The Inconvenient Truths about Human Capital
By Dr Michael Reddy, Director of Human Potential Accounting
- People are our biggest asset yet it is seemingly impossible to find a place for them on the balance sheet in its present form. This is inconvenient.
For some time there was common expectation that a third financial reporting instrument was the solution, whether this be Narrative Reporting, an updated OFR, a new Business Review with sharper teeth, or something else. More recently however Eccles et al have argued that a separate document, apparently subordinate to the main report risked being treated as an unimportant and dispensable adjunct. His suggestion that all relevant important material, financial and non financial, should be presented as a single integrated document is gaining ground.
- On the P&L people are logged as “costs” which is an unusual rubric for an asset.
This is inevitable however in that as an accounting tool the P&L can only register historical data and expense what it finds there. Such limitations of conventional accounting methods are inconvenient in the sense that they preclude an option to treat people as investments rather than costs, which is particularly important with assets that also have the greatest potential for future as much as historical value.
- People are our biggest liability.
It is useful to highlight this, given that the P&L normally fails to identify and quantify people liabilities, costs and risks in as complete, transparent and accurate a manner as it might. Conventionally people costs include the evident out of pocket items such as recruitment, training, salary and benefits, as well as concrete on-costs such as equipment and travel, while failing however to accurately itemise, allocate and incorporate the people costs buried under legal, insurance, pension obligations and other matters, to say nothing of the soft costs of management and HR wear and tear. This means that on a quarterly basis the FD can give only an incomplete and possibly misleading account of what it is really costing to employ its people, and consequently of their current value to the business.
- The same lack of accurate information about the value of human capital, as distributed throughout the business, is a feature of M&A activity, but appears to be accepted as irrelevant or intractable.
Despite the fact that merger and acquisition is one of the most common financial growth strategies for large corporations, multiple studies over the last two decades show that most M&A deals don’t achieve financial goals. For example, in the mid-1990s, Bain & Co. found that 85% of M&A deals failed to meet financial projections or delivered negative value to shareholders. A 2007 study by Hay Group and the Sorbonne found that more than 90 percent of mergers in Europe fail to reach financial goals.
Such studies pinpoint people issues — poor communication of the benefits of the deal, lack of definitions of success for the organisation and individuals and culture clashes — as a cause of financial failures. Or worse, M&As destroy corporate value.
Our own experience suggests that many acquisitions ride on a tide of brand enhancement, and a touch of board level ego-boosting, rather than a sober assessment of the human capital that will make or break the new organisation. The development of more refined pre and post-merger leadership and behavioural and cultural auditing tools and expertise in group process and psychodynamic consulting techniques would improve the odds of an acquired business reaching its potential in 3 to 5 years.
- A fundamental characteristic of markets is their short-termism.
The quarterly report is a cornerstone of financial reporting but acts as an inhibiting factor in terms of growth, yet it is set in stone by the demands of shareholders with an eye to short term gains. Analysts too use the short time horizon to justify their existence while they focus on the breaking news delivered by the financial media. The logic of the thread above suggests that a potential line of reform could be explored when significant shareholders, possibly institutional funds, put their weight behind a medium to long term human capital investment strategy.
- The systemic nature of the current version of Anglo-American capitalism with its interlocking Inter-dependencies can threaten systemic breakdown in certain circumstances.
All the components of this market-based phenomenon interlock into a mutually supportive or destructive system, with a range of business models, processes of capital raising, investment strategies and performance reporting as potential avenues or obstacles to reform.
- The shift of economic power from West to East is likely to accelerate rather than slow down and has probably already passed its tipping point.
This is an inconvenient truth principally for those who believed that the now discredited anglo-american version of capitalism was the pinnacle of human achievement, instead of the distorted, unhealthy and unstable experiment which, against all the evidence, some are already racing to restore. Meanwhile alternative models of capitalism are surfacing through a dispersion of non-Western norms for valuing and managing human capital. This of itself will accelerate pressure for change and may give food for thought to penitent investment banks and to a new generation of business school students.
Crelos are working alongside HPA to bring new perspectives on human capital to organisations in the process of M&A. For more information on how we can help, please contact Michael Reddy firstname.lastname@example.org or email@example.com