Human Resource Accounting and Indian Practice

Abstract

Traditional acting practice treat expenses incurred on procurement, development, and maintenance of human resource as revenue expenditure and debit this to profit and loss account but now it is being increasingly realized that this expenses are incurred to get future benefit and as such should be capitalized and reflected in the balance sheet. This can only be achieved through introduction and implementation of human resource accounting.

The study focuses on how human resource accounting has evolved over the period and how human resource accounting is used in today business application particularly in the Indian context. In addition the study also assesses how human resource cost is treated by the accounting standard and try to discuss alternative treatment. Through the study of Indian companies, the paper will propose ways through which human resource accounting can be introduced in India and become more popular than the current application.

Introduction

The world has witnessed a transition from manufacturing to service based economies. Before 1960s most economies relied on manufacturing sector to sustain growth but the past few decades have witnessed growth in service based economies. The fundamental difference between manufacturing and service sector lies in the nature of their asset. In manufacturing, physical assets like material, plant, equipment and machinery are very important (Johanson and Mabon, 1998). On the other hand for the service sector altitude and knowledge of employee is of utmost significance. For service firm such as information technology (IT), value of physical asset is considered less worth compared to skill and knowledge of its personnel. Similarly, in academic institution, hospital, audit firm, accounting firms etc the strength of the firm depends on skill and services offered rather than physical asset. Therefore the success of service organization depends on the quality of the work force i.e. competence, knowledge, motivation, and skills.

People in the business world today cite human resources as the common greatest asset. However employee value is rarely reported on the financial statements. This may have resulted from capitalist system that tends to glorify capital resources with a lukewarm emphasis on human resources. For this reason management of business enterprises have been rewarded on the basis of their utilization of capital asset without reference to value of workers. In fact business valuation has been a manifestation of this system. The common measurement of return that are used to value business include return on investment, return on asset or return on capital. In these cases there is no reference to the value of human resources.

In service based economies it is important for employee to be recognized as part of the total worth of a firm. In estimating the worth of human capital it is vital to employ some method of quantifying human knowledge, skills, motivation and contribution of human aspect in organization process. Human resource accounting represents this process of measuring or quantifying human resource.

Definition of human resource

Leon. C. Megginson defined human resource as “the total knowledge, skills, creative abilities, talent, altitudes and belief of an organization workforces as well as values, altitude and belief of the individuals involved.”

Definition of human resource accounting

One of the definitions of human resource accounting comes from American Accounting Association’s Committee on Human Resource Accounting that defines human resource accounting as “the process of identifying and measuring data about human resources and communicating this information to interested parties.” Therefore human resource accounting involve measurement of all cost associated with recruitment, selection, induction, training and development of workers as well as the economic value of people in a firm. Flamholtz has a similar definition as he define human resource accounting as “the measurement and reporting of the cost and value of people in organizational resources.”

Human resource accounting has also been defined as the system of recording of transactions relating to the value of human resource i.e. the cost of acquisition of their knowledge and utilization of the energy for production of goods and services in the most profitable manner and thereby achieving the organization goals (bassi, et al 1997).

In general human resource accounting may be defined as the process of identifying data about human resource, recording investment made in them and measuring their cost and value. It also involves presenting the information in a significant manner in the financial statement to communicate their worth with changes over the period and result obtained from their utilization to users of financial statement.

There are no statutory requirements which demand companies to furnish human resource accounting related information in their final statement. The company act of 1956 had no provision for HRA. The subsequent accounting bodies such as Institute of Chartered Accountants of India have not yet drafted standard or measurement dealing with accounting and reporting of human resource accounting. While most organization give qualitative pronouncement on importance of human resource very few make effort to give quantitative information about human resource. Currently some organizations are furnishing additional report beyond what is required by statute. One notable statement that has gained wider acceptance among many firms is the corporate social responsibility report. This is due to recognition that the traditional financial reporting does not give sufficient information about organization performance. In India some companies have recognized the value of human resource and include related information in their annual report, they include Infosys, steel authority of India (SAIL), Bharat Heavy Electrical ltd (BHEL), Southern Petrochemicals Industries Corporation of India Ltd, Mineral and Metals Trading Corporation of India, Hindustan Zinc Ltd, Associated cement Companies Ltd, Madras Refineries Ltd, Oil India ltd, Oil and Natural Gas Commission, and the Cement Corporation of India (Punita 2007).

Historical development of human resource accounting

Human resource accounting can be traced back in the medieval European practice of calculating the expected future earning of a prisoner versus the cost of keeping him. At that time a prisoner was considered as the general property of capturing side and therefore after a victory a decision had to be made on whether to capture a prisoner or kill him depending on cost benefit analysis. If expected benefit outweighed the cost the prisoner was capture but if cost were greater than benefit he was killed. For instance in 1964 Sweden and Austria agreed upon the following price list (figures given in taler)

Field marshal 20,000

Colonel 1,000

Cavalry captain 200

Infantry captain 150

Non-commissioned officers 16

Private 8

Though this was a rough measure, it highlights the fact that human resource has value and such value can be measured using appropriate basis. Development of human resource accounting as a detailed and systematic activity began in 1960 by Rensis Likert. Likert defends long-term planning by strong pressure on human resources’ qualitative variable, resulting in greater benefit in the long run. He defined human resource as to include all such assets as a firm’s human organization, its customers, loyalty, shareholders loyalty, supplier loyalty, its reputation among the financial community and it reputation in the general society (bowers, 1973).

William potty made the first attempt to value the human beings in monetary terms. He was of the opinion that labor was the source of wealth and must be taken into consideration when making an estimate of wealth. From 1960s the behavioral scientist started a real work of studying about human resource accounting (Flamholtz, 1969).

This development can be dividend into five stages according to Flamholtz.

Stage one (1960 – 1966) – during this era there was increased academic interest in the area of human resource accounting. At this time most people focused on deriving human resource accounting concept from other theories such as psychological theory and economic theory of capital.

Stage two (1966 – 1971) – at this stage the focus shifted to developing different models for human resource accounting. The model developed covered monetary, non-monetary value and cost of human resource. The objective of developing such model was to help the firm in managing their human resource and assessing human resource asset in a realistic manner. The main contributor to the study at this era was Roger Hermanson. During his ph.D studies, he studied the problem of measuring the value of human resource as an element of goodwill. Thereafter researchers who were inspired by his work continued to develop methods and concepts of accounting for human asset.

Stage three (1971 – 1976) – there was rapid growth in research in the area of human resource accounting. The field gain more acceptance and wide spread interest. During this era most researchers tried to evaluate how human resource accounting could be applied in businesses. A notable experiment was that of R.G. Barry which gave substantial contribution to researchers (Boudreau, 1996).

Stage four (1976- 1980) – during this era there was minimal research in the field of human resource accounting. This was due to the fact that there were complex issues that needed further exploration and deeper empirical research than the simple model developed earlier. The other reason for slow growth in human resource accounting at this time was unwillingness among many organizations to offer sponsorship for research in this area.

Stage five (1980 onward) – the shifting from manufacturing to service economies in many developed countries renewed the interest in the area of human resource accounting. In addition the realization of the usefulness of human resource in facilitating growth, profitability and survival of the business contributed to the renewal of interest in the field. Unlike in the previous studies where the main interest was academic with few practical application but since 1990s the focus shifted to application of human resource accounting to business management. Various models which incorporate both tangible and intangible asset have been developed to suit the specific need of the organization. At this time most organization began using human resource accounting as part of financial and managerial accounting practice.

Objectives of HRA systems

It’s basically adopted to treat human resources as assets, to generate human data about names, to assign value to human assets in the balance sheet.

The objectives include:

• Provide information for making management decisions about acquiring, allocating, developing and maintaining human resources in order to attain cost effective organization objective.
• To develop methods of ensuring human resources cost and value and to allow management personnel to monitor effectively the use of human resources.
• Provide a system of asset control i.e. whether assets are conserved, deflated, or appreciated (Boedker et al 2008).
• Aid in the development of management principals by classifying the financial consequences of various practices.
• Develop a theory that will explain the nature and determinants of the value of people to enterprises.

Significance of human resource accounting

A well defined human resource accounting can help the management to become more efficient, in addition it is useful in internal reporting and to external users of financial statement.

Usefulness in internal reporting

1. Helps in planning – Human resource cost acting provides cost information required in human resource planning process thereby facilitating preparation of future forecasts and budget (booth 1998).
2. Help in decision making – human resource accounting provides data in areas where alternative option exist e.g. whether to acquire a trained employee or develop one from within, or whether to retrench or retain an employee. Instead of applying non-monetary measures of potential ability, the economic value of recruits will be better criteria for selection and optimization of the expected value of the organization human resource and subsequent valuation of adequacy of return on investment in human resource.
3. Helps in capital budgeting – the present technique used in capital budgeting decision consider the human dimension as a qualitative factor. This is not realistic in the present scenario where huge investment is being made in development of employees and therefore human resource accounting system would justly assess the impact of capital budgeting on human and non-human asset.
4. Helps in control – human resource accounting help to ensure that human resource objective are attained objectively and efficiently as it provide information necessary to implement the control function. The standard cost of acquisition and development is compared with actual cost incurred and the variance if any is analyzed to identify the possible lapses in personnel management function (Scarpello and Theeke, 1989).
5. Helps in performance evaluation – the present convention of measurement of return on investment ignores the changes in human resources and this encourages mangers to use their human resource to include their short term objective. Inclusion of human resource input would be a good performance measure as it would reveal the return on human asset.
6. It helps in activity analysis – measurement of human resource value would provide top management with new set of financial ratio for effective organization activities analysis e.g. ratio of human and non-human resources indicate the degree of labor intensity. Higher labor intensity could be used as a result of outdated technology requiring the utilization of high proportion of labor or employment of unwarranted existing labor (Tang, 2005).

Usefulness in external reporting

In business creditors and other external users of acting information would find data in human resource useful as it would measure change in asset value over period of time thereby reflecting the correct measure of corporate growth. Capitalization of expenses relating to development of human resource also reflects a correct financial position and performance of the organization.

The market value of share may reflect changes in value of human resource thereby enhancing the company’s image among the competitors while increasing the confidence of shareholders.

Usefulness in management of human resources

1. Acquisition of human resource – human resource accounting provide information for budget preparation for cost involved in recruiting, selecting and hiring human resource. Besides in selection process personnel executive needs data about economic value of a candidate in order to choose the one with the highest economic value.
2. Allocation of human resource – human resource accounting provide quantitative information about capabilities, skills and other personal attribute of employee which will help management in attaining a perfect allocation of organization human resources whereby employees are assigned jobs perfectly matching their own abilities in order to fully utilize their skills and capabilities.
3. Maintenance of human resource – presently organization use turnover rates to measure the extent of human resource observation. However such parameters are not adequate as they do not fully reflect the impact of turnover. With inclusion in human resource accounting the management may monitor the investment cost through human resource replacement cost which provides the economic magnitude of turnover rate as well (Drake, 1997).
4. Evaluation and reward for employees – as human resource accounting can provide management with changes in value of human resources over time both in monetary and non-monetary term, the figures will not only make possible the determination of salary and wages on the basis of employees value but will also provide a criterion to both the management and unions in negotiating any increases in compensation and reward payment.
5. Training of human resource – organization invests heavily on human resource development program without evaluating expected payoff of return because this outlay cost is considered as expenses rather than investment. Since human resource accounting involves treating this expense as asset the information about this cot and the benefit of this program would be evaluated on a rational basis.

Case for and against human resource accounting

Argument against human resource accounting

• Incase of high employee turnover rates there may be no basis for capitalization since there is no future benefits to carry asset status.
• If the definition of asset is “future economic benefits the rights of which are owned or controlled by the firm” then one may question whether human resources indeed are assets. Unless one is working in a “slave society” human resource are not owned in the convectional sense of the world, and therefore employees may be opposed to the capitalization because of the connotations that goes with it.
• The development of human resource accounting is necessary to provide a firm with accurate financial reports to guide its decisions. It’s also needed to increase the validity of criteria of measurements used in organizations research.
• According to asset recognition criteria, an asset is the future economic benefits the rights of which are owned or controlled by an enterprise. Therefore as long as future benefits are expected to come from these training costs, they can be treated as assets. However, as Cea Garcia observes, this does not hold true in reality;
• “There is a clear absence of correspondence between the real assets in the present firms and those recognized in the balance sheet, in front of a pure economic approach where assets is every instrument or way that can be used in production -distribution of a firm’s process or, in general, every category of economic value which can be transformed into goods or services or any instrument at the service of the firm or that the firm uses, regardless its juridical state, and also all those goods and rights that the firm does not own now but used to own or will own later on, by virtue of collateral contracts or agreement which may induce it.
• It may be argued that the rate of amortization and the rate of capitalization may coincide and therefore the net effect on the income statement may be as under convection human resources cost expense treatment.
• The period with which the employee will work for the enterprise is uncertain and therefore the amortization is subjective. Marvin Weiss (1972) discussed the argument for and against Human Resources Accounting argue that there is inability to determine the period of future benefits, the ownership status of such assets and inability to amortize such assets on an objective way.
• As Ebersberger (1981) argues, even where the logic of HRA is a plausible one must confront the issue of measurement. How does one place a value on an individual’s head? How can one value commitment to an employer or one’s ability to work as a team.
• The management may use human resource accounting to manipulate the workers. The manager may reduce the value of a worker as a way of punishment for perceived or real differences. There is an immense amount of power placed in the hands of the ‘valuers’ of human resource. Any value placed on an employee may have irreparable damage on employee’s attitude. Managers may also transfer some workers near the end of the period to ‘clean’ up their balance sheet.
• Employee may demand to be paid in accordance to their reported value particularly if they believe this would lead to a higher pay
• HRA may have a disastrous effect on the morale of the employee if his or her value reduces through depreciation. Moreover human beings grow, learn and mature at different rates and therefore a standard depreciation rate is inapplicable.

Case for Human Resource Accounting

• Whereas there may be workers turnover, this may not be justification for expensing the cost of human resources. Failure to capitalize may negate the going concern concept. If an employer were to expect such high turnover then he would not incur expenditure on employee training and development in the first place! On average it is expected that workers will remain long enough for the firm to recoup its investment costs.
• Workers may not be owned as such but the convention of substance over form argues that what matters in transaction is the economic substance not the legal form. Leased assets are recognized in the books despite the fact that they are not owned.
• Human resource expenditure like training and development are incurred for workers who are in the process of learning and therefore they do not benefit the operations of the year in which the costs are incurred. For that reason it is inconsistency for charging such costs in the year of expenditure. Instead they should be capitalized and amortised over the years expected to benefit from the employee’s services.
• In pension cost accounting armotisation or accrual of expenditure related to employees is required. Such accrual methods take into consideration length of service and turnover rates.
• Whereas it is agreeable that armotisation rate are subjective, it must be noted that depreciation rates for the tangible assets are mere estimates based on assumptions. It is therefore no justification to prohibit capitalization and armotisation of human resource expenditure.

Measurements in human resource accounting

The main reason why human resource accounting have taken a long period to be incorporated in the company’s final report is the difficulty or challenge of assigning monetary value to various human asset cost, investment and employees worth. There are mainly two methods that are used in assigning monetary value to employee cost, investment or worth. This includes:

1. the cost approach
2. the economic value approach

The cost approach is based on the actual cost incurred by the company in relation with employees. The economic value approach considers human resource as asset and tries to identify the future earning resulting from use of human asset.

The cost approach

Cost is the amount of cash or equivalent given to acquire property or services. If property other than cash is given to acquire property or services the cost is the cash equivalent of property given. When property or the services acquired are sold or consumed the cost are matched with related revenue to determine the amount of net income or net loss. The cost of property or service that are acquired and are still on hand at any particular time represent asset. Such costs are also called unexpired cost. As asset are sold or consumed they become expired cost or expenses. Therefore in accounting cost incurred are recorded in the financial statement as either asset or expenses. Costs which are recorded as expenses in the current period include those which provide benefit during the current accounting period (Schwarz & Murphy, 2008). for instance when machinery is purchased the portion of cost recorded as expenses include depreciation for the year (i.e. the benefit accruing from the use of asset in that particular year) while the portion of cost recorded as asset in the net book value (cost – accumulated depreciation).

Under costing approach various techniques that can be used to value human resource include

Historical cost approach

The actual cost incurred on recruiting, selecting, training and developing the human resources of the organization are capitalized and written off over the expected useful life of the human resource. Under this method the cost of acquisition i.e. recruitment, selection, hiring and training employees are capitalized and written off over the expected useful life of the employees (Flamholtz, 1999). If the employee decide to leave the employment before anticipated period of service then the amortized portion of cost remaining in the company’s book is written off against the profit and loss account in that year. If the employee stays beyond the expected term of service then amortization of cost is rescheduled. According to Caplan (1974) the basic theory behind the historical cost method is that human resources value can be determined by accumulating the cost of investment. Human resource accounting in this respect involves a decision to capitalize rather than to expense costs incurred in training and development of employees. When referring to training cost, historical cost means the sacrifice necessary to hire and train people.

The training concept is generally used to define three different issues which are difficult to distinguish in practice; they include capacitating, training, and development. Capacitating is the workers acquisition of knowledge and skills necessary for his job. Training better adapts the worker to the job while development mainly focuses on promotion to higher job levels (Guzman 1996). Once capitalized the resulting balance should be amortized as an expense in the periods when the employee became a productive member of the organization and unamortized balances should be written off when the employee leaves the organization.

Merits

1. Easy to work and simple to understand.
2. It follows the traditional concept of matching cost with revenue. It is favored because it is most similar to convectional accounting
3. It can provide a basis of evaluating a company’s return on its investment in human resources.

Limitations

• Suffers from problem of historical costs accounting. The users of accounts may view these values as a measure of the potential usefulness of an employee.
• Difficulty in estimating use of human resources. One cannot tell when an employee may quit a job.
• The economic value of human resources may increase with experience, but armotisation reduces the reported value. It is difficult to reconcile the two.
• Ignores the aggregate value of employee’s potential services.
• People may learn things outside the organization which will be useful in their jobs yet these may not be taken in account.
• Training and development cost that are capitalized do not guarantee employee increased performance.

Opportunity cost approach

The value of the human resource is determined according to its alternative use. An estimate of alternative use of the human resource is required. The value of the human resource is the price that the alternative use is ready to pay for it. Opportunity costs are considered as “an asset value when [they are] the target of an alternative use” [Hekimian and Jones, 1967]. The alternative use is the alternative department. As a result, only scarce resources would have an alternative use. This approach suggests competitive bidding for scarce employees in an organization i.e. opportunity costs of employees linked to scarcity. The approach proposes the capitalizing of additional earning potential of each human resource within the company. The opportunity cost approach requires at least two departments or cost centers both desiring the services of the same person or a group of people.

Limitations

1. It cannot value employees who have no alternative use.
2. The valuation of employees on alternative use and competitive bid is inaccurate and misleading. One may not have values in the alternative use but perfectly useful in one department. This valuation restricts alternative use within the organization. In real life there is alternative use outside the business and moreover alternative use within the business may not be identifiable because of constraints in an organizational environment.

Standard cost approach

The method was developed by David Watson. The approach advocates for a standard cost per grade of employees updated every year. Replacement cost can be used to develop standard costs of recruiting, training and developing individuals. Such standards can be used to compare results with those planned. Any resource produced should be analyzed and would form a useful basis of control. Under this method, standard cost of recruiting, hiring, training and developing per grade of employees are determined annually. The total standard cost for all personnel of the company is the value of human resources

The problem is that the determination of the standard cost from each grade of employee is a ticklish process (Moore, 2007).

Economic value added approach

This approach utilizes the concept of present value. The value of human resource is considered as the present value of future benefit expected to be received from employees’ service (Lev and Schwartz, 1971). Various scholars have suggested a number of valuation techniques under the present value approach. The technique varies in terms of recognition of benefits. Some argue that the benefits to be discounted are the expected stream of payments that the firm will make to the human resource. In either case the human resource in it is seen as a future stream of benefits up to the date of death or retirement, discounted at an appropriate discount rate. This method is perhaps the most appealing because it incorporates the entire stream of benefits. However, present value approach suffers from the following limitations

• It ignores the possibility of a human resource leaving employment in the given organization other than through death or retirement. Having many reasons as to why people may leave an organization.
• Difficult to establish the actual benefits from employment because some of the determining factors like trade unions are out of organization’s control.
• Teamwork is a thing more than the sum of the values of individuals. Present value approach does not reflect the contribution of the team as a whole.
• It ignores the organization’s effect on the value of a human resource.

The economic value of human resources may be of group, individual or the whole organization. The method for calculating economic value of human resource may be classified as either monetary or non monetary

Monetary measures of human resource value

Flamholtz model

The Flamholtz model considers the value of human resource as the present worth of services likely to be rendered by an employee in future. When an employee moves from one position to the other at the same level or to different levels the profile of services offered will be different. The value of individual will therefore comprise of the present cumulative value of all possible services to be offered by the employee his career at the organization.

The value of individual cannot be determined with certainty and is considered to have two dimensions.

Conditional value of individual

This is the amount that organization expects to realize from employee service during his productive life in the firm. It is mainly composed of three factors namely

1. Productivity – this include various services that employee is expected to undertake in his current position.
2. Transferability – this include a number of services that the employee is expected to offer in different position at the same level.