Over the past few decades, we have seen an explosion of so-called “human capital firms”—that is, firms that generate value due to the knowledge, skills, competencies, and attributes of their workforce. Yet, despite the value generated by employees, U.S. accounting principles provide virtually no information on firm labor. Barely fifteen percent of firms disclose information as basic as labor costs.
In today’s economy, human capital is likely the biggest asset missing from firms’ balance sheets. Human capital is omitted because employees are not assets for accounting purposes; after all, employees can leave the firm. Yet, the lack of disclosure on labor costs under accounting principles causes a significant gap in financial reporting for firms that are reliant on their employees. The lack of disclosure also leads to difficulty when valuing the growing number of loss firms; in 2020, for the first time, the number of public companies reporting a net loss exceeded the number of firms reporting a profit. These loss firms are valued based on future profitability, necessitating more information on labor and other operating costs.
In the absence of movement by accounting standard setters, a series of human capital disclosures have sprung up in voluntarily-disclosed sustainability reports and under Regulation S-K. These disclosures have largely focused on metrics, however, and are not a substitute for disclosures under accounting standards. Moreover, as noted by prior literature, these disclosures lack consistency, comparability, and reliability. As an illustration, we collected all human capital disclosures for four European issuers and found that they collectively disclosed seventy different metrics; only one metric was disclosed by all four issuers.
Our Article argues that human capital should be integrated with accounting standards. First, we propose that labor costs be treated pari passu with research and development costs, meaning that labor costs be expensed for accounting purposes but disclosed. We propose a standardized grid to be disclosed in the notes to the financial statements. Second, we advocate that managers be required to discuss what portion of their labor costs should be considered an investment in future firm profitability. Finally, we argue that the income statement should be disaggregated to show what portion of major expenses are attributable to labor costs. These changes would not violate the accounting principle of conservatism, but would allow investors to capitalize human capital in their own valuations, initiating the modernization of accounting principles.