Full text



Maria L. Bullen, Ph.D., CPA

Associate Professor of Accounting School of Business

Clayton State University 2000 Clayton State Boulevard Morrow, Georgia 30260 678-466-4516


Traditional accounting treats costs related to a company’s human resources as expenses on the income statement that reduce profit, rather than as assets on the balance sheet that have future value for the company. Alternatively, Human Resource Accounting (HRA) involves accounting for the company’s management and employees as “human capital” or assets that provide future benefits, and suggests that the measures themselves, as well as the process of measurement, have relevance in decision-making. Capital budgeting decisions have focused on investment decisions involving traditional assets, such as land, buildings and equipment. This paper incorporates Human Resource Accounting value measures in capital budgeting decisions utilizing Excel-based sensitivity analysis applied to the net present value and internal rate of return methods. INTRODUCTION

The economic environment has shifted from industry based with a focus on physical assets such a factory, machines and equipment to a high technology, information, innovation based

environment with a focus on the expertise, talents, creativity, skills, and experience of people— the company’s human capital. However, despite the human capital intensive economy,

traditional accounting continues to focus on traditional assets to the exclusion of the more important human assets. Current financial accounting treats human resource-related costs as expenses which reduce profit on the income statement, rather than as assets on the balance sheet which provide future benefits. As noted in Flamholtz [5], given the growing importance of human capital and intellectual capital to economic success at both the macroeconomic and enterprise levels, the nature of investments made by firms needs to shift to reflect this reality. The recognition that organizations actually do have valuable human assets in their human capital led in the 1960s to the development of the field of “Human Resource Accounting” (HRA).


Practical Application of HRA: More Managerial Than External Financial Reporting As noted in Flamholtz, Bullen and Hua [6], it is recognized that there are problems with reporting human assets on the balance sheet for external financial reporting because there is subjectivity in measuring human assets. The same is true for reporting intangible assets such as goodwill and patents that have been internally generated rather than paid for through a corporate acquisition. Generally accepted accounting principles encourage objective, reliable and

verifiable measurement in order to facilitate comparability among organizations. It is

acknowledged that until more sophisticated measurement techniques become widely accepted and used, the role of HRA in external financial reporting may best work as supplemental

information to the external financial Statements. However even if human assets are not reported on the face of external financial statements, HRA can play a crucial role in internal managerial decision-making, and HRA measures can be used to show that investments in a company’s human resources may result in long-term profit for the company.

Process of HRA Measurement Emphasizes Consideration of Human Resources in Decisions A related point is that when managers go through the process of HRA measurement, treating human resources as capital assets, they are more likely to make decisions that treat the

company’s employees as long-term investments of the company. Flamholtz [4] describes the HRA paradigm in terms of the “psycho-technical systems” (PTS) approach to organizational measurement. According to the PTS approach, the two functions of measurement are: 1) process functions in the process of measurement and 2) numerical information from the numbers

themselves. Whereas one role of HRA is to provide numerical measures, an even more important role is the measurement process itself. When managers go through the process of measuring human resources, they are more likely to consider those human resources as valuable

organizational resources who should be managed as such. For example in a potential layoff decision, management is more likely to see the hidden costs to the company’s human resources, and the long-term implications to the human assets. Layoffs may affect future long-term cash flows from lost productivity, costs of rehiring and retraining, and costs of lower morale of existing workforce. In evaluating management and employee educational and training programs, management’s involvement in a measurement process which analyzes these outlays as

investments in human resources will likely result in management taking a longer-term approach. This will benefit the company as opposed to a term cost-cutting approach to boost short-term profits at the expense of long-run productivity and competitiveness.

Other authors have expressed similar views suggesting the benefits of HRA measurements and the process of measuring human resources. For example Johanson and Mabon [8] indicate that expressing human resource interventions in financial terms and /or cost benefit terms is more effective than using soft accounting information such as data on job satisfaction. Because the classical function of accounting is the determination of the value of the economic activity, performing analysis with hard numbers such as cost-benefit analyses helps us determine how resources should be used by human resources for various interventions. Toulson and Dewe [14] conducted a survey study utilizing component analysis and found two reasons why measuring human resources is important. The first is that measurement reflects the strategic and competitive importance of human resources, and the second suggests that to earn credibility, human


resources must be expressed in financial terms. Moore [10] suggests that the value of human capital should be more fully considered when making decisions about the acquisition and disposal of people—and notes that the accounting practices currently employed by companies can have an undue influence in driving the strategic decisions of these companies. Moore notes that there are parallels between the process of acquiring an employee (a human capital asset) and that of acquiring a fixed capital asset.

The Capital Budgeting Process

Traditionally companies have gone through the capital budgeting analysis process in order to make decisions about investments in fixed operating capital assets such as land, buildings, machinery and equipment. This paper proposes that human capital investment decisions be made with the information obtained from the commonly used more sophisticated capital budgeting techniques of net present value and internal rate of return. In one of the most recently published academic studies on the preferences of various capital budgeting methods in practice, Ryan and Ryan [11] found that the chief financial officers of Fortune 1000 companies agreed with

academics that discounted methods were preferred over the simpler non-discounted methods; and that the net present value method was the preferred method, with the internal rate of return method coming closely behind.

In order to utilize the net present value and internal rate of return methods in managerial capital budgeting decisions involving human resources, estimates must be obtained of the expected net future cash flows related to the human capital investment. The next section discusses

approaches to measuring the value of human resources. Measuring Human Resource Cost and Value

Tang [13] developed a heuristic frame addressing the link between human resource replacement cost and decision-making in a human resource replacement cost (HRRC) system.

The system measures direct and indirect costs of human resources, which is then applied to a company within the metro industry in China. One of the earliest models of human resource value, Lev and Schwartz [9], was used to measure human capital by calculating the present value of a person’s future earnings. Dobija [2] proposed an alternate model for capitalization, where the rate of capitalization is determined through the natural and social conditions of the

environment. Utilizing a compound interest approach, this method takes into account the three factors for valuing the human capital embodied in a person. These include the capitalized value of cost of living, the capitalized value of the cost of professional education and the value gained through experience. Alternately, Turner [15] referred to the framework issued by the

International Accounting Standards Committee and recommended the use of the present value of the value added by enterprise, and measurement of assets by the four methods of historical cost, current cost, realizable value and present value. Cascio [1] proposed a method for measuring human capital based on indicators of human capital of innovation, employee attitudes and the inventory of knowledgeable employees. According to this method, innovation commands a premium and therefore needs to be measured, for example by comparing gross profit margins from new products to the profit margins from old products. Employee attitudes predicting


customer satisfaction and retention are an important indicator of human capital and therefore need to be measured, as well as measures of tenure, turnover, experience and learning. Measuring ROI: The VDT and Stochastic Rewards Valuation Models

The VDT model, developed by Arne Sandervang [12] and tested in an empirical study in a Norwegian business firm in the electrical sector, calculates financial returns on an organization’s investments in competence development. It focuses on employee training or competence

development as its strategic focus and aligns investment in competency development to the overall business strategy to help organizations with their strategic human resource management goals. VDT, founded on the basic premise of participant’s involvement and motivation in the process of competence development, begins with analyzing the company’s expected economic results and defines the competencies required among the workforce to achieve these results. Once the gaps in competencies have been identified, the aims for the competency development process are set and then the actual learning process is conducted. On the completion of the learning process, the participants are expected to have gained the competency and changed their behavior, which in turn helps the company achieve its economic results. The participants assess the benefits of the competency program through a benefit description statement that shows a comparison of the potential benefits and experienced improvements. A calculation is then made of the benefits to the company and compared to the costs of training in order to arrive at the ROI of training and development.

Another method of measuring the ROI of management development is through the application of the Stochastic Rewards Valuation Model (SRVM). The SRVM, originally developed by

Flamholtz [3] for human resource valuation, and further explained in Flamholtz in [5], is a five step process that begins with defining the various service states or organizational positions that an individual may occupy in the organization. The next step is to determine the value of each state to the organization, the service state values, which can be calculated either by using a number of methods such as the price-quantity method or the income method. Then the person’s expected tenure or service life in the organization is calculated and the person’s mobility

probability or the probability that a person will occupy each possible state at specified future times is derived from archival data. Next the expected future cash flows that the person generates are discounted in order to determine their present value.

According to Flamholtz [5, pp 160-161 ) there is a dual aspect to an individual’s value: (1) the amount the organization could potentially realize from his or her services if the

person maintains organizational membership during the period of his or her productive service life and,

(2) the amount actually expected to be derived, taking into account the person’s likelihood of turnover.

The statement (1) above defines the person’s “expected conditional value;” and (2) defines the persons’s “expected realizable value.” Using the SRVM, Flamholtz, Bullen and Hua [7] showed a practical method for calculating ROI on management development and showed the incremental cash flows that an organization will receive due to investment in management development. The


article concluded that use of HRA as a tool to measure the value of management development enhances not only the value of human capital but also the value of management accounting. Summary of the Application of the Stochastic Rewards Valuation Model

As reported in Flamholtz, Bullen and Hua, the steps in the above described SRVM may be summarized as follows:

Step 1: Define the mutually exclusive set of states, or service states, an individual may occupy in the organization’s system, or organization.

Step 2: Determine the value of each state to the organization, or the service state values. Step 3: Estimate a person’s expected tenure, or service life, in the organization (a measure of expected conditional value).

Step 4: Find the probability that a person will occupy each possible state at specified future times.

Step 5: Discount the expected future cash flows to determine their present value (a measure of expected realizable value).

Application of HRA Stochastic Rewards Valuation Model to Excel-Based Sensitivity Analysis in Net Present Value and Internal Rate of Return Capital Budgeting Methods The present value of the expected future cash flows calculated in the SRVM may be used in capital investment net present value and internal rate of return analysis. However, due to the subjectivity of the required assumptions in the model, this paper proposes application of Excel-based sensitivity analysis to prepare the capital budgeting analysis under

multiple assumptions of service state values, probabilities and discount rates.

Use of sensitivity analysis to look at differing outcomes considering different assumptions of future cash inflows and outflows and different assumptions of discount interest rate is advised in conventional capital budgeting decisions. And sensitivity analysis is especially useful in HRA based analysis due to the multiple layers of assumptions such as service state values,

probabilities, and discount rate. The current proposed paper and presentation will utilize the Stochastic Rewards Valuation model and sensitivity analysis in conjunction with the net present value and internal rate of return methods in capital budgeting decision analysis of a human resource related decision.


Inclusion of human resource capital investment decisions in managerial capital budgeting decisions is expected to have implications from the standpoint of providing measures that can compete with other investment proposals for the firm’s resources, and demonstrate that the long-term benefits from such investments can be positive. In addition, the very process of measurement can influence management to think in terms of expenditures for the company’s human resources as increasing the value of human capital or human assets that will provide future benefits to the company, rather than in terms of expenses. This will promote a longer-term profit perspective compatible with a long-term strategic planning approach for the organization, rather than a strictly short-term profit perspective which may neglect maintenance and jeopardize the long-term security of its most valuable capital investments.



[1] Cascio, W.F., The future world of work : Implications for human resources costing and accounting. Journal of Human Resource Costing and Accounting, 1998, 3 (2), 9-19. [2] Dobija, M., How to place human resources into the balance sheet. Journal of Human Resource Costing and Accounting, 1998, 3 (No.1, Spring), 83-92.

[3] Flamholtz, E.G. A Model for Human Resource Valuation: A Stochastic Process With Service Rewards. The Accounting Review, 1971, (April): 253-67.

[4] Flamholtz, E. Towards a psycho-technical systems paradigm of organizational measurement. Decision Sciences, 1979, (January), 71-84.

[5] Flamholtz, E.G. Human Resource Accounting: Advances, Concepts, Methods and Applications, Boston, MA: Kluwer Academic Publishers, 1999

[6] Flamholtz,E.G., Bullen, M.L., and Hua, W. Human Resource Accounting: A Historical Perspective and Future Implications. Management Decision, 2002, 40 (10), 947- 954. [7] Flamholtz,E.G., Bullen, M.L., and Hua, W. Measuring the ROI of management

development: An application of the stochastic rewards valuation model. Journal of Human Resource Costing and Accounting, 2003, 7 (No.1-2, Spring), 21-40.

[8] Johanson, U. and Mabon, H. The personnel economics institute after ten years :

What has been achieved and where we are we going?” Journal of Human Resource Costing and Accounting, 1998, 3 (No.2, Autumn), 65-76.

[9] Lev, B., and Schwartz, A., On the Use of the Economic Concept of Human Capital in Financial Statements,” Accounting Review, 1971 (January), 103-112.

[10] Moore, R. Measuring how human capital appreciates in value over time. Plant Engineering, 2007, 61 (4), 29.

[11] Ryan, P. , and Ryan, G.P. Capital Budgeting Practices of the Fortune 1000:How Have Things Changed? Journal of Business and Management, 2002, Winter, 355-364. [12] Sandervang, A.From learning to practical use and visible results: A case in

competence development from a Norwegian business firm. Journal of Human Resource Costing and Accounting, 2000, 1 (2), 87-100.

[13] Tang, T. Human Resource Replacement Cost Measures and Usefulness. Cost engineering, 2005, 47 (8), 70.


[14] Toulson, P.K. and Dewe, P. HR Accounting as a Measurement Tool. Human Resource Management Journal, 2004, 14 (2), 75-90.

[15] Turner, G. 1996. “ Human resource accounting – Whim or wisdom.” Journal of Human Resource Costing and Accounting, 1 (No.1, Spring), 63-73.





Related subjects :