Nothing matters more than your people. For most businesses, that’s a no-brainer. But take a look at your balance sheet. Your employees are nowhere to be found.
So how are you accounting for this most critical asset? Do you know how much you are investing monthly, quarterly and annually in your employees? This is not about the payroll dollars that you are spending, but the true investment that you are making in your workforce.
Investments in your workforce can include well-being programs, education, training, technology and other expenditures that can boost retention rates and productivity and lead to a higher return on investment (ROI) on those dollars. Chances are, you are not tracking or analyzing those.
Employee turnover also has a significant cost. But many have not been analyzing or reporting on it over the years. In today’s landscape of dashboards and real-time data, we sometimes miss this kind of critical information that should drive future decisions.
ESG and human capital disclosures are two ways businesses can start tracking their human capital investments and costs.
ESG and human capital disclosures are growing requirements
Based on a couple of recent developments in the environmental, social and governance (ESG) space, it appears public companies are going to be forced into some degree of enhanced reporting in the near future.
In November 2020, the Securities and Exchange Commission (SEC) issued final rules that require companies to greatly expand their human capital disclosures within the business description. Prior to this ruling, human capital disclosures were limited to a company’s number of employees. The new ruling impacts how covered entities must consider and report matters associated with human capital disclosures.
Additionally, as ESG matters gain more traction across a wide spectrum of companies and the public, the human capital disclosure has allowed businesses to highlight various human capital management initiatives that they feel set them apart from their competitors.
Determining your ROI on human capital
Most human capital disclosures, under the current SEC ruling, have depended heavily on qualitative descriptions of core values, programs and practices. Few companies are disclosing actual objectives or metrics used in the management of the business. Nevertheless, it’s expected that human capital metrics will become standardized and that eventually a business should be able to calculate an ROI on human capital and link to other financial metrics.
To that end, in June 2022, the working group on human capital accounting disclosure presented a petition to the SEC seeking the inclusion of a human capital accounting disclosure as part of the human capital management disclosure. While the SEC has been working on a proposal that seeks to increase the amount of information companies compile and provide about their workforce as part of its broader ESG reporting, the human capital accounting disclosure would address the issue of prescribed metrics and allow for greater transparency of labor costs for investors.
This petition stipulates that human capital is a financial reporting measure with the ultimate objective of allowing investors the opportunity to assess the extent to which firms invest in their workforce. A working group of 10 academics, former SEC officials and other market participants are requesting a three-fold change to the rule:
- Companies should disclose, in the management’s discussion and analysis, what portion of workforce costs should be considered an investment in the company’s future growth.
- Workforce costs should be treated on equal footing with research and development costs — meaning that workforce costs should be expensed for accounting purposes but also disclosed, allowing for investors to capitalize workforce costs in valuation models.
- Companies should provide greater disaggregation of the income statement.
In the broader sense, the working group identified two recent changes in public companies which are prompting this proposed change. First, is the fact that more and more public companies are deriving their value from intangible assets including human capital. Second, more and more companies are reporting a loss for accounting purposes, making analysis of operational costs more important to understand value creation.
Both of these issues, along with the growing emphasis and attention on ESG, are prompting a better reflection of human capital costs disclosure in financial reporting.
One challenge will be determining whether the current principles-based approach will be sufficient when determining any future disclosure rules. The absence of prescriptive rules regarding identifying and classifying workforce costs into investment and expense categories will likely lead to varying practices and increased complexity and comparability challenges for investors.
Another challenge will be the potential reluctance of financial statement preparers to provide additional income statement disaggregation to the extent that the information discloses competitively valuable insights into a company’s costs and investment decisions.
For some companies, the costs and metrics associated with human capital may already be embedded within their cost and managerial accounting practices, especially if labor and talent is a significant portion of their delivery. However, companies must be aware of the potential for changes to the way in which they measure and record such costs to comply with any possible reporting requirements.
How Wipfli can help
Risk management systems need to be able to account for changing business expectations and standards around human capital management. This is an evolving area that Wipfli advisors can help you understand and appropriately address as company practices regarding ESG policies come under greater scrutiny. We have the tools and expertise to help you identify and reduce risks regarding ESG and other business practices.
Contact us to learn more about our enterprise risk management services.
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