But is not the human the sublime asset, greatly superior to the machine because, relatively speaking, even the unskilled worker has a versatility no machine can match? On any sensible analysis employees are usually the largest single element of operating costs, the organisation' s main source of innovation, improvements, consumer service and competitive advantage (Johanson & Larsen 2000:170). The sheer magnitude of the human asset makes its quantified inclusion on the balance sheet very compelling.
Indisputably, human capital (HC) has the potential to create wealth. They are the most important asset of a company, as they are the mechanism through which, firms delivers it objectives and achieves it s performance targets. Employees, not machinery, are a company's largest single element of operating costs, and also its main source of innovation, improvements, consumer service and competitive advantage (Johnson & Larsen 2000:170). The sheer size of the human capital and the amount of money a company invest is this item makes it very compelling to include in its balance sheet.
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Rensis Likert was the first few advocates of inclusion of human capital in the balance sheet. He suggested that expenses relating to training and recruiting managers should be capitalised and then amortised over the expected useful lives of the employees (Horngren 1972: 157). Since then, the topic of accounting for human capital has attracted many interest from different academics such as Sackmann, Flamholtz & Bullen (1989), Flamholtz, Bullen & Hua (2002), and Flamholtz,Kannan-Narasimhan & Bullen (2004). Barry Corporation, a manufacturer of leisure footwear in USA, was the first company to adopt Likert's human resource measure in its 1969 financial statements. Since then, various organizations have incorporated HC in their reporting systems, as shown below (Flamholtz, 1999):-
- A US bank with more than $20 billion in assets applied HC concept and accounting models to measure the replacement cost of tellers and management of trainees to resolve and internal debate over their true cost.
- A major US financial institution sponsored a project to measure the value of human asset: acquired in a corporate income tax purposes.
- A major US aerospace firm used HRA to measure the value of executive time saved when corporate aircraft were used in place of commercial aircraft.
- A $450 million industrial component distributor was experiencing a high rate of employee turnover used HRA methods to quantify the cost of the turnover.
- A major Canadian industrial company established a project to account for human resources in order to assess costs and benefits of layoff decisions.
- An international certified public accounting firm has initiated a project to develop an operational system of accounting for the cost and value of its human resources.
Up until the 1980's, the balance sheet consisted primarily of tangibles, which represented completely an entity's market value. However, past this point, the market and book value for public companies began to part. In other words, the market value was not properly depicted on the balance sheet and, the primary cause of this was the company's intangibles. John Kendrick (1999) reported that in 1929, the ratio of intangible business capital to tangible business capital was 30:70 percent, but by 1990 it was 63:37 percent.
"This disassociation of market and book value meant that companies were now able to generate excess earnings - that is earnings higher than what would be expected for their tangible assets alone. Indeed, research has shown that the earnings on tangible assets are generally no greater than the product of a company's weighted average cost of capital and the book value of these assets. Investors and economists reasoned, therefore, that something other than tangible assets must be producing the excess earnings behind the disassociation of market and book values. In due course, the root cause was discovered to be intangibles, a whole other class of assets."
This shift highlighted the significance of intangibles, and the role it played in valuing companies engaged in merger and acquisition activity. This called for new rules to be established for disclosing intangibles. Jamie Ivey, in a recent article of Corporate Finance stated that,
"A balance sheetprovides a snapshot of a company's assets at any one moment in time, but how useful is such a snapshot when a company's currency is its knowledge and that knowledge can be transported in a split second? Enron is an example of the problem. An investor could have looked at his balance sheet in late November and have been perfectly satisfied as to the security of his investment, but by December 2 his investment had vanished in smoke."4
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So what is the main cause of the shift in the paradigm? In the ever-changing 21st century, companies have begun to realise that their primary source of wealth is not the machinery, but their human capital, as Peter Drucker puts it: " We are entering the knowledge society in which the basic economic resource is no longer capital, or natural resources, or labour, but is and will be knowledge." According to the data from the Brookings Institute. In 1982, hard assets represented 62 percent of a company's market value on average. By 1992, this figure had dropped to 38 percent.7 more recent studies place the average market value of hard assets in many companies as low as 30 percent.8
Human Capital Accounting - History
Early interest in human capital accounting dates back to 1960's when accounting theorists (Scott, 1925; Paton, 1962) supported the idea of treating labour as assets and recognizing their monetary value. Various measuring models have been proposed since then, which generated an increasing amount of interest in the subject. Recent studies by academics have also supported the idea. Tom Stewart appreciated the idea of external reporting of intellectual capital. Baruch Lev has called for a change in the accounting rules, so that these "new" intangible assets can be reported. Birgitta Olsson, Editor of the Journal of Human Resource Costing & Accounting, and her associates at the University of Stockholm's Personnel Economics Institute, have proposed their own argument of including human capital on company balance sheet. They urged for more transparency in an entity's financial reporting, and highlight the fact that, the omission of human value results in an under-valuation of the knowledge based companies that drive the new economy (for example, Grojer, 1997; Olsson, 1999, 2001a, b, 2003).
Human Capital Accounting-International Developments
Interest in HRA has also grown in number of countries across different continents. Hansen (2007) in his discussion of "HR metrics, noted that two thirds of the 250 largest companies in the world now issue sustainability reports along with their regular financial reports to depict the full value of the organization. These sustainability reports have been standardized and closely monitored by the Global Reporting Initiative, an international network of business, labour investors and accountants. Schwartz and Murphy (2008) suggested that undergraduates majoring in management should have human capital metrics as part of their study. They believe that, this will help them to evaluating management policy using data and metrics; thereby enhancing their understanding of contributions made by human resources to the organization.
Morrow (1996 & 1997) investigated the concept of football players in the United Kingdom as human assets and the importance of measurement as the critical factor in asset recognition. In another publication Wagner (2007) suggested that human capital (people and teams) is one of the intangible assets that investors look for in valuing a company, along with structural capital (processes, information systems, patents) and relational capital (links with customers, suppliers, and other stakeholders). However, according to an analysis of more than 600 manufacturing and service companies in research led by Dr. Chris Hendry, Centenary Professor of Organizational Behaviour and Human Resource Management at the Cass Business School, City University of London, Wagner notes that annual reports now overemphasize the role of relationship capital in company performance and minimize the role of human capital, giving a skewed view of companies' future performance.
Firms in India were also showing apparent interest in inclusion of human capital in its balance sheet. Mahalingam (2001, p. 19) noted that, the present industry experts appreciates the fact that an entity's various forms of capital, including material, equipment, tools and technology, only represent limited potentialities, and that it is the company's workforce that converts his potential and energises the creation of wealth. The author proposed human resource value approach that can be used to deduce the value of the company's workforce. He concurs that an entity can arrive at the current value of its workforce, by discounting the returns generated from an individual's skills over the next five years, with future years discounted. He identified a set of competencies of each individual and assigns a value to each. The net worth of the employees is the sum total of the values identified and the value of all the employees making up the human capital of the organization - which together with the customer and structural capital produces the revenue.
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Patra, Khatik & Kolhe (2003) conducted a study on a heavy engineering public sector company which adopted the Lev & Schwartz (1971) model to evaluate human capital accounting measures. They scrutinized the correlation between the total human resources and personnel expenses for their fitness and the resultant impact on production. They concluded that human capital valuation played an important factor for the decision-making in order to achieve the company's performance targets and improving output.
Ng (2004) commented on the benefits to the management of human capital accounting. He denotes the process of measuring and managing human capital as a (p.26) "defined framework to maximise the only real competitive advantage companies have in the knowledge economy - their human capital assets." The author believed that to ascertain the value of an entity's workforce, the company must employ human capital analytics - a new class of systems that totals HR data financial, customer and supplier information for exploration, analysis and presentation. According to the author, company management can use this tool, to make a more informed decision regarding its strategy, as human capital analytics not only provides quantifiable and accurate information, but also helps the entity to identify its essential insights, thereby allowing the organization to deploy strategic human capital initiatives to meet its performance targets.
Jones (2000) concurs that the current financial reporting system must incorporate human capital in its statements. The author notes that in the absence of proper guidance human resource executives are struggling to deduce a credible value of providing training and undertaking motivation programs for its employees, even though the management considers human capital as its greatest asset. The author noticed that the investment and awareness of the importance of intangible assets have increased significantly in the last two decades. He called for a creation of a knowledge base that is required for the development of a whole new measurement system for value creation that would operate hand-in-hand with the current accounting system. He appreciated the establishment of Canadian Performance Reporting Initiative Board, which provides a good opportunity for HR leader to work together to ensure that human capital is appreciated.
Accounting and Reporting of Human Capital
Human asset has always been considered to be the greatest asset of the company by its management. However, any expenditure made to enhance this asset is recorded as expenses, reducing profits, rather than investments that will provide future benefits to the company. For example, when a football club purchases a player, only his registration fee goes to the balance sheet, not the player itself. The reason being, as an accountant will argue, the balance sheet only depicts assets that are owned by the company, it would be incorrect to include human asset on the balance sheet, even the company can deduce its value. But what is a balance sheet? Should it depict what the company owns or the net worth of the firm?
Economist Ralph Turvey (1971:70) describes a balance sheet as an extraordinary historical hodge-podge, reflecting the history of the company, the development of inflation and the wisdom of the Inland Revenue about the depreciation appropriate for tax purposes. Other economists, such as, John Stuart Mill (Schultz 1961) is against the idea of including human capital on balance sheet. He asserted that asset exists on balance sheet because of the service they provide to the company and treating an entity's labour as asset themselves is demeaning.
Business leaders, especially in high tech industries and financial analysts criticises the current financial and accounting practices as outdated and 'not keeping pace' with the changes in the business world. According to Steven Williams, company's annual accounts fail to depict and fully measure its most significant building blocks, i.e. human capital. Thereby these statements fail to communicate the development of its intangible assets to the management and investors.
Intangible Asset -IAS 38
The accounting definition of an intangible asset is important in considering the proposal of putting human capital on the balance sheet. IAS 38 defines it as 'an identifiable non-monetary asset without physical substance.' It defines an asset as a resource:
- that is controlled by an entity as a result of past events; and
- from which future economic benefits are expected to flow to the entity.
IAS 38 suggests that if an item within the scope of the standard does not meet the definition of an intangible asset, i.e. identifiability, control over a resource and existence of future economic benefits. The expenditure to acquire it must be expensed.
IAS 38 also detailed the condition under which an asset can be recognised in the balance sheet:
Control is of the important features of the Framework definition of an asset. If the firm is unable to exercise control over the potential future economic benefits of an item, then it cannot recognise the asset.
An entity normally does not control its human capital to avoid the risk of employee turnover. It can train its workforce improve their productivity, but the trained employees may decide to leave the organization, fall ill, lack motivation, and even influence other employees to work against the company. In other words, firm cannot predict the performance of their employee as they are not within its control. Therefore, IAS 38 does not allow a 'potential' asset to be recognised in a firm's balance sheet because of the skills attached to it, as there is insufficient control over the item.
However, if the human capital is taken collectively, the control definition might be satisfied. If the employees are taken in aggregation, an entity can demonstrate control by replacing employees and making them redundant. Therefore, the entity has almost total control of its human capital in its collective form, as it can structure them according to the entity's needs. The magnitude of human capital, especially in IT industry, is such that it is essential for it to be recorded and understood properly through conceptualising it as an asset and including in the financial statement. The definition provided by IAS 38, might need some modification to accommodate this argument.
Identifiable and Future Economic Benefits.
IAS 38 states that an asset is identifiable if it either:
- is separable, i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, identifiable asset or liability, regardless of whether the entity intends to do so; or
- arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.
- it is probable that the future economic benefits are attributable to the asset; and
- the cost of the asset can be reliably measured.
Inherent in the Framework definition, any asset from which an entity is expecting to reap economic benefits in the future should be identified with a reasonable certainty. If an item passes the identifiability and control tests, IAS 38 allows the entity to recognise the intangible asset if:
The problem with putting human component on balance sheet lies in its identifiability and attribution of future economic benefits. There is no proper guidance to put a value on human capital. And secondly, the process of matching the marginal flow of income to the imprecisely measured human value is so feeble that accountants are reluctant to report human values as assets (Kieso, et al, 2003)
The world economy has experienced drastic changes through globalisation. The companies are becoming increasingly dependent on human capital and other intangible assets for future company innovations and profit growth. In the knowledge economy, businesses are placing more reliance on its human capital to achieve new competitive advantages and innovate for future growth, rather than relying on physical assets. This means companies will 'invest' more in its human capital development. However, the accounting system sees this capital expenditure for future growth, as an expense which should be taken off company profits.
The current financial reporting being historic and objective in nature, takes a laid back position with respect to recording company gains and losses. The primary reason behind this stance is to enhance comparability between organizations in a globalised world. It becomes increasingly difficult to compare entities when the measures are based on estimates and is highly subjective.
Subbarao and Zehgal (1997) studied the macro-level perspective to human capital accounting disclosures in financial statements by analyzing the differences across countries in the disclosure of human resource information in annual reports across six countries. They found differences in disclosures of human resource information across countries and provided accounting and professional insights on the human resource information areas.
In another study, Boedker, Mouritsen and Guthrie (2008) examined from Europe, Australia, and the United States, in "enhanced business reporting" (EBR), which included human capital accounting aspects. The authors found a vast diversity in international EBR practice, including measurement and reporting models, and called for further research about the barriers to and consequences of harmonization. Uniformity in accounting reports is important to achieve harmonization and to compare like-with-like. The absence of uniform approach to human capital accounting is one of the many reasons, why professional bodies are against the idea of including this intangible asset on balance sheet.
Why a particular transaction be recorded in company's accounts? Generally there are two conditions which needs to be applied in determining whether an event or item is worth mentioning in the books of an entity:
- Can the event or item be measured objectively in financial terms?
- And does the event or item affect the financial position of the company?
If we get a 'no' as an answer to either question, the event should not be recorded. Activities that can be measured and directly related to the financial statements are called business transactions and are recorded in pounds and cents. Now, coming back to the question of including human resources on the balance sheet, skilled employees are an important asset, no doubt. But the problem of determining value and measuring objectively poses the biggest barrier in its accounting treatment. Therefore, it cannot be recorded; however, in the future if the measurement technique gets more sophisticated, companies might mention them in supplemental form (p.65), as the examples earlier in the discussion showed. Kieso et al. (2003), 30 years later, make the same point again with reference to the R.G. Barry work and say, "certainly skilled employees are an important asset" (pp. 68,69).
It is evident from the above that accountants do appreciate the value of contributions made by the human capital. But so far, a proper standard has not been developed, with an acceptable method for valuing the item in financial terms. IAS 38 allows companies subject to takeover to include the value of its workforce in its acquisition price and record the payment made as goodwill, but besides this generosity, no objective method has been devised for the human capital value.
But, due to the complexity involved in identifying and controlling the future economic benefits attached to the asset, major accounting boards have rejected the proposal of including HC on the company's Statement of Financial Position.