Two hundred years after Adam Smith recognised the potential economic impact of manufacturing on society, the world has entered an era in which the new wealth of nations is tied directly to the creation, transformation and capitalisation of knowledge.
It is no surprise that knowledge-based industries, particularly in the science and technology sectors, are expanding faster than most others and have transformed the economic infrastructure of many countries.
As the burgeoning demand for knowledge-based products and services has changed the structure of the global economy, the role of a company’s underlying knowledge assets in achieving competitive advantage has become an increasingly important management issue.
Employee know-how, innovative capabilities and skills – or as the combination is generally called, the brains trust of an organisation – is now widely recognised as defining the productive power of a company. Similarly, the organisation is seen mainly as an institution for integrating and leveraging knowledge.
New management thinking
Dr Karl-Erik Sveiby, one of the early thinkers in the field of knowledge and intellectual capital management, holds that this new view of the corporate sector requires a new way of thinking about human assets and how they are valued. He identifies major points of departure between the traditional industrial management perspective upon which current valuation models are based, and the knowledge view.
As intangible assets grow, more people are questioning whether their value is being reflected in a timely manner.– Arthur Levitt, Former US Sec Chairman
In the traditional industrial paradigm upon which Generally Accepted Accounting Principles (GAAP) is based, people are viewed and valued as costs or factors of production. Within the knowledge view of the organisation, human resources are viewed as revenue generators whose primary task is to convert knowledge into shareholder value.
Within the knowledge organisation, production flows are idea-driven and sometimes chaotic, as opposed to sequential and machine-driven. The law of diminishing returns is replaced by increasing returns in knowledge, and economies of scale in the industrial paradigm are replaced with economies of scope in the knowledge paradigm. The power base of managers rests with their relative level of knowledge, as opposed to their hierarchical position within the organisation and finally, information flows via collegial networks rather than organisational hierarchy.
The trouble with accounting
So what does this new view of the organisation mean for financial accounting and reporting? Clearly, it has to drive changes in how the organisation is both managed and measured. Since the 1980s, market values of companies have been going up faster than book values and market values are increasingly less related to earnings.
Some estimates show that over the past half century, the percentage of hard or tangible assets in a typical company’s book value has dropped from 80 per cent to about 50 per cent, meaning shareholders understand less and less about what drives a company’s growth.
Microsoft has been used as a classic example of the unrecorded value of the intangible assets of a firm since study of the issue first became popular in the mid-1990s. In 1996, Microsoft’s market value was 11.2 times its tangible asset base. This “missing value” represented to a large degree the market’s estimation of Microsoft’s intellectual capital stock not captured in its financial statements. This is not the exception but rather the rule in financial reporting and illustrates one of the major limitations of the current financial accounting model.
Firms must clearly establish the boundaries of their human capital and identify what expenses are attributable to human capital.– James Hardie, Erie Insurance Group
If you can’t measure it, you can’t manage it…
In 1998, when a study commissioned by the Financial and Management Accounting Committee of the International Federation of Accountants (IFAC) was released, the thinking on how to value human capital assets was still in its infancy. Although most accountants and standard-setters recognised that the hidden value of the organisation lay largely in human capital, the major accounting challenges were seen to be complexity and consistency of reporting.
Many pointed out that there were no clear-cut procedures or guidelines for finding the costs of and valuing human resources and some of the assumptions underlying the models proposed to help solve the issue were arbitrary. For example, the period of the value of human capital is uncertain, so projecting its value to a certain period in the future was an inherently random process.
Consequently, from the perspective of finance professionals, understanding the value of human capital was enigmatic, maximising returns on investment in human capital remained largely outside their purview and for reporting purposes, out of necessity, it was lumped into the melting pot of other intangibles such as goodwill.
Fourteen years later not much has changed from a financial perspective, but there is growing concern over the lack of appropriate measurements that reflect the key characteristics of today’s economy, particularly among regulators. GAAP continues to be criticised for failing to recognise and measure intangible assets.
Arthur Levitt, former chairman of the US Securities and Exchange Commission (SEC), has stated: “The result is balance sheet information which is not representationally faithful. As intangible assets grow in size and scope, more and more people are questioning whether their value and the drivers of that value are being reflected in a timely manner in publicly available disclosures.”
Steven Wallman, a well-known expert on intangible valuation and former SEC commissioner, comments that “the inability to recognise as assets on the balance sheet some of the new and most significant building blocks of business has resulted in balance sheets that bear little resemblance to the true financial position of firms they are supposed to describe”. He further notes: “We are assigning the balance sheet to the status of an antique and ignoring the needs of a broad array of financial statement users, including creditors who increasingly are lending on soft assets.”
A way forward?
In April this year the Society for Human Resource Management (SHRM), a 250,000-member US organisation based in Virginia, tried to push the issue of measuring intangibles in its Draft Guideline for Reporting Human Capital Metrics to Investors. The rationale behind the guideline was to design “a series of analytical measures that will reflect the value of human capital in financial terms that are consistent with those currently used and commonly respected in financial, accounting and other business communications to investors and similar stakeholders”.
In addition, in selecting these indicators of human capital the body stated that it “strove to rely on metrics that were relevant to investors, readily produced from information corporations already had on hand, and were auditable. Practicality was an overriding concern and organisations should have little trouble adhering to this standard”.
However, the framework proposed by SHRM was generally not well received. While it attempted to address the complexity and consistency challenges in human capital reporting, many finance executives, equity analysts and investors still believed that whatever the objective, more is less when it comes to disclosure of non-GAAP measures.
Recent media reports have cited disgruntled CFOs who, in one case, said: “The effort required to pull together meaningful data will waste the time of very busy people. These metrics add nothing to the bottom line and the value of the data to investors will be questionable at best.”
Another added: “Presently, financial reports contain so much information that it is questionable that investors can digest everything.”
Even from an HR management perspective, it is argued that the SHRM reporting proposal has significant drawbacks. Senior talent management consultant for leadership and executive development at Erie Insurance Group, James Hardie, explains the more subtle complexities introduced by the document – even the definition of human capital.
“From my perspective, the primary objective of reporting on human capital spending is for organisations to consistently identify the financial impact of human capital decisions,” Hardie says. “In order to accomplish this, firms must first clearly establish the boundaries of their human capital and second, identify what expenses are attributable to human capital. The sub-metrics within this proposed standard do not provide a consistent definition of the boundaries of a firm’s human capital. Employees of the organisation are an obvious starting point, but how far from employees do we go before we reach the edge of what can be deemed to be the firm’s human capital?
“Setting this boundary is one of the strategic choices a firm can make. Therefore, it is impossible to compare consistently one firm to another without first understanding the context of the strategic choices made by the firms.” How, he asks, can potential investors compare the human capital spending of firms in the same industry sector? As an example, he points out that a franchise operation depends on the human capital of its franchisees, while a non-franchise operation relies on its own employees.
Further, he says the need to fully understand the boundaries of human capital within a firm are also important to understanding costs in support of employees and costs in lieu of employees. Certainly, which costs a firm decides are in support of employees or in lieu of employees is complex. For example, exactly how much of a retail store is customer space, employee space, or stockroom? More importantly, does the distinction matter to an investor? Regarding employees versus a contingent workforce, does it matter if the graphic artists who create in-store advertising are employees, temporary workers, contractors, or employees of a third party? The bottom line: when does the distinction of whose human capital is being deployed become material to an investor?
So, where does this leave the conversation about how we change the way we value companies in the new economy? The answer would seem to depend on whether finance professionals will take up the challenge of including voluntary (but audited) human capital metrics in their annual reports, or add to the already voluminous nature of their management discussion and analysis.
Interestingly, professional accounting bodies and the CFOs of major companies have generally been conspicuously absent from commenting on the standards proposed by SHRM. Indeed, as the 24 May cut-off date for industry input passed this year, no finance chiefs of any large US corporations had responded to the draft.
Observers are now left to wonder whether the window to embrace human resource accounting has closed. Similarly, the question remains as to whether it is even possible to properly measure the “missing value” between the book and market value of a firm, or identify that which constitutes the melting pot of so-called goodwill.
Whatever the case, getting the nod for a standard such as proposed by SHRM still seems a long way off.
This article is from the October 2012 issue of INTHEBLACK magazine.