In the past few decades, the global economy has gone through a fundamental transformation, whereby the bulk of value is no longer generated by physical assets such as machinery, buildings, and computers; today, knowledge, skills, competencies, and people are at the core of value creation.
And yet, legacy accounting rules have not kept pace with the inexorable rise of the intangible economy. In the U.S., public companies are required to report their financials based on generally accepted accounting principles (GAAP) established in the 1930s by the Financial Accounting Standards Board (FASB). These rules have been sporadically updated, but still say that employees cannot be treated as assets in the same way as physical equipment, even though a significant chunk of public companies now derive much of their value from human capital. Under GAAP, companies report virtually no information on their labor costs.
This lack of transparency has resulted in two major problems for employees, companies, and shareholders, according to Wharton management professor Peter Cappelli and Wharton accounting professor Daniel Taylor. First, investors are not able to accurately assess the asset value of human capital, and this leads to reduced price efficiency. Further, the stock market may punish companies that invest in their workforce, as it drives up operating costs, just as if those firms had massive heating bills (because of GAAP, investors cannot distinguish between these two expenses).
Second, those accounting principles lead companies to make poor business decisions that lower effectiveness and efficiency — for example, cutting back on training and development because it cannot be counted as an investment, limiting headcount, and shifting work to more-expensive agency staff to improve per-employee measures of performance, Cappelli noted in a recent Harvard Business Review article.
But these problems can be resolved, Cappelli and Taylor suggest, with some fairly simple changes to financial disclosure requirements. Though small, these tweaks would have a big impact, enabling investors to reward companies that report their labor costs. And the increase in transparency would illuminate the bad apples who skimp on workforce development, hopefully nudging firms towards better HR practices.
“We have ignored the fact that the rules of the game that determine how companies behave are super important, and they can also be changed,” said management professor Cappelli. “We usually assume that for-profit businesses are just trying to be efficient to maximize profit, but what counts as profit depends on these rules, and a dollar is not a dollar depending on where it is spent.”
“We have ignored the fact that the rules of the game that determine how companies behave are super important, and they can also be changed.”— Peter Cappelli
Standardizing Human Capital Disclosures
To be sure, investor groups have been pressing for companies to report more of their human capital data. And in 2020, the U.S. Securities and Exchange Commission (SEC), which empowers the FASB, bowed to pressure. It gave each company the power to decide what they wanted to disclose. However, so far, relatively few firms have opted to voluntarily report HR information that is material to understanding their business, partly because it’s seen as an administrative burden.
Cappelli and Taylor argue that the SEC has given companies too much discretion. Instead, the professors are urging the regulator to mandate reporting in a standardized way, to allow for comparisons between firms. Taylor has even joined the Working Group on Human Capital Accounting Disclosure, composed of academics, market participants, and former regulators. The group has submitted a petition to the SEC, asking it to develop new rules that would require public companies to disclose more financial information about human capital.
Taylor said that investors need such data for two key reasons. First, because more and more companies are generating a substantial portion of their revenues from human capital and other intangible assets, compared with when GAAP was first devised nearly a century ago. But hardly any of these firms — some 15% — are currently reporting their labor costs.
Second, a growing share of companies report a net loss for accounting purposes, making it complicated for investors to analyse their true value. To price a loss-making firm, shareholders need a way to accurately assess the cost structure, and a big proportion of that is going to be labor cost.
“If we provide investors with detailed disclosure on the employee turnover rate and how much they invest in training and development, that will allow them to make the calculation on their own,” Taylor said.
“If we provide investors with detailed disclosure on the employee turnover rate and how much they invest in training and development, that will allow them to make the calculation on their own.”— Daniel Taylor
Three Rules to Help Investors
Taylor proposes three simple disclosure rules that would improve market pricing for publicly listed firms, while staying within the existing GAAP framework. First, managers should be required to spell out what proportion of workforce costs they consider to be an investment in the company’s future growth.
Second, those workforce costs should be treated as a stand-alone item, disaggregated from other “administrative expenses.” That would stop companies being “punished by investors,” Taylor said, for perceived overspending that ultimately reduces net profit. Conversely, he said, “investments in human capital can finally be rewarded by the capital markets.”
Third, he proposes that labor costs are disaggregated in income statements, to show how much they contribute to major expenses.
Taken together, Cappelli said these changes to disclosure rules could lead to companies seeing human capital as a source of competitive advantage, weeding out problems such as high turnover costs and emphasizing good practices, such as investments in training (which studies show leads to higher profitability).
In the absence of such rules, companies may be left to cost-saving measures such as gutting their workforce and relying more on temporary “leased employees.” Cappelli’s own research has shown that using these temporary workers hits productivity, because they are less knowledgeable and committed than regular employees, while also costing firms more in agency fees.
Moreover, he said that spending on training and development has fallen in recent decades, contributing to the current staffing problems inside companies. One consequence is that large companies fill about 70% of their vacancies with outside hires, at a great cost. These external hires are up to 20% more expensive than those promoted from within. They also have substantially lower performance in the first two years on the job, and they have higher exit rates, too.
Clearly, there is a need to rethink current HR practices that are hurting firms, Cappelli said. But current disclosure rules lead companies to “make business decisions which don’t make much sense,” he noted.
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