Accountants have always been concerned about human capital - principally because it consumes the largest recurring amount of cash. The majority of this cash consumption is treated as an operating expense and is written off against income, therefore directly depleting profits. Therefore, if this expense can be reduced, profits can be increased. This is why “outsourcing” and “downsizing” are products of the capitalist business model.
As business evolves, the traditional consumption of cash to pay people to develop, create and deliver products and services has changed. Far fewer people in the work force now actually make the products and deliver the services - their roles have given way to technology or sub-contracting. Much of todays consumption of cash is caused by paying people to enhance and improve their knowledge, build work environments that foster collaboration and cooperation, and develop ideas and innovations that constantly improve products and services and streamline their delivery. People are also paid to build customer and supplier relationships, enhance, and build their reputation and brand, address the impact of their business model on society and re-engineer methods of operations to reduce or eliminate the negative factors of operations on the environment.
While these might still be considered operating expenses, their impact is strategic and lasting. Their outcomes build the capacity and capability needed to operate; through building this capacity organizations create a business model that has value in the marketplace. This “capability building” is similar to the purchase of equipment (tangible assets) that form the basis of a similar and supportive capability. However, while the purchase of tangible assets increases an organizations accounting value, the building of these other (intangible) capabilities has no accounting value. In fact, following accounting standards results in all this cash being treated as an expense, written off against earnings and as a result causing a depletion in investors equity. It might be counter-intuitive to realize that building future operating capability appears to be reducing the value of an organization.
The only benchmark to assess the value that is being created is the ability of management to continue to generate acceptable growth and profitability, and the marketplace to attribute a value to this capability. Knowing that market values are only a good indicator of underlying value over the longer term, investors face the risk of only having limited knowledge about how much cash has been consumed to build this future capability, whether management is protecting, enhancing, and optimizing this capability and the ability of these investments to sustain future operating capability. Traditional accounting together with both internal and external reporting continue to track, report, and reconcile the input, use and output of cash but as the use of cash has shifted, the visibility of its use and application has not kept track.
Theoretically, the growing need for integrated reporting is addressing this expanded need for reporting and accountability, but to date users have limited insight in the impact of these changes on the financial affairs of the organization. It is well understood that money is no longer the only driver of corporate accountability and that reporting on performance of a wider range of inputs is needed. The strongest driver for these changes has been addressing the environment and climate change; social accountability as well as understanding changing approaches to governance also rank high and are typically encapsulated as ESG reporting.
However, the leading model for integrated reporting to address this “new age” of accountability identified five critical components that together with financial capital, might be critical to success and sustainability. These are natural capital (addressing the environment and climate change), social and relationship capital, human capital, intellectual capital, and manufactured capital. Since organizational cash flow is now supporting the creation and continued capability of these additional capitals, in most cases through the cash paid to the “human capital” one would expect to see this aspect of human capital, as “material” to the organization and strongly linked to financial accountability. But that is not the case; there are many “human capital” metrics being published but they provide limited insight into the important financial aspects. Investors are left with little understanding of human capital.
Integrated reporting may be addressing the issue of risk relative to climate change and some levels of social impact but to date it has resulted in a minimal increase in understanding of how financial risk has changed because cash is being applied and consumed in quite different ways than in the past. One might argue that this is why traditional financial audits are increasingly failing to alter investors to risks relative to non-financial aspects of operational sustainability.
What would human capital reporting look like if investors and directors were as concerned about the impact of human capital on risk and sustainability, as they are about financial capital? After almost a hundred years of reporting financial capital we have learned that we need to understand:
This approach has worked reasonably well and has been fine tuned as the financial markets changed; but as business has shifted from deploying cash to capital assets to enable operations, to intangible assets, the reliance of financial reporting has revealed gaps and risks.
So, we have major amounts of shareholders capital being deployed to create, apply, and sustain human capital that is the major driver of value creation, yet there is no visibility into how well management is using shareholders funds for this purpose. Indeed, there is limited disclosure of the risk that exists by market and investor pressures to focus on and enhance financial capital, which might be depleting human capital. This would come from areas like excessive turnover, poor leadership, mental health issues that all cause lower productivity. These impact the shareholder as well as society and other stakeholders.
What is needed is a bridge that builds the scope of human capital reporting (materiality - especially of cash flow) between financial capital and human capital. Metrics that demonstrate the health of human capital in the same way that an audit verifies the health of financial capital. This can only happen if investors, investment advisors and boards start demanding the same knowledge of human capital as they obtain on financial capital. This starts with effective governance.