Including Human Capital In The Balance Sheet Accounting Essay

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Human capital creates value, and value creates wealth . Surely a true and fair view of the financial affairs of the firm should reflect human capital in the balance sheet

Our people are our greatest assets - These words are so common among companies that they usually appeared in President's and Annual Reports. Today, many organizations consider human capital to be undeniably one of the most valuable assets they hold as well as the most intangible asset to manage for a number of reasons. For one, Macdonald & Colombo (2001,p. 65) said "the strive for excellence is a continuing quest for both employers and workers as tight competition remains a challenge to the business landscape,"

No wonder, a number of companies, from small and medium enterprises to multinational corporations, are valuing their most important asset - their work forces - by investing more to keep them in their backyards. More and more businessmen are realizing that they should strive to retain their workers as this is a reflection of the firm's situation. As Berkowits (2001) has put it "people are the real creators of value, not the technology and equipment."

Considering that human resources are deemed to be their most valuable assets, how come then that human assets or human capital are not reflected on the balance sheets of firms? Is it plainly a customary practice not to include them in the financial statements? Is it due to conventions in accounting principles and standards? Could it be because an appropriate human capital valuation method is yet to be developed? Is it because setting monetary value on humans is averted? Is it since employees are deemed dispensable? And, does reflecting human assets and human capital in the balance sheet would be serving a significant purpose?

Good managers definitely knew that effective management requires measurement bearing in mind a saying which goes "what gets measured, gets managed". This therefore suggests that the basic foundation of wealth creation, which is the human capital is undermanaged in a number of organizations (Song, 2009). The reason why this is the case is the fact that most of the measurement systems of organizations are largely fashioned by accounting and reporting requirements which still follow measurement principles conceived back to the industrial period when physical capital (i.e. land, machineries, buildings, natural resources and inventories) was deemed the fundamental source of generating wealth (Song, 2009,p.3).

There is of course a reason why this accounting principle remained prevalent. Among other factors of production, human capital is the only element that cannot be owned. This makes it difficult to calculate and quantify. Omitting human capital from the balance sheet however could cause trouble in how resource should be wisely managed and allocated (Barnett, 2003).

A good example of the mischief according to Barnett (2003) committed can be seen among firms which enjoyed dramatic increases in their share prices after announcing massive lay-offs as part of their restructuring amid difficult environment. The surge in the share prices of these firms could be traced to common perception that cutting employment also means cutting "fat" (Barnett, 2003, p.127) . This is for the fact that when number of employees is reduced, operating cost is lessened and hence, increases in earnings, at least temporarily, according to the author.

Studies however showed that most of the companies that conducted massive lay-offs suffered several years of dwindled stock prices, even lower than before the lay-off. Experts explained that the temporary euphoria of cost cutting is followed by the realization in due course that when an organization reduces its employees this means as well a decrease in assets that are source of future revenue and profit generations, Barnett said.

Human capital does not simply refers to the people that compose the organization. Weatherly (2003, p.1) defined human capital as the "collective sum of the attributes, life experience, knowledge, inventiveness, energy, and enthusiasm that its people choose to invest in their work."

Human capital according to experts represents both the single greatest potential asset as well as the sole greatest potential liability that a firm will get hold of as it goes about its enterprise (Holland, 2002, p.16). Unlike other intangible assets, human capital according to Holland (2002) is the only elusive asset that one can exert influence on but will never be fully controlled; one could wisely invest in, but could also be tired out thoughtlessly; and still maintains great value. As the author has put it "Many chief executive officers recognize their investments in their most valuable asset (i.e. wages, training and development, benefits, recruitment, etc.), almost none of them however could identify the worth of their most valuable asset," (p.18).

The Human Capital

Human resources make or break a company. Considered the most important asset of a corporate entity, the service of a working man comes at a price. Too few of them, then the work cycle runs inefficiently; too many of them is ineffective allocation of resources.

To be able to scale competition nimbly, factory managers have to strike a balance or seek an equilibrium point. But when survival under a prolonged economic downturn is the objective, no matter how difficult it is, companies are left with no other choice but to let some heads roll.

Thus, Peter Drucker, the legendary management guru, once deplored the bromide, "People are our greatest assets," pointing out that most organizations honor this principle in the breach rather than in the observance (Johanson & Larsen, 2000,p.186). He said that when companies face difficulties, they first let go of their people, cutting payroll and trimming training and employee benefit programs. Reorganization or downsizing was the main reason for the cutback in personnel,. This was followed by "lack of market" or "slump in demand" for their products (Schultz, 1961, p.6). Financial losses also led to the firing of many workers.

As executives and management experts sang paeans of praise on workers as assets, "Employees took their places in the corporate pantheon, right next to desks, computers, and the executive jet," observed Thomas Davenport, author of Human Capital: What It Is and Why People Invest It. To be sure, he wrote, this is one notch higher than being regarded as costs and problems.

Expectedly, other naysayers - foremost of them financial executives and accountants - disputed the proposition. An "asset" after all, is a thing of value that is owned by a company. Does a company own its people? People go home after quitting time, take vacations, and can leave their employers at will. Assets are willfully utilized, disposed, or sold by their owners.

Enter Mr. Davenport, a San Francisco-based strategy, organization, and human resource consultant at Towers-Perrin, who was also involved in one of the US' largest mediation and arbitration companies. He suggests that the metaphor of workers and employees as investors is more appropriate:

"I suggest that thinking of employees metaphorically as investors awakens managerial minds to the reality that workers are free agents; therefore organizations can win their allegiance through one means only - returning value for value."

Mr. Davenport acknowledges that when Adam Smith compared people to machines in The Wealth of Nations, the latter observed: "The work that the worker learns to perform, it must be expected, over and above the usual wages of common labor, will replace to him the whole expense of his education, with at least the ordinary profits of an equally valuable capital."

In other words, the individual worker acts like an investor. His parents or guardians stake sums of money in his education and he derives knowledge and skill-sets that become part of his personal capital. Then he brings such capital to the marketplace and offers it to organizations that, he hopes, can harness and deploy his talents and skills optimally. Whether such aspiration will, in fact, be fulfilled in the crucible of the workplace depends to a large extent on the philosophy and capacity of the employer.

The concept of workers as investors has become even more significant in view of the ascendancy of knowledge workers whose value comes from what they know instead of what they produce with their physical capabilities. A study of the American Management Association (AMA) indicates that while in 1983, people in administrative, professional, technical, and sales jobs represented 55% of the full-time work force, this figure rose to 58% by 1995, "continuing a steady, century-long shift."

Another important change is the emergence of contingent work performed by project-based employees, temporary and seasonal- peak employees, consultants, subcontractors, out-sourced providers, and the just-in-time work force - that are aptly characterized by Mr. Davenport as "fluid, flexible, disposable."

He observes: "This new world sounds dangerous and daunting, but it brings some distinct advantages for human capital investors. The freer the human capital markets are, the more readily an individual can shift investment to the place that yields the best bundle of returns."

Such increase in flexibility is paralleled by an increase in mobility. Certainly, this has been affected, too, by rapid shifts in the work force profile brought on by business process reengineering that has triggered downsizing (or, euphemistically, right-sizing), but the net effect has been to reduce average tenure, especially in the age 45 to 54 and 55 to 64 categories. This trend toward shorter employee tenures reflects not just downsizing from unilateral company cuts but "worker confidence in the availability of another job."

The concept of workers as human capital owners and investors should also spur a rethinking of accounting policy. Balance sheets should also reflect how much companies invest in human resources, as it must be realized that human capital is key to their success and survival. Human capital is the link between a firm's direction and its strategies. Hence, Effective Human capital rmanagement helps discern if existing skills are helping a firm meets its targets.

Meantime, we return to the workplace, the arena in which the production of goods and the delivery of services that sustain the life of a nation take place and take off. If we truly value our people and provide them with an environment that enables them to fulfill their highest potentials - and if we offer them the highest possible returns on the investment of their human capital - then they are likely to respond by contributing their creativity, dedication, and loyalty in building a successful enterprise.

A lot of emphasis has traditionally been placed on the importance of physical capital - defined as produced goods used for further production - in the growth process (Hitt, et a., 2001, p.14). Its unique feature is that it is both a resource (input) and a product (output). So as more and more capital is produced, that means more and more resources are available for further production. Little wonder that capital, and increases thereof (called investment) is considered the engine of growth.

Unfortunately, the concentration on capital and how to acquire it - that's what this business of "attracting foreign investment" is all about - can get so intense that all else is relegated to the sidelines. It has gotten so that the trick to getting more attention paid to a subject or an issue, is to relate it to capital. Thus, the term "human capital," which, let's face it, has much more pizazz than the conventional and boring "labor." And lately, researchers and policy analysts are also using the term "social capital" (Hand & bev, 2003, p.234).

But somehow, something gets lost in the translation. Not because it would sound awkward to say "love's human capital lost," or talk about the President's Human Capital Day speech. But because the term human capital, ironically, dehumanizes labor. How? Using it, one tends to treat human beings merely as inputs, as resources, as means of production (Fitz-Enz, 2000). It becomes easy to forget that they are not just the means, but the ends of production. That goods and service are produced to satisfy people's wants.

If labor were merely some form of capital - i.e. some sort of produced good which is used for further production, there would be no inspiring stories which highlight the fact that labor and management in some companies are preferred to call their understanding a Social Partnership Accord, rather than a collective bargaining agreement (Hand & Bev, 2003, p.239). This is a very telling indication of the degree to which the concept that labor is much more than a means of production is internalized in various companies.

The work force should be treated more like family than as hired help. Cradle-to-grave care seems to be the best description of the relationship, with both parties striving for human development rather than just human capital development. This earned them the award for quality of work life.

The lesson is clear for all concerned: When labor is treated not only as human capital, but as human beings, the rewards are great (Fit-Enz, 2000). And who knows - perhaps this will turn out to be the country's secret weapon in its quest for international competitiveness.

The Human Capital and the Balance Sheet

Presidents referring to employees as their firms' "greatest assets" are sometimes suggested as nothing more than a figure of speech and hence, must not be taken literally. At some point, this could be true. However, it should not be discounted that presidents could have seen their employees as possessing some sort of capital value, otherwise it would be a senseless statement. Although some organizations honor this principle in the breach rather than in the observance, there are also cases who strongly and genuinely consider their man force as their company's greatest asset (Blair, 1996)

Early pioneers of the advocacy to include human resource accounting in the formal accounting standard suggested that outlays on the recruitment and training programs for managers must be capitalized and then amortized over the anticipated significant services to be rendered by the employees (Blair, 1996, p.178). There were companies that have heeded to this call by showing their investments to human resources in their balance sheets.

Critics however have argued that although such human resource accounting has placed something on the balance sheet, it appears not necessary when related to the value of the total human asset of the firm. Several accountants claimed that since employees are not "owned" by the company (as they just come and go), it is not appropriate to regard them as an asset, even if placing value on human would be soon possible (Divanna, 2005). Nonetheless, this argument brings us to the questions: What is balance sheet actually for? A description of what a company owns or an exhibition of what a firm as an enterprise is worth?

Business enterprises started to be a dichotomy when philosopher Karl Marx divided society into labor and capital, which he considered contradictory with each other (Cascio, 1998). This was however highly contested as others believed that they are not antagonists when in fact business enterprises are a synthesis of the two, which requires that both be expressed in accounting terms.

According to DiVanna & Rogers (2005, p.323), a number of critics would argue that human resources should not be deemed as assets, since assets are meant to serve individuals and treating people as assets themselves means demeaning their humanity. The authors however noted that, it must not be discounted that humans themselves are also considered the "sublime asset", higher to the machines since, no machine could ever match the versatility of workers even the unskilled ones.

More so, any sensible analysis according to the authors would point that human resources are more often than not the largest single component of operating costs, the major source for innovations, development, and competitive advantage of several organizations. The utter importance of the human asset therefore makes it worthy to be quantifiably included on the balance sheet.

A balance sheet is usually described as a reflection of a firm's history, inflation development and depreciation of assets for tax purposes. Many believe that it must be a reflection of the worth of a business enterprise in terms of current values and the premiums like goodwill on acquisitions, which when included drains up the shareholders funds (Mayo, 2001, p.37). Identifying a significant denominator that would serve as the basis of the key ratio, "return on capital employed" is what the proponents of this advocacy look for.

The other side of the coin however were those believing that including human capital in the balance sheet is unnecessary especially in years where profits are high, so that improvements on return on capital employed could be seen in the following years (Mayo, 2001). This is for the fact that higher return on capital employed is derived through lower capital employed. Higher return on capital employed would mean on the other hand earning "brownie points". This practice nonetheless is deemed "fraud" according to Divanna & Rogers (2005,p.232) even if the intention is to make the company's management appear competent and professional.

Meanwhile, with the advent of information technology, firms emerged with little capital employed and high profits which are actually gobbledygook of the return on capital employed ratio (Cascio, 1998). What left for these firms are the "human assets" which are not written on the balance sheet. Hence, the development of the concept "human asset" or "human capital" is justified in giving meaning for the return on capital employed.

Defining Asset

Defining the concept of asset in the field of accounting is necessary as this could point us to the explanation on why accountants themselves paid little attention to the issue on including firm's capitalizing in human resources in the balance sheet and why researches regarding this subject had been mostly done by sociologists and human resource specialists. It is also necessary to define it as to give further weight to the argument for including human capital in the balance sheet.

A generally accepted definition of asset in the context of accounting is: "it composes rights or other access to potential economic benefits, in which an individual or an organization has control over as a consequence of previous transactions or events" (DiVanna & Rogers, 2005, p.12) According to the authors, the definition itself suggests that the capacity to take advantage of benefits (which are implied to be uncertain with the use of vague words such as "rights" or "other access") does not necessarily mean an "ownership interest". The key word in the definition according to them is "control", which implies the ability to acquire economic benefits and impose restrictions for others to access. The concept on "human asset" seems to fall under the general definition of asset except for this issue, which consequently makes it contestable.

On the one side of the debate, one would argue that the control criterion is violated since employees at any time are free to leave the organization, and hence potential benefits out of them as well are not assured.

The other side of the coin however would counter argue said Divanna and Rogers (2005, p.15) that although potential benefits in the future are not assured, these benefits remains probable as the employers and employees agrees to enter into a relationship for a considerable period of time. Hence, the control criterion is satisfied by the restriction placed in the access to the organization, through its ability to find replacements for employees who leave and to dispose those who are not necessarily needed in the enterprise. In other words, the organization is vested with full control of its human asset, by and large, since it has the ability to mold and structure it based on what the enterprise requires for.

In practice however, the debate on whether human asset accounting satisfies or not the control criterion which is under the definition of an asset does not matter really. The extent of the human resources composing an organization already makes human capital necessary to be written in the financial statements and correctly understood through proper conceptualization in relation to asset. This strengthens the advocacy to make the generally accepted accounting practice to be more accommodating of the arguments as advanced earlier. It could also help it the definition of asset could be revised so as to make it fair and just in presenting necessary elements of what should be included or not in the balance sheet. While accounting standards are usually deemed necessary to achieve regularity and uniformity, they are still nonetheless not tablets of stones (Mayo, 2001). Sometimes, reconsidering and amending these standards are also essential. A continued debate on the control criterion in the definition of asset largely inhibits development in the recognition and acknowledgement in the context of accounting the significance of the people which compose an enterprise (Di Vanna & Rogers, 2005).