conservation of natural resources: prevention and monitoring of
pollution;
(f) environmental report or statement: environmental expenses, emissions,
raw material and products consumptions, environmental performance
indicators;
(g) relationship with society: the relations between company and external
subjects;
(h) glossary;
(i) auditors’ report.
The form and contents of the such a document and that proposed by
Fondazione ENI Enrico Mattei have many points in common. The
most of investigated companies chose this model for the preparation
of environmental report, except for some firms, which adopt only the
form and do not offer any financial data. The information collected in
the “environmental report or statement” section could be included in
the environmental report in the following alternative manners: the
environmental expenses in a) section or between the c) and f) sections; the
emissions, raw material and products consumptions, and environmental
performance indicators together or separately in b), d), e) sections. The h)
and i) sections are considered only by some companies.
(2) The environmental account/declaration is prepared with the same criteria of

environmental statement, the unique difference is the definition. Only one
company does not supply financial information.
(3) The environmental report does not offer financial information and define
the f) section of the environmental statement as “environmental data”. The
glossary is not annexed.
(4) The socio-environmental statement/report is chosen by five companies.
It includes environmental information and dedicates one section to data
relating to social report. Only one firm, which defines the document
“social and environmental statement”, publishes financial data. The socio-
environmental statement/report and environmental statement/account use
the same methods for the disclosure of environmental information.
From the analysis of the above methods, it is clear that the environmental
statement and environmental statement/account have a similar form to the financial
statements. Such documents, indeed, contain both quantitative financial information,
and qualitative information describing business policy, programs and objectives of a
firm. On the contrary the environmental report and socio-environmental statement/
report contain qualitative information, offer a small number of quantitative data and
not financial data. the documents have the same function of Management Report in
the financial statements.
Social report The empirical analysis of social report has highlighted the following
models and methods (see Table 4.2).
(1) The social report is chosen by the most of investigated companies. The social
and financial information are articulated in the next sections:
(a) company identity: presentation of company, description of its activity, and
introduction of value-drivers of company decisions;
(b) calculation of value added: production and distribution of value added, i.e.
measurement of firm profit and its breakdown on territory;
(c) social accounting and/or social relationship: analysis of politics adopted
towards human resources, qualitative and quantitative breakdown of
expenses and revenues in the areas referring to the relationship between
the company and social context; sometimes such a section is divided into
other two sub-sections: internal and external stakeholders;
(d) social relationship or social role: description of relations with universities
and other institutions, cultural initiatives, sport organisations, and social
campaigns;
(e) auditors’ report;
(f) glossary.
The form of such a document refers to that suggested by the Istituto

Europeo per il Bilancio Sociale: the first two sections correspond to IBS
model, while the characteristics of social relations and social accounting,
respectively third and fourth sections in IBS model, are included both in c)
and d) sections of social report. The financial information are included in
the “calculation of value added: production and distribution” and/or “the
social accounting and/or social relation”.
(2) The social statement/declaration is chosen by five companies. It does not

include frequently financial data, and it is articulated into a first section
describing the company identity, while the others refers to each stakeholders
(consumers, clients, society; associated companies; agents and employees).
(3) The social co-operative report adopts the methodology suggested by the
Coop in 1992, whose applicability is determined by the co-operative nature
of a company (Ranghieri 1998). The document contains financial information
relating to each stakeholder, and the sections are articulated into shareholders,
consumers, employees, civil society, and co-operative movement.
(4) The socio-environmental statement/report is adopted by five companies,
which prepare only one document both for environmental report and
social report. In the social report section, the document collects social and
financial information. The data relating to “social role” and “social relation”
are similar to those included in social report.
Almost all of the analysed report models are similar to the financial statements.
But the separation between quantitative and qualitative information, and objectives
and programs, is not well defined. Therefore, it seems not possible to assert that,
as in the traditional financial statements, there are a Balance Sheet, Profit and Loss
Statement, and Notes to the Accounts to whose the Management Report is annexed.
There is instead a uninterrupted sequence of qualitative and quantitative data relating
to information, managerial, image, and strategic objectives.
Content Analysis
Environmental report Appendix 4.A gives an overview of the most frequent

information in Italian environmental reports.
As observed previously, the companies adopt different definitions of environmental
reports, but a unique reference scheme, which could suggest that also the information
included in each section of document should be uniform. The content analysis of the
reports, on the contrary, underlines the presence of heterogeneity within the classes,
in particular relating to the variables and indicators of environmental respect,
technology, and processes.
During the period 1991-2001 the environmental information disclosed annually
by each company has not increased, because the number and nature (qualitative/
quantitative and financial/non-financial) of information is always the same. Indeed,
some companies have changed only the definition of their environmental report, but
not the contents.
The subject areas are the following six:
1. Human resources. The small number of variables and indicators could suggest
that the companies do not give more frequently this type of information in
environmental report, because its main aim is the description of environment
impact in internal and external company activities. Indeed, the companies
producing two sets of accounts include such a information in the social report.
2. Audit and supplementary information. A quite large number of companies
include the auditors’ report and audit principles, and there is often a glossary
for the description of report’s items. The introduction of a glossary in the
environmental report could suggest that companies are adopting some criteria for
the standardization of report’s items, so that they could be more comparable.
3. Environmental respect. The most frequent variable is the environmental
protection.2 A large number of documents content also the statement of
environmental principles, which includes the main company principles and aims
for the environmental respect.
4. Technology. There is only one variable included in all reports referring to
energy sources, where there are the descriptions of the energy plants/stations
connotations. All the other information is not comparable, because the companies
relate data to their specific activity and so their frequency is equal to 1.
5. Processes. The information in this subject area describe some several aspects
of processes: the legal sources for the preparation of such a document, i.e.
2 The emphasis on pollution prevention has been also recognized as one of the main
themes, which emerged from the research conducted by the ECOMAC – Eco-Management
Accounting Research Project (Bartolomeo, Malaman, Pavan and Sammarco 2000).
environmental certification (ISO 14000), work safety certification (law no.
626/94) and EMAS regulation; the impact on environment (e.g. pollution
monitoring system, consumptions, and emissions); and the description of the
features of a energy process (e.g. energy indicators, transport and distribution).
6. Financial variables. The most frequent variables refer only to the Environmental,
work safety and health expenses. The subject area shows a small number of
variables and indicators, because the companies producing also the social report
do not give financial information in the environmental document, or there are
some companies which do not include any financial information.3 For the others
the dispersion of indicators is very high, that is their frequency is equal to 1.
Social report Appendix 4.B shows the most frequent information in Italian social
report.
The analysis of layout methods has highlighted that a large number of the
investigated companies adopt the same terms and form for the definition of social
report. This convergence is reflected also on information included on the document.
The frequency of each subject area, variable and indicator is high. The financial
variables and human resources subject areas are the most uniform and full of
information, even if sometimes they have some innovative or specific elements,
which are not comparable.
Regarding the increase of social information during the period 1990-2001, as in
the environmental report, the companies has not changed and increased the data. A
small number of companies have modified the definition of their social report.
The variables and indicators are classified in five subject areas as follows.
1. Human resources. This subject area have a large number of classes and
indicators, and collect the mainly information in social report. The variables and
indicators refer to the relation between company and internal (e.g. number of
employee, seniority, training) and external subjects (e.g. company socialising
activities, description of social and company context). Even though the subject
area has some uniformity connotations, there is a large number of indicators
with frequency equal to 1. Such dispersion is determined by the use of specific
report’s items, which could be more comparable if the companies would adopt
3 The lack of information on environmental expenses is determined by the problems

relating to the input of data and interpretation of some report’s items, e.g. expenses for
environmental services. On the contrary, in Spain, Moneva and Llena have found an increase
in the disclosure of financial information, because there is the tendency of companies to report
on environmental expenses, investments and liabilities (Moneva and Llena 2000). Relating
to the measurement of the environmental parameters, the results of the ECOMAC – Eco-
Management Accounting Research Project focus also on the problems about the reliability of
environmental and environment-related cost data. The main reasons of such problems are the
impossibility and expensiveness of the measurement of environmental parameters, and the
variability in their definitions. These problems depend partly on the lack of standardisation of
terms and techniques (Bartolomeo, Malaman, Pavan and Sammarco 2000).
some criteria of standardisation.
2. Audit and supplementary information. Within this subject area the data refer to
the auditor’s report and audit principles. The auditor’s report verifies also if the
report is conformed to the preparation principles. Such principles are frequently the
GBS, GRI, IBI and ABI standards. The conformity of company to the preparation
principles is reported in the “presentation of company” section. Some companies
include also a glossary and the chart of company values.
3. Customers. This subject area contains information relating to the suppliers and
clients. The more frequent indicators are: as regards to suppliers, distribution
channels by service nature, and relating to clients, number of surveys, number
of company newsletter copies distributed, and number of claims. Such data
underlines the company efficiency in managing its relation with external
stakeholders.
4. Processes. The indicators classified in this subject area give information about
the supplied services by companies, and the tools for environmental respect and
quality of life. Some companies refer also to quality certification (ISO 9000).
5. Financial variables. The most frequent variables are the fixed assets investments
and production of value added. A quite large number of documents content also
the income statement, breakdown of value added by stakeholders, profitability
ratios, and financial ratios. The information on production of value added and its
breakdown by stakeholders is the more uniform.
Points of Convergences between IC Statement and Environmental and Social

Reports in Italy
The production of environmental and social reports reflects a more general issue
relating to the creation of company value: this value is not only based on profit,
but it is complemented also by the benefits coming from the attainment of wider
aims, because of the company embeddedness in a social and environmental setting.
A social and environmental-compatible activity has then a relevant connotative
role in constituting and re-constituting the social legitimation of a company. In this
respect, one could say that there are some conceptual and institutional points of
contact between the notion of IC and that of a social and environmental friendly
organisation, in that the availability of a good IC – and especially of a relational-
external capital – cannot transcend from the presence of a good set of social and
environmental relationships.4
The notion of IC appears to be wider and more management-oriented that the
notion of social and environmental performance. In this respect, it is perhaps possible
to say that IC contributes to get company internal and external reporting closer.
4 In the socio-environmental report of Merloni and Unicredito Italiano there is a clear

indication of the non-material drivers that enforce the “real” value of the firm. Such variables
are the work safety, the social behaviour, the involvement and training of employees, the
relationship with community, the products’ quality, the environmental impact of firm activity
and environmental protection. As noticed further, those elements are also identified as
“ingredients” of an IC report.
Figure 4.4 The theoretical relationship between IC, social, and environmental
reports
In this chapter, we therefore assume that the IC report is the generalisation of the
social and environmental reports with the additional consideration of financial and
management-related variables on the one hand (such as measures of the customer
satisfaction, internal productivity, and so on), and with a stronger human resource
focus on the other hand. As a result, we would expect that there will be some areas
of overlapping between these three types of documents (see Figure 4.4).
The empirical analysis has confirmed this conceptual expectation. Indeed, from
the investigation of the form and contents of Italian environmental and social reports
it emerges that a good deal of variables and elements relating to environmental,
social and financial information correspond to some “ingredients” of the IC
statement. In particular, the comparison between the variables and indicators of IC
report by Skandia and Celemi (and implicitly the Italian companies Brembo, Plastal,
and Eptaconsors) and those of Italian environmental and social reports, reveals some
significant overlapping of IC subject areas and variables (see Appendix 4.C).
Also the general subject areas (six for environmental reports, and five for social
ones) in which the information contained in the Italian reports has been allocated
reflect some of the basic “ingredients” of an IC report: human resources, customers,
internal processes, value added, and environmental impact.
The empirical analysis seems therefore to confirm theoretically that the IC
report could be seen to some extent a generalisation of environmental and social
reports – even though the respective general aims are different. Indeed, the empirical
Figure 4.5 The empirical relationship between IC, social, and environmental
reports in Italy
investigation demonstrates that there are some information overlapping also between
the social and environmental reports (see Figure 4.5).
For sure, one can say that a social and environmental sensibility is entrenched
in the IC framework, possibly as a reflection of the fact that the IC is made up
essentially of a web of good human, social, environmental, and financial nexuses. As
a consequence, variables such as the company impact on social welfare of employees
and citizens and on environment are fairly common to be found in IC statement.
Conclusions
The empirical analysis of the form and contents of Italian environmental and social
reports has showed three main results: a) the very large dispersion of the composing
information; b) the overlapping information between the two different reporting
representations, that suggests a harmonisation of environmental and social reporting;
and, above all, c) the correspondence between many elements of environmental and
social reports and IC components.
As regards to the first result, the lack of uniformity between the two set of
accounts underlines that the models proposed by associations (such as FEEM for
environmental report, and IBS, GBS, and ABI for social report) are not homogeneous.
Consequently, the diffusion of information adopts different criteria and the reports
are hardly comparable, in particular relating to the environmental reports, because
for the social accounts something is changing. On the other hand, the lack of a
legal obligation explains the arbitrariness of companies in adopting principles and
models.
The overlapping of information in the two sets of accounts seems recently to
be resolved by firms preparing together the environmental and social report. To a
deeper analysis of the results, indeed, there are some commons areas between such
reports, that could be remove if the firms could collect the data into an individual
document. Such areas are the human resources, processes and financial variables,
and the accountability of the issues relating to such categories. The benefits in terms
of reduction of costs and dispersion of information would be various, but the most
important result would be a unique and global representation of the impact of firm’s
activity on both environment and society.
However, the current lack of uniformity in and between social and environmental
reports might pave the way to interesting developments for the IC statement. The
common set of information that has been found in the Italian context between IC
statement and social and environmental reports seem to suggest that, even tough
such reports have different objectives and users/stakeholders, perhaps it would be
possible to prepare an IC report as an evolution of the latter reports. It is probably
too early for thinking that IC report could replace the social and environmental
statements, which are well known and currently prepared in many European
countries. However, because of the above mentioned benefits deriving from the
aggregation of environmental and social reports, the IC report could be a useful
tool for generalising these two sets of accounts by interpreting (and visualising)
the “society” and the “environment” as part of the new value-drivers of a company
value. After all, such elements are an essential component part of the organisational
setting, and hence they can contribute to future economic benefits by fostering
company value and social legitimation.
Acknowledgements
This study is part of the PRISM Research Project funded by the European
Commission’s Information Society Technologies Directorate General. The author
wishes to thank Professor Stefano Zambon for his suggestions and assistance, as
well as the anonymous reviewers for their comments. The responsibility for the
contents of the chapter remains entirely with the author.
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Appendix 4.A
The More Frequent Information in Italian Environmental Report
A) Human resources
Variables* Indicators No.
1. Work safety** Frequency index (no. of work accidents on 19
total working hours)
Gravity index (no. of working days lost on 17
working hours)
2. Training (on):
- employees’ health, work safety and No. of hours 8
environment
No. of participants 3
- work safety and environment No. of hours 4
No. of participants 4
3. Information to and relations with society:
- newsletters and journals No. of copies 7
- congresses and cultural/social initiatives 6
- projects within research institutions and 5
society
4. No. of employees** Total no. of employees 8
No. of employees by factory and for the 4
whole group
5. Employees’ health No. of checkups and medical exams 3
B) Audit and supplementary information

Variables Indicators No.
1. Glossary 26
2. Audit of the Environmental Report:
- auditor’s report 14
- audit principles (completeness, 9
understandability, reliability)
C) Environmental respect
1. Environmental protection:
- rubbish** Breakdown of disposed rubbish by sector 15
and by country
Production, recycling and disposal of 8

rubbish by its nature
- air pollution components Total emission of air pollution components 7
by nature
2. Statement of environmental principles 30
3. Testing and research laboratories 6
D) Technology
Energy sources** No. of energy plants/stations 15
Production capacity of the plants/stations 14
E) Processes
1. Energy indicators** Specific emissions 18
Specific consumption 18
2. Energy distribution** Extension of energy distribution channel 7
No. of energy distribution plants 6
3. Consumption Total consumption 31
Consumption by country and by sector 3
4. Energy transport** Total size of energy transport lines (km) 7
No. of energy transport lines 7
5. Pollution monitoring system** Types of pollution components found 9
No. of analysed parameters 8
F) Financial variables
1. Environmental expenses** Current costs (by intervention area) 12
Capital investments 10
2. Work safety and health expenses** Current costs 5
3. Main financial data 9
4. Environmental expenses and work safety Current costs 3
* The listed variables are the top 5 frequent for each subject area.
** The listed indicators are the top 2 frequent for each variable.
Appendix 4.B
The More Frequent Information in Italian Social Report
A) Human resources

1. Company socialising activities** Cultural initiatives 24
Social meetings 18
2. Training** No. of participants 35
No. of training hours/participants/courses
27
by subject area
3. Work absences** For illness (%) 20
For work accident (%) 17
4. Seniority** No. of new employees 20
No. of resignations 19
5.
Total no. of employees 40
6. No. of employees**
No. of employees and breakdown by
19
department
B) Audit and supplementary information

1. Audit of the Social Report:
- auditor’s report 9
- audit principles:
• GBS & GRI principles 7
• completeness, understandability, reliability 3
2. Glossary 3
3. Chart of company values 3
C) Customers

Distribution channels by service nature
1. Suppliers** 24
(%)
Suppliers (no. and %) 19
2. Customer satisfaction** No. of surveys 17
Activation, reparation and quality of
16
supplied service
No. of company newsletter copies
3. Company information activity 12
distributed
4. Public relation office No. of claims 9
5. Members and their general meetings No. of meetings 3
Average presence of members 3
D) Processes

1. Use of natural resources Wastage by resource type 12
Costs and investments by resource type 8
2. Supplied services:
- sewerage system and water purification** No. of purifiers 3
Plant capacity 3
- water Tariff trend 3
3. Quality standards** Time for producing a service estimate 4
Accessibility to service 4
4. Breakdown of emissions by nature 11
5. Hygienic conditions control 7
E) Financial variables*

1. Fixed asset investments:
- fixed assets** New works 7
Maintenance expenses capitalised 7
- works in process** New works 7
Maintenance expenses capitalised 7
2. Production of value added 39
3. Income statement 30
4. Breakdown of value added by stakeholders Value and % 29
5. Profitability ratios** R.O.E. 12
R.O.A. 6
* The listed variables are the top 5 frequent for each subject area.
** The listed indicators are the top 2 frequent for each variable.
Elements of an IC Statement in Italian Environmental and Social Reports
ENVIRONMENTAL REPORT SOCIAL REPORT

Subjects areas: Variables: Subjects areas: Variables:
A) Human resources A): 1. Work safety A) Human resources A): 1. Company socialising activity
2. Training 2. Training
B) Audit and supplementary B): Audit of environmental report 3. Work absence
information 4. Seniority
C) Environmental respect C): 1. Environmental protection 5. No. of employees
2. Statement of environmental principles 6. Work safety and health
Appendix 4.C
D) Technology D): Energy sources 7. Qualification, age, education
E) Processes E): 1. Consumption 8. Salaries
2. Pollution monitoring system 9. Relations with social community and institutions
3. Environmental certification (ISO 14000) 10. Geographical origin
4. Process description 11. Working shifts
F) Financial variables F): 1. Environmental expenses 12. Social actions
2. Work safety and health expenses B) Audit and supplementary B): Audit of social report
information
C) Customers C): 1. Suppliers
2. Customer satisfaction
D) Processes D): 1. Use of natural resources
2. Supplied services
3. Quality standards
4. Quality certifications
E) Financial variables E): Production and distribution of value added
PART 2
DISCLOSURE ON INTANGIBLES:
VALUE RELEVANCE, SCORING
AND RATING
Chapter 5
On the Informational Usefulness of R&D

Capitalization and Amortization
Baruch Lev, Doron Nissim and Jacob Thomas
New York University, Columbia University and Yale University
Introduction
Expenditures on research and development (R&D) are the major drivers of

innovation and economic growth. The size of resources devoted to R&D by private-
sector corporations, governments and universities is very large—currently about
$250 billion annually in the U.S.—and constantly growing. In developed countries
investment in R&D typically amounts to 3-4% of GDP. R&D is clearly the major
drive of growth of corporations, national economies, and the standard of living of
their citizens.
The accounting for R&D by private-sector companies is widely regarded as
outdated. In the U.S., the accounting standard for R&D, FASB Statement No. 2, was
issues 30 years ago (1974), before the emergence of key R&D-intensive sectors,
such as software, biotech, and Internet. No wonder then that this accounting rule
is outdated. The main directive of Statement No. 2 is the immediate expensing of
all R&D (except for software development costs, under certain circumstances).
Thus, despite the fact that R&D generates, on average, significant future benefits
(sales increases, cost savings)—which is the main characteristic of an asset—R&D
is not regarded an asset in corporate financial reports.1 Rather, R&D is expensed
in the period it is incurred, like salaries, interest, and insurance. The international
Accounting Standard (IAS No. 38) takes a somewhat more modern view toward
R&D, allowing capitalization under certain circumstances, but most public companies
expense R&D nevertheless. One reason is managers’ concern that financial analysts
will consider capitalization as a means of earnings manipulation.
There has been considerable controversy about R&D expensing in the last 20
years. Some commentators argue that it is an outdated accounting technique and
should be changed, while others counter that the uncertainty of the outcomes of
R&D (new products, cost savings) precludes recognizing R&D as an asset (e.g.,
Kothari, Laguerre and Leone 2002). We join in this chapter the discussion about
the preferred accounting and reporting for R&D, by showing empirically that the
current accounting for R&D leads to a systematic undervaluation of R&D-intensive
1 Numerous studies have established the association between R&D and subsequent
benefits, see Lev (2001).
companies in capital markets. Stated differently, by showing that the current
procedure of expensing R&D causes investors to misprice securities—thereby
adversely affecting resource allocation by corporations and in capital markets—we
provide supporting evidence for a change in the accounting and reporting of R&D.
Under current U.S. GAAP (SFAS No. 2, FASB 1974), investments in research
and development (R&D) are immediately expensed. This study investigates whether
capitalization and subsequent amortization of R&D expenditures improve the
information conveyed by earnings and equity book value about intrinsic equity
value. To address this question, we adjust reported financial statements to reflect
R&D capitalization, followed by straight-line amortization over assumed industry-
specific lives, and examine the effect of these simple adjustments on the association
of earnings and equity book value with 1) current stock price, 2) future earnings
(excluding R&D), and 3) future stock returns.
Consistent with intuition and the results of prior research (e.g., Loudder and
Behn 1995, Lev and Sougiannis 1996, Monahan 1999, and Chambers, Jennings
and Thompson 2001a), we find that our adjustments increase the association in the
first and second analyses. These results indicate that despite the crude nature of our
adjustments, they capture partially the economic amortization of R&D investments
reflected in contemporaneous stock prices and future earnings. The results of our
third analysis, which along with the associated robustness tests represent our main
contribution, suggest however that stock prices initially undervalue unamortized
R&D, measured by our adjustments to book value, and then rise predictably over
the next 20 months.
A more descriptive summary of our analyses follows. We identify seven R&D-
intensive industries (based on two-digit SIC codes) and begin our contemporaneous
stock price analysis by computing adjusted earnings and book value for different
assumed R&D lives between one and eight years. For each assumed life, we
capitalize the reported R&D investment and amortize it equally over that assumed
life, and then contrast the association between price and adjusted earnings/book value
for each industry with the corresponding association for reported earnings/book
value. Although we find that the former association is increased for any assumed
useful R&D life for all industries examined, there is considerable variation across
industries. First, the improvement in association is not economically significant in
two industries, suggesting that the benefits of capitalizing and amortizing R&D may
be limited in some cases. Second, the optimal useful R&D life (assumed useful life
generating the highest association) varies across the remaining industries, consistent
with the competitive environment and characteristics of R&D undertaken (consider,
for example, differences in gestation periods and longevity of benefits between
pharmaceuticals and software firms). Third, even though there is some across-
industry variation in the relative contribution of adjusted book value versus adjusted
earnings, the former is generally more important than the latter.
Our second analysis (association with future earnings) is designed to alleviate
potential concerns caused by recent research that stock prices may not fully impound
R&D information (e.g., Lev and Sougiannis 1996, and Chan, Lakonishok, and
Sougiannis 2001). To provide a perspective that does not rely on market efficiency,
we assume that the sum of realized pre-R&D earnings over the subsequent three
On the Informational Usefulness of R&D Capitalization and Amortization 99
years represents an unbiased proxy for current intrinsic values and repeat the
association analysis.2 Our results for this second analysis are generally consistent
with those from the first analysis, which confirms the validity of using the association
with contemporaneous prices to study alternative accounting treatments of R&D
investments.
Our third analysis (association with future returns) is potentially the most
important as it offers policy implications regarding capitalizing and amortizing
R&D. Since it is easy to generate the adjusted book values/earnings we use in the
first two analyses, and the stock market is implicitly aware of those adjustments
in the first analysis, there could be reasonable disagreement about the incremental
benefits of requiring firms to capitalize and amortize R&D. There should, however,
be no disagreement about the benefits of capitalization/amortization if as our results
suggest those adjustments are related to future returns because they are not fully
incorporated in contemporaneous stock prices. Our results also suggest that the link
between R&D and future returns is less likely to be due to mismeasured risk (e.g.,
Chambers, Jennings, and Thompson 2001b) and more likely to be due to mispricing
(e.g. Lev and Sougiannis 1996, Chan, Lakonishok, and Sougiannis 2001, Lev, Sarath,
and Sougiannis 2000 and Penman and Zhang 2002).
When investigating subsequent stock returns, rather than rely on the approach
used in the prior literature where firms are partitioned based on R&D intensity, we
focus on differences between adjusted and reported book value/earnings, and use
the insights from our first analysis when measuring these differences. Specifically,
we use the optimal industry-specific lives indicated by our price association analysis
when amortizing R&D, and multiply the earnings and book value adjustments by
the corresponding industry-specific coefficients from the price association analysis
to convert those adjustments into estimated impact on market value.3 We find that
our proxies for the value impact of differences between adjusted and reported book
values are positively related to subsequent abnormal stock returns over the next 20
months.4 After that point, although we continue to observe positive abnormal returns
for firms with high book value adjustments, we believe those abnormal returns are
unlikely to be due to correction of residual mispricing since they are concentrated
in January.
2 Using a simulation model, Healy, Myers and Howe (1999) also provide evidence
that is not subject to the assumption of market efficiency. They find that capitalizing and
subsequently amortizing successful R&D costs improve the relation between accounting
information and economic values even when there is widespread earnings management.
3 As explained in Section 4, it is reasonable to use estimates from our first analysis
(where prices are implicitly assumed to be efficient) to generate proxies for the extent of
mispricing.
4 To ensure that our results for this third analysis are not contaminated by any “look-
ahead” bias, we use parameters derived from historic data that were available when creating
the different portfolios. To confirm that the abnormal returns we observe are due to mispricing,
rather than mismeasured risk, we conduct several robustness checks, including, controlling
for a variety of risk proxies, and examining industry-by-industry, year-by-year, and long-term
returns. We also control for R&D intensity to confirm that the abnormal returns are indeed due
to the distortion caused by reported book value/earnings deviating from adjusted numbers.
These results suggest that requiring firms to capitalize and subsequently amortize
R&D in a representative way should improve the efficiency of market prices and
resource allocation. Also, finding that future returns are related to adjusted book
values, not adjusted earnings, suggests that market mispricing is related more to
levels of R&D investments, rather than changes in those levels. Finally, finding that
abnormal returns after 20 months are concentrated in January provides a potential
explanation for the result in Chambers, Jennings and Thompson (2001b) that
abnormal returns persist for up to 10 years. Our results suggest that the abnormal
returns observed after the first two years are due to mismeasured risk and could
simply reflect the higher risk of firms with higher levels of R&D.
The remainder of this study proceeds as follows. The variables and sample
are described in Section 2. In Section 3, we present the first and second analyses,
investigating the association of R&D-adjusted earnings/book value with price
and future earnings, and in Section 4 we discuss the third analysis, examining the
association with future stock returns. Section 5 contains robustness checks, and
Section 6 concludes the study.
Data
Variable measurement
To examine the usefulness of R&D capitalization and amortization, we calculate

pro-forma or adjusted earnings and book value under alternative R&D useful lives
(T), ranging between one and eight years. In all cases, we assume R&D expenditures
are made at the middle of the fiscal year and have a salvage value of zero. The R&D
adjustment to earnings involves: (1) adding back the current year R&D expense
(COMPUSTAT #46) times (1-0.5/T), representing the full cost minus a half-year’s
straight-line amortization;5 (2) deducting amortization of previous years’ R&D,
computed as 1/T times the total of R&D expense in the previous T-1 years plus
0.5/T times the R&D expense T years ago; and (3) adjusting the income tax expense
by applying the statutory federal tax rate plus 2% average state tax rate to the
previous two components of the R&D adjustment.6 The R&D-adjusted book value
is calculated by adding the sum of unamortized R&D expenditures over the last T
years×(1- tax rate) to the reported book value. In effect, the adjustment to book value
of equity nets the R&D asset, representing the pre-tax unamortized amount, with the
corresponding deferred tax liability, representing the tax effect.
We measure reported earnings as income before extraordinary items (#18) minus
after-tax special items (#17×(1- tax rate)), and reported book value of common
equity as common equity (#60) plus preferred treasury stock (#227), minus preferred
dividends in arrears (#242). Market value of equity is measured as the product of the
number of shares outstanding (#25) and price per share at fiscal year end (#199).
5 We use #n as an abbreviation for COMPUSTAT data item n.

6 For all sample firms, we assume a federal tax rate of 48% for 1975-1978, 46% for
1979-1986, 40% for 1987, 34% for 1988-1992, and 35% for 1993-2000.
Sample selection
To construct the sample for the contemporaneous price association analysis, we

apply the following criteria. First, data items #60, #18, and #6 (total assets) from
COMPUSTAT’s industrial, full coverage, and research files are available for the
current year and for each of the previous eight years, and data items #199 and #25
(i.e., price and number of shares outstanding) are available for the current year.
(Other required data items are set to zero when missing.) Second, the fiscal year
is between 1983 and 2000. We drop years before 1983, since we need eight prior
years of R&D data, and uniformity in R&D accounting is required only since 1975
(see FASB 1974). Third, to mitigate the effect of influential observations, we delete
observations for which any of the variables we use in the price association regressions
(see below), deflated by total assets at the end of the current year, lie outside the 1%-
99% range of its sample distribution. Fourth, to focus on firms for which R&D is
important, we include only those industries (based on 2 digit SIC code) with positive
median R&D expense. Finally, we require that selected industries have at least a
thousand firm-year observations over the sample period 1983-2000. These selection
criteria result in a sample of 20,503 firm-year observations, derived from seven
industries. Panel A of Table 5.1 lists the seven industries and provides the number
of observations per industry along with summary statistics for the ratio of R&D
expense to market value.7
For the second analysis (association with future realized earnings), we use the
same sample as in the first analysis, except that we exclude firm-year observations
with missing pre-R&D earnings for any of the subsequent three years (which in
effect excludes all observations from the years 1998 through 2000, as well as firms
that did not survive for the three subsequent years). The resulting sample includes
13,852 observations.
For the market efficiency (association with future returns) analysis, we begin
with the sample from the first analysis and require that the CRSP number of shares
outstanding and closing price be available as of the end of April in the subsequent
calendar year. We also drop fiscal years 1999 and 2000.8 These requirements result
in a sample of 15,341 observations. Panel B of Table 5.1 provides the number of
observations per year for each of the seven industries.9
7 These industries correspond with those identified in prior research.

8 We cannot use fiscal years after 1998 for this third analysis, since the CRSP files we
use contain data through December, 2000. Recall that we measure abnormal returns from the
beginning of May of the subsequent year, and cumulate returns until April of the following
year.
9 We reassign firms to years based on the calendar year in which the fiscal year ends,
rather than use the COMPUSTAT year (which includes in the same year all fiscal year-ends
between June of that year and May of the following year). Then we form our portfolios for this
analysis in May of the subsequent year, to ensure that at least four months have passed since
the fiscal year-end.
Table 5.1 Descriptive statistics for samples
Panel A: Distribution by industry of R&D intensity (R&D expense, scaled by end-

of-year market value of equity) for price association analysis.
Industry (abbreviation; SIC) Obs. Mean SD Median

Chemicals and Pharmaceutics (Chem.; 28) 2,981 0.0423 0.0655 0.0272
Fabricated Metal (Fab.; 34) 1,431 0.0262 0.0653 0.0075
Machinery and Computer Hardware (Mach.; 35) 3,803 0.0929 0.2081 0.0423
Electrical and Electronics (Elec.; 36) 4,311 0.0836 0.1526 0.0411
Transportation Vehicles (Trans.; 37) 1,354 0.0454 0.0687 0.0203
Scientific Instruments (Scient.; 38) 3,400 0.0930 0.1405 0.0552
Business Services (Bus.; 73) 3,223 0.0659 0.1887 0.0013
Total 20,503 0.072 0.153 0.032
Panel B: Observations by industry and year for subsequent returns analysis
Year Chem. Fab. Mach. Elec. Trans. Scient. Bus. Total

1983 119 79 152 172 68 119 83 792
1984 135 84 178 198 81 139 106 921
1985 126 81 173 185 76 138 104 883
1986 122 73 163 181 71 130 99 839
1987 116 72 169 183 69 128 98 835
1988 116 74 154 188 64 138 103 837
1989 114 71 157 178 62 138 108 828
1990 124 67 172 184 63 154 115 879
1991 135 66 179 197 67 166 134 944
1992 142 67 185 193 69 172 139 967
1993 160 75 190 202 68 178 171 1044
1994 170 72 194 223 70 190 183 1102
1995 173 68 194 232 71 183 184 1105
1996 179 65 197 242 74 188 192 1137
1997 180 62 195 242 69 190 187 1125
1998 185 61 184 228 66 192 187 1103
Total 2296 1137 2836 3228 1108 2543 2193 15341

Impact of Capitalizing and Amortizing R&D on the Association of Earnings
and Book Value with Contemporaneous Stock Prices and Future Earnings
Association with stock prices
In this section we estimate the useful life of R&D (length of its benefits) in the main
R&D-intensive industries. To do this, we employ a widely-used stock valuation model
(Ohlson 1995) which relates the market value of a firm’s equity (capitalization) to
its book value of net assets and earnings. We use this model first for reported (i.e.,
R&D-expensed) book value and earnings. And alternatively, for various versions of
book value and earnings under R&D capitalization. The model producing the best fit
of market value with book value and earnings will indicate the optimal capitalization
period of R&D, as perceived by investors. We calculate pro-forma (R&D-adjusted)
earnings and book value assuming useful lives of R&D from T = 1 through T = 8
years. Then, for each T (including T = 0, corresponding to reported numbers), we
estimate the following regression separately for each industry:
2000
P/A = †1y D y+ β2 1/A + β3 BT/A + β4 ET/A + β5 DNE × ET/A + β6 DNE + ε (1)
y =1983
where P is market value of common equity at fiscal year-end; A is total assets; Dy is a
dummy variables that equals one for year y; BT and ET are pro-forma book value and
earnings, respectively, assuming a useful R&D life of T years; and DNE is a dummy
variable that equals one when pre-R&D earnings are negative.10
The specification of equation (1) is based on evidence provided in prior studies
that earnings and book value jointly explain cross-sectional variation in share
prices (for a review, see Chambers, Jennings and Thompson 2001a). We allow for
a different earnings coefficient for loss firms because a) losses are less permanent
than positive earnings (see, e.g., Hayn 1995), and b) losses may proxy for the effects
of conservative accounting.11 The variables in equation (1) are deflated by the book
value of total assets to mitigate the effect of heteroskedasticity, and the year dummy
variables are included to mitigate the effect of autocorrelated regression errors. Note
that the year dummies represent intercept dummies in the deflated equation. It is
important to include an intercept in the deflated equation, which is equivalent to
including total assets to the undeflated equation, to capture the average effect of
omitted factors that are likely to be correlated with firm size.
Our choice of an eight-year maximum for T represents a compromise between
two competing considerations. While increasing the number of years allows us
to better identify the correct useful life of R&D when it is relatively long, it also
requires us to delete firms without a relatively long history. The ex post experience
10 We measure pre-R&D earnings by adding the R&D expense times (1 – tax rate) to
reported earnings.
11 We allow the loss dummy variable (DNE) to have both an intercept effect (β6) as
well as a slope effect on earnings (β5) to mitigate potential biases due to differences between
loss firms and positive earnings firms that are not captured by the earnings coefficient. Our
inferences remain unchanged when we a) drop the intercept effect, or b) allow for the other
regression coefficients to depend on DNE.
of such “surviving” firms may not be representative of the anticipated profile of
R&D benefits captured in contemporaneous stock prices. To estimate the potential
impact of limiting our choice of T to eight years, we repeated the analyses described
in sections 3.1 and 3.2 using values of T equal to 5 and 10 years, and observed
qualitatively similar results.
To evaluate the change in the association of earnings and book value with price
due to R&D capitalization and amortization over T years, we compare the R2 of each
of the eight pro-forma regressions (T =1 through 8) with that of the regression using
the reported numbers (T = 0). These comparisons are valid because we use the same
observations and dependent variable in all nine regressions.
We first report the benchmark regressions, using reported numbers. As shown
in Panel A of Table 5.2, the coefficients on earnings (E0/A) and book value (B0/A)
are positive and significant for all seven industries, and the earnings coefficient is
always significantly smaller for loss firms, relative to that for firms with positive
earnings (indicated by significant negative values for the coefficient on DNE×E0/A).
However, there are substantial differences in the magnitudes of these coefficients
across the industries. For example, the book value coefficient for the chemicals and
pharmaceuticals industry is almost four times larger than that for the fabricated metal
industry. The R2s for the seven industries also vary widely, between 16.4 percent
(scientific instruments) and 45.8 percent (transportation vehicles).
Panel B of Table 5.2 presents the percentage increase in R2 from using adjusted
earnings and book value, over those presented in Panel A (based on reported
numbers). It is evident that in all cases (i.e., for all seven industries and for all useful
lives between 1 and 8 years), capitalization and subsequent amortization of R&D
expenditures result in an improved association with price. However, the magnitude
of improvement and the R&D useful life that yields the best fit (indicated by the bold
value in each column) vary significantly across industries. The largest improvement
is observed for chemicals and pharmaceutical firms. For this industry, it appears that
the benefits of R&D investments are spread, on average, over at least eight years, as
the price association is highest for T = 8. On the other hand, for the two industries
with the highest R&D intensity (machinery and computer hardware, and scientific
instruments), the price association is highest when the assumed useful life is four
years.
The smallest improvement in R2 is observed for the transportation vehicles and
fabricated metal industries (values are less than 5 percent for all values of T). This
finding is not surprising since most firms in these industries are relatively mature with
low and stable levels of R&D. Consequently, the R&D adjustments are relatively
small, especially the earnings adjustment (for mature firms with low growth in
R&D, earnings based on immediate expensing is similar to earnings based on R&D
capitalization). Indeed, the R2 from the reported numbers regressions in Panel A are
substantially higher for these industries, relative to those for other industries.
Differences in firm maturity and the level of R&D are not the only factors that
potentially explain the differences we find across industries. The economics and
managerial literature on R&D suggests additional explanations.12 The value and
12 For a recent survey, see Lev (2001, Ch. 3).

useful life of R&D projects depend, among other things, on the ability of firms to
appropriate the benefits of R&D. Appropriation, in turn, depends on the ability to
enforce intellectual property rights, namely the legal protection afforded by patents
and trademarks. The most effective enforcement of property rights (maximum
appropriation of benefits) exists in the chemical and pharmaceutical (including
biotech) sectors, since the new inventions resulting from R&D are clearly defined in
terms of chemical formulas, and are easiest to defend in courts against infringement.
This is consistent with our findings (Panel B of Table 5.2) showing the highest
improvement in R2 and longest life of R&D for this industry group.
At the other extreme is the business services sector (which includes software),
where most patents are of the controversial “business practice” type, and are
notoriously difficult to defend against infringement (“inventing around the patent”),
given the imprecise, non-scientific nature of the patents.13 Accordingly, the ability
of firms to appropriate the benefits of such R&D is relatively low. Indeed, the
results in Panel B indicate relatively low improvement in R2 and short R&D life
for the business services industry. In between these two extremes are industries
with intermediate levels for the ability of firms to appropriate benefits, such as the
electrical and electronics and machinery industries, and consequently intermediate
useful lives for R&D.
The improvement in R2 in Panel B ranges between 3.6 percent and 32.3 percent.
The average improvement (measured as the mean percentage change in R2 across
the seven industries) is 13.6 percent. Although this measure is quite large, it likely
understates the improvement due to R&D capitalization since the regressions include
additional variables besides earnings and book value (the year dummies and total
assets), which increase the benchmark R2. That is, the percentage increase in the
explanatory power of earnings and book value due to the R&D-adjustments is larger
than the increase in R2 reported in Panel B.
Panel C of Table 5.2 presents statistics for tests of the null hypothesis that the
improvement in R2 (between those reported in Panel B for adjusted book values/
earnings over those presented in Panel A for reported numbers) is zero. These
statistics are calculated as (N5×mean[r02 – rT2]) / std[r02 – rT2], where N is the number
of observations, r0 is the residual from the reported numbers regression, rT is the
residual from the pro-forma numbers regression, and std is the standard deviation.
Invoking the central limit theorem, these statistics have a standard normal distribution
in the limit.
In Panel D of Table 5.2 we report coefficients from estimating regression (1) for
T*, the “optimal” R&D life; i.e. the value of T that yields the largest improvement in R2
in Panel B for each industry. Comparison of these results with the estimates in Panel
A (based on reported numbers) suggests that the improvement in R2 is generally due
to both the book value adjustment and the earnings adjustment, as both t-statistics
are larger in Panel D than in Panel A. However, for some industries the improvement
13 Consider, for example, Amazon’s attempt to patent “one click” ordering. While
requirements for prior years’ data cause us to exclude from our sample Amazon and other
firms that mushroomed during the Internet boom, we believe they illustrate the inherent
difficulty associated with appropriating rents in this industry.
Table 5.2 Analysis of the impact of capitalizing and amortizing R&D on the
association of earnings and book value with stock price
Panel A: Statistics from the reported numbers regression (T = 0)

2000
P/A = †1y D y + β2 1/A + β3 BT/A + β4 ET/A + β5 DNE × ET/A + β6 DNE + ε
y =1983
Chem. Fab. Mach. Elec. Trans. Scient. Bus.

1/A 0.090 1.583 1.071 0.022 0.070 0.440 0.968
0.330 9.222 6.929 0.132 0.183 2.285 5.399
B0/A 2.056 0.568 1.168 1.130 0.963 1.389 1.309
17.303 7.546 16.358 14.669 12.540 14.667 14.160
E0/A 8.789 7.341 6.304 7.708 8.661 4.581 10.688
15.271 15.289 16.410 20.504 20.024 10.350 19.870
DNE × E0/A -13.918 -11.630 -8.634 -10.071 -9.976 -7.534 -13.623
-22.056 -21.249 -21.041 -24.621 -18.749 -15.108 -24.083
DNE 0.002 -0.223 -0.063 0.054 0.092 0.094 0.037
0.017 -3.899 -1.134 0.904 1.561 1.091 0.453
R2 0.268 0.418 0.226 0.250 0.458 0.164 0.284
N 2981 1431 3803 4311 1354 3400 3223
Panel B: Percentage increase in R2 relative to reported numbers (T = 0)
T Chem. Fab. Mach. Elec. Trans. Scient. Bus.

1 7.950 1.198 4.457 3.983 1.169 11.743 4.087
2 14.921 2.175 7.433 7.393 2.175 18.130 5.895
3 19.621 2.823 9.408 9.637 2.839 20.441 6.891
4 23.392 3.377 10.205 11.730 3.289 20.910 7.656
5 26.283 3.803 9.808 13.764 3.531 20.584 7.715
6 28.659 3.749 9.186 15.239 3.594 19.638 7.074
7 30.590 3.474 8.552 16.185 3.496 18.505 6.004
8 32.283 3.346 8.123 16.706 3.168 17.351 4.803
Panel C: Test statistic (standard normal) for the change in R2, reported in Panel B

1 7.322 1.597 4.223 4.316 2.689 2.435 3.309
2 7.948 1.695 4.272 5.797 2.902 2.544 3.210
3 8.035 1.738 4.247 6.224 2.823 2.615 3.155
4 8.209 1.747 3.960 5.918 2.725 2.560 3.171
5 8.169 1.619 3.471 5.062 2.583 2.447 2.977
6 8.086 1.500 3.061 4.361 2.432 2.288 2.563
7 7.965 1.432 2.651 3.902 2.244 2.116 2.051
8 7.838 1.333 2.294 3.564 1.941 1.949 1.558
Table 5.2 continued
Panel D: Statistics from the “optimal” regression for each industry (T with the
highest R2)
2000
P/A = †1y D y+ β2 1/A + β3 BT/A + β4 ET/A + β5 DNE × ET/A + β6 DNE + ε
y =1983

1/A 0.233 1.541 1.057 -0.031 0.253 0.441 1.111
0.905 9.095 6.933 -0.198 0.673 2.338 6.285
BT*/A 2.220 0.643 1.117 1.028 0.970 1.384 1.227
24.023 8.575 17.525 16.903 12.845 15.761 14.904
ET*/A 10.459 7.087 6.743 8.760 8.402 6.918 11.061
19.549 15.066 18.825 26.113 20.592 15.247 22.588
DNE × ET*/A -13.581 -11.308 -8.671 -10.379 -9.522 -9.356 -13.404
-22.300 -21.049 -22.341 -27.519 -18.699 -18.383 -25.532
DNE 0.480 -0.218 0.030 0.272 0.136 0.367 0.208
4.808 -3.868 0.555 4.645 2.350 4.277 2.578
R2 0.355 0.434 0.249 0.292 0.475 0.198 0.306
N 2981 1431 3803 4311 1354 3400 3223
Panel E: Mean (first row) and standard deviation (second row) of the “optimal” book
value and earnings adjustments

BT*/A – B0/A 0.1246 0.0189 0.0729 0.1329 0.0408 0.0954 0.0892
0.1692 0.0323 0.0847 0.1574 0.0493 0.0868 0.1444
ET*/A – E0/A 0.0111 0.0002 0.0031 0.0082 0.0026 0.0058 0.0052

0.0334 0.0083 0.0232 0.0296 0.0107 0.0332 0.0345
Notes:
P is market value of common equity, A is total assets, Dy is a dummy variables that equals one for year
y, BT (ET) is pro-forma book value (earnings) assuming R&D usefule life is T years. T = 0 corresponds
to reported book-value and earnings.DNE is a dummy variable that equals one when pre-R&D
earnings are negative. Panel B reports the percentage change in R2 (relative to the benchmark T = 0
regression) from using earnings and book value that have been adjusted to reflect R&D capitalization
and amortization over the subsequent T years. The test statistics in Panel C are calculated as
(N.5 × mean[r02 – rT2]) / std[r02 – rT2], where N is the number of observations, r0 is the residual from the
benchmark regressions, and rT is the residual from the adjusted earnings and book value regression. The
test statistics have a standard normal distribution in the limit. T* denotes the value of T that maximizes
the percentage change in R2 (identified in panel B using bold font).
is mostly due to the book value adjustment (chemicals and pharmaceuticals), while
for others it is primarily due to the earnings adjustment (electrical and electronics,
and scientific instruments).14
Finally, in Panel E of Table 5.2, we report the mean and standard deviation of
the R&D adjustments to earnings and book value for the optimal R&D life in each
industry. As expected, the magnitude of the adjustments varies substantially across
industries. The average earnings adjustment is relatively small, but its standard
deviation is quite large (it is the standard deviation, not the mean, that indicates
the potential improvement in explanatory power). For the book value adjustment,
both the mean and standard deviation are generally large. The implied percentage
increase in total assets due to R&D capitalization can be calculated by dividing the
book value adjustment by (1−tax rate). Thus, for example, in the chemicals and
pharmaceuticals industry, total assets are on average understated by more than 20
percent (assuming an average tax rate of 40 percent).
Association with future earnings
To alleviate potential concerns about stock prices failing to fully reflect information
about earnings/book value adjusted for R&D capitalization and amortization, we
re-estimate equation (1) after replacing stock prices with the sum of observed pre
R&D earnings over the next three years. This methodology has remained relatively
unexplored in the prior literature, and represents a valuable approach when market
prices are either not available or suspected to be inefficient. This way of studying the
association between accounting numbers and intrinsic value is especially relevant
for those who subscribe to the view that the primary role of financial statement items
lies in predicting future earnings and cash flows.
Panel A of Table 5.3 reports the change in R2 from using proforma earnings and
book value based on capitalizing and amortizing R&D over assumed lives between
1 and 8 years, relative to the regression on reported earnings and book value, and
Panel B reports the statistical significance of these R2 changes. For all industries,
R2 increases as a result of capitalizing and subsequently amortizing R&D, and for
five of the seven industries (fabricated metals and scientific instruments are the two
exceptions) the improvement is statistically significant. In addition, for all seven
industries, the R2 is maximized for T = 8. This last result differs from the unique
optimum lives observed for each industry in the price association analysis (Table
5.2, Panel B), and we are unable to reconcile these differences in estimated optimal
lives. Comparison of the regression coefficient estimates (not reported here) for
adjusted book values and earnings with those for reported numbers reveals that the
adjustment causes (1) an increase in the significance of both the earnings and book
value coefficients, (2) no change in the level of the earnings coefficient, and (3) an
increase in the level of the book value coefficient.
14 The t-statistics measure the unique information in the corresponding variables.

Therefore, the change in the common information in earnings and book value about price
cannot be gauged from the t-statistics. However, the total change in the information is indicated
by the change in R2.
Table 5.3 The impact of capitalizing and amortizing R&D on the association
of earnings and book value with future earnings (before R&D)
y +3 2000
(preRD) /A = †1y D y+ β2 1/A + β3 B0/A + β4 E0/A + β5 DNE × E0/A + β6 DNE + ε

y +1 y =1983
Panel A: Percentage change in R2, relative to benchmark regression using reported

numbers (T=0)

1 2.660 0.089 2.262 0.605 2.771 3.015 1.964
2 4.083 0.119 4.199 1.506 5.787 1.982 2.830
3 4.758 0.245 5.789 2.821 8.083 1.833 3.536
4 5.300 0.269 6.906 4.192 9.897 2.372 4.330
5 5.936 0.204 7.935 5.448 11.404 3.195 5.274
6 6.677 0.225 8.901 6.459 12.538 3.901 5.886
7 7.389 0.414 9.651 7.177 13.470 4.395 6.031
8 8.036 0.570 10.547 7.828 14.343 4.821 6.039
Panel B: Test statistic (standard normal) for the change in R2 in Panel A

1 4.179 0.233 2.376 1.093 3.147 1.214 2.252
2 3.927 0.205 2.703 1.646 3.315 0.716 2.441
3 3.709 0.359 2.999 2.451 3.313 0.620 2.487
4 3.707 0.344 3.160 3.143 3.468 0.755 2.612
5 3.842 0.227 3.343 3.638 3.642 0.970 2.932
6 4.067 0.225 3.579 3.934 3.737 1.134 3.042
7 4.273 0.381 3.790 4.054 3.820 1.227 2.868
8 4.441 0.489 4.008 4.196 3.929 1.297 2.725
Notes:
The R2s correspond to within-industry panel data regressions of pre-R&D earnings (preRD) over the
subsequent three years on an intercept, total assets (A), book value (B) and earnings (E), allowing
for a different coefficient when pre-R&D earnings are negative. The equations are deflated by total
assets and include year dummies (Dy). The benchmark regressions use the reported earnings and book
value (corresponding to T=0). Panel A reports the percentage change in R2 (relative to the benchmark
regressions) from using earnings and book value that have been adjusted to reflect R&D capitalization
and amortization over the subsequent T years. The test statistics in Panel B are calculated as (N.5 ×
mean[r02 – rT2]) / std[r02 – rT2], where N is the number of observations, r0 is the residual from the
benchmark regressions, and rT is the residual from the adjusted earnings and book value regression. The
test statistics have a standard normal distribution in the limit.
In sum, the results of this section suggest that capitalization and subsequent
amortization of R&D expenditures using the straight-line method improve the
association of earnings and book value with intrinsic value, as represented by
contemporaneous stock prices and future earnings. Our results also indicate that the
magnitude of improvement, the driver of improvement (i.e., book value or earnings
adjustment), and the useful life of R&D vary substantially across industries.
Analysis of Future Returns
The question we turn to next is whether these cross-sectional differences between

reported and adjusted book value/earnings are fully incorporated in contemporaneous
stock prices. To address this question, we examine the association between future
abnormal stock returns and optimal R&D adjustments to earnings and book value. If
investors do not fully incorporate in current stock prices the information contained
in R&D capitalization, these R&D adjustments should be positively related to
subsequent abnormal returns, as prices gravitate to fundamental or intrinsic values.
We elected not to use the parameters estimated in our second analysis to
generate optimal R&D adjustments and measures of potential mispricing because
those parameters may be less precise and potentially biased.15 We rely instead on
parameters estimated in our first (price-association) analysis and use the differences
between reported earnings/book value and the R&D-adjusted earnings/book value
for the value of T that maximizes the R2 of the industry-specific regression described
by equation (1).
Because the results in Panel D of Table 5.2 indicate that there is substantial
variation across industries in the estimated earnings and book value coefficients,
we multiply the R&D adjustments to earnings and book value by the corresponding
industry coefficients. Specifically, for each combination of industry and year (t), and
using data from the years 1983 (i.e., first sample year) through year t, we estimate
equation (1) with reported earnings and book value, and with pro-forma earnings
and book value assuming useful lives of R&D from T = 1 through T = 8 years. We
then identify the optimal useful life (T*) that maximizes the regression R2, and the
coefficients (β3, β4, and β5) from that regression. Finally, for each firm i and year t,
we estimate the “distortion” effect on market value caused by the difference between
BT*, the adjusted book value for the optimal useful life T*, and B0, the reported book
value, as follows:
BVDISTit = β3 (BT*/A – B0/A)it (2)
15 Precision could be decreased because observed future outcomes measure ex ante

projections with error, and because we exclude earnings past the next three years, which
are especially relevant under conservative accounting for long-lived R&D investments.
Moreover, if near-future earnings reflect different proportions of the total benefits from past
and recent R&D investments (due, for example, to conservative accounting), the estimates
could be biased. Bias could also be created because of survivorship, to the extent that the firms
we delete (because earnings over any of the next three years is missing) are systematically
different from the firms that remain in our sample.
The distortion effect for earnings is computed as follows:
EARDISTit = β4 (ET*/A – E0/A)it + β5 DNE it× (ET*/A – E0/A)it (3)
where E0 and ET* are the reported earnings and adjusted earnings for the optimal
useful life T*, respectively, for that firm-year. Note that T*, β3, β4, and β5 are re-
estimated for each industry-year combination using data that are available before the
stock return holding period (which starts on May first of the subsequent year).16
It is not clear, a priori, whether multiplying the book value and earnings
adjustments by industry-specific coefficients results in better estimates of BVDIST
and improves the power of our inefficiency tests. If the same R&D adjustment
has different value implications in different industries, incorporating the industry-
specific coefficients will result in more powerful tests. On the other hand, differences
in the level of market efficiency across industries causes the use of industry specific
coefficients to result in weaker tests, since the industry coefficients capture differences
in mispricing.17 Empirically, we find that the abnormal returns are smaller (consistent
with the results in Chambers, Jennings and Thompson 2001b) and insignificant when
industry-specific coefficients are not incorporated (results not reported). In contrast,
the abnormal returns are large and significant when industry-specific coefficients are
used to calculate BVDIST (see results discussed below).
To assure robustness, in examining the association of BVDIST and EARDIST
with subsequent abnormal stock returns, we use three alternative approaches to
control for risk: buy-and-hold portfolio returns adjusted for size and book-to-market;
Fama and MacBeth (1973) cross-sectional regressions; and Fama and French (1993)
three-factor time-series portfolio regressions. To evaluate further the extent to which
any documented abnormal returns are due to market mispricing or improper risk
adjustment, we examine in Section 5 industry-by-industry, year-by-year, and long-
term stock returns.
Although the use of book value/earnings adjustments and pricing coefficients from
the first analysis, which implicitly assumes efficient pricing, to generate measures of
potential mispricing may appear inconsistent, we explain below why this approach
is reasonable. This analysis explores the possibility that the market underestimates
the magnitude of unamortized R&D and/or the valuation multiple, and the degree of
underestimation does not vary systematically across firms or industries. To be sure,
there are other possible structural ways in which the market might misprice R&D
investments. However, given observable data and the simple procedure proposed
16 Of the 112 industry-year combinations (16 years times 7 industries), the optimum
useful life (T*) is zero for only one combination. For the 68 observations in this industry-year
combination (see Table 5.1), BVDIST and EARDIST equal zero.
17 Specifically, our results show that market prices on average underprice the proforma
unamortized R&D asset, and the level of underpricing varies across industries. In effect,
ceteris paribus, industries with greater underpricing will have lower values of β3, relative
to the case where market prices are efficient, and this will result in greater understatement of
BVDIST.
to measure adjusted book value/earnings, we believe we are limited in the types of
mispricing that we can investigate.18
Buy-and-hold portfolio returns
For each of the 16 calendar years between 1983 and 1998 (referred to as year t),
we compute firm-specific BVDIST and EARDIST (representing the distortions in
book value and earnings, respectively, due to immediate expensing of R&D). We
then form quintiles based on the magnitudes of BVDIST and EARDIST. For each
set of quintiles, we examine the annual return from May 1 of year t+1 through April
30 of year t+2. The results of this analysis for BVDIST and EARDIST are reported
in Panels A and B of Table 5.4. For each quintile, we report the time-series mean
of each year’s cross-sectional mean for BVDIST, EARDIST, three measures of
subsequent returns (raw returns, size-adjusted returns, and returns adjusted for both
size and B/M), and five firm and return characteristics (SIZE, B/M, BETA, VOLAT
and R&D/M). For the three return measures, we also report the t-statistics associated
with the time-series distribution of the cross-sectional means.
The first measure of subsequent returns in Table 5.4 (Raw Returns) is the one-
year ahead buy-and-hold return. The second measure (Size Adjusted Returns) is
calculated by deducting the contemporaneous size-decile return from the firm’s
raw return. The third measure (Size & B/M Adjusted Returns) is calculated as the
difference between the firm’s return and the contemporaneous return on a matched
portfolio based on size (five quintiles) and book-to-market (five quintiles). In effect,
we construct 25 benchmark portfolios, and subtract the return of the corresponding
benchmark portfolio from the firm’s raw return.
The benchmark size and book-to-market returns are calculated using all firms
with available data on CRSP, including firms from non-R&D-intensive industries.
SIZE is measured as the log of the market value of equity at the end of April in year
t+1. The book-to-market ratio (B/M) is calculated using the market and book values
at the end of the fiscal year that ended during calendar year t. The returns include all
distributions to shareholders. For securities that delist during the one-year holding
period, proceeds from the issue are invested in the NYSE, AMEX, and NASDAQ
value-weighted index until the end of the holding period.
The data in Panel A of Table 4 indicate that BVDIST exhibits a positive
monotonic relation with one-year-ahead returns. For example, focusing on the
size and book-to-market adjusted returns, the mean abnormal return for portfolio
5 (i.e., stocks with the highest value for BVDIST) is 12 percent (t-statistics of 2.2),
the mean abnormal return for portfolio 4 is 5.8 percent (t-statistics of 1.5), and for
the other three portfolios the mean abnormal returns range between –0.4 and 1.1,
18 Relatedly, we do not consider all possible ways to sharpen our measure of mispricing.
For example, using finer industry partitions, allowing for time variation in the estimates of
regression parameters from our first analysis, and allowing for firm-specific variation in tax
rates might increase the degree of mispricing documented here. While our measures are
potentially noisy, we are careful to reduce the likelihood that they may unintentionally suggest
mispricing when that is not the case.
Table 5.4 Annual buy-and-hold portfolio returns and other characteristics for quintiles of BVDIST and EARDIST
Adjusted Returns
Port. BVDIST EARDIST Raw Returns SIZE SIZE &B/M SIZE B/M BETA VOLAT R&D/M
Panel A: Portfolios sorted by BVDIST
1 0.000 0.000 0.155 0.006 -0.004 10.927 0.758 0.946 0.133 0.001
3.868 0.493 -0.317
2 0.015 0.009 0.152 0.005 -0.003 11.477 0.714 1.005 0.120 0.029
3.996 0.291 -0.189
3 0.050 0.035 0.171 0.019 0.011 11.475 0.694 1.096 0.127 0.063
3.719 1.245 0.740
4 0.109 0.072 0.214 0.061 0.058 11.601 0.623 1.191 0.133 0.101
3.657 1.539 1.496
5 0.317 0.099 0.270 0.113 0.120 11.819 0.518 1.186 0.137 0.136
3.248 1.848 2.156
Panel B: Portfolios sorted by EARDIST

1 0.135 -0.077 0.215 0.071 0.065 10.792 0.703 1.109 0.150 0.096
3.527 2.292 2.150
2 0.007 0.000 0.156 0.006 -0.002 10.961 0.758 0.963 0.132 0.014
3.774 0.455 -0.193
3 0.055 0.011 0.163 0.009 0.003 11.648 0.716 1.010 0.118 0.053
4.464 0.669 0.216
4 0.103 0.054 0.206 0.051 0.048 11.902 0.619 1.085 0.119 0.070
4.196 2.278 2.260
5 0.195 0.228 0.221 0.067 0.069 12.039 0.512 1.264 0.131 0.101
3.038 1.189 1.307
All firms 0.098 0.043 0.192 0.041 0.037 11.460 0.662 1.086 0.130 0.066
4.055 2.179 1.994
Notes.
The numbers reported in each cell are the time-series mean of the cross sectional means of those variables for each quintile. For the three return measures, we also report
the t-statistic associated with the time-series distribution of the cross-sectional means. The number of cross-sections (i.e., years) is 16, from 1983 through 1998. BVDIST
(EARDIST) measures the valuation impact of the “optimal” R&D adjustment to book value (earnings) (see equations (2) and (3)). The annual returns are measured from May
1 of year t+1 through April 30 of year t+2. SIZE (log of market value of equity) is measured at the end of April in year t+1. BETA is estimated using monthly stock returns
and the CRSP value-weighted returns including all distributions during the five years that end in April of year t+1 (at least 30 observations are required). VOLAT is the root
mean squared error from the BETA regression. R&D/M is the ratio of R&D expense to the market value of equity in year t.
and are insignificant.19 Note that the abnormal returns for all five quintiles of firms
from the seven R&D-intensive industries are positive (3.7 percent), on average,
and significant (t-stat of 1.99), as indicated in the bottom row of Table 5.4. This
result, which is consistent with those of prior studies (e.g., Chambers, Jennings and
Thompson 2001b), suggests an average undervaluation of R&D assets.20
Prior research has documented that R&D investments are on average more risky
than other investments (e.g., Kothari, Laguerre and Leone 2002). Our results in
Table 5.4, Panel A, however, indicate that high BVDIST firms are larger in size
and have lower book-to-market, relative to low BVDIST firms. To the extent that
risk is negatively related to size and positively related to book-to-market, our high
BVDIST portfolios appear to be of lower risk than the low BVDIST portfolios,
along these two dimensions. Also, observing similar differences between the high
and low BVDIST portfolios (between 11 and 12 percent) for all three measures of
returns in Table 5.4 (raw, size-adjusted, and size and B/M adjusted) indicates that
mismeasurement of risk related to size and book-to-market is unlikely to induce a
spurious positive relation between BVDIST and abnormal returns.
The three columns on the right of Table 5.4 report three additional characteristics
that may be related to risk: BETA, VOLAT and R&D/M. BETA is estimated
using monthly stock returns and the CRSP value-weighted returns (including
all distributions) during the five years that end in April of year t+1 (at least 30
observations are required). VOLAT, which reflects idiosyncratic volatility, is the
root mean squared error from the BETA regression. R&D/M is the ratio of R&D
expense to the market value of equity. The relations between these characteristics
and BVDIST, unlike those for SIZE and B/M, are consistent with the argument that
high BVDIST firms are more risky than low BVDIST firms. In particular, BVDIST
is positively related to BETA and to R&D/M (consistent with the argument in
Chambers, Jennings and Thompson 2001b, that R&D intensity proxies for an omitted
risk factor). In addition, the high BVDIST portfolios are characterized by higher
volatility of returns. We show, however, in our Fama-MacBeth analysis (section 4.2)
that BVDIST is positively related to abnormal returns, even after controlling for
all five potential risk factors. Furthermore, the evidence reported in Section 5 (in
particular the year-by-year and long-term returns) is also consistent with BVDIST
capturing market underpricing.
Panel B of Table 5.4 presents the results for portfolios sorted by EARDIST.
Unlike the data in Panel A, which indicates a monotonic, positive relation between
BVDIST and EARDIST, in Panel B the two extreme EARDIST portfolios have the
largest values for BVDIST. This is not surprising since EARDIST will be larger in
absolute value for firms with substantial R&D activity. Examination of the returns
reveals a pattern that is monotonically related to the portfolios’ BVDIST rather than
19 We obtained similar results when controlling for size and book-to-market using 100
(=10×10) portfolios.
20 Chan, Lakonishok and Sougiannis (2001), however, report that the average historical
stock returns of firms investing in R&D matches the return of firms without R&D. This
difference in results is likely due to differences in the sample years (1975-1995 versus 1983-
1998) and to our focus on a smaller group of R&D intensive industries.
EARDIST: the extreme portfolios (which have the largest value for BVDIST) earn
the highest abnormal returns. Moreover, the highest magnitude of abnormal returns
in Panel B is substantially smaller than that in Panel A (7 percent compared with
12 percent). This evidence suggests that distortion in book value due to immediate
expensing of R&D (BVDIST) better captures mispricing than distortion in earnings
(EARDIST), and any differences observed across EARDIST quintiles in Panel B are
due to EARDIST proxying for BVDIST. This conjecture is confirmed by the results
we report next in section 4.2.
Cross-sectional regressions
Using the Fama-MacBeth (1973) cross-sectional regression approach, each month

we regress stock returns on BVDIST, EARDIST, and firm-characteristics that
proxy for risk. The relation between abnormal returns and BVDIST or EARDIST
is examined by testing the significance of the time-series mean of the coefficient of
these variables. By including both BVDIST and EARDIST in the same regression,
we are able to identify the separate effects of each measure of distortion due to R&D.
Another advantage of the Fama-MacBeth approach is that it allows us to explicitly
and simultaneously control for various factors that may be related to expected returns.
These factors include risk characteristics that have commonly been considered, such
as size and B/M, as well as other factors, such as R&D intensity, that could potentially
proxy for omitted risk factors. Finally, since only firms from the seven R&D intensive
industries (see Table 5.1) are included in the Fama-MacBeth regressions, the average
positive abnormal return associated with these industries (see Table 5.4) does not
affect the results (it is fully captured by the regression intercept).
Table 5.5 provides estimates from the Fama-MacBeth cross-sectional regressions
of monthly stock returns on BVDIST, EARDIST, |EARDIST| (i.e., the absolute
value of EARDIST), and five control variables that are potential risk factors: ln(B/
M), SIZE, BETA, VOLAT and R&D/M. We report regressions using |EARDIST| in
addition to EARDIST, since the pattern of abnormal returns in Panel B of Table 5.4
suggests that abnormal returns are related to the magnitude of EARDIST rather than
its sign. Fama and French (1992) show that when SIZE and ln(B/M) are included in
the regression, other factors that explain expected returns (such as BETA) become
insignificant. However, because of our focus on R&D intensive industries and the
evidence in Table 5.4 that BVDIST and EARDIST are correlated with BETA, VOLAT
and R&D/M, we also control for these variables in the Fama-MacBeth regressions.
To mitigate the effects of outliers (see Knez and Ready 1997), we delete
observations with values outside the 1%-99% range of the pooled empirical
distribution of any of the explanatory variables. The resulting sample includes
154,184 monthly observations. The first two regressions in Table 5.5 correspond
to Panels A and B in Table 5.4 (SIZE&B/M adjusted returns). Consistent with the
results in Table 5.4, the coefficient on BVDIST (first regression) is positive and
highly significant, even after controlling for SIZE and ln(B/M), while the coefficient
on EARDIST (second regression) is insignificant. As expected, when substituting
|EARDIST| for EARDIST (third regression), the coefficient becomes positive
and significant. However, the fourth and fifth regressions demonstrate that neither
Table 5.5 Monthly cross-sectional Fama-MacBeth (1973) regressions of firm returns on BVDIST, EARDIST and risk factors
M Int. BVDIST EARDIST |EARDIST| SIZE ln(B/M) BETA VOLAT R&D/M R2 N

Mean 0.016 0.036 0.000 0.004 0.021 803
t-stat 1.717 4.132 -0.190 4.129
Mean 0.019 0.008 0.000 0.004 0.021 803

t-stat 1.866 1.087 -0.201 3.275
Mean 0.017 0.025 0.000 0.004 0.022 803

t-stat 1.755 2.407 -0.134 3.840
Mean 0.016 0.037 -0.004 0.000 0.004 0.024 803

t-stat 1.702 4.622 -0.566 -0.171 4.119
Mean 0.016 0.031 0.007 0.000 0.004 0.024 803

t-stat 1.722 4.323 0.837 -0.198 4.277
Mean 0.015 0.023 0.000 0.003 0.000 0.000 0.027 0.038 803
t-stat 2.045 3.471 -0.328 3.003 0.164 -0.002 2.180
Notes:
The first row reports the time-series mean of each coefficient. The second row reports the t-statistic for the time series distribution of the coefficient (mean coefficient divided
by its standard error). The number of regressions (i.e., months) is 192, from May 1984 through April 2000. The dependent variable in all regressions is the monthly stock
return. BVDIST (EARDIST) measures the “optimal” R&D adjustment to book value (earnings) (see equations (2) and (3)), SIZE (log of market value of equity) is measured
at the end of April in year t+1. BETA is estimated using monthly stock returns and the CRSP value-weighted returns including all distributions during the five years that
end in April of year t+1 (at least 30 observations are required). VOLAT is the root mean squared error from the BETA regression. R&D/M is the ratio of R&D expense to
the market value of equity in year t. in year t.
EARDIST nor |EARDIST| is significant when BVDIST is included. BVDIST, on the
other hand, is highly significant in both cases. We therefore conclude that EARDIST
does not contain information regarding future abnormal returns incremental to
BVDIST, and focus on BVDIST in the remaining analyses.
The last regression in Table 5.5 includes BVDIST and all five control variables
(SIZE, ln(B/M), BETA, VOLAT, and R&D/M). The Fama and French (1992) result
that BETA is insignificant holds in our sample as well.21 The coefficient on VOLAT
is also insignificant, but the coefficient on R&D/M is positive and significant. As
may be expected (given the correlation between BVDIST and R&D/M, see Table
5.4), the inclusion of R&D/M erodes the explanatory power of BVDIST. However,
the BVDIST coefficient remains positive and highly significant (in fact, it is the most
significant coefficient). This result deserves emphasis. Several recent studies (e.g.,
Chan, Lakonishok and Sougiannis 2001, and Chambers, Jennings and Thompson.
2001b) indicate that R&D intensity is associated with subsequent abnormal returns
and may proxy for an unknown risk factor associated with R&D. The estimates
reported in the bottom row of Table 5.5 show that even after controlling for R&D
intensity (R&D/M), BVDIST is still incrementally associated with subsequent
abnormal returns.
Time-series portfolio regressions
As discussed in Fama (1998), the buy-and-hold matching portfolio returns approach

(subsection 4.1) and the Fama-MacBeth cross-sectional regressions approach
(subsection 4.2) may lead to invalid inferences. As an alternative, we use the Fama
and French (1993) method of estimating abnormal returns, where, the monthly excess
portfolio return (ER), representing the raw portfolio return minus the risk-free return,
is regressed on the following three factors22: (1) the overall excess market return
(RMRF, or market return minus the risk-free return); (2) the performance of small
stocks relative to large stocks (SMB, or the excess of returns for small capitalization
over those for large capitalization firms), and (3) the performance of value stocks
relative to growth stocks (HML, or the excess of returns for high B/M stocks over
that for low B/M stocks). The specific relation estimated for each portfolio is:
ER t = ‡1 + ‡2 RMRFt + ‡3SMBt + ‡4 HML t + e t (4)
Fama and French (1993) contend that these factors explain most of the cross-
sectional variation in excess portfolio returns, and hence the intercept (γ1) from such
a three-factor regression is a reliable estimate of abnormal returns. Moreover, Fama
and French (1996) report that most of the documented anomalies disappear when
abnormal returns are measured using this three-factor model.
21 The insignificance of SIZE in all six regressions is consistent with the findings in
Knez and Ready (1997).
22 Data for the three factors can be obtained from Ken French’s web site (http://mba.
tuck.dartmouth.edu/pages/faculty/ken.french/)
Table 5.6 Time-series regressions of monthly excess returns for BVDIST
portfolios on the three Fama and French (1993) factors (market
return, size, and B/M)
Portfolio Inter. RMRF SMB HML R2

1 (low 0.000 0.949 0.800 0.429 0.858
BVDIST) 0.259 26.759 17.453 7.145
2 0.000 1.028 0.676 0.498 0.842

-0.078 27.232 13.836 7.790
3 0.002 1.020 0.847 0.237 0.857

1.287 25.236 16.204 3.459
4 0.006 1.026 1.005 -0.002 0.864

3.417 22.842 17.299 -0.025
5 (high 0.010 0.943 1.046 -0.283 0.852

BVDIST) 5.289 18.900 16.220 -3.347
Notes:
The number of observations (i.e., months) in each of the regressions is 192, from May 1984 through April
2000. The first row reports the coefficient and the second row reports the t-statistic. BVDIST measures
the “optimal” R&D adjustment to book value (see equation (2)). Shares are assigned to the five portfolios
at the end of April each year. The dependent variable in each regression is the monthly portfolio excess
return over the risk free interest rate for the month. RMRF is the excess return on the value-weighted
stock market portfolio. HML is the return on a zero-investment portfolio that is long on high book-to-
market (B/M) stocks and short on low B/M stocks. Similarly, SMB is the return on is a zero-investment
portfolio that is long on small capitalization stocks and short on large capitalization stocks.
The monthly returns for each of the five BVDIST portfolios are computed for each of
the twelve months starting with May of t+1. These twelve monthly returns times the
16 sample years (1983-1998) yield 192 monthly returns for each of the five BVDIST
portfolios. Table 5.6 reports the three-factor regression results for the five BVDIST
portfolios. As shown, the intercept (abnormal return) increases monotonically with
BVDIST, and is positive and highly significant for the two portfolios with the largest
value for BVDIST (portfolios 4 and 5). The magnitudes of the abnormal returns are
quite large. For example, for portfolio 5, the monthly abnormal return is 1 percent
(t-statistic of 5.3), which translates to roughly 13 percent annual abnormal return.
The three-factor tests are thus consistent with our previous results, indicating that the
distortion in book value due to immediate expensing of R&D (BVDIST) is positively
associated with risk-adjusted returns over the year after the R&D information is
disclosed.
Robustness Tests
Industry analysis
We consider next the possibility that technology and science-based sectors may have
experienced unexpected good fortune during our sample period (1983-1998). If so,
the positive abnormal returns documented above for R&D intensive firms are not
representative, and are not likely to recur in the future. To the extent that R&D
intensity (as measured by the ratio of R&D expenditures to market value) proxies
for the ex-post success of R&D intensive firms, the evidence in Table 5.5 mitigates
this concern (BVDIST is significant even after controlling for R&D intensity). To
further evaluate the validity of this concern, we re-estimate the Fama and French
(1993) three-factor regression for the high BVDIST portfolio (top twenty percent of
the observations) for each of the seven R&D-intensive industries we study. While it
is possible that during our sample years (particularly the 1990s) R&D activities in
certain industries were unusually successful, it is less likely that such success would
be observed in all seven industries. Therefore, observing positive abnormal returns
for the high BVDIST portfolios in every industry should mitigate concerns based on
unrepresentative samples.
Table 5.7 provides the results of this investigation. In addition to the regression
estimates, we report the time-series means of the portfolio values of BVDIST, SIZE,
B/M, BETA, VOLAT and R&D/M. It is evident that in all seven industries, abnormal
returns (as measured by the intercept) are positive and statistically significant,
suggesting that the returns are not merely a reflection of ex-post success in a few
sectors. The abnormal returns are as high as 2.1 percent monthly (about 28 percent
annually) for the business services industry (mainly software companies), and are
economically significant (0.5 percent monthly, or more than 6 percent annually)
even for the industry with the lowest abnormal returns (transportation vehicles).
As expected, the mean industry returns are positively related to the portfolio
values of BVDIST. For example, the two industries with the lowest mean
BVDIST (fabricated metal and transportation vehicles) have the lowest abnormal
returns. However, the relationship is not entirely monotonic. The chemicals and
pharmaceuticals industry has by far the largest value for BVDIST, but its abnormal
returns, although relatively high, are not the highest. Similarly, the business services
industry has the highest returns, although its BVDIST is only slightly above the
median. This difference in delayed appreciation of the BVDIST variable could be
due to investors having more experience with R&D investments in the chemicals and
pharmaceuticals industry, relative to other industries with more recent technological
innovations. Accordingly, mispricing of pharmaceutical firms is less severe than that
of firms in the business services sector, even though the magnitude of BVDIST is
greatest for pharmaceutical firms.23
23 Another possible explanation is that public information regarding the success of

R&D investments is more widely disseminated for firms in the chemical and pharmaceutical
industry.
Table 5.7 Time-series regressions of monthly excess portfolio returns on the Fama and French (1993) factors
Each portfolio invests in the twenty percent of firms with the highest value for BVDIST within the corresponding industry
Regression Results Portfolio Characteristics

Industry Inter. RMRF SMB HML R2 BVDIST SIZE B/M BETA VOLAT R&D/M
Chem. 0.017 0.877 1.129 -0.545 0.583 0.710 12.776 0.312 1.211 0.127 0.073
4.029 7.981 7.939 -2.926
Fab. 0.007 1.050 0.813 0.456 0.504 0.059 11.832 0.580 1.068 0.119 0.083
1.923 11.242 6.730 2.881
Mach. 0.009 1.143 1.191 -0.239 0.672 0.191 11.110 0.572 1.423 0.161 0.189
2.474 11.861 9.560 -1.465
Elec. 0.016 1.035 1.228 -0.439 0.736 0.173 11.373 0.662 1.328 0.154 0.166
4.812 12.328 11.317 -3.092
Trans. 0.005 1.022 0.521 0.448 0.712 0.056 13.569 0.593 1.106 0.087 0.116
2.446 18.702 7.516 4.805
Scient. 0.014 0.896 1.531 -0.054 0.703 0.337 10.666 0.676 1.174 0.148 0.163
4.111 10.391 13.734 -0.369
Bus. 0.021 1.066 1.182 -0.264 0.611 0.193 10.597 0.599 1.291 0.178 0.180
5.082 10.009 8.583 -1.464
Notes:
The number of observations (i.e., months) in each of the regressions is 192, from May 1984 through April 2000 (except of industry 37 where it is 180, see footnote 13). For
the regression statistics, the first row reports the coefficient and the second reports the t-statistic. For the portfolio characteristics, the reported statistic is the time-series mean
of the portfolio value (cross-sectional mean across the stocks in the portfolio). BVDIST measures the “optimal” R&D adjustment to book value (see Section 4), deflated by
total assets. SIZE (log of market value of equity) is measured at the end of April in year t+1. BETA is estimated using monthly stock returns and the CRSP value-weighted
returns including all distributions during the five years that end in April of year t+1 (at least 30 observations are required). VOLAT is the root mean squared error from the
BETA regression. R&D/M is the ratio of R&D expense to the market value of equity in year t.
To the extent that the idiosyncratic volatility of returns (VOLAT) captures
uncertainty regarding firm value, and SIZE is negatively related to the efficiency
of stock prices, the differences in the mean values of these characteristics across
the portfolios are consistent with the differences in abnormal returns. In particular,
VOLAT is substantially larger, and SIZE is substantially smaller, for firms in the
business services industry relative to firms in the chemical and pharmaceutical
industry (0.178 compared with 0.127 for VOLAT, and 12.8 compared with 10.6
for SIZE; both differences are highly significant). Another noticeable difference
between these two industries is that R&D intensity (R&D/M) is substantially higher
for the business services firms.
These findings may have policy implications with respect to the capitalization of
R&D. They indicate that the usefulness to investors of capitalizing and amortizing
R&D (in terms of improving market efficiency) is increasing in BVDIST (which
is positively related to R&D intensity and the duration of R&D benefits), and
the perceived uncertainty of obtaining R&D benefits, as proxied by idiosyncratic
volatility, firm size (negative relation), and industrial membership. This latter result
suggests that investors do not fully incorporate R&D benefits, especially when the
benefits are highly uncertain.
Year-by-year Returns to Hhgh BVDIST firms
In Tables 5.4 through 5.7 we document that high BVDIST firms earn substantial
abnormal returns in the year following portfolio formation, and argue that these
returns suggest that stock prices do not fully impound R&D information. An
alternative explanation is that BVDIST is correlated with an omitted risk factor.
If, however, the documented abnormal returns to the high BVDIST portfolio are
compensation for risk bearing, that risk should surface in the form of negative
realized returns in at least some periods. In particular, during periods of negative
market performance (e.g., declining stock market indices), high-risk stocks should
underperform lower risk stocks. On the other hand, if the returns are always positive,
risk-based explanations are strained; they must be based on the notion that even
though such losses were never observed within the sample period, their ex ante
probability is still significant.
Figure 5.1 presents the annual (post-portfolio formation) mean raw returns and
mean abnormal returns earned by the high BVDIST portfolio. Abnormal returns are
measured using the 25 SIZE and B/M matched portfolio approach. While the mean
raw and abnormal returns are high for the entire period (27 percent and 12 percent
respectively, in Table 5.4), it is also clear from Figure 5.1 that they are highly volatile.
However, these future raw (abnormal) returns are negative in only three (four) out
of the 16 years, and the losses observed in those years are relatively small. In fact,
the largest contribution to the return volatility is due to the years 1994 and 1998, in
which the returns are very high. When these years are omitted, the mean total returns
(abnormal returns) drops to 16.6 percent (5.2 percent), but, because the volatility
drops even more, the significance of the returns increases (t-statistics of 4.0 and 2.23
respectively). In other words, the high volatility of abnormal returns appears to be
Figure 5.1 Year-by-year 1-year ahead raw and abnormal returns (adjusted for size and B/M) for the
high BVDIST portfolio
The figure plots the annual total returns and abnormal returns for the high (top twenty percent) BVDIST portfolio. Annual abnormal return is measured as the difference
between the firm’s annual return and the contemporaneous return on a SIZE and B/M matched portfolio (see subsection 4.1).
largely driven by positive skewness, which in turn implies that the downside risk is
limited and the “price” of such volatility is likely to be relatively low.
In addition, the correlation between the annual abnormal return for the high
BVDIST portfolio and the market return (as measured using the CRSP value-
weighted returns including all distributions on NYSE, AMEX and NASDAQ firms)
is negative (albeit insignificant), which is inconsistent with the significant positive
coefficient predicted by the risk-based explanation. Overall, the year-by-year forward
returns appear more consistent with market mispricing than with compensation for
risk.
Figure 5.1 indicates that in 1994 and 1998 the portfolio with high BVDIST earns
high returns in the following year. Since the late 1990s have been characterized by
some as a period when technology stocks were overvalued, these unusually high
returns could potentially be due to that bubble. Note, however, that the returns
earned in other periods are also positive. Specifically, the one-year returns for
high BVDIST portfolios formed in 1983 through 1993 are mostly positive and
statistically significant (mean abnormal returns equal to 7.3 percent, t-statistic of
2.8). Accordingly, the miscpricing we document here is unlikely to be due to the high
valuations for technology firms during the late 1990s.
Long-term returns
If the documented abnormal forward stock returns on the high BVDIST portfolio
are compensation for bearing risk, they should persist for long time periods. On
the other hand, if BVDIST captures market mispricing, the returns should fade out
relatively quickly as investors learn about the mispricing. We therefore examine
abnormal returns over three years subsequent to portfolio formation (from May of
year t+1 through April of year t+4).
Figure 5.2 presents the cumulative abnormal return (CAR) for each of the five
BVDIST portfolios for the 36 months subsequent to portfolio formation. CAR is
measured as the cumulative sum of the portfolio monthly abnormal returns. Portfolio
monthly abnormal return for each of the 36 months is calculated as the average
abnormal return for the corresponding month across all firm-year observations.
Monthly abnormal return is calculated as the difference between the firm’s return
and the contemporaneous return on a SIZE and B/M matched portfolio (SIZE and
B/M are updated every twelve months). To control for characteristics that are unique
to our sample, and which may have affected returns during the sample period (see
Table 5.4), the 25 SIZE and B/M benchmark portfolios are based only on firms from
the seven R&D intensive industries included in our sample.
Because the reference group for measuring abnormal returns includes only firms
from the seven R&D intensive industries, the abnormal returns in Figure 5.2 are
smaller than those in Table 5.5 (as reported in Table 5.4, the average abnormal return
for these industries in the first twelve months is about 3.7 percent). Figure 5.2 indicates
that for the first nine months after portfolio formation, the CARs increase in absolute
value almost linearly and the slopes are positively related to BVDIST. Between
the tenth and twentieth month, the slopes are smaller in absolute value, although
they are still positively related to BVDIST. However, from month 21 through 36,
Figure 5.2 Cumulative abnormal returns (CAR) for BVDIST quintiles over the three years following
Cumulative abnormal return (CAR) is measured as the cumulative sum of the portfolio monthly abnormal returns. Portfolio monthly abnormal return for each of the 36 months is
calculated as the average abnormal return for the corresponding month across all firm-year observations that “belong” to the portfolio. Monthly abnormal return is calculated as
the difference between the firm’s return and the contemporaneous return on a SIZE and B/M matched portfolio (SIZE and B/M are updated every twelve months).
excluding the January returns (months 21 and 33), the slopes are generally flat for all
five portfolios. As argued earlier, such a pattern of prices initially adjusting to new
information and then flattening out after a few months is consistent with BVDIST
capturing market mispricing rather than compensation for risk.
We consider next the substantially higher returns earned by the high BVDIST
quintile in January of the second and third years (months 21 and 33), even after
controlling for SIZE and B/M. Previous studies (e.g., Chen and Singal 2001) have
linked the January effect to SIZE (negative relation) and to the potential for tax-
loss selling in December (positive relation).24 The potential for tax-loss selling
increases with the probability of large price movements, which in turn is likely to
increase with BETA, VOLAT and R&D/M (see Chan, Lakonishok and Sougiannis
2001). Since Table 5.4 shows that BVDIST is indeed positively related to these firm
characteristics, the strong January effect for the highest BVDIST portfolio may be
due to the relatively large values of BETA, VOLAT and R&D/M, which in turn
proxy for potential tax-loss selling.
Table 5.8 Cross-sectional Fama-MacBeth (1973) monthly regressions for

January returns
M Int. SIZE ln(B/M) BETA VOLAT R&D/M R2 N

Mean 0.092 -0.007 0.002 0.006 0.297 0.145 0.054 805
t-stat 3.657 -3.232 0.372 1.250 3.712 3.297
Note:
The first row reports the time-series mean of each coefficient. The second row reports the t-statistic
based on the time series distribution of the coefficient (mean coefficient divided by its standard error).
The number of monthly regressions is 16 (January 1985 through January 2000). The dependent variable
is the stock return in January. SIZE is measured in April of the previous year. BETA is estimated using
monthly stock returns and the CRSP value-weighted monthly returns including all distributions during
the five years that end in April of the previous year (at least 30 observations are required). VOLAT is the
root mean squared error from the BETA regression. R&D/M is the ratio of R&D expense to the market
value of equity a year ago.
To examine whether BETA, VOLAT and R&D/M proxy for potential tax-loss
selling, we estimate for each year the cross-sectional regression of January returns
on SIZE, B/M, BETA, VOLAT and R&D/M. Table 5.8 presents estimates from the
16 cross-sectional regressions. In contrast to the results in Table 5.5, and consistent
with prior evidence on the January effect, the coefficients on VOLAT (BETA)
are positive and highly (marginally) significant, the coefficient on SIZE is highly
significant, and the coefficient on B/M is insignificant. In addition, the coefficient on
R&D/M is substantially larger than the corresponding coefficient in Table 5.5. These
results support the conjecture that the strong January effect for high BVDIST firms
in Figure 5.2 is due to the potential for tax-loss selling. The fact that the January
24 Roll (1983) argues that SIZE is negatively related to the January effect because it
proxies for the potential for tax-loss selling.
effect in the ninth month is small relative to the 21st and 33rd months may be due
to the high stock returns in year t+1, which reduce the potential for tax loss selling
in that year.
In summary, the evidence in Sections 4 and 5 suggests that prices do not fully
impound the information in adjusted earnings and book value, calculated assuming
capitalization and straight-line amortization of R&D. The tentative conclusion is that
allowing firms to capitalize and subsequently amortize R&D costs would improve
the relevance of earnings and book value.
Conclusion
This study evaluates the potential improvement in the informational usefulness of

earnings and book value when R&D expenditures are capitalized and amortized
equally over assumed useful lives. We first examine the effect of these R&D
adjustments on the association of earnings and book value with current stock price
and future pre-R&D earnings, and find that this association is increased for adjusted
earnings and book value numbers. Our results suggest that firms in some but not
all industries may improve the informativeness of their financial statements if they
capitalize and amortize R&D expenditures over industry-specific useful lives. This
suggestion is based on the implicit assumption that increasing the association of
reported numbers with intrinsic value is a desirable objective of financial reporting.
Given that our R&D adjustments are relatively crude, it is reasonable to project
that allowing firms to follow individual amortization schedules would increase
further this association between adjusted numbers and intrinsic values (and future
earnings). To be sure, accounting standard setters should also weigh concerns about
firms managing their earnings and assets when more measurement freedom is
allowed.25 While our results do not address directly the impact of providing such
freedom, we believe they encourage standard setters to review the current policy of
requiring immediate write-off of all R&D investments by all firms.26
The results of our main analysis, which links future returns to the crude
adjustments we make to book value for unamortized R&D, emphasize even more
strongly the need for standard setters to review current rules. To the extent our results
are due to stock prices systematically undervaluing unamortized R&D, requiring
firms to capitalize and amortize R&D should unambiguously increase the efficiency
of market prices and resource allocation. Again, even though our evidence relates
25 Proponents of capitalization have argued that the actual incidence of earnings/asset

management caused by allowing more freedom in choosing amortization schedules is likely
overstated, and the benefits of managers using this opportunity to reveal truthfully their
estimates of future prospects is likely understated. Also, the simulation study conducted by
Healy, Myers and Howe (1999) suggests that earnings is quite robust to such management.
Finally, it should be noted that the timing of R&D (and other intangibles) expenditures can
also be manipulated, and the impact on current earnings of such manipulation is greater under
immediate expensing, relative to capitalization and amortization.
26 We hope that the January, 2002, announcement by the FASB that it has added an
“intangibles disclosure” item to its agenda will result in deliberation of this issue.
only to the case where firms are required to follow strict industry-specific guidelines
for amortization of R&D, we believe our evidence also suggests a review of the
trade-offs associated with a more flexible policy.
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Chapter 6
Scoring Company Disclosure on

Intangibles: An Application of an
Innovative Methodology
in a European Perspective
Stefano Zambon and Ilaria Bergamini
Introduction
It is well known that investors’ request for relevant and always more penetrating
company information is being rapidly growing in the last few years. This increasing
demand is the result of the need felt by operators to try to understand the “real”
value of a business. In fact, the gap between accounting value and market value of
a company has been quite large in the last 10 years or so (Lev and Zarowin, 1999),
this primarily depending on the “real” value of its intangible investments which
by large is not shown in the traditional accounting statements. Indeed, it is today
widely accepted that the value of a business activity is no longer based on material or
financial assets, but on intangible ones. The importance of intangibles is clear to all
market’s operators. Notwithstanding the explosion of the financial bubble in 2001-
02, businessmen, shareholders, analysts recognise that intangible assets play a key
role in today’s company value creation.
In the light of this irreversible evolution, it therefore appears more and more
as a contradiction in terms that in today’s knowledge economy company financial
statements devote a large part of their contents to illustrate and explain the generally
least important part of the business value, i.e. that associated with tangible assets.
This information gap becomes of course even wider, and then more urgent, for
technology-based and service enterprises. For these companies the application of
the standard accounting procedures often means that their financial statements reveal
far too little about their intangible assets and, hence, about their value creation core.
A reverse relationship can almost be established according to which the more a
company is rich in intangible assets, the less useful its financial statements are in
explaining the difference between company book value and market value (Stewart
1995, 1998).
As a consequence, most of the information provided by companies on intangible
assets are of voluntary nature, since regulations requiring companies to disclose on
this type of assets are few and ask generally for scarce and superficial information
(Zambon 2002). Therefore, it is widely believed that the annual accounts fail a
long way to represent the correct value of a company and to provide the necessary
informational elements to this end.1
Although it is difficult to understand and assess the amount of this contribution
and the value of these items, many researchers and practitioners have developed in
recent years several models and approaches to measure intangible assets and/or to
disclose them in annual reports or in other company documents (e.g. intellectual
capital statements, and so on).
In this respect, the University of Ferrara, in collaboration with the Italian
Association of Financial Analysts (AIAF), has developed in 2002 a three-dimensional
model for measuring the level of external communication on intangibles, and for
representing the informational level achieved in a Radar Diagram (cf. also Malagoli’s
chapter in this volume).
The aim of the chapter is then to test this methodology by applying it in a European
context in order to appreciate the level of information on intangibles disclosed by
European companies. The French, German, Italian and UK companies included in
Dow Jones Total Market Indexes will be considered, excluding banks, insurance and
financial service companies as well as holdings.2 In particular, the financial statements
of these companies will be examined, and information on intangible assets contained
therein will then be assessed according to the above model. It should also be noted
that the original 2002 model has been here improved and refined to make it more
comprehensive and consistent with the analysis that will be undertaken.
The examination conducted in this chapter focuses only on annual reports,
because they represent a general information purpose document, that is produced
for all kinds of stakeholders, and that is mandatory in all the countries investigated.
However, companies produce several different types of documents (e.g., social
reports, environmental reports, sustainability reports, and intellectual capital
statements). In our analysis we do not consider these documents, since in the four
countries considered in the study practices are different. The analysis will focus on
2001 and 2002 annual reports.
The chapter is organised as follows. It starts off from a brief description of the
University of Ferrara-AIAF model, to move then to the presentation of the changes
that have been made to improve its representational capacity. After that, research
methodology will be illustrated, also pointing out the differences in respect to one
used in the original AIAF’s 2002 document. Finally, the results of the analysis will be
shown, and some conclusive considerations on the model and results be provided.
1 Clearly one could also support the alternative view that financial statements should
not serve as a means to document the value and the value creation processes of an entity, but
rather to provide essentially a report on the activity carried out by the entity management with
the resources entrusted to it (i.e. the “old” and well-known stewardship function).
2 Stock markets have been chosen which, by weight, number of quoted companies and
significance, are the most important within the European context.
Scoring Company Disclosure on Intangibles 131
Description of the model
In recent years, the Italian Association of Financial Analysts (AIAF) has become
involved in the study of several issues about intangibles, in particular addressing the
persistent difference between the value of the companies as disclosed in financial
statements, and that expressed by the stock market.
Within AIAF an ad hoc Study Group was set up in 2001 called “Mission
Intangibles”. In 2002 this Group produced a study, the AIAF Official Report No. 106,
in cooperation with the University of Ferrara, which deals with the communication
of company information on intangible assets to the financial market and the
general public (AIAF 2002). The purpose of this study was to propose a company
classification system articulated on various levels in relation to the capacity by the
reporting entity to provide more or less satisfying information about its intangibles.
The model is based on a three-dimensional framework (cf. Figure 6.1).
The three dimensions are the following:
a) the nature of information: forecast and actual;

b) five communications dimensions/areas: strategy, customers and markets,
human resources, processes and innovation, and organisation and human
resources;
c) level of communication on intangibles: “minimum” information, “reasoned”
information, and extended information.
As to the levels of communication, there could also be a “zero” information level,

where information on intangibles provided by a company covers none of the five
communication dimensions. In such cases, stockholders are not able to formulate
any evaluation, as data available is inadequate. The difference between “zero”
information and “minimum” information is that the latter allows the analyst and the
investor to form at least a “minimum” representation of the intangible investment of
a company, whilst this is not possible with “zero” communication level.
The second communication level, that of the “reasoned” information, reflects a
company’s specific intention to increase its communications concerning intangible
assets. At the third information level – “extensive information” – a company
generally prepares a specific document relating on intangible assets. This document
may be structured on the basis of the five communication dimensions (or alike), and
each part may include qualitative and quantitative information on the company’s
intangible assets.
To fully develop the model, a Radar Diagram was introduced (cf. Figure 6.2).
This graphic helps to represent the results obtained and facilitates assessments and
conclusions. The diagram can represent either the level of information supplied on
intangibles by an individual company, and the level of information supplied on this
field by a sample of companies.
The communication level of a company in each intangibles area/dimension is
measured in the Radar Diagram through a scoring scale that goes from 0 to 15.
A “zero” score represents a nil information level; on the other side of the scale, a
score of 15 represents optimal (extensive) information. Between these extremes, two
Figure 6.1 AIAF-University of Ferrara’s original model

Source: AIAF, 2002
Figure 6.2 Radar diagram
Source: AIAF, 2002

intermediate information levels have been identified: insufficient (“minimum”) with
a score up to 5, and sufficient (“reasoned”) with a score ranging between 5 and 10.
The model is quite flexible and can be adapted to different analyses. For instance,
it is applicable to different industries, obviously considering that for certain of them
information on several dimensions could be not as relevant for the analysis. For
example, the “processes and innovation” dimension is unquestionably relevant for ICT
and pharmaceutical companies, but it does not necessarily have the same importance
for entities operating in traditional/mature markets (even though intangible assets
are always important for all types of companies) (Bergamini 2002).
Research Methodology
The original model, as described in the 2002 AIAF Report, will be subject to a few
changes and enrichments for the analysis to be carried out in this chapter. First, a
sixth communication area/dimension of intangibles – i.e. corporate governance - is
introduced in the model. Second, a list of the information contained in financial
statements which falls within the (now) six communication dimensions is provided.
Third, a few mathematical and statistical concepts are presented, that will be later
employed to summarise and evaluate the results attained through the application of
the model. The changes and enrichments are discussed more in detail below.
The Sixth Communication Dimension: Corporate Governance
Corporate governance, intended as the system of rules according to which companies

are managed and monitored, is the result of regulations, traditions and lines of
conduct worked out by individual economic and legal systems, and cannot certainly
originate from one single model that is exported to and imitated by all countries.3 It
is made up of all the relations between managers, directors, staff and shareholders
as a whole. Corporate governance refers to the manner in which the company is run
and controlled (Gregory 2000).
A good corporate governance system is able to ensure that the company is using
its resources efficiently. Furthermore, it helps to ensure that, as it goes about its
business, the company is also aware of, and has an interest in, the issues affecting
the social environment in which it operates. In short, this system is meant to ensure
that the company be concerned with the good of society at large, and takes care of
maintaining investors’ confidence and attracting fresh capital.4
3 In Italy, the fundamental bodies are the Board of Directors and the Auditors’ Committee.
In the UK, it is the Board of Directors together with a variable number of committees, each
with their own specific tasks. In Germany, working along the Board of Directors, there is also
a monitoring committee. In France, a few committees are also present in addition to the Board
of Directors. In all these countries an important role is of course played by the Annual General
Meeting of the shareholders (Carriere et al. 2002).
4 OECD (1999).
In the original AIAF-University of Ferrara model, information about corporate
governance is included within the Strategy dimension. Here, we have preferred to
create a sixth new dimension to distinctively consider all the information about
companies’ corporate governance considered as a special intangible. On the one
hand, it is believed that this information should be more clearly connected with the
institutional structure, rather than with the problems and trends linked to strategy. On
the other hand, considering any information about corporate governance as a specific
piece of information within the strategy dimension would have meant to belittle
considerably the weight and importance that this system has within a company both
in the process of value creation and as an intangible factor per se.
The differences between the corporate governance systems of the countries we
have analysed are significant, especially with regard to the institutional structure and
the way responsibilities are assigned. Above all, considerably diverse should also be
the informational importance attributed to this business system in these countries.
Through our analysis we will attempt to highlight this aspect as well. Indeed, the
weight attributed by each country to this communication dimension should in
principle emerge from the results attained. Of all the countries investigated, the
UK is expected to reveal more information about corporate governance in financial
statements, as this country has been the first to open the doors to self-regulation with
the Cadbury Report of 1992 and, therefore, the first business environment to show
concrete concern about these issues.
The Information Considered for Each Communication Dimension
Drawing on the list proposed by the AIAF-University of Ferrara 2002 Report, the
Appendix 6.A shows the information on intangibles which have been considered in
that document to be part of each communication dimensions/areas. This information
operates as a qualitative/quantitative benchmark and can refer to the current period
or future periods.
Looking at this list, one can see that some information is far from being of an
intangible nature (e.g. the number of employees). However, it is thought that the
information elements composing each area can help somehow to represent the
situation relative to a certain set of intangible resources within a company. In the
case of the variable “number of employees” and all the information belonging to this
communication dimension, they are intended to provide a view of the intangibles
amenable to the human resources operating within a company. In this respect,
certain information elements may then serve as proxies for aiding the visualisation
of intangibles that are difficult to measure/represent directly.
The above list of indicators proposed by the AIAF (2002) was changed to make it
more consistent with the five communications dimensions. To this end, information
on licenses and suppliers has been moved from the Organisation dimension to the
Customer and Market dimension, because this is considered more suitable when
examining this dimension. In addition, information on average supplier payment
conditions and average financial resource cost conditions, have been eliminated
from the Organisation dimension, because they cannot be directly correlated to the
latter. For the very same reason we have eliminated economic and financial indexes
from the Strategy and Corporate Governance dimension, except for those which are
company objectives/targets for the future activity. Adjusting the categories was also
seen appropriate for improving the correlation between information and indicators
on the one hand, and the communication dimensions on the other.
It is to be clarified, though, that both the list supplied by the AIAF in its Report
(which is not exhaustive and comprises of 80 indicators distributed between the five
dimensions) and the information inventory used in this chapter (cf. Table 6.2 below)
are not the outcome of a specific research aimed at establishing what information can
be included in any given communication area, or what information must necessarily
be present in company annual accounts.
Mathematical and Statistical Elements
A formula to calculate the area of a hexagon is here introduced. This formula will be
useful for calculating the area of the figure emerging from reporting the results of the
empirical research in the Radar diagram.
A way of calculating this area is to divide the hexagon into six triangles, calculate
the area of each triangle, and then sum up the six areas to obtain the total area. The
formula for calculating the area of a triangle is:
S = l1 x l2 x sin– ,
2
where l1 and l2 represent the sides of the triangle and α the angle between the two
sides. Angle α measures 60 degrees as a result of dividing the turn angle of 360°
by 6.
As for the statistical analysis, we will use standard deviation for the scatter
analysis of data around their average value. Clearly, the higher the standard deviation
is, the more data are scattered.
Furthermore, the formula that will be used to calculate the average information
score reached annually by one country’s companies for all the communication
dimensions, is:
xi
…=
n
Scoring Methodology
The next step consists of establishing the methodology to be applied to the analysis.
AIAF, in its 2002 Report, has also developed a limited empirical analysis of nine
companies listed on the Italian Stock Exchange in order to verify the validity of the
model presented there. The investigation conducted by the AIAF was centred around
the identification of three pre-determined key indicators5 for each communication
5 With this term AIAF refers to the indicators that are relevant to the type of companies
considered, also according to the kind of activity they carry out.
Table 6.1 AIAF’s scale for ranking company disclosure on intangibles
Information quality Score
No information 1
Insufficient information 2
Sufficient information 3
Sufficient and detailed information 4
Detailed and forecast information 5
dimension/area. In turn, each of these three indicators was attributed points following
the guideline provided in Table 6.1.
The result of this analysis was that the companies taken into account were rated
as having an adequate level of information disclosure. AIAF has also come to the
conclusion that the more these companies disclosed information that was not required
by current Italian regulations, the more they provided information that enabled them
to be positioned at an adequate level of disclosure (from 5 points upwards). This
study also confirmed that most of information disclosed on intangible assets is of
voluntary nature, being the accounting rules in this field rather unsatisfactory.
The methodology adopted in this chapter differs from that utilised by the AIAF. First
of all, we will consider all (and not just three per area) intangibles-related information
disclosed in financial statements which falls into any of the set six dimensions.
The scoring methodology represents a highly complex choice. The method
employed by the AIAF assumes that the reader has certain knowledge of financial
statements, and that he/she is therefore capable of rating each piece of information
by himself/herself and, hence, of awarding the appropriate number of points. In our
view, this scoring methodology is too subjective, as the person who is about to assess
financial statements and the intangibles information therein decides the points to
attribute. The choice of the three key information to be considered can indeed be
biased and too personal, and does not preclude the fact that someone else might have
chosen different types of information from the same annual accounts.
Searching for the least subjective valuation method possible, several options
have emerged. After a careful analysis, we have decided to consider two general
parameters for our scoring methodology: the scope of information (i.e. the number
of different types of information released on a given communication dimension),
and the number of information provided on a given communication dimension. The
first parameter offers some indication on the breath of information given about one
dimension of communication; the second about the depth of that information (i.e.
how much detailed is the disclosure given on a specific communication area).
An example can clarify the methodology adopted. Let us assume that for the
Customers and Market dimension, we find an information about market share. Such
information is considered as one type of information. In a set of annual accounts,
this piece of information can be expressed as referring to (i) the group, or (ii) an
individual company, or (iii) a specific product market, or (iv) a geographical market.
Assuming we find all these four information, we will have four items as far as the
number of information is concerned. Of course, each piece of information present in
the annual accounts will be counted only once, even though it appears several times
therein.6
On the basis of these parameters, for each country two lists (one by type and one by
number of information) are produced out of the companies considered, rating them in
a descending order from the one supplying more information to the one supplying the
least of it. The top company of each of the two lists is assigned 15 points,7 while the
others will be attributed a score proportional to the amount of information released in
comparison to the best practice company.8 In doing so, each company will obtain two
different scores (information scope and number) for each dimension of communication.
The average between these two scores becomes the overall rating attributed to the
information disclosed by a company about that communication dimension/area. It has
been decided to use the simple average without attributing any weight to the two scores,
because it is thought that both help provide, in equal measure, a useful representation
of the communication on intangibles provided by the annual reports.
Another example may further clarify this methodology. A, B, C, D and E are five
companies. In 2001 financial year they provide these different types of information
about Strategy (scope of information):
Companies Information scope

about trategy
A 5
B 9
C 3
D 1
E 4
One type of information can be “objective”, but a company can provide

information about its future aims, the objectives achieved, the market competitors,
and so on. After calculating the scope of information, we pass on to consider the
number of information disclosed.
Companies Number of information

about strategy
A 6
B 9
C 5
D 3
E 7
6 For example, the number of employees can appear in many sections of financial
statements. At any rate, it has only been counted once, both as a type and as a number for the
purpose of our analysis.
7 The rating system proposed by the AIAF has been maintained.
8 For example, if company A (ranking first in the list) provides 10 types of different
information about one dimension, it is awarded 15 points. Company B provides instead 7
pieces of diverse information. The score B will be awarded is calculated using the following
proportion: 10 : 15 = 7 : X. Therefore, Company B will be awarded 10.5 points.
Then, we assign the score: 15 points to the best discloser, and proportionally
scaled down scores to the remaining companies (see note 8).
Companies Information scope Score

about strategy
A 5 8.33
B 9 15.00
C 3 5.00
D 1 1.67
E 4 6.67
Companies Number of information Score

about strategy
A 6 6.67
B 9 15.00
C 5 8.33
D 3 5.00
E 7 11.67
Now we calculate the average for each companies of the two scores assigned.
Companies Information scope Number of information Average

Score Score
A 8.33 6.67 7.50
B 15.00 15.00 15.00
C 5.00 8.33 13.33
D 1.67 5.00 3.36
E 6.67 11.67 9.17
If A, B, C, D and E are companies of the country X, the average of the five overall
scores obtained provides the general level of disclosure about Strategy dimension
reached by the companies of the country X. The average in this example is 8.67.
Sample and Data Collection
The analysis presented in the following stems from an application of the illustrated
scoring model of company communication on intangibles in the European context.
Indeed, we take in consideration French, German, Italian and UK companies
included in the Dow Jones Total Market Indexes, excluding insurance and banking
companies, since they are subject to different accounting and disclosure regulations.
For the same reason, financial service companies have also been excluded from
the analysis. Even holding companies have been omitted for they seldom provide
information about intangible assets, because their main activity is to either buy
or sell shares in other companies, without producing any goods or providing any
services. 35 companies9 for each country compose the final sample, after excluding
the above mentioned cases and the non-national companies.10
The company documents examined are the annual reports referring to the 2001
and 2002 financial years.11
The Information on Intangibles Collected in Annual Reports
Table 6.2 shows the indicators collected during the analysis of 2001 and 2002 annual
reports of the companies considered in our study.
Table 6.2 Information on intangibles detected in company annual reports
Strategy Customers and Market Human Resources

Strategies Total potential market Number of employee
Focus, vision and mission Market position Employee by category
Strategic agreements Competitors Employee by division
Objectives Active customers Employee by region
Social responsibility Customers divided into Employee by type of contract
Environmental Policy categories Incentives by category
Risk management Market analysis Company benefit policy
Strategic position Industry analysis Employee policy
Regulatory environment Orders backlog Educational level
Value drivers or key New customers Average age
competitive advantages Number of sales outlets Seniority in company
Targets Distribution network Training program
Security program Contacts (audience, Number of male and female
subscribers, visitors) Employee target
Level of customer Number of apprentices
satisfaction
Registered users
Active users
Number of pages visited on
the site
Market served
Market penetration index
Competitive environment
Description of brands/
licenses/copyrights
Target customers served
Name of some customers
Number of supplier
9 After excluding banks and insurance companies, 35 companies are left for Italy, and
therefore, for homogeneity’s sake, we decided to consider the same number of companies for
every country. Companies of the final sample have been selected on the basis of their position
in the market capitalisation order (the first 35 have been retained).
10 The complete list of companies analysed is shown in Appendix 6.B.
11 We have considered only the companies that produced an English version of their
annual report.
Organisation Innovation and IPR Corporate Governance

Company organisational R&D activities Board members
chart Projects developed internally Board activities and
Indication of legally New product development responsibilities
protected intangible assets Technology used Ethical code
Company culture R&D laboratory Committee members
Information system R&D objectives Committee activities and
description R&D partnerships responsibilities
Description of organisational Number of researcher Internal control
change Description of other firm
bodies
Investor relations
Relationships between
different board or committee
Combined code
Results
Prior to initiating the commentary of the results obtained, it seems useful to

recall a frequently shared interpretation infusing international accounting studies.
National accounting practices could be grouped in various clusters. Two of these
are the Anglo-American and the Continental European one. The first of these two
accounting systems is thought to be oriented towards supplying information to meet
the decision-making requirements of investors and creditors, and is based more on the
concept of substance over form. The second appears to be more designed to comply
with regulatory requirements, and hence more legally and conservative oriented.
The countries considered in our analysis belong to these two clusters, i.e. the UK
belongs to the first, and the other three to the second (Nobes 1992). We can then
wonder whether and to what extent our results have confirmed this interpretation.
The Radar Diagrams below show the outcomes of the analysis conducted.12
Figure 6.3 illustrates the results for financial year 2001 and Figure 6.4 for financial
year 2002. In general, French and German companies seem to disclose on average
more information on intangibles than the other companies considered (see also
Table 6.6 below for the areas of the hexagons obtained in the diagrams). German
companies appear to release more information about Human Resources, Strategy,
Innovation and IPR, and Corporate Governance. Italian companies provide more
information about Organisation than the other countries analysed. As to Customers
& Market, Germany offers the highest level of information in 2001, and France
in 2002.
The communication dimensions that are more developed for all countries
considered are Human Resources, Strategy and Corporate Governance.
As to the Organisation dimension, the scores remain instead small in general
for the companies of all the countries investigated, revolving mostly around a level
12 In Appendix 6.C the individual results obtained for each country are reported.
Figure 6.3 Levels of information in 2001 fiscal year
Figure 6.4 Levels of information in 2002 fiscal year

deemed to be insufficient. In particular, UK companies are positioned at a level of
disclosure that is almost nil. The scope and the number of information disclosed
about this dimension are low (2-3 types or number of information maximum13), and
many companies do not provide any information at all on this subject. Companies
that present information about Organisation release information especially about
their organisational structure or offer a little description of this topic (for example,
several Italian companies reproduce, in their annual report, the organisational chart
of the company or the group).
On the other hand, for Customers & Market, German and French companies
provide a level of disclosure close to the sufficiency level, whilst Italian and UK
entities on average do not even reach this level.
The disclosure regarding the Research and Development (Innovation and IPR
dimension) verges around the insufficient level, with German companies showing a
slightly better amount of information, and UK companies disclosing less than other
countries. It must be said that many UK companies do not provide any information
about their R&D, because for their primary activities they do not utilise research
assets. In fact, the Innovation and IPR dimension appears to be greatly influenced by
the sector in which the company operates. This dimension is in fact very important
for high-tech companies or those active in related industries. By contrast, nearly all
German companies provide information about their R&D (activities, investments,
partnerships, researchers, and so on). In this case, the primary activity carried out
does not seem to influence the amount of information disclosed by these companies
on this communication dimension.
The Strategy and the Corporate Governance areas appear to be of informational
interest to all the companies considered. Unlike the latter, these two dimensions do
not appear to be at all influenced by the sector the company being analysed belongs
to. In fact, the level of disclosure for these dimensions generally reaches the sufficient
level, and some time it is higher than that.
As far as the Human Resources dimension is concerned, despite the little
information required on this subject by the various accounting regulations (only the
total number of employees and their breakdown by function and/or by geographical
area and/or by business unit), it would appear that companies tend, on the contrary,
to enrich their annual accounts with information about these resources.14
Table 6.3 shows the average scores and standard deviations calculated, in relation
to 2001 and 2002 financial years, vis-à-vis each scoring range, each communication
dimension, and each of the four countries considered. This Table is useful to fully
appreciate and assess the diversity of communication behaviours that companies put
in place as to the various areas of intangibles.15
13 See also Table 6.6 and 6.7 below.

14 Also for Strategy dimension national and international accounting standards do not
require much information. It is interesting to observe that for Human Resources the types of
information disclosed about them are very diversified.
15 For instance, one can observe that, with reference to the Organisation dimension, UK
companies have an overall standard deviation of 3.18, but zero as to the standard deviation
relating to the three score ranges. This is because companies analysed provide the same
Table 6.3 Average and standard deviation for the six communication dimensions
FRANCE GERMANY ITALY UK

2001 2002 2001 2002 2001 2002 2001 2002
Score ranges Total Score ranges Total Score ranges Total Score ranges Total Score ranges Total Score ranges Total Score ranges Total Score ranges Total
0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15 0-5 5-10 10-15 0-15
CUSTOMERS
& MARKET
% companies 2.9 71.4 25.7 100 5.7 71.4 22.9 100 5.7 65.7 28.6 100 8.6 68.6 22.9 100 45.7 45.7 8.6 100 51.4 40.0 8.6 100 48.6 48.6 2.9 100 54.3 42.9 2.9 100
Average 4.63 7.29 12.16 8.47 4.86 7.30 12.58 8.37 4.39 7.49 12.17 8.65 4.75 7.51 11.88 8.27 2.69 6.14 11.89 5.06 3.57 6.37 12.31 5.44 3.97 6.29 15.00 5.41 4.21 6.57 5.53 5.53
Standard Deviation 0.00 1.31 1.62 2.61 0.00 1.23 1.35 2.66 0.00 1.56 1.46 2.77 0.17 1.26 1.28 2.43 0.69 0.90 2.20 2.85 0.95 0.74 1.93 2.68 0.76 1.00 0.00 2.19 0.53 2.36 0.00 2.19
HUMAN
RESOURCES
% companies 0.0 80.0 20.0 100 0.0 74.3 25.7 100 0.0 57.1 42.9 100 0.0 60.0 40.0 100 14.3 71.4 14.3 100 22.9 57.1 20.0 100 0.0 88.6 11.4 100 0.0 77.1 22.9 100
Average 0.00 7.89 11.98 8.71 0.00 7.84 11.94 8.89 0.00 8.21 11.65 9.68 0.00 8.07 12.55 9.86 3.65 7.13 12.23 7.36 4.16 6.90 11.44 7.18 0.00 7.99 11.41 8.38 0.00 8.43 12.03 9.25
ORGANISATION
% companies 34.3 60.0 5.7 100 31.4 62.9 5.7 100 37.1 60.0 2.9 100 34.3 62.9 2.9 100 22.9 51.4 25.7 100 25.7 42.9 31.4 100 88.6 8.6 2.9 100 88.6 8.6 2.9 100
Average 0.31 7.50 13.13 5.36 0.00 7.50 15.00 5.57 0.00 5.00 15.00 3.43 0.00 5.11 15.00 3.64 0.00 6.46 13.06 6.68 0.00 6.42 13.18 6.89 0.00 7.50 15.00 1.07 0.00 7.50 15.00 1.07
STRATEGY
% companies 0.0 71.4 28.6 100 0.0 51.4 48.6 100 0.0 34.3 65.7 100 0.0 31.4 68.6 100 14.3 54.3 31.4 100 0.0 68.6 31.4 100 5.7 68.6 25.7 100 0.0 62.9 37.1 100
Average 0.00 8.04 11.55 9.04 0.00 8.54 10.86 9.66 0.00 8.47 11.64 10.55 0.00 8.98 11.65 10.81 3.79 7.40 11.87 8.29 0.00 7.59 12.39 9.10 4.79 8.13 12.27 9.00 0.00 8.43 11.40 9.53
INNOVATION AND
IPR
% companies 40.0 45.7 14.3 100 45.7 45.7 8.6 100 25.7 65.7 8.6 100 14.3 74.3 11.4 100 51.4 34.3 14.3 100 45.7 37.1 17.1 100 82.9 8.6 8.6 100 82.9 8.6 8.6 100
Average 1.73 7.15 11.75 5.64 2.38 7.59 12.07 5.59 2.19 7.47 12.98 6.58 1.86 6.58 12.33 6.56 2.50 7.06 11.70 5.38 1.68 6.88 11.98 5.38 1.25 7.40 12.86 2.78 1.73 8.54 13.02 3.29
CORPORATE
GOVERNANCE
% companies 20.0 42.9 37.1 100 11.4 37.1 51.4 100 0.0 60.0 40.0 100 0.0 20.0 80.0 100 28.6 34.3 37.1 100 25.7 20.0 54.3 100 0.0 54.3 45.7 100 0.0 40.0 60.0 100
Average 3.75 8.03 11.02 8.28 4.27 8.94 12.07 10.02 0.00 8.36 12.13 9.86 0.00 9.50 12.39 11.81 3.06 8.07 11.30 7.84 3.40 8.35 12.47 9.31 0.00 8.50 11.14 9.70 0.00 8.33 11.22 10.07
The standard deviation emerges to be quite high. Tables 6.4 and 6.5 shed light
on this phenomenon. In particular, Table 6.4 shows the descriptive statistics for
the type/scope of information disclosed for each communication dimension by the
companies of each country, whilst Table 6.5 illustrates the statistics for the number
of information provided by the same companies. The results of Table 6.3 are the
outcome of data analysed in Table 6.4 and 6.516, and these two Tables clearly
reveal that the data about the types and number of information collected from the
financial statements examined, are considerably divergent. In particular, it can be
seen that standard deviations in the Table 6.5 are in general quite higher than those
in Table 6.4.
These two tables demonstrate that the companies considered have different
disclosure practices. Indeed, nearly all the information found in financial statements
is of voluntary nature17, thus companies may decide whether to disclose information
about one topic. The results show that, with the exception of the Organisation and
Innovation and IPR dimensions, companies seem to understand the importance of
presenting information about intangibles in their annual statements.
As a confirmation of the results achieved, Table 6.6 shows the hexagons’ areas
calculated for each country. Germany and France areas are the largest, whilst the UK
one is much smaller than the others. On the other hand, for all countries the hexagon
areas increase from 2001 to 2002. This could be a signal of the perceived growing
importance of intangibles information for the companies of all countries.
From the national results obtained it may be interesting to construct a pattern
of European best practices with reference to the disclosure on intangibles. This can
be built up by choosing from all the countries the best communication practice for
each dimension. Accordingly, Figure 6.5 and Figure 6.6 show graphically the best
disclosure practices for fiscal years 2001 and 2002, respectively. In this respect, if
a company is willing to adopt the average best practice per communication area
which has emerged with reference to the four countries considered, then the area of
the hexagon which would result is 189.86 for 2001 (cf. Figure 6.5), and 204.46 for
2002 (cf. Figure 6.6). The larger area of the latter “European best practices hexagon”
confirms the average improvement in the company communication on intangibles
also with reference to the peak points of this subject area.
(low) number of information. As to the Human Resources dimension, French companies

score zero for both points and standard deviation in the range 0-5. This is because no French
companies fall into this latter score range, given that these entities produce a relatively rich
and homogeneous communication on these resources. A similar argument can be made for the
same communication dimension vis-à-vis German companies in 2001. It is also interesting to
observe that from 2001 to 2002 German companies have clearly and uniformly increased their
disclosure on the Corporate Governance area.
16 See the example in the “Scoring methodology” section above.
17 See Appendix 6.D.
Table 6.4 Statistical data about the type/scope of information
Type/scope of information France Germany Italy UK

Customers and market 2001 2002 2001 2002 2001 2002 2001 2002
Average 5.80 7.00 5.11 7.00 4.63 5.66 4.54 5.63
Standard Deviation 1.60 1.80 1.79 1.51 2.55 2.71 1.64 1.90
Median 5 7 5 6 4 5 4 5
Max 9 11 8 11 13 15 10 12
Minimum 3 5 2 4 2 2 2 4
Human resources
Average 5.37 6.07 6.11 7.17 5.06 6.17 4.14 5.40
Median 5 7 6 7 5 6 4 5
Max 11 12 9 10 11 13 7 8
Minimum 3 5 4 4 2 2 2 4
Organisation
Average 0.71 0.74 0.69 0.71 1.06 1.06 0.14 0.14
Median 1 1 1 1 1 1 0 0
Max 2 2 3 3 2 2 2 2
Minimum 0 0 0 0 0 0 0 0
Strategy
Average 6.37 7.89 6.60 7.63 4.06 5.34 5.94 7.03
Median 6 8 7 8 4 6 6 7
Max 9 11 9 10 7 8 9 10
Minimum 4 5 4 6 2 3 3 5
Innovation and IPR
Average 2.91 3.49 3.97 4.77 2.23 2.69 1.57 1.83
Median 3 3 4 4 2 3 1 1
Max 7 8 9 10 5 6 8 8
Minimum 0 0 0 0 0 0 0 0
Corporate governance
Average 2.63 3.57 3.17 3.83 3.14 3.91 4.09 5.09
Median 3 4 3 4 3 5 4 5
Max 5 5 5 5 6 6 6 7
Minimum 1 1 2 3 1 1 3 4
Table 6.5 Statistical data about the number of information
Number of information France Germany Italy UK

Customers and market 2001 2002 2001 2002 2001 2002 2001 2002
Average 14.06 14.86 9.77 11.00 8.60 10.80 9.89 11.00
Median 12 13 8 10 7 10 9 10
Max 29 31 19 21 27 31 37 41
Minimum 5 6 4 5 2 4 3 5
Human resources
Average 7.40 7.26 7.34 7.77 6.26 6.49 6.83 6.14
Median 7 7 7 7 6 6 7 6
Max 11 12 12 13 12 13 13 11
Minimum 4 5 5 5 2 4 4 4
Organisation
Average 0.71 0.74 0.69 0.74 1.09 1.17 0.14 0.14
Median 1 1 1 1 1 1 0 0
Max 2 2 3 3 3 3 2 2
Minimum 0 0 0 0 0 0 0 0
Strategy
Average 9.46 10.29 9.43 10.17 5.26 6.54 9.66 10.23
Median 9 11 10 10 5 6 9 10
Max 19 18 14 15 10 12 18 18
Minimum 5 6 5 6 2 4 5 6
Innovation and IPR
Average 3.69 4.03 4.80 5.17 2.71 3.23 2.26 2.51
Median 4 4 4 5 2 3 1 1
Max 11 13 11 13 10 12 13 12
Minimum 0 0 0 0 0 0 0 0
Average 4.63 4.97 4.09 4.86 4.06 4.71 6.74 6.77
Median 5 5 4 5 4 5 7 7
Max 8 8 6 6 8 8 11 11
Minimum 1 1 2 4 1 1 4 4
Table 6.6 Hexagons’ areas
Areas
Country 2001 2002
France 145.81 160.91
Germany 161.39 174.43
Italy 116.15 130.30
UK 72.92 82.89
Figure 6.5 European best practices on intangibles communication in 2001

fiscal year
Figure 6.6 European best practices on intangibles communication in 2001

fiscal year
Table 6.7 shows the European best practices scores for each communication
dimension in the two financial years considered. It can be noted that German practice
results to be the best in nearly all the communication dimensions, the only exception
being the Organisation dimension where Italian companies perform better.
Table 6.7 Highest scores per communication dimension on intangibles

representing the European Best Practices
European Best Practice

2001 2002
Customers & market 8.65 (Germany) 8.37 (France)
Human resources 9.68 (Germany) 9.86 (Germany)
Organisation 6.68 (Italy) 6.89 (Italy)
Strategy 10.55 (Germany) 10.81 (Germany)
Innovation & ipr 6.58 (Germany) 6.56 (Germany)
Corporate governance 9.86 (Germany) 11.81 (Germany)
Mandatory and Voluntary iInformation
In Appendix 6.D it is shown for each country what information on intangibles has a
mandatory or a voluntary nature.
It should be pointed out that it is not always straightforward to distinguish whether
one information is mandatory or not. The problem lies with the fact that disclosure
in annual reporting is very often more detailed than that prescribed by accounting
standards and regulations. Therefore, by looking at the relevant national accounting
rules and by interviewing a selection of accounting researchers of the countries
concerned, we have classified the information appearing in the annual reports of the
countries considered under mandatory or voluntary categories.
We can see that almost all the information found in annual reports are of
a voluntary nature. And this fact, as we have pointed out earlier on, could have
influenced our results, in particular contributing to make them more variable than we
anticipated (cf. high standard deviations).
In the Organisation dimension we do not have any mandatory disclosure, and in
fact this is the dimension with the lowest number of information found. With regards
to the other dimensions, we have at least one or two mandatory information required
by the accounting rules, even though we have anyway ascertained – especially for
Human Resources and Customers and Market dimensions – many different types of
information disclosed in company annual reports.
Conclusions
It is rather clear that the traditional financial statements are not able to provide detailed
information on the intangible assets that are key to the company. The absence in the
annual accounts of the valuation and disclosure of some intangible resources, which
do not meet the requirements for inclusion as assets in the accounts, is a strong
drawback of this document. This shortcoming contributes to the fact that the main
document through which companies have to disclose information, loses some of its
relevance (Lev and Zarowin 1999).
Disclosure, however, is to date the only possible solution to the scarce
representation of intangibles provided by financial statements. The model proposed
by the AIAF in collaboration with the University of Ferrara allows for representing,
both quantitatively and graphically, the results obtained from its application.
Furthermore, the model is suitable both for an inter-temporal analysis between the
financial statements of a group of companies analysed in respect to a period of time,
and for a comparison of companies active in various sectors, markets or countries.
This analysis has focused here only on annual reports. We could also have
extended it to social, sustainability and environmental reports and to presentations
to analysts. In this case, the analysis would have tended, however, to reward those
companies that produce all this information and to penalize those that neglect these
new forms of reporting.
It is clear, on the other hand, that the differences between the economic activities
carried out by the companies examined have a bearing on the results obtained. A
research concentrating on companies operating in the same sector could possibly
limit this downside.
In our analysis, we have furthermore attempted to use the most objective
valuation method possible, so that to reduce any valuation of subjective nature on
the part of the researcher which could mislead the results obtained. This does not
rule out that the same investigation carried out by different researches may lead to
different results, since there is no pre-set information research template. Taking as a
reference all the information provided in financial statements on the six dimensions
considered, we might think that the results obtained by two different observers
should not differ materially.
The results that emerge from our research are partly unexpected. The continental
European companies examined seem to supply much more information on intangible
assets than the UK companies considered. In general, the accounting rules of those
countries are thought to be highly conservative and influenced by factors of a fiscal
nature (e.g. Nobes and Parker 2002). However, it is not for this reason that these
companies appear to neglect the disclosure on intangible assets. Indeed, this type
of disclosure develops outside their conservative accounting rules and assumes the
nature of voluntary information. On the contrary, it is interesting to observe that
companies from a country such as the UK, with a strong and entrenched culture of
accounting standards, appear to provide, on average, a more limited disclosure on
such assets. These results are somewhat surprising. The UK companies considered
seem to provide a generally low level of information about intangible assets,
notwithstanding that in the international accounting textbooks this country is almost
invariably seen to occupy a high ranking in the accounting information spectrum,
possibly close to the United States (Nobes and Parker 2002; Meek et al. 1995).
Moreover, in the continental European companies examined there appears to be
a management attitude that is more favourably oriented towards the supply of non-
financial information, whilst UK companies’ managerial culture appears on average
to be more focused on the financial aspects and shareholder communication. Also
corporate governance information follows this trend.
Hence, the results here obtained seem to be at odds with the conventional wisdom
of international accounting studies concerning these countries.
Of course, these results are limited by, and contingent upon, the small number of
companies examined, even though these entities are economically very significant.
The sample group taken as a benchmark was designed to serve merely as an indication
of the reporting practices in the subject area of the national contexts investigated.
Another limitation is linked to the methodology adopted, and in particular to the
method devised to attribute a score to companies. This is in fact weak when facing
radical situations, such as, for example, when many companies have intangibles
disclosure equal to zero with reference to a given dimension/area. In this case,
the average score of the country (or of the analysed group of companies) for that
particular dimension will be close to zero, thus not rendering justice to any virtuous
organisations that depart from the communication behaviour generally pursued by
the others.
Notwithstanding these limitations, the outcomes and methodologies appertaining
to the current work appear to remain relevant. Given the ever increasing weight
that the problems linked to the accounting and reporting of intangibles have and
will have in realm of practice and academia, this analysis could represent the
foundation of other studies based on different company sample groups. Being still
at a developmental stage, the model itself should indeed be tested and possibly
improved, in order to further progress the measuring of company disclosure and
communication on intangible resources.
References
AIAF (Italian Association of Financial Analysts) (2002), The communication of

intangibles and intellectual capital: an empirical model of analysis, Official
Report no. 106, Milan, AIAF.
Bergamini I. (2002), La comunicazione sugli intangibles delle imprese italiane:
un modello di valutazione e di ranking [The Communication on Intangibles
by the Italian Companies: A Valuation and Ranking Model], Graduation thesis,
University of Ferrara, July.
Carriere G., Cowen A., Marco J. A., Monson D., Pievani F. and Rasker T. (2002),
European Corporate Governance: A changing landscape?, MIT Sloan School of
Management 50th Anniversary Research Project, October.
Gregory H. J. (2000), The globalisation of corporate governance, in Global Counsel,
September and October.
Lev B., Zarowin P. (1999), The Boundaries of Financial Reporting and How to
Extend Them, Journal of Accounting Research, Vol. 37, pp. 353-385.
Meek G. K., Roberts C. B. and Gray S. J. (1995), Factors influencing voluntary
annual report disclosures by U.S., U.K. and Continental European multinational
corporation, Journal of International Business Studies, Vol. 26, No. 3, pp. 555-
571.
Nobes C. W. (1992), International classification of financial reporting, II ed., London
and New York, Routledge.
Nobes C. W., Parker R. (2002), International and Comparative Accounting, VI ed.,
London-New York, Prentice Hall International.
OECD (Organisation for the Economic Co-operation and Development) (1999),
OECD Principles of Corporate Governance, OECD, Paris.
Stewart T. (1998), Real assets, unreal reporting, Fortune, Vol. 138, No. 1, July 6, p.
90.
Stewart T. (1995), Trying to grasp the intangible, Fortune, October 2, pp. 157-161.
Zambon S. (2002), Presentation of the AIAF’s Official Report no. 106 “The
communication of intangibles and intellectual capital: an empirical model of
analysis”, Milan, AIAF.
Appendix 6.A
List of Indicators Proposed by AIAF
“Strategy” communication dimension
Market analysis
Industry analysis
Competitors
Company’s competitive strategy
Products/Services: degree of diversification and exclusivity
Information sources for market analysis
Description and history of brands/licenses/copyrights
Internal growth vs. external growth
Business/manufacturing alliances
Product life cycle (description and company positioning)
Disclosure on corporate governance
Summary financial indexes (ROE, EVA, and so forth)18
“Customer & market” communication dimension
Total potential market

Active customers
Customers divided into categories
New customers
Number of sales outlets/affiliates/sellers (network)
Number of new sales outlets
Franchising agreements
Distribution channels (description)
Advertising expense for corporate campaigns
Recurring advertising expenses
Orders backlog
Time necessary for fully operational sales outlet
Contacts (audience, subscribers, visitors)
Level of customer satisfaction
Audience by time of day
Audience by type
Registered users
18 The AIAF list does not contain this item, though it is included in this dimension
in the analysis fact sheets for the new companies considered by the Association. It was
recommendable, then, to include this item in the list, also in view of the considerations
illustrated in section 3.
Active users
One-time visitors
Number of pages visited on the site
Average duration of site visit
Number of registered domains
Number of servers hosted
“Human Resources” communication dimension
Employees
Employees by category
Employees per division
Incentives by category
Company benefits policy
Top management’s track record
Degree of management alignment to strategy
Education level
Average age
Seniority in company
Average time of employment and seniority in company
Training programs
Training programs by category
Training expenses
Turnover
Turnover by category
Ability to attract qualified human resources
Degree of employee satisfaction
Versatility indexes
Multi-skill indexes
“Organisation” communication dimension
Company organisational Graphic (decision structure)

Plants/headquarters/location
Number of suppliers
Supplier turnover
Average supplier payment conditions
Average cost of capital
Indication of legally protected intangible assets
Seniority intangibles rights ownership
Cohesiveness of company culture
Licenses sold
Licenses paid
Information system description
Network connections
Internet connections
Database consultations (shared knowledge)
Database contributions (shared knowledge)
“Process & Innovation” communication dimension
Internal research (initial stage)

Projects developed internally (development stage)
Ongoing research
New product development (design, implementation)
New ideas
Number of publications
Technology used
Technologies in competition
Productivity indicators
Appendix 6.B
Sample
French companies
Companies Sectors
1 Accor S.A. Lodging
2 Alcatel S.A. Communications Technology
3 Aventis S.A. Pharmaceuticals
4 Bouygues S.A. Heavy Construction
5 Carrefour S.A. Food Retailers & Wholesalers
6 Casino Guichard-Perrachon et Cie. S.A. Food Retailers & Wholesalers
7 Christian Dior S.A. Clothing & Fabrics
8 Compagnie de Saint-Gobain S.A. Building Materials
9 Compagnie Generale des Etablissements Michelin Tires
10 Essilor International S.A. Medical Supplies
11 European Aeronautic Defence & Space Co. EADS Aerospace
12 France Telecom Fixed-Line Communications
13 Groupe Danone Food Products
14 Lafarge S.A. Building Materials
15 Lagardere Groupe Publishing
16 L’Air Liquide S.A. Chemicals Specialty
17 L’Oreal S.A. Cosmetics
18 LVMH Moet Hennessy Louis Vuitton Clothing & Fabrics
19 Pechiney S.A. Aluminium
20 Pernod Ricard S.A. Distillers & Brewers
21 Peugeot S.A. Automobile Manufacturers
22 Pinault-Printemps Redoute S.A. Retailers Broadline
23 Publicis Groupe S.A. Advertising
24 Renault Automobile Manufacturers
25 Sanofi-Synthelabo Pharmaceuticals
26 Schneider Electric S.A. Electric Components & Equipment
27 Sodexho Alliance S.A. Restaurants
28 STMicroelectronics N.V. Semiconductors
29 SUEZ Electric Utilities
30 Television Francaise 1 S.A. Broadcasting
31 Thomson Consumer Electronics
32 Total S.A. Oil Companies Major
33 Veolia Environnement S.A. Water Utilities
34 Vinci S.A. Heavy Construction
35 Vivendi Universal Broadcasting
German companies
Companies Sectors
1 Adidas-Salomon AG Footwear
2 Altana AG Pharmaceuticals
3 BASF AG Chemicals Commodity
4 Bayer AG Chemicals Commodity
5 Bayerische Motoren Werke AG Automobile Manufacturers
6 Beiersdorf AG Cosmetics
7 Celanese AG Chemicals Commodity
8 Celesio AG Retailers Drug-Based
9 Continental AG Tires
10 DaimlerChrysler AG NA Automobile Manufacturers
11 Deutsche Lufthansa AG Airlines
12 Deutsche Post AG Air Freight
13 Deutsche Telekom AG Fixed-Line Communications
14 Dr. Ing. h.c. F. Porsche AG Automobile Manufacturers
15 E.ON AG Electric Utilities
16 Fresenius Medical Care AG Healthcare Providers
17 HeidelbergCement AG Building Materials
18 Henkel KGaA Pfd. Household Products Nondurable
19 Infineon Technologies AG Semiconductors
20 Linde AG Chemicals Specialty
21 MAN AG Industrial Diversified
22 Merck KGaA Pharmaceuticals
23 Metro AG Food Retailers & Wholesalers
24 ProSiebenSAT.1 Media AG Broadcasting
25 Puma AG Rudolf Dassler Sport Footwear
26 Qiagen N.V. Advanced Medical Devices
27 RWE AG Electric Utilities
28 SAP AG Software
29 Schering AG Pharmaceuticals
30 Siemens AG Communications Technology
31 Stada Arzneimittel AG Pharmaceuticals
32 ThyssenKrupp AG Steel
33 T-Online International AG Internet Services
34 TUI AG Recreational Products & Services
35 Volkswagen AG Automobile Manufacturers
Italian companies
Companies Sectors
1 Acea S.p.A. Electric Utilities
2 Alitalia S.p.A. Ord Airlines
3 Arnoldo Mondadori Editore S.p.A. Ord Publishing
4 Autogrill S.p.A. Restaurants
5 Autostrade S.p.A. Transportation Services
6 Azienda Energetica Municipale S.p.A. Electric Utilities
7 Benetton Group S.p.A. Clothing & Fabrics
8 Bulgari S.p.A. Clothing & Fabrics
9 Caltagirone Editore S.p.A. Publishing
10 Compagnie Industriali Riunite S.p.A. Ord Industrial Diversified
11 e.Biscom S.p.A. Fixed-Line Communications
12 Edison S.p.A. Electric Utilities
13 Enel S.p.A. Electric Utilities
14 ENI S.p.A. Oil Companies Major
15 Fiat S.p.A. Ord Automobile Manufacturers
16 Finmatica S.p.A. Software
17 Finmeccanica S.p.A. Aerospace
18 Gruppo Editoriale l’Espresso S.p.A. Publishing
19 Impregilo S.p.A. Ord Heavy Construction
20 Italcementi S.p.A. Building Materials
21 Luxottica Group S.p.A. Clothing & Fabrics
22 Manifattura Lane Gaetano Marzotto & Figli S.p Clothing & Fabrics
23 Mediaset S.p.A. Broadcasting
24 Merloni Elettrodomestici S.p.A. Ord Furnishings & Appliances
25 Parmalat Finanziaria S.p.A. Food Products
26 Pirelli & C. Ord Electric Components & Equipment
27 RCS MediaGroup S.p.A. Publishing
28 Recordati S.p.A. Ord Pharmaceuticals
29 Saipem S.p.A. Ord Oil Drilling Equipment & Services
30 Seat-Pagine Gialle S.p.A. Publishing
31 Snam Rete Gas S.p.A. Gas Utilities
32 Snia S.p.A. Ord Advanced Medical Devices
33 Telecom Italia Mobile S.p.A. Wireless Communications
34 Telecom Italia S.p.A. Fixed-Line Communications
35 Tiscali S.p.A. Internet Services
UK companies
Companies Sectors
1 Allied Domecq PLC Distillers & Brewers
2 Amersham PLC Biotechnology
3 Anglo American PLC Mining
4 Astrazeneca PLC Pharmaceuticals
5 BAA PLC Transportation Services
6 BAE Systems PLC Aerospace
7 BG Group PLC Oil Companies Secondary
8 BHP Billiton PLC Mining
9 Boots Group PLC Retailers Drug-Based
10 BP PLC Oil Companies Major
11 British American Tobacco PLC Tobacco
12 British Sky Broadcasting Group PLC Broadcasting
13 BT Group PLC Fixed-Line Communications
14 Cadbury Schweppes PLC Food Products
15 Centrica PLC Gas Utilities
16 Compass Group PLC Restaurants
17 Diageo PLC Distillers & Brewers
18 GlaxoSmithKline PLC Pharmaceuticals
19 GUS PLC Retailers Broadline
20 Imperial Tobacco Group PLC Tobacco
21 Kingfisher PLC Retailers Specialty
22 Marks & Spencer Group PLC Retailers Broadline
23 mmO2 PLC Wireless Communications
24 National Grid Transco PLC Electric Utilities
25 Pearson PLC Publishing
26 Reckitt Benckiser PLC Household Products Nondurable
27 Reed Elsevier PLC Publishing
28 Rio Tinto PLC Mining
29 Scottish & Southern Energy PLC Electric Utilities
30 Scottish Power PLC Electric Utilities
31 Shell Transport & Trading Co. PLC Oil Companies Major
32 Tesco PLC Food Retailers & Wholesalers
33 Unilever PLC Food Products
34 Vodafone Group PLC Wireless Communications
35 WPP Group PLC Advertising
Appendix 6.C
Results
France
15
10
0
CUST. & HUMAN RES. ORGANIS. STRATEGY R&D CORP. GOV.
MRK
FRANCE 2001 FRANCE 2002
Germany
15
10
0
CUST. & HUMAN ORGANIS. STRATEGY R&D CORP. GOV.
MRK RES.
GERMANY 2001 GERMANY 2002

Italy
15
10
0
MRK
ITALY 2001 ITALY 2002
UK
15
10
0
MRK
UK 2001 UK 2002
Appendix 6.D
Mandatory and Voluntary Disclosure
France Germany Italy U.K.

List of information/
Type of Type of Type of Type of
disclosure on intangibles
information information information information
Strategy Mand. Volun. Mand. Volun. Mand. Volun. Mand. Volun.
Strategies x x x x
Focus, vision and mission x x x x
Strategic agreements x x x x
Objectives x x x x
Social responsibility x x x x
Environmental Policy x x x x
Risk management x x x x
Strategic position x x x x
Regulatory environment x x x x
Value drivers or key
x x x x
competitive advantages
Targets x x x x
Security program x x x x
Organisation
Company organisational chart x x x x
Indication of legally protected
x x x x
intangible assets
Company culture x x x x
Information system description x x x x
Description of organisational
x x x x
change
Human resources
Number of employee x x x x
Employee by category x x* x x
Employee by division x x x
Employee by region x x x
Employee by type of contract x x x x
Incentives by category x x x x
Company benefit policy x x x x
Employee policy x x x x
Educational level x x x x
Average age x x x x
Seniority in company x x x x
Training program x x x x
Number of male and female x x x x
Employee target x x x x
Number of apprentices x x x x
Board members x x x x
Board activities and
x x x x
responsibilities
Ethical code x x x x
Committee members x x x x
Committee activities and
x x x x
responsibilities
Internal control x x x x
Description of other firm
x x x x
bodies
Investor relations x x x x
Relationships between
x x x x
different board or committee
Combined code x x x x
Customers and market
Total potential market x x x x
Market position x x x x
Competitors x x x x
Active customers x x x x
Customers divided into
x x x x
categories
Market analysis x x x x
Industry analysis x x x x
Orders backlog x x x x
New customers x x x x
Number of sales outlets x x x x
Distribution network x x x x
Contacts (audience,
x x x x
subscribers, visitors)
Level of customer satisfaction x x x x
Registered users x x x x
Active users x x x x
Number of pages visited on
x x x x
the site
Market served x x x x
Market penetration index x x x x
Competitive environment x x x x
Description of brands/licenses/
x x x x
copyrights
Target customers served x x x x
Name of some customers x x x x
Number of supplier x x x x
Innovation and IPR
R&D activities x x x x
Projects developed internally x x x x
New product development x x x x
Technology used x x x x
R&D laboratory x x x x
R&D objectives x x x x
R&D partnerships x x x x
Number of researcher x x x x
Notes
* German companies show a disclosure of employees articulated according to different
criteria (division, category, region).
Chapter 7
Credit Rating and Intangible Assets:

A Preliminary Inquiry into
Current Practices
Adele Del Bello
Introduction
It is well-known that the today’s fundamental role carried out by the rating agencies
to foster transparency in, and to guarantee the efficient running of, financial markets
is essentially dependent upon a concise and effective communication device, i.e.
the rating. The larger importance of this evaluation tool over the recent years is
basically amenable to three interconnected factors: the gradual market diversification
(companies, government, public utilities, etc.); the accelerated integration between
markets, which implies the need for more reliable information; and the strong IT
development, which induces the necessity to take rapid and effective decisions on
the basis of credible and relevant information.
In these very years, the nature itself of companies has quite dramatically changed.
The traditional relevance of stock, fixed assets and debtors has increasingly shifted
in favour of assets such as goodwill, brands, intellectual properties, know-how and
formulas and, more in general, intangible resources and liabilities that do not find
any representation in conventional company annual reports. This shift has made in
parallel company value calculation and risk assessment procedures more complex and
problematic. Indeed, the value of, and the risks related to, intangibles are significantly
linked also to the qualitative (i.e., non-financial) aspects of company activity, which
have progressively gained in importance versus the financial criteria.
In this different company and valuation environment, the responsibility of rating
agencies is bound to further expand in relation to their function and distinctive ability
to process information of different types and sources, and to perform a credible
company appraisal on this basis.
Therefore, in the light of the above premises, and especially considering the wide
influence exerted by the rating agencies in issuing synthetic and almost universally
recognised evaluations, it appears significant to devote some attention to what
are the methods and methodologies used by such organisations in producing their
reports and ratings. Accordingly, the present study intends to examine the credit
rating practices adopted by the three most important rating agencies in the world, i.e.
Standard & Poor’s, Moody’s, and Fitch.
It has to be clarified, though, that the purpose of this chapter is not to study the
whole rating assignment process, but to focus on whether, how and to what extent
credit rating agencies consider intangible assets, and what is the weight attributed
to such assets in the above process. In this sense, the present research is neither
addressed to investigate financial aspects of the rating assignment, nor the role of
the whole class of qualitative (non-financial) aspects in the rating practice, yet it is
limited to a sub-class of such aspects, i.e. that of the intangible assets and liabilities.
It has also to be pointed out that the analysis is deliberately centred on the long-term
credit ratings, since intangible resources, being qualitative in character, are expected
to have a greater influence on these valuations than on the short-term ones.
Moving from the hypothesis that the more intangible assets a company owns,
the higher will be its credit rating, another thrust of the study is to verify whether
rating agencies have developed a formalised procedure or some commonly accepted
guidelines in order to facilitate the assessment of intangibles in the credit rating
assignment process.
The methodology used is twofold: a content analysis of the rating methods
publicly available in 2005 on the websites, as well as semi-structured interviews
conducted with analysts from the above mentioned rating agencies. The decision
to support the content analysis of the methodologies with such interviews is based
on the conviction that the former do not allow the researcher to fully capture all the
content and meaning nuances hidden in the analysts’ choice of their practices.
The chapter is structured as follows. The second section provides the reader with
some of the main rating definitions and concept, as well as some brief historical
notes about the three rating agencies studied. The third section deals with the content
analysis of the rating methodologies; for each rating agency the results are presented
by category of intangible resource, following basically the three categories suggested
by the literature, in order to help the practices’ comparability. Section four shows the
results emerging from the semi-structured interviews carried out with the analysts.
In this section the outcomes are presented by type of questions that are, in turn,
organised by category of intangible resource. The answers to the interviews are
intentionally not presented by rating agency for confidentiality reasons. The main
findings and some concluding remarks and critical comments are presented in the
final section.
Main Rating Definitions and Concepts and Brief Notes about S&P, Moody’s
and Fitch
What is a debt or credit rating?
A credit rating is an opinion by an external and independent organism (the rating

agency) of an issuer/obligor’s capacity to fulfil its bond obligations1, with respect
to principal and interest payments and to further eventual financial obligations.
This opinion finds expression in a synthetic judgement, generally represented by
1 This study focuses on the long-term bond obligations.

Credit Rating and Intangible Assets: A Preliminary Inquiry into Current Practices 167
an alpha-numerical character, which is sometimes accompanied by “+” and “-”
modifiers within the same category. This value allows stakeholders to compare the
risks associated to different bonds offered on the market (from both a geographical
and an industry point of view); therefore it is possible to choose the best investment
alternative given a specific purpose (investment or speculation) of the investor.
The judgement is based both on public and on confidential data and information,
and it is carried out in order to assess the issuer capacity to generate and keep cash
flows (which repay the debt). Some of the most relevant elements of a company taken
into account are the present and future financial conditions, as the characteristics of
the industry and environment in which it acts.
The credit rating is not a suggestion to buy, maintain or sell a bond.2 Nor does it
comment on the suitability of an investment for a particular investor. In fact these
issues depend on some patrimonial characteristics of the bond, price volatility and on
the investor risk propensity. Nevertheless, given its capacity to provide stakeholders
with the bond default probability,3 the credit rating is often improperly read as a
suggestion for investment.4
Ratings can be classified on the basis of the two following variables:
1) The subject requiring the rating;

a) rating required by the issuer itself;
b) rating required by external institutions (e.g. institutional investors); and
c) rating autonomously provided by a rating agency.
2) The “confidentiality” of the rating, according to which one can distinguish

between:
a) public rating, and
b)confidential rating (also called indicative rating).
In case 1b. and 1c., if the company does not know about the rating, this is called
shadow rating.
Phases of the rating evaluation process and credit rating scales used
In general, the rating evaluation process follows four phases:
2 Actually many analysts state that there is a correlation between the rating and the
suggestion to buy/maintain/sell the bond, likewise the security prices, even if the causal link
between these variables is still unclear.
3 According to Fitch Ratings definition “a company has defaulted if it fails to make
a timely payment of principal and/or interest. Defaults includes any bankruptcy filings or
distressed exchanges, in which bond investors were offered securities with diminished
structural or economic terms compared with existing bonds”.
4 A research leaded by Moody’s showed the negative correlation between the rating and
the default probability (Cantino, p. 77).
a) a preliminary meeting;
b) analysis of the information collected;
c) rating assignment and publication (only if the rating is public); and
d) monitoring.
A preliminary meeting between the analysts team and the company managers is
required in order to collect information from both the documentation offered by the
entity, and the interviews conducted with the managers, which are focused especially
on qualitative aspects, such as company culture, strategy and management value.
The second phase, taking normally about two months, is represented by the
process of analysis of the information collected, with the aim of providing a general
evaluation of company financial condition and risk.
After having examined all the information collected, the analysts confer a
synthetic score accompanied by the relative justification. The issuer is free to accept
the rating or to ask the analysts its revision on the basis of further information (third
phase). The publication phase does not occur when the rating is asked uniquely for
internal purpose (confidential rating).
Finally, the fourth phase implies a periodical activity of monitoring through
financial data, updated information received from the company, and further meetings
between management and analysts.
Table 7.1 presents the rating scales employed by Standard & Poor’s, Moody’s
and Fitch for mid-long term bonds.
Table 7.1 Rating scales for mid-long term bonds (due beyond 12 months)
Source: adapted from Cantino, 2003, p. 66.
Capacity to meet financial obligations Standard & Poor’s Moody’s Fitch

Investment-Grade
Absolute AAA Aaa AAA
Very high AA* Aa 1,2,3** AA
High A* A 1,2,3** A
Likely BBB* Baa 1,2,3** BBB
Adequate Ba 1,2,3** BB
Speculative-Grade
Adequate BB*
In the short term B* B 1,2,3** B
Immediate CCC* Caa 1,2,3** CCC
Unlikely CC Ca CC
Almost null C C C
Insolvent D DDD,DD,D
* These ratings can be modified by the addiction of a plus or a minus sign to show relative standing
within the major rating categories.
** The numerical modifier 1 indicate that the obligation ranks in the higher end of its generic rating
category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower
end.
Brief historical notes about Standard & Poor’s, Moody’s and Fitch
Standard & Poor’s, Moody’s and Fitch IBCA are the three most important rating
agencies in the world.
Standard & Poor’s Rating Services was founded in the USA in 1916 and is now
a business unit of the editorial group “McGraw-Hill”. It was the first rating agency
that made public its rating criteria and procedures. It was also the first rating agency
to offer an on-line information service and to publish a weekly rating review.
Moody’s investor service was set up in New York in 1900 by John Moody. In
1909 Moody introduced the scale of standard symbols (letters) for the evaluation of
the credit capacity. In 1924, almost the whole American bond market was assessed
by Moody’s. Today Moody’s is included in the group Dunn & Bradstreet.
Fitch was founded in 1913 in New York and grew in importance and size during
the nineties, through a mergers and acquisitions policy. Indeed, in 1997 Fitch investor
service, American group leader in financial industry, merged with the European
group IBCA, group leader in banking and companies. In June 2000 Fitch acquired
Duff and Phelfs Credit Rating Co (DCR). Fitch Rating is a wholly owned subsidiary
of European-based Fimalac and it is the only European-owned rating agency. In the
last years, Fimalac has also launched CoreRatings, a global rating agency providing
only qualitative risk analysis.
Content Analysis of the Credit Rating Methodologies
The rating evaluation process judges both quantitative and qualitative company’s
aspects, but this section is specifically dedicated to the analysis of the rating
methodologies used by Standard & Poor’s, Moody’s and Fitch in assessing intangible
assets. In particular, the documents analysed are the “Criteria reports” and the
“Special reports” 5 available in the official websites of the agencies. For each rating
agency the methodologies’ description has been structured by category of intangible
resource, in order to help the comparison between the three agencies. The categories
employed are the same suggested by literature, which divides the intellectual capital
(the whole set of intangibles) in three categories: relational capital, organisational
capital and human capital. In addition to these categories, two further aspects that are
intangible in nature are investigated: company strategy and its corporate governance.
These are discussed separately from the three above categories because they deal at
the same time with all the above categories.
A comparative table, summarising the main outcomes emerged from the content
analysis, is presented at the end of this section.
5 “Criteria reports” usually include credit rating methodologies with a general validity,
while “Special reports” refer to specific industries or issues. For more information see the
references section.
Standard & Poor’s
In assigning its credit ratings Standard & Poor’s considers two broad categories of
risks:
• Business risk: industry characteristics, competitive position, management,

business strategy; and
• Financial risk: financial policy, profitability, capital structure, cash flow
protection, financial flexibility.
Intangible resources affect directly the business risk, while evaluation of the
financial risk is totally based on financial data, therefore we will concentrate the
analysis only on the first category of risk.
Other key rating factors are the overall strategy, leverage tolerance level and
goals, and shareholders value considerations.
Human Capital Management is assessed for its role in determining operational

success (financial performance goals) and also for its risk tolerance. The first aspect
is incorporated in the competitive position analysis; the second is weighted as a
financial policy factor. Opinions formed during the meetings with senior management
are as important as management track record. While a track record may seem to offer
a more objective basis for evaluation, it is often difficult to determine how results
should be attributed to management skills. In fact, the analyst must decide to what
extent they are the result of good management, or achieved despite management.
Plans and financial policies have to be judged for their feasibility. The way they
are implemented determines the view of management consistency and credibility.
This can become a critical issue when a company is faced with stress or restructuring,
and the analyst must decide whether to rely on management to carry out plans for
restoring credit-worthiness.
The significant reliance on an individual, especially one who may be close to
retirement, is also considered as a negative factor.
Relational Capital As already pointed out, the firm’s competitiveness within

the industry is one of the relevant features to assign the credit rating. It includes
investigations about marketing, technology, quality/price of products/services,
distribution capabilities, customer service etc. For some particular companies, one
or more factors can hold special significance, even if those factors are not common
to the industry.
Market share analysis often provides important insights. However large shares
are not always synonymous with competitive advantage or industry dominance.6
6 For instance, if an industry has a number of large but comparable-size participants,

none of them may have a particular advantage or disadvantage. Conversely, if an industry
is highly fragmented, even the large firms may lack pricing leadership potential. The textile
industry is an example.
The competitive position depends also upon the product diversification. When a
company participates in more than one business, each segment is separately analysed
weighting each element according to its importance to the overall organisation. S&P
analysts bear in mind that a firm is not diversified since its success was still determined
substantially by one line of business. Limited credit will be given if the various
lines of business react similarly to economic cycles. For example, diversification
from nickel into copper cannot be expected to stabilise performance because similar
risk factors are associated with both metals. Most critical is a company’s ability
to manage diverse operations. The ever-changing character of company assets is
typically viewed as a negative aspect. On the other hand, there is often an off-setting
advantage: greater flexibility in raising funds if each line of business is a discrete
unit that could be sold off.
Analysts also take into account the way the company is seen by the community
i.e:
• its reputation which is also part of the competitive position; and
• its standing within its home financial community (access to bank financing).
Both these factors can influence company capacity to repay its obligations.
Organisational Capital One of the organisational aspects examined by S&P

is company size. S&P has no minimum size criterion for any given rating level.
However, size usually provides a measure of diversification and often affects
competitive issues. Obviously, the need to have a broad line or national marketing
structure, is a factor in many businesses and would be a rating consideration. In
this sense, sheer mass is not important; demonstrable market advantage is. Small
companies also can possess the competitive benefits of dominant market positions,
although that is not common. However, small companies are almost by definition,
more concentrated in terms of product, number of customers, or geography. In effect,
they lack some element of diversification that can benefit large firms. In addition,
lack of financial flexibility is usually an important negative factor in any case of very
small firms.
The level of innovativeness and of technology used is also crucial.
Strategy As enlighten above, the strategy assessment is part of the management

evaluation process. In order to stress the crucial role of this topic in obtaining the
final rating, it is worth to mention at this point that in 1998, S&P formalised its rating
advisory role under the name Rating Evaluation Service (RES). S&P analyses the
potential credit impact of alternative strategic initiatives, establish a definitive rating
outcome for each, and share these with management.
S&P evaluation is sensitive to potential organisational problems as well. These
include situations where: the relationship between organisational structure and
management strategy is unclear, shareholders impose constraints on management
prerogatives.
Corporate Governance Other important issues are related to a company’s ownership

structure. Without a guarantee or other form of formal support arrangement, a state-
owned corporate issuer does not intrinsically carry the same level of credit risk as
its sovereign owner. Nevertheless, state ownership can bolster a company’s credit
profile through implicit support. The analysis of an issuer on a stand-alone basis
allows the rating to reflect both the likelihood of the issuer needing to seek external
state support and the likelihood ton receiving such support.
There are both positive and negative implications of group affiliation. In many
cases, a company may benefit from operating relationships or greater access to
financing. Conversely, a company’s group affiliation could bring responsibility for
providing support to weaker group companies. S&P assesses whether constraints on
group influence, such as an external minority interest position, justify rating an issuer
on a stand-alone basis. If not, the analysis attempts to incorporate the economic and
financial trends in the issuer’s affiliate group as well. Affiliation between a stronger
and a weaker entity will almost always affect the credit quality of both, unless the
relative size of one is insignificant. A weak subsidiary owned by a strong parent will
usually, although not always, enjoy a stronger rating than it would on a stand-alone
basis. A strong subsidiary owned by a weak parent generally is rated no higher than
the parent. The reason for this is:
• the ability of an incentive for a weak parent to take assets from the subsidiary
or burden it with liabilities during financial stress; and
• the likelihood that a parent’s bankruptcy would cause the subsidiary’s
bankruptcy, regardless of its stand-alone strength.
Both factors argue that, in most cases, a “strong” subsidiary is no further from
bankruptcy than its parent, and thus cannot have a higher rating.
Formal support, such as guarantee, by one parent or sponsor ensures that the debt
will be rated at the level of the support provider. When the default risk is considered
the same for the parent and its principal subsidiaries, they are assigned the same
corporate credit rating. Obviously the opinion may reflect the creditworthiness of
guarantors, insurers or other forms of credit enhancement on the obligation.
Moody’s
Moody’s methodologies are characterised by an explicit focus on transparency and

disclosure quality (extent and reliability - quality is more important than quantity),
because in this rating agency experience a lack of transparency is often used to
obscure problems and on management quality.
Human Capital Moody’s attempts to form an opinion of management’s quality and

motivation. The first aspect to be analysed is its track record. This depends upon the
ability of the management to respond to its challenges. In this sense, the following
aspect are investigated:
• management experience and competency;

• management credibility and reliability also examining whether its goals and
ambitions are adequate to the context of the firm’s economic, competitive and
regulatory environment; and
• management appetite for risk (financial culture,7 propensity towards share
buybacks and dividends,8 appetite for acquisitions9).
It is also examined as to whether a company is run by a dominant CEO or by

a board together with a cohesive team. Dominant CEO can be useful in pushing
through overdue change and in making decisive strategic initiatives, but a dominant
CEO all too often becomes a domineering CEO, with the results that expertise and
opinions of other senior mangers are ignored. There is also the problem that a bank
can lose direction if a dominant CEO suddenly leaves the bank.
Rapid turnover is usually indicative of dysfunctions in corporate governance.
There is also a review of the “second tiers” managers, who implement strategies
formulated by the board and the senior management.
From 1999, Moody’s provides institutional investors with Management Quality
Ratings (MQs). These are appraisal of asset management companies (investment
management of institutional and/or retail asset), custodian banks (process and
safekeeping of securities), and administrative service providers (pricing and
accounting of securities, fund and other pooled investments). MQ ratings are different
from traditional debt ratings, in that they do not apply to a management company’s
ability to repay a fixed financial obligation of its own, or satisfy contractual financial
obligations which it may have been entered into through an actively managed
portfolio,10 In fact, they assess an entity’s organisational structure, risk management
capabilities and operational controls, and provide the market with an opinion on
the overall quality of the organisation including management characteristics and
operational practices. Ratings are expressed in the form of a scale ranging from
MQ1 (excellent) to MQ6 (unsatisfactory). 11
In the following list, some of the fundamentals examined by Moody’s when
assessing an MQ rating are presented.
7 For instance a strategy of higher return on equity implies high leverage, this means
higher risk for bondholders.
8 The focus is on the impact that buybacks can have on the level of debt relative to cash
flow, and on their timing.
9 Acquisitions are not inherently negative. Moody’s focuses on factors like coherence
with the company strategy, price and mode of financing acquisitions, and possible risks
associated with integration.
10 Nevertheless, it seems worth at this point to mention this new service to show that
rating agencies focus more and more on qualitative aspects, and in particular on human capital
characteristics.
11 The scale used for Management Quality Ratings is the following:
• MQ1: excellent management;
• MQ2: very good;
• MQ3: good;
• MQ4: average;
• MQ5: adequate;
• MQ6: unsatisfactory.
• Organisational structure: ownership structure and relationship to parent or
related entity; size of firm; market share; number of employees; number and
type of product offered, and so on. It is important in determining the firms
overall ability to exercise timely, accurate and properly authorised control
over the many diverse activities involved in its obligations.
• The assessment is based on discussion with senior management and key
employees, on the examination of internal documents (e.g. procedure manuals),
and on the review of past practices. It is important to note that Moody’s does
not only evaluate the structure by itself, but also whether it is appropriate to
the size of the firm, and whether the firm utilizes its resources effectively.
• Management quality, strategy and the investment decision making process.
The loss of key personnel, particularly members of senior management and
leading portfolio managers are also controlled because they could have an
adverse effect on investment performance. In addition there is a review of the
contingency plans and systems for sharing information (IT).
• Risk management: practices and procedures a company uses to manage
business risk.12
• Client servicing: general quality of servicing.
Relational Capital One of the most relevant aspects of Moody’s credit analysis is
the “franchise strength”,13 that is the company ability to generate – on the basis of its
competitive advantage – a reasonable risk-adjusted return on capital in the foreseeable
future. It is considered both a company’s overall market and its position in the market
(a strong market share for example may give the company pricing power).
The key components of franchise strength are the following:
• product/service offering: level of innovation, expected long-term trends for

volume growth;
• market presence: Moody’s does not judge a strong presence in the emerging
economies as an absolute positive, and conversely, a strong presence in
developed markets as an absolute negative. Other factors can have a critical
influence (size, products/services quality).
A trait that may provide franchise strength is diversification, because it can reduce
the volatility of a firm’s asset quality, earnings and cash flows. Once a company’s
strength is established, it is analysed whether its competitive advantage is defensible
and sustainable in the long-term.
The distribution strategy is also important because it may provide flexibility in
terms of costs and business volume management: brick network (number of branches
and locations, whether they are within department stores or shops and the number
12 Some examples of risk are the technology risk (associated to inadequacy or malfunction
of computer systems); strategies risk (associated to bad decision policies); reputation risk
(associated to bad publicity); product risk (associated to a specific product/service), and so
on.
13 Sometimes it is also called “franchise value”.
of independents); telephone, internet, mailing, geographic presence. Distribution is
particularly important for banks and insurances; they analyse the type of markets
a company serves, the cost structure of its distribution network, and the retention
and productivity of distribution as well as a company’s ability to control its own
distribution and, by extension, its ultimate customers. The exclusive or non-exclusive
nature of various distribution relationships may also pose opportunities or risks for
individual company.
The market presence is also affected by the brand value, that is one of the most
important and most elusive of the qualitative factors to analyse. Brand equity
describes the degree of attachment or loyalty of consumers to company products. If
this attachment is strong, consumers have higher propensity to pay higher price for
the products and a lower propensity to consider competitive products. Brand equity
is built through advertising and promotional expenditures: Moody’s found that
generally, the higher the spending over the medium-term, the higher a company’s
margins are over the medium-term. In gauging a company’s brand equity, Moody’s
asks three questions: “How high and how sustained is brand equity spending?”,
“How committed is management to sustained brand building?”, “How much of the
spending is truly brand building?”.
The value of a firm’s intellectual property is another component of relational
capital which is inextricably tied to company value. Intellectual property can consist
of various items including trade names, trademarks, contract rights, and so on.
Moody’s typically does not isolate the specific component of IP, but rather puts a
value to the whole IPs – seen in a holistic perspective – based on an overall enterprise
valuation. Yet, there are certain cases in which it makes sense to value certain
components separately. For example, the film library of a movie company could be
separately valued because it would have an intrinsic and separate worth. The ability
to protect IP for extended period (e.g. pharmaceutical) provides a substantial barrier
to entry and supports the sustainability of high gross margins, once a new product
has been brought to the market.
A further crucial aspect that is investigated by the analysts is the quality of the
customer service; it is evaluated for example through the retention rate, the level of
sales etc.
Organisational Capital What is most important for Moody’s in order to evaluate

the financial strength of a company, is not only its size but also, and especially, its
level of innovativeness in products or services. This is assessed also though the
level of R&D expenses. Furthermore, Moody’s looks at the investment in and use of
technology, as key drivers of credit-worthiness.
Strategy A review of the strategy includes the firm’s long-term vision, risk-return
appetite, attitudes towards financial and operating leverage, strategies for raising
capital and view of shareholder value creation. The growth strategy of acquisitions,
joint-ventures or strategic alliances, can alter a company risk profile too.
Corporate Governance Moody’s also refers to ownership structure aspects.

Emphasis is put on partnership as a key driver of expansion.
Strong and committed shareholders can have a positive influence on the financial
strength and consequently on the debt ratings. Much depends on whether a small
group of committed shareholders exercises effective control over the company, or
whether ownership is dispersed amongst a large number of shareholders.
Succession issues are also considered in family-owned companies.
The privatisation of banks in Europe generally leads to higher credit ratings
because private shareholders tend to demand higher rates of return than governments,
and this forces management to focus on profitability and efficiency.
Private and public companies may be subject to conflicting pressures from
shareholders. With private companies, they take into account whether a company is
a pure independent, a captive finance company that finance its owner’s products, or
a strictly financial subsidiary of a larger entity.
Moody’s analysts also examine the many different forms of parental supports
provided by financially stronger entities to subsidiaries, affiliates or other related
entities with lower intrinsic credit quality than issue debt. Such support mechanisms
are an important rating factor for the debt issued by the supported entity. In many,
but not all cases, the debt issued by the supported entity is rated as the same level
as that of the supporting entity. Some of the elements considered by Moody’s to
evaluate the support mechanisms are the credit quality and the guarantees provided
(structures and terms)14 by the supporting entity, the intrinsic credit quality of the
supported entity on a standalone basis, and the incentive of the supporting entity to
provide support15 (the last one in case of maintenance agreements).
The equilibrium of responsibility, the adequacy of delegation mechanism, the
middle management involvement in the decision making process and the presence
of conflicts of interests between shareholders and policyholders, are also taken into
account.
Fitch
The three basic areas of interest examined by Fitch in order to confer a credit
rating are company risk, the financial risk, and the financial flexibility.16 Some of
the most important intangibles such as market position, organisational structure and
management, are included in the first of these areas (company risk). The “company
risk” is often also called “economic” or “qualitative” risk, and it differentiates from
financial risk because it focuses more on qualitative than on financial aspects of
company activity. These qualitative aspects differ from financial ones also as they
have a longer-term effect. What seems interesting, is that the weight of qualitative
14 If the credit substitution is unconditional, irrevocable, enforceable and on time the

rating will be in the range of A.
15 For instance, analysts try to understand whether there is a common interest between
the supporting and the supported entity.
16 The financial flexibility is defined as the issuer capacity to meet debt obligations
against economic scenarios reasonably adverse to its specific circumstances.
characteristics compared to financial, on the final credit rating is not always the
same, but greatly depends on the specific industry and company.17
Furthermore, Fitch examines the intangible assets/liabilities both from an
historical than from a prospective point of view.
Human Capital The objective of the evaluation of management is to appraise its

capacity to carry out company plans. This is why it is assessed not only on the basis
of its competence (based on experience), but also and especially on the basis of the
results achieved in both strategic and financial terms (credibility), also in comparison
with the peers. The management evaluation process is perceived as one the most
subjective, because it can largely vary according to company specificity and/or the
analysts’ choices; in this sense, a major aim of the analysis of the management past
performance (track record) is to put a boundary to the degree of subjectivity of such
a process.
It has to be said at this point that long-term objectives are supposed to be better
than short-term ones; furthermore, the management characteristics (aggressive or
prudent), especially its risk tolerance and its investments decisions, are scrutinised
according to the industry examined. Also studied is the management’s attitude to
possible negative scenarios, represented by its flexibility as well as its capacity to
manage crisis.
In addition to the ordinary management assessment for the final credit rating, Fitch
offers also anew service18, the “Asset Management Rating”, in order to examine:
• the level of security that an asset management organisation can provide to an

institutional investor that delegates the management of all or part of its assets;
and
• the added value that an asset manager provides to an institutional investor on
the management of a given asset class.
The first issue implies the asset management organisation analysis (trough
questionnaires) as well as the exploration of structure, means and control processes.
The result of this investigation is an “intrinsic rating”19 on the capacity to master
the risks linked to asset management. The second issue, the value added, implies
the analysis (through questionnaires) of the management of a given asset class
17 For instance, Fitch assumes that banks are more likely to fail than other non-bank
corporates because they are inherently risky institutions.
18 This service could also have been included in the “Organisational Capital” section
because it is strictly related to organisational issues. For further information see www.
fitchratings.com.
19 The scale used for the “intrinsic rating,” is the following:
• aaa superior;
• aa+, aa, aa- excellent;
• a+, a, a- good;
• bbb acceptable;
• bb+,bb, bb- weak;
• b+, b, b- insufficient.
and in particular its capacity to generate high level of performance through a solid
investment process. As a result a “performance rating”20 is assigned. The “intrinsic
rating” is a prerequisite to the “performance rating”.
The asset management ratings often become a decision tool in the process of
selecting asset managers, through asset manager searches and through direct
purchases of open mutual funds.
Relational Capital Fitch divides the investigation of the relational capital

between aspects linked to the relationship with the market, and aspects linked to the
relationship with the Government and the economic environment in general.
To assess the relationships with the market, the strengths and weaknesses of the
competitive position are explored. Here is a list of some features examined:
• Market share;
• Capacity to influence prices;
• Distribution channels control;21
• Marketing expenses;
• New products;22
• Leadership degree of the main products/services;
• Reputation (strength of the brand);
• Degree of dependency on suppliers and customers (relevance, types of
contracts, concentration of clients, number, substitutability, and so on); and
• Geographical diversification of revenues.
The analysis of these factors is fulfilled to verify whether and to what extent
external events affect company activity.
Also assessed is the role of a company in relation to the Government and, in
general, to the economic environment (e.g. trade unions, banking system, and so
on). A protective or hostile legislation could in fact represent a threat to company
development.
Organisational Capital The size is an important feature as it has a great effect on

the ability to react to external turbulence, as well as on company financial flexibility.
In this sense a small company is perceived as more fragile than a large one.
20 The scale used for the “performance rating” is:

• 7 superior;
• 6 excellent;
• 5 satisfactory;
• 4 acceptable;
• 3 weak;
• 2,1 insufficient.
21 The company capacity to control distribution channels will also be considered as an
element of the organisational capital.
22 The no. of new products will also be presented as one of the aspects evaluated within
the organisational capital section.
The company capacity to control distribution channels is also considered crucial,
as well as the diversification of products/services, that is strictly linked to the amount
of R&D expenses.
Strategy The company strategy, especially with reference to acquisitions and

investments, is investigated since the first meeting with its managers. The strategy
can be aggressive or conservative; in this sense, its evaluation is related to the above
mentioned management characteristics. In any case, the most important element
considered by the analysts is the consistency between the strategy adopted and the
organisational structure, i.e. its feasibility.
Corporate Governance Another crucial element to assess a company’s financial

solidity is the ownership structure. When a company is family owned, it finds more
problems to gather financing funds. This type of company can also be penalised by
its dependence on people. Nevertheless, an excessively complex property structure
(with many shareholdings in other companies) is perceived as negative too, because
it hinders the information transparency.
The shareholders structure and composition are studied too with the purpose of
understanding the specific corporate governance model (benefits and weaknesses).
If a company is family owned, the succession issue is also considered, given the
dependency from key-men could endanger a company’s state.
Similarly to the Moody’s choice, the equilibrium of responsibility, the adequacy
of delegation mechanism, the middle management involvement in the decision
making process and the presence of conflicts of interests are investigated.
In order to summarise the overall results emerging from the above content analysis
a comparative Table is presented. Indeed, Table 8.2 includes the main intangible
elements considered by the three rating agencies in their credit rating assignment
process, according to the methodologies publicly available. The results are grouped
using the above mentioned five categories of intangibles.
Summarising the results emerging from the content analysis it can be argued that
along the documents there is a frequent reference to specific intangible aspects, but
they are very generic statements. In particular, there are two possible reasons for this
circumstance:
• the fact that this set of information is usually considered very sensitive and
thus it is confidential; and
• the lack of a specific methodology to weight intangibles in order to provide a
more realistic credit rating.
The aim of the following section is to deepen the above issues and to investigate
some of the aspects that did not clearly emerge from the content analysis of
documentary sources, because they were missing or were not sufficiently spelled out
in the publicly available rating methodologies.
The Interviews with Financial Analysts
This section shows the results of the semi-structured interviews conducted with the
analysts of the three rating agencies. The analysts involved were in charge of the
corporate and bank credit rating processes. The outcomes are presented by the type
of questions actually raised, which, in turn, are structured by category of intangible
resource (relational, organisational and human capital, strategy and corporate
governance). There has also been added a short section on “other information” dealing
with information collected during the interviews that is not specifically related to any
type of intangibles, but that it is believed to be essential in order to better understand
the relationship between these resources and the credit rating practice.
Intentionally, the answers are here not presented by rating agency to respect the
analysts’ will and a confidentiality agreement. Thus, for each question, the answer
will be a reasoned aggregation of the three responses given by the rating agencies
interviewed.
Further, the questions have deliberately been posed in the most possible generic
form. This choice was aimed not to push the analysts’ answers in a specific direction;
in other words, the objective was to grant the analysts as much freedom as possible
in their answers.
Human capital
“How do you assess the management value (e.g. its credibility and motivation)?”
Top managers credibility is measured on the basis of their track record (past
performance), thus examined especially is their capacity to carry on successfully
their plans and goals, even in situations of crisis. In other words, the long-term
company performance23 is monitored. The evaluation of the management activity is
perceived as one of the most subjective amongst the intangible aspects. Therefore,
a number of more objective measures (of financial or quantitative nature) is used,
like sales, management turnover, customer satisfaction, market share, consistency
between objectives and strategy, but also transparency and number of years that a
manager passed in the company or the industry.
Managers can be aggressive if they tend to maximise short-term results, or
conservative if they maximise long-term cash flows; the first case is considered more
risky, therefore it generates lower level credit ratings.
In addition, it has to be pointed out that in general the management tendency
towards risk is perceived as negative, if the industry is mature, and positive if the
industry is dynamic.
“Do you consider the skills and competences of the other employees?” The
analysts confirm that, most times they don’t consider the lower level employees.
They only dialogue with CEOs and CFOs, even if sometimes they involve lower lever
personnel to present innovative projects. These moments are useful to investigate the
23 It is relevant here to remember that we are dealing with long-term credit rating
assessment.
Table 7.2 Main results emerging from the content analysis regarding the intangible resources considered in the credit rating process
S&P’s Moody’s Fitch

HUMAN CAPITAL - Management track record - Management track record motivation, - Management track record and flexibility
- Risk tolerance quality - Risk tolerance
- Risk tolerance
- Turnover
RELATIONAL CAPITAL - Customer service - “Franchise strength” - Market share
- Product innovativeness, quality and (Products’ quality and innovativeness, - Capacity to influence price
price, distribution capabilities Diversification in general, - Marketing expenses
- Reputation/External image Distribution strategy) - Products leadership degree
- Brand and IP - Reputation
- Client service - Geographical diversification
- Others
ORGANISATIONAL - Size (impact on the financial flexibility) - Product/service innovativeness (also - Size (impact on the financial flexibility)
CAPITAL - Diversification R&D expenses) - Product/service diversification
- Technology - Size (impact on the financial flexibility) - Distribution channels
- Technology
STRATEGY - Valuation of the potential credit impact - Growth strategy - Consistency between strategy and
of alternative strategic initiatives - Long-term vision organisational structure
- Consistency between strategy and - Risk-return tolerance - Acquisitions
organisational structure
CORPORATE - Ownership structure (impact on the - Ownership structure (impact - See Moody’s
GOVERNRANCE financial flexibility and solidity) on the financial flexibility and solidity)
- Equilibrium of responsibility
- Adequacy of delegation mechanisms
- Middle management involvement
- Conflict of interests
relationships between different management levels. One of the reasons why they
do not consider lower level employees, is because it is difficult to measure their
competencies. Additionally, a good manager is supposed to take with him/her good
skills.
The training is usually not weighted up. An exception is the case of the banking
industry, when the bank may have had some troubles due to the lack of lower level
employees’ competencies. In this circumstance the employees’ training is seen as a
positive factor.
Generalising, we could say that skills and competencies of the other employees
are considered only when a company presents some problems (e.g. reduction of sales
or customer satisfaction).
The age of the human capital is considered as an element that increases company
costs.
Relational capital
“How is the external image (reputation) evaluated and what is its impact on the
credit rating?” The external image is examined on the basis of public information.
For instance, when a company withdraws a new product, the analysts simulate the
cash flow decrease, according to the product relevance. In particular they take into
account the negative effect of a brand’s worsening on the capacity to produce cash
flows, or the possible negative impact of a new product on the customer satisfaction
and thus on the amount of sales.
The relationships with Unions and NGOs are also considered, especially when
they could cause problems.
“Is the internal image (employees) evaluated?” The internal image is not
considered as much as the external. It is only examined when strikes occur with in
the organisation, or when the personnel’s turnover is too high.
“When is a brand considered strong?” The brand value is very important and very
vulnerable; in spite of this there is no a scientific method to evaluate it.
The significance of brand value is different by industries: it is very important in
the retail industry (brand awareness: 80-90%) as well as in banking and insurance,
whilst, generally speaking, it is less relevant in the industrial.
Brand value is calculated looking at the premium price for company products/
services, and at its capacity to maintain the market share. Furthermore, the analysts
examine the historical series of the statistics generated by the brand, but they also ask
the managers their forecasts about their future trend. Analysts also order to external
institutions market surveys to establish the brand awareness’ level per each industry;
for example in the food industry the strength of the brand is particularly important
as well as the customer loyalty.
“Do the marketing expenses have an impact on the rating?” They have an impact
on the credit rating because they represent a way to built the brand. Nevertheless,
their impact is different according to the industry observed: in the retail it is about
5/8% of the total sells, whilst in the industrial is not so relevant like the R&D
expenses’ impact .
“How do the analysts point out the dependence on a particular supplier or

customer?” The dependency upon one or few suppliers/customers is seen a
negative factor, because it increase the risk level; on the other hand, also too many
suppliers represent a negative situation, since they limit company flexibility.
To assess this dependency degree, rating agencies carry on peer analysis.
In addition, when a company is not new, analysts look at its past performance in
facing crises related to suppliers or customers dependency. The product/service
substitutability by the customer, strictly related to the complexity of the product/
service itself, is also considered.
“What methodology do you use to value customer satisfaction?” The customer

satisfaction is crucial in determining company reputation, and it is assessed on the
basis of public information (e.g. trend of customers’ number, sales, retention rate).
Similarly to the brand, it is weighted mainly a heavy reduction of the customer
satisfaction.
“Is the internationalisation assessed?” The answer is positive, since this is always
seen as a means of risk reduction.
Organisational capital
“How is innovation evaluated in the credit rating process?” The innovation

opportunities are not necessarily perceived as positive to factor because they are
risky.
“In what way R&D expenses influence the credit rating?”. Analysts evaluate R&D
expenses on the basis of the industry benchmark parameters. The absence of R&D
expenses is weighted negatively because it may affect the amount of future sells.
R&D expenses are not considered in any case of financial difficulties.
In the banking industry R&D expenses are not so relevant, however it is crucial
the bank capacity to develop new products/services, that is its innovativeness.
“How do rating agencies evaluate the organisation’s technological capability?” It

is investigated only on the basis of information collected from both the company
itself and the media. There is no a technical inspection of the technological capability
by analysts, because they are not experts in this field. However, in some cases of
smaller size companies, analysts could ask them to show their factories to weigh up
the facilities’ state of the art.
In the banking industry, the technological capability assessment implies the
evaluation of the control systems’ adequacy, measured by the analysts on the quality
of information received by the banks themselves.
“Do you take into account the corporate culture?” Analysts do not consider the
corporate culture per se (e.g. spirit, approaches like knowledge-sharing), because
this is not believed to have an influence on company’s ability to generate cash
flows, except when a change of culture is occurring. In this case, the reasons and
aims of such a change are investigated. The culture issue is usually examined as a
management or a strategy issue. For example, analysts look at risk tolerance.
“What type of impact does the performance-based culture stimulated by managers

have on credit rating?” Good compensation mechanisms are able to diminish the
management turnover, thus they improve company stability and credit rating. This
circumstance is supposed to have positive effects on company ability to meet its
financial obligations. An example of performance-based culture is given by the stock
options plans (in particular in the banking industry), that represent an indicator to
simulate the performance and to hold the management.
“How the structure of the ownership influence the final credit rating?” The
more the structure is transparent (e.g. flat structure), the easier to understand is the
type of activity carried on by the controlled and connected companies. Under this
circumstance a company will be able to resort to multiple financial markets.
Strategy
“What elements do you consider to evaluate the organisation strategy?” The

evaluation of the strategy is strictly linked to the assessment of the management
characteristics. In particular, analysts try to understand if the strategy is aggressive,
that means focused on the short-term results, or conservative, that is oriented at the
mid-long term results.
Another relevant element is the consistency of the strategy with company
objectives.
“What aspects of the corporate governance do you consider most carefully?” The
management independence and experience, the relationships between managers
and shareholders, the quality of the audit process, the personnel and management
incentives as well as the ownership structure are some of the elements considered.
Additional questions
“What are the issues on intangible resources that never miss in a questionnaire to
the management?” Usually all the above intangible aspects are considered.
“Did you find out that the ‘additional information’ asked to the management is mainly
related to intangibles?” All the interviewees responded positively to this issue,
adding that such an evaluation is due to the circumstance that traditional accounting
reports and the other documents provided by companies do not usually include many
relevant information regarding intangible aspects of the latter’s activity, like strategy,
organisational culture, management characteristics, and so on.
“Do you also weigh the quality and quantity of the information produced and
disclosed by the organisations? In the positive case, do you also consider additional
reports such as intellectual capital statements, social and environmental reports,
sustainability reports, and so on?” In general, internal communication (internal
disclosure of objectives and strategies) is taken into account only when negative,
that is when company objectives are missed.
As regard to the new forms of reporting, rating agencies do not consider them too
seriously, since their contents are perceived as superficial and repetitive. In any case,
their value also depends upon the industry, the country, and the market analysed.
“How do the analysts summarize the information collected?” Sometimes there is

an internal methodology, which is neither a score model, nor a fixed matrix. It is a
set of non-formalized guidelines, coming from the analysts’ experience, in order to
think in a more structured way. By “structured way” analysts mean that they look
for a common trace to decide what are the qualitative elements to take into account
in the rating assignment. This does not necessarily mean that they have a structured
methodology stating how to evaluate these aspects. Often, the structure development
consist of a “challenge process”, involving a committee of analysts discussing about
the best elements to consider in the rating process.
“In your opinion, how much does the evaluation of intangible assets weigh on the
final credit rating?” A crucial part of the rating assignment process in order to
understand the significance of intangibles in the rating is the dialogue with the
company. Some of the questions the analysts try to answer are “Are intangibles
relevant for the industry examined?”, “Are they relevant in the balance sheet?”, and
so on. In this sense their relevance can largely vary according to the industry and
company specificity.
In the banking industry they are supposed to affect the 20/35% of the final credit
rating. This very high percentage may be due to the fact that in this industry the most
important value drivers – such as the brand, the strategy, the ownership structure, the
management capacity, the technology24 used, the franchise value, and so on are, by
definition, intangible.
As regard to corporate sector, intangibles can weight up to 70% on the final credit
rating.
“How do financial analysts limit the high degree of subjectivity related to their
judgements in relation to qualitative, and in particular intangible, aspects?”
24 It has to be pointed out that in this meaning, technology is the capacity to develop new
products.
Table 7.3 Main results emerging from the interviews with the analysts regarding the intangible aspects considered in the credit
rating process
HUMAN CAPITAL Confirmed the relevance of managers’ track record as proxy of competence, ability, etc.
Less attention on the other employees’ skills and capabilities
Training activity scarcely analysed (just in case of problems)
RELATIONAL CAPITAL Sales and Market share
Customer satisfaction (derived indirectly form sales)/ reputation (impact on financial stability)
Brand (in terms of capacity to maintain o increasing the product price)
Dependence from one or few clients/suppliers (negative, risk implication)/ Diversification is positive
Internationalisation (positive, risk implication)
No internal image (of the employees), just a focus on turnover in some critical cases
Relations with Unions (only it is a source of instability)
Marketing expenses: not crucial
Communication:
- External: scepticism towards supplementary statements (social/environmental/sustainability, etc.)
- Internal: just if problematic (consistency of the management objectives with the strategy)
ORGANISATIONAL CAPITAL R&D always important (comparative analysis by industry)
Technology, according to the industry
Level of innovativeness (can increase the risk)
Diversification (both geographical and of products) is always positive
Change in corporate culture (motivation and management)
Ownership structure
Personnel compensation mechanisms
STRATEGY Risk tolerance/Style of management (aggressive is more risky)
Cohesion/coherence between strategy and culture/Feasibility of strategy
CORPORATE GOVERNANCE Relevant, especially the ownership structure, in terms of financial solidity.
Also board composition, no. of meetings, audit committee expertise and independence, executives compensation strategies
Judgements subjectivity is limited through the involvement of international rating
committees composed by at least two analysts, as well as through the analysis of company
past performance, considered an objective evidence of its strength. Another way to
frontier the subjectivity is to look at the industries’ benchmarking parameters (peers
analysis). In fact, it is often stressed that the industry is the critical variable. For each
industry analysts use some sort of grids or pondering mechanisms to evaluate the impact
of a particular feature on company’s creditworthiness. Nevertheless, the peer analysis is
not necessarily a numerical comparison; context variables are also examined.
Table 8.3 presents the results emerging from the interviews conducted with the
analysts with regard to the intangible aspects considered in the credit rating process.
The results emerging from the additional questions are intentionally excluded
because they will be commented on in the following section.
Main Findings and Critical Final Remarks
The main results from the content analysis of the methodologies are the following:
1. As a general comment, it has to be pointed out that intangibles are quite

frequently mentioned along the documents and during the interviews, but
usually a clear explanation of the methods used to assess them is absent, even
though it has to be recognised that Moody’s provides more comprehensive
methodologies (both in details and explanation’s richness and in number of
examples and exceptions from different industries) compared to the other two
agencies.
In other words, there is not an official quantitative model to evaluate intangibles,

but only some informal guidelines. Indeed, the assessment of the intangible assets
in the credit rating assignment process is almost totally based on the analysts’
experience and intuition, thus implying a high level of subjectivity of the process.
2. A second relevant aspect is that intangibles aspects are currently assessed

through tangibles and objective measures, especially linked to company
financial performance, such as sales, rate of return, and similar.
This circumstance is due to the nature itself of the credit rating. Indeed, the basic
philosophy to assign a credit rating is to minimise the risk for the investor. In fact, all
the analysts interviewed emphasise the fact that the rating assignment is based upon
a prudential and conservative viewpoint.
The best way for a company to minimise the risk is to guarantee the capacity to
generate cash flows. Therefore each features is weighted on the basis of its effect on
company capacity to create cash flows.
3. This prudential approach implies that intangibles are considered only

when they have a negative impact on the capacity of a company to repay is
obligations, that derives from its capacity to generate cash flows. Nevertheless,
analysts recognise the crucial role of intangibles for company success because
in general the presence of relevant intangible assets is associated with high
level rating. This circumstance represents a major paradox of the credit rating
assignment process.
4. Further remarkable findings are represented by the fact that additional
information asked by analysts to managers, in order to assign the final credit
rating is mainly of intangible nature, thus confirming their relevance for the
credit rating process.
Indeed, according to analysts’ opinion intangibles aspects may influence up to the

70% of the final credit rating, even though their relevance can largely vary according
to the industry and company specificity.
5. In terms of human capital, it emerged that the most important element assessed
the management quality. Management is evaluated both for its experience and
competence, and for its past performance. The latter feature is supposed to
provide objectivity to this assessment process, commonly perceived by the
rating agencies as the most subjective between the qualitative ones. A weak
point of the human capital assessment is the fact that analysts almost always
totally overlook the role of the lower level employees.
6. The study of organisational aspects shows that it is commonly recognised the
relevance of size and ownership structure, on the contrary very little is said
about the way to assess the technological capabilities of organisations. An
emerging paradox in the rating assignment practices involving organisational
aspects is that R&D expenses are considered almost only in the pharmaceutical
industry, while they are crucial in many other industries. Innovation is another
factor often missing through the methodologies and, even if it examined, it is
perceived as a risk factor; thus it leads to lower credit ratings. This practice
discourages investment in innovative activities that obviously are riskier than
the non-innovative ones, but that potentially may confer a better competitive
position (which is typically the basis for a good rating), or reconstruct the
financial position. This seems to be a quite myopic and contradictory view
of the organisation, because it assumes erroneously that a particular financial
position is independent from the level of innovation. In addition to that,
analysts completely ignore key features like knowledge monopoly by the top
managers.
7. The strategy issue is treated similarly to the management assessment, assessing
basically the level of risk of the type of strategy adopted (aggressive, more
risky, or conservative).
8. Last, but not least, it has to be pointed out the increased relevance of the
corporate governance issue, that is maybe due to the recent financial
scandals.
There are many research challenges associated to the issue analysed and this
study is itself a work in progress. In this sense an interesting possibility could be to
compare the rating of large, listed companies preparing Intellectual Capital Reports
(e.g. Skandia), with ratings of companies without Intellectual Capital Reports, in
order to understand whether this new form of disclosure helps a company to gain
value in terms of credit rating.
Another possibility is to use a laboratory experimental approach. For example, one
could study two separate groups of analysts assigning a rating to the same company.
The two groups should have the same set of information, except for one having on
top the company Intellectual Capital Report. This is another way to observe whether,
and in what direction, information about intangible assets drives credit rating.
In conclusion, from the study emerged that the rating assignment is not an exact
science and that because it involves a look into the future, credit rating is by nature
subjective. Indeed, most of times, while rating agencies clearly explain what are
the intangibles they take into account, they are often deficient in the explanations
of the way in which they weigh these factors. It is not clear in fact how they do
assess features like company strategy, its image and brand, and, most of all, it is not
clear the weight of intangible assets on the final credit rating. Perhaps, this is due
to the fact that the rating assignment still remains almost completely based on the
analysts’ experience than on formalised procedures. This is the main reason why
this study is also based on the interviews carried out with the analysts. Moreover,
because long-term credit judgements involve so many factors unique to particular
industries, issuers, and countries, any attempt to look for a formulaic methodology
seems useless. This study shows that the approach adopted by rating agencies to risk
analysis aims to bring at first an understanding of all the relevant risk factors and
viewpoints to every rating analysis, then they rely on the judgement of the analysts
in light of a variety of plausible scenarios for the issuer.
The credit rating is the result of a combination of both quantitative financial
analysis (historically oriented) and qualitative assessment (future oriented). From
this study there comes out a clear predominance of the former, nevertheless the latter
seems to affect more than in the past the final level of the credit rating. On the other
hand, this research is based only upon a subclass of qualitative aspects, the intangible
assets, excluding other significant qualitative features for the rating assignment,
such as the industry analysis, the stage of life cycle, the role of regulation and
legislation, the country risk (local/economic/political risk factors), the importance
of transparency, and so on.
As a final remark, this study highlighted the need for more transparency and
objectivity in the credit rating assignment, especially with reference to intangibles
and, more in general, qualitative aspects of such practices, since these elements –
due to their increasing economic relevance – are today capable to heavily affect the
outcome of such an influential evaluation process.
Acknowledgement
The writer would like to gratefully acknowledge Professor Stefano Zambon for his
precious help in improving the incisiveness of the work.
References
Cantino V. (2003), Valore d’impresa e merito creditizio – Il rating [Company value

and credit merit – The rating], Giuffrè, Milan.
Fitch Ratings (2000), “Pharmaceuticals: Formulary for a strong credit profile”,
Criteria report, Corporate Group, February 2.
Fitch Ratings (2002), “Italian medium-size companies: who are they and how does
Fitch rates them?”, Criteria report, Corporate Group, March 28.
Fitch Ratings (2003), “Corporate rating methodology”, Criteria report, Corporate
Group, June 13.
Fitch Ratings (2004), “Evaluating corporate governance: the bondholders’
perspective”, Criteria report, Corporate Group, April 12.
Fitch Ratings (2004), “Fitch approach to rating European retailers”, Criteria report,
Corporate Group, April 29.
Fitch Ratings (2004), “Bank rating methodology”, Criteria report, Banks, May 25.
Fitch Ratings (2005), “Rating real estate asset managers in Europe”, Criteria report,
Corporate Group, June 30.
Moody’s Investors Service (2004), “Global cigarette and smokeless tobacco
industry”, Rating methodology, November.
Moody’s Investors Service (2005), “Rating methodology: global packaged goods
industry”, Rating methodology, January.
Moody’s Investors Service (2005), “Rating methodology: global telecommunications
industry”, Rating methodology, February.
Moody’s Investors Service (2005), “Global auto supplier industry”, Rating
methodology, June.
Standard & Poor’s (2001), “Rating methodology: evaluating the issuer”, Ratings
criteria, September 7.
Standard & Poor’s (2004), “Health insurance criteria: evaluating health plans’ and
health insures’ competitive position”, Ratings criteria, April 22.
Standard & Poor’s (2004), “Health insurance criteria: management and corporate
strategy”, Ratings criteria, April 22.
Standard & Poor’s (2004), “FI criteria update: securities company ratings analysis
methodology profile”, Ratings criteria, April 29.
Standard & Poor’s (2004), “Structure finance: servicer evaluations”, Ratings criteria,
September 21.
Standard & Poor’s (2006), “The evolving role of corporate governance in credit
rating analysis”, Ratings criteria, January 9.
PART 3
NEW PERSPECTIVES ON THE

MEASUREMENT AND
REPORTING
OF INTANGIBLES
Chapter 8
XBRL as a New Language for Business

and Intangibles Reporting
Kurt P. Ramin
Chairman, XBRL International Steering Committee at the
International Accounting Standards Committee Foundation, London
and Prism Research Project (WP4)
Introduction
The enormous success enjoyed by developed economies with regard to rising

standards of living is due, in part, to an efficient allocation of capital. The distribution
of capital depends on the effectiveness of the competitors; the more effective a firm
is at allocating its resources, the lower its cost of capital will be.
Making corporate financial information available in a thorough and timely or
extensible manner is in the best interest of companies, investors and the public. XBRL
is a solution to improve the costly, labour-intensive model of handling financial data
that is currently in use by investors and analysts around the world.
The content reported by companies is integrally linked to the format and
presentation. If the format enables stakeholders to understand the content more easily,
they will use the content more effectively. The evolution of information formats
– from print to e-mail, websites, and PDF files – has enhanced the accessibility,
understandability, and usefulness of the content. The link between content and format
has never been more crucial than now, because the Internet is quickly becoming the
primary platform for communications and commerce. Today, however, the Corporate
Reporting Supply Chain (see Figure 8.1) has essentially replicated a paper format
- with all of its limitations - in the electronic environment. Corporate reporting on
paper or in its electronic equivalent will not suffice in today’s environment.
XBRL supplies the Corporate Reporting Supply Chain with a new universal
language for financial reporting that is both easy to use and learn – and that is not
limited by the constraints of other technologies which chose to replicate a paper
based format.
Figure 8.1 The corporate reporting supply chain

Source: Di Piazza – Eccles (eds), 2002, p. 11.
XBRL Explained
Who’s involved?
XBRL International, which oversees the XBRL specification, is an organization

made up of over 300 global companies worldwide and includes the world’s largest
accounting firms (PwC, KPMG, Deloitte , Ernst & Young, …) and technology
firms (Microsoft, SAP, Oracle, …), as well as significant accounting jurisdictional
members (IASCF, ICAEW, AICPA, …) and financial services bodies (FDIC, Dow
Jones, Morgan Stanley, …).
By virtue of the fact that it is a cooperative effort of so many competitors in a
diverse number of business areas - XBRL is, and shall remain, an open standard
freely available to all users.
What is XBRL?
XBRL is an electronic format for simplifying the flow of financial statements,

performance reports, accounting records, and other business information between
software applications. It is an XML-based framework that provides the financial
community with a common method to prepare, publish, use, reuse and exchange the
financial information of both public and private companies.
XBRL is not a new set of accounting standards. It merely enhances the usability
and the transparency of financial information that is reported under existing
accounting standards. It simplifies disclosure and allows companies to communicate
financial information more readily via a digital language of business.
Not only does XBRL accommodate today’s accounting standards and policies but
it is also flexible enough to accommodate future accounting standards and direction.
It may also be used to elicit additional disclosures from companies to outside
audiences. It allows financial information to be less ambiguous and exchanged in a
common way.
XBRL gives business information a context by tagging information. A “tag” is
a unique identifier that is assigned to a financial (or business) fact. By using these
tags computers can “crunch the numbers” efficiently, accurately and with far fewer
XBRL as a New Language for Business and Intangibles Reporting 195
errors. XRBL is not limited to the financial information at Tier One of the Three-Tier
Model of Corporate Transparency (i.e. GAAP reporting – see Figure 8.2) but may
also extend to Tiers Two (industry specific disclosures) and Three (company specific
disclosures). XBRL tags can be associated with virtually any type of business
reporting information, including non-financial information.
Figure 8.2 The three-tier model of corporate transparency

Source: Building Public Trust, 2002, page. 15.
Financial statements published in XBRL contain all the information included

in traditional paper-like format, e.g. balance sheet, income statement, statement of
equity, statement of cash flows and notes to the financial statement. A significant
difference between XRBL documents and their paper counterparts is the improvement
in processing financial reports. XBRL enables both preparers and users of financial
information to prepare and exchange information more reliably and to publish and
analyse data more quickly.
What is XML?
XML is an acronym for eXtensible Markup Language. Looking at each of its parts
in turn:
• Extensible simply means that something can be extended or expanded.

• XML documents are “marked up” with tags that help identify specific pieces
of information.
• Language means just that - an Internet language - just like HTML (HyperText
Markup Language) to which we are so accustomed in our day to day browsing
on the web, except that unlike HTML, XML does not concern itself with
formatting. Instead it focuses on wrapping text with tags that have meaning.
Although XBRL refines XML for use in the business reporting domain, being
based on XML, it is independent of any particular software platform. Among other
things, XML technology also offers:
1. XML Digital Signature, which allows users to authenticate the source and
integrity of the information presented;
2. Validation that information complies with pre-set rules;
3. Linkages to other relevant internal and external content.
XML provides the foundation for the next phase of the global information
revolution and it is being quickly adopted for commercial and private use throughout
the world. XBRL extends XML’s functionality specifically to business reporting.
XML data can be exchanged with many different devices such as computers,
mobile phones, PDAs and tablet devices. XML allows developers to deliver rich,
structured data from in a standard and consistent way. Whereas HTML, which is
primarily a formatting language, offers a fixed/pre-defined number of tags, XML
neither defines nor limits tags.
Consider the following (simplified) HTML to display this author’s name, position
held and employer in a browser.
<html>
<body>
Kurt Ramin<br>
Commercial Director<br>
IASC Foundation<br>
</body>
</html>
A computer which reads this code, doesn’t really know which part of the text is
my name or which part is my employer. Contrast the (simplified) XML below:
<?xml version=”1.0”?>
<employmentDetails>
<firstName>Kurt</firstName>
<surname>Ramin</surname>
<positionHeld> Commercial Director </positionHeld>
<employer>IASC Foundation</employer>
</employment Details >
From the XML code a computer can determine the first name, surname, position
held and employer of the author with ease.
How does XBRL work?
XML provides a framework for defining tags (i.e. taxonomy) and the relationship
between them (i.e. Xlink). XBRL’s specification defines how to create XBRL
documents and XBRL taxonomies (i.e. under US GAAP, IFRS, etc) in a standard
way.
Using this technology, XBRL lessens ambiguity and increases reusability by
tagging reportable business information. The tagging process keeps the information
within its context. By doing so, the various stakeholders can decide precisely how
information should be presented and analysed.
There are several components in XBRL that work together. First is the XBRL
specification, which is a sort of rulebook that defines how XBRL taxonomies and
instance documents are structured. The XBRL specification defines rules such as
“each tag in a taxonomy must be unique” or “each monetary item in an XBRL
instance document must have an associated numeric Context.” Second is the XBRL
taxonomy, which is a dictionary of tags that can be used in an XBRL instance
document. An XBRL taxonomy contains definitions for business-related information
such as “goodwill” or “tax expense.” Third is the XBRL instance document itself
containing the data which is marked up against the taxonomy. An instance document
adds entity-specific information to a tag. For example, if the tag “goodwill” is used
in an instance document, the tag would have associated contextual information such
as “$56 million, as of December 31, 2002 for Gigantico, Inc.”
Each XBRL element identifies one financial reporting concept (see Figure 8.3).
For example, Property Plant and Equipment carried at cost and Property Plant and
equipment carried at fair value, while similar concepts, are represented with unique
XBRL elements in the IFRS-GP (International Financial Reporting General Purpose)
taxonomy - the former concept referenced to IAS 16.30 and the latter to IAS 16.31
through 16.42.
Having well-defined and unique XBRL elements invariably leads to less
ambiguous information, which is precisely what banks, investors, governmental
agencies and other financial information stakeholders are demanding. Using
an XBRL taxonomy keeps financial reporting information digital. And keeping
information digital facilitates straight-through processing – transferring information
directly from an entity’s reporting system to systems at financial institutions or stock
exchanges, and even to software on an investor’s desktop. Business information is
now dynamic and reusable and ultimately, more valuable.
Figure 8.3 Example of XBRL IFRS tag reuse

Who should develop an XBRL taxonomy?
So who should be developing a taxonomy? Should it be developed by business experts

or by programmers? The answer: it depends. Some aspects of this process should be
dealt with by business experts, while others should be developed by programmers.
Understanding the XBRL specification and creating applications for building XBRL
taxonomies and instance documents falls within the domain of the programming and
IT communities. Insofar as the content of an XBRL taxonomy and/or XBRL instance
document is concerned, it is a job for the business experts within a given business
domain to construct them with user-friendly tools which hide the complexity of
XBRL from the user. In other words, programmers make tools that can build XBRL
taxonomies and instance documents and business experts use those tools to create
the XBRL files that are the taxonomies and instance documents.
Example 1: IASC Foundation IFRS Taxonomy Project
The International Accounting Standards Committee Foundation (IASC Foundation)

plays an important role in developing XBRL language. The IASC Foundation is
a member of XBRL International and is working with other members to translate
International Financial Reporting Standards (IFRS) into XBRL: That means creating
an XBRL IFRS core taxonomy.
This current taxonomy is based on the 2005 IFRS Bound Volume (i.e. standards
current at 31 December 2004), which is the same basis that is used to translate IFRS
into other languages. The result of this work, which involves several groups of
accounting and software experts, is the creation of a set of “bound volume” tags
and “common practices” tags. The former is based on the 2005 Bound Volume and
represents IASB financial reporting concepts. The latter is based on Global IFRS
model financial statements which capture those disclosures commonly observed in
practice.
The XBRL IFRS-GP (“general purpose”) taxonomy is made of over 4,000
unique elements that define financial reporting concepts. Each element name is based
primarily on its IFRS reference rather than its language translation: The consequence
of using this taxonomy is a less ambiguous disclosure. Uniqueness is a prerequisite
for storing, retrieving, analysing, sharing and reusing information. XBRL makes
information digitally available, which in turn makes business information more
dynamic, reusable and valuable.
Example 2: XBRL International General Ledger Taxonomy Project
XBRL International is separately developing an XBRL General Ledger (XBRL GL),

which will integrate with XBRL IFRS and other structured data formats to maintain
the identity and context of information which typically “rolls up” to a financial
report. The XBRL GL makes it possible to “drill-down” from a financial statement
disclosure to the events that comprise its value.
For example, when a firm records a transaction in an ERP system and that
transaction is eventually aggregated with similar transaction to produce a summary
balance. The balance is aggregated with transactions from other ERP systems
during consolidation. The consolidated figures are then used for multiple purposes;
internally consolidated information may be aggregated and de-aggregated for
managerial purposes. There are two key points in this process. First, the original
figures have original contexts, which may be lost when data moves through the
corporate reporting supply chain. This loss of context makes it difficult to trace the
figures back to their sources. XBRL maintain the original context. A second point is
that information that is tagged can be interpreted and analysed more easily because
XBRL tags are designed to carry contextual information with them. XBRL IFRS
tags not only carry the values related to IFRS concepts, but also each concept’s
reference and its labels in multiple languages.
What else should we be doing?
With regard to the development of XBRL by the IASC Foundation, some research
opportunities have been defined, regarding:
a) Global reach of Standards (The European Commission requires all listed EU

companies to prepare IFRS consolidated accounts by 2005);
b) Development and maintenance of the IFRS-GP taxonomy;
c) Development of industry extensions taxonomies, e.g. insurance;
d) Reporting formats;
e) Convergence with other jurisdictions.
The aforementioned issues are very crucial to the development of XBRL and
constitute a challenge to face in order to extend the use of this new digital language
among an even greater number of companies.
XBRL Applications
The relation between XBRL and Intellectual Capital (IC) is still to be fully explored
and appears promising. It seems fruitful to articulate this relationhip around three
potential lines which can contribute distinct types of benefits to XBRL users.
Accordingly, the relation between XBRL and IC resourses can be appreciated
along the following lines:
• The benefit of XBRL in managing the relationships with some relevant

stakeholders;
• The potential application of XBRL to intangibles in financial statements;
• The potential application of XBRL to IC reporting;
Benefits from the use of XBRL
A significant amount of corporate information on the Internet still appears and

functions much like a piece of paper pasted to a computer screen. Neither sophisticated
graphics, nor hyperlinks to supplementary information, are an adequate replacement
to the context and understandability that XBRL offers data when it is tagged.
Reusing paper-based, non-contextual information, requires a manual transfer of data
from one format to another, which is both labour-intensive and time-consuming.
Moreover, users cannot see through or beyond a paper-like electronic format and
therefore cannot glean anything extra in terms of accuracy or authenticity simply by
analysing a document’s prima facie content.
The cost of reporting business information is high both for companies and
stakeholders. Companies must produce accurate disclosures - both internal and
external - often from disparate internal systems that require manual interfaces
which impede the flow of information for decision making. Different information
systems are forced to work together to perform two separate functions: collecting
the information and turning it into something usable. XBRL can change this by
providing quicker access and a greater reusability so investors can conduct more
complete and timely analyses.
Sophisticated users of business information may not be privy to all of the
information available simply because many information distributors do not provide
certain types of information in a standardised format. Relying on information
produced from third parties exposes users to a wide range of potentially significant
information risks, including distortion, time delays, and even fraud. A possible
reason for these risks is the normalization that characterizes the information reported
by intermediaries. It is true that normalization greatly increases the accessibility
and often the reusability of information that survives the process although that
same normalization often distorts or excludes some of the information the company
originally reported. To a large degree, frauds are possible because of format
deficiencies. A paper report or its electronic (paper) equivalent provides virtually
no solutions for investors to authenticate a document. XML-based tools will be
available to help solve this problem. Technologies such as XML Digital Signature
can provide integrity, authentication, and non-repudiation of information presented
in XBRL.
By using XBRL, management can enhance the transparency of its reporting.
However, it cannot force management to report in a clear, complete, honest, and
informative way, i.e. prevent fraud or malfeasance. XBRL is a reporting format and
not an enforcement agency, so some potentially useful information that investors
would value is not deliberately hidden – it is simply not disclosed.
Timely information, is valuable information. Some stakeholders can receive and
process reported information faster than others. At issue is “information arbitrage”.
Regulators generally try to eliminate information arbitrage and reduce differences
in information speed through initiatives such as the U.S. Securities and Exchange
Commission’s much discussed Regulation FD (Fair Disclosure).
Analysts and other users of financial information are at the receiving end of the
least standardized and least-automated link in the entire value chain of capital markets.
Although many corporate results are available online, analysing those results is a
time-consuming and intellectually intensive process that requires converting static
data from a company report into data that fits analytical models and other forms that
are useful to analysts and investors. Most financial information consumers would
agree that too much, time, energy and intellect is consumed at the lowest level of
transposing data from a static paper or paper-like format into useful formats that
facilitate and enhance firm by firm and industry analyses. This is particularly true
for small investors, who do not have the analytical staff available to professional
investors.
XBRL aims to bring standardization to tomorrow’s business information Supply
Chain. On a high level, XBRL improves the efficiency of communications to
investors, as well as provides aggregation and analysis of business information, and
financial statements. XBRL may also reduce the cost of analysing and reporting
business information by increasing the speed and efficiency of making business
decisions. Consistent information tagging allows comparisons and analyses to occur
more quickly and efficiently, without any loss of data integrity. Rather than creating
multiple report outputs for multiple data requestors, XBRL allows the same financial
information to be “reused” for different purposes. Simply put, XBRL revolutionizes
the way financial data is extracted and used by various members of the Financial
Information Supply Chain. Electronic availability of financial information and
transparency of data is key in today’s investor community.
Among the many benefits of using XBRL one is that companies can distribute a
higher value stream of information about themselves to the owners. They can send
the same information to multiple sources, who in turn can analyse the information
according to their own needs and requirements.
The use of XBRL in the financial reporting system will bring several benefits
for the various participants in the financial reporting supply chain. Therefore, it
is possible to give a brief summary of how XBRL will affect the various parties
involved:
1. Companies. By using XBRL it is possible to enhance the efficiency in

preparing accounting documents. The primary advantage is the possibility of
creating financial information once and reusing it for multiple purposes.
2. Analysts, Investors and Regulators. XBRL creates a more efficient and
automated environment in which financial information is exchanged. It
eliminates the need to re-key financial information from one form to another,
as it allows XBRL-enabled applications to receive information in on format
and then render it in one or more specific formats for analytical purposes.
3. Financial Publishers and Data Aggregators. XBRL lowers the costs associated
with customised data feeds. In addition, it lowers the chances of introducing
errors while adding value to the data.
4. Independent Software Vendors. XBRL permits financial data to be imported
and exported in a common format, which increases the potential for
interoperability with other financial and analytical applications.
To fully understand the benefits of adopting XBRL, it is helpful to look at the

constraints on, and consequences of, traditional reporting methods. Those constraints
and consequences distribute themselves along the entire Corporate Reporting Supply
Chain (see Figure 8.1).
In Figure 8.4, the upper diagram depicts today’s Corporate Reporting Supply
Chain. Information from subsidiaries and business units goes through multiple
consolidations until it reaches the report preparation process. Generating the
disparate internal reports required by management for decision making requires
labour-intensive and costly processes. The lower diagram in Figure 8.4 depicts the
simplification of the Corporate Reporting Supply Chain through XBRL. Companies
can consolidate their subsidiary and business unit information from multiple sources
and systems. The consolidation process is simplified and information flows quickly
and efficiently for internal management decision-making purposes. Concurrently,
any public information can be made available through the Internet to investors,
analysts, and other stakeholders who will request only the information they require,
which would flow into their spreadsheets and software programs for analysis. The
XBRL information flow in the lower diagram illustrates “publish once and reuse
many times”. Investors are no longer forced to retrieve opaque paper-like electronic
documents from individual companies. Timely, relevant, accurate, and complete
information is available simultaneously to all parties. Everyday adoption and use of
XBRL in the global marketplace will come from key participants taking the lead in
developing and promoting it as the standard in business reporting.
Figure 8.4 How XBRL changes the consumption of corporate reports

Source: Di Piazza – Eccles (eds), 2002, page 11.
Current applications
A fair number of prominent organizations and companies have started to publish

information in the XBRL format, including Edgar-Online, Microsoft, Morgan
Stanley, Reuters, and Others. In addition, there are many e-government initiatives
under way to leverage the Internet as a means to decrease the cost of regulation
and improve the overall regulatory process. The Australian Prudential Regulation
Authority (APRA) (www.apra.gov.au) is one of the earliest example of how XBRL
allows information to be transferred from one company to a regulator and be put to
immediate use: every lending institution in Australia currently reports to the APRA
using XBRL.
APRA In Australia, every lending institution currently reports to APRA using

XBRL. APRA believes that XBRL enhances the transfer of data between financial
institutions and prudential regulators. APRA is preparing a range of special definitions
(taxonomies) that will comply with the standards set down by XBRL International.
APRA noticed that one of the key issues of exchanging data is that systems have
usually been proprietary or unique to one purpose or for a single application. In the
past, APRA might have allowed the import of data into its systems using comma-
delimited files or proprietary tags. Now it will now be using XBRL tags. The tags
used will either be from the official Australian taxonomies for financial institutions,
from an APRA specific taxonomy or perhaps from a combination of both.
Other regulators are currently evaluating and prototyping similar processes,
including Inland Revenue and Companies House in the United Kingdom , the
Japanese FSA and Taxation Authorities in Japan, all major government filings in the
Netherlands, and importantly the SEC and the Federal Deposit Insurance Corporation
(FDIC) in the US.
Microsoft Microsoft, as one of the original members of the XBRL consortium,

has interests in both supplying its own financial information in XBRL as a public
company and creating XBRL tools as a software development company. To
accomplish the former, Microsoft has allowed a number of vendors to create a tool
to transform financial data into XBRL using Microsoft Excel or Word. These XBRL
builder “plug-ins” streamline the following four processes:
1. Mapping the financial report line items with the appropriate XBRL tag;
2. Building and maintaining taxonomies (dictionary of XBRL terms);
3. Creating XBRL Instance Documents (the marrying of the XBRL tag with the
actual financial results);
4. Transforming Instance Documents into publishable format (create once,
report in multiple formats).
Microsoft supports the notion that XBRL represents not only a transformation in
business reporting, but also a new market opportunity for developing applications
that leverage XBRL’s capabilities. By having financial information publicly
available in XBRL, Microsoft is providing an example for both internal and external
software developers as they move forward in creating XML and XBRL tools.
Software and services businesses will be able to expand their market by building
new tools for everyone from company executives to individual investors. Microsoft
has a long-standing commitment to help develop and promote the adoption of the
XBRL standard. Microsoft sees XBRL not only as the future standard for financial
reporting, but also as a logical business choice.
The benefits Microsoft is realizing from allowing XBRL enablement of its
products are now available to companies of any size in any industry. For the financial
executive, there are two key perspectives on the XBRL value proposition. The first
is from the point of view of the company that reports business information both
internally and externally. The second is from the point of view of the consumers
of that business information. From both perspectives, the great virtue of XBRL is
in how it simplifies and hastens the process of assembling and moving information
within the company and to its shareholders.
Potential Application of XBRL to Intangibles in Financial Statements
Using XBRL enhances the usability and the transparency of the information produced
by companies. This also allows companies and final users of accounting disclosures
to make more accurate comparisons among data disclosed by different companies in
different countries. This aspect is particularly important with regard to Intellectual
Capital.
Tagging intangible assets information in a common way by using XBRL
“elements” in XBRL instance documents (financial statements), can help to identify
how individual firms treat intangibles differently. The basis for a useful tagging
system for this type of data can be found in Statement of Financial Accounting
Standard (SFAS) no. 141, Business Combinations, issued in June 2001 by the
Financial Accounting Standards Board (FASB).
This standard requires that all business combinations be accounted for using the
purchase method FASB 141 requires that Intangibles be recognised as assets apart
from goodwill if they meet one of the two prescribed criteria – the contractual-
legal criterion or the separability criterion. It also requires disclosure of the primary
reason for a business combination and the allocation of the purchase price paid for
the major assets acquired and the liabilities assumed in a condensed balance sheet.
FASB 141 provides an illustrative list of intangible assets that meet the criteria
citied above in order to facilitate the identification of those intangible assets that
must be recognised apart from goodwill. This list divides intangible assets that are
different from goodwill into five categories:
a) Marketing-related intangible assets

b) Customer-related intangible assets
c) Artistic-related intangible assets
d) Contract-based intangible assets
e) Technology-based intangible assets.
Each of these categories can contain sub-categories of more specific
intangibles.
These classifications provide a logical starting point for a taxonomy that defined
Intangible Assets. One possible structure for this taxonomy follows:
Balance Sheet
Assets
Intangible Assets
Market-related Intangible Assets
Trademarks, tradenames
Service marks, collective marks, certification marks
…
Customer-related Intangible Assets
Customer lists
Order or production backlog
…
…
One tag has the label “Market-related Intangible Assets”, which represents – and
may directly reference – the example given in FASB 141.
If a US-GAAP compliant company releases an XBRL instance document with
“Market-related Intangible Assets” using an XBRL International-approved US-
GAAP taxonomy, then its results will be more easily compared to other companies
that use this tag.
Potential application of XBRL to intellectual capital
Even in relation to the new forms of IC reporting XBRL can provide a decisive
contribution. This language indeed has a strong harmonisation potential due to its
capacity of identifying unambiguously information and its underlying “significant”.
Today in fact one of the main problems affecting the diffusion of IC reporting
is the lack of a standardised content as well as a certain degree of terminological
fuzziness, in so that, for instance, two intangible resources can be referred to using
two different terms or the same term can refers to dissimilar intangibles. In the latter
aspect, XBRL can assure, by its own nature, a new level of terminological clarity
and univocal meaning, vis-à-vis all preparers and users of this type of information,
provided of course that a generally agreed taxonomy of intangibles can be soon
developed and adopted in practice.
Conclusions
Reporting financial information and other accounting disclosure in a broad and

timely manner is in the best interest of companies of all makes and sizes. The
technology that is making this possible is XBRL, whose aim is not to establish new
accounting standards, but to represent financial information disclosed by companies
in a consistent manner to prepare financial statements more efficiently, to exchange
information more reliably, to publish more easily and analyse data more quickly.
This is possible by tagging financial information, which allows information to
retain its context as it moves through the business reporting supply chain.
The importance of comparing data is important in areas such as Intellectual
Capital: Comparing information published by different companies in a common
format permits users to identify more easily the differences in the treatment of
Intangibles.
As with any new technology, adoption and implementation is achieved through
trial and error. There are differing views on how best to work with multiple
taxonomies and or how to build instance documents. Because there are multiple
sets of accounting principles, there must be different XBRL taxonomies to represent
each. However, because XBRL International represents a broad spectrum of interests,
those views and others are resolved quickly yet collectively.
There are several research areas that can be explored. One regards the approach
used to develop taxonomies; another concerns the quality of a taxonomy, in terms
of comparability and completeness. A final research issue involves testing and
validating taxonomy processes. It is concerned with several concepts, like the use
of the taxonomy for external and internal uses, the collaboration with organisations
such as the IASC Foundation or the attempt to identify similarities between one
GAAP to another GAAP.
There is no doubt that XBRL will bring about a “revolution” in a financial
reporting world that is typically accustomed to gradual “evolution”. But it is a new
technology and as with any new technology there is both a learning curve and an
adoption period. XBRL International members are working together to provide a
successful implementation. This consensus is not will information be reusable but
when will this occur. And we think that now is the right moment.
References
Australian Prudential Regulation Authority (APRA) (2002), http://www.apra.gov.

au.
Di Piazza, S. A. and Eccles, R. G. (2002), Building Public Trust – The Future of
Corporate Reporting, John Wiley & Sons, New York.
International Accounting Standards Committee Foundation, www.iasb.org.uk
Matthews, D. (2002), ‘XML/XBRL and the NAIC Databases’, National Association
of Insurance Commissioners.
Microsoft Corporation, www.microsoft.com.
Ramin, K. (2001), ‘Development in XBRL and Reporting for Intangibles’,
presentation in Ferrara, 5th June.
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in San Antonio, 16th August.
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XBRL International Inc., www.xbrl.org.
Chapter 9
The Neglected Intangible Asset:

Organisational Power in the
Knowledge Economy
Giovanni Masino
Introduction
The research about intangible assets (IA) has always been very grounded in practice,
and somewhat guided by it. In their literature review, Petty and Guthrie (2000)
show that some innovative practitioners’ interest in the topic of IA, and their need
for IA management tools, had a relevant role in pushing the academy to take the
issue seriously. In the early period of the IA “movement”, most research effort
was devoted to the definition of “usable” management tools for visualising and
measuring intangible assets and intellectual capital, and to establish the legitimacy
and the relevance of the topic.
In the last few years, however, the debate about how to improve the theoretical
foundations of the IA research began to develop. Not surprisingly, several conceptual
problems emerged. Many authors (for detailed reviews, see Kaufmann and Schneider
2004, Marr et al. 2003, Petty and Guthrie 2000) pointed out that there is still no clear,
specific, shared conceptualisation about what intangible assets actually are – that
is, in what sense they are “intangible”, and in what sense they are “assets”, how
and why they are relevant in strategic and organisational terms, and how they can
be managed by firms (or other organisations) in order to achieve desired outcomes
(efficiency, effectiveness, innovation, value, etc.). There is a plethora of broad,
general definitions, sometimes so generic that they tend to be tautological, as they
provide very little help to a deeper understanding of the IA phenomenon. We believe
that in the IA academic community there is a need of a broader, and somewhat
different, theorisation effort, and, most of all, there is a need for more autonomy
from the hic-et-nunc needs of the business community. As Mouritsen put it (2004),
the problem is not that we need to test the available theories, but that it is not yet so
clear how a theory should look like. Do we really have an “intangible assets-based
theory of the firm” yet? The answer is highly doubtful.
Calling for “better theory” does not mean that the IA research should abandon, or
even relax its traditional intervention orientation. Mouritsen (2004) stated that
… measurement is not to be evaluated on its reflection of reality but rather on its ability to
help actors transform their agenda. This is particularly true for intellectual capital, which
is widely accepted as part of an agenda for transformation and growth – it is a strategic /
political agenda (Mouritsen 2004).
The idea of an intervention-oriented field should be further expanded and

explored. This is not contradictory with a call for better conceptualisations. On the
contrary, a better conceptual understanding of the IA phenomenon would help the
IA discourse to emancipate from, or at least to loosen up, the cumbersome link with
the business immediate needs and interests. This, in turn, will eventually lead to an
improved capacity to help practitioners with better tools and ideas.
There are a number of theoretical directions that need to be explored by the IA
community. In this respect, we think that an important one concerns what Mouritsen
called the “strategic / political agenda”. In fact, while it is true that the research work
on intellectual capital and intangible assets is widely recognised as strongly tied to
goals of “transformation and growth”, it is also true that the “political” aspect is
almost – if not totally – neglected. There is hardly any sign (to our knowledge) of IA
students working on power-related issues. In their extensive review, Gordon and Grant
(2005) found extremely sparse research contributions about the relationship between
knowledge management and power. Although one could argue that intangible asset
management is more comprehensive than knowledge management, we are strongly
convinced that an analogous review about the intangible assets research field would
find a very similar pattern. In Kaufmann and Schneider (2004) exhaustive review,
for example, there is no mention of power as a relevant “dimension” of the numerous
intangible assets proposed concepts and definitions, no reference to power as an
element of the many available taxonomies of intangibles, no citation of power in the
several measuring and reporting models.
This lack of attention for power issues by the IA scientific community is
somehow curious – however, as we will show later, it is also explainable. In fact,
one could easily argue, as we will in this chapter, there are at least three reasons why
IA students should be much more interested in power issues. First, power is a very
relevant intangible asset in itself. Second, it is deeply, almost inextricably connected
with other, more traditional intangible assets (like, for example, knowledge). And
third, it is also very relevant as an interpretive key of the whole IA discourse and
its rhetoric. In many ways, indeed, this lack of attention appears more than just a
happenstance, or just a consequence of the relative youth of this research stream.
Instead, it may be interpreted as a “symptomatic silence”, one of those “holes” that,
in social sciences, are more revealing than what is openly said and told.
In the following paragraphs, we will briefly explore these issues. The goal of
this contribution is not to provide a comprehensive, detailed analysis, but to suggest
some stimuli for further reflections and research. First, we will offer a few ideas
about why and how power can be considered a relevant intangible asset in itself.
Second, we will examine the relationship between power and knowledge, and we
will show why such a relationship is relevant for the IA field. In the last paragraph,
we will propose some final remarks about how, and why, the IA research would
benefit from exploring different epistemological directions.
The Neglected Intangible Asset: Organisational Power in the Knowledge Economy 209
The Concept of Power
In order to see how power could be considered a relevant intangible asset, we need
to briefly review some of the most important conceptualisations of power. Several
different approaches can be found. Hardy e Clegg (1996), for example, identify two
main streams of research.
The first one stems from the classic works of Marx and Weber, in which the
fundamentals of the Critical Management Studies’point of view on power relationships
can be found. Marx’s concept of power was related to the ownership of the production
means, while Weber focused on knowledge as the main source of power. Thus,
Weber was the first social scientist to identify the relationship between power and
knowledge, which is obviously very relevant for the IA literature, however widely
neglected1. Both authors, in different ways, show that domination structures are not
implied by a social (or organisational) order which is inherently superior in terms of
some sort of supposedly “neutral” rationality. Instead, domination structures are the
outcome of historically determined, social (or organisational) processes. Change is
always possible, because the legitimacy of existent power arrangement is neither the
only practicable one, nor (necessarily) the most desirable. In Weber’s thinking, more
specifically, is evident how power relations are conceived as “reciprocal”, there is
always a co-dependence (although not necessarily symmetrical, of course) between
actors. This idea sheds light on the fact that domination structures contain the seeds,
and the opportunity, for their own change, even if those seeds are often overlooked or
difficult to recognize. A great part of the critical management studies largely builds
upon the work of these classic contributions.
Hardy and Clegg (1996) identify a second approach to power, which is based
on a functionalist stance, widespread in the mainstream literature. According to this
view, organisational power is fully legitimated in the functional rationality of the
organisational designs, forms and hierarchies. Any attempt to deviate from such
arrangements is considered illegitimate because it would lead to system dysfunctions.
As such, any deviation is negatively labeled as a “political” use of power – in other
words, it’s considered a kind of action that represents the interests of only some of the
relevant groups involved in the social (or organisational) setting. As a consequence,
the functional equilibrium of the system is damaged.
It is worth noting that the functionalist view neglects the fact that the so called
“system rationality” (as any kind of rationality) does reflect some group’s interests
as well – in this case, the interests of organisational élites, ownership and senior
management. On the contrary, the functionalist approach seems to imply and convey
a “double” interpretation of power. On the one hand, the exercise of power by the
management is seen as an exercise of pure rationality, a legitimate use of the right
managerial tools for the best efficiency and functionality of the system. In this sense,
power is not a relevant aspect of the management studies, because rationality is all
that matters – thus, power is just a necessary (and desirable) consequence of superior
rationality. The study of management is the study of rationality. On the other hand,
1 The relationship between power and knowledge will be examined in more details in
the next paragraphs.
the exercise of power by other stakeholders is seen as “political” action, a one-sided
activity which is detrimental for the system as a whole. In this sense, the exercise of
power (that is, any action taken to change the current dominations structures, which
are seen as “structures of rationality”) has to be neutralized.
Another well known and useful conceptualisation of power is provided by Lukes’
work (1974). The author identifies three “dimensions” of power.
The first one refers to the overt existence of conflict: power is openly exercised in
order to influence decision making, and its very nature lies in the control of crucial
or scarce resources, resources upon others depend. It is such resource-dependency
relation that enables those individuals who control such resources to influence
decisions or, in other words, to exercise power.
The second dimension refers to the existence of conflict without actual
participation to decision making. Power, in this case, is used in order to suppress
certain options and alternatives – or, in other words, to exclude certain actors to
decision making. In theoretical terms, this dimension seems to be a variant of the
first one. In the former case, power depends on the capacity to control resources. In
this case, power depends on the capacity to control the decision process itself. In
both cases, however, conflict is present because interests are not only opposed, but
also recognised as such by the actors.
The third dimension refers to the absence of conflict as a consequence of power
exercise. Power is used in order to control the perceptions of the various interests at
stake: people’s interpretations, preferences, judgments. Power is no more a way to
directly manage conflict, but a way to avoid it by suppressing the perception of its
existence.
Lukes’ work is useful because it helps to better understand in what sense power
can be considered an “intangible asset”. In order to explore this issue, we need to go
back to the most common definitions of intangible assets and intellectual capital.
Power as an Intangible Asset
Despite the use a variety2 of terms (Kaufmann and Schneider 2004), the most relevant
taxonomies of intangible assets refer to three main, general “areas” or “types” of
assets (Sveiby 1997, Stewart 1998, Sullivan 2000, Sanchez et al. 2000, Mouritsen et
al. 2002). The first type of intangible assets refers to the “external capital” of the firm
– that is, everything that concerns the relationships between the firm and external
actors like customers (actual or potential), suppliers, institutions, but also patents,
reputation etc. The second one refers to the “internal capital” – that is, everything
that concerns the internal organisation of the firm, the technologies, the processes,
the routines, and so forth. The third one refers to the “human capital” – that is,
everything that concerns the human resources, like the skills, the knowledge, the
competencies, the motivation of people, etc.
2 We will argue in the final paragraph that such variety is mostly terminological, rather
than a conceptual one.
Given this commonly accepted classification, we need to ask the following
questions: does power have something to do with these “assets”? How does power
fit within this classification scheme?
If we look at the so called “external capital”, it is not difficult to see that it is
absolutely crucial to take into account power in order to really understand why and
to what extent a certain relationship with some external actors (customers, suppliers
or others) could be considered an actual “asset” for the firm’s competitiveness. In
fact, not only all relationships are not necessarily “assets”, but some can even be
considered as liabilities. It depends mostly (if not completely) on the capacity of the
firm to influence the ongoing decision process that is relevant in the relationship – or,
to avoid being influenced by others. Indeed, all three Luke’s dimensions of power
are, in different ways, very relevant at that. Marketing and commercial activities,
for example, are mostly a matter of creating dependencies, suppressing alternatives,
and influencing judgments and perceptions. And this is not much different from
other management areas, like the relationships with suppliers, with institutions, or
with other external actors. The boundary between “cooperation”, “trust”, and power
exercise (especially if one considers the second and the third dimension of power,
in Lukes’ distinction) is always very ambiguous. It is very difficult to see how a
firm’s “cooperative” relationship with a supplier (or a customer) could sustain itself
without some sort of influence on the “partner’s” decision making, either through
overt power exercise or, as it happens more often in the “post-fordist” economy,
through (more or less subtle) elimination of alternatives or control of decision
premises. Convergence of interests, of course, can have a relevant role, but it is
highly doubtful that convergence alone can fully explain the “external” dynamics of
current firms and organisations.
Similarly, we are not saying that anything concerning the “external capital” of
the firm can be directly related to, or completely explained by, power dynamics.
We are just saying that power is still, even in the “knowledge”, “post-fordist”
economy, a major element for the interpretation of firms’ competitive advantages
and organisational actions, especially – but not only – if we look at the “external”
types of intangible assets. What is changing in the “post-fordist economy” are the
ways power is exercised, not its relevance. Lukes’ second and third dimensions of
power are becoming more and more relevant. This also means that power exercise
is becoming more difficult to recognize. It is becoming more “intangible”. In this
sense, power could – and should – be considered as a major intangible asset in itself.
Or, depending on the level of analysis that one chooses for its interpretation, it could
be a major conceptual reference in order to understand the actual “value” of other
intangible assets.
Power seems to be very relevant even if we consider the second general type of
intangible assets, the “internal capital”. Several authors have noted how the “new”
organisational forms and practices (the ones that are more frequently associated with
“new” ways of organising, as opposed to the “traditional”, fordist organisational
form) do not imply necessarily a shift of relevance from power to other organisational
principles. It can be argued, instead, that the new organisational forms and practices
are based on different ways of using power, different methods of controlling. The
traditional mechanisms of formal authority and direct supervision are replaced by
more subtle, unobtrusive control techniques. The fundamental principle remains the
same, while the change occurs at a more “superficial” level. And the widespread
managerial rhetoric about the “new economy” helps to convey and diffuse the
idea that something radically innovative is happening inside the firms in terms of
organisational solutions and principles.
There is an increasing number of authors (although still a small minority if
compared with the mainstream literature, which vastly supports the “organisational
innovation” managerial discourse) whose work is very helpful in highlighting the
growing gap between rhetoric and reality. For example, Hardy and Leiba-O’Sullivan
(1998) argued that the commonly cheered “empowerment” practices imply very
little, if any, transfer of decision making capacity from the management level to the
workshop level. In many cases, as Kizilos (1990) clearly stated, we see companies
that
are attracted to a fantasy version of empowerment and simultaneously repelled by the

reality. How lovely to have energetic, dedicated workers who always seize the initiative
(but only when “appropriate”), who enjoy taking risks (but never risky ones), who
volunteer their ideas (but only brilliant ones), who solve problems on their own (but make
no mistakes), who aren’t afraid to speak their minds (but never ruffle any feathers), who
always give their best to the company (but ask no unpleasant questions about what the
company is giving back). How nice it would be, in short, to empower workers without
actually giving them any power.
Total Quality Management (TQM) and Business Process Reengineering (BPR)

practices have also been criticised by several authors for similar reasons, both from
a theoretical and an empirical point of view, despite the rhetoric of liberation and
emancipation surrounding them. Parker and Slaughter (1988 and 1994) provided
empirical examples about how TQM principles can lead to highly stressful and highly
constrained (controlled) work settings. According to Clegg (in Jermier and Clegg
1994), TQM represents a new way of exercising centralised control and authority
over the subjects, rather than a practice for emancipation. TQM implies
… a new kind of reflexivity, a totally reflexive loop fashioned on a one-dimensional

human subjects, constantly regarding themselves, their labor processes, their products
and practices, from the singular auspices of zero defects as a discourse organisationally
implanted to them! On the one hand it seems rather a liberal intervention, removing the
need for external surveillance, but replacing it with this new form of neurotic subjectivity.
It has rather an authoritarian impulse, I think, because of its one-dimensionality. From the
perspective I have, I wouldn’t see these as any kind of liberation. They’re just another part
of the network of power within which we get framed, literally and punningly. (Clegg, in
Jermier and Clegg 1994).
This is not an isolated point of view. There are several other authors who criticised
TQM and BPR in a similar manner, using both theoretical arguments and empirical
evidences (see, among many others, Boje and Winsor 1993, Collins 1996, Vallas
1999, Wilson 1999, Prujit 2000, Nichols 2001, Kidwell and Scherer 2001). The
new control methods implied and used by the “new” managerial “mantras” can take
different forms: peer pressure constraints generated by the use of teamwork (Sewell
1998, Boje and Winsor 1993), centralisation of actual decision making capacity
through organisational design and sophisticated information systems (Prechel 1994,
Wilson 1999), and cultural control practices (Pucik and Katz 1986, Clegg 1989,
Hardy and Leiba O’Sullivan 1998).
The critical discourse about the “new” organisational practice should at least be
considered as a warning for IA researchers. The capacity to control internal processes,
to centralise decision making, to culturally standardise and homologate judgments
and perceptions (as opposed to the current rhetoric on decentralisation, autonomy,
empowerment, motivation, teamwork, continuous learning, TQM and BPR designs
and practices) are still (even in the self-proclaimed “post-fordist” economy) crucial
features of firms’ intangible “internal capital”. The exercise of power “inside” the
firm is certainly changing, sometimes dramatically, its ways and methods, but this
does not mean that it’s becoming obsolete. On the contrary: if intangible assets
reporting, analysis and measuring techniques fail to clearly consider and reflect these
aspects, then they run the risk to provide an incomplete picture, if not a distorted one,
of the organisational characteristics of many current firms.
Power and Knowledge
The third dimension of many IA classification schemes concerns the “human

capital”, that is, employee motivations, competencies, skills and knowledge. It is
not surprising that many consider knowledge as the most important of all intangible
assets, the “holy grail” of current business competition. Instead, it could be surprising
that, in the IA discourse, the relationship between power and knowledge, a long
examined and studied one in the organisational literature, has been almost ignored.
Even in the knowledge management area, as we will see, the construct of power has
been either neglected, or considered in a very limited way.
As we already pointed out, Gordon and Grant (2005), in their very comprehensive
review, found that in the knowledge management literature only a very small
percentage of contributions concerned the issue of power. Moreover, almost all of
the (few) works who addressed this issue used a conceptual approach by which
power is seen as a mere consequence of knowledge. In this sense, the main idea is
that “knowledge is power’, meaning that actors (either individuals or organisations)
with better knowledge have the capacity to exercise power, for example by
establishing resource allocation and dependencies, influencing decision making,
controlling judgments and consciousness of interests. According to this point of view,
knowledge generates (it is a basis of) power. Even such a “traditional” approach to
the power/knowledge theme, should be inspirational for IA writers. If we consider
such a relationship, in fact, it becomes clear that different kinds of knowledge can
yield different kinds of “impacts”, as intangible resources, on the competitiveness of
the firm. In other words, while some knowledge can be relevant for well known and
studied reasons (because it generates innovation, ability to react rapidly to changing
market conditions, and so forth), other “pieces” of knowledge, that might not seem
so relevant for those traditional reasons, instead can be very relevant as far as the
capacity of the firm to exercise power is concerned. This is very relevant, for example,
when we consider the firm’s knowledge about external actors, like key customers or
institutions. A deep, detailed knowledge of these actors’ internal decision making
processes might not be so relevant, for example, in terms of immediate innovation
capabilities, but it could be crucial in terms of the firm’s ability to influence their
choices, needs and expectations. So, considering how knowledge can affect power,
should lead to a better understanding about why and how (in what circumstances,
and to what degree) knowledge can be considered an “intangible asset”.
However, the relationship between knowledge and power could and should be
explored further. The “causal arrow” between the two elements is not a unidirectional
one. Several authors, many of them building upon Foucault’s work, have shown that
there is a much more complex connection (Townley 1993, Flyvbjerg 1998, Haugaard
2000, Clegg 2000, Knights 2002).
Firstly, Foucault (1977) emphasises that knowledge is produced as truth within
existing meaning systems that are socially and historically constituted. This is very
relevant for IA scholars. The extent to what knowledge can be considered an “asset”
is not context-independent – on the contrary, it depends not only on the present
context, but also on how the current state of affairs has been historically created. As
Gordon and Grant (2005) put it:
For knowledge management systems to actually manage knowledge they need to

recognize, reflect on, and encapsulate how the meaning systems in which they exist guide
truth production.
This, of course, creates major complications for the goal of visualizsing, reporting
and measuring knowledge. However, this is a problem that cannot be avoided, unless
depriving the knowledge management tools and systems of most significance.
The obvious next question is: how do the meaning systems evolve? How do they
change, and why? This is where power comes into play. According to the Foucauldian
view, not only it is true that knowledge is power, but also that power is knowledge.
That is, power is deeply coupled with knowledge because, through power, meaning
systems are created and defined. It is power that shapes what is considered “true”, and
how “new truths” are constituted into socially accepted “knowledge”. In this respect,
power and knowledge are inseparable, they are two faces of the same medal.
It is not possible for power to be exercised without knowledge, and it is impossible for
knowledge not to engender power (Foucault 1977).
This idea leads necessarily to a “strategic” view of knowledge (or, better, of the
power/knowledge duality). It is impossible to understand knowledge (even more so,
to understand knowledge as an “asset”) without considering the strategies of actors
(individuals and collective actors), their goals, their intentionality, their mobilisation
of power, their struggles for power. This view, for the IA literature’s goals, seems to
generate two kinds of problems.
First, it becomes very hard to imagine how one can report and measure knowledge
as an “intangible asset” without some explicit reference to the “strategic context”
within which such knowledge has been produced (in the past) and it is mobilised
(in the present). In other words, the “value” of knowledge is hardly separable from
the power dynamics that, inside and outside the firm, at different levels, define its
“truth”, its “legitimacy” and its “usefulness”.
Second, power in itself becomes, if seen as an “asset”, no less important than
knowledge, because power defines, generates and sustain (the value of) knowledge.
So, it could be argued that the current efforts to design accurate intangible assets
reporting and measuring tools should focus not only on knowledge, but also on the
capacity of the firm to legitimate, to sustain and to constitute the “truth status” of its
knowledge – in other words, its power.
A Meta-discourse on Intangible Assets
It can be argued, as Mouritsen did (2004), that one of the most important goals of the
intangible assets “movement” is to design measuring systems (or, more in general,
managerial tools) so that it becomes possible, or easier, to intervene on reality. In
other words, a good measuring system does not necessarily have to provide an
accurate description of reality, but it has to allow to take action, to promote some
kind of organisational or strategic change.
While it is true that a good measuring system does not necessarily reflects reality
in an ontologically accurate way (and this is probably true for most measuring
systems in the organisational and managerial field, including financial reports),
it is also true that a measurement system conveys (or try to) knowledge about a
certain reality. As Foucault clearly showed, knowledge does not concern some sort
of “objective” reality, because knowledge is socially and historically constituted,
as well as context-dependent. Nonetheless, once accepted and legitimated, once its
“truth” status is taken for granted, a measurement system does describe “reality”,
again, not because that reality is actually “true” in an ontological sense, but because
that “truth” becomes socially recognised as such.
So, while it is acceptable that measuring systems about intangible assets do not
need to describe the “real” reality, however it is very important that the IA debate
takes seriously the issue of what kind of “knowledge” (in the foucauldian sense),
what kind of “reality”, the IA reporting and measuring systems, and the IA discourse
as a whole, are trying to legitimate and convey to the public. This is why, we believe,
there is still a relevant need for more and better theorisation and conceptualisations
efforts about intangible assets. The goal of having a better theory, in this case, is
not necessarily (or not only) to get closer to the “objective reality”, but to develop a
better, deeper awareness of what “knowledge” the IA discourse is trying to establish
as “true”.
The reasoning behind our argument is not about the quality of AI current research.
We are not saying that the available theoretical work is too low in quality. On the
contrary, there are many interesting and stimulating contributions, as this book
clearly demonstrates. What we believe is that variety is seriously lacking within the
IA discourse. We disagree with most of the literature reviews, when they state (see
for example Kaufmann and Schneider 2004) that the IA field is characterised by a
too wide variety of views and interpretations, and that a dominant view still needs to
emerge. In epistemological terms, we believe that the very opposite is much closer to
truth. The field is very homogeneous, and while there is a terminological variety – but
not a conceptual one – and a plethora of minor variants of classification schemes and
definitions, the great majority of contributions (if not all of them) are all based on a
positivistic and objectivistic stance. Most research works seem to adopt a strategic-
contingentist, or a structural-functionalist view of the firm and its organisation. In
this sense, the IA discourse is monolithic. Not only there is a dominant view, but that
view is the only available one. Let us provide a couple of examples of this.
The most common analytical scheme of intangible assets (the internal-external-
human capital framework), derived from Sveiby’s work, is the best (and most
relevant) example. This approach clearly reflects the most typical distinctions
proposed by the functionalistic views of the organisation.
On the one hand, the distinction between “external” and “internal” elements of
the organisation is consistent with the idea of social reality conceived as a set of
separable systems and sub-systems, connected with each other, whose boundaries are
clearly identifiable, and where the overall goal of social (and organisational) design
is to achieve and maintain a functional equilibrium between them. So, in this sense,
it is possible to distinguish and separate the “organisation” from the “environment”,
“functional units” from other “functional units” and, more in general, “systems”
from “sub-systems”, each one with an internal functional equilibrium to achieve
and maintain, and each one contributing to its own external environment in terms of
higher (or lower) functionality.
On the other hand, the conceptual separation between the “human capital”
and “rest” of the organisation is also typical of a functionalistic view, where the
individual and the system are seen as different and separated “entities”, and where
the needs and requirement of the system must have a higher priority over the ones
of the “sub-systems” (including individuals), in the name of the overall systemic
rationality and functionality.
In this article, we showed how neglecting power within the IA discourse
represents a serious limitation. However, given the functionalist posture of the
debate, this lack of attention can be easily explained. As we have seen in the previous
paragraphs, the functionalist approach treats power as a necessary managerial tool
for achieving system rationality. As such, power is not relevant for management
studies: its exercise (by the management) is always justified for the sake of “system
rationality”, which is legitimated because it is supposed to be “neutral” (that is, it
does not serve any specific interest, but a general, superior interest for efficiency and
effectiveness).
The intangible assets discourse shows a similar posture. Terms like “intellectual
capital” and “intangible assets” are the keys that lead to a renewal of management’s
legitimacy. Management in the “new” economy requires new passwords, new
rhetoric forms, new languages, new ways of affirming itself as a major source of
organisational and strategic rationality. The IA discourse seem to provide these
requirements. Indeed, the shared belief among IA scholars seems to be, to put it
simply, that designing tools that allow to visualize, report and measure intangible
assets, will help managers to better manage their firms. System rationality, in this
respect, is all that matters. Which is, of course, a seemingly sensible point of view.
But, and this is why we call for more conceptual variety, it is not the only possible
one. It would be interesting, and very enriching for the IA field, to explore research
paths that build upon different epistemological approaches, use different concepts,
generate different theories and, eventually, interpret differently the link between
research and practice.
For example, it should be possible to reflect about the intangible assets’ relevance
for organisational design and change using Giddens’ structuration theory (1984) as
the main conceptual reference. In that case, the relationship between action and
structure would be conceived in a way so radically different from what implied by
the current IA literature, that the very concepts of intangible asset and intellectual
capital, and their relationship with organisational structuring, should be deeply
reconsidered. Similarly, it would be interesting to see what a “critical” stance (as
developed by the Critical Management Studies) would have to say about the issue of
intangible assets. Most likely, the role of power, and the relationship between power
and knowledge, would be brought in full light, and considered as a crucial issue. Also,
such an approach would help the debate not to focus on the management’s point of
view only, but to also take other interests, goals and rationalities into account, that
represent an important part of every firm and organisation, but that seem somewhat
(if not completely) excluded from the current intangible assets discourse.
In summary, we believe that more conceptual variety in the IA debate would
help not only its theoretical richness, but also its relevance for intervention purposes.
Comparison between different conceptualisation proposals – not just between mere
different terminologies and definition variants – would greatly benefit the evolution
of the field. The lack of attention for power as an intangible asset in itself, and
as an element that would help to assess the relevance of other assets, represents a
serious limitation but, most of all, it also represents a symptom, among others, of the
insufficient conceptual broadness that characterises the current IA discourse. Finally,
we believe that a closer interaction to the organisation science would also benefit the
IA debate. After all, organisation science’s main research object has always been,
although through the use of different terms, what nowadays’ managerial discourse
calls “intangible assets” and “intellectual capital”.
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Chapter 10
Intangibles and Performance

Measurement Systems in Opera Houses:
Case Studies from Italy and
the United Kingdom
Fabio Donato
Introduction
Cultural organisations are undertaking strong processes of modification of their

management systems (Anselmi, 2003). This is tied to a broader re-thinking of
the principles on which they are to operate. More and more cultural organisations
encompass financial considerations in their decision processes for a better utilisation
of the financial resources. Furthermore, there is a growing awareness of the need
for a stronger orientation towards stakeholders as well. For these main reasons
(reduction of the level of public funding, economy in the expenses and efficiency
in the utilisation of the resources, stronger openness and orientation towards
stakeholders), cultural organisations have changed or are changing their attitude to
operate in many European countries.
This chapter aims at pointing out how two of the most important European Opera
Houses, the Royal Opera House in Covent Garden, UK, and the Teatro dell’Opera
in Rome, Italy, are facing a different operating environment and new challenges.
Intangibles are critical factors for any organisation (Lev and Zambon, 2003), and
this is especially true for opera houses. Indeed, in recent years the importance of
intangibles has become even stronger, this calling for a better management of such
factors.
As well known in the managerial literature, to manage means to measure. However,
as it will be argued in this chapter, the analysed opera houses do manage intangible
resources but without a consistent performance measurement system. In fact, their
performance measurement systems are largely based only on financial information.
This paradox will be investigated in the chapter, under two different perspectives.
First, it is controversial whether the more popular categorisations of intangibles are
consistent with the features of an Opera House. Second, it is controversial whether
it is necessary to measure intangibles by figures, or it could be preferable to have a
descriptive approach (Mouritsen, Larsen and Bukh, 2001).
As it will be shown in the chapter, the analysed cases have opted for a descriptive
approach, but using a weak formalised structure. It means that these organisations focus
on intangibles without having a clear and formalized categorization to be followed.
This calls for a deeper analysis of intangibles, when referred to opera houses.
For this reason, this chapter suggests a categorisation of intangibles, specifically
suited for opera houses. Such a categorisation will possibly be used either through a
quantitative approach, or through a descriptive approach. In the first case, it would
be necessary to employ a consistent system of indicators. In the second case, specific
reports should be prepared, on the basis of a pre-defined structure.
The chapter is articulated as follows: the first section aims at pointing out the
methodology and the objectives of the research. Furthermore, the reason underlining
the choice of the Royal Opera House and the Teatro dell’Opera di Roma for a deeper
analysis will be described.
The second section will illustrate the above mentioned Opera Houses. For this
purpose, the chapter aims at giving some (short) details of the Royal Opera House
and the Teatro dell’Opera di Roma under the following perspectives: institutional
framework, organisational processes and structure, artistic production system,
relationship with the stakeholders, strategies carried out and in progress.
The third section will carry out a comparison between the two organisations
under a managerial system perspective. In this respect, their attitude towards the
management of financial resources as well as the management of the relationship
with stakeholders will be pointed out.
The following section will highlight the need for a more focused classification
of intangibles, when referred to opera houses. In this chapter, the categorisation of
intangible resources in human capital, organisational (structural, internal) capital
and relational (external) capital will be initially taken into consideration. In order to
better represent the distinctive features of the opera houses this categorisation will be
refined by dividing intangibles in two macro areas: intangibles that represent factors
of input and intangibles that represent factors of outcome for an opera house.
The final section presents some critical considerations about the consistency
of the performance measurement systems adopted by the analysed theatres. In
this perspective, the refined categorisation of intangibles will allow to suggest a
performance measurement system specifically crafted on the characteristics of an
opera house, composed of indicators of input (quality of the internal structures and
processes, and quality of the artistic and non-artistic personnel) and indicators of
outcome (quality of the artistic performance and quality of the relationship with
stakeholders). In the same section, the reasons for either the adoption of either a
quantitative approach, or the adoption of a descriptive approach will be debated.
The Objectives and the Methodology of the Research
The objectives of the research are two-fold. On the one hand the research aims at
understanding the Opera Houses under a managerial perspective. On the other hand,
the research aims at the definition of a performance measurement system suited
for an opera house. For this purpose, a categorisation of intangibles consistent
Intangibles and Performance Measurement Systems in Opera Houses 223
with the distinctive features of an Opera House will be suggested. Indeed, Opera
Houses are quite complex organisations that have been only partially considered by
the majority of the business economics studies. Nevertheless, it has to be pointed
out that some of the characteristics of such organisations seem to be strongly
interesting in a managerial view. This is particularly true since intangibles seem to
be the most critical factors for such organisations. The institutional framework has
a strong influence on the way they are to operate and on their overall performance.
The organisational processes have a high degree of complexity tied to the presence
of different kinds of professional figures that work closely interrelated with an
administrative area. This means that there could be difficulties in the interrelation
both between the professional and administrative area and between different
professional areas (Orchestra, Opera, Ballet). The artistic production system is
characterised by a strong level of complexity because every concert, every opera,
every ballet is a unique performance whose success is influenced by a large number
of factors, and the possibilities of standardisation are relatively low (in some cases
even not possible at all). Furthermore the time of delivery of the productions is
pre-defined and not changeable. The relationship with the external stakeholders
is particularly complex as well (Chong, 2002). In fact, for an Opera House, there
are many categories of stakeholders: the citizens and the public institutions (Arts
Councils, Municipalities and so on); the Opera lovers, the artistic community in
a broader sense; the patrons. All these categories of stakeholders have different
individual objectives and perspectives. As it can be seen, intangibles play a crucial
role in the Opera Houses management processes.
Hence, this research aims at the comprehension of the critical factors for the
success of these organisations. Consistently with what has been stated above, it
seems apparent that internal and external information systems should particularly
encompass measures of intangible resources. This assertion raises the need for a
definition of a consistent performance measurement system based on intangibles.
In fact, in many cases, the management control systems adopted by cultural
organisations are at an early stage of development, and are based only on financial
information. Furthermore, opera houses are not often used to address their activities
through the evidences of a performance measurement system. Hence, a categorisation
of intangibles consistent with the distinctive features of an Opera House will be
suggested, and the reasons for either the adoption of a quantitative approach or a
descriptive approach are debated.
As for the methodology of this research, a deductive-inductive approach has been
followed. The deductive approach has been based on a literature review focused on
the subject of the management of opera houses, and cultural organisations more
in general. The inductive approach has been carried out through the realisation of
several in-depth interviews with executive directors, administrative directors and
artistic directors of opera houses, as well as through a comparative analysis with
international cases.
For the purposes of this research, amongst all the Opera Houses investigated,
the cases of Royal Opera Houses (ROH) and Teatro dell’Opera di Roma (TOR)
have been selected. This choice derives from the evidence that both Houses are
international Houses, with excellent artistic performance and positive financial
outcomes. Furthermore, both Houses come from a period of difficulties that has
been overcome by the development of a managerial approach based on a coherent
combination of the artistic and economic perspective.
Royal Opera House and Teatro dell’Opera di Roma: An Overview
The Royal Opera House is considered as the most important opera house in the UK.
It is located in Covent Garden, London, and its artistic productions are envisaged
as high-quality ones at an international level. The foundation of the Royal Opera
House can be dated back to 1732 under the name of Theatre Royal. In 1847 the
theatre changed its name to Royal Italian Opera and, eventually, in 1892, it was
named Royal Opera House. At the moment, the personnel who work full time at
ROH are composed of 820 persons. The artistic area is structured with an orchestra,
a ballet and a choir, while casting processes attract the opera companies. The Royal
Orchestra is made up of 104 musicians, the Royal Ballet of 88 ballet-dancers and the
Choir of 49 singers.
The organisational structure can be described as seen in Figure 10.1:
The management processes are realised in a transfunctional perspective and the
style of leadership is a participative one.
Figure 10.1 ROH organisational structure
As for the institutional framework, the actors who play a role in the governance
of the ROH are: the Parliament and the Government (particularly the Department of
Culture that is part of the Ministry for culture, media and sports), the Arts Council,
the Chairman, The Board of Trustees, the Executive director.
The Department of Culture has the responsibility to point out (following
negotiating processes with the other departments of the Ministry and the other
Ministries, and eventually with the approval of the Parliament) the budget that is to
be devolved to the overall sector of the arts in UK. The allocation of such amounts
of financial resources is devoted to the Arts Council that is an independent authority.
The Board of Trustees (whose President is elected by the Board itself) is responsible
for addressing and controlling the activities of the ROH. On this topic, two major
considerations are to be highlighted. Firstly, the composition of the Board itself is
quite interesting. In fact, the Board is composed not only of experts in the field
of the opera or the arts more in general, but also by experts in management, law,
fund raising and marketing. In other words, the competencies that are present in
the board, are related to all activities of the ROH. Secondly, the recent change of
name of the Board should be pointed out. This has been modified from Board of
Directors to Board of Trustees, to better mark the difference in role between the
Board and the Executive Director. Indeed, the Executive Director is responsible for
the management of the House and he/she towards the Board for the artistic and
financial performance achieved.
As for the artistic performance, it has to be underlined that ROH is one of the
most important opera houses at an international level. The artistic reputation of the
House is high and the performances are often considered of excellent artistic quality.
Every year the ROH realises some 20 opera productions, 8-10 being new productions,
while the opera performances are 130-150 circa. Also ROH ballet performances are
ca130-150 per annum. Usually, there is a new production (particularly important in
an artistic perspective) annually, and the overall productions are 10-14. Furthermore,
small groups of musicians hold soloist concerts and, recently, a new ROH office has
been set up (named ROH2) for the development of innovative productions realised
by young artists. As it can be seen, the artistic production is quite complex which
is reflected in the difficulties of definition of the annual season. The plot of opera
performance, ballet performance, soloist concerts, ROH2 productions calls for a
careful scheduling activity of times and spaces.
The Teatro dell’Opera di Roma (TOR) is one of the most important and prestigious
opera houses in Italy, and the quality of its artistic productions are recognised at an
international level.1 In particular, it has been declared by Italian law as the “Teatro
di rappresentanza nazionale per quanto riguarda le fondazioni lirico-sinfoniche
italiane”, e.g. Italian national representative Opera House, together with the Teatro
alla Scala di Milano. The foundation of the TOR can be dated back to 1877 under the
name of Teatro Costanzi. The first performance was held 27 November 1880 in the
presence of the Italian Royal family. In 1928 the theatre changed its name in Teatro
Regio dell’Opera di Roma and, eventually, after the referendum that abolished the
monarchy in Italy, in 1948 it got the name Teatro dell’Opera di Roma. Currently,
personnel who work full time at TOR are composed of 547 persons. The artistic area
1 As for the management of Italian Opera Houses, see Zan (1997), Sicca (1997),
Sicca and Zan (2004).
is structured with an orchestra, a ballet and a choir, while the opera companies are
attracted by casting activities. The TOR Orchestra is composed of 120 musicians,
the Royal Ballet of 70 ballet-dancers and the Choir of 96 singers.
As for the organisation structure, it can be described as below:
Figure 11.2 TOR organisational structure
As for the institutional framework, the actors who play a role in the governance
of the TOR are the Parliament and the Government (particularly the Department of
performing arts that is part of the Ministry for Cultural Heritage), the Chairman and
the Board of Directors, the Executive director.
The Department of performing arts has the responsibility to define and assign the
F.U.S. “Fondo Unico per lo Spettacolo”, e.g. Overall Funding for performing arts. It
has to be underlined that in the Italian case F.U.S. is generally a large fraction of the
total amount of financial resources of an opera house.
The governance system has been set by a decree issued in 1996. Following the
decree n. 367, 29 June 1996, the major Italian Opera Houses have been transformed
into private foundations. Nevertheless, at moment, the governance is still in charge
of representatives of public authorities. In fact, the objective of the participation
of members of private organisations in the foundation capital (and then in their
governance) is still far from to being fully reached. The executive director (i.e.
Sovrintendente), who is appointed by the Board, is responsible for the management
of the House and he/she is responsible towards the Board for the artistic and financial
performance achieved.
As for the artistic performance, in the recent years the TOR has constantly
increased the number of performances realised. In 2002 TOR has carried out 118
opera performances, 87 ballet and 27 concerts. The performance is staged both in
Rome and abroad. When in Rome, the “traditional” performance is staged in Teatro
Costanzi, while the innovative ones run in the nearby Teatro Nazionale. During
the summer season the performance are realised in an open-air environment in the
Terme di Caracalla area.
In a comparative perspective, some major points could be highlighted. Both Opera
houses have their roots in the far past and are recognised by the artistic community as
Opera Houses whose productions are of a high quality. The management processes
are more fluent in the case of ROH. Probably this is tied to the utilisation for a
long time of an effective information management system, able to integrate all the
activities in a transfunctional view. At the moment TOR is going along this path,
also management processes seem to be more structured in the ROH case, while
more flexible in the TOR case. In both organisations an essential role is played by
the Executive director/Sovrintendente whose style of leadership is participative. The
attitude of the Executive director/Sovrintendente appears to be the prime factor that
influences the organisational culture. The organisational structure is more articulated
in the case of ROH, with the presence of more focused departments. This could be
linked to the ROH’s longer attitude towards market orientation. As it will be shown
later on, the public funding is a smaller fraction of the total amount in the case of the
ROH compared with the TOR.
Paradoxically enough, in an institutional view TOR is a private organisation
(foundation) whilst this is not the case of ROH. Nevertheless, the members of
the Board of Trustees of the ROH are self appointed – but it is necessary to gain
the approval of the Arts Council and the Ministry of Culture; in the case of TOR
it is a public body (Municipality, Regional Authority, Ministry of Culture) that
appoints the Members of the Board. The differences in the productions reflect the
distinctive artistic culture of the two countries (UK and Italy). In particular, of Italy
there is a lower number of revivals, and this enhances the orientation towards new
productions.
Finally, it is quite interesting to point out that the main strategic objectives are
common to the two opera houses. In both cases they are threefold: excellence of
artistic performance, broadening of the audience (also in the direction of attracting
younger people and reducing the image of elitism) and opening the House and
enhancing the social cohesion.
Royal Opera House and Teatro dell’Opera di Roma: The Financial Performance
and Relationship with Stakeholders
This section aims at pointing out both the financial performance and the capability
of achieving a social cohesion with the different categories of stakeholders of the
analysed opera houses. As to financial performance, both Royal Opera House
and Teatro dell’Opera di Roma are at moment in good condition, but they have
faced financial difficulties in recent years. In the case of ROH, the closing of the
auditorium in Covent Garden due to restoration work has essentially caused this. In
the case of TOR, the improvement of the financial performance is particularly tied
to the innovation introduced at managerial level. To ROH, financial performances in
2001 and 2002 have been as shown below. The revenues have been:
Year 2002 Value in pounds Percentage of the total

amount
Arts Council 20.5 m. 34,63%
Box office 19,8 m. 33,45%
Fundraising* 11,2 m. 18,92%
Commercial 5,3 m. 8,95%
Summer season 1,7 m 2,87%
Interests 0,7 m. 1,18%
Total amount 59,2 m. 100%
* Note that in year 2002 there has been a modification in the accounting of the fundraising
Year 2001 Value in pounds Percentage of the total

amount
Arts Council 20,0 m. 38,91%
Fundraising 6,6 m. 12,84%
Interests 0,3 m. 0,58%
As to the ROH costs, they have been:
Year 2002 Value in pounds Percentage
Performance, education and outreach 41,2 m. 70,07%

Premises and depreciation 7,1 m. 12,08%
Marketing 4,2 m. 7,14%
Management and Administration 2,5 m. 4,25%
Fundraising* 2,2 m 3,74%
House management 1,6 m. 2,72%
* Note that in 2002 there has been a modification in the accounting for fundraising.
Year 2001 Value in pounds Percentage

It has to be considered that the year 2000 was concluded in financial equilibrium,
whilst previous years suffered a financial crisis (in that period the auditorium in
Covent Garden was closed for restoration). As it emerges, ROH has gradually
improved its financial performance.
Also in the case of TOR, the recent years have shown a trend of improving
the financial conditions, even if not in a systematic way, as it is figured out below
(Euro):
Year Year Year Year Year Year

1999 2000 2001 2002 2003 2004
- 697.726 + 255.576 + 1.987.546 - 1.233.015 + 550.000 + 150.000
However, it has to be highlighted that in the period 1999-2002 financial

performance derived from different components, as it is shown below:
1999 2000 2001 2002

Net value of the production 2.680.360 2.319.555 -4.721.008 -2.104.565
Financial performance -639.901 -376.815 -71.988 -41.978
Extra-ordinary performance -1.378.814 -283.933 7.752.488 1.539.848
Financial results before tax 661.646 1.658.806 2.959.492 -606.695
Net Financial performance - 697.726 + 255.576 + 1.987.546 - 1.233.015
It appears that the good financial performance of the last two years above shown
(2001, 2002) has been supported primarily by extraordinary performance. Hence, it
could be quite risky not to consider this information in giving a judgement on the
overall performance of the TOR. Nevertheless, financial data related to recent years,
and particularly related to year 2003 and 2004 (see Table before) indicates a situation
of improving financial conditions.
Even if both opera houses appear to be in good financial conditions, it seems
to be necessary to proceed with a comparative analysis in order to focus on the
differences, also as a consequence of their different management approaches.
ROH and TOR: A comparison
The comparative overall financial performances of the two theatres have been
(pounds and euro):
2000 2001 2002

Royal Opera House +£0 + £ 11.000 + £ 385.000
Teatro dell’Opera + € 255.576 + €1.987.546 - €1.233.015
The respective total revenues have been:
1999 2000 2001 2002

Royal Opera House n.d. n.d. £ 51,1 m. £ 58,5 m.
Teatro dell’Opera € 46,3 m. € 51,7 m. € 49.1 m. € 52,5 m.
The respective total expenses have been:
1999 2000 2001 2002

Royal Opera House n.d. n.d. £ 51,4 m. £ 58,8 m.
Teatro dell’Opera € 43,7 m. € 49,3 m. € 53,8 m. € 54,6 m.
The comparison between the incomes is shown below. In this respect, the total
amount is shown net of interest expense, that is a non-operating value. It must be
highlighted that, without this amount, the ROH net performance is negative (revenue
£ 58,5 – costs £ 58,8).
Royal Opera House – 2002 Pounds Percentage

Arts Council 20,5 m. 35,04%
Teatro dell’Opera – 2002 Euro Percentage

Public funding 45,6 m. 86,86%
Other incomes 1,7 m. 3,24%
As for the costs, the analysis of the financial conditions shows the following data:
ROH 2002 Pounds Percentage

Fundraising 2,2 m 3,74%
TOR 2002 Euro Percentage

Costs for goods and materials 2.395.732 4,39%
Costs for services 14.276.515 26,16%
Costs for services (use of goods) 1.066.187 1,95%
Costs for personnel 34.947.555 64,04%
Depreciation 1.085.891 1,99%
Modification of the value of the stock -15.837 0%
Risks and future costs 639.413 1,17%
Other costs 170.783 0,30%
Total amount 54.566.239 100%
As it can be seen, the different value of income and costs shows a different way
of management of the analysed Opera House.
In regard to the management control systems, both Opera Houses have
implemented an accrual accounting system. They both adopt a budgetary system as
well. Nevertheless, it has to be pointed out that in the case of ROH the budgetary
system has been in operation for a longer period and it seems to be more accurate.
As stated at the beginning of this section, Opera Houses should be deeply conscious
of the importance of the quality of the relationship with their own stakeholders.
For an opera house the relationship with the stakeholders is characterised by a
distinguishing complexity. As well known, any organisation has several groups of
stakeholders: internal and external, and with a different degree of relevance. For an
Opera House, the management of the relationship with the stakeholder is a quite
difficult task, since it regards the relationship with a large spectrum of subjects, often
with a different attitude and orientation. Opera Houses have internal and external
stakeholders. The internal ones regard all the subjects who are involved into the
governance and the organisation processes of the opera house. The external ones
regard any subject, who is not part of the organisation itself in terms of governance
or organisational processes, but has a personal interest in the activities of the opera
house.
In this chapter, the analysis of the internal stakeholders has been carried out in the
third section, through the analysis of the governance and organisational processes.
Hence, in this section, the external stakeholders will be highlighted. For an Opera
House, the social cohesion derives primarily from the quality of the relationship
with: citizens and public institutions2, opera lovers, artistic community in a broader
sense and patrons. All these categories of stakeholders have different individual
objectives and perspectives.
For citizens and public institutions, it is considered that Opera Houses have
an institutional mission in terms of education of the citizens to the music culture.
Furthermore, the citizens finance (through the fiscal system) the public-owned
opera houses. The relationship with the opera lovers and the artistic community in a
broader sense appears under a different perspective. For instance, it could affect the
decisions on the degree of innovation of the opera and ballet productions during the
season. More precisely, it could regard the trade off between productions realised by
new artists and “traditional” performance. In this second case, another choice affects
the trade off between new productions and revivals. In this respect, the decisions of
the Opera House mark its strategic positioning in the artistic community as well.
Indeed, the importance of the perceived prestige of the individual Opera house must
also be emphasised. In fact, the prestige of the Opera house is an essential factor for
attracting the best artists, which is the essential factor for delivering performance of
high artistic quality. Patrons have different perspectives as well. In their case, the
decisions for funding or not an Opera house, appear to be tied to a broad range of
reasons, from either the pure love for the art, to the ambition to be part of a lobby, or
2 Some public institutions are internal stakeholders as well, since they are involved in
governance structures and processes.
simply the desire to attend special occasions such as Gala Dinners, or the premiere
of a Ballet or Opera.
As for the specific Opera houses analysed, some further comments deserve
attention. As for ROH, following the above-illustrated scheme, the relationship
could be structured along three areas: the relationship with the national and
international artistic community; the relationship with UK citizens, the relationship
with the patrons and the members of the ROH membership programme. As for the
relationship with the international artistic community, it has to be pointed out that
there is a bi-directional influence: on the one hand the quality level of the ROH
artistic performance contributes to increase or decrease the perceived prestigious of
the Opera house. On the other hand, the increasing or decreasing of the perceived
prestigious of the ROH supports or obstacles the attraction of the best artists, that is
the prime factor for a qualitative success of the performance. The relationship with
the national artistic community has recently been improved by the setting up of the
ROH2. ROH2 is a section of the organisation specifically devoted to the attraction,
support and development of the young artists. The relationship with UK citizens goes
beyond the public funding (through the fiscal system) and the attraction of potential
audience. The ROH has an institutional duty in terms of developing the opera and
ballet culture at a national level. For this reason, a specific department is responsible
for the ROH education programme. The programme is particularly addressed to
young students. Furthermore, during the last years, ROH has increasingly opened
itself to the community, through specific programmes that are addressed to reduce
the gap between the ROH and the community particularly the low and middle classes,
attempting to reduce and progressively eliminate the image of the ROH as an elitist
organisation. Finally, ROH has set up a specific department and has built up several
initiatives in order to develop their fundraising activities, introducing a membership
programme of a tiered structure of prices, for different levels of membership. Hence,
members can accede to specific benefits in terms of information, additional services
incorporating gala dinners and special nights, and advance booking advantages. It
should be emphasised that ROH can afford a membership programme, instead of a
subscriptions programme, due to the high percentage of seats coverage during the
season, usually around 95%.
Also in the case of TOR the external relationship can be structured along three
areas: the relationship with the national and international artistic community; with
Italian citizens, and with the patrons. As for the relationship with the national and
international artistic community, TOR is perceived as one of the leading Opera Houses
in Italy, at an international level. Joint activities with other national and international
Opera Houses are frequent, but they can not be defined as part of a network structure.
On the contrary, the relationships are often informal and founded on personal basis.
In the case of TOR, the relationship with the community, and particularly with the
local community, has peculiarities emerging from the distinctive features of the
city of Rome. Rome is one of the cities with the largest cultural heritage in the
world. This allows TOR to develop a large number of contacts with other cultural
institutions based in Rome. Finally, TOR is recently striving to improve the level
of fundraising.
In conclusion, from a comparative perspective, it appears the main difference
between the two Opera Houses, in terms of relationship with the stakeholder, is
represented by the degree of orientation towards fundraising and membership
activities. The reason could be explained in that the ROH is more developed in
these areas, and also has comprehension of the cultural roots of individual
countries. In fact, in the case of the UK, there is a higher attitude to fundraising and
membership schemes.
A Categorisation of the Intangibles Consistent with the Distinctive Features of

an Opera House
As it does emerge from the above-illustrated empirical research, intangibles

represent a critical factor for opera houses. Indeed, the results of this research are
quite consistent with previous theoretical analysis and other empirical researches
(Chong 2002, Donato, 2004), which put in light that the success of an opera house
is largely based on resources that could be defined as intangible ones. In fact opera
houses are founded on intangibles both on the side of the production and on the side
of the outcomes. The quality of the artistic production can largely range on the basis
of the quality of artistic and non-artistic personnel, as well as of the quality of the
internal organisation. Artistic production is a quite complex task where different
subjects, often with different perspectives, gather together. Furthermore, in every
organisation, and even more in an opera house where the presence of an orchestra, a
ballet company, and a team for casting external artists makes the internal complexity
greater and greater, the quality of the internal organisation is one of the most
relevant factors.
As stated above, opera houses are critically based on intangibles also on the side
of the outcomes. Generally, an opera house is a non-profit organisation, embedded
in its national or local environment, aiming also at the artistic education of the
citizens and at the development of the artistic culture. Not surprisingly, in these cases
financial outcomes are not the only institutional objectives pursued. The qualities of
the performance, the capability of developing the artistic culture, the social cohesion
with stakeholders, are part of the institutional aim of an opera house. To clarify,
these outcomes (quality and innovative degree of the artistic production, quality of
the relationship with the stakeholders) are intangibles themselves. Hence, in the case
of opera houses, intangibles can not be considered just as leading resources able
to improve their financial performance, but their objective itself (at least, some of
them). Obviously, this feature has to be considered while crafting a categorisation of
intangibles consistent with the characteristics of an opera house.
As for what concern the results of this study, it appears to be in place a strong
consciousness of the relevance of intangibles on behalf of the key subject of the
Opera Houses analysed. Executive directors, Sovrintendenti, artistic directors,
music directors, ballet directors, administrative directors, commercial directors, all
of them state that intangible resources are the essential platform for the success
and development of an opera house. Nevertheless, at the same time, intangibles
are not measured inside the organisation. This could represent a problem for these
organisations, since, as it is often highlighted in managerial literature, that you can
(better) manage what you (better) measure. The lack of a measurement system
referring to intangible resources makes it difficult to comprehend the trend of the
value of the intangibles itself. Furthermore, the lack of a formalised measurement
system pave the way to a risk: when the individual who holds a top-management
position leaves the organisation, the opera house loses the information capital as
well.
For all these reasons it appears necessary to improve the studies on intangibles in
such organisations with both a theoretical and an empirical perspective.
In particular, in the first aspect, it seems primarily necessary to focus on the
concepts and the categorisations of intangibles proposed by the academic literature,
in order to understand whether they are consistent with the distinctive features of an
opera house.
During recent years, studies and research on the subject of intangibles has
flourished, but interestingly not enough attention has been given to the role and value
of intangibles in public sector organisations, and especially in cultural organisations.
In fact, it could be observed that much attention is being devoted to the role and
value of intangibles in companies (Guthrie and Petty, 2000). Furthermore, in some
cases, confusion has occurred in the definition of the topic itself. In this respect, it
should be stressed that the concept of “intangibles” and the concept of “intellectual
capital” are similar but also somewhat different. In this sense, intellectual capital
is considered as a subset of the overall intangible resources. As stated by Guthrie
“there are items of an intangible nature that do not logically form part of a company’s
intellectual capital. A firm’s reputation is one such item. Reputation may be a by-
product (or a result) of the judicious use of a firm’s intellectual capital, but it is not
part of intellectual capital per se” (Guthrie, 2000, page. 158). Hence, the reason for
which in this chapter the concept of “intangibles”, instead of “intellectual capital”,
has been used: in order to focus such resources in a broader sense.
As for the categorisation of intangibles, a great influence has had the classification
proposed by Sveiby (the intangibles asset monitor) (Sveiby, 1997), Kaplan and
Norton (the balanced scorecard) (Kaplan and Norton, 1996) and Edvinsson and
Malone (Skandia Value Scheme) (Edvinsson and Malone, 1997).
In this chapter, the categorisation of intangible resources in human capital,
organisational (structural, internal) capital and relational (external) capital has
been initially taken into consideration (Edvinsson and Malone, 1997). However, in
order to better represent the characteristics of opera houses, it is argued that such
categorisation needs to be refined.
In fact, as stated above, in the case of an opera house some categories of
intangibles represent one of the institutional aims of the organisation itself. This is
the case of the quality of the relationship with stakeholders and the artistic quality of
the performance staged. As for the first aspect, it has to be outlined that opera houses
are non-profit organisations and, generally, public owned bodies, embedded in their
social environment. As for the latter, for an opera house, performing the artistic
heritage (as a means for strengthening the local or national identity) or spreading
the artistic culture (as a means for the education and development of the society) are
institutional aims itself. Therefore, it seems necessary for a division of the intangible
in two macro areas: intangibles that represent factors of input (specifically quality of
artistic e non artistic personnel, and internal organisational quality) and intangibles
that represent factors of outcome (specifically quality of the artistic performance and
quality of the relationship with the stakeholders).
The need for a division between factors of input and factors of outcome could
also be considered under a different perspective. In market-oriented companies,
the development of intangibles is deemed necessary in order to meet their financial
objectives in the short term or in the medium-long term. But in opera houses, the
balancing between incomes and expenses is based only for a short fraction on market
incomes (typically through box office or commercial incomes). A large fraction of
incomes derives from public bodies or from fundraising activities. It is quite apparent
how the quality of the relationship with stakeholders (and primarily with the local or
national community) as well as the prestige of the opera house (primarily obtained
through the quality or the degree of innovation of the performance staged), can
influence such sources of incomes. At the same time, good financial performance
can allow opera houses to strengthen and develop intangible resources. It means that
opera houses could strongly be subject to positive or negative loops. A worsening of
intangibles could have a significant influence on their financial conditions, and that
with a greater intensity than in other organisations, since the influence could be both
on box office incomes, and on public funding and fundraising incomes. This could
then force Opera Houses to reduce investment in intangibles with another negative
effect. In other terms, Opera Houses could be subject to vicious loops, or, hopefully,
virtuous loops. The categorisation, visualisation, measurement and management of
intangibles could help them to move in the latter direction.
An Extension of the Management Control System in Opera Houses: Towards

an Overall Performance Measurement System Based also on Intangibles
The management control systems of the analysed opera houses are based on a
budgetary system focused on financial data. The ROH the system is well structured
and has been currently working for several years. For the TOR, the process of
implementation of the budgetary system is in progress. It means that it is currently
working, improvements will be made in the next few years. Furthermore, both
organisations monitor quantitative data, tied to the artistic performance. In both cases
the evaluation of the artistic quality of the performance is not part of the management
control system. Notwithstanding, it does not mean that there is not an evaluation
at all. In both cases there is an auto-evaluation and for the ROH it is written in a
descriptive way in the annual report to be delivered to the Arts Council. However,
other critical dimensions are not formally controlled, such as the relationship with
stakeholders, the organisational capital, or the capability of learning and growth.
This chapter argues that in an Opera House, a management control system based
only on the budgetary process and focusing only on financial data is necessary but
not sufficient.
In fact, in first instance, it is necessary to monitor the financial performance
both in a project perspective (horizontal organisational view) and in a centre of
responsibility perspective (vertical organisational view) as well. Furthermore, it is
essential to back the financial data with other information focused on intangible
resources (Guthrie, 2001), to create a consistent performance measurement system
able to encompass both factors of input and factors of outcome (Kaplan and Norton,
1996).
In this view, the overall performance measurement system could be structured
as follows:
The project control system is related to the single production in a transfunctional
view. It focuses on both the opera and ballet productions. In these cases, the elements
that are to be monitored regard the artistic quality of the production, its financial
performance and the punctuality. The artistic quality should be not measured only
through a self-evaluation. It could be useful to set up a panel of external experts
(other members of the artistic community) and to ask for their evaluation over a
monitored period of time. That could allow the opera house to track the trend of
the reputation of its artistic productions. The control of the financial performance
could allow analysis of the net contribution of each production to the coverage of
the fixed costs. In this case, the variable costs and the box office incomes should be
Figure 10.3 The overall performance measurement system

considered. Finally, the monitoring of the punctuality should regard both the delivery
of the production, and the respect of the times during all the intermediate phases of
an artistic production.
At a centre of responsibility level, the effectiveness and efficiency of the centre of
responsibility could be monitored, as well as the degree of growth and capability of
learning. The first topic regards the traditional analysis in an organisational vertical
view. The effectiveness regards the capability to meet the objectives; the efficiency
regards the capability of reducing the costs necessary for meeting the objectives.
Finally, the learning and growth analysis is related to leading indicators that show
whether the centre of responsibility will presumably be able to meet its objectives
in the future.
As for the overall performance measurement system, it should focus both
financial indicators and intangible indicators. The analysis of the financial data could
be the traditional one, and in particular the analysis of the incomes, the costs and
their inter-relations. Instead, the choice of the intangible resources to be monitored
should derive from the characteristics of the individual opera house. This decision
highlights which are the most important factors to focus on. From this perspective,
the management control systems as a tool for addressing attention, as well (Mouritsen,
Larsen and Bukh, 2001).
This chapter suggests an overall performance measurement system structured
as shown above, through a distinction of intangibles between factors of input and
factors of outcome. However, this structure is not intended to be considered with a
general validity. The performance measurement system must be structured “ad hoc”
for every organisation.
In the suggested performance measurement system, the indicators tied to the
factors of input are the quality of the artistic and non-artistic personnel on the one
hand, and the internal organisational quality on the other hand. As for the quality
of the artists, the degree of learning and growth of the internal personnel should
be tracked. Furthermore, the capability of attracting the best artists and opera
companies should be monitored. This is tied both to the financial conditions and
to the perceived reputation of the Opera House. The internal organisational quality
should be measured under two points of view. First, the functionality of the processes
of the artistic productions, in a horizontal view. Second, the capability of innovation
of the Opera House, both at an artistic level and at a managerial level.
The indicators tied to factors of outcome are the quality of the artistic productions
on the one hand and the quality of the relationship with stakeholders on the other
hand. As for the measurement of the artistic quality, as already mentioned during
the description of the project control system, a panel of experts should be formed.
In this way the self-assessment could be combined with an independent and external
evaluation. As for the quality of the relationship with stakeholders, the measurement
system should focus on the most important categories of stakeholders for an
opera house. Since the quality of the relationship with the internal stakeholders is
considered among the factor of inputs, a suitable categorisation could be related
to external stakeholders, and specifically the citizens, the artistic community and
the patrons.
Obviously, the building up of the performance measurement system should
consider the choice of following either a quantitative approach, or a descriptive
approach or a melting together of the two. In fact, it is controversial as to whether
it is preferable to measure intangibles by figures, or through a description of the
performance achieved: there could be reasons both for the adoption of a quantitative
approach, and of a descriptive approach. In any case, the first step seems to be the
definition of a consistent categorization of intangibles, underpinning the building up
of the performance measurement system. If an opera house decides on a quantitative
approach, it is necessary to select measurable indicators that could effectively be
representative of the state of the performance achieved. The main advantage is the
clarity of the data; the risk is that the indicators could not encompass all the significant
variables, and all their aspects. On the other hand, the choice for a descriptive
approach, through written reports, has the advantage of being more flexible in
capturing all the different aspects of the performance; at the same time the risk is a
lower clearness in the visualization of the data and a stronger degree of subjectivity
in writing the results of the performance. The performance measurement system,
both in the case it is structured in a quantitative perspective, and it also structured in
a descriptive perspective, it should allow the opera houses: to address attention; to
define and communicate priorities, and to understand the trends occurring. Emerging
from the research of the analysed Opera Houses, even if in a non-systematic way,
and without a formalized categorization of intangibles, both quantitative indicators
and written reports to monitor their performance have been used.
Finally, it is necessary to outline that the performance measurement system should
point out the relationship between intangible resources and financial performance. In
fact, as already stated in the previous section of this chapter, in Opera Houses a large
fraction of incomes does not derive directly from market operations but from public
funding or fundraising activities. In these cases, the total amount is largely influenced
from the quality of the relationship with stakeholders, and from the reputation of the
individual Opera House. At the same time, good financial performance can allow
Opera Houses to improve their intangible resources. That can lead to a positive or
(on the contrary) negative loop. An effective performance measurement system
could help them to move towards a virtuous loop instead of a vicious loop.
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Chapter 11
Macro Indicators of Intangible Assets

and Economic Policy
Patrizio Bianchi and Sandrine Labory
Introduction
This chapter builds on the research performed by the team of the PRISM network
headed by Patrizio Bianchi and co-ordinated by Sandrine Labory. The research
showed that the “intangible economy” neither means that some new assets have
suddenly appeared and should now be taken into account nor that a new buzzwords
has been coined to be used in political rhetorics. Intangible assets have always
existed but what is new is the importance they have taken in recent years. Their
growing importance is a tangible phenomenon that has important policy implications.
The focus of this team was precisely the analysis of the policy implications of the
growing importance of intangible assets in economies, and the work was published
in a book (Bianchi and Labory 2004a).
The main findings are twofold. First, intangible assets are important determinants
of a country’s competitiveness and should be measured in order to provide an
adequate set of indicators. Examining indicators lead to the conclusion that some
intangible assets have been measured but imperfectly, while others have not been
measured at all. Human capital and innovation are of the former kind, while
organisational and social capital are of the latter type. It is our view in particular
that the social capital is an important asset because it allows all other assets to
interact and combine to produce new assets and value. Second, these interactions
should be the target of policies towards intangible assets and towards innovation and
competitiveness. In other words, policy should aim at favouring the development of
the complementarities between assets.
A first step in better understanding these complementarities is to try an evaluate
them. For this purpose, indicators of intangible assets have to be improved. In
turn, improvement in indicators requires to examine the reasons for the growing
importance of these assets in the economy. This is what Bianchi and Labory (2002b)
do and they argue that this growing importance is determined by a number of factors,
including:
• improvements in financial markets that have made it easier to finance

large investments, so that capital intensity is no longer a defence against
competition;
• the continuous increase in cross-border trade that has expanded markets, so that
firms that enjoyed oligopoly power at home now face global competition;
• the large fall in communications and production costs, thanks to the spread
of ICT;1
• the diffusion of a new flexible production process invented by Japanese
producers, especially in the automotive industry (particularly Toyota), which
has replaced the mass production system in many industries.
The knowledge content of products has therefore increased, implying a change in

the value creation process. While in the “tangible” economy (the economy where the
tangible capital contributed more to value than the intangible one) the manufacturing
stages of the production process are key, in the intangible economy the pre- and post-
manufacturing phases take primary importance, because the latter are the phases at
which products are invented, renewed and fit to consumers’ needs. In other words,
these are the phases where knowledge is collected (about markets and technologies),
processed, exchanged and created. These phases also primarily require intangible
assets (human capital, knowledge, organisational capital and social capital).
For firms this means that intangible assets are important determinants of their
value and hence the need to define accounting and reporting systems that account
well for these assets. At country level too, a country’s competitiveness now primarily
depends on intangible factors and appropriate indicators must be used. At the country
level, it can be argued that the main intangible assets are knowledge, innovation,
human capital and social capital (Bianchi and Labory 2002a).
The growing importance of these assets at country level has meant that
governments have focused policies aiming at their development: recently stress
on human capital and innovation in particular has been put in many governments
programmes or plans of action, as witnessed by the definition of the Lisbon strategy
in Europe.
In this chapter we show two things. First, there are important intangible assets
that have tended to be neglected but it is high time to consider them fully: we
intend here one intangible asset in particular which is social capital. Second, there
are important complementarities between assets that have to be taken into account
in order to formulate adequate policies towards individual intangible assets. An
important source of complementarity is the social capital.
This chapter is organised as follows. Section 2 briefly discusses both the indicators
of intangible assets currently used and the evidence of the growing importance of
intangible assets. Section 3 and 4 examine the complementarity between assets, in
the case respectively of innovation policy (section 3) and competitiveness policy
(section 4). Innovation policy has been increasingly focusing on favouring networks
and we show that this is an adequate policy to favour complementarities; however,
the creation of such networks should not neglect issues related to the creation of the
1 The OECD stresses that the diffusion of ICT has allowed improvements in productivity
but has not created a ‘new economy’: ‘While some of the more fanciful tales that ICT had
created a ‘new economy’ have proved unfounded, there is growing evidence that it has been
increasing productivity’ (OECD 2003a, p 12).
Macro Indicators of Intangible Assets and Economic Policy 243
necessary social capital. The social capital is also one of the endogenous determinant
of growth; we show this at regional level in section 4. Section 5 concludes.
Indicators of Intangible Assets
Given the confusion as to the nature and characteristics of intangible assets, there
are no perfect indicators. The review by Bianchi and Labory (2002a) of the main
indicators of a country’s performance highlights three characteristics. Firstly,
intangible assets are imperfectly measured, in that existing indicators do not capture
all their aspects. It is widely asserted for instance that measures of human capital
based on an achieved level of education do not include learning during working
life, and those countries with a large proportion of early school leavers, who are
later trained on the job, are therefore penalised. Another example is that although
innovation is often measured by R&D expenditure, not all R&D leads to innovation.
Secondly, some intangible assets, social capital in particular, are not measured.
Finally, although intangible assets appear to be undervalued, there is strong evidence
of their growing importance (OECD 2003a, b; OECD 2001a, b; Eurostat 2001).
Intangible assets have been partially measured using a number of proxies,
including R&D spending, employment in ICT, public spending in education, and
so on. For instance, Abramovitz and David (OECD 1996) estimate that the share of
tangible capital in the total stock of capital in the US economy fell from 65 per cent
to 46.5 per cent over the period 1929 to 1990, while the share of intangible capital
rose from about 35 per cent to 54 per cent.
OECD measures of investment in tangible versus intangible assets across OECD
countries (OECD 2001b), in terms of percentage of GDP, over the period 1991-
98 show that compared to the US, the EU has higher annual average growth rates
in investment, but the US has a higher proportion of intangible investments. In
Europe, the Scandinavian countries show the highest rates of growth of intangible
investments. The case of Finland is noticeable since it shows negative growth of
physical capital and a very high growth rate of investments in intangibles, the highest
among all reported countries.
To compute these measures, intangible assets are assumed to comprise higher
education, software and R&D, presumably measuring respectively the following
intangibles: human capital, knowledge and innovation. However, this procedure
raises two problems. First, the measures are incomplete: the percentage of the
population with higher educational degrees does not measure the whole human
capital of a country, since for instance it excludes training during the working life.
R&D spending is an input to innovation and does not measure how much a country
innovates but how much it invests in innovation. Software does not summarise
the whole knowledge base of an economy. Second, other intangible assets are not
considered, especially organisational and social capital (see the next two sections).
The result is that intangible assets are underestimated in these measures. Despite
these shortcomings, the evidence is that all countries are investing heavily in
intangible assets and therefore their importance is growing in the economy.
The OECD also provides evidence of their growing effect on growth. The OECD
(2003b) shows that growth is essentially determined by labour productivity, which in
turn crucially depends on three factors. Growth can thus be improved by improving
first the quality of labour used in the production process; second, the use of capital
and especially new capital like ICT; and third, by increasing overall efficiency, i.e. the
multi-factor productivity (MFP) by improved managerial practices, organisational
change and innovation in the production process. Evidence on the determinants of
the MFP is difficult to find because the MFP is a residual. However, a number of
studies make progress in this sense.
Intangible assets are peculiar in that they are both assets and generators of assets,
and that they result from the combination of various assets. An intangible asset is
created from a combination of both tangible and intangible assets. This result is very
important because it means that in order to favour the development of intangible assets
one needs to act on the combinations of assets, favouring interactions so that the best
combination is created autonomously, according to evolutionary mechanisms.
Hence complementarities have to be analysed in more depth.
Complimentarity betweenIntangible Assets: The Case of Research Networks
Research and innovation are increasingly made in co-operative projects, in which

firms relate to competitors, to research centres such as universities and to public
agencies, thereby constituting networks of innovation. Such networks have received
wide interest of both scholars and policy-makers, so much so that the policy approach
of the European Commission regarding policies for innovation and knowledge
diffusion (as well as policies for competitiveness) has changed from one of direct
intervention to favour specific actions to one of providing the proper environment
for innovation to take place (Labory 2004).
Actual EU policies towards innovation and knowledge diffusion are based on
the approach on which an environment favourable to such interactions is created. As
shown by Bianchi (1995), this is the case both of policies towards innovation and
knowledge diffusion and of policies for territorial development and for firm creation.
As Labory (2004) points out, this policy orientation evident since the beginning of
the 1990s can be interpreted as a change from “government policy” to “governance
policy”.
In the past, policies were interventions aimed at conditioning the specific
behaviour of economic agents in a sector, on the basis of given objectives; the
instruments were therefore either incentives such as state aids for the realisation of a
project, or disincentive such as taxes or specific tariffs in order to inhibit a particular
individual action.
The new approach of the European Union aims at building a governance - that
is a degree of interactions between different actors of a territory or in a sector- in
order to create conditions favourable to a collective action such as innovation and its
diffusion or firm creation.
Therefore, creating “favourable conditions” means making explicit and
developing the collective and shared intangible assets that can favour the co-
operative interactions and therefore the complimentarity between various types of
specialisation which is at the basis of productive efficiency.
The case of biotech clusters are particularly interesting in this respect. Bianchi
- Labory (2002b) show that the success of such clusters crucially depends on the
ability to create collective intangible assets and the creation of a public agency might
be crucial in this respect.
Clusters are local systems of firms which work at the territorial level in strong
synergy with the university or other research centres, as well as the local or national
government. High tech clusters exist in various regions of the world and generally
each specialises in a particular technology or in a group of technologies. According
to Bianchi – Labory (2002b), the characteristics common to high tech clusters appear
to be:
• the existence of operative links with universities, research centres or other

higher education institutions;
• the objective of creation of industrial firms based on knowledge or service
firms producing high value added;
• the presence of a stable management team able to encourage the transfer of
technologies and managerial competence between the firms of the cluster.
The clusters vary widely in reality. The major differences are in terms of:
• origin: a cluster can originate from a spontaneous initiative from a group of

researchers or from an initiative by the university or a public agency;
• objectives: clusters can aim to promote research and development of the
technologies of the future or they can have as an objective the development
of a region;
• dimension: the area covered by the cluster can be a small building with labs
or a vast area of several square kilometres;
• activities: the industrial orientation of clusters varies from case to case, often
guided by the group of technologies on which the cluster focuses;
• incentives: the cluster generally receives incentives and these seem to be
higher when the cluster is supported by a national or supranational programme
rather than a regional one;
• infrastructure and services: clusters have been characterised by a wide range
of infrastructure and services including the presence of labs and space for
research, firm incubators with services specific to start-ups; buildings with
modern offices; conference centres; telecommunication services, and so on.
The success factors of clusters are difficult to identify. In the period 1954-
1990, 25% of European clusters failed and 50% of the surviving clusters had to
change orientation in order to survive. Most cases are clusters started from a local
administration or from development agencies, which still pay more attention to
tangible rather than intangible goods. The case of Sophia Antipolis in Nice (France)
and numerous cases in Italy show that the approach adopted by the government
is often critical because what needs to be organised is a context able to stimulate
innovation and interactions among the various actors involved in the various stages
of the generation and diffusion of innovation. Such productive aggregations are
difficult to build in places characterised by a social fragmentation that makes the
relationships between the various institutions difficult.
The case of the Bio-Region of Heidelberg, Germany, is a success story in this
respect. This cluster was built in the second half of the 1990s in order to develop a
biotech competence in Germany. The programme from which it is built is national
and designed by the German Ministry of education and research. Heidelberg therefore
received funds in order to develop a centre of excellence in biotechnology.
The cluster is organised around a non-profit organisation, the Bio-Region Rhein-
Neckar-Dreieck e.V. (BRND), composed of all the local actors, namely R&D
institutions, the local communities, the chamber of commerce and the financial and
service organisations. The role of the BRND is essential in that it is the centre of
a network of relationships between all the involved actors. Large pharmaceutical
firms are also present. They play an active role, particularly in helping start-ups by
direct financing or by participating in regional venture capital funds. However, the
BRND ensures that the large players do not take too large a stake in the activities of
the cluster. This ensures that they do not take on a too dominant role in the cluster as
that could inhibit initiatives.
The result is that the Bio-Region has become an incubator of new firms and the
activity has been very dynamic, as shown by Figure 11.1.
The figure shows the evolution of the number of new firms created in the 1990s
in the Bio-Region. The acceleration of the increase in new firms from the start of
the cluster (1996) is clear. New firms include start-ups from the university and from
research institutions, as well as spin-offs from existing firms and the creation of new
Figure 11.1 Firm Creation in the Bio-Region (numbers of firms

Source: Bio-Region (2002)
divisions of large firms. Parallel to this, numerous new products and services have
been launched on the market.
Bianchi and Labory (2002b) also mention the interesting results of a survey
conducted in the Bio-Region. According to the actors of the region, the factors
conducive to firm creation in the region are:
• the quality of life;

• scientific collaboration;
• the quality of scientific structures in the area;
• the presence of highly skilled personnel; and
• the public programmes aimed at sustaining research and firm creation.
The combination of both public and private financing appears to be positive.

Public institutions tend to favour a higher diffusion of knowledge, while private
firms push towards the patenting of innovations in order to procure adequate returns
on R&D investments. The result is a combination of objectives that stimulate
public action.
More importantly, “quality of life” as a factor of success for the Bio-Region
illustrates in our view a more fundamental result: a key element of the success of
innovative networks such as high tech clusters is the social capital that is created,
i.e. the set of collective intangible assets that favour the interactions between actors
in the system.
Such social capital creates the conditions for cultures to interact and evolve,
for human resources to be available and for a co-operative behaviour to develop.
It could be called “innovative atmosphere” somewhat analogous to the famous
concept of “industrial atmosphere” that Marshall (1890) uses in the case of
productive collaboration in industrial districts. Bianchi (1995) defines the innovative
atmosphere as the set of indivisible intangible assets that belong to the productive
system as a whole which reduces the costs of the relationships between agents by
decreasing information costs and maintaining coordination costs low. The innovative
atmosphere is difficult to copy and provides benefits that are difficult to reproduce.
Bianchi and Labory (2002b) apply this concept to the case of biotech clusters and
argue that the success of the Bio-Region critically depends on the rapid creation of a
social capital, i.e. a set of collective intangible assets that makes relationships easier
and less costly. In other words, the factor for success has been the creation of an
“innovative atmosphere”, that is in a way summarised in the concept of “quality of
life” mentioned by the actors in the cluster.
An implication in terms of policy toward innovation and knowledge diffusion
is that networks favoured should be of a small scale or local level in order for
knowledge creation (innovation) to effectively arise. The different networks should
then be put into relationships at a higher level, -national or European- in order for
knowledge to diffuse across the various networks.
Another policy implication of the Bio-Region case is that policy-makers wishing
to create a network should make sure that power is equally distributed in the
network. In the Bio-Region case, large firms did not assume a dominant position in
the network but instead collaborated with the local authorities (for financing) and
with scientists (wishing to create a firm). A central, non profit actor like the BRND
appears also to be fundamental to the success of the cluster, acting as a strategically
neutral co-ordinator of the network.
A problem with a network led by a dominant player such as a large firm is that
the dominant player may be tempted to ‘lock in’ the network in order to ensure
control over it. Lock in may arise by making the other network members dependent
on the large firm’s resources for their activities (for instance, financial resources if it
is much more costly for the network members to access to financial resources from
other organisation like banks; or monopoly over the access to some raw material); in
such a case they cannot threat to leave the network in case they are not happy about
the benefits they get from it because they would no longer have access to the essential
resources. In this way they have no alternative but to continue their activities within
the network, hence the perfect control of the dominant actor over it.
The disadvantage of such a situation is that the network and its activities are
closed and fixed. The network is closed since it is not possible to have relationships
to actors outside the network; it is fixed because in this way it does not change
configuration, keeping the same members. The problem is that in this way it is not
open to changes and the risk is lack adaptation to changing technology or market
conditions, leading to reducing performance.
We think that “openness” is an important characteristic of successful innovation
network, since being able to collect new information and develop new linkages is
crucial to knowledge exchange and creation, hence innovation.
The social capital appears therefore as a key intangible asset in that it allows
the other asset to relate: it allows the human capital to move and relate, knowledge
to be exchanged and created, hence innovation to take place. It should therefore
be measured or at least assessed. The following section discusses the consideration
of social capital and other endogenous resources in estimates of growth and
development. It does so at a regional level.2
Complimentarity between Intangible Assets and Regional Growth
This section discusses the determinants of competitiveness and the associated

measurement problems. For this purpose, an analysis at local level is performed,
outlining the main determinants of a region’s performance, considering both
tangible and intangible assets, and discussing what could be the best indicators of
such performance.
A particular focus is made on human capital and social capital. These intangible
assets represent interesting cases not only because of their key importance in the
intangible economy, but also because of their interactions: in fact, the two capital
interact so much that they are intrinsically linked, the social capital allowing the
human capital to develop and the human capital allowing the social capital to
develop too.
2 Section 3 builds on the work performed by Bacci (2003) within this team headed by
Patrizio Bianchi.
Although the scope of the analysis is limited to the local level, a number of
general insights are derived, especially in terms of the implications for the analysis
of performance indicators at country level. It appears in particular that:
• The main level at which the collective intangible assets (social capital, history,
traditions) can be measured is at the local level, because the set of interactions
of individuals is defined at mainly that level;
• Assets, especially intangible ones, can be asset in some areas but also liabilities
in other areas, depending on the socio-economic features of the local system;
the policy implication is that the analysis of performance should be made
taking account of the whole set of tangible and intangible assets available in a
country, and the judgement on whether investment in particular assets should
be encouraged should be made taking account of its complimentarity with
other assets;
• Intangible assets are intimately related due to their common denominator,
namely knowledge: knowledge is created by the human mind and therefore
intimately linked to human capital; knowledge communication arises through
interactions between individuals, hence innovation arises only if human capital
and social capital (the set of relationships and the trust, norms and behavioural
rules guiding interactions between individuals) are present. Intangible assets
are therefore highly complimentary.
Human Capital and Social Capital as Key Endogenous Resources
There is wide consensus in the economic literature that the possibility of regional
system to grow is closely related to its capacity to export products outside its
boundaries and to sell its services to the non resident population. Economic activities
are triggered in the regional system from this “basis for exports” (Richardson 1969).
The competitive advantages of the productive system are therefore key to a region’s
(national or at lower level) competitiveness. The economic literature has discussed
such competitive advantages in depth, from Smith to Ricardo, Krugman and Porter.
Very briefly, the determinants of the competitive advantage of a local system relative
to the production of a good depend on the hypotheses made on the good considered,
on the technology, an the type of competition and on many other factors. The set
of hypotheses constitute different theoretical frameworks representing economic
activities, of which two extreme cases can be defined. First, the hypotheses of
homogenous good, perfect information and hence similar technology of production
everywhere, limited mobility of the factors of production, perfect competition and
perfect flexibility of prices and wages. In such a case, the capacity to export of a local
system totally depends on the prices of the local productive factors and its growth
is determined by a rise in the quantity of the available factors, namely the stock of
capital and the available labour force. Second, hypotheses of differentiated goods
such as niche products, for which cost is not a fundamental competitive advantage,
but rather its quality, in the sense of uniqueness, be it due to the incorporated
technology or to the beauty of design and the perfection of its production. In this
case, factors such as traditions, culture, know-how of the workers, availability of raw
material with specific characteristics and the story of the territory where the good is
produced are important determinants of the competitive advantage of the products,
hence of the region.
In addition, the competitive advantage of a region significantly depends on
the quality of the local environment and of its artistic and cultural patrimony,
which can be considered as public goods and/or externalities. These (collective)
intangible assets can also become liabilities, depending on the productive context: in
specialised productive contexts, where one industry dominates the local productive
system, it is likely that polluting emissions be accepted by the local community, as
an unavoidable bye-product of the industrial activity. In contrast, in contexts relying
on tourism activities such emissions become a reason for conflict between the local
economic actors.
Hence in order to explain the performance of a region an important consideration
is that of the endogenous resources, be they tangible or intangible. The literature
on endogenous growth has outlined the importance of intangible resources, such as
the human capital and the technological capacity (see Romer 1994 for a review).
The regional economics literature has stressed an important additional endogenous
resource: the local collective intangible assets. The literature on industrial
districts (Becattini 1979, 1991; Brusco - Paba 1997) in particular has shown that
the competitiveness of a region (in the sense of a territory) depends not only on
endogenous intangible resources such as human capital and the technical progress,
but also the relationships between firms, the localisation economies and the set of
social, historical and geographical aspects of the territory that make it more than
the sum of its parts. The endogenous resources thus become the set of natural and
human elements that are locally rooted, that define the characteristics of the territory
and that take different value across territories. Such resources take a particular value
depending on which resources they are associated with.
The analysis of competitiveness and therefore of the development level of a region
requires both to consider all the endogenous resources, including the collective ones,
and to analyse the relationships between the various elements of the local system
(between the individuals and the firms, between the firms and the institutions, and
so on). The speed at which such resources grow is not enough to account for such
performance. It is also essential to analyse whether and how the characteristics of
the system (the economic characteristics but also social and territorial ones) also
continue to reproduce or to evolve. The economic, social and territorial variables are
all important variables to consider in order to explain a region’s performance.
Notice that such analysis is intrinsically dynamic, in that a proper account of
the economic performance of a region requires a dynamic analysis of the evolution
of its resources and the way they combine to produce particular characteristics and
competitive advantages over time. A dynamic analysis is particularly important
when dealing with intangible assets. Tangible assets are rather easy to quantify and
the growth of their stock over time is obtained by just adding quantity. Intangible
assets are more complex and uncertain, and changing over time. Take the example of
human resources. The tangible aspect of human capital is easy to quantify and their
dynamic analysis is straightforward (adding the number of workers). The intangible
aspects is more complex: difficult to measure, since it is difficult to evaluate the
intellectual abilities or the capacity to adapt to changes. The intangible human capital
is made of dexterity, intelligence, culture, and evolve in complex ways over time.
However, a proper account of the intangible human capital of a region requires a
dynamic analysis: the history of the place, the cultural and social background of the
place help explain the actual stock of intangible human capital.
In addition, in a phase of economic development in which services take growing
importance relative to manufactured goods and in which the ability, the know-
how and the productive traditions, together with information, knowledge and the
cognitive and relational processes replace homogenous factors in the endowment of
productive factors that determine competitiveness, the most fundamental resources
become the human resources. Contrary to the availability of raw material or other
resources such as natural or artistic resources, the stock of human capital is not given
and constantly evolve over time, for two major reasons. First, human resources move
from place to place, mainly due to wage differentials across regions. Second, human
resources are intimately linked to the level of development reached: the current level
of knowledge and the competence of workers depend on the productive history
of the place and on the knowledge that has been created in the local context; the
investment in education depends on the financial possibility hence on the level of
development reached; the participation rate of the population, its capacity to generate
and renew entrepreneurial resources and the density and fluidity of the economic
relationships between local actors depend on the social model that has prevailed in the
recent past.
Therefore, human resources not only determine economic growth but are also the
result of economic growth, thereby being really endogenous.
Human resources are therefore the core of the endogenous resources of growth.
However, the possibility to empirically verify the relationship between human
capital and growth, at local level in particular, is very difficult, for a number of
reasons. First, the two-way relationship between human resources and growth makes
the identification of the causality difficult. Second, the mobility of human resources
across regions, especially the movements across local systems, imply the need to
consider not only the resident population of a local system, but also the working
population of neighbouring systems. Third, the available statistical information
does not allow to measure the quality of human capital and to compare it across
regions. Beyond the absence of statistical information, how should workers’ skills
be measured? How should their ability to learn and to adapt their knowledge to new
information be measured? How should the set of formal and informal relationships
that contribute to the economic activities and the economic performance of a region
be measured? This set of relationships constitute in large part the social capital of
a region.
The widespread method is to proxy human capital by the level of education,
but such indicator has been criticised for being incomplete (see Bianchi - Labory
2002, for a review of the criticisms to such indicator). Briefly, such indicator does
not include the knowledge and competencies learnt outside school. A country might
have a relatively low education level but large training at work, so that most of the
knowledge and competence acquired by workers are acquired at work. In any case,
the knowledge acquired on the job and required by the job is an important part of
the human capital of a country, especially in economies based on intangible assets.
It is therefore important to evaluate what type of knowledge and competencies are
required by the productive activities of the region’s firms in order to get an idea of
the human capital of the area.
In addition, not all knowledge translate into resources for growth and development
and only a part of the knowledge base, which vary according to the sector, to the
job position and especially to the territory, represent a competitive advantage for
the firms and their regions. It is therefore important to understand how this type of
knowledge is created, communicated and renewed; and what type of relationships
they have with the patrimony of knowledge acquired in the educational system.
The literature on industrial districts has analysed the process of creation,
transmission and diffusion of knowledge in depth, on the basis of the assumption that
production is intrinsically a localised process and that therefore each area mobilises
to this end its history, its culture and its social organisation.
In fact, this literature reaches the same conclusion as the literature on social
capital, which can be formulated as stressing that the collective intangible assets,
namely the shared norms and values, i.e. culture and history, are essential to
economic growth. The problem is then to understand how the variety of contexts
generates competitive advantages for the local system and how the latter reproduces
such advantages through time.
The role of human capital is essential in this respect in that the set of entrepreneurial
capabilities and of abilities of the workers represent a large part of the competitive
advantage of a region.
In the intangible economy, what matters is the quality and rapid renewal of
products and this requires a particular form of firm organisation (as stressed by
Bianchi - Labory in the core of this report), characterised by network relationships.
Knowledge is the core of the value generation process and therefore the human
capital is key to the production process. Another important capital in this context is
the social capital: the individual or the firm become the element of a system in which
learning is continuous and knowledge is exchanged, shared and above all created
in accordance with the contexts in which it is used. Hence the set of relationships
developed by individuals, firms and institutions play a key role in the growth of
a region.
As a consequence, the endogenous resources related to the human capital take
a wider meaning: in order to understand the potentialities of human capital as an
endogenous resource one needs to consider the whole set of relationships that exist
between the various elements of the system (workers, employers, institution, other
areas with which tight links are developed). These relationships can increase or
decrease the potentialities of the human capital of the region.
The set of relationships can be viewed from the point of view of the individual
(resource useful to increase the remuneration of the worker) or the collectivity
(collective resource that favours the reproduction and diffusion of knowledge and
the efficient use of individual capabilities). From both points of view the set of
relationships appears as a sort of multiplier that emphasises to different degrees the
potentialities of the various resources. The reproduction and innovation of the local
knowledge, the realisation of training and career for individuals, the capacity of the
local system to select and make the best use of human resources, all depend on the
width and density of such networks of social relationships.
Another important resource for economic growth is thus introduced: the social
capital (Coleman 1988). The introduction of this resource in the analysis implies that
a new determinant of individual choices is introduced: individuals are conditioned
in their choices by the organisational, institutional and social context in which they
perform their activities. Individuals will therefore have interest in events that are
partly or totally under the control of other individuals, and therefore will develop
long term relationships with them in order to pursue their interest. Authority
relationships, trust, the norms of reciprocity, i.e. the interaction structure that is used
to this end represent the social capital.
The more individuals depend one from the other, the denser their relationships,
and the higher is the endowment in social capital. From an individual point of view
the social capital is “the set of relational resources that an individual in part inherits
and for a large part builds on its own, within a family and other social circles” . From
a collective point of view the social capital is the set of “structural and normative
characteristics of a given social system: organisations, norms, institutions, etc.”
(Piselli 1999).
The following example shows the importance of the social capital as a
determinant of economic activity and growth. The patterns of entry into the labour
market and labour mobility in a country vary largely according to the social capital
of the country. In some countries (or regions) the relationships used to find a job are
so-called “strong links”, namely family links or friendship (or the belonging to an
ethnic group in the case of immigrants); in others the links are “weak”, and the useful
relationships are represented by business or university contacts. The same is true at
a collective level. Thus a successful cluster of firms is characterised by an informal
network of relationships between entrepreneurs, so that the social capital is generally
a very important determinant of the success of such a form of organisation.
The collective element of the social capital is also strongly related to the
territory. The informal network of relationships between entrepreneurs in industrial
districts thus creates a set of non written norms and rules that allow the investment
in reputation, resulting in the reduction of transaction costs and the realisation of
exchanges that would not be possible otherwise (Dei Ottati 1995; Bianchi 1995). In
urban centres where the control of the social capital over individuals is less pervasive
the same relationships do not create the same co-operative behaviours. However,
other forms of co-operation can be used, possibly more formal, such as the creation
of business associations.
Measuring the Level of Development of a Region
The extension of the conceptual borders of human capital, beyond simply formal
education to knowledge as a relational process or to the social capital, takes us
further away from the possibility to give an univocal measurement. Any attempt
to provide some indicators of human capital has to start with a number of existing
indicators that either proxy some aspects of human capital, represent a generating
factor of human capital or a consequence of human capital on the socio-economic
system. Such exercise has been performed in an analysis of the Tuscan region. The
analysis is performed at local level, i.e. using a unit of analysis smaller than the
region, namely the local economic systems. These systems have been defined on the
basis of the local labour systems3, taking the administrative areas into account and
asking the local communities whether they agreed with the areas thus defined (Bacci
2002, p 42- 45).
At local level, the complexity of the relationships that link the productive
structure and its competitive advantages to the socio-demographic characteristics
of the local community make it necessary to define a number of hypotheses in order
to explore this set of relationships. The Table 11.1 presents some aspects of human
capital that are directly measurable. Such aspects can however represent either assets
(resources) or liabilities (constraints), depending on the area taken into consideration
within the region.
Table 11.1 Measurable elements of human capital
Resources Constraints
Education High levels of formal education Early entry into the job market
Family relationships Large families with strong ties Small families with weak ties
Entrepreneurial capacity High level of entrepreneurship Marginal diffusion of activities
Production organisation Single sector of specialisation High sectoral dispersion and
and density of the relationships few relationships between firms
between firms
Bacci (2002) examines the different elements of the table in turn, using data
of a particular Italian region, that of Tuscany. First, concerning education, the data
available for Tuscany do not show a significant relationship between the level
of education and the employment rate. This is true regarding both the average
education level of the resident population of Tuscany (an indicator which ignores the
education choices of the previous generations) and the indicators of the education
level according to age classes.
Some systems present a higher level of education than the region’s average yet
do not exhibit high levels of occupation. This however is only partly due to the
difficulty of finding a first job for young people, since the correlation between the
education level and young unemployment rate is almost nil. In fact, the education
level, namely an aspect of human capital, appears to be closely related to the local
productive structure, since it is higher in urban centres (that play the role of job
3 The territory can be divided into different local labour systems, which are defined
according to daily movements from home to work (a division created by the Italian central
statistical office, ISTAT, the Tuscan regional research institute IRPET and the universities of
Newcastle and Leeds (Sforzi, Openshaw and Wymer, 1982; Sforzi, 1989).
poles) and in productive areas largely based on the tertiary sector. Note the link
between intangible assets (human capital) and other tangible (technology and raw
materials available to the local production) and intangible (production organisation)
assets. The high education level in areas where the unemployment rate is relatively
high is explained by the social value of higher education: young people take a high
education degree primarily to attain social recognition.
The local average education level is significantly correlated with both per
capita GDP and consumption. This suggests that the higher welfare level allows
families to finance longer studies. Nevertheless, the average education level is low
in the areas characterised by a productive system based on small firms, and yet the
unemployment rate very low. In such areas young people leave school early and find
a job in a small firm, where they receive further on-the-job training. In fact, the level
of formal education plays a different role according to the area in consideration: in
urban centres, a high level of education is associated with higher employment level;
in areas based on small firms, a low level of education is associated with a high
employment level, since young people receive on-the-job (informal) training.
Thus in some cases the human capital represented by a high education level is
an asset, an advantage (in urban centres), while in other cases the level of formal
education does not have the same value, being rather a liability. At country level
too, an intangible might be an asset in a country but a liability in another, because
the conditions are different. For instance, a certain type of knowledge, such as a
new technology, may be an asset in a country, because the technology is useful
for the existing productive system and there are human resources able to use the
new technology; it might be a liability, because totally inadequate with the local
productive system or with the local traditions. A simple example is that of agricultural
technologies brought to third world countries that result in the ruin of local agrarian
economies because they are not adequate to the necessities of the local climate (not
leaving time for the soil to fertilise, etc.).
The problem in terms of economic performance over time, hence competitiveness
policy, is to understand whether the country in consideration has a set of tangible and
intangible assets that will allow it to adapt to changes.
The second element of Table 11.1 is family relationships. The importance of
such relationships for economic performance are illustrated by the industrialisation
of the Tuscan countryside in the 1970s, i.e. the take-off phase of the SME systems
in Tuscany. The industrialisation process has transferred large amounts of the
population of the countryside to small and medium manufacturing cities, thereby
taking in the family organisation of the farmers. This family model was made of
different nuclei all living under the same root (hence families with strong linkages)
and allowed a higher flexibility of the labour force and represented one of the main
channel of entry into the job market. Regarding the first point, the family ensured
workers against periods of unemployment, hence their acceptance of more flexible
job contract. Regarding the second point, entry into the job market was eased by the
fact that members of the family already working used to introduce their younger
family members to the job.
Looking at today’s data, the relationship between extended families and the
occupation level still holds. Bacci (2002) constructs an indicator of the extent of
the family relationships and finds a strong correlation with the employment level of
the area. In particular, the strong family ties appear to continue to play an important
role for entry into the job market. However, the correlation does not mean causality,
and the result does not mean that an extended family is a factor determining the
employment level.
Regarding the third element of Table 11.1, Bacci (2002) finds a significant positive
effect of the entrepreneurship capacity (measured by the proportion of entrepreneurs
in the total population) on the employment level in the industry. The same is not
true of the service sector, in which the creation of firms does not always induce a
significant rise in employment (when the activities are micro-activities performed by
a very small firm of one, maybe two persons).
The fourth element of the table is the social capital. The importance of the social
capital in areas characterised by the strong presence of as sector and small firms
vertically related should be high and associated with a higher employment level.
In order to measure such social capital the density of the relationships associated
with a productive process has been computed using labour data and industry
specialisation indices (Bacci 2002). The main result is that the areas with a high level
of specialisation and single, vertically integrated sector are associated with higher
GDP and employment levels. Hence the social capital appear to play an important
role in systems of small firms (industrial districts). This is not true of urban areas
where GDP levels are high and yet the specialisation of the productive process is low
and the number of sectors relatively high; in fact, big cities are rather open economic
systems which develop relationships with the rest of the region and outside. The
networks are larger than those of systems of small firms, and this characteristic might
be important to guarantee the continuity of their performance over time.
A cluster analysis is useful to point to particular socio-demographic types.
Hence the above indicators of human capital were considered together and analysed
statistically to see whether they form particular types of endogenous resources for
growth. The indicators considered are the family types (importance of extended
families, of families with one source of income only, and the elder people living on
their own); the duration of studies (school-work conflict: working population aged
14-24 over population aged 14-24); the education levels (average number of years
of schooling), the entrepreneurship levels in the industry and in the service sector
(entrepreneurs and self-employed in the industry or in the service sector over total
population), together with two indicators of unemployment (the unemployment rate
of the young age class and of women).
The local economic systems are thus grouped into 5 clusters (see Table 11.2). A
first cluster is characterised by families which are typical of fordist societies related
to the large firm: small families, often with one wage earner only, with a separation
from the family of origin more marked than the average. The concept of job in the
mentalities is that of life employment in a large firm. The young unemployment rate
is high in such systems and young people therefore tend to remain at school as long
as possible. A second cluster is characterised by the areas with systems of SMEs,
which represent the heart of the Tuscan productive system. In such systems the
family structure of the farmers that left the countryside to work in the manufacturing
sector still remains: extended families, with less lonely elder people. These areas are
Table 11.2 Characteristics of development (Tuscany average = 1)
Cluster 1 Cluster 2 Cluster 3 Cluster 4 Cluster 5

High education 0.96 0.76 0.68 1.42 0.84
Importance of extended families 0.81 1.18 0.76 0.94 1.17
Importance of lonely elder persons 1.12 0.91 1.24 0.98 0.94
Families with one wage earner 1.31 0.86 1.15 0.91 0.85
School-work conflict 0.75 1.27 0.88 0.69 1.18
Entrepreneurship in the industry 0.63 1.40 0.64 0.71 0.97
Entrepreneurship in services 1.00 0.87 0.62 1.18 0.79
Female unemployment rate 1.24 1.02 1.01 0.86 0.80
Young unemployment rate 1.31 0.96 1.16 0.82 0.77
Source: Bacci (2002).
also characterised by a very high entrepreneurship rate, and this seems to correspond
to a working mentality which sees the foundation of an own firm as a source of social
prestige. The average education level tends to be low. A third cluster is characterised
by the rural and mountain areas, which tend to desertify and the proportion of elder
people is increasing. The fourth group is that of the main cities of Tuscany: Florence,
Pisa and Siena. In these urban areas, the education level is the highest of all groups
and families are smaller. The unemployment rate of these areas is relatively small,
given the wide possibility of jobs offered, in the service and in the industrial sectors.
The fifth group consists of a vast set of territories that range from areas neighbouring
big cities to more rural areas. The economic system of this clusters have experienced
an economic boom due to the development of manufacturing or tourism activities
after the boom experienced by the second cluster. These areas do not specialise
as much as the areas of the second cluster do. However, they keep a number of
characteristics in common, such as the extended families, the small number of lonely
elder people and the predominance of families where both parents do work.
The socio-demographic conditions of each cluster can be confronted with
the traditional indicators of the level of economic performance (here the level of
development). Figure 11.2 makes such a confrontation. The clusters characterised
by big urban systems, districts and large firms are those with highest GDP per
capita levels. The highest values of the three indicators, namely employment, GDP
and consumption are in the fourth cluster, the urban systems, where the values are
always greater than or equal to the Tuscan average. Cluster 5 is characterised by
high employment and high consumption levels, but relatively low GDP level; this
is probably due to their including areas neighbouring big cities, where the resident
population consumes but often works in the big city.
In addition, the regression analysis of the extent to which the cluster classification
explains the different levels of development gives quite positive results: a regression
on the cluster dummies explains the following proportion of variance (adjusted R-
squared): 40% of GDP, 51% of consumption and 71% of employment. Given the
data on which the clusters are built, which do not have any significant correlation
with the dimensions of development, such results are quite encouraging.
Figure 11.2 Dimensions of development according to the socio-demographic

typology (per capita value, Tuscany = 100)
Source: Bacci (2002).
In short, the human and the social capital appear as determinants of the level
of economic development of an area. Their consideration therefore improves the
analysis of an area’s growth level.
Conclusive Remarks
This chapter has provided an illustration of the findings of the research performed
the PRISM team headed by Patrizio Bianchi and coordinated by Sandrine Labory.
The research aimed at analysing the policy implications of the growing importance
of intangible assets in the economy. The main findings are that countries should
favour the development of intangible assets in order to be competitive and this means
two things. First, better indicator of these assets should be computed in order for
policy-making to be improved. Second, complementarities between assets should be
taken into account. One particularly important source of these complementarities is
according to us one intangible asset, the social capital.
The social capital is an intangible assets that has been particularly neglected by
statistical offices and other scholars discussing indicators of a country or a region’s
performance.
The research performed by this PRISM Ferrara team shows that the social capital
is in fact a key (collective) intangible asset. Besides, as argued by Galassi-Mancinelli
(2004), social capital is very difficult to define and no consensual definitions appear
to have been found among economists. The above discussion leads us to suggest
that social capital might be defined as the set of collective (in the sense of shared)
intangible assets available in a territory (a city, a region, a country, a set of countries).
Collective intangible assets allow communication and exchange to take place,
because they provide behavioural rules (formal or informal) that avoid free rider
problems or other misbehaviour in relationships. One example of such rules is the
requirement that firms produce balance sheets where all the costs and revenues are
detailed and allow authorities to check the transparency of the firm’s activities.
Social capital is deeply rooted in a territory, because it stems from the language
and the culture of particular societies. It can extend to a country or to a set of countries
thereafter. Di Tommaso - Paci - Schweitzer (2002) also stress that initially at least,
geographical proximity is essential to allow the collective intangible assets that
compose social capital to develop in a place. Hence the often observed clustering
of firms in a territory. Clusters manage to perform well if they manage to create and
maintain a certain level of collective intangible assets locally. This allows the cluster
to organise a production system locally, which results in the creation of knowledge,
hence innovation and successful products. The set of collective intangible assets
cannot be transferred to other localities; they have to be recreated locally, as shown
by the example of the Japanese transplants in the US or in Europe (Abo 1994; Labory
1997). As a consequence, the development of collective intangible assets implies the
necessity to incur sunk costs, since the investment has no alternative use elsewhere.
At a country level also the set of available intangible assets cannot be transferred
from country to country; each country has to develop its own set of intangible assets.
This explains the high failure of development policies. A developing country can
import tangible assets such as machines and technologies, but it cannot import
intangible assets such as social and human capital. The latter must be developed
in the territory, by providing rules (individual rights, property rights, contract laws,
etc.) and institutions (education system, justice, and so on) that form a framework
in which intangible assets grow in a positive way. Rules and institutions represent
an enormous investment. The problem is that if wrong, the investment cannot be
recuperated and losses are high, because the wrong framework creates intangible
liabilities and not assets.
Therefore in promoting economic growth and devising a competitiveness policy,
the first priority should be the provision of such a framework, with clear rules and
sanctions.
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Index
AA 1000, social accountability and 75 capitalization and amortization, of R&D 97-

AccountAbility 1000, social accountability 128
and 75 categories of, intangible assets 54
Accounting, human resources 69 categorisation of intangible assets, in opera
Accounting myopia 51 house 233-5
Accounting myopia, limitations of GAAP Celemi intangible asset monitor 71
49-50 complementarity, between intangible assets
agency, of credit rating 169 249-53
AIAF-University of Ferrara model 134-51, content analysis
152-4 credit rating methodologies 169-79
best practices on intangible assets environmental report 82-84
communications and 140-8 social report 83
corporate governance 131-4, 139-40 Contingent Claims Analysis 33-4, 44
customers and markets 131-4, 139-40 convergence between environmental, social
description of 131-3 and IC report, social accountability
human resources 131-4, 139-40 84-6
information on intangible assets and corporate governance 184
annual reports 139-40, 152-3 AIAF-University of Ferrara model and
information on intangible assets and 131-4, 139-40
financial statements 139-40, 152-3 credit rating and 184, 186
innovation and internal processes 131-4, corporate social responsibility 72-6
139-40 corporate strategy, intangible assets and
mandatory and voluntary information 52-6
148, 161-3 corporate transparency, Three Tier Model of
organisation 131-4, 139-40 195
strategy 131-4, 139-40 cost versus value, intangible assets and 60-1
amortisation and capitalisation, of R&D 97- credit rating
128 agency 169
Associazione Bancaria Italiana/Italian business risk, 170
Banking Association, Social content analysis of credit rating
accountability and, methodologies 169-79
Associazione Italiana degli Analisti corporate governance 184, 186
Finanziari, see AIAF-University of definitions, 166-7
Ferrara model financial risk 170
audit and supplementary information, in human capital 177, 180-2, 186
environmental report 82, 90 intangible assets 187-9
intellectual capital and 165-89
between intangible assets and regional organisational capital 183-4, 186
growth, social accountability 248-9 phases and process of 167-8
book values, versus market values and process 167-8
intangible assets 57-60 relational capital 182-3, 186
scales 167-8
strategy 184, 186 market values versus book values and
Critical Management Studies, and power 57-60
209 narrative reporting versus quantitative
customers and markets, AIAF-University of reporting and 63
Ferrara model and 131-4, 139-40 principles 63-5
relationship to Generally Accepted
Dynamic Programming, 34 Accounting Principles (GAAP) 56-7
reporting versus optional reporting and
empowerment, and power 212-3 63
endogenous resources results measures versus process
human capital as 249-53 measures and 62-3
social capital as 249-53 sustainability of profitability and 65
environmental report 73 sustainability report and 65, 75
audit and supplementary information 82, tactility of 64
90 global comparability index 20, 22-3
environmental respect 82, 90-1 Global Reporting Initiative, social
EU standards and 73-4 accountability 75
financial variables 83, 91 goodwill, Generally Accepted Accounting
human resources 82, 90, 94 Principles (GAAP) and 9-27
processes 82, 91 GRI, see Global Reporting Initiative
technology 82, 91 Gruppo di studio per la statuizione dei
environmental respect, in environmental principi di redazione del Blancio
report 82, 90-1 Sociale, social accountability 75
EU standards, environmental reports 73-4
Extended Business Reporting Language, see human capital (see also human resources)
XBRL as endogenous resource 249-53
Extensible Mark-up Language, see XML credit rating and 180-2, 186
knowledge and 249-53
FASB Business Combination Project, 9-11 measures 254
financial performance and stakeholders in human resources (see also human capital)
opera house 227-33 accounting 69
financial variables, in environmental report AIAF-University of Ferrara model and
83, 91 131-4, 139-40
in environmental report 82, 90, 94
GAAP, see Generally Accepted Accounting
Principles IC statement, see Intellectual Capital
GAIP, see Generally Accepted Intangible indicators, of intangible assets 70, 139, 152-
Principles 4, 235-8, 243
Generally Accepted Accounting Principles information asymmetries, intangible assets
(GAAP) and 60, 65
goodwill and 9-27 information on intangible assets and annual
intangible assets and 9-27 reports
limitations 49-50 AIAF-University of Ferrara model and
R&D and 97-128 139-40, 152-3
relationship to Generally Accepted XBRL 204-5
Intangible Principles (GAIP) 56-7 information on intangible assets and annual
Generally Accepted Intangible Principles reports,
(GAIP) AIAF-University of Ferrara model and
cost versus value and 60-1 139-40, 152-3
Index 265
XBRL 204-5 and intangibles 1, 234
innovation 242 and XBRL 199, 204-6
intangible asset monitor 69 Celemi intangible asset monitor 71
in Celemi 71 credit rating and 165-8
intangible assets report/(statement) 69
as input and output 235 reporting 68-72
categories of 54 Skandia Navigator/Skandia Business
complementarity between 249-53 Navigator 70-2
complementarity between regional value platform 69-70
growth and 248-9 value scheme 69-70
corporate strategy and 52-6 investment life-cycle 37-40
cost versus value and 60-1 investment life-cycle, intangible assets and
Generally Accepted Accounting 37-40
Principles (GAAP) and 9-27 ISO standards 73
indicators of, 70, 139, 152-4, 235-8, 243 Istituo Europea per il Bilancio Sociale
indicators of intangible assets in opera (European Institute for Social
house 237-8 Report), social accountability 75
information asymmetries and 60, 65
information on intangibles in annual knowledge
report 139-40, 145-6 as an intangible asset 242, 249
investment life-cycle and 37-40 as source of power 209
knowledge 242, 249 human capital and 249-53
mandatory and voluntary information knowledge management and power 208,
on intangibles in annual report 148, 210-5
161-3 limitation of GAAP on knowledge-
market values versus book values and based firms 49
57-60 real options value and 36, 39-40
narrative reporting versus quantitative knowledge-based firms, limitation of GAAP
reporting and 63 on 49
performance measurement systems in knowledge management and power 208,
opera house and 235-40 210-5
Porter’s “five forces” and 52-6
real options and 40-5 managerial flexibility 32-4
regional growth and 248-9 mandatory and voluntary information,
report 65-6 AIAF-University of Ferrara model
required reporting versus optional and 148, 161-3
reporting and 63 market values, versus book values and
results measures versus process intangible assets 57-60
measures and 62-3 Marketed Asset Disclaimer 33-4
risk and 36-7, 40-45 measures
sustainability of profitability and 65 human capital 254
sustainability report and 65, 75 process 62-3
tactility of 64 results 62-3
valuation with real options 33-7 mispricing 99, 110-5
Intellectual Capital 2-5, 67-8
and credit rating 165-89 narrative reporting, versus quantitative
and FASB’s view 13 reporting and intangible assets 63
and financial statements 204
opera house capitalisation 97-128
categorisation of intangible assets in Generally Accepted Accounting
233-5 Principles (GAAP) and 97-128
distinctive features of 233-5 rating, see credit rating
financial performance and stakeholders real options
in 227-33 and investment life-cycle 37-40
indicators of intangible assets in 237-8 and irreversibility, specialisation and
performance measurement systems and competitive positioning and path-
intangible assets 235-8 dependence 35
optional reporting, versus required reporting and new information 32-4
and 63 and path-dependence 35
organisation, AIAF-University of Ferrara and uncertainty/risk 32-4
model and 131-4, 139-40 basic concepts on 32-4
organisational capital, credit rating and contingent claims analysis 33-4, 44
183-4, 186 definition 32
organisational/structural capital 183 dynamic programming 34
intangible assets and risk 36-7, 40-45
partial comparability index 20, 23-4 intangible assets, risk, value and 40-5
path-dependence, and real options 35 irreversibility 33
performance measurement systems, and lens 34-7
intangible assets in opera house managerial flexibility 32-4
235-8 Marketed Asset Disclaimer 33-4
policies risk-neutral valuation 34, 42, 44-5
competitive 248-9 valuation 33-7
innovation 244-8 value and firm specificity 36
Porter’s “five forces”, intangible assets and value and uncertainty 36
52-6 valuation of intangible assets 33-7
power reductions in information asymmetries,
and knowledge 213-5 intangible assets and 60, 65
concept of 209-10 regional growth
Critical Management Studies and 209 complementarity between intangible
empowerment and 212-3 assets and 248-9
in intangible assets analysis 208, 210-3 relational capital 182
of buyer 55 relational capital, credit rating and 182-3,
of rivalry 56 186
of supplier 55 reporting
process measures, versus results measures environmental respect in environmental
and intangible assets 62-3 report 82, 90-1
processes, in environmental report 82, 91 EU standards and environmental reports
73-4
quantitative reporting, versus narrative financial variables in environmental
reporting and intangible assets 63 report 83, 91
Generally Accepted Intangible
R&D Principles (GAIP) 49-66
accounting and stock prices 103-8 human resources in environmental
amortisation 97-128 report 82, 90, 94
and buy and hold portfolio returns 112-5 information on intangibles in annual
and future earnings 108-10 report 139-40, 145-6
and future returns 110-12 intellectual capital report 68-72
Index 267
mandatory and voluntary information convergence between environmental,
on intangibles in annual report 148, social and IC report 84-6
161-3 Global Reporting Initiative 75
narrative 63 Istituo Europea per il Bilancio Sociale
optional 63 (European Institute for Social
processes in environmental report 82, 91 Report) 75
quantitative reporting versus narrative Social Accountability 8000 75
reporting and intangible assets 63 social report
required reporting versus optional and environmental report in Italy 76-82
reporting and intangible assets 63 audit and supplementary information 84,
social accountability and Global 92
Reporting Initiative 75 customers 84, 92-3
social accountability convergence financial variables 84, 93
between environmental, social and human resources 83, 92, 94
IC report 84-6 processes 84, 93
social accountability Istituo Europea strategy
per il Bilancio Sociale (European AIAF-University of Ferrara model and
Institute for Social report) 75 131-4, 139-40
social report and environmental report credit rating and 184, 186
in Italy 76-82 structuration theory 217
sustainability report and intangible structural capital, see organisational capital
assets 65, 75 sustainability
technology in environmental report 82, of profitability and intangible assets 65
91 report intangible assets 65, 75
required reporting, versus optional reporting intangible assets and sustainability of
and intangible assets 63 profitability 65
results measures versus process measures, sustainability report
intangible assets and 62-3 Generally Accepted Intangible
risk Principles (GAIP) and 65, 75
business risk and credit rating 170 intangible assets and 65, 75
financial risk and credit rating 170
intangible assets and 36-7, 40-45 tactility, Generally Accepted Intangible
risk-neutral valuation 34, 42, 44-5 Principles (GAIP) and 64
technology, in environmental report 82, 91
SA 8000, social accountability 75 Three Tier Model of Corporate
SFAS 141, 142, and goodwill and Transparency 195
intangible, 11-16
Skandia Navigator 70-2 valuation with real options, intangible assets
Skandia Business Navigator, see Skandia and 33-7
Navigator value
Social Accountability 8000, social cost and 60-1
accountability 75 firm specificity and 36
social accountability market and book values 57-60
AA 1000 75 real options value and intangible assets
AccountAbility 1000 75 31-48
and GRI project 75 real options value and knowledge 36,
between intangible assets and regional 39-40
growth 248-9 uncertainty and,36
value platform 69-70
value scheme 69-70 subjects involved in 194
taxonomy 198
XBRL use of 196-7
application to financial statements 204-5 XML and 195-6
application to intellectual capital 205 XML
applications 199-205 definition 195-6
benefits of 199-202 XBRL and 195-6
definition 194-5, 196-7

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British Library Cataloguing in Publication Data

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ISBN: 978 0 7546 4628 0

List of Figures vii

Introduction: Visualising the Invisible: Measuring and Reporting on Intangibles

PART 1 MEASUREMENT AND REPORTING ISSUES

1 Regulatory Changes in Accounting for Goodwill and Intangible

2 Intangibles and Real Options Theory: A Real Measurement

3 Intangible Assets:The Next Accounting Frontier 49

4 IC Statement vs. Environmental and Social Reports: An

PART 2 DISCLOSURE ON INTANGIBLES:

5 On the Informational Usefulness of R&D Capitalization and

7 Credit Rating and Intangible Assets: A Preliminary

PART 3 NEW PERSPECTIVES ON THE MEASUREMENT

8 XBRL as a new Language for Business and Intangibles

9 The Neglected Intangible Asset: Organizational Power

10 Intangibles and Performance Measurement Systems

11 Macro Indicators of Intangible Assets and

2.1 Investment life cycle, real options and intangible assets. 38

1.1 Alternative accounting behaviours of the analysed companies 18

Ilaria Bergamini She worked as a research assistant at the Faculty of

Visualising the Invisible: Measuring and

1 In 2004 Ashgate published a book titled “The Economic Importance of

Regulatory Changes in Accounting for

• the reporting level at which to measure goodwill impairment. The FASB

A Presentation of SFAS 141 and 142

An overview of SFAS 141 and SFAS 142

• Market-related intangible assets;

This is not an exhaustive classification and inside each category various

Regarding to the information to be disclosed in the interim report, companies

3 SFAS 131 defines an operating segment as a component of an enterprise about which

Research and Methodology

An opportunity to compare US financial results to financial results obtained by

Alternative Accounting Behaviours of the Analysed Companies

In analysing the accounting behaviour of the companies composing the sample

1. Fully compatible accounts: these companies prepare their consolidated

Table 1.1 continued

Source: writers’ elaboration

1 – US value – non-US value

1 – partial adjustment value

This index expresses the explanatory weight of the adjustments related to an

6 As above mentioned, only companies producing a reconciliation between local and

The global distance between domestic accounting principles and US GAAP7

7 See Appendix 1.B for details on the global comparability indexes.

The partial distance between domestic accounting principles and US GAAP8

8 See Appendix 1.B for details on the partial comparability indexes.

a) Companies Analysed by European Country

Austria Telekom Austria

Switzerland ABB, Adecco, Alcon, Centerpulse, Ciba Specialty Chemicals Holding,

b) Companies Excluded from the Analysis

Company Reason for exclusion

a) Global Comparability Indexes

Set of Net income Shareholders’ equity ROE global index

b) Partial Comparability Indexes Referring to Goodwill

Set of Net income Shareholders’ equity

Intangibles and Real Options Theory:

Some Basic Concepts on Real Options Theory

Using Real Options Lens with Intangible Assets

• Non-rivalry, since an intangible asset can be at the same time exploited in