Accounting for the True Value of Human Capital

This is my second article in my series about Human Capital, so if you’ve missed the first one, please take a moment and check it out now.

We understand (NOW) that human capital—comprising employee skills, experience, knowledge, and abilities—is a crucial driver of organizational success. However, traditional accounting practices fail to reflect this reality. Specifically, payroll, which represents an organization's investment in its workforce, is classified as an expense rather than an asset. This placement on the financial statements significantly understates the true value that human capital brings to a company.

The current corporate accounting system dates back to a time when physical assets, such as buildings and machinery, were considered the primary sources of value for businesses. Consequently, human capital expenses, like salaries and training costs, are recorded as current period costs on the income statement rather than being capitalized and reflected on the balance sheet as assets. This conventional approach to accounting overlooks the fact that investments in employees can produce significant future economic benefits.

Contrary to the traditional view, payroll should be viewed as an investment, not a mere cost. When a company pays salaries, it isn’t merely purchasing labor for the current period—it’s investing in the skills, creativity, and productivity of its workforce, which contribute to future revenue and growth. If we shift our perspective and recognize payroll as an investment in human capital, it becomes clear that it should be categorized as an asset, reflecting its potential to generate future economic benefits.

Moreover, the current practice of treating payroll as an expense distorts performance metrics such as return on assets (ROA) and return on equity (ROE). By omitting human capital from the asset base, these ratios can be inflated, providing a misleading picture of company performance. Recognizing human capital as an asset would result in more accurate and meaningful performance metrics, enabling better decision-making by management and investors.

In 2020, the World Economic Forum (WEF) argued that companies must do more than merely shift payroll from the expense to the asset side of the balance sheet. They propose the development of “Human Capital as an Asset: An Accounting Framework” to systematically measure, value, and report investments in people. The framework promotes viewing employees as assets whose value increases with investment and should thus be reported on the balance sheet. It also emphasizes transparency in reporting human capital information, enabling companies to demonstrate their commitment to their employees and helping investors make more informed decisions.

Implementing such a framework poses challenges, primarily due to the difficulty in quantifying human capital accurately. However, the WEF asserts that it’s a necessary step to align accounting practices with the realities of the modern business landscape. The proposed framework represents a bold, transformative shift in how companies understand and communicate their investments in people. By recognizing human capital as a tangible asset, companies can better reflect their true value, drive sustainable success, and contribute to a more equitable and inclusive economy.

So… HOW do you actually do this? Implementing a human capital accounting framework requires a shift in both mindset and practice. Firstly, businesses must recognize and communicate the belief that human capital is not an expense but an investment, an asset that appreciates over time. This conceptual change should permeate throughout the company, from the highest level of management down to individual contributors. It’s crucial for businesses to understand that each dollar invested in an employee, be it in salary, training, health and wellness programs, or professional development, contributes to the overall value of the company.

In terms of practice, companies need to develop methods to measure and quantify the value of human capital accurately. While it’s challenging to put a dollar value on aspects like experience, knowledge, skills, and motivation, some proxies could include costs of hiring and training, wage levels, and employee turnover rates. Companies could also measure productivity, engagement, and employee satisfaction to get a sense of the return on their investment in their workforce. Moreover, adopting transparency in reporting these measurements can demonstrate the company’s commitment to its employees and provide a more holistic view of the company’s value to investors and other stakeholders. The shift to a human capital accounting framework is a transformative process that takes time and requires commitment, but the benefits to both the company and its employees make it a worthwhile endeavor.

The way forward requires a shift in our accounting paradigm to recognize and account for the true value of human capital. Companies should consider reporting investments in employee development as assets, reflecting their potential to create future value. Such a change would not only provide a more accurate picture of a company's financial position but would also underscore the importance of investing in people for sustainable success. In the current era of knowledge-based economies, human capital is indeed an asset too valuable to be left off the balance sheet.

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