More financial information about human capital? FASB looks to require disaggregation of expenses on the income statement

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In June, the Working Group on Human Capital Accounting Disclosure, a group of ten academics that includes former SEC Commissioners Joe Grundfest and Robert Jackson, Jr. and former SEC general counsel, John Coates, submitted a rulemaking petition requesting that the SEC require more disclosure of financial information about human capital. According to the petition, there has been “an explosion” of companies “that generate value due to the knowledge, skills, competencies, and attributes of their workforce. Yet, despite the value generated by employees, U.S. accounting principles provide virtually no information on firm labor.” (See this PubCo post.) The Group may be about to have its wishes granted—at least in part—but not by the SEC. Rather, the FASB is hard at work on a project to disaggregate income statement expenses, and high on all of the FASB board members’ lists was the need to separately disclose labor costs/employee compensation. Of course, as reported by Bloomberg (here and here), there has been a push for disaggregation of expenses on the income statement since at least 2016, but in 2019, the FASB voted (5 to 2) “to put its once-high priority financial reporting project on pause.” It’s been quite a lengthy pause, but, in February 2022—perhaps hearing the call from investors and others—the FASB decided to restart work on the project to “improve the decision usefulness of business entities’ income statements through the disaggregation of certain expense captions.” It seemed from the FASB Board discussion that the Board members were favorably inclined to proceed with a disaggregation requirement—especially with respect to labor costs.

[Based primarily on my notes, so standard caveats apply.]

Currently, companies typically include in their income statements expense captions for selling, general and administrative (SG&A) expenses, cost of services and other cost of revenues, and cost of tangible goods sold.  Total compensation costs are rarely disclosed—only about 15% of companies disclose that data, according to testimony at the SEC’s Investor Advisory Committee.  In February, the FASB considered several potential approaches to addressing the topic through various disaggregation principles and quantitative thresholds, and determined to conduct outreach.  At the meeting on July 27 (see the Board meeting handout, beginning p. 6), the Board discussed the feedback received through its outreach efforts, as well as potential approaches to disaggregation. As to principles-based approaches that were considered, the FASB Chair wryly observed that employing a one-size-fits-all principle sounds great until they try to write it and see if anyone can understand it.  The feedback from the outreach was mixed, with preparers generally advocating flexibility and lamenting the cost and challenges of implementation, particularly with regard to inventory (“because it may be challenging to disaggregate costs after they have been capitalized into inventory”). In contrast, investors typically advocated for disaggregation, with some expressly urging disclosure of specific expenses, such as labor, particularly in light of inflationary trends, as well as the shift in the economy from corporate value based on tangible to intangible assets.  

In the discussion, one Board member suggested that this project on disaggregation could be the most significant that he’s worked on, with substantial benefits to users. He thought that, although companies may be reluctant, they typically do have the necessary information about these costs because they often provide the information on analyst calls, especially recently in the context of the impact of inflation.  He thought disclosure of the information was necessary to understand margin structure and would enable better forecasts, increasing market efficiency as result. Another Board member advocated looking at costs incurred for items that are capitalized and breaking out SG&A. According to another Board member, there’s one type of cost that every company has, and that’s labor, adding that information about labor costs has been widely requested by investors.  He agreed with the concept of making disclosure of certain costs explicit; in addition to labor, he would include amortization and depreciation, as well as, adding a little accounting humor, material, “where material is material.”  Another Board member added that the FASB should acknowledge that there will be incremental systems costs and audit costs, but she believed that the benefits outweighed these costs. She also suggested that the FASB look at splitting off selling expenses in SG&A. The Chair of the FASB echoed the views of others, indicating that he too favored the hybrid approach.

At this point, a loose consensus appeared to form around a two-pronged hybrid approach (somewhat similar to the approach being taken by the IASB): a prescriptive component that would require disaggregation of some specific costs, including labor, depreciation and amortization and, in some cases, materials or purchases; and a principles-based component for disaggregation of other costs, which might involve management judgment or a quantitative threshold or backstop. More elusive perhaps may be a simple approach to addressing inventory and capitalized expenses. The staff plans to perform analysis and develop alternatives for discussion at a future Board meeting. Clearly, there’s still a way to go here, but the project does appear to be moving forward. Separately, the FASB is working on a proposal to require more granularity about segments.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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