IMGCAP(1)]A major financial reporting and accounting deficiency needs our long-overdue attention: the failure to reflect the value of human capital as an asset on a firm’s balance sheet.
Admittedly, financial statements in general have many limitations. Probably the most accepted limitation of any financial statement is that the preparer, while adhering to GAAP and other authoritative accounting rules, attempts to objectively present financial information in a manner that will assist the investor in making a financial decision. That decision may be to buy the firm’s stock, lend money to the firm, extend short-term credit, or to determine compliance with regulatory requirements. Invariably and quite understandably, the investor will apply his or her own subjective analysis of the objective data presented.
The second generally accepted limitation we find with financial statements is the various timeframes incorporated within the statements. For instance, the balance sheet will have current balances of cash, receivables of up to one year (in actuality, receivable aging generally extends well past one year), inventories of many dates, fixed assets purchased many years prior to the balance sheet date and intangibles covering an extended and long period of time. Long-term debt could have been initiated many years prior to the balance sheet date.
Some amounts reflected on the balance sheet are adjusted for their market value, while others are not, such as land.
Intrinsic to the reporting model is the need to make estimates. In many cases we are merely providing educated guesses at best. Receivables have to be valued as to their collectability, inventories have to be priced, fixed assets have to be depreciated, natural resources have to be depleted, and intangibles amortized or evaluated for impairment.
Qualitative information about the firm does not appear anywhere in the statements. We do not know whether the firm adheres to a heightened level of product or service quality control, maintains a rigorous ethical code, or aggressively encourages adherence to a firm-wide compliance program.
Human capital is not valued or even footnoted anywhere in the financial statements; however, should a firm be sold or merged, the value of that human capital will undoubtedly be valued by the purchaser or merger partner.
Finally, it is a given axiom of accounting that the true value of a firm can only be determined upon its sale.
With all the shortcomings inherent in the financial reporting and accounting model, the failure to reflect human capital as an asset may be the most serious.
The accounting equation, which I call ALE (Assets= Liabilities plus Equity) should be our starting point. FASB’s Concepts Statement No. 6 states that “assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.”
I like to think of assets as things of value that are either owned or controlled by the firm for either the firm’s current or future use. Assets, as we know, take many forms. Some assets are obvious, such as cash or buildings or large pieces of equipment. Other assets are not so obvious, such as fully depreciated assets that still provide utility to the firm (and by the way are still insured).
The Concepts Statement goes on to say that an asset embodies a probable future benefit that involves a capacity, singly or in combination with other assets, to contribute directly or indirectly to future net cash inflows. A particular entity can obtain the benefit and control others’ access to it; and the transaction or other event giving rise to the entity’s right to or control of the benefit has already occurred. The Statement further points out that “assets are the lifeblood of a business enterprise.”
What asset has more “lifeblood” than human capital? We know that service firms are virtually totally dependent on their working staff to achieve their firm’s mission and vision. Then why not record these tangible assets?
Are there corollaries to the logic of recording some intrinsic value for our “assembled staff”? In the area of revenue recognition, we seek to determine if a transaction has occurred, can be measured, and finally can be matched with the expenses incurred to generate the revenue.
Under the premise that no one purposely goes into business to lose money we know that one incurs expenses, takes on commitments and toils fervently to generate revenues, which hopefully will exceed the expenses incurred. We also know that virtually all expenses are expired assets. In the world of professional sports, teams newly acquired can for IRS purposes depreciate their players’ contracts through what’s called the roster depreciation allowance.
In reality, when a firm acquires another firm and pays an amount in excess of fair value for the target firm, goodwill is recorded. However, we know that very often the goodwill is really attributable to the assembled staff, top sales personnel, scientists, inventors or other key employees. Thus, we do recognize “human capital,” camouflaged as it may be. I believe that employees evolve in their value to a firm, although that evolution is not linear. We invest in our staff through training and education, acculturating, bestowing benefits and perks upon them, incentivizing them, and cuddling them if necessary. The direct expenses of these activities and costs, in addition to the wages, salaries and statutory and non-statutory benefits we pay for, are expensed in each period. However, the intrinsic growth in utility to the firm is not captured anywhere on the books.
I remember an old adage that asks, “Do you have 30 years’ experience or one year’s experience 30 times?” Therein is the hub of the cost/asset recognition conundrum. Let’s analyze this issue from various perspectives:
1. Historical Cost: Is human capital like land, a non-depreciable asset that by virtue of its nature serves as a major utility in the generation of revenues. I say yes.
2. Conservatism: Are we being overly generous or creating something out of nothing by suggesting that an “unrecorded asset” now be recorded? I think not. Conservatism in accounting dictates that when presented with two or more possible outcomes, we select the outcome that will yield the least benefit; it does not say we should ignore bona fide assets.
3. Recognition: Should we recognize human capital historical costs at the date of employment or after a fixed period of time or “probationary period.” Recognition criteria could be developed based on industry-specific characteristics.
4. Matching: Failure to recognize the expenses incurred to generate revenues is a major concern to accountants for all entities. I believe that human capital, just like goodwill, needs to be accounted for. Goodwill requires an exchange transaction, whereas human capital simply should require a starting point.
5. Consistency: Oh consistency! If we were really preoccupied with this notion, nothing would ever change. Liability recognition for compensated absences and post-retirement benefits would never have been required. Some, but not all, seem to think consistency is a rigorous mandate rather than an evolving tenet.
6. Full Disclosure: Management should be required to discuss and analyze the impact and import of their human capital. The financial statements should have a line item in the asset section of the balance sheet, and the independent auditors should opine on it.
7. Materiality: I defy anyone to come up with an item or accounting element that is more material to a company than its human capital.
In any organizational entity, be it for profit or not for profit, to exist and to flourish requires assets. Without assets, creditors would not transact with us, customers would ignore us, and investors would be non-existent. Assets in their original state provide any entity certain benefits that can be exchanged, invested or expanded upon. The definition of assets is in Concepts Statement No. 6, paragraph 25: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Paragraph 26 describes the three characteristics that qualify an item as an asset:
1. Is there a future economic benefit?
a. Generally recognized as the capacity to provide services or benefits to the entity that holds them. It serves the holder by being able to be exchanged, being able to produce something, or being used to extinguish debt.
2. If so, to which entity does it belong?
a. An entity must control an item in order to benefit from that item’s future economic benefit. Therefore it is that entity's asset.
b. An entity must control an item’s future economic benefit to be able to consider the item as its asset. To enjoy an asset’s benefits, an entity generally must be in a position to deny or regulate access to that benefit by others, for example, by permitting access only at a price. Thus, an asset of an entity is the future economic benefit that the entity can control and thus can, within limits set by the nature of the benefit or the entity’s right to it, use as it pleases. The entity having an asset is the one that can exchange it, use it to produce goods or services, exact a price for others’ use of it, use it to settle liabilities, hold it, or perhaps distribute it to owners. Concepts Statement No. 6, paragraph 184.
3. What made it an asset of that entity?
a. Items become assets of an entity as the result of transactions or other events or circumstances that have already occurred. An entity has an asset only if it has the present ability to obtain that asset’s future economic benefits. Concepts Statement 6, paragraph 191.
I believe human capital meets all three requirements to be duly recognized as an asset. How we choose to depict this asset on the balance sheet, as a specific value or merely as a line item with a deliberate and detailed footnote, must be worked out.
Under International Financial Reporting Standards, biological assets are measured upon initial recognition and at the end of each reporting period at fair value, less costs to sell. But I promise not to get involved in that!
We, as a profession, need to take up this issue. Valuation and the clarification of concept will take time, but they will take more time if we do not begin at once.
Charles J. Pendola, CPA, Esq., CFE, FHFMA, FACHE, CMC, CFF, is an assistant professor at St. Joseph’s College in Patchogue, N.Y., and an independent management consultant.
