The SEC has been working on a rule proposal that is intended to increase the amount of information public companies provide about their workforce or what many call human capital management (HCM) disclosure as part of broader environmental, social, and governance (ESG) reporting.
But a working group that includes former SEC officials, academics, and market participants believe this is also a financial reporting matter, framing it as human capital accounting (HCA) in changing times when intangibles have become more prominent for certain industries such as information technology.
In a June 7, 2022, rulemaking petition to the SEC, the Working Group of Human Capital Accounting Disclosure asked the commission to write a rule that would require public companies to give pertinent information to investors so they can assess the extent to which companies invest in their employees. They asked for three rule changes:
- companies should disclose, in the Management’s Discussion & Analysis (MD&A), what portion of workforce costs should be considered an investment in the firm’s future growth;
- workforce costs should be treated on equal footing as research and development (R&D) costs, meaning that workforce costs should be expensed for accounting purposes but disclosed, allowing investors to capitalize workforce costs in valuation models; and
- greater disaggregation of the income statement.
The disaggregated income statement would allow investors to figure out what portion of disclosed income statement accounts, such as cost of goods sold, R&D, and selling, general & administrative, are attributable to labor costs, the group said.
“Disaggregating labor costs in this manner would allow investors to better understand the job function of employees, their expected value creation, and the firm’s reliance on those employees,” the petition noted.
The working group has 10 members, including former SEC commissioner Robert Jackson who is a law professor at New York University; John Coates, Harvard Law School professor who previously served as SEC general counsel and acting director of the Division of Corporation Finance; and former SEC commissioner Joseph Grundfest a law professor at Stanford University.
“We differ in our views about the regulation of firms’ relationships with their employees generally,” they wrote in the petition. “But we all share the view that investors need additional information to examine whether and how public companies invest in their workforce—and that the Commission’s rules should therefore require that information to be disclosed.”
Advisory Panel Starts Discussion on Non-Traditional Accounting
During a meeting of the SEC’s Investor Advisory Committee (IAC) on June 9, accounting experts gave presentations on accounting for non-traditional financial information. SEC Chair Gary Gensler said that this is an important conversation to have as the agency continues to evaluate types of information that are relevant when people make investing decisions.
“Whether the information in question is traditional financial statement information, like components in an income statement, balance sheet, or cash flow statement, or non-traditional information, like expenditures related to human capital or cybersecurity, it’s important that issuers disclose material information and that disclosures are accurate, not misleading, consistently applied, and tied to traditional financial information,” Gensler said.
Departing SEC Commissioner Allison Herren Lee also chimed in during IAC meeting, saying that audited financial statements are a cornerstone of the commission’s disclosure regime.
Thus, she said it is critical for regulators and standard-setters to always evaluate relevant requirements and accounting principles to make sure they are keeping pace with changing understanding of the type of information that affects company valuation and financial performance.
“And top of mind for me in this space is human capital,” Lee said, adding that the SEC’s March climate change proposal includes disaggregated financial metrics. The agency proposed three categories of information in the financial statements: financial impact metrics; expenditure metrics; and financial estimates and assumptions. It proposes the impacts on any relevant line item in the company’s consolidated financial statements presented from severe climate-related events such as flooding, extreme temperatures, and sea level rise.
“Both of these topics, human capital and climate, are increasingly core disclosure topics,” she said. “And as such, we should consider how they might be integrated into our financial reporting regime in a manner that ensures we keep pace with the risks and the opportunities of modern markets.”
Timing of Proposal
It is unclear when the SEC will issue a workforce proposal, and Chair Gensler as usual did not discuss specific timing during 2022 RFK Compass Summer Investors Conference hosted by the Robert F. Kennedy Human Rights organization on June 14.
But he defended that the commission has every right to write human resources disclosure rule in response to critics who say that this rather falls under the rubric of social justice matters, not under the SEC’s purview.
Gensler said that workforce is the most important asset for many companies. And he explained that when he was at Goldman Sachs working in acquisition, his team looked at company employees, including turnover, pay, benefits, and had serious discussions about how important they were to the company and to compare with other companies in the industry.
Thus, the SEC over the years addressed this issue. In the most recent rulemaking, Gensler pointed to the HCM rule adopted in August 2020 when Jay Clayton headed up the agency during the Trump administration. But in a split vote, the commission decided to leave the disclosure rule principles-based and rooted in the concept of materiality. Investors, however, said they need more detailed, useful, comparable information, including diversity of employees and executives.
In drafting a more standardized disclosure proposed rule, Gensler said that the staff is also looking at what companies are disclosing in 2021 and 2022 under the rules adopted two years ago and see how the disclosures can be improved.
Rationale for Petition
To support its argument for HCA, the petition noted that two recent changes warrant prompt SEC rulemaking.
Increasingly public companies derive much of their value from intangible assets, including human capital. But about only 15 percent of the companies disclose their labor costs. Moreover, more companies report a loss for accounting purposes, making analysis of companies’ operational costs more important than ever to understand company value.
The working group noted that when the first accounting standard-setter was formed in the 1930s, businesses made and sold tangible products using tangible assets. Thus, the accounting rules made sense at the time. The legacy of those rules exist in accounting today as different forms of investment are treated differently.
For example, there is different accounting treatment for a company’s spending on capital expenditure, research, or its employees. If a company invests in capital expenditures, that property’s value is included as an asset on its balance sheet and depreciates over time. By contrast, spending on research and labor are typically treated as expenses. They reduce net income in the current period, and they do not appear as assets on the balance sheet.
“These legacy rules do not reflect the current reality that the largest firms add value through internally developed intangible assets such as human capital,” the petition stated. “And while accounting rules have been sporadically updated over time, they have not been sufficiently reimagined to address the changes in the characteristics of today’s public companies.”
To illustrate the trend, the group said that in 1975, two years after the SEC adopted disclosure rules to require companies to report the total number of employees, intangibles represented 17 percent of the value of S&P 500.
By 2020, when the SEC adopted principles-based workforce disclosures, intangibles represented 90 percent of the S&P 500 market value. Two industries—healthcare and IT—account for more than 33 percent of the market capitalization of the S&P 500. And companies in these industries rely heavily on human capital.
“Accounting rules, however, have not kept pace, leaving investors without information necessary to accurately value the firms that they own,” the petition stated.
Further, the working group said that there is an increasing number of public companies that now record a net loss, which complicates analysis of their value. Common valuation techniques such as price-to-earnings ratios cannot be used to put a price tag on those companies. Instead, the working group said analysts must project future earnings, which require reliable information on costs, margins, and scalability that is commonly obfuscated under current GAAP.
Thus, the group asked the SEC to require companies to provide investors with the necessary information to value companies that report losses.
To better explain its request, the group said that in 2020, more than half of public companies reported negative earnings. The main explanation for the growing number of net loss companies is that many of the companies are relatively young, tech firms, and investors are betting on their future profitability. But investors need detailed breakdown of the company’s cost structure to identify contribution margins. This requires distinguishing whether cash outflows should be considered investments or maintenance expenses.
When a company buys new equipment that improves its operational efficiency and helps in growing revenue, this can be considered an investment as it will be used going forward and create future value. However, the replacement of existing equipment to maintain current levels of revenue can be considered a maintenance expense as that allows the company to maintain its current productivity but does not increase productivity.
Current accounting rules allow investors to estimate the portion of capital expenditures that can be considered investment and the portion that can be considered maintenance expense, and sophisticated investors such as Warren Buffet have long incorporated this information in valuation, the petition stated.
“By contrast, when it comes to workforce, investors typically cannot even determine total workforce costs—much less identify the distinction between investments and maintenance workforce expenses,” the working group said.
This article originally appeared in the June 15, 2022 edition of Accounting & Compliance Alert, available on Checkpoint.
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