Should human capital be included in financial statements?

The global economy has over time shifted from an industrial economy to an economy that is based on information and knowledge (Monday, 2017). As a result, human capital has more than ever before become of greater benefit to organisations. Many human resource and business experts agree that the human capital is an organisation’s most important asset (Dean, et al. 2012 ; Cobb and Wallace, 2016). Although this is the case, employees are often considered to be liabilities in financial statements given that they are paid wages and add to business expenses such is the case with their pension contributions. People play an important role in creating intangible such as research and development, brands, patents and intellectual property. In turn, these intangible assets greatly contribute to the creation of tangible assets such as land, equipment, vehicles and plants. Human capital, therefore, emerges as a core contributor to company profits and shareholder value (Dean et al. 2012). While this is the case, human capital often does not feature in balance sheets as assets in spite of its direct and indirect contribution to business profitability and shareholder value.

Human capital and financial statements

Washer and Nippani (2004) hold the opinion that the importance of human capital in financial decisions can be appreciated by including human capital in the statement of financial position. Given that financial statements are mainly aimed at trying to portray as accurately as possible a company’s economic reality as well as providing users with relevant information to enable them make sound investment decisions, it is relevant and logical that human capital is featured as an asset in such statements. This is more so the case given that human capital is a key contributor to the organisation’s profits and shareholder value.

Definition of Human Capital

Human capital is the skills, training, education, competencies, experiences, and innovation of a person that enables the transformation of raw materials into more valuable products (Micah et al., 2012; Dean et al. 2012; Oseni and Igbinosa, 2015). Cobb and Wallace (2016) define human capital as the productive capacity of an individual including their talent, innate ability, skills, and learned knowledge among other attributes. Essentially, the human capital of an individual determines their ability to generate ideas and produce goods and services, as well as their economic productivity (Cobb and Wallace, 2016). An organisation’s human capital can be said to be sum of the current and future economic valuation of the capabilities and skills embodied within all the persons that together make the organisation’s entire work workforce at a given date (Cobb and Wallace, 2016). In essence, human capital contributes to a business’ market value as it contributes to intellectual value. Intellectual value on its part contributes to organisational reputation and brand value.

Challenges in Recording and Quantifying Human Capital

Human capital is not often recorded as an asset in financial statements for a number of reasons. One reason for this is that human capital is difficult to quantify. As noted by Washer and Nippani (2004), the value of human capital is affected by numerous factors including age, mortality rate, worker’s health, household consumption, and job security among other factors, which makes it very difficult to quantify. Also, since companies do not really own their employees, there is always the possibility that manpower will change in the course of the organisation’s operation. When employees leave the organisation or are replaced, there is the challenge of determining the human capital replacement cost (Monday 2017). At the same time, the quantification of human capital, just like the quantification of stock, is greatly subjective. In this regard, two competent financial analysts, each applying a well justified approach, could compute the values for an individual’s human capital and come with significantly different results. As noted by Dean et al. (2012), given that quantifying human capital is very subjective, including it in financial statements can lead to incomparability and opportunities to sharply increase an organisation’s assets.

Several models including the cost, market and income-based approaches have been developed in an attempt to quantify the value of human capital. Each of these approaches has its share of limitations making it difficult to create a uniform accounting standard for measuring, recognising and reporting human capital. Scarbrough (2003), for example, notes that the cost based approaches do not recognise the importance of the value creation
effect which, in the first place, is the major reason for seeking greater information on human capital. Appreciating the nature of human capital and the challenges experienced in its valuation, Petkov (2009) concludes that human capital is dynamic and demands multiple indicators for its valuation.

The Changing Value of Human Capital

When human capital is included in financial statements, the value of human capital will be subject to change. This is the case since human capital (and therefore the value of human capital) is subject to biological, physiological, cultural and social factors (Igbalajobi, 2015). These factors are subject to change over time and, therefore, inevitably impact on the value of human capital. (Cobb and Wallace, 2016). Using the human life value approach as an example, a person’s human capital is a function of several factors such as the probability of disability, the probability of death, and the expected number of years of years remaining for the individual, inflation among other factors (Washer and Nippani, 2004). Some of these factors keep changing and therefore lead to changes in the value of human capital.

References

Cobb, G. and Wallace, K. (2016). Valuable People – What is human capital and how do you quantify it? A practical approach from the utility industry. Available at: https://www.icaew.com/-/media/corporate/files/technical/sustainability/rethinkingcapitals/tecplm15059-1-george-cobb-and-kate-wallace.ashx

Dean, P., McKenna, K. and Krishnan, V. 2012 Accounting for Human Capital: Is the Balance Sheet Missing Something? International Journal of Business and Social Science 3(12): 61-64.

Micah, L., Ofurum, O. & Ihendinhu, J. (2012). Firms financial performance and human resources accounting disclosure in Nigeria. International Journal of Business and Management 7(14) Available at www.ccsenet.org/ijbm

Monday, O. (2017). Human Resources Accounting: Issues, Benefits and Challenges. International Journal of Economics, Finance and Management Sciences 5(3): 129-138

Oseni, A. and Igbinosa, P. (2015). Accounting for Human Capital: Is the Statement of Financial Position Missing Something? Journal of Educational Policy and Entrepreneurial Research (JEPER) 2(5): 108-114.

Petkov, R. (2009). Perspectives on disclosing human capital into the notes of the financial statements. New York: City University of New York.

Scarbrough, H. (2003). Human capital External reporting framework. London: CIPD Change Agenda Report.

Washer, K. and Nippani, S. (2004). Human Capital and the Balance Sheet. Journal of Financial Counseling and Planning, 15 (1): 13-20.