Working Group Urges Modernization of Accounting Treatment as Key to HCM Disclosure

As the SEC moves toward an October 2022 release of a proposed rule on Human Capital Metrics, a working group of academics and former SEC officials has offered a proposed disclosure regime that it claims is consistent with existing accounting frameworks and will result in improved market pricing for public companies, while minimizing compliance costs. The Working Group on Human Capital Accounting Disclosure’s Petition for Rulemaking is based on the view that because accounting rules have not kept pace with the “rise of the human capital firm,” investors do not have sufficient information to understand a firm’s true value. Stating that current rules “have not been sufficiently reimagined to address the changes in the characteristics of today’s public companies,” the proposal argues for three new disclosure rules that would allow investors to better understand the value of a firm’s investment in human capital:

• Management Discussion & Analysis (MD&A) Discussion. Given the importance of labor to the value of public companies and the challenge of valuing companies that report an accounting loss (over 50% of US public companies in 2020), investors need the ability to distinguish between labor expenses and labor investments. To achieve this, companies should be required to disclose in the MD&A what portion of labor costs they view as an investment, and why. This will allow investors to determine how much of those costs should be capitalized in their own valuation models.
  
  
• Standardized Grid Disclosure. Noting that “the limits of qualitative disclosure are well documented”, the proposal advocates for a required table showing total labor costs (including salary, incentives, equity, benefits, and training), tenure, number of employees (including contractors), and turnover. This would allow investors to make their own determinations as to which types of costs should be considered an investment rather than an expense and is consistent with how research and development expenses are treated under Generally Accepted Accounting Principles. It would also allow investors to decide whether to amortize labor costs when valuing a company.
  
  
• Income Statement Disaggregation. Noting that investors need detailed information on operating costs to predict future margins, the proposal would require labor costs to be disaggregated in the company’s income statement. This would allow investors to determine, for example, what portion of Cost of Goods Sold was attributable to labor costs so that they can better understand how employees contribute to future value creation.

The Working Group proposal is worth careful consideration, as it builds on existing frameworks, creates greater transparency for investors, and focuses primarily on information that companies already collect for tax reporting. More importantly, it recognizes that expanding the disclosure of human capital metrics must be paired with changes to accounting rules to ensure standardization and provide investors with meaningful information. Harmonizing the accounting treatment of human and physical capital is a long-overdue shift, reflecting the reality of how value is created and further elevating the role of the HR function.