Accounting for intangible assets of firm

Abstract

Intangible assets form an important part of the organization's pool of assets. IAS 38 explains the nature of these assets and the way it should be accounted for in the books of accounts of a firm. Among the intangible assets, lies the most valuable asset of all- Human Capital. Through this essay I try to evaluate the concept of Human Capital including how and to what measure it contributes to the success of an organization, a reason why it should be included in the financial reports.

Introduction on Intangible Assets

The International Accounting Standards Board defines intangible assets as, "an identifiable non-monetary asset without physical substance." Some of the examples of intangible assets are Research and Development, Goodwill and Human capital.

In accordance with the International Accounting Standards, the accounting treatment for intangible assets is prescribed in IAS 38. As per the prescribed standard, Intangible assets can be defined as:

  1. Separable or capable of being transferred or sold, individually or together with a related contract, asset or liability.
  2. One that arises from contractual or other legal rights.

An intangible asset can be recognized only if:

  1. The expected future economic benefits that are attributable to the asset will flow to the entity.
  2. The cost of the asset can be measured reliably.

An organization can choose to value its intangible assets in either the Cost method or the Revaluation method. Under the cost method, after the initial recognition, the asset is carried at its cost deducting any accumulated amortization or impairment losses. Whereas under the revaluation model, the initial recognition is followed by carrying it at the revalued amount which is its fair value at the date of revaluation less any accumulated amortization or impairment losses (IFRS, IAS 38). Sometimes investors undervalue intangibles, which can be a cause of concern for companies with a high cost of capital, leading them to under invest in intangibles. This ruins their opportunities for the kind of earnings and growth they seek (Lev, 2004).

What is Human Capital?

One of the many intangible assets of an organization is Human Capital. It includes all the competencies, intelligence and commitment of the people in an organization which is a mixture of their experience, capacity, skills and potential.

It is essential to understand that human capital captures all the people oriented capabilities that are necessary for the success of a business. Most of the firms in the economy invest in their human capital to add value to their business as it is not to be viewed as mere economic units but as assets that contribute towards the success of the firm. Human capital is an essential component that contributes to the business success of a commercial organization and if the firm is able to understand how and what this contribution is, this intangible asset can be easily measured and managed. Apart from human capital there are few other intangible assets that a company deals with, example: brand, design, software and working practices.

Why is Human Capital an important issue today?

Over the last decade, we have seen a complete revolution in the world economy, specifically the work place and the associated work force. Human capital is not only gaining recognition, but also turning into the most critical aspect of competitiveness. As the world moves toward a developed stage, information and service is becoming the common word among the various economies. These are two areas where human capital is inevitable and amounts to over 80 percent of the company's worth. Gaining a competitive edge over each other is now dependant on the skills, competence and people's ability, unlike the past where financial capital was the source and solution for a successful stand in the economy. The labor scene is also rapidly changing with new entrants like women, dual earner couples and even aging individuals. The organizations are not just concerned about using these people to deliver value in new and different ways; they also have to ensure that they find good and skilled people to fit into organizational hierarchy. The worry of the Chief executives does not end with hiring the right people but they are also required to keep them, for which many of them have resorted to elements other than the traditional pay and job security, The human capital market is vast and growing in terms of skill and know-how and it would be foolish if businesses take for granted that individuals would want to invest themselves in an organization unless they are convincingly attracted by the firms to join one of them.

Challenge for organizations and Finance Directors?

Human capital is the most valued of all assets in an organization as they hugely contribute to the success of the firm they are part of, but they are also the most difficult to measure among all other assets. Many organizations term their human capital as the greatest asset but would fail to give even an approximate measure of its skill or competency. Quantifying this asset has become a challenge as there is no particular or accepted way of doing this, which leaves the organizations thinking about how would they make the best investment in their 'asset' and what would be the returns?

Accounting for human capital is literally non-existent among various organizations, hence, revealing the fact that traditional accounting has no provisions to measure the capability and competence of this intangible asset. Most of the Finance professionals hardly understand the performance of their investments in human capital unlike their accuracy in calculating the returns on any other assets in their business. People within a firm are often looked upon as operating costs and all the related costs are also minimized, though it is considered to add value to the firm. Optimization of such costs may have to be dealt with, by the HR, Finance or both, as per the situation and context. The organizations are also faced with another worry in relation to reporting of information about human capital, both internal and external. A company would be assessed on account of it's internal labor market information and how successfully have they served its business objectives. Though firms are not compelled to conduct an external human capital reporting, changes are expected to take place. (Human Capital White Paper Version 1.1)

The organization does not own its human capital but there exists an employment relationship, which is one of the reasons why its measurement is difficult. Some of the measures that can give us an idea of the contribution of the people are out of the control of the business.

Human capital in itself cannot create any value, they need to be motivated and properly managed in order to bring out their competence and use it to the benefit of the organization. If these skills and knowledge cannot be tapped and used for the production of goods and services, then it is totally futile and will not be of any value. The employees can put in more or less effort to retain their job, as long as it stays above the required minimum, this is sometimes referred to as 'discretionary effort'. In order to extract more effort from their human capital, organizations should be able to identify the factors that could trigger such discretionary effort (Chartered Institute of Personnel and Development, 2009).

Knowledge has become a key ingredient to achieve a competitive edge over another, especially in this new economic landscape. Much of a company's know- how rests in its human capital, thus making it the most competitive and valuable asset it possesses, says Grant (1996 cited in Hitt, Michael A et al., 2001)

In order to gain success in the economy where the firm operates, it is essential to select, develop and use human capital in the appropriate way. Unlike the valuation of other assets in an organization, calculating human capital is difficult. This intangible asset can be influenced but it can never be entirely controlled or invested wisely or wasted thoughtlessly, yet maintain its value. Human resources are also finite, it can be developed and cultivated but it also has a mind of its own, unlike any other asset. It can decide when to leave the organization, can become sick and influence others around them to act in ways that do not benefit the firm. In general, though companies believe that human capital is their greatest asset, they can also fail to predict or even control the performance this valuable asset, thus, making its measurement and management a complicated issue. These features distinguish human capital from other capital assets and make it an elusive and unique asset (Weatherly, Leslie A, 2003).

In terms of an organization, the word 'capital' is made up of multiple elements like stocks and shares, infrastructure, bank account or even property, these are assets that can yield income over a long period of time. But, in today's fast changing economy, these are not the only forms of capital. Skills, education, health, to name a few, have formed this vast aspect termed as human capital. Economists have started regarding schooling, on- the- job training, medical care and so on as investments in human capital because they add value to the human factor and ultimately contribute towards the growing per capita income of a country. This growth can also be associated with the expansion of technical and scientific knowledge which aids the increase in productivity of a company. Trade and specialization can maximize the returns on human capital by the efficient use of resources in spite of the fact that they are identical and they exhibit constant returns to scale (Becker, G. S., 2008) (Rosen, S., 1983).

The concept of Human Capital Management

Studies have shown that there is a link between human resource strategies and the performance of an organization; hence, it is clear that managing the people of an organization will have an impact on their performance. Human capital management is a strategic approach that seeks to analyze, measure and evaluate how people and their practices contribute towards creating value in the organization. This approach treats people management as a valuable strategic issue and does not leave it to be sorted out by the HR personnel. This is indeed essential in this fast paced competitive world. Human capital management is a strategic approach that focuses on factors that contribute towards the success of the organization. It is not a technique that would treat people like any other assets of the firm; rather, it recognizes the fact that human capital can generate value through its skills and commitment only when the organization can strike a balanced and quality relationship with the people. This approach focuses on the factors, such as retention, motivation and skills development, which has an impact on the performance of the company.

There is a Task Force in place to aid Human Capital Management and it was established by the Secretary of State for Trade and Industry, in the year 2003. The main duties include:

  • Evaluate the various measures in place that are used to assess investment in Human capital.
  • Come up with the best practices for human capital reporting and analyze the performance to inform the shareholders.
  • Submit a final report after adequate appreciation. (Accounting for people report, 2003)

Why should it be reported?

Human capital management is not just an internal affair that is looked after by the management. The disclosure of its practices and policies is highly essential to evaluate the effectiveness of the management and it's also reflects the performance of the people within the organization, which is important to the shareholders, tax payers and even the employees themselves. The Parliament, sponsors or grant-givers are the least interested in what returns would they get from their investment but they are looking for performance to ensure that their investment is being put to the best possible use. The reports are of interest to the shareholders, suppliers and customers because they demonstrate how the organization focuses on the elements that create value for the firm.

The reports not only satisfy the above mentioned people but it also helps the employees and prospective employees to identify their contribution towards the overall success of the firm and also how much they are valued. This is a means by which the company, not just interacts, but also tries to attract and motivate the employees in order to retain them. Such reports and information enables the organizations to focus on the key factors of people management, thus, helping them to evaluate the contribution of the workforce and make effective and informed decisions on investment in this capital asset. The information provided would include; the ways, in which employees add value to the organization, evaluating whether Human Capital Management's policies and practices are in line with the firm's strategies and how successful are policies.

Sound human capital management improved standards by producing better accountability and performance to all shareholders, thus improving management decision making. In spite of this, quantifying the contribution of human capital and how it can be linked to improve financial results, still remains an issue. (Ridgian Human capital Reporting) (Accounting for people report, 2003).

Companies may choose to report human capital management for strategic reasons, mainly the recruitment, development and retention of talented people especially where there is strong competition.

The kind of information required would be different for different categories of people within the organization. These are a few of the categories of people within a business and the kind of information they need:

  • Shareholders- Stakeholders are interested to know what would have an impact on long term financial performance. Since they are part owners of the firm, they keep track of its performance and evaluate the factors which may or may not bring success to the organization, ultimately having an influence on the returns.
  • Customers- They look forward to know if they are going to get what they want and if they would get good service. Customers are also interested to know about the quality of sales support and how effective it is.
  • Employees-The workforce is concerned about their job security and how they can retain it by their performance. This encourages them to develop their skill and knowledge.
  • Managers-The management's main responsibility is to ensure that their business units are performing efficiently and what are the necessary steps to be taken in order to improve it (Chartered Institute of Personnel and Development, 2009).

Method and content of reporting

Organizations have always tried to ensure that their shareholders, suppliers, customers and all the concerned individuals would be accurately informed about their attempt to manage and develop their greatest asset- human capital. There is no particular accepted rule or method of doing so, yet there can be a few reasons why it would be beneficial to have set guidelines for Human Capital Management reporting, since there are highly diversified firms in the market today. Here are a few of those reasons:

  1. There would be some sort of a consistency and assurance, for the companies being compared, that evaluation and comparison is being made on common grounds.
  2. Unless there is a common practice or set guideline to be followed for reporting purposes, the organizations would struggle to provide anything informative and meaningful.
  3. Investors and shareholders would consider the information reported by Human Capital Management as too 'soft' to be used, if they are not reported within a set framework. A systematic design would build their confidence and reliability in such information.
  4. If there is a proposed way to report human capital management, the over interference and influence by the Public relations department would be limited (Accounting for people report, 2003).

Means to report Human Capital

Though measuring human capital is impossible, many organizations are required to report on their Human Capital Management. A method that is commonly used for this purpose is the Operating and Financial Review (OFR); this is usually attached to the annual report of a firm. As of April 2005, more than 1200 publicly listed companies in the UK are required to state their performance with regard to their human capital or they would need to justify formally why they did not do so.

Many companies have adopted this approach, including Government departments and agencies. This would help to understand the performance of the business and the factors that would affect the future, hence, informing the users about the strategies adopted and successfully achieving them. The directors determine what needs to go in and what does not. Though it is not compulsory to produce the Operating and Financial Review, many of the public sector undertakings voluntarily take the lead in reporting on human capital issues. All the large organizations have not yet come under any sort of obligation to produce the report; neither do the local government and the organizations in the charitable sector do so. Some of the local government departments that report human capital may not have a board of directors who will be collectively responsible for their annual reports but will have a senior officer with formal responsibility and will be overseen by a management board. Whereas in the charity sector, the trustees bear legal responsibility for the reporting. Other countries around the globe have started to influence their reporting practices but a lot of effort needs to be put in to encourage this practice among companies all around (Accounting for people report, 2003) (Ridgian Human capital Reporting).

Human Capital reporting used by UK companies

Though there may be various kinds of measures used to report on human capital in different countries and circumstances, we can focus on the reporting methods used within the UK. Some of the large companies have adopted the following measures:

  • Workforce profile
  • Turnover
  • Retention rates
  • Absenteeism
  • Employee performance and productivity
  • Employee engagement.

Such reporting is not usually part of the annual report and accounts; mostly it is published on the company's website or passed on to other organizations or consultants. Some of the data that the companies in the UK publish in these ways are:

  • Diversity statistics
  • Health and safety statistics
  • Employee survey findings
  • Number of employees in the organization
  • Description of the fair procedures used within the firm
  • The number of hours worked overtime by the employees
  • Training statistics- number of participants, hours spent.

Sometimes UK companies do not report Human Capital Management and this reluctance can be due to the following factors:

  • Certain companies would not want to report information for confidential reasons or sometimes due to the sensitivity of the data.
  • Many times, firms avoid human capital reporting due to the shortage of time and appropriate resources.
  • Some companies consider this kind of reporting as futile, and would not want to spend time and effort.
  • Usually companies struggle to do this reporting due to the absence of a prescribed practice and set guidelines.

Human Capital Management reporting can differ from country to country as per their local legal requirements. A few of the countries like France, Germany, Netherlands, Switzerland and South Africa have extensive requirements, mainly focusing on preventing discriminatory employment practices (Accounting for people report, 2003).

Human Capital- As valuable as any asset of the organization

In conclusion, we understand that human capital is a combination of individuals' talents, skills, competence and knowledge that they acquire through education and training. The people invest in their education and training in order to build the necessary skills and know-how expecting long term return. This long term return can in turn benefit national economies and help in raising the per capita of a nation (Organization for Economic Co-operation and Development, 2007).

It is also worth noting that though human capital is the most important element towards the creation of value for the firm and one that contributes to the overall success of the firm, it is very rarely accounted for like the other physical assets. The returns on all the other assets are recorded accurately for the benefit of the shareholders and other recipients, yet the returns from the most important intangible asset of the organization is not seen in any of the books of accounts. A systematic method or practice should be introduced to not just measure the contribution of the human capital in a company but also ensure that it is recorded and accounted for in the books for the benefit of the economy as a whole.

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