Why Labour Should Not Be Classified Only as Expense in Financial Accounting

The value of human resources has taken the cover story in many organization’s focus areas to remain competitive in this era of the knowledge economy. Yet, I am pondering why human resources as a business unit is usually classified only as a cost centre in organization’s accounting books.

If we agree that employees are truly an organization’s greatest assets, why then do they appear only as a line—staff expense, in a company’s income statement?

Plants and machineries are assets whose resale value reduce with time—and they are reported in income statements over time. The competency of labour, on the other hand, appreciates with time—yet the contributions of labour are not categorically distinguishable in the total value of an organization when reporting income in income statements.

If there is an accounting line for depreciation of physical assets, isn’t it reasonable to have a system that can show (in qualitative and quantitative terms) the appreciation of the value of human resources over time, hence their contributions to growth?

It was quite interesting to see that some Professors from Ivy League schools in the United States and Columbia, The Working Group on Human Capital Accounting Disclosure in the United States, are already thinking like this. Their thoughts echoes mine, albeit premised on a different perspective.

“An increasing proportion of public companies derive much of their value from intangible assets, including human capital—yet roughly only fifteen percent of those firms even disclose their labour costs,” shared the Group in their petition to the secretary of the Securities and Exchange Commission in Washington.

“Should a firm invest in capital expenditures, that property’s value is included as an asset on the firm’s balance sheet and depreciated over time. By contrast, spending on research and labour are typically treated as expenses: they reduce net income in the current period, and they do not appear as assets on the balance sheet,” the Group asserted.

In their proposal for reforms, the Working Group raised a need for prompt action on human capital accounting. Their proposal is motivated by the need for investors to distinguish investments from maintenance expenses.

?“First, managers should be required to disclose … what portion of workforce costs should be considered an investment in the firm’s future growth. Second, workforce costs should be treated pari passu with research and development costs, meaning that workforce costs should be expensed for accounting purposes but disclosed, allowing investors to capitalize workforce costs in valuation models as appropriate. Finally, the SEC should require greater disaggregation of the income statement to give investors more insight into workforce costs.”

I agree with the Group on the above reforms—and I will add that beyond helping investment decisions, having a human capital accounting will help foster an environment of creativity and innovation for employees to constantly develop themselves. Employees who see quantitatively how less a certain job skill or function contributes to the overall growth of an organization would be forced to improve his/her role or even value addition via another function to improve productivity of the business area. Competing skills in an environment where employees have agency to acquire new skills irrespective of job role and influence their value contributions may push employees to go beyond what is required to be successful on a role.

The key to unlocking these behaviours is transparency of contributions via human capital accounting.

For organizations, human capital accounting is also a way to lead the conversation and measure progress on social sustainability. With respect to training and education, one requirement in Global Reporting Initiative (GRI) under Disclosure 404-2, requires reporting organizations to report information on the “type and scope of programs implemented and assistance provided to upgrade employee skills.” Disaggregation of the cost of labour to include cost of personal development of individual employees, by employees themselves, can help in identifying the type and scope of programs that are needed to upgrade employee skills. This will be clearly understood even in a changing work environment, when different employees with different performances are investigated for how their personal development efforts are influencing their work output—and how certain skills can be incorporated into employees’ professional development plan to maintain quality employees across board.

Certainly, the proposal will not come with its own costs. Marginal operating performance to cover the increased cost of human capital disclosure has already been acknowledged by the Group. I would add that, at first, there may be conflicts between managers and their lower-level staff on defining scope of work for the latter’s role, as managers may prioritize working within the constraints of time and budget over experimentation to discover novel ways of working. Likewise, the decision to classify labour costs as investment or maintenance cost—conflicts may result in the definition or attribution of these terms to labour, or they work they do.

Secondly, human capital accounting is but the first dice to be rolled—if there is no follow-up on the data generated from this periodic exercise, it may become a red pill to employees who may leave if they do not feel satisfied with revelations about their contributions to the overall organization’s growth. The transparency of such a disclosure is a two-edged sword, hence the implications of such disclosure should be considered especially for organizations in the manufacturing industry.

In all, it is a good call to have a human capital accounting framework in organizations, one that should be analyzed for the benefits as well as the unintended consequences. I acknowledge that humans capital is a complex subject to integrate into a financial statement, and my expectation is that it will take considerable time to make progress and also for a consensus to be reached as we have witnessed, are still witnessing, in other sustainability reporting fields. But imagine growing a business without human resources: what will it look like? I can only imagine…