What is your organization's most important asset? CEOs often respond that the organization's people are its greatest asset. But if this is true, where are people accounted for in the financial statements? Today, people are generally classified as expenses on the income statement and liabilities on the balance sheet -- not as an investable asset. Thus when CEOs seek to increase profit, they cut costs -- like people -- rather than investing in assets -- like people -- that can appreciate.
"The most valuable assets of a 20th-century company were its production equipment," said management guru Peter Drucker in 1999. "The most valuable asset of a 21st-century institution, whether business or non-business, will be its knowledge workers and their productivity." Drucker's prescient observation clearly highlights the reality that a majority of corporations face in today's "knowledge economy." Intangible assets -- patents, intellectual property, brands, and research & development -- are all created by people, and they are the core contributors to profits and shareholder value. In fact, investment advisory firm Ocean Tomo estimates that in 1975 more than 80% of the value in the S&P 500 firms consisted of tangible assets -- like land, plant and equipment. In 2010, approximately 80% of the S&P500 market value is attributed to intangible assets. But, today's accounting systems and financial reporting are still using 20th century definitions, creating a "gap in GAAP" (the Generally Accepted Accounting Principles) on how value is created in the 21st century.
So why are employees categorized only as expenses (i.e. salaries) and liabilities (i.e. pensions) in the financial statements? The accounting profession has not adequately developed tools to address the structural changes in our new economic landscape. Traditional accounting methods have been designed to account for tangible assets -- like a manufacturing plant -- that depreciate over time and are reported at historical cost. Since intangible assets are not easily valued -- like a company's brand -- measuring and pricing them can be difficult. Many people may use this as an argument against creating updated accounting standards. New rules could give companies the ability to manipulate their financial statements under the guise of valuing their intangible, human assets. However, this would be missing the point.
The overarching goal of financial statements is to attempt to accurately depict the economic reality of a company and to provide users with relevant information that is going to enable investors to make sound decisions regarding their investments. A reporting system that fails to provide information on the core aspect -- more than 80% of the stock price value -- of a company's ability to create value is missing the mark. People invent products (like Apple's iPad), and people serve customers (like Zappos). Teams of people work with networks of suppliers (like Walmart) that make goods and provide services, yet all of this value is under-accounted for because people are an "invisible" asset -- and one not quantified at that.
Four decades ago in the 1960s, researchers and academics created methodologies to close the information gap created by the increasing value of intangible assets. A group of researchers at the University of Michigan authored a series of papers to develop the field of "Human Resource Accounting." In January 1967, the Harvard Business Review published, "Put People on Your Balance Sheet," which discussed various methodologies for classifying human resources as assets, including:
- historical cost,
- replacement cost, and
- opportunity cost.
Even the American Accounting Association allocated expertise to evaluate these approaches. In 1972, and again in 1973, the AAA formed a committee to evaluate the merits of "Human Resource Accounting." However, according to Eric Flamholtz, due to the difficulty of finding public companies to serve as test cases, the movement to put "People on the Balance Sheet" lost its momentum.
Fortunately, the effort to understand, measure, and value intangible assets has resurfaced nearly 43 years later. HIP Investor, along with our research partner Solaron, has discovered at least half a dozen companies -- including global firms Infosys and Tata -- that are pioneering the integration of human asset reporting into their financial statements.
For example, Infosys (NASDAQ: INFY), the global technology company based in India, hasmeasured the value of its human capital - a method co-developed by Professor Baruch Lev of NYU-Stern's School of Business - in its public and transparent annual reports for the past four years. By using the Lev-Schwartz model, which calculates today's value of future compensation to employees of varying ages and experience levels, managers and investors can now track a variety of measures related to Infosys' human resources, such as "return on human resource value" and "value of human resources per employee." Infosys's annual report also includes a "comprehensive intangible assets score sheet" that can be used as a decision-making tool to determine how successful the firm has been at investing in its people from year to year.
A key factor in the shift toward viewing people as an asset is recognizing that an employee's value can appreciate with training, engagement, and teamwork -- all investments that are essential for 21st century firms. That is why our research at HIP Investor looks for all leading indicators of"human impact and profit (HIP)" in our ratings and ranking of companies, the composition of our portfolios, and the managing of our client's wealth.
In academia, researchers are striving to link intangible value to a company's profit and performance; you can find many of these papers at www.SRIstudies.org. The winner in 2010 was Alex Edmans at the Wharton School at the University of Pennsylvania, who found that the stock market does not fully value information about intangible assets, including employee satisfaction. Professor Edmans analyzed Fortune magazine's annual "100 Best Companies to Work For in America" lists from 1998-2010 and found that a portfolio of the publicly-listed firms consistentlyoutperformed the standard benchmarks.
Let's bring financial statements into the 21st century. Get your company to follow the lead of companies like Infosys and Tata, and begin to quantify the value that people add to your organizations. Currently, there are no apparent leading U.S. or European companies performing this calculation -- or at least not communicating it to their staff or investors. This powerful, transparent reporting on all the assets of a company has the potential to be a catalyst for developing a set of best practices that will provide a reliable methodology for the measurement and valuation of intangibles. When this eventually happens, CEOs seeking to increase shareholder value should be more apt to spur investment in -- and not so easily lay off -- the core creators of value in their business: the people. It is only then that CEOs can be truly authentic when they herald that "people are their company's greatest asset."
In the real world, the human capital value increases assets on the balance sheet, and boosts net income on the financials. Leaders using this method focus on enahncing the training, development and empowerment of people- who create products and serve customers.
The massive shift towards people as assets to be invested in can ripple through the management systems, goals and aspirations of the firm. The full power of innovation can be unleashed.
Mindshifts shift, measurements measure intangibles more comprehensively, and the full value of the firm can be managed proactively.
Total your employees by type and role
Estimate how long they will be gainfully employed at your firm
Calculate the total future cost of compensation for each group
Apply a net present value formula to that future compensation
The answer is your "total human capital value"
Compare that to the valuation of the overall business, as a percentage
Manage the business focused on human capital value, instead of expense
Co-authored and researched with Tom Bowmer
Dr. Baruch Lev and several other professors initiated these ideas back in the late 1960s and early 1970s
Are the added assets the people themselves, along with their service time and compensation, or are the assets the actions and eventual results of their actions in terms of added profitability generated? Headcount and college degrees may, or may not, add real value. The difference may lie more in leadership and right actions that produce added customer value and company profitability.
Although a firm's people and their knowledge can be viewed as an asset, the firm's value to a buyer still is measured in terms of multiples of EBITDA!
It seems to me that the effectiveness of people, not just warm bodies, makes the difference.
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Thank you, R.Paul Herman. It's an excellent article, and I appreciate your sharing.
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