Working Group petitions SEC to mandate financial disclosure requirements for human capital

Cooley LLP

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Do companies disclose enough information about investments in their workforces?  Not according to 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. The Working Group has submitted a new 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.” The petition requests that the SEC “develop rules to require public companies to disclose sufficient information to allow investors to assess the extent to which firms invest in their workforce”—in the same way that “SEC rules have long facilitated analysis of public companies’ investments in their physical operations.”  Asked about the petition, Grundfest told Bloomberg that it “aims to move the accounting treatment of a company’s workforce to the same level as its physical capital….’Current accounting rules give us more information into the economic consequences of buying or leasing a drill press than of hiring and training a software engineer….How much sense does that make in today’s world?’”

Why is this disclosure necessary? The petition offers two reasons.  First, companies’ value is increasingly derived from intangible assets, such as intellectual property and human capital, rather than tangible assets, such as property, plant and equipment. According to the petition, in 1975, intangibles represented just 17% of the value of companies in the S&P 500; in 2020, intangibles represented 90% of the S&P 500 market value. That trend is illustrated by the growth of the healthcare and information technology industries, both of which depend heavily on human capital and now together represent about a third of the market cap of the S&P 500.  Yet the accounting rules are still fashioned around corporate value as structured in the 1930s, when the first accounting standard-setter was created.  For example, current accounting standards treat investments in capital expenditures as assets on the balance sheet to be depreciated over time, while investments in R&D are typically treated as expenses, not assets, and reduce net income in the current period.  Similarly, labor appears as an expense that reduces net income, but, the petition observes, labor costs are typically included as part of administrative expenses, and only 15% of companies even separately disclose their labor costs. “These legacy rules,” the petition concludes, “do not reflect the current reality that the largest firms add value through internally developed intangible assets such as human capital[,]… leaving investors without information necessary to accurately value the firms that 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—necessitates more disclosure about 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-to-earnings ratios, when companies report losses and instead must “project future earnings—an analysis that requires reliable information on costs, margins, and scalability that is commonly obfuscated under current accounting principles….To best value lossmaking firms, investors need a sufficiently detailed breakdown of the firm’s cost structure to identify contribution margins. That requires distinguishing whether cash outflows should be considered investments or maintenance expenses.”  For example, while salary is typically considered a maintenance expense, expenses such as training and even equity could be expected to increase productivity, improve retention and create future value and could be considered investment expenses.  Although many investors can estimate the proportion of capex devoted to investment, “when it comes to workforce,” the petition contends, “investors typically cannot even determine total workforce costs—much less identify the distinction between investments and maintenance workforce expenses.”  (Although the focus of the petition is labor costs, the authors advocate that the SEC consider the opacity of cost disclosures more generally.)

To address this issue, the petition advocates three reforms, combining quantitative and qualitative disclosure, that are designed to help investors distinguish between maintenance and investment expenses.

  • Require disclosure in MD&A of the portion of workforce costs that should be considered an investment in the firm’s future growth and an explanation why. The authors believe that this disclosure would “allow investors better insight as to what portion of labor costs should be capitalized in their own models—and incentivize management to consider employees as a source of value creation.”
  • Treat workforce costs on the same basis as R&D, requiring that they still be expensed for accounting purposes but disclosed.  The authors recommend the use of standardized tabular disclosure that would disclose employee mean tenure and turnover as well as various components of compensation and benefits, including healthcare and training expenses, distinguishing among full-time, part-time and contingent workers. This approach would, in the authors’ view, allow investors to create valuation models that capitalize workforce costs if desired.
  • Require 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 to better understand the contribution of workers to the company and the dependence of the company on its employees. As noted above, the petition maintains that, for companies that report losses, investors “need information on product margins to estimate future profitability. To do that, investors need detailed information on operating costs, the most important of which is labor, to predict future margins and to determine what portion of cash outflows reflect investment. Without this information, it is difficult, if not impossible, to reliably value these firms, or to stress-test the market’s valuations of a firm using fundamental analysis.”

The petition contends that the improved price efficiency resulting from the proposed disclosures would outweigh the initial costs of compliance.  The proposal fits within current accounting frameworks, should improve market pricing and should involve minimal costs to implement, especially given that much of the information is already required to be produced for tax purposes.

One of the Working Group’s co-chairs told Bloomberg that SEC plans to expand disclosures about human capital “must be paired with accounting changes to give investors more details about a company’s labor costs and to better hold management accountable for what they report….’Companies are really reliant on highly skilled labor to actually create value and the financial statements just don’t reflect that.’” (The co-chairs of the Working Group both participated as panelists discussing accounting for nontraditional financial information at the recent SEC’s Investor Advisory Committee meeting. See this PubCo post. )

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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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