What is Human Resource Accounting?

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Human Resource Accounting is the process of identifying and measuring data about Human Resources and communicating this information to the interested parties. It is an attempt to identify and report the Investments made in Human Resources of an organisation that are currently not accounted for in the Conventional Accounting Practices.

Thus, Human Resource Accounting is a term applied by the Accountancy Profession to quantify the cost and value of employees of their employing organisation.

Objective of Human Resource Accounting

The Aim of HR Accounting is to depict the Potential of the Employees in Monetary Terms. This concept can be examined from 2 directions i.e.

  1. Cost of Human Resources i.e. the expenditure incurred for recruiting, staffing and training the Quality of the Employees and
  2. Value of Human Resources i.e. the yield which the above investment can yield in the future.

Importance of Human Resource Accounting

The 21st Century has been referred to as the Century of the Service Sector. All major expansion scope seems to be happening in the service sector and the scope of expansion of the manufacturing sector is minimal.

But are the Accountants properly able to value this Service Sector and show this on the Company’s Balance Sheet?

For any Company operating in the Manufacturing Sector, its core assets are its Machinery and Fixed Assets but for a Company operating in the Service Sector, its core assets are its employees which are Intangible Assets. For a Service Sector Company, the value of employees gains importance as earnings are based on the per-employee per hour billing model and profitability is linked to the value added by the workforce.

The Concept of Human Resource Accounting was established primarily for the service sector has now started gaining so much relevance that now Companies in all Sectors have applying HR Accounting and a good weightage is given to these reports when making any Company Analysis.

Benefits of Human Resource Accounting

The main benefits of Human Resource Accounting are:-

  1. HR Accounting helps the company ascertain how much Investment it has made on its Employees and how much return it can expect from this Investment
  2. The Ratio of Human Capital to Non-Human Capital computed as per the HR Accounting Concept indicates the degree of Labour Intensity of an Organisation.
  3. HR Accounting provides a basis for planning of physical assets vis-a-vis Human Resources
  4. HR Accounting provides valuable information to Investors interested in making Long Term Investments in Service Sector Companies

Methods of Human Resource Accounting

Quite a few Models have been suggested in the past for the Human Resource Accounting and these can be classified into 2 parts each having various Models. Some of the Important ones are:-

   A. Cost Based Models

          I. Capitalisation of Historical Costs Model

         II. Replacement Costs Model

        III. Opportunity Cost Model

   B. Value Based Models

          I. Present Value of Future Earnings Model/ Lev and Schwartz Model

         II. Reward Valuation Model/ Flamholtz Model

        III. Valuation on Group Basis

A. COST BASED MODELS

I. Capitalisation of Historical Costs

As per this Method of HR Accounting, the sum of all costs related to Human Resources (i.e. Recruitment, Acquisition, Formal Training, Informal Training, Informal Familiarisation, experience and development) is taken together to represent the value of the human resources.

The value is amortised annually over the expected length of the service of individual employees and the unamortised cost is shown as Investments in the Human Assets. If an employee leaves the firm (i.e. Human Assets expire) before the expected service life period, then the net value to that extent is charged to the Current Revenue.

Limitations

This Model of HR Accounting is simple and easy to understand and satisfies the basic principles of matching the costs and revenues.

  1. As the historical costs are sunk costs and are irrelevant for decision making, this model was severely criticised as it failed to provide a reasonable value to the human resources.
  2. This method of HR Accounting capitalises only the Training and Development Costs incurred on the employees and ignores the future expected costs to be incurred for their maintenance.  
  3. This Model of HR Accounting distorts the value of the highly skilled human resources as such employees require less training and therefore, according to this model, they will be valued at a lesser cost.

II. Replacement Costs

The Historical Cost Method was highly criticised as it only takes into account the Sunk Costs which are irrelevant for Decision Making. Thus, a new model for Human Resource Accounting was conceptualised which took into the account, the costs that would be incurred to replace its existing human resources by an identical one.  

  1. Individual Replacement Costs – which refers to the cost that would have to be incurred to replace an individual by a substitute who can provide the same set of services as that of the individual being replaced
  2. Positional Replacement Costs – which refers to the cost of replacing the set of services referred by an incumbent in a defined position

Thus, the Positional Replacement Cost takes into account the position in the organisation currently held by the employee and also the future positions expected to be held by him.

Limitations

As per this method of HR Accounting, the determination of replacement cost of an employee is highly subjective and often impossible. Particularly at the management cadre, finding out an exact replacement is very difficult. The exit of a top management person may substantially change the human assets value.

III. Opportunity Cost Model

This model was advocated by Hekimian and Jones in the year 1967 and is also known as the Market Value Method.

This method of measuring Human Resources under this Model is based on the concept of opportunity cost i.e. the value of an employee in its alternative best use, as a basis of estimating the value of human resources. The opportunity cost value may be established by competitive bidding within the firm, so that in effect, managers bid for any scarce employee. A human asset therefore, will have a value only if it is a scarce resource, that is, when its employment in one division denies it to another division.

Limitations

One of the serious limitations of this method for Human Resource Accounting is that it excludes employees of the type which can be hired readily from outside the firm.  Thus, this approach seems to be concerned with only one section of a firm’s human resources, having special skills within the firm or in the labour market.

B. ECONOMIC VALUE MODELS

I. Present Value of Future Earnings Model

This Model of human resource accounting was developed by Lev and Schwartz in the year 1971 and involves determining the value of human resources as per the present value of estimated future earnings discounted by the rate of return on Investment (Cost of Capital).

As per this valuation model of Human Resource Accounting, the following expression is used for calculating the expected value of a person’s human capital

human resource accounting What is Human Resource Accounting?

Limitations

  1. This Model of HR Accounting ignores the possibility and probability that an Individual may leave an organisation for reasons other than Death or Retirement.
  2. This Model of HR Accounting also ignores the probability that people may make role changes during their careers. For example, an Assistant Engineer will not remain in the same position throughout the expected service life in the Organisation.

Despite the above limitations, this model is the most commonly used model across the Globe for the purpose of Human Resource Accounting.

II. Reward Valuation Model/ Flamholtz Model

Flamholtz advocated that an Individual’s Value to an organisation is determined by the services he is expected to render. This model of Human Resource Accounting is an improvement to the “Present Value of Future Earnings Model” as it takes into account the probability that an individual is expected to move through a set of mutually exclusive organisational roles or service states during a time interval. Such movement can be estimated probabilistically by using the following model

hr accounting 550x239 What is Human Resource Accounting?

Limitations

  1. The major drawback of this model of Human Resource Accounting is that it is difficult to estimate the probabilities of likely service states of each employee.
  2. Determining the monetary equivalent of service states is also very difficult and costly affair.
  3. Since the analysis is restricted to Individuals, it ignores the value added element of Individuals working as groups.

III. Valuation on Group Basis

While applying the above models, the Accountants realised that proper Valuation as per Human Resources Accounting is not possible unless the contributions of the Individuals as a Group are taken into consideration.

An Individual’s expected service tenure in the organisation is difficult to predict but on a group basis it is relatively easier to estimate the percentage of people in a group likely to leave the organisation in the future. This model of Human Resource Accounting attempted to calculate the present value of all existing employees in such in each rank. Such Present Value is ascertained with the help of the following steps:-

  1. Ascertain the number of employees in each rank
  2. Estimate the probability that an employee will be in his rank within the organisation or will be terminated in the next period. This probability will be estimated for a specified time period.
  3. Ascertain the economic value of an employee in a specified rank during each time period.
  4. The present value of existing employees in each rank is obtained by multiplying the above three factors and applying an appropriate discount rate.

Limitations

Although this process simplifies the process valuation of Human Resource Accounting by considering a group of employees as a valuation base, but this method ignores the exceptional qualities of certain skilled employees. Thus, the performance of a group may be seriously affected in the event of exit of a single individual.

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