Why are employees not technically assets?

Why are employees not technically assets?Executives often claim that employees are a company’s most important asset. But employees aren’t assets, technically. Employees don’t appear on the balance sheet, where you’ll find cash, inventory, property, equipment, etc.

If employees are such an important asset, why don’t they appear on the balance sheet? Here are three reasons:

  1. The company doesn’t own its employees, but it does own its balance sheet assets.
  2. There is no reliable way to compute the balance sheet value of the employee base.
  3. Companies want to disclose as little information as possible, especially when it concerns their people.

The company doesn’t own its employees

We start here with semantics. A company owns its cash, its inventory, its property, plant, and equipment. But it doesn’t own its employees.

In his book, The Dao of Capital, Mark Spitznagel describes “the market value of firms” as “the price of title to existing capital”. He’s using the property law definition of title:

In property law, a title is a bundle of rights in a piece of property in which a party may own either a legal interest or equitable interest.

You can have title to a car. You can have title to a house. You can’t have title to a person. People aren’t property, and thus can’t be owned. If the value of a firm is the price we assign to ownership of its existing capital, then we shouldn’t put people on a firm’s balance sheet. People aren’t financial capital, and don’t technically contribute to the market value of firms.

Think about what would happen if a company had to liquidate. It would sell its assets and use the cash to pay its debt holders first, and its equity holders second. But the company couldn’t liquidate its employees. When the company went belly up, employees would be free to find work at other firms. 

Including employees on the balance sheet would be misleading. The company would have built-up equity in its employee base, through training and development investments it made in the past. On the balance sheet, because of the book value of the employee base, it would look like equity holders had a larger claim than they actually do. Considering the real world mechanics of financial capital, employees simply have no place as an asset.

What would the balance sheet value of employees even be?

If we put employees on a company’s balance sheet, we would need to know the value of these employees. Where do we even start? 

First, we need to appreciate the difference between an operating cost and a capital cost. Operating costs are the ongoing costs necessary to keep the business running. Capital costs are the investments a company makes in building durable assets.

One example of a capital cost is a piece of manufacturing equipment. This equipment is a durable asset the company will use to create value over several years. An example of an operating cost is the electricity required to power the manufacturing equipment. We pay for the electricity as we use it. Because the electricity isn’t durable, and we don’t accumulate it for use over future periods, we call it an operating cost.

A big challenge of computing a balance sheet value for employees is deciding how much of our personnel cost is a capital cost, and how much is an operating cost. In other words, how much are we spending to train and develop our employees, and how much are we spending to have our employees do their daily duties?

One approach is to classify all training and development expenses as capital expenditures, which go toward building our employee asset. Compensation and on-boarding expenses would remain as operating costs, as all personnel costs are today.

A big difference between an employee asset, and, say, property, plant, and equipment, is that the employee asset doesn’t depreciate. It holds its value, right up until the employee leaves the company. Then the asset disappears. At that point, we would have to write down the value of the employee asset.

But we would get new employees, and we would train and develop them. The employee asset valuation would rise and fall, depending on who left the company, who entered the company, and how our training and development dollars were distributed across these groups.

If a company actually reported employee value in this way, management would probably rely on a lot of averaging. We would estimate an average training and development investment per head. We would use a holistic retention figure to estimate the outflow of employee value over a given period. And we would adjust the employee asset balance with time, tracking the flow of employees and changes in our training and development budget.

Isolating training and development expenses isn’t as easy as it sounds

When I first think of training and development, I think of a classroom. I imagine putting employees through a program where they can learn a new skill, or master an existing one. But training and development comes in all shapes and sizes.

For instance, some promotions are geared dominantly toward development. Maybe you take an engineer and put her in the marketing organization. The idea is to let her learn more about the company’s products, how they fit in different markets, and how the company reaches out to its customers. Sure, part of her compensation is for deliverables she’ll produce in her new role. But a lot of her compensation is for her to develop new skills that she’ll use in the future.

How would a company account for these expenses, in terms of building its employee asset? We would probably have to rely on averaging again. We would estimate what fraction of our work force is in a stretch role, designed to enhance their long-term productivity. We would also have to estimate what fraction of the compensation for this group is meant for new skill development, and what fraction is meant for day-to-day output. Put all these inputs into a model, and out comes an estimate for training and development investment.

This example shows the discretion that is involved in valuing the employee asset. Management has to make a lot of assumptions. Reasonable people could come to wildly different answers about how many personnel dollars are actually steered toward employee development, versus how many personnel dollars sustain the daily operations of the business. Employee assets on the balance sheet would always be shrouded in uncertainty. 

The balance sheet would not be the only financial statement to change. The income statement would change too. The size of some operating cost buckets would go down, since some of the personnel cost that today is an operating cost would be a capital cost instead. But, we would add an employee impairment charge, to account for the fraction of employees that left the business during that period. The impairment charge would be somewhat like the depreciation charge for equipment. The company’s profitability shouldn’t change, but the income statement would look a little different.

The cash flow statement would also look different. We would have a new line in the investing activities section to account for investment in the employee asset. The company’s cash from operating activities would go up, since not all personnel costs would be considered operating costs. The company’s cash from investing activities would go down, since the company would be classifying more cash expenditures as investments. Free cash flow values would change accordingly.

The argument is not that these changes are bad. It’s just that including employees as assets on the balance sheet requires a thorough overhaul of the company’s financial accounting practices. Doable? Certainly. Would you see resistance to that kind of change? Absolutely.

Companies want to disclose as little information as possible, especially when it concerns their people

Now we get to politics. Companies want to disclose as little information as possible. Investors want to see as much information as possible. The tension between companies and investors informs almost all securities regulation efforts.

Most companies report their total headcount in their financial reports. For example,

  • Apple reported it had approximately 116,000 full-time equivalent employees at the end of its 2016 fiscal year (September 24, 2016)
  • GM reported it had approximately 225,000 employees, as of December 31, 2016
  • Walmart reported it had approximately 2.3 million employees at the end of its 2017 fiscal year (January 31, 2017)

That’s about as far as these companies would like to go. (And I’m sure they’d prefer to keep total headcount numbers private, if possible.) 

In 2015, the SEC approved a rule requiring companies to disclose the ratio of the CEO’s pay to the median employee’s pay. The rule is under the political microscope, and may not survive. If it does survive, though, companies will have to disclose the median employee’s pay, which would provide more visibility into their work forces. 

Valuing employees as an asset would require even more disclosure than median pay. Companies would need to break down their personnel expenses, categorizing a portion of them as capital expenditures. Companies would have to disclose their retention rates, or at least allow investors to infer these rates based on the rolling employee asset impairment charges. Management would likely have to write a note, describing the change in employee base valuation from year to year. They would have to answer questions on earnings calls.

It opens a whole can of worms that makes life more difficult for the management team. You should expect to see huge pushback from industry if reporting employees as balance sheet assets ever gained momentum.

What do we learn by having employees appear as an asset on the balance sheet?

We would learn how many resources companies claim they’re devoting to employee development. We would learn a bit about employee turnover. We might learn about how management makes personnel investment decisions, depending on the commentary they offer about the new balance sheet numbers.

While this information would be interesting, it probably wouldn’t help us tell a different story about the company in question. Yes, employees are the most important asset for most companies. What really matters, though, is the aggregate skill level of the employee base. We care about employees’ ingenuity. Their ability to respond effectively to ambiguity. Their commitment to execute against the stated strategy, even when early results are hard to see.

In short, we care most about the intangible skills that the employee community brings to the table. The dollars spent on employee development correlate weakly with these important skills. Yes, training and development dollars make for a more effective employee base. But are those dollars targeted at developing the right skills in the right people? How intelligently is management steering its personnel budget? The balance sheet wouldn’t be able to tell you. It would just tell you the financial investment the company has made in the growth of its employees.

We already have the most important information about the company: 

  • A description of its financial assets, liabilities, and equity via the balance sheet
  • A description of its revenue stream, cost structure, and profitability via the income statement
  • A description of how cash drives its operating, investing, and financing activities via the cash flow statement

Employees are an extraordinarily important means for achieving the ends of robust financial performance. As investors, we want as much information as possible. Ultimately, though, we measure management by financial return, given the available resources. 

We could learn more about companies by requiring them to compute a book value for their employee base. But, we wouldn’t learn a whole lot more than we already know, given what’s in the financial statements, and the fact that we already know the total headcount. We can compute revenue per head, and various measures of profit per head, given what we already know.

Having more information would be better, no doubt. More disclosure would make it harder for companies to shirk their responsibilities to employees. Realistically, though, given the resistance to increasing disclosures, I don’t anticipate seeing employees as balance sheet assets any time soon.

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