Explain how employers put themselves at potential risk with reporting on issues that lead to financial risks. Offer at least two ways they can avoid or

Financial implications of accounting for human resources using a liability model

Herman Theeke,  John B. Mitchell  

Journal of Human Resource Costing & Accounting

ISSN: 1401-338X

Article publication date: 27 June 2008 

1 Introduction

A reading of intellectual capital (IC) human capital (HC) or human resource accounting (HRA) articles written during the past ten years would reveal that the research concerns for IC, HC, and HRA are wide ranging and diverse. Some articles focus on demonstrating a link between IC, HC, or HRA measures and organization or firm performance (Afiouni, 2007;  van der Zahn  et al., 2007 ;  Johansson, 2007;  Martin‐de‐Castro  et al., 2006 ;  Youndt and Snell, 2004; Roos  et al., 2004;  Perez and Ordonez de Pablos, 2003). Some focus on the measurement or valuation of IC or HC ( Carrell, 2007;  Catasus and Grojer, 2006;  Burr and Girardi, 2002; Bontis  et al., 1999;  Boudreau and Ramstad, 1997). Some address issues of reporting, standards or regulations (Cuganesan, 2007;  Bozzolan  et al., 2006 ;  Catasus and Grojer, 2006; Roslender  et al., 2006). As diverse as these articles are in purpose and focus it would be fair to conclude that common to them is the notion that IC and HC assets are import because they affect the value of organizations.

While many of the writers implicitly assume that IC has a positive effect on firm value and thereby would be an asset, a concern for IC liabilities is sometimes raised.  Caddy (2000) following  Harvey and Lusch (1999), introduces the concept of IC liabilities when IC might require capital write downs or generates what might be called “BADWILL.”  Abeysekera (2007) follows  Caddy's (2000) depiction of IC liabilities suggesting there may be both intellectual assets and intellectual liabilities. A convergence between human resource management and liabilities occurs in discussions about reporting pension liabilities, a future human resource cost, and also can often be found in the literature ( Broadley, 2007;  Grant  et al., 2007 ;  Jorgensen, 2004;  Rao and Walsh, 1999).

Human resource liabilities, as opposed to IC or HC liabilities, with the noted exception of pension liabilities, are mentioned specifically and independent of IC with less frequency (Theeke, 2005;  Hermanson  et al., 1992 ).  Hermanson  et al. (1992)  and Theeke (2005) introduce a meaning for human resource liability that is different and distinguishable from the pairing of IC or HC with the liability concept in either  Abeysekera (2007) and  Caddy (2000).

In the reference by  Hermanson  et al. (1992)  to human resource liabilities and the proposal (Theeke, 2005) that HR and HRA researchers adopt a human resource liability paradigm, the authors are thinking of the HR liability in the same way that one thinks of pension liabilities. In fact the pension liability is one among many liabilities that is incurred to procure human resources. In his paradigm, Theeke (2005) proposes that this human resource liability could be used to value HC in a manner that is similar to some other accounting asset valuation conventions. Theeke (2005) further proposes that such valuation then could allow inclusion on financial statements. He also suggests that managing and minimizing the human resource liability is a primary purpose of human resource management.

In what might be considered a radical departure from most IC, HC, and HRA literature, Theeke (2005) proposed that, the asset paradigm for HRA be abandoned in favor of what he called a human resource liability approach. Two issues flow from the Theeke (2005) suggestion that, an acceptable method to include human resources on financial statements is to account for and report them as contingent liabilities. First is the feasibility and requirements for creating such a report and second is the potential effect from reporting human resources as contingent liabilities. This paper will consider these two issues. At a minimum the first issue, reporting contingent liabilities, requires two things. An estimate of the amount of the liability and the likelihood that the liability amount will need to be paid are both necessary. The first part of this paper will examine the general criteria for reporting contingent liabilities and the extent to which the minimum requirements might be met for reporting human resource liabilities. In the second part the effects of contingent liabilities on financial decisions generally, and the potential effects from reporting human resources as contingent liabilities, are discussed. In summary, this paper explores:

· the possibility for operationalizing the accounting for human resources as contingent liabilities; and

· the human resource liability paradigm's potential impact on internal and external decision making.

2 Accounting for human resource liabilities – an introduction

In a perfect world accountants would produce financial statements that would show the market value of their company. Investors would thus see a detailing of value in the various accounts and could make predictions as to how a company's total value would change over time. In reality, accountants do not, and cannot, reliably produce such assessments of value. Instead it becomes the work of financial analysts to estimate the value (stock price) that the market will assign to a company. They do this by using information generated from consistently applied accounting principles along with other relevant factors.

Theeke (2005) points out that accounting for human resources as assets has not gained acceptability within the accounting or finance professions. Basically the reason is that human resources are not owned or controlled by the company and therefore do not meet the accountants' definition of an asset. Theeke (2005) does point out that, there are some other items that make their way onto the balance sheet as assets that are not owned and may not even be controlled by the company. Demand deposits and capitalized leases are examples of two things that do not meet the specific definition of assets but are treated in a fashion that generates an addition to the company assets. Theeke (2005) argues that, the impetus for reporting these as assets is really an artifact of the accounting methods. His position is that because a company's financial statements need to accurately reflect the company's liabilities for leases and demand deposits that the reporting of these liabilities generates the corresponding assets on the balance sheet. The fact that it is relatively easy to measure these two liabilities, making it difficult to inflate the asset value that is reported, differs from the problematic measurement of the amount of human resource liabilities. Theeke (2005) therefore recommended reporting human resources as contingent liabilities. His recommendation, if followed, would provide information to financial analysts without changing the quality of information on the balance sheet or income statement. But, the issue of how to precisely measure the contingent liability for human resources is not answered by Theeke (2005); instead he charges the finance and accounting professions with solving this problem.

3 Measurement issues

As Theeke (2005) suggests, looking at the treatment of financial leases does not solve the human resource measurement problem. With financial leases, the value that is reported as an asset is inferred from the present value of the future liability. Accountants capitalize (discount) the amount of the future liability and reflect the fact that the cost has not yet been incurred by showing an equal amount as an asset. Of importance is the fact that companies that minimize the lease cost will appear to have less asset value than do firms with higher lease costs, but the firm with the higher lease cost will have more difficulty creating value above and beyond the cost of the leased item. Hopefully firms make good decisions about what things to lease. From the financial analyst perspective minimizing the amount of liability incurred to lease items reduces the amount of assets reported on the balance sheet. This liability minimizing behavior increases company value because the reported liability and the corresponding asset are both the present value of the expenses that will eventually be recognized on the income statement. Lower reported assets and liabilities today mean less expense tomorrow.

For example, a company paying $1,000 annually (beginning of year) for a machine with a ten‐year lease and 10 percent discount rate; would report a $6,759 present value of the liability and a corresponding asset. A less efficient firm which negotiated a $1,100 lease price for the same asset would report a $7,435 liability and corresponding asset. However, over the ten‐year life of the lease the less efficient firm will pay an extra $1,000 for the use of the same asset. The machine is the same. What the machine can produce is the same. The firm that minimizes the cost of acquiring the use of the machine is in a better position to generate profits, and value, for its investors.

In the same way, minimizing expected future expense caused by human resource policy and practices can be thought of as generally increasing the value of the firm. The problem with assigning an asset value based on these expected future expenses is that it is virtually impossible to assess the value that has been created by incurring them. An equal value from a human resource program might flow from either larger or smaller expenditures. It is indefensible to say that merely because equal human resource program costs have been incurred that equal value, in the form of assets, has been created [1]. Human resources, like leases, involve future expense for uncertain value. While the value itself might not be able to be accurately measured, it might be possible to consistently, and conservatively approximate differential relative expected future expenses that will arise as a result of different human resource programs, practices and policies. The human resource effect on the firm's value might be calculated as the present value of all future unavoidable human resource costs including wages, benefits, and contingent claims such as lawsuits arising from human resource practices.

Theeke (2005) explored and explained the reasons for accounting for human resources as liabilities. Firms exchange future obligations to attract, retain, and motivate a workforce. Thus, human resource policies, practices and procedures cause liabilities. Some of these, such as post‐retirement benefits, are known with relative certainty. For others, contingent on some event such as a lawsuit for wrongful termination, the estimate is less certain but still important for estimating the firm's value.

4 Reporting liabilities

According to accounting convention, liabilities reported on the balance sheet are existing obligations while contingent liabilities are noted if they have reasonably estimable amounts and relative certainty of occurrence ( Statement of Financial Accounting Standards Number 5, 1975). Under current US Generally Accepted Accounting Principles (GAAP), the expenses of defined benefit plans (DBP) are accrued as earned by the employees and a liability is created to reflect the excess of commitments above the amount of plan assets ( Statement of Financial Accounting Standards Number 132, 2003). Similarly post‐employment benefits (benefits after employment but before retirement) such as salary continuation, supplemental employment compensation, severance compensation, disability related expenses including workers compensation, job training and counseling, and continuation of benefits for health care and life insurance are accrued and reported if; the expense is for service already rendered, the benefit is vested, payment is probable, and the amount can be reasonably determined. The company is also required to disclose if such expenses are not being accrued solely because they cannot be reasonably estimated ( Statement of Financial Accounting Standards Number 112, 1992). The accounting profession has clearly moved towards a fuller disclosure of the expense related to human resources. In these above mentioned situations no offsetting asset is created to reflect the value of the human resources. The reason no asset is reported is because the liability placed on the balance sheet reflects a future cost for past labor. By reporting post‐retirement and post‐employment benefits the accounting profession has already created a precedent in the case of a limited list of liabilities caused by human resource policies and programs. Differences between various companies' human resource policies is thus reflected in the differences between the liabilities created on their respective balance sheets. It is our contention that this precedent should be followed by recognizing additional, if not all, liabilities caused by human resource policies and programs.

Following the preceding conventions and rules, if human resource costs reflect future expense for past labor they should be reported as a liability with no offsetting asset. Any asset created by past labor has already been recognized [2]. This is similar to the liability treatment of DBP under current GAAP.

Following these same conventions, when a human resource cost reflects future expenditures for future labor, it should be reflected on both the liability and asset sides of the balance sheet. See  Lev and Schwartz (1971) for this argument. This situation is similar to the capitalized lease as discussed by Theeke (2005). However, because the accounting profession has shown no inclination to capitalize human resources in the same manner they capitalize leases, such reporting of human resources as assets does not appear to be a viable option [3].

The unwillingness of accountants to create assets and report future human resource costs as line items on the balance sheet and income statement does not, and should not, however, prevent those same future human resource costs from being reported in the notes section of these financial reports. Reporting the present value of future human resource expenses will provide vital information that can be used both for better internal management decisions and for external financial analyst use. As the following section of the paper argues, it would be particularly useful if firms divulged the portion of their human resource liabilities that are unavoidable, and therefore might be considered part of the firm's fixed costs.

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