How Financial Accounting Screws Up HR

Many common practices for managing employees are hard to explain. Why do companies obsess over cost per hire but spend so little time trying to see if they make good hires? Why do they provide so little training when we know it improves performance and many candidates say they’d take a pay cut to get it? Why do firms delay filling vacancies and let work go undone? Why do they spend so much money leasing personnel from vendors rather than hiring their own?

One answer to those questions is the peculiar way that financial accounting in the United States treats employment costs (which differs from the way that international standards treat them). Despite all the rhetoric about “investing in our people,” training and development aren’t considered investments; they’re categorized as a current expense, a type of fixed cost—just as carpeting is. So are other employment costs such as wages and salaries for all administrative work. Given that U.S. companies enjoy considerable freedom to lay off workers, treating such expenditures as fixed costs that can’t be reduced during economic downturns makes little sense. Along with other rules, it helps explain why more and more firms are shifting work to nonemployees, a trend that begins in cost accounting. By transferring work away from employees, companies get rid of fixed costs and move employment costs into another accounting category. In short, the financial accounting system distorts business decisions in ways that are worse for everyone—investors, employers, and employees.

Financial accounting, much more than the tax code, causes employers to make choices about work and employees that are at odds with effectiveness and efficiency. As I will explain in this article, you can see the negative consequences in practice after practice. If you add them all up, their impact is massive. The remedy is to make some simple, modest additions to reporting requirements, which I will describe. Despite being small, these changes would have a large positive effect on employees and business outcomes. But first, let’s examine in depth the distortions that the financial accounting system produces.

Employees Aren’t Treated as Assets

In the United States public companies are required to report their financials using standards based on generally accepted accounting principles (GAAP) established by the Financial Accounting Standards Board. Those accounting rules say that items with value are assets—but only if they’re owned by the company. On that basis, employees are not considered assets—even though the tenure of a valuable employee is often far longer than the life of any piece of capital equipment. Even when a company buys other businesses to get access to their skilled employees, the acquisition of talent cannot be treated as an investment.

Meanwhile, GAAP rules allow a firm to count purchased software or equipment as an asset that can offset liabilities. They also permit a firm to depreciate the value of that purchase over its useful life. Depreciation forces managers to remember that assets wear out and that they have to budget for their replacement.

But what happens with acquisitions of employees? Suppose a company pays a lot of money—for signing bonuses and so forth—to bring in a team of hot computer scientists who are central to its new strategy. Those costs are current expenses that have to be completely deducted from taxable income the year they’re hired, even though the business’s managers don’t expect to start getting value from them for at least another year or so. That may cause the firm to take a big hit to its income that year, and if it doesn’t have enough to cover the expense, the overall operation will appear to be losing money, a huge red flag for investors. This is the case even if employees are essentially locked in with deferred payments, noncompete agreements, and other contracts.

A company also cannot claim to have made an “investment” in current employees on its books, because the accounting rules say it can’t invest in something it doesn’t own. Consider a firm that decides to send an employee to an expensive computer-programming course. It makes that investment because it believes the employee will be valuable for some time thereafter. But the financial accounting rules stipulate that the cost of such training is an expense that needs to be completely offset by income earned that year. This stipulation helps explain the continual decline in employee training and development, which in turn is one reason U.S. companies now fill almost 70% of their vacancies with outside hires. And the fact that companies cannot depreciate investments in human capital the way they can physical assets creates an additional problem: They have no equivalent way to plan and budget for the replacement of critical talent.

Another way financial accounting rules screw up training and employee development is by aggregating outlays on them with other costs in the very broad “general and administrative” category. Are you spending a lot on training employees—or on carpet? An interested investor will not know and can’t find out.

Some may argue that it’s sensible not to treat employment expenses as investments, because employees can walk away. But that reasoning overlooks the restrictive covenants companies have been piling on employees—the noncompete agreements, vesting periods on stock options, and even requirements that they refund employers for their training and education should they leave the organization. The irony is that, unlike capital assets that steadily and predictably erode, employees actually become more valuable over time simply through “learning by doing,” which costs nothing.

Benefits Are Seen as Liabilities

Many employee benefits—including vacation time, sick leave, and health care coverage—are accrued or earned by the workers and owed to them in the future. Under GAAP, those benefits show up on the liability side of the balance sheet as obligations that must be offset by current assets. From an accounting perspective they’re an even bigger burden than simple expenses are.

The enormous move away from pensions, or defined-benefit plans, to defined-contribution plans, such as 401(k)s, was in all likelihood largely driven by this financial quirk. Pensions are future obligations and are a guarantee to employees. The standard view in economics was that it was valuable for employees to have that guarantee and much easier for a large company than for an individual employee to manage any investment risk. In fact, a series of studies show that, on a per dollar basis, pensions, which had strong investment returns before the pandemic, would have been cheaper for employers in recent years than the equivalent defined-contribution plans.

But pensions are also treated as liabilities, and sometimes are the biggest ones companies have. Need to improve the appearance of your financial position quickly? Drop pensions and move to defined-contribution retirement plans. A big liability goes away, and the company instantly becomes more valuable.

The new “unlimited vacation” craze in Silicon Valley and among start-ups has a similar origin. In most organizations employees accrue or earn vacation days in line with their service, and the company owes that paid time off to them, which is a liability on the company books. By moving from an explicit commitment to a vague promise of unlimited time off, the firm removes the liability and immediately looks more valuable. This also helps explain why a growing number of companies are granting employees unlimited sick leave; that too helps them avoid an accrued liability.

GAAP Rules Are Fueling a Shift to Nonemployees

Arguably, a number of rules have been prompting a major effort by companies to move work to nonemployees. One involves treating wages and salaries as fixed costs. Such costs are a big worry for investors because if business and revenue decline and those costs can’t be cut, the profitability and value of the business collapse in a hurry.

Why wages and salaries are ever considered fixed costs in the United States is a puzzle given that virtually all employment there is “at will,” which allows companies to end it unilaterally for any business-related reason. Employers don’t seem to have much difficulty laying off people if it improves financial performance and indeed seem to be cheered along by investors when they do so.

In addition, GAAP rules require companies to report their number of employees but not their total number of workers. Because several key performance measures are generated on a per employee basis—revenue and profit per employee being the most popular—a company that has moved jobs to nonemployees, reducing its head count, instantly looks more successful.

A final reason that companies have been increasingly using nonemployees has to do with the costs that go into producing whatever is sold—the cost of goods sold. These are called “above the line” costs, and they have a huge effect on perhaps the most important measure of profitability: gross profit margins. Other costs—those that are “below the line”—do not. A company that can move costs from above the line to below it will improve its gross profit margins. Work done under contract by nonemployees that is below the line also looks more like a nonrecurring expense—which is a variable cost, not a fixed cost—than employment does. And a company that pays for leased employee contracts in advance can even include some of that cost in the assets on its balance sheet.

The most common way large organizations shift work to nonemployees is not with independent contractors, known as gig workers, because businesses need stability and predictability in most of their activities. It’s with the regular employees of vendors who work for clients at the clients’ locations—“leased employees” who do the jobs that employees routinely would do. Direct numbers on the size of this workforce are hard to obtain, but some surveys indicate as much as 30% of the total amount spent on workers by corporations goes to nonemployees, and much of that goes to leased employees.

This helps explain why corporate budgets for leased workers are so large. My colleague Matthew Bidwell’s study of one company’s decisions about whether to have vendors or the company’s own employees perform IT work found that managers had quotas for the amount of work that had to be awarded to vendors in given projects. That decision was not driven by local business needs. Remarkably, managers were allowed more slack in achieving cost targets when they used vendors than when they used employees. As one manager noted, the buckets for costs were not the same, and the process and the bureaucracy involved in getting approval for a vendor were far less onerous than those for bringing on an employee.

Another fairly common corporate practice is outsourcing administrative tasks related to employment, like hiring, to avoid needing in-house staff to handle them. The size of the industry that provides outsourced HR services is now well over $500 billion. Some companies are also reducing internal HR payrolls by replacing people with software. HR executives often say that it’s much easier to get money for an IT solution than it is to get the equivalent amount of money for personnel. But there are also questions about whether HR software really is as good as the professionals it replaces. A 2020 PwC survey found that C-suite executives, who tend to focus on priorities dictated by financial accounting, were 270% more likely to believe HR technology cuts costs than the line managers who actually used the software were.

There’s strong evidence that these approaches have serious downsides. Research, including my own, has found that using temporary and leased employees hurts productivity and that such workers are less knowledgeable and less committed than regular employees are, make more demands on management, create coordination challenges with regular employees, and irritate regular employees, who worry about their own status and jobs and become less engaged. The fact that corporations need to create their own “vendor management” departments just to handle all those outsourcing contracts also suggests that dealing with vendors is neither simple nor cheap.

The rationale for contracting someone else’s employees is not increased efficiency; it is exploiting GAAP rules to make your company appear more valuable to investors.

It’s Hard to Get Approval for Employment

The squeeze is on to further cut the remaining jobs done by employees. In addition to setting dollar budgets for business units, many companies now set head count limits too. Operating managers often have part of their bonuses tied to their success in keeping their unit’s head count below the ceiling.

It’s easy to see how all this causes companies to be penny-wise and pound-foolish. One of the clearest examples is the brick-and-mortar retail industry, which historically has viewed labor as expendable and cut staffing and training budgets as it struggled to compete against online rivals. Research conducted by Marshall Fisher and his colleagues at the Wharton School, however, found that this run-lean strategy often backfires because having more and better-trained personnel would boost sales and operating profits at many stores. (See “Retailers Are Squandering Their Most Potent Weapons,” HBR, January–February 2019.)

Another example is the airline industry. During the pandemic, the government gave airlines substantial subsidies to keep employees on their payrolls. Yet in 2021 airline leaders told Wall Street analysts that they were intentionally bringing back fewer workers than they’d had before the pandemic so that they could run even leaner, according to Peter Coy of the New York Times. The result was a staffing shortage during the holiday season, when demand for travel predictably surged. Flights had to be canceled, and the airlines lost business. Economywide, the difficulty that so many companies have had with unfilled jobs since the spring of 2021, when Covid restrictions began to lift, can be traced at least in part to delays in hiring. A lack of personnel has caused those companies to lose business too. This isn’t surprising, given that evidence shows that companies that cut sooner and deeper in downturns struggle to get going when business returns and, as result, perform worse financially than their peers do. The productivity lag that the United States experienced during the 2010s has been attributed to the fact that employers cut their staffs too hard and too deep during the Great Recession, hampering their ability to rebound with the economy.

This misguided focus on minimizing head count is another reason HR staffs have been slashed. The ratio of HR staff to employees has fallen from one to 100 in 1980 to one to 150 now. The idea of eliminating employees like recruiters, who might be paid $75,000 a year, and adding their tasks to the plate of line managers, who are probably paid at least twice that, flies in the face of most cost-minimization strategies.

What Can Be Done?

The current treatment of human capital in financial accounting has no real defenders. Investor groups, believing that it leads to a lack of information that makes it more difficult for them to estimate the true value of companies, have led the drive for change. They have pushed companies, including those they hold significant ownership stakes in, to report more HR data—but so far with little success. It’s not that businesses like the current practice, but they have a knee-jerk reaction against any additional reporting, largely because it increases the amount of work they have to do.

In 2020 the U.S. Securities and Exchange Commission, which oversees financial accounting in the United States and empowers the Financial Accounting Standards Board, responded to investor groups’ complaints by requiring that companies report on aspects of human capital that are material to understanding their businesses. But instead of stipulating what information companies had to report, the SEC gave each the power to decide what to disclose. The results so far have been discouraging: Seventy percent of companies reported hardly any metrics and seemed mainly to express platitudes about their commitments to diversity and inclusion or other socially desirable outcomes. Giving that much discretion to companies defeats a central purpose of accounting: to present information in standard ways to allow comparisons.

What should be done? Businesses have every incentive to report more information about their spending on training and other things that almost everyone but financial accountants would call investments. If investors could see that a lot of “administrative expenses” were actually being used to improve employees’ ability to do their jobs, companies would look more valuable to them. The knock-on effect would push companies away from the imprudent and counterproductive practices the current accounting approach encourages.

Companies that see human capital as a source of competitive advantage could also require their vendors to report on measures that indicate bad practices, such as turnover costs, and good ones, such as training investments. That information helps customers assess what vendors can actually do: Is the promise of reliability from a vendor credible if half its employees quit every year?

For its part, the investment community needs to keep pressuring the SEC for change. It can point out that the new reporting requirements have had little effect and that there is an alternative model: the International Financial Reporting Standards (IFRS) used by companies outside the United States. Under those global accounting practices, companies can report more of the asset value of human capital. Arguably the best examples have been in valuing football (soccer) teams, whose assets are virtually all in players. IFRS practices allow their human assets to be amortized and the teams to be revalued when players are traded, released, and so forth.

What ultimately should we want the SEC to make companies report? A few simple measures would go a long way. The first is simply to break out cost categories that are already reported:

• How much are companies spending on workers other than their own employees? We have no sense of how efficient operations are when labor costs such as leased workers are hidden.
• How much is spent on training and other development efforts?
• What is the employee turnover rate, which measures the human capital going out the door? How much of that is due to quitting? That information, along with the total number of employees, which companies already report, will allow us to estimate the number of dismissals—a true sign of management problems.
• What percentage of vacancies are filled from within? That reveals the extent to which a company is growing its own talent or having to buy it from outside. This data is already collected by many companies’ applicant-tracking software (as is turnover data).

. . .

Financial accounting is the scorecard that tells companies how well they’re doing. The fact that it provides such a misleading view of human capital is a huge problem. While investor concerns about not being able to value companies accurately have gotten some attention, it’s a much smaller problem than the systematic distortions that hurt operating efficiency and have largely gone unnoticed. Not all the problems of the financial accounting for human capital can be addressed by the simple changes described here, but it’s hard to think of many other important issues where small changes could make as much difference.