In the past decades, it has become common knowledge among managers that human factor is the decisive force in the company and the main contributor to increases in efficiency. However, accounting systems have not yet found a way to report the value of human capital because this concept remains too vague and elusive for accountants. Companies now have to assess their human capital in very subjective terms and do not have any reliable measures for evaluating their human capital.
Economists, too, are challenged with computing the cost of human capital. Manuelli & Seshadri (2005) state that human capital can be calculated with the help of using output per worker, marginal return on the year of schooling or in terms of total factor productivity (TFP). Thus, there is no standard measure according to which economists can evaluate the human capital and compare it across countries.
There is even less consensus in accounting as to what contstitutes a reliable measurement of human capital in accounting. At this point, ratio analysis mostly ignores human capital and concentrates only on ratios that account for the “hard” assets such as buildings, equipment etc.
Companies that are not required by legislature to report on their human capital often prefer not to worry about this ‘extra’ problem. This attitude was discovered by the Water for Fish company that performed a survey of executives’ attitudes toward reporting on human capital, trying to evaluate the prospects for its Human Capital Management Toolkit. One Interim Finance Director reacted to their question with saying “Are we required to do this? If we are, we will, but if we are not, we won’t” (Water for Fish, 2005).
However, accounting for human capital opens up important possibilities for companies. Introducing reporting standards in accounting principles and procedures would enable companies to assess objectively their human resources, how they compare to other companies, what they can contribute in terms of productivity etc. One can consider, for instance, two companies, one of which has an excellent building and equipment, but under-qualified personnel that works sloppily, and another where the building and equipment are somewhat outdated and lower quality, but at the same time the personnel is exceptionally qualified and highly motivated and organized. Under the standard reporting system that does not account for human capital, the first company that has good equipment will be seen as having as good asset base, better than that of the second company.
However, what does this tell the investor about the company’s prospects and productivity? A tightly cooperating, enthusiastic workforce can generate more income than a totally disorganized one where production assets are excellent. Without the effort of the working people, machines lose their value and will not lead to high revenues. Therefore, to give investors accurate information about the prospects of a business venture, the company has to account for the value of human capital. After all, supplying investors with information that will assist them in decision-making is the main function of accounting.
Jeffrey A. Schmidt, a consultant with experience in the banking field, believes that human capital is “a form of intangible assets” as “by definition, an asset is something that creates future economic value” (Cline, 2004). The knowledge of the employees, in a bank, for instance, help the bank to acquire new companies and to retain existing clients. The fact that the bank’s intangible, not only tangible assets are important is confirmed by the fact that while tangibles create book value, the stocks of the banks trade above their book value. Schmidt claims that this difference is explained by the value of human capital that makes an additional component of bank’s value.
Thus, accounting for human capital is a necessity if the company wants to show investors its true value. Since human capital is an important component of the company’s assets, it has to be accounted so that the company can demonstrate both tangible and intangible assets.
Cline, Kenneth. Leveraging Human Capital. Banking Strategies (BAI) LXXX.VI, (November/December 2004). 21 January 2006 <http://www.bai.org/bankingstrategies/2004-nov-dec/leveraging/>
Manuelli, Rodolfo E. and Ananth Seshadri. Human Capital and the Wealth of Nations. University of Wisconsin-Madison, May, 2005. 21 January 2006 <http://www.ssc.wisc.edu/~manuelli/research/humcapwealthnation5_05.pdf>
Water for Fish. Are you appreciating your …capital? Accounting for people or just for books? 2005. 21 January 2006 <http://www.waterforfish.com/downloads/EPRResearcharticleFINAL.pdf >.