Past attempts to develop standards for financial reporting, whether in the form of the ARB, the Accounting Principles Board, or the more recent Financial Accounting Standards Board, took place in an economic environment where capital investment and productivity were the key drivers of revenue and profit growth in the private sector, and where classical economists proclaimed that maximizing profits was the only goal governing decision-making in corporate America.
But we are now in a new era in which knowledge and skills have become the key drivers with the shift of productive activity to low-cost producers outside of the U.S. As more corporate managers embrace the concept of “environmental, social and governance” or ESG investing, investors and analysts are forced to resort to non-GAAP or “off the books” measures to convey this information, as the external audit function wrestles with issues of how to embrace ESG for inclusion in primary financial statements.
How does existing GAAP deal with the new reality of corporations coming to market with few assets other than the unique intellectual capital that underlies the “snowflakes” and other recent initial public offerings? How does the market deal with the reality that costs incurred to attract talent, which are currently expensed, result in large operating losses in the years following an IPO?
I recall a recent interview on CNBC in which the CEO of a major video game maker complained that the firm had incurred significant outlays to find and retain new talent, and I am sure he is not alone. Are these outlays current period expenses?
I am an academic, not a practitioner, but I do recall the basic concept underlying accrual accounting, namely the matching of revenue and expense. Are those outlays referred to above, or expenditures to reduce carbon footprint, to increase diversity, or to develop mentoring programs for underserved populations, really a current expense, since they produce no immediate revenue, but rather focus on multi-period growth? Or perhaps to restate that — perhaps doing “good” now leads to increased future profits in a highly competitive environment.
The proponents of ESG reporting want to measure the “value” of such investments, but GAAP does not focus on value — it measures cost, since outlay cost is objective, and value is not. The focus on value has justifiability been the reason that ESG measures remain “off the books.” If the focus shifted somehow to cost, or actual outlay for environmental expenditures or projects to improve society, I believe capitalization of such costs would become more acceptable.
Outdated positions
The existing GAAP position is that such internally generated intangibles are to be expensed as incurred. I do not think it necessary to restate all of the reasons for this position here, but given the role of such intangibles in the “new” economy, I believe that this position is archaic and not in accord with economic reality.
Before ESG became the new “buzzword,” there was the closely related idea of HRA, or Human Resource Accounting (including some of my own contributions).
Again, the idea of capitalizing certain employee-related expenditures never made it into GAAP. This information, if released at all, had to be in non-GAAP format or as supplemental disclosures, As with ESG, the number of different measurement proposals quickly relegated HRA to an interesting but impractical idea. As with ESG, many of the proposals focused on value in an ongoing organization, and not on outlay cost.
Can any number express what an HRA or ESG outlay is “worth” in financial terms? I doubt that this issue will be resolved in my lifetime.
However, if the matching concept was properly applied, and the “assets” recorded in the process at actual outlay cost, I believe that this would be a vast improvement over existing practice.
For example, consider the recent trials and tribulations at a large bank. Suppose the costs of recruitment and training, including costs incurred when senior execs at the bank (and other companies) are “lent” to nonprofits while receiving full salary, and other non-direct-revenue-producing costs were capitalized rather than expensed, and then written off as a loss when an employee departs prematurely, or amortized using the same actuarial base used in their pension plan. Does the resulting amount measure the “value” to the organization? Of course not, nor should it, since we do not record “values.”
However, increases or decreases in the accumulated HR cost account would give a very clear picture of how this or any other company is retaining or expanding its employee base. That is information not available in existing GAAP, and when it was reported that before and during the bank’s false account scandal, turnover in the retail division was close to 50 percent, that information would have been of great use to a prospective investor. As FASB and the International Accounting Standards Board work to establish global standards, the treatment of internally generated intangibles will be a major issue.
