Mind the Human Capital GAAP

By Gerard F. McDonough, Lisa Moceri

September 8, 2018

Investment in human capital has a balance sheet problem. In the contemporary economy, there is a large and growing gap in Generally Accepted Accounting Principles (GAAP). When leaders consider the key levers that drive performance and growth, effective management of financial capital rises (unsurprisingly) to the top of the list. However, in today’s economy, physical and financial assets are plentiful and increasingly well-managed, but talent capital, which is scarce and growing scarcer, is poorly managed. As a result, growth-oriented managers who are flying solely by GAAP are flying blind.

 

Forty years ago, tangible assets typically comprised 83 percent of a company’s market value, with intangible assets representing the remaining 17 percent.[1] In the contemporary economy, however, intangible (off balance sheet) assets created by workforce talent, comprise 84% of corporate value. Traditional GAAP accounting makes little allowance for this profound change. It obscures and understates the value contribution of a talented workforce.


“Any analysis of capital structure should recognize that most balance sheets are dramatically inaccurate because (with the exception of professional sports franchises) they fail to include the value of human capital.”

− Michael Milken

Philanthropist and Financier


A convergence of research forecasts a rapidly shrinking talent supply across industries and geographies, with a global talent shortage looming in the coming decade. This dramatic and growing talent chasm requires a mindset and methodology shift from talent-as-cost, which GAAP fosters, to talent-as-capital-asset, an asset we call Human Equity Value™. If human equity as intangible asset is the driver of performance and intrinsic corporate value, then we must learn to effectively measure, value, and invest in (manage) human assets as well as, if not better than, financial and physical assets.

This requires bridging the human capital gap in GAAP.

Total workforce cost is typically a company’s first or second largest operating expense, but GAAP accounting and standard financial statements are ill-suited to quantifying this expense, nor to providing the requisite insight for managing and optimizing it. Traditional performance ratios, including Return on Assets (ROA) and Return on Invested Capital (ROIC), are poorly correlated with Compounded Annual Growth Rates (CAGR) and corporate value. They can be misleading to executives seeking to maximize investment returns. Human Equity Value™ is a much stronger predictor of growth and corporate value creation in most industries.

In their quest to drive top and bottom-line growth, many executives do not have the means to understand and track Human Equity Value™.

The following are lessons learned in working with companies to bridge the human capital gap in GAAP:

  • Create Leadership Visibility for the Strategic Value of Human Capital

To reframe the conversation and leverage human equity value, the CEO, CFO, and CHRO must harmonize on talent’s true economic value for the business. After these key leaders are aligned on the financial value of the firm’s human equity, the CHRO must be prepared to advocate for the role of human capital in the company’s long-term strategy. Too often, we partner with clients where the CHRO “has a seat at the table” but does not have the language to communicate the outsized contribution of people to the business. When new opportunities are discovered, or performance issues arise, the CHRO must be equipped to articulate to C-suite colleagues, particularly the CFO, the investment logic and strategic imperative of promoting a talent-first, human equity value strategy.

  • Reposition and/or Fortify HR as a Core Business Value Enabler

It goes without saying that accelerating a human equity value approach must directly support a company’s strategy and reveal new priorities. The process of repositioning HR for human equity value execution requires an increase in the function’s analytical, financial, and strategic acumen, enabling it to increase the ROI of human capital as an asset. HR needs to be able to rigorously determine workforce value contribution – current and needed – and allocate capital to drive ROI and shareholder value returns. To successfully reposition the HR function for long-term strategic execution, HR must have the latitude and authority to redefine roles, reallocate workforce investments, set new employee expectations, and unleash commitment and motivation in progressive ways.

  • Redefine Human Equity Value Contribution via Supplemental Statements and KPIs

Ultimately, for Human Equity Value™ to successfully drive corporate performance and accelerated growth, leaders and teams must know how to define and measure success. Data is no longer the issue. Companies often have an abundance of Key Performance Indicators (KPIs), but many of them are at best only indirectly linked to financial value.

Regardless of the extent of agreement among leadership about HR’s strategic impact, without accurate measurements and reporting, no company can bridge the gap in GAAP. Below are three representative Human Equity Statements designed to effectively measure Human Equity Value™:

Companies employing this approach can more thoroughly benchmark against public competitors’ allocation of talent, positioning themselves for success as industries and markets evolve.

Bridge the GAAP to Drive Value Creation

We recently performed a Human Equity Valuation analysis for a publicly traded healthcare company. The analysis revealed people and organizational initiatives that, when implemented to achieve a lift in the Human Equity ROI Ratio of a modest 0.05 (typically achievable in 12 months), would see an increase in Net Operating Income of 7 percent. There is a clear financial and strategic impact on reevaluating Human Equity Value™.

Shifting the paradigm of talent-as-cost to Human Equity Value™ results in bridging the gap in GAAP and uncovering critical sources of productivity gains, long-term growth, and value creation. The era of the talent-first company is upon us, one where the combined expertise of the CEO, CFO, and CHRO in new, strategically synced ways is essential to profitable growth. In this era, a highly-tuned approach that rightly values people and credibly connects to company financial statements will be essential to survival. How will you start building bridges?


[1]  “Components of the S&P 500 Market Value”, Ocean Tomo, LLC, January 2015.