Much of our modern management practices stem from the Industrial Age.
We have for some time been dealing with a fundamental shift in the basis of our economy, which has shaped the way organisations create value. This, in turn, ultimately shapes how the people within the organisation need to be valued.
We live and work in the knowledge worker age but operate our large organisations in a controlling industrial age model that suppresses human potential.
Even though companies consider their employees to be their most important asset, especially those in the service industries, many continue to believe that:
People need to be controlled and managed tightly, not empowered and guided.
Investing in and developing people is an expense to be tightly controlled, not a force multiplier to accomplish greater achievements.
This shift means that human capital and employees are more important to service and creative industries than ever. And conversely, physical assets are less important than before. New technologies such as the internet and mobile devices are drivers of this transformation that have expanded and opened up knowledge and information, intangible assets embodied in people.
At this point, it would be typical for someone like me, whose coaching is at the nexus of leadership, effectiveness and productivity, to delve into why a command and control management philosophy is bad and why collaboration and empowering your people is the path to success. However, this time I want to take a different direction. After all, I have already written extensively on those points HERE, HERE, and HERE. So instead, I want to focus on something more subtle but potentially more profound. Something that I feel is suppressing the potential of your teams.
Generally Accepted Accounting Practices (GAAP), International Financial Reporting Standards (IFRS) and double-entry accounting.
Yawn! I get it. But please bear with me. As someone who qualified as a chartered accountant many years ago, I want to dust off my double entry skills to highlight this issue.
Assets versus Expenses
In accounting, assets are any resources that a company controls and deploys to produce future value.
It makes sense to focus on asset categories like property, plant, and equipment in a manufacturing-driven economy. But for countries whose economies have transitioned from one based on the production of goods to one mainly driven by people's services, creativity, and knowledge-work, does it make sense to consider a change?
Companies follow accounting rules (for many countries, this is either Generally Accepted Accounting Practices or International Financial Reporting Standards). These rules instruct the companies to report physical things as assets on the balance sheet and people as an expense in the Profit and Loss statement. People, i.e. Labour, is the overhead of producing a good or service, separate and apart from the assets on the balance sheet.
Yet the technical definition of an asset is something that has the potential to generate a benefit in the future.
That sounds a lot like people, i.e. Human Capital.
First, what is Human Capital? It is an organisation's ability to create economic value derived from its unique combination of its habits, knowledge, talent, motivation, experience and attributes. It is a critical asset not captured by the company's balance sheet. The intangible nature of this asset is frequently why it is overlooked. Yet, it is extremely vital for a company's long-term existence.
There seem to be two primary reasons for not recording people as assets in the financial statements:
1 - It is really (I mean really) difficult to do. And, as such open to manipulation and abuse.
2 - People are not controlled the same way a physical asset is. They can quit and move to a competitor or leave and do something entirely different with their time.
Let's come back to these points and what my recommendation is. But first, let's take a look at the annual financial statements from two large successful service and creative public businesses.
Example 1 - Global Financial Services firm - Morgan Stanley (US)
From the 10-K (annual financial report), we quickly find the statement:
"Our employees are our most important asset."
The staff costs are shown on one line, Compensation and benefits, totalling almost $25 billion for 2021.
Example 2 - Global Creative Media firm - Netflix (US)
From their 10-K, we find their powerful one-liner:
"We view our employees and our culture as key to our success."
Yet, like for Morgan Stanley, the current GAAP doesn't require the company to provide further details on staff costs, including training and development (outside of stock compensation and executive compensation).
Doesn't this mean the accounting rules are materially understating the value of the assets for both organisations and service/creative businesses more broadly? Or am I missing something here?
I posit that the current accounting rules, constructed for the industrial age type companies and not the information/knowledge age, enable leadership teams to hide behind platitudes and encourage short-termism.
First, because staff and development in people are variable costs, one can turn up or turn down relatively quickly. A cost-conscious company or one overly focused on quarterly financials for reporting to external stakeholders will likely struggle to invest in their people.
Second, words have power. Requiring people to be reported as costs and expenses encourage us to think of them as costs. So money towards their training, development and learning to make them even better is also viewed as a cost rather than an investment in your most important asset. Think about distributed or hybrid working rather than remote working during the pandemic. Who wants to be remote from their friends and work colleagues? Instead, we want to work in a distributed or hybrid manner.
Is there an alternative?
The topic of accounting for human capital is substantial, and a method of effectively accounting for human capital would vastly change the landscape of financial accounting and reporting.
I, therefore, propose two focused enhancements to the accounting rules, specifically for service and creative businesses, that I believe will incentivise better behaviour in executive teams:
1 - Treat staff learning and development investments as an intangible asset similar to Research & Development. Intangible assets are a catchall category for elements of a business that have potential value but are difficult to measure. Brand value, goodwill and research and development are already included as assets. Each generates value for the organisation in the future.
This way, the cost would not be recognised as an accounting "loss" immediately on the Profit and Loss (P&L) statement but instead as assets on the balance sheet. In this way, the costs of, say, leadership development, coaching, executive education, the learning of new technical skills to keep up to date with technology or the latest accounting rules would be amortised over a period of time.
The argument here is simple. The cost of that investment does not occur in the same period as when the business benefits are earned. The cost should therefore be matched up to those future revenues.
2 - Require disclosures that call for companies to substantiate their throw away comments, such as we have seen earlier. (LINK)
So, for example, if you spend $25 billion on compensation and benefits with 75,000 employees and say that employees are your "most important asset", how much is spent making them better at their jobs, keeping them up to date and levelling them up?
The devil is, of course, in the detail, especially if we want to reduce the risk of manipulation and accounting fraud. So, for example, I would like to see the annual online training to ensure employees are up to date on the many policies and procedures remain an expense and not require disclosure. As someone who has sat through dozens of online compliance courses that make one click to proceed, answer the occasional question and then pass a quiz at the end, not only are they mind-numbingly boring, they should be expensed - there is no future value.
Done well, these changes will support and encourage further investment in your human capital and incentivise longer-term decision making.
Investment in your staff, done wisely, will generate value for your customers and clients, leading to more business and better financial performance and returns for your investors and broader stakeholders.
Employers and leaders need to create those conditions that allow people to excel and enjoy their work.
We can't expect the conditions to emerge by themselves.
Our current accounting rules treat employees as mass production. Part of an efficient process. They are substitutable very easily. Consequently, these rules incentivise employers to make short-term decisions, especially when the business environment is challenging. We have been complicit when considering investing in our people as a cost and reporting it as an immediate loss in the P&L.
You lead people. You manage and control things.
GAAP and IFRS are outdated and inadequate tools for documenting the behaviours of the modern service or creative industries where people can be the strategic differentiators. The service and creative-led economy have grown in ways that leave the current rules behind, which can have negative consequences for the employees of these companies.
There are many reasons why accounting for human capital has not been embraced. It would involve complex, massive changes, yet tangible progress can be made by breaking the problem into smaller chunks. Then after successful implementation, move on to the next element.
Adding staff development and learning to the intangible asset category and requiring essential disclosures of investments in human capital will, I firmly believe, help reduce the short-termism that can often be found in leadership teams when it comes to spending money on their employees.
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