Authors of a recent article in Strategic Finance assert that the accounting profession “needs to move beyond the narrow breadth of current financial accounting and reporting and shift to value creation.”
The drive to focus on the importance of human capital and engagement is coming from investors, ISO (the International Organization for Standardization) and, increasingly, the accounting field. In a recent Strategic Finance article, "The Power of Intangibles," authors Gary Cokins and Nick Shepherd, who have multiple financial accreditations, assert that “The traditional balance sheet understates the economic value of a company because it doesn’t include a large portion of intangible assets.” The article explains how the authors believe “it’s possible to estimate the value of these assets based on logic, not ‘fuzzy math,’” and that such information can be disclosed through what is called Integrated Reporting (IR).
The article references the Enterprise Engagement Alliance’s implementation framework, as well as the performance of its Engaged Company Stock Index (ECSI) at TheEEA.org.
In the article, a must-read for anyone dealing at the strategic level with organizations on issues related to human capital investment, the authors contend that: “Management accountants have a clear and important role in developing integrated thinking that expands beyond financial capital into the underlying aspects and capitals that create an organization’s capability and value. The challenge is how to actually do this. Traditional accounting information is based on strict standards and rules defined by regulatory agencies, so it’s unrealistic to attempt to influence the regulators in the near term to modify their rules to include these nonfinancial ‘capitals.’ Yet there are ways to start creating supplemental information that helps companies understand and report these intangibles and their impact. The ultimate goal should be to enhance the user’s ability to understand the value of these intangibles, as well as their linkage to both economic and financial value and to operational impact.”
The authors believe that organizations have to look at three additional types of capital: intellectual capital, human capital and social/relationship capital, because “more than 80% of an organization’s attributed value is represented by intangibles such as its intellectual capital, workforce, supply chains and other key relationships. From an accounting perspective, this has driven the growth in calculating a goodwill amount as organizations have been bought, sold and amalgamated, and the excess of the purchase paid over accounting book value has been reported as goodwill.”
The authors make the point that both investors and internal managers are hurt by this “increasing inability of financial reporting to reflect true economic value. Users of external reports, such as investors, are at greater risk if they can’t see what’s behind the numbers. Internal users, especially management and the board of directors, can also be misled to make poor or wrong decisions if they fail to have a clear picture of how intangibles create economic and financial value.”
The failure to understand the power of intangibles carries serious risks, the authors contend. “Understanding these factors is important to investors when they are assessing current and future earnings streams and the risk of sustaining the value of their investments. Management’s resource allocation decisions can appear to create positive financial capital results through increased earnings, but they may have been created through cost reductions that depleted the human capital and thus set the stage for a less innovative and creative future. The inclusion of intangible assets acknowledges interdependencies and allows for trade-off analysis.” The article cites multiple examples of specific companies that “suffered a strategic loss of competitiveness by improving profits through under-assigning adequate resources,” including leading auto and technology firms.
The authors outline multiple ways to account for intellectual property, human capital and what they term social and relationship capital. The latter is defined as “The institutions and the relationships within and between communities, groups of stakeholders and other networks, and the ability to share information to enhance individual and collective well-being. Social and relationship capital includes shared norms and common values and behaviors; key stakeholder relationships; and the trust and willingness to engage that an organization has developed and strives to build and protect with external stakeholders, intangibles associated with the brand and reputation that an organization has developed; an organization’s social license to operate.”
Among other resources, the article cites the Human Maturity Index, known as OMINDEX, for measuring human capital. See ESM, Human Capital Rating System Available at No Cost. The article also provides a table demonstrating a method for calculating brand value.
The authors conclude that “The value attributed to an organization in the free market increasingly exceeds the value as presented on a financial balance sheet—its book value. The reasons for this increasing valuation include capacities and capabilities that an organization has created—its intangible assets—which create financial value and returns to investors, but that don’t appear in the financial records as assets. External financial reporting provides a limited insight to investors and other users about the value, condition and sustainability of these nonfinancial factors. For investors, board members, or management, intangible assets must become part of what’s measured and managed. Their impact on economic and financial value must be sustained and developed, and any depletion occurring as a result of management decisions must be questioned and understood.”
The stakes for the accounting profession are high, they claim: “Further development of the Integrated Reporting framework is also needed for it to evolve from a reporting model to one where intangibles become part of integrated thinking in driving strategic planning and resource allocation. If the accounting profession fails to embrace this emerging aspect of value creation and decision making, it might be relegated to a minor role in reporting that focuses only on the 20% of an organization’s value and neglects the 80%.”