Accounting Essays - Accounting for Human Capital

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Accounting for Human Capital


Despite the long and (generally) honourable tradition of their profession, accountants have only relatively recently (50 years ago or so) come to realise that accounting should focus its primary attention on supporting the decisions of managers and external stakeholders. This limit in their vision was probably due to a preoccupation with the “stewardship” function of accounting – the provision of mostly factual information, to those with a financial interest in a business, about its past transactions. Little attention was paid to intangible assets, and even less to that valuable resource, the knowledge and skills of the workforce. The cost of “labour” was treated as an expense, just like rent and heating, and the skills and knowledge people provided to their employers were not considered. Even the emergent discipline of cost and management accountancy based its interest on tangible “things”, and attempted “scientific” measurement of labour cost through such techniques as time and motion studies. It was only after accounting began to be recognised as an academic discipline in its own right (in the mid-twentieth century) that any significant interest was taken in efforts to measure the elusive but crucial asset that is human capital.

In part, this reluctance to consider the intangible is not the fault of accountants, for it is necessary that they try to be objective in their reporting; users of accounting information hope to rely upon its utility, which means relevance to their needs, consistency in measurement, neutrality and reliaiblity. As will become obvious, such techniques that have been developed for accounting for human values could hardly be called objective. Accountants shy away from areas that require them to present too much of their own judgement; it is better to present an historic fact, and let the decision-maker draw the inferences he or she wishes from it. Indeed, this is the approach that has emerged in the embryonic field of human capital accounting – most techniques suggest the reporting of factual data, rather than any attempt at overall valuation.

It is probably also important to see the work done on human capital accounting in its political context. The internal provision of information about human resources for corporate management is likely to be motivated as much by ideas of increased efficiency, reduced costs, greater competitive advantage (and thus greater profit), rather than by a deeper concern for the social welfare of the workforce. Of course greater prosperity for the organisation may well bring benefits to its personnel, but that is rarely the primary objective, whatever the rhetoric. Change may yet be forced, however, by the developments taking place in the global economy as we move increasingly to the achievement of competitive advantage through knowledge application as well as technological excellence. It is the knowledge, skills and other intangible assets, especially those that are rare and hard-to-imitate, that provide businesses with a leading edge. Good husbandry of such resources becomes essential, and such management is difficult without appropriate information (accounting or otherwise) on which to base decisions.

Academic interest in the external reporting of human capital information has waxed and waned over the last fifty or sixty years, but the complexity and subjectivity of the practical application of the conceptual models posited by researchers has encouraged the profession to eschew change. Big Business is often complicit in this reluctance, given that reporting on the workforce is seen (wrongly?) as unlikely to improve profits (and may, indeed give unwelcome advantage to the competition), and is likely to prove costly in terms of data collection. The topic has recently seen a resurgence of interest in the UK, nevertheless, in part as a result of Government (and CIPD) pressure.

Academic work on the nature and management of knowledge, and knowledge assets has continued apace, however, and writers on human capital accounting now draw heavily upon the work of their colleagues in this related domain. A long, but readable and well-written summary of this literature is that provided by Stiles and Kulvisaechana (2003).

So what is human capital accounting?

Authorities differ, but perhaps the simplest definition is:

“The process of identifying, measuring and communicating information about human resources to decision makers.” Flamholz (1972, p588)

This is an accounting definition, of course, which avoids the need to define what is meant by “information” in this context. A definition of the nature of the asset concerned is given by Dess and Picken (1999, p8):

“[Human capital consists of the] capabilities, knowledge, skills and experience of the company’s employees and managers . . . as well as the capacity to add to this reservoir of knowledge, skills, and experience through individual learning.”

Even this definition fails wholly to capture that the collective asset represented by an organisation’s people is likely to provide a much greater resource than the simple sum of value that individuals can offer, provided, always (also crucial) that they are motivated (and facilitated) to do so.

Wright, Dunford and Snell (2001) argue that human capital is one of three components of “intellectual capital”, the other two being “social capital” (the networks and informal relationships within the organisation – this might be seen as the informal culture), and “organisational capital” (the formal structures and systems within the organisation, including the formal culture). There are parallels here with the Kaplan and Norton “Balanced Scorecard” (1992), and earlier writing by Likert and Bowers (see below).

Why Measure Human Capital Values?

Once there is a recognition that human capital represents an asset, it follows readily that effective management of that resource is necessary to maximise the benefits to be achieved from it. It must be noted, however, that attempts to show a causal link between various human resource management (HRM) practices and business performance have proved to be problematical. It may be intuitive to suggest that “good” HRM practice will improve organisational performance, but this has been difficult to prove conclusively, given the many confounding variables. It is even possible to suspect a reverse causation – profitable companies can afford to treat their employees well.

Few would disagree, nevertheless, that measurement of human capital is likely to provide useful information both to management and to external stakeholders. Many benefits can be hypothesised; some of these are:

  • Measurement of business performance, based on all the assets employed, rather than just those that can be measured readily in money terms;
  • Allocation of personnel on the basis of most valuable to most critical tasks;
  • Comparison of the use of labour as against the use of other resources, such as machinery;
  • Consideration of the effectiveness of training and development expenditure;
  • Business valuation for take-over and merger purposes;
  • The provision of a basis for more appropriate calculation of wages and salaries;
  • The setting of human resources policies.

Even a relatively incomplete and rather crude list such as this highlights at once a further difficulty with human capital accounting – its application is likely to raise sensitive internal issues in people management, as well risking exposure of valuable information to competitors.

The Techniques of Measurement

In order to make many decisions in business, comparison must be made between very disparate things. Someone has to decide, for example, whether to build a new canteen with the available funds, or invest in some new machinery on the shop floor. Accountants are obliged to use money as the basis for comparison, as no satisfactory alternative exists. The primary purpose of money, however, is as a medium of exchange, not a measure of value. This leads to difficulties in the valuation of almost any asset, but the problem is particularly severe with human capital. Indeed, the most traditional accounting method, which is commonly used for most tangible assets – historic cost – is not directly available for human capital. Apart, perhaps, from footballers, human beings are fortunately no longer (legally) bought and sold, and thus the last known exchange value cannot be used as an estimate of present value.

This question of ownership is an important one, for the accountants’ definition of an asset assumes some sort of rights over it by the recipient of the future benefit. There can be no question that organisations do benefit from their employees, and that the existence of a present workforce is likely to be of future benefit. The reality is that people work for organisations for long periods of time, and an assessment of what proportion of the workforce will leave in the coming years is not a difficult matter. But it is a big step from this to say that the organisation owns its workforce! The assumption of human capital accounting is that it is the knowledge and skills of the employee over which the organisation exercises some rights. The provision of knowledge and skills for a salary is not necessarily, in itself, however, reason to believe that an asset exists: this could be seen as simply the purchase of a resource on a daily or monthly basis. The asset, if one does exist, is something even less tangible, and related to loyalty, motivation, tacit and/or specialist knowledge, and the “added value” that a capable and committed workforce provides in the pursuit of competitive advantage. In this context, it is not difficult to see that any measurement model will inevitably be problematical and subjective.

Attempts to measure the value of human capital can use two broad approaches: the aggregation of the measurement of the value of each individual, or the measurement of the value of the workforce as a whole. The latter is likely to prove less costly, although not necessarily the most useful.

Flamholz (1973) was one of the earliest theorists to give serious thought to the problems of measuring the value of an individual. He argued that this should be based on three variables: productivity, transferability, and promotability (these could perhaps be seen as surrogate ways of measuring skills and knowledge). He also proposed, however, that the value of an individual will be linked to the likelihood that that individual will stay with the organisation (loyalty, perhaps measured by job satisfaction). The difficulty, of course, is measurement. It is possible to construct profiles of employees, assessed on key variables, such as loyalty, trust, motivation, effectiveness, experience, etc.. Cataloguing these, individually, and in total, may give a useful insight into the development of the organisation. It could be, for example, that a short-term increase in profit has been brought about only at the expense of an overall decline in motivation.

Recognising the difficulties of measurement through the behavioural variables he proposed, Flamholz and a number of others have suggested approaching the measurement problem by applying existing techniques of economics and accounting. Some of these are:

  • Replacement Cost

It is relatively straightforward to assess the direct cost of replacement of an employee; direct recruitment costs can usually be calculated. Less easy is the measurement of the economic cost to the organisation of the period during which the newcomer is trained up to full potential. This method is sometimes used by life assurance companies in calculation of premiums on key personnel in the organisation. (A good example of a situation where training cost is very significant is that of the fighter pilot, who often costs even more – many millions of pounds – than the aircraft he or she flies.)

  • Opportunity Cost

Opportunity cost looks at the next best alternative use for an employee to the present employment. Attempts are made to value an individual on the benefits he or she could provide if not doing his or her present job. This technique can only be used for those employees who have special skills, transferable within the organisation, but not readily bought in from outside. The only way of actually finding a value would be by asking managers to “bid” for the employee. This idea of competitive bidding may have limited application.

  • Capitalisation of Salary

A model borrowed from the economist’s technique of cost-benefit analysis is salary capitalisation. It has been fairly well developed, not least because of the need to attempt to assess the loss suffered by a family when a breadwinner is killed as a result of someone else's negligence. This idea is attractive, in that it is forward-looking and attempts to measure future benefit, which is the only real source of present value. There may not, however, be much correlation between earnings and productivity (and such correlation may even be negative for some workers!). A further difficulty is that other assets are not often valued on the basis of future benefit, and comparison may be difficult and misleading.

  • Economic Value

As does salary capitalisation, economic value looks at future benefits, but it attempts to measure the service the employee will provide to the organisation, rather than what he or she will be paid for that service. If this could be done effectively, it would be of enormous use; again, the measurement problems are the difficulty.

It will be evident that there are still significant difficulties with each of the above, and whichever is adopted, the cost of applying the technique to each individual in a whole workforce would likely be prohibitive.

Measuring the value of the workforce as a whole is probably a more attractive route, both in terms of practicality and cost. Early proponents of this approach were Likert and Bowers (1969). Their seminal ideas can be traced through to much of what is written in the domain today. They suggested that three variables influence the effectiveness of the human organisation: causal, intervening, and end-result. Causal variables are the enabling structures put in place by management (without which no workforce will be effective), such as policies, strategies, organisational structure, leadership, etc.. Intervening variables are measures of the health and performance capabilities of the organisation (often cited in human capital measurement discourse today) such as attitudes, loyalty, motivation, culture, and the “collective capability for effective action.” End-result variables are measures of organisational success, such as profitability, market share, productivity, growth, etc.. Causal variables induce levels of intervening variables which yield end-result variables. Then as now, the reporting of profit and loss account and balance sheet says much about some of the end-result variables, but Likert and Bowers highlight the poverty of these accounts in delivering information about the value and effect of the critical causal and intervening variables.

Present Practice

Few, if any, public corporations attempt to provide detailed monetary estimates of the overall value of their workforces; it should be evident from the above that, even if it could be provided, such data would be so subjective as to be of dubious value, and perhaps even misleading and damaging.

Most present-day authorities suggest surrogate measures that may give some guidance to workforce value, and are more readily measured and reported. The list suggested for the Operating and Financial Review (Accounting Standards Board, 2005) is hardly innovative, nor comprehensive, but would represent something of a step forward for many companies, many of which do not even collect, let alone publish such data:

  • Health and safety data, including RIDDOR reports, absenteeism, working hours, stress levels, etc.;
  • Recruitment and retention data, including turnover, retention rates, remuneration policies, skills shortages, etc.;
  • Training and development data, including hours and money spent, type of training, policies, etc;
  • Morale and motivation, measured by employee feedback;
  • Performance and profile data such as productivity, revenue or profit per employees, diversity, levels of employee qualification, etc..

Rather more comprehensive lists of possible proxy indicators are provided by Foong and Yorstan (2003), and the Centre for Business Excellence in Management and Leadership (2002). Both sources are at pains to point out, however, that there are serious methodological difficulties in presenting such data in a robust form that would be useful to readers of external reports, even if the difficulties of commercial sensitivity could be overcome.

CIPD have published a number of excellent reports considering the measurement of human capital. Perhaps the most interesting is a commissioned study by Scarborough (a University of Warwick academic), entitled “Human Capital: External Reporting Framework” (2003), published as part of the “change agenda” series. Appended to this paper is a copy of Scarborough’s suggested metrics. Once again, it will be evident that only surrogate measures are used. Despite their breadth and comprehensiveness, there is no attempt to do other than leave it to the reader to impute a value for the workforce from the data. Indeed, Scarborough is somewhat dismissive of the value of trying to value the workforce as a whole, as well as being extremely pessimistic about the future of human capital reporting generally (he talks of the “intransigence and ignorance of analysts and investors” (p16), many of whom, of course, will be accountants themselves, or advised by accountants!).


  • CIPD (2003) Human capital: External reporting framework [Online] (accessed January 2006)
  • Dess, G and Picken, J (1999) Beyond Productivity: how leading companies achieve superior performance by leveraging their human capital. New York: American Management Association.
  • Dess, G G and Picken, J C (2000) “Changing roles: Leadership in the 21st century” Organizational Dynamics, 29 pp18-34
  • Flamholz, E (1972) “Toward a Theory of Human-Resource Value in Formal Organizations.” The Accounting Review, October, pp666-78
  • Foong, K and Yorston, R (2003) Human Capital Measurement and Reporting: A British Perspective, London Business School MBA Project [Online] (accessed January 2006)
  • Kaplan, R S & Norton, D P (1992) “The balanced scorecard: Measures that drive performance”, Harvard Business Review, 70, 1, pp71-79.
  • Likert, R and Bowers, D G (1969) “Organisational Theory and Human Resource Accounting”, American Psychologist, 24, 6, pp588-601
  • Stiles, P and Kulvisaechana, S (2003) Human Capital and Performance [Online] (accessed January 2006)
  • Wright, P M, Dunford, B B and Snell, S A (2001) “Human resources and the resource based view of the firm.” Journal of Management. 27, pp701-721.