Why Buy When You Can Rent: SEC’s Push for Human Capital Disclosure
This article is written to discuss: Proposed SEC Human Capital disclosure and the implications of what is considered investment in Human Capital. Coauthored by Cole Napper.
Context
People Analytics and Workforce Planning functions are arguably in their adolescence when compared to more mature corporate functions like FP&A or Accounting. But movement in the regulatory environment may change that. In 2022 the Working Group on Human Capital Accounting Disclosure submitted a petition for rulemaking to the SEC. We may see a Notice of Proposed Rulemaking as early as October of this year related to Human Capital Disclosures. (To better understand how regulations are created, see here). In essence, the petition recommends the SEC adopt a rule that would require publicly traded companies to disclose certain aspects of their human capital management that have previously gone unreported. In this article, we discuss what the working group recommended, why they recommended it, and what the implications are for the maturity of People Analytics and Workforce Planning functions.
From the petition:
“First, managers should be required to disclose, in the Management’s Discussion & Analysis section of Form 10-K, what portion of workforce costs should be considered an investment in the firm’s future growth.
“Second, workforce costs should be treated pari passu with research and development costs, meaning that workforce costs should be expensed for accounting purposes but disclosed, allowing investors to capitalize workforce costs in valuation models as appropriate.
“Finally, the SEC should require greater disaggregation of the income statement to give investors more insight into workforce costs”
In essence, organizations will need to report which workforce-related costs are considered expenses and which are considered investments. Expenses typically include wages and salaries, but organizations usually don’t disclose them as a separate line item. Instead, wages and salaries are called-out in footnotes and wrapped in with other line items such as R&D Expense, SG&A, or even Cost of Goods Sold. This petition would change that by requiring organizations to quantify and report the salary and wage expenses. Further, the petition calls for organizations to quantify and report investments made towards their human capital.
The reason for this: to allow investors to distinguish between labor expenses and investments in labor, which, the working group points out, is critical given what they call the rise of the human-capital firm. Current accounting rules, which dictate what organizations publish in their publicly-facing financials, were developed almost a century ago when most organizations made, moved, and/or sold tangible products using tangible assets. Human capital, however, is considered intangible. The economy has evolved such that most organizations rely heavily not on machinery, but on their workers to differentiate themselves from their competitors. But given the lack of information on costs and investments related to workers, the working group argues, investors do not have the information they need to make informed investment decisions.
The implications of this are far reaching within an organization. If a rule is adopted as proposed, organizations would need to delineate workforce expenses from workforce investments. Questions that may arise:
How might these disclosures influence strategic positioning in the market?
How would the proposed rule changes impact our current accounting practices?
Will we need to change our current systems and processes to collect and report the required data?
Is my contingent workforce considered an expense?
Will money spent to retain employees be considered an investment or an expense?
Rather than attempting to draft sweeping statements to address these questions, we should consider the relationship between the worker and the firm. In doing so, we can create guiding principles that will assist organizations in identifying human capital expenses and investments.
Labor as a rented input. Many leaders will say that their workforce is their greatest asset. While they may mean well, a firm cannot own a worker. (Cole wrote about this last year. See The First Principles of Talent. Further, as Peter Cappeli points out in his article “How Financial Accounting Screws Up HR,” employees aren’t treated as assets under generally accepted accounting principles (GAAP).) Instead, we should think of a worker as someone who provides a critical input to the business: their labor over time. The worker can be thought of as renting their labor to the organization in the same way a building owner rents a floor of their building to a tenant.
For example:
Firm XYZ needs 90,000 sq ft of office space. Building owners A, B, and C each have 50,000 sq feet to rent. Firm XYZ enters into a rental agreement to rent 30,000 sq ft from A, B, and C to meet the firm’s needs. As a result, for the life of the rental agreement, owners A, B, and C each have an additional 20,000 sq feet of space to rent to other tenants.
In the same way, Firm XYZ needs 20M hours of labor per year, and goes to 10,000 workers to access the labor they provide (each with their own education, skills, knowledge, and experience). Let’s say each worker has 50 hours of labor capacity each week for 50 weeks, and each decides to enter an agreement with Firm XYZ to provide 40 hours or their labor per week for 50 weeks. Each worker still has the capacity to provide 10 hours of labor each week, and can choose to “rent” it to any party they choose.
We have seen this dynamic play out via the rise of the gig economy, (see here to read more on this), but this example applies to all worker classifications, even traditional, full-time workers, because each worker can provide their labor for a finite period of time. In fact, the Bureau of Labor Statistics found that the median employee tenure is around 4 years.
Our example illustrates how the relationship between a worker and a firm can be thought of as a rental agreement, rather than an ownership agreement. As such, it’s easy to see how money spent on accessing the labor inputs are considered expenses. But what should be considered an investment if a firm doesn’t own the worker nor the labor inputs? Some might argue that learning and development would count as an investment because it enhances the output provided by the laborer. Some might also argue that money spent on retention strategies, such as bonuses, RSUs, or perks should also be considered investments. However, if we consider the rental agreement analogy, such retention strategies serve only to provide ongoing access to the labor inputs needed, not to enhance the labor input or make the labor input more valuable to the firm. (This is analogous to Firm XYZ maintaining the leased properties in such a way as to influence building owners A, B, and C to rent to the firm again in future periods). Instead, we should consider any actions the firm takes to enhance the capabilities of the worker as an investment, no matter what the formal worker classification may be. Additionally, money spent on wages, stock, etc., is provided as a result of labor output. These payments are made based on what happened in the past, while investments are made based on what might happen in the future.
Adam Gibson notes in his book on workforce planning, “when we consider a workforce, we can view capability as a construct of five components: knowledge, skills, mindset, physiology, and environment.” It follows that the money firms spend in enhancing the knowledge and skills of their workers and in improving workers’ mindsets, physiology, and environment can count as investment since it is intended to improve the output of labor provided by workers. Taking this definition of “capability” into account, and assuming the SEC agrees that money spent towards enhancing said capability would qualify as an investment expense, the quantitative disclosure grid should include improvements to worker environments and improvements to worker physiology. The tables below show the grid provided in the petition. The grid that follows is a summary of our recommendation for what organizations should consider as workforce expense and workforce investment. Note that our recommendation is a more formal standard for disclosing human capital expenses and investments.
Source. Quantitative disclosure grid provided by the Working Group on Human Capital Accounting Disclosure.
Quantitative disclosure grid as revised by the authors, including clear delineation of line items designated as expenses and as investments. *Denotes the grid section added by the authors.
What does the future hold?
Such disclosure requirements, if adopted, would necessitate a shift in the human capital reporting and forecasting processes and standards in most organizations. (It could also be used to wield as a political weapon against firms, particularly in the current social and political environment which has presidential hopefuls publicly at odds with iconic businesses.) People Analytics will play a key role in shaping how data is shared in partnership with business executives, Accounting, and FP&A. Strategic Workforce Planning functions would be relied upon to create forecasts not only of the capability gaps that might stymie organizational strategy execution (it’s current remit), but also of the plans for investing in workforce capabilities in order to meet SEC disclosure requirements. The link between People Analytics, Workforce Planning, Accounting, and FP&A would become stronger than ever, and would perpetuate across industries. To get there, People Analytics and Workforce Planning functions must have the trust and a partnership of equals with their SG&A functional peers. Accounting and Finance have been producing reports and analysis for decades with a level of rigor and detail rarely seen in the HR space. If implemented in a nuanced way, a new disclosure regulation might just be the push HR needs to realize its data-oriented potential. Or it could be just a mis-guided exercise none of us intended.
Coauthor biography
Cole Napper is the Co-Host of Directionally Correct, A People Analytics Podcast with Cole & Scott and owner of Directionally Correct LLC. He is also the Vice President of People Analytics & Product Evangelist for Orgnostic, an innovative people analytics, generative AI, data orchestration, & employee listening platform. Cole has 12+ years of rapidly escalating experience building HR centers of excellence from the ground up to scale — with an expert focus on People Analytics. He creates competitive advantage using People Analytics for companies big (Texas Instruments, Toyota, PepsiCo) & not-so-big (Orgnostic, Motive, Booster).