GAAP is obsolete; treat talent like the asset it is

CFOs are familiar with a big weakness of generally accepted accounting principles (GAAP): they don’t recognize the investment characteristic of knowledge-based startups. As a result, these companies must tell their story using non-financial and non-GAAP metrics, for which there is no standardization.

To reiterate what has been stated by others — as a set of standards, GAAP was developed when production was the primary driver of profitability, and labor was considered replaceable and expendable. While there was an element of intellectual capital, it was minor when compared to investment in production.

As the U.S. economy expanded and took on a global perspective, production was outsourced to lower-cost foreign producers, and companies were and are still being created that are knowledge- and service-based rather than production oriented.

Shares in publicly held knowledge-based companies have reached levels that cannot be explained solely on GAAP-based financial statements. That’s because the large operating losses of these companies, as they invest in talent, is expensed in the current fiscal period while their most significant asset, workforce intellectual capital, is not recognized until the company is acquired, at which time the excess paid to acquire that talent is recognized as goodwill.

As a result of the limitations of existing GAAP, non-GAAP and non-financial metrics have been used by investors and analysts to evaluate company performance.

As these non-GAAP metrics have proliferated, organizations such as the Sustainability Accounting Standards Board (SASB) have been formed to standardize non-GAAP disclosures, and to eventually create a uniform reporting system that would incorporate both financial and non-financial data and to possibly extend the audit function to the entire report.

However, as the Securities and Exchange Commission (SEC) has demonstrated in its recent ruling requiring expanded disclosure in form S-K of non-financial data relating to several areas, including human capital management (HCM), not even regulators can decide what information should be provided by registrants.

They only specified that the information be material in understanding how the workforce-related data impacts company performance. What’s more, there’s no requirement this information be presented in monetary terms.

As a result, human resource consulting firms have been quick to fill in the absence of guidance by proposing what HCM data should be provided, leading to what can be best characterized as a kitchen sink approach. 

The SEC also accepted the idea that what is material can vary from industry to industry. So, for example, a high turnover ratio would be material in a publicly held consulting firm but would probably be considered normal in the retail sector. This is reflected by the fact that SASB has also approached standardization on an industry-by-industry basis.

Intangibles as expenses

I do not think it relevant to detail why the accounting standards setters decided to treat certain internally generated intangibles as expenses, even if the outlays incurred are intended to produce future rather than current revenue, and thus meet the technical definition of an asset.

Some internally generated intangibles, such as patents, have led to identifiable and separable status, with definitive amortization periods. These intangibles are recognized as assets. 

But what about the cost of developing the intellectual capital, represented either individually or collectively, by the workforce itself?

Standards setters rejected capitalization for workforce outlays because such “assets” were not identifiable or separable. There was no basis for amortization, and there was no legal ownership that would justify capitalization. 

At one time that reservation might have been justified, because public policy — the Employee Retirement Income Security Act (ERISA) is a good example — actually encouraged labor mobility. 

However, the economic environment has changed. Recruitment of talent in knowledge-based companies has become so competitive that, because of large initial outlays, retention of talent is crucial if these companies want to recoup their investment. That’s why companies are offering expensive incentives such as profit sharing, stock options, “Cadillac” fringe benefits, at the same time that GAAP treats these outlays as period expenses. 

I believe that the original basis for expense versus capitalization has changed. Companies would not incur these HCM costs if they expected their newly hired talent to leave, and they are willing to incur the costs required to retain that talent.

Will employees still leave prematurely? No doubt, but this is the exception, not the rule. From a behavioral perspective, when it comes time for those in the c-suite to make strategic decisions about their workforce, what will have the greater impact, information provided in financial terms in internal accounting statements, or the non-financial metrics proposed by the SASB and others?

With regard to amortization, actuaries are able to estimate average service life for pension and benefit programs, and these same estimates can form the basis for amortization and immediate write-off as a loss if employees leave prematurely.

Before environmental, social and governance (ESG) investing became the focus of attention, there were many proposals to incorporate workforce investment under the rubric of human resource accounting, or HRA. The problem with many of these proposals was that the amounts to be capitalized were based on esoteric methods that were far removed from the concepts underlying GAAP.

What seems to have been lost along the way was the idea to capitalize the original outlay cost of HR-related investments that met the definition of an asset (intended to produce future benefit) and amortize that asset using the expected service life of the employee. Those leaving prematurely would result in the unamortized balance written off as a loss. (Conventional GAAP treatment would apply for tax purposes).

Most HRA proponents rejected this as too simplistic and also not providing information about the value of the workforce in an ongoing organization.

However, the increase or decrease in the balance of this “asset” would be a clear indication of whether or not investment was being made to increase or retain the workforce, and the expression of this amount in traditional financial terms would be a common denominator in all industrial sectors. That’s different from the industry-specific non-financial disclosures proposed by SASB.

Incorporating these “assets” in GAAP-compliant financial statements would bring this information under the attest function, a marked improvement over the non-financial disclosures that today are often the product of a company press release. 

Critics of capitalizing and amortizing talent like the asset it is complain that deferring such costs would overstate income in the early stages of workforce development, but if a company cut back on its workforce investment, the reverse would be true.