Posts tagged ‘Accounting for people’
Book value accounts for about 20% of a company’s market value today. The rest – 80% – is down to immaterial ‘assets’. This makes valuing companies very difficult indeed.
There are many good reasons why book value always will be lower than market value. However one way to close this gap – and thereby making the value more transparent – is to capitalize more of the immaterial value. This could be ‘Brand Value’, ‘Customer Loyalty’ or ‘Innovation’. All of these things obviously makes a company worth more. However, one candidate stand out to me – people or ‘Human Capital’.
Why ‘Human Capital’ is a strong candidate is because it accounts for the bulk of the cost for most companies today. For some it is about 75% of total costs. It is also universally recognised, that people and their ability to perform, is the single most critical reason behind value creation today.
How practically this should be done is quite difficult to say. One way is to capitalise the total cost of the people including wages, pension, recruitment, training etc. But many questions are difficult: Should people be depreciated? If you spend money training them, should this be capitalised as any other investment? What happens when somebody leaves – should a cost be booked on the income statement? Can you ‘buy’ people below their value and should this be a gain on the income statement? How do you measure the value of people (if you don’t just use the cost base)? Some people are clearly worth different to the company despite perhaps getting the same pay – how should that be accounted for?
Perhaps these questions illustrates why Human Capital is not capitalised today. It is simply too difficult to find a meaningful way forward. But I would like to see a good, public debate about this. Perhaps there is a way?
Looking through financial statements today it is clear that there is a huge gap between what companies say are their most important asset – people – and what they report in their financial statement – tangible assets, products etc. Financial regulators – such as SEC and FSA – as well as stock exchanges are not much better. They demand certain items to be in the financial statements but not one demand information about people. This is amazing when you consider that more than 80% of the market value of the average S&P500 company is intangible assets i.e. above the book value of a company.
I think a major reason has to do with the fact that no credible standard has been put forward. If a company wanted to show the value of their software developers, sales people and marketing departments as well as receptionists and top managers how should they account for this? By number of people? By total cost of the people? And how do you show investments into this asset base and what about depreciation of it? Does CROIC (Cash Return On Invested Capital) make sense for people or do we need completely new metrics? I just don’t think they know.
Luckily a bunch of really good initiatives are underway to try to come up with standards for accounting for people. An interesting White Paper about this topic can be downloaded here: http://hcminst.com/articles/
I believe it is very important to come up with global standards for financial accountability of human capital. Today it is impossible for investors to have any feel for the quality of software developers at company X compared to company Y. The financial accounts today simply does not begin to describe this important asset base. How should investors and owners understand what they have invested in?