6.1 Introduction

Management practices have undergone many innovations. Companies have been downsized, delayered, and hollowed out. Newly trained and empowered employees have implemented many innovative practices including continuous improvement, reengineering, just-in-time manufacturing, and total quality management ^[1]. Many of these innovations have fundamentally changed the relationship between the organization and its employees, customers, suppliers, and other stakeholders ^[1]. In many instances, arms-length transactions between independent parties have been replaced by long-term partnerships in which intangibles such as service, innovation, and flexibility are essential to success. Intangible and difficult-to-measure resources are driving the creation of wealth in many companies ^[1]. That is the reason why many authors have been advocating that organizations increasingly rely on intangible assets for competitive advantage. Human capital is an ever more important intangible asset because it is the basis for the development of all the other intangibles. Yet, managing this intangible, when financial accounting sees it as an expense in the income statement, remains a challenge.

It was a challenge back in the 1970s when the problem was first identified. But almost fifty years later we are not even close to solving the problem. Human capital, intellectual capital, knowledge management, and innovation management are several terms to identify mainly the same concept whilst tackling the problems of being valued, measured and also reported. As Flamholtz, Bullen and Hua ^[2] stated, most of the relatively easy preliminary research is accomplished, that is the identification of the problem and development of cost and value models to measure human capital. However, the remaining research required to develop this field of study is complex, there are not many scholars interested in performing this work, and it requires the cooperation of organizations willing to serve as research sites for applied research studies ^[2]. Moreover, we believe that this field of research needs contributions from several disciplines to develop and achieve the expected results.

Surprisingly, or maybe not, there are still calls for the need to measure human capital in order to manage it, since this capital is crucial in today’s developed societies. Case studies and cross-sectional analyses have provided evidence that intangibles are the fundamental source of competitive advantage for business companies in most industrial sectors. Therefore, the successful management of companies requires that intangibles must be identified, measured and controlled ^[3] because companies based on material assets are no longer able to achieve further economies of scale, and they are unable to gain competitive advantage with tangible assets alone ^[3]. Innovation is one possible approach to developing competitive advantage and human capital isis inherent to the innovation process.

Human capital pertains to knowledge resources such as innovation, education, training, learning and development, employee demographics, industrial relations, compensation and remuneration, career planning and development, senior executive performance and results, involvement in the community, knowledge identification, sharing and retention of work-related qualifications ^[4]. People own human capital. People are part of the intellectual capital. People are responsible for maintaining and growing intellectual assets. Their unique contribution comprises their command of information and previous experience, their ability to integrate and use judgment, toto be innovative and intuitive, and to develop and use human relationships. This contribution is knowledge, and it is seen as a continual creation in which its flow around the organization is seen as the vital dynamic of progress ^[5].

The constant generation of new knowledge and experience, and its availability for the benefit of all who can use it effectively, are fundamental issues ^[5]. Arguably, the most important of all business processes are those designed to accomplish these tasks, and the role of employee development takes on a specifically strategic mantle as a primary means of achieving the goals ^[5]. When senior management describes ‘people’ as a strategic asset, they describe employee performance and behaviors that help execute the company’s strategy. But just as organizational performance is a function of people and systems, the appropriate human resource system is required to select, develop and reward employees in ways that produce strategic behaviors ^[6].

Although measuring human resources/human capital is a challenge to accountants, from the human resource management (HRM) perspective it is also rather important because measuring human resources’ performance is an increasingly important concern for human resource professionals, senior managements and CEOs. The challenge here is to answer the CEO or senior management team when they ask the human resource function to justify its contribution to the organization ^[6]. Therefore, some authors argue that managing the human resource function efficiently is important. However, they warn that focusing on cost reduction as the primary measure of human resource’s performance will ultimately result in human resources being managed like a commodity, rather than a strategic asset ^[6]. The human resource function contributes to company performance by driving human capital to activities that, due to strategic positioning, means performing different activities from rivals or performing similar activities in different ways ^[6].

Since the 1970s, human capital accounting (HCA) has been promising its contribution to management, namely from a management control point of view. Most managers hold very positive attitudes towards HCA, but the integration of HCA in the management control process has never really been attained. In this chapter, the role played by HCA within organizational performance is thoroughly discussed in several areas of study.

This chapter is structured in the following manner. First we present and discuss HCA from the accounting literature point of view. Then, we present and discuss the call for developing HCA by the strategic and measurement branch of human resources management (HRM) literature, followed by the implications of HCA for the emergence of the intellectual capital field. Stakeholders want to know how human capital is managed and to what extent human capital management practices are successful. Therefore, we present the reporting problem associated with HCA and the challenges that assist the development of this field of research. We end by drawing conclusions on the state of the art of HCA.

6.2 The Evolution of Human Capital Accounting

We need to go back to the 1960s and 70s to fully understand the emergence of human capital accounting. The designation of this field of study has also evolved over time. In the 60s and 70s, the field was identified as human resource costing and accounting (HRCA). With the emergence of intellectual capital literature and the balanced scorecard, some authors named it human capital accounting (HCA). Today, there are also authors who designate this field as intellectual capital accounting, due to the fact that human capital is a component of intellectual capital. In this chapter we use these designations indiscriminately because they all embrace the human capital concept, and they address the tracking, measuring and controlling of this capital. In sum, these different designations represent the evolution of thought which has occurred in the management and accounting sciences.

Brummet, Flamholtz and Pyle’s paper ^[7] is one of the first works in the area of HCA. They addressed the issue of how to put people in the balance sheet. They noticed what managers were saying, and are still saying today, in corporate annual reports: “our employees are our most important – and most valuable – asset”. However, if we look closer into the remainder of the corporate annual report, we might ask what information we can get from this ‘asset’ – “where is this human asset on these statements which serves as reports on the company’s resources and earnings? What is the value of this ‘most important’ or ‘most valuable’ asset? Is it increasing, decreasing, or remaining unchanged? What return, if any, is the firm earning on its human assets? Is the firm allocating its human assets in the most profitable way?” ^[7]. The information was (and in general still is) absent from the corporate annual report.

At this stage, several cost and value-based models were developed. For example, Hekimian and Jones ^[8] proposed the concepts of original cost, reposition cost and opportunity cost related to human resources; Brummet, Flamholtz and Pyle ^[7] proposed a human resources accounting system for investments in managers; Hermanson ^[9] proposed two methods for valuing human resources in the balance sheet, using discounted earnings and wages approaches (the unpurchased goodwill method and the adjusted-present value method); Flamholtz is the most preeminent author in the field and proposed several models, namely the model for measuring human resource positional replacement cost, and the model of the determinants of an individual’s value to a formal organization ^[10]; and, Lev and Schwartz ^[11] and Friedman and Lev ^[12] proposed models to value human resources using economic theory (discounted wage flows).

This initial stage of evolution of this field of research is not free of criticism. In fact, putting people on the balance sheet was heavily criticized because human resources (HR) are not a commodity. Although several HCA cost and value-based models have been developed to tackle these issues, there are some flaws: lack of reliability due to subjectivity and considerable use of estimates are inherent to those models; the company does not actually own human assets because human capital is owned by the HR (people) and, therefore, it is not a commodity; and there is always the risk of employee turnover, that is, the owner of human capital leaves the company. Consequently, normative accounting theory has not been sensitive in considering human capital as an asset, since the international accounting standard of intangibles (IAS 38) does not recognize human capital as an intangible asset. This absence raises another problem. When information on human capital is not mandatory, it is not possible to compare the use and value of this capital across companies. What can we conclude on firms’ human capital management performance? It depends on the management narrative, whenever it exists.

However, human capital is not totally absent from the financial statements. It is considered as an expense in the Income Statement. And this has not changed, yet. It has a pernicious effect on the management-making decision process because it is a cost to be set against revenue. In this light profit can be increased by reducing human capital cost. Therefore, from an agency theory perspective, management holds an incentive to make people work harder for the same payment ^[13], or worse. This has been the management’s argument to move industries to ‘low cost’ economies. Similarly, in the management accounting literature, investments in people such as training, upgrading skills, funding educational courses or redeployment expenses are designated discretionary costs. These are invariably represented as being amongst the most susceptible to reduction in times of declining financial fortunes ^[13], thus compromising not only the human resources short and long-term interests but also the company’s interests in building knowledge stocks capable of providing innovation.

The first stage of the field’s evolution had few important implications for external financial reporting. It led to a second stage characterized by a decrease of interest in the field. However, in the 1990s, the increasing importance of concepts such as intellectual capital and intangibles has renewed international interest in HCA theory and practice. The gradual yet fundamental transformation that most of the world’s advanced economies made in shifting from industrial economies in which plant and equipment are the core assets, to post-industrial economies in which human capital, knowledge and intellectual property are the core assets, has stimulated interest in the contribution of HCA ^[2]. The potential success of an organization now lies upon its intellectual capabilities rather than upon its physical assets. Accordingly, organizations must pay attention to the development and deployment of intellectual capital, which includes human capital [2, 5]. The emergence of technology companies has put HCA in the spotlight, because these companies rely more heavily on their human resources /capital than industrial companies [2, 14]. Unfortunately, the accounting discipline has not yet responded to this change, and therefore the critics say that it is likely that investors are paying a price due to lack of information about managerial and human capital ^[2], in the sense that there are several empirical research studies which determined that HCA has an impact on decision making. For example, Elias’ ^[15] experiment found that external user’s decisions on investments in common stock were made differently when resorting to the use of HRCA information. Following this author, Hendricks ^[16] found that stock investment decisions were significantly affected by additional HRCA information. Schawn ^[17] further extended Elias’ and Hendricks’ studies by examining the effects of HRCA information on financial decisions in comparison to decisions based on conventional financial information. Results showed that companies using HRCA information were considered better prepared and the inclusion of human resource accounting information resulted in statistically significantly better predictions of companies’ net income ^[2]. More recently, Hansson ^[18] and Moreno-Campos ^[19] reached the same conclusions.

As a result, the measurement tools available cause anomalies, because they are based mostly on costs. But organizations now need systems that continually assess and reassess the people they employ, including their skills, talents and behavioral attributes, while paying attention to how human resources impact the bottom line. HCA is an accounting tool that is relevant to the measurement and, in turn, to the management of intellectual capital and innovation, specifically human capital ^[2].

HCA has even greater importance as a powerful managerial tool in internal HRM decisions ^[2]. Flamholtz contributed to the HCA literature with several models, thereby incorporating the monetary and behavioral emphases of human resources valuation. He introduced an alternative perspective on accounting for people. His objective was to demonstrate the value of human resources to businesses (through the model of the determinants of an individual’s value to a formal organization) rather than their valuation per se ^[13]. Once the value of people was appraised, Flamholtz believed that senior management could be persuaded to make better use of their human capital. He also believed that it was possible to develop better accounting practices that would serve the interests of all stakeholders ^[13]. According to Roslender and Stevenson ^[13], he faced two difficulties, however. First, at his time any development in management accounting practices was under the influence of the financial accounting principles and reporting. As a consequence, any new approach to accounting for people was destined to be linked to the prevailing thinking of “putting people on the balance sheet”. Secondly, and most importantly, in the 1970s “very few within the realms of senior management were persuaded of the necessity to contemplate whether ‘our people are our greatest asset’” ^[13]. Although Flamholtz ^[10] argued that it was more appropriate to embed accounting for people within the traditions of managerial accounting rather than financial accounting and reporting, he hoped the intellectual capital movement would lead to changes in financial accounting and reporting.

Flamholtz ^[10] has identified three objectives for HCA: to develop methods for measuring human resource cost and value in order to provide a quantitative basis for decision making by managers and investors; to develop methods of measuring human resource cost and value necessary to monitor the effectiveness of management’s utilization of human resources; and to develop a theory explaining the nature and determinants of the value of people to formal organizations. This last objective is more critical – people are a scarce resource that managers must manage as efficiently and effectively as possible in order to ensure that it delivers the greatest benefits to the company ^[3].

Many stakeholders, even those outside Sweden where HCA was more flourishing, agree on the need for a better transparency of investments in human capital. According to Johanson ^[20], the Organisation for Economic Cooperation and Development (OECD) position was that improvement on the information and decision making systems that shape human capital acquisition and utilization was a key factor in helping a nation’s companies to be competitive with others. The implication is that human capital measurement and accounting for human resources have to be further improved ^[20]. The topic of HCA was also introduced by the European Commission at the end of 1995 in a white paper on education and learning. The intention of the Commission was to prepare guidelines for action to promote teaching and learning in the member states. One of five general objectives of this work was to “treat capital investment and investment in training on an equal basis” ^[20].

In sum, despite the pronounced interest in HRCA in Sweden, Turner cited by Johanson ^[20] remarked that human resource accounting “has progressed at something less than a snail’s pace”, and it may still be accurate to some extent. In comparison with what has been expected of HRCA, progress has moved at a dilatory pace ^[20]. Why? We present some evidence in the following sections that might explain this situation.

6.3 Call for HCA from Human Resources Management Literature

“How much does human resource management matter?” continues to be an important question for both practitioners and academic researchers in the HRM field. One of the most effective arguments demonstrating the importance of human resource decisions lies in demonstrating their empirical relationships with valued company outcomes, particularly financial performance. Although both practitioners and researchers have reported substantial money value benefits associated with the use of certain human resources practices, the task of ensuring the validity of these substantive estimates rests most heavily with researchers ^[21].

According to Becker and Huselid ^[6], a common source of human resources’ measurement problem is that human resources largely represent a cost to be minimized (due to financial accounting that induces this behavior), to adopt performance measures that are limited by efficiency goals. In the absence of a business case for human resources’ strategic impact, human resources managers are trapped ^[6]. In this case, human resources responded by significantly improving its performance on efficiency measures. However, the consequences for the company’s performance may not be anticipated or even acceptable, because the ‘commoditization’ of human resources lead to a losing proposition between accessibility and appropriateness ^[6]. According to Becker and Huselid, by executing business strategy, human resources share the responsibility for business problems with all managers. Measuring human resources’ strategic performance is not about doing the same things human resources professional have always done. It is about developing new measures based on the unique demands of the company’s strategy ^[6].

Many authors from the HRM field, namely Gerhart, Wright and McMahan ^[22], Huselid and Becker [6, 21], and Huselid, Becker and Ulrich ^[23] argue that a company’s human resources (people) constitute a potential source of major sustained competitive advantage, and it is through human resources practices that companies can leverage the value of people in ways that result in positive performance outcomes. Therefore, management needs to develop an information system that allows them to monitor and link human resources policies to organizational performance. However, most companies use formal performance measurement systems that are extensions of their financial reporting systems ^[1]. They justify this practice because the financial reporting system provides measures that, on one hand, are generally regarded as reliable and consistent, thereby giving a solid foundation for developing reward and accountability structures; and, on the other hand, it engages with the primary objective of creating profits for owners, thereby giving a performance measurement focus consistent with organizational objectives ^[1]. However, criticisms of conventional performance measurement systems have been increasing.

Critics argue that financial performance measures lack the requisite variety to give decision makers the range of information they need to manage processes ^[1], because a critical question is to know whether a company’s human capital is growing or not, and to have a more internal and detailed track of this than merely watching how the market values the company’s intellectual capital. However, financial accounting does not give an answer to this since the accounting standard does not recognize all the intellectual assets as intangibles assets. Nevertheless, it is a fact of organizational life that “numbers speak louder than words” ^[5], and as some CEOs say, if it can be visualized it can be measured and if it can be measured it can be managed. Quantification is what is important ^[5]. Replacement costs of knowledge, systems or people can be calculated ^[5]. Levels of competence and expertise can be tracked ^[4]. Calculate financial effects of poor intellectual capital management – for example, the loss of key people, repeated mistakes due to lack of knowledge transfer, lost revenues due to inadequate capability, and so on – can be computed. However, these are outputs. We more commonly track inputs – ratios of investment in training, research and development, information technologies – but such measures alone give us no clues as to how effectively such investments are being used. The convinced proponent of the principles of intellectual capital will always be in a disadvantaged position compared to the financial community, without a set of credible measures for those components that are strategically important ^[4].

HCA has been developed in three main branches: as a valuation/measurement of human capital (providing numerical information about the cost and value of people as organizational resources); serving as an analytical framework to facilitate decision making; and, as motivating decision makers to adopt a human resource perspective ^[2].

One role of HCA measurement is to provide numerical information as an input to management and financial decisions. But another and even more important role comes from the measurement process, from the act of monitoring and quantifying the costs and value of people from a human resource perspective ^[2]. From a managerial perspective, the process of measuring, as well as the measurements themselves, send the message that people are valuable organizational resources and should therefore be managed as such. In the past, the impact of managing layoffs and downsizing could be better planned and monitored if costs involving these operations were tracked and followed in order to be controlled, namely by identifying and predicting the hidden costs associated with these events (e.g. in the layoff situation, the costs associated with rehiring qualified human resources, and the hidden costs associated with impacts on the morale and productivity, and the retention of the people that were not laid off). Nowadays, the focus goes to managing innovation, through a better management of organizational knowledge. HCA technology allows the analysis of the effects of such decisions and a better understanding of the long-term implications and hidden costs of management’s business decisions.

However, there are also other motivations for developing HCA. Corporate managers make expenditures which they justify as investments in human resources, but accounting recognizes these investments as expenditures without considering the timing of expected benefits. Therefore, HCA must develop an information system that provides information on how those investments contribute to a company’s performance. In other words, by reporting on actions taken and results achieved in relation to objectives and goals, namely bring individuals to the level of technical competence and familiarity required for a given position at the company; by identifying the competences available at the organization, and the ones identified as necessary to achieve organization’s goals; and, by making company aware of the replacement costs of individuals or functions. Flamholtz, Searfoss and Coff ^[24] report on a study taken place at the Touche Ross & Co., one of the ‘Big 8’ international CPA firms that represented the state-of-the-art of HCA at that time, where the goal of the system developed was concerned with replacement cost of the audit senior position, a key position for company’s operations. HRCA was implemented and tested because management was particularly interested in the replacement cost and how its management would enhance HRM.

However, we do not find many case studies in the literature of the practice of human resource accounting. According to Cantrell, Benton, Laudal and Thomas ^[25], many companies are concerned with recruiting and training top talent but they fail to control for their human resources investments because managers lack the tools they need to accurately measure the return on investment in human capital. Johanson ^[20] reports that all the firms he surveyed that were adopting some kind of HRCA tools or were starting to use some kind of those tools, managers produced an ‘aha’ reaction. The use of such tools made them see a clear connection between HRM and the company’s financial results.

Cantrell, Benton, Laudal and Thomas ^[25] tested a tool known as the human capital development framework over more than 60 organizations. Their empirical results suggest that financial performance improves as a company improves its scoring in the critical human capital processes with strong relationships with financial success. Lundberg and Wiklund cited by Johanson ^[20] found that 70 percent of the personnel managers in Stockholm-based companies with more than 200 employees claimed that they were applying HRCA to some extent. Most of the organizations had started to do so in the beginning of the 1990s. In an investigation conducted by the Swedish Association of Local Authorities in 1994, it was found that 22 percent of the responding 276 Swedish local authorities had decided to use an accounting approach to HRCA. Only 5–15 percent of personnel, accounting and financial managers have declared their lack of interest in HRCA ^[20]. Sweden seems to be an exception in the sense that HRCA applications are commonly applied ^[26]. In turn, a survey taken by Accenture ^[25] revealed that, in fact, many companies do not even make the attempt to measure human capital. Why do companies avoid implementing and taking advantage of having such a measurement system?

6.4 The Emergence of Intellectual Capital – New Demands Over an Old Problem

Nowadays the success of a company focuses more upon its intellectual and systems capabilities than on its physical assets. The capacity to manage human intellect, and to convert it into useful products and services, is becoming the critical executive skill of the age. As a result, there has been a flurry of interest in intellectual capital, creativity, innovation, and the learning organization ^[27].

One of the first definitions of intellectual capital is that one provided by Edvinsson and Malone ^[28]. To these authors, intellectual capital is the possession of knowledge, applied experience, organizational technology, customer relationships and professional skills that provide the company with a competitive edge in the market.

In an innovative company the professional intellect (knowledge) is crucial. The professional intellect of an organization operates on four levels ^[27]: cognitive knowledge (know-what), achieved through training and certification; advanced skills (know-how), the ability to apply the rules of a discipline to complex real-world problems is the most widespread value-creating professional skill level; systems understanding (know-why) is deep knowledge of the web of cause-and-effect relationships underlying a discipline (it permits professionals to move beyond the execution of tasks to solve larger and more complex problems); self-motivated creativity (care-why) consists of will, motivation, and adaptability for success. Highly motivated and creative groups often outperform groups with greater physical or financial resources.

HCA can contribute positively to the innovation management process. Firstly, it can identify the human capital available at the company in terms of competences and knowledge owned by the people working in the company. It can compare the stock of competences and knowledge to the company’s needs, in order to define recruitment policies to catch and/or define training programmes to develop those competences and knowledge. It can also help identify the functional positions that are most critical for organizational success. Then, it can associate the costs that underline the reposition of that human capital function, to provide financial information on how it would cost the company to substitute the human capital lost when human resource leaves. Finally, competences and function performed by people are then linked to organizational goals. People’s motivation is fundamental to outperform their tasks and goals. A survey can help the company to monitor the HR motivation level in order to not only improve the work environment but also to identify the informal processes that need to be developed to stimulate and nurture human capital’s creativity.

Nevertheless, to be successful, the company must first define its strategy and define the guide map that allows it to achieve its strategic goals. In the strategic HRM perspective, there is a call to link strategy to policies of HRM in order to potentiate the organizational performance. The HR Scorecard of Becker, Huselid, and Ulrich ^[23] is a tool that allows analysis of the impact of HRM policies upon the organizational performance, and therefore to identify what needs to be changed. This information system is available through HCA. However, organizations have made little progress in developing measures of how people (or human resources/human capital) make a strategic contribution ^[23]. But, managing intangibles assets, like human capital, demands a different accounting system because the traditional accounting system fails to track or analyze these assets. Management tends to overlook their importance and skew their decisions in favor of tangibles when they do not have available reliable figures ^[29].

Many companies had been making investment decisions in their people largely on the basis of faith rather than empirical, quantifiable data, and instead of resorting to the use of HCA information systems. But as the company moves to instill a more disciplined culture, management knows that facts supported by data would be more valuable than intuition in many instances [24, 27].

Cantrell, Benton, Laudal and Thomas ^[25] describe a case study of SAP America, a technological company, that was largely unsatisfied with many of the data-based measurement options it had tried, such as economic value-added and return on invested capital because they did not reflect the increasing importance of people assets. According to the authors, the company had also tried other metrics, people-oriented metrics such as training budget per employee, but they proved not to be helpful for making investment decisions, because these numbers did not tell anything about the effectiveness or the company’s people programs. On the other hand, survey data collected from employees was seen as helpful but limited in utility. Then, the company tested the human capital development framework ^[25].

The architecture of the framework comprises four levels. At the first level, the company assesses its human capital processes, such as competency management, rewards and recognition, career development, employee relations, performance appraisal, workplace design and planning, learning and knowledge management, human capital strategy, succession planning, recruiting, and human capital infrastructure. These are the processes that contribute to developing human capital capabilities, the second level of the framework. At this level, the company analyses its human capital capabilities, such as human capital efficiency, talent management, leadership capability, workforce performance, employee engagement, workforce adaptability, and the ability to change. Improved human capital capabilities are the support for driving improvement in key performance drivers like innovation, customer satisfaction, or quality (third level). Finally, key performance drivers are those targets that management might hope to improve financial organizational performance measured through the business results that company aims to achieve, such as total return to shareholders or revenue growth ^[25]. For each element of the first three levels of the model, it was provided with effectiveness scores on a scale of 1 (low effectiveness) through 5 (high effectiveness).

According to the authors ^[25], using the information provided in the initial assessment, SAP America had access to better information to help determine where it should focus its human capital investments in order to produce the greatest business benefits. Management based investment decisions on three criteria: the relative effectiveness of each human capital process, the presence or absence of evidence that a given process was strongly associated with financial performance, and the strategic or cultural importance of each process based on its linkage to particular key performance drivers of human capital capabilities. This framework helped SAP America to assess and visualize the importance of each element of the framework. For example, certain key performance drivers like innovation or quality could be of greater strategic importance as compared to others. Likewise, an organization’s culture may favor certain human capital capabilities over others. In general, companies will achieve the greatest benefits if they focus on developing processes that are the least mature and most related to either financial performance or the performance of an important key business driver or capability ^[25]. Cantrell, Benton, Laudal and Thomas ^[25] showed that in the case they analyzed, SAP America, the ability to deliver a steady stream of innovative new software applications to the customers and to tailor the company to their targeted market segments was vital to its strategy. Hence, management needs to be focused on those processes that can help the company to maintain its innovative capability.

In summary, Cantrell, Benton, Laudal and Thomas’ ^[25] findings suggest that organizations with more mature human capital processes have better financial performance than those organizations with less mature processes. Specifically, they found that those organizations that focus on processes devoted to three key areas – creating a people strategy aligned with the business strategy, providing supportive work environments, and developing employees by giving them ample opportunities to learn and grow (investments in human capital) – achieve far greater economic success than those that do not. Cantrell, Benton, Laudal and Thomas ^[25] found statistically significant relationships between an organization’s innovation capability and employee engagement; employee engagement in turn has statistically significant relationships with almost all the elements of the human capital processes (10 in 13). These results suggest that organizations competing on innovation will achieve better financial results by improving employee engagement through improving a broad range of human capital processes.

Other case studies and cross-sectional analyses have provided evidence that intangibles are the fundamental source of competitive advantages for business companies in most industries. Therefore, successful management requires that company’s intangibles must be identified, measured and controlled ^[3]. That is why we encourage a growing interest in the new techniques of intellectual capital accounting as a method of measuring and reporting the range of human and knowledge-based factors that create sustained economic value ^[30]. The concept of intellectual capital, however, can also be placed in the context of a more general expansion of management knowledge, which is increasingly assuming the role of a “self-sustaining and self-reinforcing system” of integrated knowledge sources ^[30].

Underpinning the current interest is the claim that knowledge-based or intellectual assets, such as human capital, increasingly provide crucial sources of economic value. A discourse is under construction that expresses a sense of urgency about adopting these new approaches, and a sense of a compelling need to manage intellectual capital for sustained value creation ^[30]. At the same time, because this kind of organizational knowledge is tacit and intuitive, controlling it is highly problematic. The resources and assets involved have long been regarded as lying outside the reach of traditional accountancy in its role of measuring and reporting business performance. Indeed, attempts to devise new ways of making ‘hidden value’ visible have met with a growing awareness that the dynamics of value creation are not being adequately represented. Such an environment of rapidly changing ideas, coupled with ambiguity and unease about established ways of operating, is precisely the kind of scenario in which new forms of management knowledge expand ^[30]. And this is an opportunity for HCA to fulfill its aims of providing information on how human capital is creating value for the organization.

6.5 Reporting on Human Capital

Studies on the usefulness of intangibles for policy-making purposes have identified a number of critical changes in our societies (such as the globalization of business activities, the intensification of competition, and the unprecedented development of information technologies) as a result of which knowledge has become the fundamental production factor. Research has demonstrated that productivity gains are mainly driven by the use of knowledge and that intangibles are the key drivers of competitiveness [3, 29]. When an company’s management is not aware of what its intangible assets are, it can miss business opportunities based on these intangible resources, because managers will be making key decisions without taking them into account among possible variables ^[3]. Thus, the move to a knowledge-based economy demands the emergence of an accurate measurement of the value of knowledge in a company: a broader asset framework. Managers must recognize that there are intellectual capital assets, such as highly skilled employees, that need to be identified and managed. There are human assets, not in the sense as normative accounting gives to the concept of ‘asset’ but management need information about top management quality, top management experience, ability to execute on strategy, leadership capabilities, problem solving ability, employees loyalty (behavioral and attitudinal), personnel reputation, workforce adaptability and employee engagement ^[29]. However, the revision of current financial accounting principles and standards would only be justified if it improves the usefulness of accounting information and leads to the overcoming of important problems facing companies and their stakeholders. Therefore, researchers have devoted effort to the identification of a number of significant damages resulting from the lack of publicly available relevant and reliable information on intangibles (e.g. ^[32]). Recent studies have shown that the lack of information on intangibles may increase uncertainty, and lead to the undervaluation of companies and the existence of greater errors in analysts’ earnings forecasts [18, 31].

The Skandia Group, an international corporation that offers insurance and financial services, has experimented HCA since its vice-president Leif Edvinsson noticed that as much a company invested in their human capital, the lowest value was presented in the financial statements, because human capital/resources are treated asas an expense in the Income Statement. Under the direction of Edvinsson, the Assurance and Finance Services Division pioneered the field of knowledge management by creating the first intellectual capital supplement to a corporate annual report in 1991 [2, 33]. Designed to reflect the value of intellectual capital within the organization, it measured the impact that human capital had on shareholder-owned structural capital, and gauged how intellectual assets had been leveraged over the preceding year. This experience has led to the Skandia Navigator concept. This concept was designed toto provide a balanced picture of the financial and intellectual capital within an organization (since it focuses on four intellectual capital areas: customer, process, human, and research and development). In addition to providing a general overview of intellectual capital, the Skandia Navigator provides a management process with which toto develop and predict the future value of this capital [2, 33].

The work at Skandia developed by Edvinsson ^[33] and of thinkers such as Sveiby ^[34] and the Roos brothers ^[35] has demonstrated the inadequacy of the traditional balance sheet to reflect the health of a company, but has also looked for alternatives. According to Mayo ^[5], the work developed by these authors is also important for those who work as professionals in HRM for several reasons. The reasons are: if taken seriously, it balances the focus of a company, between money and people, between short and long term; it provides an opportunity for HRM to be firmly linked to the bottom line and toto the agenda of top management; it helps HRM to prioritize activities according to the level of value that will be contributed to the organization.

The concern for intellectual capital is different from the balanced scorecard, according to Mayo ^[5]. Kaplan and Norton ^[36] highlighted the inadequacy of financial measures alone as indicators of performance and success. They argued that financial measures should be balanced with those relating to customers, innovation and learning, and internal efficiency. But the balance may not reflect the true strategic drivers of value (that is, creating today’s wealth but also generating the capability of tomorrow’s wealth). It is the dynamics of growth, rather than mere measurement itself, that makes a difference ^[5].

Knowledge management itself emerged a couple of years earlier than intellectual capital, but reflects the same broad changes: the rise of the knowledge economy; the role of information; and the creation and leveraging of knowledge assets ^[37]. In order to enhance knowledge management, it is important that the underlying division of managerial labor is rejected in favor of an integrated pursuit of measurement, management and reporting. Accountants are not to be concerned with only the measurement and reporting aspects, leaving their managerial colleagues the task of management itself. All three aspects should be of interest to both parties. In this way, knowledge management and intellectual capital, as contemporary management themes, are best understood as being two sides of the same coin ^[38].

The demand for better information about human capital has been evident during the 1990s. This interest has been shown by many different parties (e.g. human resource departments, financial departments, company doctors, unions and, more recently, from top management, investors and politicians) ^[20]. The disclosure of information on organizational knowledge resources and related knowledge management activities in annual reports has become a much debated issue within the intellectual capital discourse. Boedker, Guthrie and Cuganesan [4, 36] contrasted and compared the case study of organization’s internal intellectual capital management issues and practices with its external intellectual capital reporting practices. Their empirical analysis demonstrated inconsistency between those variables. It showed that strategically important information about the organization’s management challenges, knowledge resources, knowledge management activities and intellectual capital indicators were not disclosed to external stakeholders in the organization’s annual reports ^[4]. An increasing body of literature is documenting a high payoff from human capital investments. However, not all the empirical studies reveal the importance of human capital, namely the low ranking of human capital indicators. And the reasons appointed are a knowledge problem (people are not aware of the payoff of these investments, the uncertainty and the ownership problem associated with human capital issues, and the insurance that management has the capability to take action upon data) ^[39]. Moreover, even if there are human capital indicators that can be disclosed, there is the problem of reliance. Do indicators of human capital transform adequate information? Are they valid? And are the methods of measurement reliable? These issues of validity and reliability could be referred to as the uncertainty problem and they are important from the stakeholders’ point of view ^[40]. Besides, the users of that information on human capital do not know if the measures disclosed actually matter in the management control processes of the company, that is, if management takes the necessary action on data ^[40].

6.6 Human Capital Accounting as a Challenge to Both Accounting and HRM Fields

Some attempts have been made to put HCA on the political agenda.

Roslender and Stevenson ^[13] describe what happened in the UK with the Accounting for People initiative. In January 2003, the government announced the formation of a task force on human capital management, charged with considering how it might be possible to “account for people”. According to the authors, the Accounting for People initiative was seen by several people as the possibility of a real step forward in promoting the interests of employees, and therefore, human capital accounting /management. Despite its distinctly managerial discourse, the initiative acknowledged that having now recognized that “people are our greatest asset”, companies should begin to consider how to report on their human capital management activities in the annual corporate report. By doing so, they were as well as contributing toto increased transparency in financial reporting, since mandatory reporting on human capital management affords considerable support to those individuals and organizations who believe that people are now the most valuable asset available to management. However, and according to Roslender and Stevenson ^[13], after more than three and half years of consultation, debate and deliberation, no substantial evolution has been made because larger UK quoted companies continued to be charged with providing a minimal level of general information on their employees ^[13]. This output laid down all the expectations for evolution where HCA reporting is concerned.

Indeed, several authors were advocating that: managers were willing to know more about intangibles in order to be able to improve their information systems and control mechanisms; companies were disclosing increasing amounts of voluntary information on their intangibles; managers were not only concerned for what accounting standards currently require or would require in the future; and companies need to communicate with their stakeholders, be transparent and trustworthy ^[31]. However, when we compare these arguments to the experience reported by Roslender and Stevenson, we conclude that we should be worried about the real intentions of management. On the one hand, they are aware that human capital is the source of competitive advantage, that knowledge and innovation management are crucial for the company’s success. On the other hand, they seem to be unwilling to develop human capital performance and measurement systems because ambiguity gives them flexibility in order to manage at their free will. That is why we claim that the accounting discipline plays a crucial role in developing HCA to the benefit of the whole society and all the stakeholders of the company. However, it is necessary that the discipline should be free of the powerful sectional interests mentioned by Roslender and Stevenson ^[13].

Most senior managers intuitively understand that human capital has the potential to be strategically important. There is little beyond anecdotal evidence, however, to demonstrate its impact on financial performance, much less the contribution of human capital. Becker, Huselid and Ulrich ^[23], experienced researchers in this field, showed a clear relationship between what is called the high performance human resources systems and various measures of company financial performance. However, for management and reporting purposes, companies need to implement a performance measurement system, and develop measures that, on the one hand, monitors employee motivation because it is the basis for developing skills and increasing effort, the end point of which is the company’s increase of profitability; and, on the other hand, to control for compensation, culture, management style and also job design because they give support to the employee motivation/satisfaction. According toto Atkinson, Waterhouse and Wells ^[1], this performance measurement system applied to human capital must do four things: (1) help the company evaluate whether it isis receiving the expected contributions from employees; (2) help the company evaluate whether it is giving to human capital what it needs to contribute to the increasing of profitability of the company (by monitoring this element, the company can identify problems quickly and correct them before they significantly affect the organizational goals); (3) guide the design and implementation of processes that contribute to the company’s compensation, culture, management style, and also job design; and (4) help the company in evaluating its planning and the contracts, both implicit and explicit, that it has negotiated with human capital by helping evaluate the effect of compensation, culture, management style and also job design on human capital satisfaction/motivation, and in turn the financial goals of the organization.

For companies to improve performance, they must develop a comprehensive system of measures that monitor and evaluate the ability of its processes to achieve employee motivation. By focusing on results, rather than on their causes, the company resigns itself to being reactive rather than proactive in meeting the need for organizational change. Therefore, the performance measurement system is a vital management system that includes both financial and nonfinancial measures of performance ^[1]. The performance measurement system supports the development of organizational knowledge and leads to more systematic, effective decision making. While the process is not easy, it is necessary for managing and improving a company’s performance.

The HCA framework allows management access to better information to help determine where it should focus the human capital investments in order to produce the greatest business benefits. Management base investment decisions on three criteria: the relative effectiveness of each human capital process, the presence or absence of evidence that a given process was strongly associated with financial performance, and the strategic or cultural importance of each process based on its linkage to particular key performance drivers of human capital capabilities ^[25].

Delivering performance is more than just having individuals with necessary capability ^[5]. Company performance is the result of the mixture of individual capability, individual motivation, leadership, the organizational climate and work effectiveness.

Individual capability is the set of knowledge, skills, experience, and the sense of network, the ability to achieve results, and the potential for growth of the individual. Its motivation, aspirations, ambitions and initiative, the work motivation, productivity, along with the capabilities, potentiates performance. According to Mayo ^[5], studies show repeatedly that the most important motivator is the nature of the work itself and its appeal and interest to the person. Matching people to roles that bring interest and enjoyment is thus a key process and management’s responsibility. At the same time, leadership is also important (the clarity of vision of top management, their ability to communicate it, and the consistency of their behavior). Another factor that promotes performance is organizational climate, that is, the culture of the organization, mainly in its freedom to innovate, openness, flexibility, and respect for the individual. And finally, work effectiveness, that is, supportiveness, mutual respect, and sharing in common goals and values. The organizational climate can be measured by questioning employees, namely through surveys ^[5].

According to Johanson ^[39], measuring and reporting intangibles are one thing, but to ensure that understanding and action are based on the information from intangibles indicators, a number of supporting processes need to be performed. These processes are: the recognition and measurement routines (human capital surveys, market capital surveys, accounting); reporting routines (continuous internal reports, informal information to analysts); evaluation routines (evaluation of single indicators by each manager, statistical analysis); attention routines (meeting); motivation routines (benchmarking, dialogues, salary bonus); commitment routines (ownership of indicators, action contract); and follow-up routines (statistical analysis). Measuring without doing anything is worthless or even dangerous ^[39].

Although both researchers and managers have been talking extensively about intellectual capital for almost two decades, it appears that people still do not fully understand what it encompasses ^[3]. Although it is fully appreciated that intellectual capital or human capital can provide substantial competitive advantage, managers do not fully understand what it is and how it works. This may be particularly so inin the context of how investments in human capital have impact on the operation of a business ^[3]. Therefore, due to the concern and awareness of the importance of human capital as a strategic organizational resource as a key asset in the innovation process, it is time for management to take action. With the assistance of accounting professionals, management implements performance measurement systems capable of providing information to manage the human capital, to report to the stakeholders, and toto respond to questions related to company’s social responsibility and sustainability.

However, many companies are likely to remain reluctant to publish such information, fearing that action of this sort may result in exposing a company in two different ways. In the first place, for many firms nowadays these assets are part of their core business; therefore, disclosing too much about them might reveal the company’s competitive advantage. They may prefer to withhold this information from competitors until they are required to do so ^[40]. Although this argument makes sense, it seems it is used to camouflage the absence of an HCA system, capable of providing information of this core asset, and how it is considered in the company’s management process, namely how it is related with company’s performance. Besides, since financial accounting has not changed where human assets is concerned, and requirements toto disclose information on intellectual capital are still voluntary, information is provided only at management’s will. Therefore, arguing that the reporting model does not require it, it is the same as stating that companies would not disclose this information at their own will, and they boycott any attempt to change this – see what happened with the Accounting for People initiative reported by Roslender and Stevenson ^[13]. Secondly, intellectual capital reporting might not only expose the bases of competitive advantage but may provide clues as to a company’s weaknesses. Revealing information of this sort might provide problems for managers, not only because their competitors can act or perform better, but also with internal stakeholders, who now realize that, in fact, the business is not performing quite as well as they thought it was ^[3]. This is the problem that had been already identified early in the 1960s: CEOs stating that “our employees are our most important!– and most valuable – asset”, providing no other information about it in the rest of the annual report ^[7]. Moreover, it could put in evidence that managers’ action is not in accordance with the managers’ discourse.

Fortunately for managers, organizations that choose to make information available on human capital can decide what is disclosed and how it is communicated. The history of social and environmental accounting developments has demonstrated how such unregulated accounting spaces can be populated to the benefit of those whose motivations might not withstand rigorous scrutiny ^[3].

Some authors speak of the competition between accountancy and HRM professions for organizational dominance, namely that this phenomenon could explain the failure of the Accounting for People initiative ^[13].

Armstrong ^[41] documents how the accounting and personnel functions, among others, have been involved in a process of interprofessional competition for organizational dominance, with the former traditionally enjoying greater success. The passage of time, and the emergence of the (strategic) HRM profession, has done little to change this situation of no recognition of human capital assets in the company’s reporting, despite the acknowledgment that “our people are our greatest asset” ^[13]. In fact, the progress in accounting for people has been rather limited during the last 50 years, with the exception of the Scandinavian context. Indeed, for the greater part, accounting for people has been principally an academic preoccupation, attracting very little interest in the accountancy profession. However, there are many indications of the awe in which the accountancy profession is held by senior management, and there is a sense that the accountancy profession alone is deemed capable of providing the necessary measurement metrics and that it also possesses the authority to provide the legally sanctioned external report of organizational performance ^[13]. However, we claim that it is not possible to evolve HCA and reporting without the contribution of the human capital management field. When questioning why the Accounting for People initiative disregarded recent developments in intellectual capital that could be of positive benefit to progressing HCA, Roslender and Stevenson ^[13] answered that those developments threaten to promote the interests of labor (people) within the prevailing social arrangements because it poses a problem to capital (senior management), and the accountancy profession does nothing because management is its most important client.

In an early study by Rhode and Lawler in 1973 ^[26] that focused on the usefulness of HRCA, it was found that managers opposed HRCA because it was perceived to limit their freedom of action. Organizational learning processes were initiated though seriously hampered by management’s ambivalent support of HRCA. As Rhode and Lawler reported ^[26], the added clarity provided by HRCA implies that a manager’s freedom of action, and therefore power, is circumscribed. HRCA can also be employed to assess the efficiency of the managers themselves. These may be reasons for its lukewarm support ^[20].

Managers have to learn about HRCA models (e.g. How can the cost of absenteeism from work be calculated? What models can be used to estimate the financial impact of a training program?). Thus, two types of knowledge have to be improved ^[20]: (1) knowledge of human resource costs and values or the normal outcome of different human resource measures within the organization, and therefore appropriate information systems are needed; (2) knowledge of models of how to calculate costs, incomes and values. Lynn cited by Fincham and Roslender ^[30] claims that management accounting has a ‘natural affinity’ with intellectual capital accounting and that the movement to manage intellectual assets is fundamentally a management accounting issue. In like fashion, Booth cited by Fincham and Roslender ^[30] seeks to convey the message that the measurement of intellectual capital is actually unproblematic and falls within conventional intellectual capital accounting as management fashion accounting skills. He suggests that a range of off-the-shelf methods are ready to be simply plugged in. The real difficulties lie in the managerial processes of understanding intellectual capital and using it to improve organizational performance – tasks atat which most managers probably think they excel – but the “modelling tools are readily available and computational requirements rarely a hurdle” ^[30].

6.7 Conclusions

The preceding pages have documented how human capital evolved in two areas, measurement and reporting, and how human capital is important not only in the context of strategic HRM, but also as a factor in knowledge/innovation management, and the intellectual capital literature. Although facing several designations, HCA has not achieved yet the status that it aims for, that it deserves, and that it is crucial. While empirical research studies show that it is vital for senior managements to view intellectual capital in a strategic way if they wish to maximize the benefits that these assets can bring to their organizations, it is also vital to manage them effectively. However, we can manage only what we can measure. Therefore, from a specifically accounting perspective, the task has been to identify appropriate ways of measuring and reporting the success with which stocks of intellectual capital have been grown over time. InIn this regard it seems unlikely that accounting, as it has traditionally been understood, is capable of meeting these new challenges ^[3].

The conclusion is that performance measurement systems are still based primarily on financial performance measures, which lack the focus and robustness needed for internal management and control ^[1]. Financial performance measures are derived from accounting systems that generate and communicate financial information to support the contractual relationships and the capital markets that result from separating owners and managers in the modern corporation ^[1]. These accounting systems were designed with the priority of consistency and hardness – attributes needed to instantly compare firms and evaluate a company’s behavior over time. These systems were not designed to communicate decision-relevant information to people inside the organization. Some complaints raised with conventional financial information are that it ignores important issues like human capital or customer satisfaction, cannot predict because it is based on historical cost, and provides little or no basis to judge the effectiveness of processes like personnel relations systems ^[1].

A company’s success is created by monitoring and managing its performance on the compensation, management style, organizational culture, and job design, since success in achieving performance on increasing profitability follows from the former variables. Therefore, performance measures of those variables are the way to improve the company’s financial performance and should be the focus of the company’s measurement ^[1].

A HCA framework can help organizations diagnose their strengths and weaknesses in key human capital practices, to set investment priorities and track performance, and to establish an empirical link between human capital investments, business practices, and overall business performance ^[25]. Most managers would agree, however, that mature people processes do not immediately impact financial performance; they first improve human capital capabilities like employee engagement and workforce performance, which in turn improve key performance drivers like customer satisfaction and innovation ^[25].

A HCA framework provides the human resources function and the business leaders with a common language and vocabulary concerning the value of human capital investments and the contribution to the bottom line ^[25]. The only way for the human resource function to be successful is to learn to think and act like a business person ^[25].

Companies seek to share knowledge and provide information to their various stakeholders; in order to incorporate information on intellectual capital, they need redesign their information and reporting systems ^[31].

Any lack of visibility of intellectual capital within accounts, especially on human capital, results in information asymmetries favoring those who have privileged access to that information, because they work within the organization. It is unknown data for those who are not involved in the management of the company. As a result, a management team might report unusually positive performances, while competitors report losses ^[3]. Furthermore, when a company values and reports its intangible assets, its capacity for raising capital increases ^[3].

Accounting encompasses two complementary activities: measurement and reporting. Monetary valuations are the archetypal measurement metric associated with accounting, while the balance sheet has traditionally provided the vehicle for reporting the aggregated valuations of tangible together with some intangible assets. Denied the former in the case of intellectual capital, the latter was of little use for such purposes. The new approaches might usefully be categorized into three generic types: alternative hard number metrics; scoreboards populated by sets of softer indicators; and narrative accounts of intellectual capital growth in which indicators performed a largely supplementary role ^[3].

In the case of accounting for intellectual capital the most telling issues again refer to human capital. Visualizing the growth of specific employee attributes in the form of nonfinancial metrics to be incorporated into some form of scoreboard reporting framework remains problematic on the grounds that, from a critical accounting perspective, accounting numbers applied to employees have invariably worked to their disadvantage ^[3]. However, if HCA wants to be part of the management process, and in the disclosure process to all the company’s stakeholders, it is necessary that those numbers that allow management and stakeholders to assess the company’s practices and its financial performance.

In summary, while ‘employee matters’, together with those relating to society, the community and the environment, continue to be invoked by many people, it is difficult to avoid concluding that, after a brief interlude when encouraging accounting for people was on the political agenda, it is once again a very minor consideration ^[13]. Accounting for people continues to be resultantly represented as a largely technical problem, a solution to which might eventually be found within the prevailing conceptual framework of financial accounting and reporting ^[13]. The great attraction of this situation is that as long as it persists, it provides senior management with a rationale for continuing to account for people as costs to the company rather than as assets. And therefore, HCA is nothing more than a beautiful management and accounting fairy tale.

Although the result of the Accounting for People initiative reported by Roslender and Stevenson ^[13] comes as no surprise, we share the authors’ view that the existence of renewed interest in accounting for people through a focus on intellectual capital ultimately provides critical accounting and HCA scholars with grounds for a degree of optimism. Research in the intellectual capital field is being pursued against a background of growing interest in developing a strong critical orientation across the whole spectrum of management studies. Increasing numbers of scholars may therefore be more likely to be receptive to arguments that promote the interests of those who are managed, designated ‘human capital’ in the intellectual capital field ^[14].

Bibliography