The Securities and Exchange Commission (SEC) has been working on a proposal that’s intended to increase the amount of information public companies provide about their workforces — what many call “human capital management disclosures” as part of broader environmental, social and governance (ESG) reporting. Here’s why an SEC working group believes this is also a financial reporting matter, framing it as human capital accounting.
3 key changes
In June, the Human Capital Accounting Disclosure Working Group — which includes former SEC officials, academics and market participants — asked the SEC to write a rule that would require public companies to provide pertinent information to help investors assess the extent to which companies invest in their employees. Specifically, they requested the following three rule changes:
- Companies should disclose, in the Management’s Discussion & Analysis (MD&A), what portion of workforce costs should be considered an investment in the company’s future growth,
- Workforce costs should be treated on an equal footing with research and development (R&D) costs, meaning that workforce costs should be expensed for accounting purposes but disclosed, allowing investors to capitalize workforce costs in valuation models, and
- Companies should provide greater disaggregation of the income statement.
The disaggregated income statement would allow investors to figure out what portion of disclosed income statement accounts are attributable to labor costs. This includes cost of goods sold; R&D; and selling, general and administrative expenses. “Disaggregating labor costs in this manner would allow investors to better understand the job function of employees, their expected value creation, and the firm’s reliance on those employees,” the working group noted.
Time for change
The Human Capital Accounting Disclosure Working Group noted that the following two recent developments in the marketplace warrant prompt SEC rulemaking:
1. Increasing intangible value. Public companies are deriving more value from intangible assets, including human capital, than in the past. But only about 15% of the companies disclose their labor costs.
The working group noted that when the first accounting standard-setter was formed in the 1930s, businesses made and sold tangible products using tangible assets. Thus, the accounting rules made sense at the time. The legacy of those rules continues in accounting today as different forms of investment are treated differently.
For example, the accounting treatment differs depending on whether a company is investing in capital expenditure or spending money on research and employees. If a company invests in capital expenditures, that property’s value is included as an asset on its balance sheet that’s depreciated over time. By contrast, research and labor costs are typically treated as expenses. These items reduce net income in the current period, and they don’t appear as assets on the balance sheet.
Intangibles represented only 17% of the market value of the S&P 500 in 1975, according to the working group. By 2020, intangibles represented 90% of the S&P 500 market value. Two industries — health care and IT — account for more than 33% of the market capitalization of the S&P 500. And companies in these industries rely heavily on human capital.
2. Mounting losses. More companies are reporting losses for accounting purposes, making analysis of companies’ operational costs more important than ever to understand company value. Common valuation techniques, such as price-to-earnings multiples, can’t be used to put a price tag on companies that report losses. Instead, the working group said analysts must project future earnings, which would require reliable information on costs, margins and scalability.
More than half of public companies reported negative earnings in 2020, according to the working group. The main explanation for this trend is that many companies are relatively young technology firms, and investors are betting on their future profitability. Investors need detailed breakdowns of a company’s cost structure to identify contribution margins. This requires distinguishing whether cash outflows should be considered investments or maintenance expenses.
For example, when a company invests in new equipment that will improve its operational efficiency and build revenue, it creates future value. However, the replacement of existing equipment to maintain current levels of revenue can be considered a maintenance expense that allows the company to maintain its current productivity but doesn’t increase productivity.
However, when it comes to workforce expenditures, financial statement users typically can’t determine total workforce costs, much less identify the distinction between investments and maintenance workforce expenses.
Timing of proposal
It’s unclear exactly when the SEC will issue a human capital accounting proposal. But SEC Chair Gary Gensler said the staff is currently evaluating what companies are disclosing in 2021 and 2022 under the principles-based human capital management disclosure rules adopted two years ago to see how the disclosures can be improved. In the meantime, he encourages companies to provide robust human capital disclosures, including such information as turnover, pay, benefits, recruitment costs and training expenditures.
Sidebar: IAC homes in on nontraditional financial information
During a recent meeting of the SEC’s Investor Advisory Committee (IAC), accounting experts gave presentations on accounting for nontraditional financial information. SEC Chair Gary Gensler said this is an important conversation to have as the SEC continues to evaluate types of information that are relevant when people make investing decisions.
“Whether the information in question is traditional financial statement information, like components in an income statement, balance sheet, or cash flow statement, or nontraditional information, like expenditures related to human capital or cybersecurity, it’s important that issuers disclose material information and that disclosures are accurate, not misleading, consistently applied, and tied to traditional financial information,” said Gensler.
Departing SEC Commissioner Allison Herren Lee urged the IAC to evaluate relevant requirements and accounting principles to make sure they’re keeping pace with changing understanding of the types of information that affects company valuation and financial performance. “Top of mind for me in this space is human capital,” said Lee. She identified climate-related events, such as flooding, extreme temperatures and rising sea levels, as another top concern.
Lee indicated that these two categories — human capital and climate — are core disclosure topics to integrate into the financial reporting regime to help “keep pace with the risks and the opportunities of modern markets.” The SEC has proposed three categories of ESG information in the financial statements: 1) financial impact metrics, 2) expenditure metrics, and 3) financial estimates and assumptions.
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