Wednesday, 27 November 2013

CIPD / IASB - HR and Financial Reporting: Why the Value of Talent CAN'T appear on the Balance Sheet!

One of the things the CIPD Valuing Your Talent report suggests is that the onus is now on the IASB to explain why the value of human resources cannot appear on the balance sheet as an asset in its right, rather than just as a cost on the P&L.
I’m not sure why they think this is the case, but anyway, in case the IASB is struggling, here are some inputs from my 2006 book which describe why putting people on the balance sheet isn’t just difficult but actually quite impossible.
This doesn’t mean that we shouldn’t support the concept of people as providers of human capital:
'HCM recognizes that people are investors of their personal human capital and that this provides the main source of value for an organization. Of course, financial reporting standards will not allow us to account for human capital in the same way as financial capital, but with a nominal shift from the right-hand to the left-hand side of the balance sheet, the term ‘human capital’ at least implies the right level of importance. It describes an investment, not a cost. It indicates something that can appre- ciate if it is managed appropriately over time, rather than being utilized for short-term gain. It also recognizes that organizations do not have to own the capital to utilize it, but that it will only be made available for as long as investors (the people working for the organization) gain value in return for making their investment.'

And if we could somehow put people on the balance sheet that would be great:
'Organizations may recognize their employees as their most important asset but our reporting requirements do not allow them to be considered like this. Spending a million pounds on training employees is treated as an expense and would have an immediate impact on earnings. If expenditure on training was treated as an investment, these costs would be treated as assets and capitalized on the balance sheet. So the same spending would be depreciated over the useful life of the training and earnings would be reduced gradually over this period. Treating this spending as an investment would also mean that it would be much more likely to be monitored over the period it is amortized for.'

Unfortunately, we can’t.  To be able to do so, we would need to be able to to a direct valuation of our stocks of human capital:
‘The assumption in direct valuation is that intangibles have an absolute, fixed value. This can lead to some further questionable conclusions. For example, it can be taken to mean that intangibles account for an absolute part of market value and potentially the difference between book and market value. In this situation, it makes sense to quantify each type of intangible capability in order to justify market value and keep share prices high.
I believe the search for an approach to direct valuation will also prove futile. It has already become less popular since the downturn in the stock market in March 2000 when it became clear that intangibles could not be measured as a simple differ- ence between market and book values but involve a more complicated relationship than this. A powerful criticism is that direct valuation tries to cope with complexity by pretending it does not exist and this can be dangerous if it leads to managing in an inappropriate way.'

(Multiply my comment about the downturn in 2000 by 100 for the recession in 2008!)

The only way we can value human capital appropriately is indirectly:
'In this perspective, which takes more account of complexity, intangibles are just the cause, not the substance of the difference between market value and financial value. Intangibles have no self-standing value in themselves; their value is created through their potential impact on future earnings. Investors’ expectations about these future earnings are what results in a company’s market value. These expectations are influenced more by intangibles than tangible assets because the market believes that intangibles will have a much bigger impact on future earnings than tangible assets. So investors pay for the expected impact of intangibles, not the intangibles themselves.
But the expectations of investors are subjective. Market value is only indirectly affected by intangibles and is also subject to a number of external factors including the political and economic climate, actions of competitors, changes of technology and general rumour. Some models introduce an additional element, ‘market premium’, into company valuation. This market premium is based solely on investors’ subjective perceptions about the future and means that it is now the adding together of financial capital, intangible capability and market premium that results in market value. However, it seems much more likely that the whole entirety of market value, not just a smaller market premium, is the result of investors’ subjective expectations. Intangible capabilities are the main driver for these expectations, but they cannot be the basis of an absolute calculation of intangible value.
An indirect approach to measuring intangibles recognizes that intangibles and the processes that are used to develop them only result in increased financial value through their contribution to business activities. For example, Kaplan and Norton explain that:
"The value of an intangible asset such as a customer database cannot be considered separately from the organizational processes that will transform it and other assets – both tangible and intangible – into customer and financial outcomes. The value does not reside in any individual intangible asset. It arises from the entire set of assets and the strategy that links them together."

Kaplan and Norton note that creating value from intangibles differs from managing physical and financial assets in four important ways:
1. Value creation is indirect ... Improvements in intangible assets affect financial outcomes through chains of cause-and-effect relationships.
2 Value is contextual ... The value of an intangible asset depends on its alignment with the strategy.
3. Value is potential. The cost of investing in an intangible asset represents a poor estimate of its value to the organization. Intangible assets ... have potential value but not market value ... if the internal processes are not directed at the customer value proposition or financial improvements, then the potential value of employee capabilities, and intangible assets in general, will not be realized.
4. Assets are bundled ... Maximum value is created when all the organization’s intangible assets are aligned with each other, with the organization’s tangible assets, and with the strategy.” '

It was interesting to hear someone at the CIPD conference challenge Peter Cheese and Anthony Hesketh about they work using this point that human capital is potential.  It’s absolutely the central point here.  Human capital does not have financial value until it’s put to use.  It therefore can’t be put on the balance sheet.  Simple.
However, in case you want it, my more comprehensive argument continues:
'Rather than trying to ‘fix’ accounting, this perspective realizes that financial accounting does not attempt to convey the market value of a company on its balance sheet. All it does is to value a company’s assets in accordance with financial reporting standards. International Accounting Standards (IAS 38) specify that a company can only recognize an asset if it is identifiable and controlled.
Control means that an organization has the ability to gain future economic benefits from an asset and to restrict the access of others to these benefits. If an asset meets these requirements then it should normally be amortized over the best estimate of useful life up to a maximum of 20 years. However, companies do not own an individual’s human capital so it cannot be controlled. It therefore lacks the essential characteristics of an asset. In fact, the standards specifically prohibit capitalizing internally generated goodwill, brands, publishing titles, customer lists and similar items including staff training costs. Outlays on intangibles therefore need to be recognized as expenses when they are incurred.
The important pointis that the accounting standards do not exclude intangibles from a balance sheet because they are too difficult to include. The real reason is that they do not really belong there. As Boston Consulting Group explain:
"The fact that companies don’t own their employees, as they do their capital assets, is why methods for valuing ‘human capital’ on balance sheets are so tortuous."

Keeping intangibles off the balance sheet means that the information on it is still relatively comparable. But it also needs to be recognized that the total value of the balance sheet will not reflect the market value of the company and that some of the things that are not on the balance sheet will be more important than what is included.
In this perspective, financial reporting still needs to be improved to meet the new, broader information needs of its users, but by developing and improving non-financial forms of reporting. Rather than changing the information that is included in the financial accounts, the need is to share more knowledge, to describe qualitatively what an organization is doing, and the sorts of intangibles it is creating, in order to provide earnings in the future. This is what Becker et al. are referring to when they encourage HR to take a different approach to measurement:
"The bottom line is this: If current accounting methods can’t give HR professionals the measurement tools they need, then they will have to develop their own ways of demonstrating their contribution to firm performance ... Investors have made it clear that they value intangible assets. It’s up to HR to develop a new measurement system that creates real value for the firm and secures human resources’ legitimate place as a strategic partner."

The rest of the book goes on to provide the required new measurement system that demonstrates HR contribution to firm performance that creates real value and secures HR”s legitimate place as a strategic partner.
You can buy my book here (and on Kindle).

But going back to the CIPD report, this is where they have messed up.  We can’t put people on the balance sheet.  We can’t accept accounting’s current paradigms about reporting and try to squeeze HR into them somehow.  We have to educate other business communities that this is the only way to effectively report on HR.
What gets me slightly irritated about this is that both Peter and Anthony should know better.  Anthony in particular endorsed my book but seems now to have forgotten about the content and the complexity involved in reporting on people management:
"That people’s capacity to unlock the performance of organizations is far from a simplistic and causal model is hardly new. A book offering a new way of explaining how such complexity can be managed and harnessed for the good of organizations certainly is. This is a book to address HR’s continuing inability to think outside the box of how people influence performance. Read, reflect and act."

Dr. Anthony HeskethDirectorCentre for Performance-Led HRLancaster University Management School

I did however appreciate Anthony's comments during the CIPD conference presentation about my great website.  You’re reading it now by the way! - do come back again…

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  • jon [dot] ingham [at] strategic [dash] hcm [dot] com

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