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The problem with financial accounting—and how it’s holding talent management back

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Peter Cappelli
Peter Cappelli is HRE’s Talent Management columnist and a fellow of the National Academy of Human Resources. He is the George W. Taylor Professor of Management and director of the Center for Human Resources at The Wharton School of the University of Pennsylvania in Philadelphia. He can be emailed at [email protected]

Those readers who have been around the block a few times are all familiar with the ill-fated result of most talent management initiatives: When it comes to money, no one at the top wants to authorize spending it, and the best way to advance one’s career is to do the opposite—instead of spending, find ways to cut employment costs, especially by reducing headcount.

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When we get to the day-to-day operations, we find workplace practices that seem to be self-defeating: We leave openings unfilled despite the fact that the work of the organization does not get done; we skimp on training, knowing that it means we will be forced to go outside to hire more expensive candidates; we skimp on practices that drive up turnover, ignoring those costs; we fill jobs with leased employees who are difficult to manage and integrate and who are—especially with the administrative fees—at least as expensive as regular employees.

The explanation we fall back on for this “pennywise and pound foolish” behavior is that the finance people are in charge, they want to squeeze costs down to maximize profits, and they just don’t understand that these practices are actually raising costs elsewhere.

Having seen this behavior for decades, and also hearing that explanation, it just did not sound right to me. So, I thought it would be useful to dig a little deeper to understand why the seeming payoff of good employee management practices like training just does not seem to matter to the way businesses operate.

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The answer lies in how the game of business is played. We have been conditioned by generations of economics classes to think that the goal of business is simple: Maximize profit. And that doing so is also simple: Take in more money than you spend. But that is manifestly not the case. The rules that determine how business is played and what constitutes success are far more complicated and are set by financial accounting, where a dollar of cost is treated quite differently depending on how it was spent.

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In particular, there is no acknowledgment of human capital: To be an asset, something must be owned by the business. Employees cannot be owned, so they cannot be assets. It is only possible to invest in assets, so it is not possible to “invest” in employees. Money spent doing so on training and development is simply an expense. In the categories of financial accounting, which is what investors see, development investment is lumped in with other administrative expenses—along with things like spending on coffee.

Overall, employment costs are seen by investors as the worst kind of expenses, in part because—despite the ease of layoffs—they are still seen as “fixed costs” that cannot be cut in downturns. Of those employment costs, the absolute worst are benefits that will be paid in the future like paid vacations, as they create liabilities that must be offset with assets. The financial benefits of good management, such as reduced turnover, show up nowhere in the financial accounts.

Yes, but won’t more efficient businesses ultimately be worth more, assuming other things are equal? Other things are never equal, and unless the information is clear and available to investors, the market cannot take that into account. As an example of the disconnect between share prices and operations, witness the highest-flying share prices at companies like Tesla and Amazon when their businesses had yet to even turn an operating profit.

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It may well be the case that our CFOs simply don’t understand that good employee management practices end up costing less, but that is not the root of the problem. The rules of financial accounting make the costs of employee management the worst costs, and they hide the benefits of good management. The job of CFOs in public companies is to play to the investors, which means follow the incentives that financial accounting creates.

OK, what do we do about this? The good news is that big investors—who one would think have the most clout with business—have been arguing that we need better accounting standards to see what is really going on in human resources. Can we see how much is spent on training, for example? That would reduce at least some of the self-defeating nature of current practices. Companies have resisted calls from their investors to report anything voluntarily, but there is new and growing pressure on the Securities and Exchange Commission to require reporting. I’ve laid this story out in more detail in the most recent Harvard Business Review. Surprisingly, human resources and investors are on the same side.