What if Human Labor Was an Asset, not an Expense?
People add more to a business than their salary expense. What if the books reflected that?
As much as CEOs like to broadcast that their people are the company’s most valuable asset, budgets are balanced with employee wages listed as one of the biggest expenses. In accounting, assets are any resources that a company controls and deploys to produce future value. In a manufacturing-driven economy, it makes sense to focus on asset categories like property, plant, and equipment (PP&E), inventory, and short-term investments. But as countries like the United States transition from an economy based on production of goods to one mainly driven by people’s services and knowledge-work, it might now make sense to change our classification of workers from liabilities (under the cost of their wages) to assets.
I’m not the first to point out the problems with how we classify labor. The modern theory of human capital was first discussed in 1965, and the possibilities of Human Resource Accounting gained initial traction in the 1970s. Accounting academics have explored potential models that could improve the way we report, track, and measure the value of a company’s human resources. But there is no consensus on a solution.
In order to build a better future, we should think critically about the problems with the status quo — namely, how the existing accounting system treats human capital — as well as the barriers to changing it, and also consider any negative side effects that could result from moving to a new framework. What might the world look like if human capital were a tangible asset?
Understanding intangible assets
Full disclosure: I am not an accountant. If you aren’t, either, I hope you’ll find this breakdown helpful. If you are, I hope you’ll build on or challenge my model.
What are intangible assets?
In his seminal book Intangibles: Management, Measurement, and Reporting, Baruch Lev defines intangible assets as “a claim to future benefits that does not have a physical or financial (a stock or bond) embodiment.”
In other words, intangible assets are a bit of a catchall category for the elements of a business that have potential value, but are difficult to measure objectively.
Common intangibles are things like:
- The brand: recognition, logo, reputation.
- Intellectual property: patents, trademarks, domain names, copyrights.
- Employee knowledge: organizational expertise, trade secrets, customer relationships.
- Goodwill: the difference between a company’s identified assets and the greater amount that a firm is willing to pay to acquire that company, which represents its potential future growth.
Intangible assets get a bit of special treatment on a company’s financial statement; companies don’t have to pay taxes on them. And if they are developed internally, they only ever need to be capitalized when a company is acquired. They also factor into the valuation price during an IPO. And as we recently saw with WeWork, overestimating the future value of intangible assets can severely inflate a company’s overall worth.
The consequences of classifying human capital as an intangible
Before changing out our current system, it’s important to understand why human capital is not already considered a fixed or tangible asset:
- Fixed assets are owned or controlled by the company, and companies don’t own humans.
- The value of human labor is incredibly difficult, if not impossible, to capture in an objective measure.
- Companies might use these measurement standards in dubious ways, such as under/over reporting assets on their books, or using these measures to lock employees into wage brackets.
- Asking companies to report on their human capital adds complexity to the system, which might hurt smaller organizations with fewer resources.
On the other hand, current methods have some troublesome consequences:
- Intangible assets widen the gap between a company’s market value and its book value. Investors and shareholders will have a distorted view of a company’s performance without information on the quality and efficiency of its human capital assets.
- Managers focus on actions they can take to increase their net income. When managers are looking for ways to reduce costs, they can easily rationalize cutting down wages, without having to directly tie that decision to losses in value-add labor.
- Through accrual accounting, firms are allowed to break down the expenses associated with certain assets over that asset’s lifetime, making it financially feasible to invest in them. However, the costs associated with acquiring (recruiting) or investing in (training) human assets are expensed at the time that they occur.
While it might seem self-evident that human capital is difficult to measure, the graph below outlines some of the concrete reasons.
Because property rights are fuzzy, market valuation is limited, and outcomes are uncertain, the value of the asset is difficult to define. So, in the thought experiment below, we have to imagine that we’ve developed reliable ways to account for these measurement challenges, and remember that every modification to the existing system will probably pose additional challenges
A future of tangible human capital
Now it’s time for the fun part. It’s 2035. Human capital is an asset on the balance sheet. How did we get here, and what does this system look like?
- Expansion of income share agreements to depress spillover effects: Today, some coding boot camps and colleges offer income share agreements for students to pay back the costs of their training as a percentage of their future salary. In the future, firms could use this model to make formal financial claims to the increased value of employees that they have trained who have moved on to other opportunities.
- Platform based markets of exchange to address tradability: Imagine if we had a perfectly competitive market for exchanging our time and our skills that supplied all parties with complete and accurate information. This is an extrapolation of the current trends with the gig economy, where platforms like TaskRabbit and Upwork have created more centralized and trackable markets to complete labor. Prices on those transactions could be used to determine the market value of that work.
- Improved predictive analytics to address inherent risk: The inherent uncertainty in the expected value of human capital could be eased with predictive analytics enabled by machine learning.
To continue the thought experiment, I’ve adapted the existing asset category of Property, Plant, and Equipment (PP&E) to use as a framework for human capital as a tangible asset.
PP&E is a long-term asset category, which represents something that the company owns, such as its office buildings or servers, which are vital to business operations. When a company is investing in its PP&E, this is usually interpreted as a signal of health, as it expects to use that purchase efficiently to generate profit.
Typically when a company rents property or equipment, it isn’t accounted for on its balance sheet. A notable exception is capital leases. In this method, a leased asset is treated as if it were owned. This is a good analogy for an employment contract, where a company is renting the time of their employee over some duration of that employee’s working life. Companies currently use this method if the asset meets certain criteria, such as the lease term being at least 75% of the useful life of the asset.
When PP&E (including capital leases) are acquired and used for operations, it is capitalized on the balance sheet and given a depreciation rate (acquisition price minus salvage price divided by useful life), to split up the cost to the future associated gains.
Okay, enough technical jargon, let’s look at an example.
Tasha is a young engineer who wants to work for Workable (which happens to be the name of my monthly newsletter on the changing nature of work). When she signs her employment contract, Workable uses information from the labor market to set a present value for her skills, and adds the cost of recruiting her to set a contract value of $300,000. The value of her contract is added to the new asset category of “Human Capital & Talent (HC&T).”
The journal entry for the new asset would look something like this, where “+A” stands for “asset” and “+L” stands for “loss”:
(1) Human Capital & Talent (+A) …………….. 300,000
— > Contract Liability (+L) …………………………300,000
Next, by looking at her profile and historic data, we set an amortization rate for her contract, which splits up expenses over the expected amount of time she’ll be at the company. Because Tasha is young and we predict she will be with the company for about three years, we will amortize the expense at a rate of $100,000/year. The amortization schedule for her first two years of employment might look something like this:
But wait, there’s more! Let’s say Workable invests heavily in Tasha’s training (an “improvement” or “betterment outlay” in accounting terms). We give her a mentor, access to training resources, and put her on projects that make her an incredibly competitive candidate for senior level positions. What now?
Because it’s 2035 and we have an income-share system to attach financial incentives to our investment in the workforce, we can do a prospective evaluation on Tasha’s work and find that her contract value is actually higher than it was when she started at the company. Perhaps it’s the value of her skills, or perhaps she is planning to stay with the company longer than originally anticipated. So the amortization costs will start to become appreciation gains.
When Tasha accepts her next job at Unworkable, Workable will realize a gain on our investment in Tasha’s growth and development, even though we lost an asset. This gain comes either from a fee paid by her new employer or a small percentage of her salary gain. We remove her as an asset from our books, and continue the process of hiring and developing new talent.
The consequences of change
For as long as I can remember I’ve been fascinated by systems — the ways that rules, whether explicitly stated or socially normalized, can shape the way that people behave and interact with one another.
Our current system of accounting already shapes the way we perceive human capital. So if we changed the rules, what would the business world look like?
Management and investment incentives would look very different in this imagined future. When looking at financial statements, managers would now have data to measure the talent turnover rates and look at revenue as a function of the total human capital. Ideally, this would encourage investment in the workforce above and beyond what is already done today.
Companies are already incentivized to take good care of their assets, because damage means recording an asset impairment. So extrapolating this to human capital, another potential consequence would be an increased financial consequence for workplace injuries, and more direct incentive to keep workers safe.
There are certainly potential negative consequences to this type of future. First, the whole premise is based on the commodification of human labor. And aren’t we worth more than just the sum of our skills? Beyond the incredible discomfort of putting a price on human capital, there’s also risk of bias within whatever predictive analysis mechanism we would use to set that price.
Next, there’s always the potential that bad actors will try to manipulate new metrics we introduce. If we’re not careful, this could create more dubious accounting and obfuscation of meaningful indicators. Last, it’s not clear how different employment classifications would fit into this system, and whether companies would go to more extreme lengths to classify workers as part-time or independent contractors to avoid legal obligations to a fully employed worker.
Whether or not we find a way to modernize the accounting rules to fit the changing role of human capital, it’s still important to understand the effects that this system has on the business landscape. There is no perfect nor permanent system, but with a little imagination, we can see beyond today’s reality.