Task Force Asks SEC to Require Financial Disclosure Requirements for Human Capital | Cooley LLP
Are companies disclosing enough information about investments in their workforce? Not according to the Human Capital Accounting Disclosure Task Force, a group of ten academics that includes former SEC Commissioners Joe Grundfest and Robert Jackson, Jr. and former SEC General Counsel John Coates. The task force has submitted a new regulatory petition asking the SEC to require more disclosure of human capital financial information. According to the petition, there has been “an explosion” of companies “that generate value because of the knowledge, skills, competencies and attributes of their workforce. Yet despite the value generated by employees, US accounting principles provide virtually no information about the company’s workforce. The petition asks that the SEC “develop rules to require public companies to disclose enough information to allow investors to assess how well companies are investing in their workforce” – similarly to “the SEC rules have long made it easier to analyze investments by public companies in their physical operations.Asked about the petition, Grundfest said Bloomberg that it “aims to move the accounting treatment of a company’s labor to the same level as its physical capital….” Current accounting rules give us more information about the economic consequences of buying or leasing a drill press than hiring and training a software engineer… What sense does that have? it in today’s world? »
Why is this disclosure necessary? The petition offers two reasons. First, business value is increasingly derived from intangible assets, such as intellectual property and human capital, rather than tangible assets, such as tangible capital assets. According to the petition, in 1975, intangibles accounted for only 17% of the value of S&P 500 companies; in 2020, intangible assets accounted for 90% of the S&P 500 market value. This trend is illustrated by the growth of the healthcare and information technology sectors, both of which are highly dependent on human capital and now together about a third of the market cap of the S&P 500. Yet accounting rules are still shaped around enterprise value. structured in the 1930s, when the first accounting standards body was created. For example, current accounting standards treat capital expenditure investments as balance sheet assets to be amortized over time, while R&D investments are generally treated as expenditures, not assets, and reduce the net income for the current period. Similarly, labor appears as an expense that reduces net income, but, the petition observes, labor costs are generally included in administrative expenses, and only 15% of companies even disclose separately. their labor costs. “These legacy rules,” the petition concludes, “do not reflect the current reality that larger companies add value through internally developed intangible assets such as human capital.[,]…leaving investors without the information needed to accurately assess the companies they own.
The second reason identified in the petition is that the increase in the number of public companies reporting losses – more than half in 2020 – requires greater disclosure of operational costs, especially human capital, to analyze their value. Why is that? As explained in the petition, analysts and investors cannot use common valuation techniques, such as price-earnings ratios, when companies report losses and must instead “project future earnings – an analysis that requires reliable information on costs, margins and scalability which is generally obscured under current accounting principles… To best value loss-making companies, investors need a sufficiently 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. For example, while salary is generally considered a maintenance expense, expenses such as training and even equity could increase productivity, improve retention and create future value and could be considered capital expenditures. Although many investors can estimate the proportion of capital expenditure devoted to investment, “with respect to labor,” the petition asserts, “investors generally cannot even determine the total costs of labor, much less identify the distinction between investment and maintenance labor expenditures”. (Although the petition focuses on labor costs, the authors advocate that the SEC consider the opacity of cost disclosure more generally.)
To address this issue, the petition calls for three reforms, combining quantitative and qualitative disclosure, which are designed to help investors distinguish between maintenance and capital expenditures.
- Require disclosure in the MD&A of the portion of labor costs that should be considered an investment in the future growth of the business and an explanation. The authors believe that such disclosure “would provide investors with a better understanding of what share of labor costs should be capitalized in their own models and encourage management to view employees as a source of value creation.”
- Treat labor costs on the same basis as R&D, requiring that they still be expensed but disclosed. The authors recommend the use of a standardized tabular disclosure that would disclose average employee tenure and turnover as well as various elements of compensation and benefits, including health and training expenses, distinguishing between full-time workers full, part-time and casual. This approach, the authors say, would allow investors to create valuation models that capitalize labor costs if they so choose.
- Require the disaggregation of labor costs in the income statement, allowing investors to determine the proportion of COGS, R&D and SG&A attributable to labor costs and thus better understand the contribution of workers to the company and the company’s dependence on its employees. As noted above, the petition argues that, for companies reporting losses, investors “need information about product margins to estimate future profitability. To do this, investors need detailed information on operating costs, the most important of which is labor, to forecast future margins and determine how much of the cash outflow reflects the investment. Without this information, it is difficult, if not impossible, to value these companies reliably or to test a company’s market valuations using fundamental analysis.
The petition argues that the improved pricing efficiency resulting from the proposed disclosures would outweigh the initial compliance costs. The proposal fits within current accounting frameworks, should improve market prices and should involve minimal implementation costs, especially since much of the information must already be produced for tax purposes.
One of the co-chairs of the working group said Bloomberg that the SEC plans to expand human capital disclosures “must be coupled with accounting changes to give investors more detail about a company’s labor costs and to better hold management accountable for it.” she reports…. “Companies really depend on a highly skilled workforce to really create value and financial statements just don’t reflect that. (The task force co-chairs both participated as panelists in the discussion of non-traditional financial reporting accounting at the recent SEC Investor Advisory Committee meeting. See this PubCo post.)