Quadrant I

Module 7: Human Resource Accounting

1. Learning Outcome
2. Introduction
3. Human Resource Accounting: Critical Assessment
4. Benefits & Limitations of HRA
5. Methods of HRA
6. The Relevance of HRA to Effective Financial Reporting
7. Evaluation of HRA practices in India
8. Summary

MODULE 7: HUMAN RESOURCE ACCOUNTING

1. LEARNING OUTCOMES
After completing this module the students will be able to:

 Provide cost value information about acquiring, developing, allocating and maintaining
human resources of the organisation.
 Enable management to monitor the effective utilization of human resources.
 Assess depreciation or appreciation among human resources.
 Assist in development of effective management practices.
 Increase the managerial awareness of the value of human resources.
 For better decisions about people, based on improved information system.
 Assist in effective utilization of manpower.

Source: MBASkool

2. INTRODUCTION
As per the American Association of Accountants (AAA), HRA may be defined as follows:
‘HRA is a process of identifying and measuring data about human resources and communicating
this information to interested parties’.

Human capital has become one of the most important factors to measure success of any
organization and still many companies don’t consider them as assets to show in balance sheet.
All the companies which recognise the need to show them on balance sheet do not have a
standard procedure to measure the value derived from human resources.

Global scenario has witnessed a massive shift from production based economy to service based
economy. Human capital is the factor that now outweighs other production factors like raw
materials and physical input. This transition has brought about the need to make changes to the
traditional accounting practices and make provisions for accounting human capital laying
significance on knowledge, skill, abilities and growing reliance on intellectual property. Stock of
human capital of any company create competitive advantage owing to their knowledge and
unique talent and supposing a company loses its workforce overnight its value will depreciate
significantly.

Despite of the fact that human capital has so much value, for years it didn’t feature in account
statements of organizations due to difficulty in quantifying this data. This is the major challenge
faced by researchers to finds a way to report value derived from human capital in a consistent,
accurate and objective manner in balance sheet.

This module will examine the methods that have been used by companies for human resource
accounting and their advantages and limitation. Taking example from Indian perspective the
module analyses, through the secondary resource how HRA has benefitted the company.It also
examines the scope of Human Resource Accounting in future.
3.HUMAN RESOURCE ACCOUNTING: CRITICAL ASSESSMENT

The module critically examines the importance of human resource accounting and the methods
that can be used for the same. It further delves on how HRA can help organizations in decision
making, its impact and implications. The research also helps us understand what led
organizations to realize the importance of its intangible assets i.e. its human capital and the scope
of HRA in future.

Human resource accounting is basically a cost-benefit analysis of all the investment done on
human resources of the organizations in terms of recruitment, selection, hiring, training and
development and the benefits derived from them owing to their knowledge, skills, ability and
productivity. An organization will be profitable if it derives more benefits at less expenditure.
HRA has potential to become a key driver of decision making especially in service orientated
industry where human resource management is one of the main cost centres. Most prominent
classes of decision makers who are likely to be affected by this financial accounting of human
capital are managers who are accountable for resource allocation and investors. Investors will
particularly be interested in the current state of business and growth opportunities whereas
managers would be interested in cost aspect associated with human capital. But the question is
whether accounting of the human capital is possible. Can human capital be treated as assets that
can be measure/quantified? If yes, what are we actually measuring and can we establish a
standard procedure for the same that will give uniform results across businesses.
To answer this we must first understand what is meant by asset. Assets are acquired through
transaction and have net future economic benefits but as per traditional economic analysis of
wage rate determination, net economic benefit should be zero. As per marginal productivity
theory, net human resource value in equilibrium should be zero which might not hold relevance
in today’s environment where positive value exists due to imperfections or firms resorting to
giving non-monitory employee compensation which leads to increased productivity at reduced
cost or highly mechanized work environments that increase resource efficiency.
It is desirable for the firms to be able to create net human resource value greater than the
expenditure- ceteris peribus.

4. Benefits and Limitations of HRA:

There are certain benefits for accounting of human resources, which are explained as follows:

1. The system of HRA discloses the value of human resources, which helps in proper
interpretation of return on capital employed.

2. Managerial decision-making can be improved with the help of HRA.

3. The implementation of human resource accounting clearly identifies human resources as valu-
able assets, which helps in preventing misuse of human resources by the superiors as well as the
management.

4. It helps in efficient utilization of human resources and understanding the evil effects of labour
unrest on the quality of human resources.

5. This system can increase productivity because the human talent, devotion, and skills are
considered valuable assets, which can boost the morale of the employees.

6. It can assist the management for implementing best methods of wages and salary
administration.

HRA is yet to gain momentum in India. The limitations are as follows:

1. The valuation methods have certain disadvantages as well as advantages; therefore, there is
always a bone of contention among the firms as to which method is to be treated as an ideal one.

2. There are no standardized procedures developed so far. So, organisations are providing only as
additional information.

3. Under conventional accounting, certain standards are accepted commonly, which is not
possible under this method.
4. All the methods of accounting for human assets are based on certain assumptions, which can
go wrong at any time. For example, it is assumed that all workers continue to work with the same
organization till retirement, which is difficult to even imagine now.

5. It is believed that human resources do not suffer depreciation, and in fact they always
appreciate, which can also prove otherwise in certain organisations.

6. The lifespan of human resources cannot be estimated. So, the valuation seems to be
unrealistic.

5. Methods of HRA:

Several research papers have suggested methods of accounting human capital by evaluating
individual contributions and assigning values to the same. Though it is difficult to isolate
individual contributions from team or group efforts but these have much more potential to aid in
decision making.

1. Historical cost method:

The first attempt towards measuring the human resource was made by a footwear
manufacturing company R. G. Barry Corporation of Columbus, Ohio with the help of
Michigan University in 1967.
R. G. Barry Corporation was the first organization to use this method for human resource
accounting. This method uses historical cost associated with recruiting and training
resources. This method poses several constraints which include:

 People are efficient enough to acquire skills to enhance their productivity even
without organizations conducting specialized training for the same. For example,
a software professional, who gains proficiency in MS-Excelsoftware can leverage
this for team management and data analysis without being given any formal
training by the organization.
 Different individuals respond to trainings differently and they might not produce
same results
 Individuals are capable of developing processes that have far fetching impact that
no amount of training could bring
 Training do not always produce desired effects, sometimes they have shown
negative effects in situations where resources are forced to attend certain
behavioural trainings which they think are not required. In order to produce
positive results it is very important to sensitize resources.
 The rate at which individuals grow and deteriorate is different so are the need of
organization. Also, the changes are difficult to predict and so they pose the
biggest challenge in terms of estimation of value derived from human capital.

2.Replacement cost method:

This model was proposed by Flamholtz and it uses cost incurred for hiring people for
existing positions, movements within and outside organizations & learning and
development costs.

There are several limitations to this approach as well. They are,

 This approach considers salary data and doesn’t take into account some
employees are underpaid while others are overpaid and salary can’t be the
only measure to gauge employee value
 Secondly, Flamholtz considers individual values and doesn’t take into
account benefits derived out of team efforts and goals

Future Scope of HRA

To be able to leverage HRA for decision making following must be ensured:

 Standardized form to represent human resource information
 Proper approach to measure and establish human resource value to be
developed
 Research to establish the impact of HRA in enhancing organizational
effectiveness and decision making
 Most importantly managers must be equipped to be able to think and apply
information obtained from HRA in practical applications and scenarios
Source:
http://www.civilserviceindia.com/subject/Management/notes/images/hraccountingandaudit.jpg

6.THE RELEVANCE OF HUMAN RESOURCE ACCOUNTING TO EFFECTIVE

FINANCIAL REPORTING

Let us critically analyse the importance of human resource account for efficient and effective
financial reporting. This modulewill dwell in detail about models & theoretical frameworks of
HRA. It also reports about study in this particular field. Recent research has shown several
models and theoretical frameworks of HRA that were developed.

Stephen Knauf(1983) defined HRA as "the measurement and quantification of human

organizational inputs such as recruiting, training, experience and commitment."

There are 2 reasons that are taken into account while treating human resources as assets, they
are:
 Investors will use this information for business valuation.
 Massive investment in building human capital of an organization justifies their being
treated as assets.
The gap in this accounting research arises due to the confusion about where exactly to place
human asset in the balance sheet and the implication of recruitment policies on such assets.

This modulefocuses on the integration of human resource into the conventional financial
statement, the need for employee retention for effective financial reporting.

6.1 THEORETICALFRAMEWORK

6.1.1Learning curve theory

This theory states that when a new job is started, workforce doesn’t reach maximum efficiency
or productivity. As they master the techniques, productivity increases and then achieves stability
which means time taken to finish the job declines eventually till it reaches stability, Every time
the output doubles, cumulative average time per decreases by a constant percentage called
learning percentage denoted by b.

The formula for calculation is:

Where
 K is the direct labour hours to produce the first unit.
 Yx is the direct labour hours to produce the xth unit.
 x is the unit number.

6.1.2 MODELS OF HRA

The Lev and Schwartz Model

As per this model, we calculate the future earnings of an employee during the remaining
service period and then calculating the present value by discounting it at cost of capital.
This method finds its applicator when relevant data that can be quantified and analysed is
available.

The formula can be written as:

E (Vy) = ΣT=Y Py (t + 1) ΣT I (T)/(I + R)t - y
Where, E (Vy) = expected value of a ‘y' year old person's human capital
T = the person's retirement age
Py (t) = probability of the person leaving the organization
I (t) = expected earnings of the person in period I, r = discount rate

The Morse Model

According to this model value of human resources is equal to present value of net
benefits derived from employees by the organization.
Steps involved are:
 Individual as well as collective gross value of services to be rendered by
employees in future is to be determined
  Both direct and indirect forms of payment made to the employees to be
determined
 Net benefits owing to excess of value derived over payments made are to be
ascertained
 Present value of net benefits are determined by discounting at a predetermined
rate

Likert and Bowers Model

Researchers Likert and Bowers have proposed 3variabe namely causal, intervening and
end-result variables to determine the value added by the group as their contribution to the
organization.

These variables include managerial behaviour, capabilities, group processes, climate, and the
subordinates’ satisfaction. Both the causal and the intervening variables determine the
end result variables that reflect achievements of the organization in terms of sales, cost,
market earning etc

Oceanic Bank Plc Study.

 Annual reports for 5 years starting 2002 were carefully examined
 The Lev and Schwartz model was used to analyse the value of human resource
 Assumptions:
o Employee remain for a minimum of 5 years in the organization
o Cost of Capital is 10%
 Analytical technique was further employed to test the impact of human resource
accounting using simple linear regression equation.

Data Analysis and Representation

Source: Oceanic Bank Plc Annual Report

 High co-efficient of correlation exists between the total asset and PAT which indicates
variables are useful in explaining impact of assets including human capital on profit
 The Durbin Watson (DW) Statistic indicates that there is no problem of serial correlation
in theregression model
  Rate of return was determined to measure the differences of return on asset with and
without accounting human capital
 From above data its evident, inclusion of HRA increases the value of return on assets

From the study carried out, it is evident that human assets affect profit and capital employed.
The human asset value increases investment in the organization as investors have the
assurance that their resources will be effectively and efficiently managed to create wealth.

7. EVALUATION OF HUMAN RESOURCE ACCOUNTING PRACTICES IN

INDIA

In India, HRA was introduced in annual reports for the first time by BHEL( Bharat Heavy
Electricals Ltd) post which several other companies including GAIL, ONGC, NTPC,
MMTC, SAIL, EIL,PEC, HSL, MECON etc. followed the trend.

Most of the organizations in India follow Lev and Schwartz model which is the present value
of future earning model

The same model was followed by Infosys for accounting purposes:

 The formula suggested by Lev and Schwartz is:

E (VT) = expected value of human capital

PT (t) =probability of a person’s dying at age t
Ii = value of a person’s each possible service state or future annual earnings

For application of this formula,

 Firstly, employees are divided according to their age into homogenous groups
skilled, semi-skilled, unskilled etc.
 Present value of average earning for each group is calculated
 It is assumed that employees will not change their role during their service period
in the organization
The best aspect about this model isin its objectivity in valuing human resources and the
limitation is its assumption of resources not changing their roles during their service tenure.

In fact major learning in any organization occurs due change of roles. Also, it doesn’t take into
account that value of an employee is not solely due to skills but also the kind of roles he takes
up. Other limitation is that it does not take into account employee turnover.

Analysis of HRA at Infosys:

 Infosys has been disclosing valuation of HR in its annual report in supplementary

statement also as part of balance sheet that included intangible assets
 ITL has shown category wise value of its resources also some critical HR ratios but
didn’t mention appreciation or depreciation in value
 HRA provided them with critical information regarding number of employees, cost and
value of its resources
 Percentage increase in the number of resources between 2002-03 and 2007-08 was
493.82&
 Total employee cost has seen an increased from Rs. 1677 crore in 2002-03 to Rs. 8878
crore in 2007-08
 Although total employee cost increased by 429.39%, cost per employee decreased by
11%
 Increase in valuation of HR is largely due to decreased discounting rate
 Positive high correlation of .999 between total income and total employee cost indicates
that the employee performance at Infosys is efficient
 .

FINDINGS & RECOMMENDATIONS

 Infosys hasn’t disclosed training and development cost, induction cost etc. It
should make a separate entry for these
 Infosys must also account amortization of resources, lockouts etc.
 Keeping a constant rate of discounting will eliminate incompatibility issues in
HR ratios and help in better decisions owing to standard results
 Frequent HR audits will help enhance credibility of data

As a conclusion, it can be said HRA practices at Infosys are good and can be further
improved if sufficient measures and practices are put in place.

8.SUMMARY
Thus, we may say that Human resource accounting is basically a cost-benefit analysis of all the
investment done on human resources of the organizations in terms of recruitment, selection,
hiring, training and development and the benefits derived from them owing to their knowledge,
skills, ability and productivity. An organization will be profitable if it derives more benefits at
less expenditure. HRA has potential to become a key driver of decision making especially in
service orientated industry where human resource management is one of the main cost-centers.
Most prominent classes of decision makers who are likely to be affected by this financial
accounting of human capital are managers who are accountable for resource allocation and
investors. Investors will particularly be interested in the current state of business and growth
opportunities whereas managers would be interested in cost aspect associated with human
capital.

In this module, we understood the definition of Human resource accounting and gained a deeper
insight into its working as a system for monetizing, recording and accounting for the human
capital of an organization. We also identified the relevance of developing a system of accounting
its human capital, in today’s ever changing HR dynamics and the value that it creates for the
organization in terms of increased accountability. There are 2 reasons that are taken into account
while treating human resources as assets, they are:
 Investors will use this information for business valuation.
 Massive investment in building human capital of an organization justifies their being
treated as assets.

Different methods and models of human resource accounting were discussed along with
examples from Indian scenario of the companies that have successfully used this technique to
leverage decision making.The Lev and Schwartz Model helps to calculate the future earnings of
an employee during the remaining service period and then calculating the present value by
discounting it at cost of capital. As per the Morse Model, value of human resources is equal to
present value of net benefits derived from employees by the organization. The Likert and Bowers
Model, has variables namely causal, intervening and end-result variables to determine the value
added by the group as their contribution to the organization.

From the research papers included in the module, we could understand that majority of
companies use Lev and Schwartz model for inclusion of human resources in the balance sheet
but the bigger challenge is educating managers and investors to decipher the information and use
it wisely for decision making.Companies have begun to realise the importance of human
resource accounting owing to rapid advancement from production based to service based
economies, though they face a lot of difficulty in devising a process that can consistently and
efficiently measure the value and contribution derived from human resources.

HRA is yet to gain momentum in India and there are several limitations that include:

1. The valuation methods have advantages and disadvantages both thus it’s difficult to identify
the suitable one.

2. There are no standardized procedures developed so far.

3. Under conventional accounting, certain standards are accepted commonly, which is not
possible under this method.
4. All the methods of accounting for human assets are based on certain assumptions, which can
go wrong at any time.

5. It is believed that human resources do not suffer depreciation, and in fact they always
appreciate, which can also prove otherwise in certain organisations and finally, the lifespan of
human resources cannot be estimated.

In India, HRA was introduced in annual reports for the first time by BHEL( Bharat Heavy
Electricals Ltd) post which several other companies including GAIL, ONGC, NTPC, MMTC,
SAIL, EIL,PEC, HSL, MECON etc. followed the trend.Most of the organizations in India follow
Lev and Schwartz model which is the present value of future earning model. The example of
Infosys was elaborated in this module and it was found that Infosys has good Human Resource
Accounting processes.