Financial accounting undervalues people, and that’s bad for business
Financial accounting can tell us a lot about the state of a business. It’s how public companies keep investors informed, and in the U.S. it’s a requirement of generally accepted accounting principles. Public companies have no choice but to do it. This emphasis on financial accounting leads to practices that don’t make a lot of sense and are actually detrimental to businesses and stakeholders. That’s because it fails to account for some of the biggest drivers of value: good employees.
“Financial accounting can’t treat human capital sensibly, at least in the U.S.,” Peter Cappelli, the George W. Taylor Professor of Management at The Wharton School, said. “Financial accounting says unless you own something, it can’t be an asset, and unless you own people, then they can’t be assets for you. And as a result, if you’ve got a company whose value is largely human capital, in financial accounting, it looks like nothing.”
Cappelli, the author of “Our Least Important Asset: Why the Relentless Focus on Finance and Accounting is Bad for Business and Employees,” spoke with BOSS about how it’s made the modern workplace worse and what can be done to turn things around.
‘A Dollar Is Not A Dollar’
Although it’s economically efficient to spend more money on employees than most companies do, financial accounting discourages it. It measures financial performance on a per-employee basis, so companies are rewarded for having fewer employees.
“A dollar is not a dollar under financial accounting,” Cappelli said. “It depends on where that dollar is spent.
“A dollar that is spent more efficiently will create value for the company. But if you’re an investor, you can’t even observe how these dollars are spent. So companies play to what an investor can see rather than what is economically efficient.”
Spending money on management training, for example, would pay off for companies in the long run because they’d be better run. But under the rules of financial accounting, that training doesn’t count as investment because people don’t count as assets. As a result, companies focus on cost per hire, not whether they’re hiring good people who might cost more up front but deliver more return. It’s penny-wise and pound-foolish, Cappelli says.
It’s one reason large companies are quick to initiate layoffs at the first sign of a downturn. If things are going to get bad, they don’t want to have a lot of liabilities on the books. Research shows, though, that the longer a company can hold off on layoffs during a downturn, the better it is for shareholder value.
“The companies that delay layoffs or avoid them altogether, when the upturn comes, they’re off and running,” Cappelli said.
Meanwhile, CFOs at companies that laid off workers then want to wait until the recovery is in full swing before hiring and adding more employment expenses. By then, they’re late to the game and competing against other scrambling companies.
“That’s what we saw in 2021, when the (Covid) restrictions started to be lifted and then everybody waited until the business was already back. They were all trying to hire the same people at the same time, and they couldn’t do it. Then we were making up all these stories about how workers don’t want to work and all that stuff, and that wasn’t what was happening.”
Financial accounting stacks the deck against human capital, Cappelli says. It’s led to an overemphasis on “optimization,” where optimization simply means using as little labor as possible. Since the corporate world has largely given up on management training programs, companies have people who are great producers but lack interpersonal skills in management positions. Managing people is an entirely different skill, one that is infrequently taught these days.
“There’s some nice studies showing that if you promote individual contributors to management roles, everything is worse,” Cappelli said. “The people they manage perform worse. The teams perform worse. The organizations perform worse, and it’s not surprising if you think about it. Would you like to have Michael Jordan as a coach? Probably not.”
In another example of financial accounting making organizations penny-wise and pound-foolish, they’ve cut budgets for recruiters who were relatively inexpensive and shifted hiring responsibilities onto line managers. Those managers already have full plates, and because they make considerably more than recruiters, their time is much more valuable to the organization. When they’re spending precious hours performing tasks like determining prerequisites for a job, that’s time and money wasted.
“This is kind of a reverse inefficiency to do it that way,” Cappelli said.
It might look efficient on paper, but it’s not in reality.
While the recent emphasis on employee benefits like mental healthcare is a welcome improvement, employee benefits have largely gotten worse the last few decades. Any accrued benefits (such as PTO, pensions, or tuition reimbursement) are seen as liabilities under financial accounting.
“That’s like the worst cause, because they have to be offset by assets,” Cappelli said. “If that doesn’t happen, then it looks like you’re insolvent. For a lot of companies, their pensions were their biggest liability, and that was really unfortunate because pensions were super smart thing even for employers because people will pay a price for certainty.”
Similarly, companies have largely cut tuition reimbursement programs. The thinking used to be that helping an employee earn a college degree would make that employee more valuable to the company. Under financial accounting it’s a line item that can be cut, and employers think that people would just quit once they’ve secured their degrees. But considering how long it takes people who are also working full-time to finish a degree, employers should look at tuition reimbursement as an effective retention policy.
“The average tenure is four years now in the U.S. If you could keep them for six years, you start cutting your turnover by 50%. That’s hugely valuable. I think one of the problems for employers is that they don’t really know what their cost to turnover is because they haven’t tried to calculate it. So if you ask somebody, they’ll say, “Well, the figure we hear is $4,000.’ That figure is only the administrative cost of bringing a new person on. It’s not the cost of lost productivity. It’s not the cost of lost knowledge. It’s not the cost of compensation.”
If a CFO who thinks the cost of turnover is $4,000 calculates all that and discovers it’s really 2.5 times the annual salary of the person leaving, the approach to benefits like tuition reimbursement and executive MBA programs might change. Retaining good employees, training them for management, and promoting them from within the company can pay huge dividends. Wharton research shows that external hires cost 18-20% more and take years to get up to speed compared to the promoted from within.
“Doing more of that has completely obvious benefits,” Cappelli said.
It just makes financial sense.