Blog Archive - Terawatt

Wed, Apr 3, 2024

by Francie Jain

The Human Capital Tsunami

Less than a month from now, in April 2024, we’re expecting the U.S. Securities and Exchange Commission (SEC) to announce new human capital disclosure requirements. We’ll be curious to learn how the SEC views key workforce risks for publicly-traded companies. But more importantly, the very fact that these regulations now exist marks the beginning of a shift for anyone who works in, with, or adjacent to Human Resources (HR).

This article’s authors, Eduardo Villegas and Francie Jain, haven't seen much commentary about the impending SEC Human Capital disclosures in HR-specific, popular, or even social media, but they believe it should be easy for all people, not just accountants, to understand the new disclosures and their possible ripple effects.

If we can envision so much change, why is no one talking about the impact of the human capital disclosures? Maybe we’re the ones we’re waiting for! Eduardo and Francie decided to write this article to inform business people everywhere about the short and long-term implications of the new SEC Human Capital disclosures.

Why us?

Eduardo is a former CFO who worked for a multinational pharmaceutical company for over 25 years in Latin America, South Asia, and the U.S. He transitioned to executive coaching to help leaders expand their perspectives in order to amplify their influence.

Francie is the Founder of Terawatt, an online marketplace for Human Capital solutions. Terawatt connects vetted experts to companies who’re looking to solve specific problems and achieve top-tier company-level results.

Let's Get Started

We’ve arranged this article into three sections. Let’s dig in.

What are the new Human Capital SEC disclosures and why are they important?
How can we effectively and ethically measure the value of an organization’s Human Capital?
How will these disclosures change the role of Human Resources? How can organizations proactively address these changes?

At the bottom of the article, we provide a summary of our discussion as well as links to resources mentioned throughout the article.

What are the new Human Capital SEC disclosures and why are they important?

Within accounting, there’s a concept of intangible assets, defined as non-physical assets with a monetary value. This is in contrast to physical assets with a value, such as an office building or an investment security like a bond. Examples of intangible assets include copyrights held, goodwill (the difference between the book and sell-value of your company), or patents, and U.S. exchange-traded companies must disclose and value them. Over the years, a lesser-known intangible asset, Human Capital, has seen increased U.S. and international interest from regulatory bodies, academics, pensions, think tanks, and unions.

In 2020 the SEC announced their first disclosure requirements for material Human Capital risks. (In this context “materiality” is defined as 1-10% of a company's value.) Human Capital disclosures are intended to make it easier for outsiders to understand company relationships with their employees, whether the relationships lead to value-creation or destruction, and how these relationships position a company relative to its peers. Before the human capital disclosure rule was announced, there was no requirement. Publicly-traded companies were able to decide for themselves whether human capital should be reported in its company filings.

In our minds, the SEC’s Human Capital disclosure rules are exciting because we expect them to ultimately lead to best practices sharing and insight into company values. Once companies report on human capital, meaning when they discuss in paragraph form, via a line item on their income statement, or via financial metrics, we'll better understand that company’s priorities and values. Instead of just saying, “employees are our greatest asset,” companies will show us their values through how they spend money, hire and retain employees, etc.

We believe employees will be as interested in Human Capital reporting as Sustainability/Environmental Reporting

The other reason this change is noteworthy is that it’s likely to trickle down to private companies. Take the precedent of Sustainability & Environmental reports. Many groups have long argued about the importance of understanding publicly traded companies’ relationship to the environment and the related risks. Because of the broad stakeholder interest, 90% of the companies on the S&P 500 publish voluntary sustainability reports, source here. And in Terawatt’s polling, we’re seeing similar numbers among private companies. We contend that, similar to Environmental & Sustainability, Human Capital will become commonly reported.

Some observers note that while there is indeed near universal environment reporting, but the content of the reports varies widely, and for many companies the reports are more akin to marketing without any quantification of risk. Just now (early March 2024), the SEC announced Sustainability disclosure requirements, creating more structure and uniformity in how companies disclose environmental risks.

Before we go any further, what is Human Capital?

The Oxford Dictionary defines Human Capital as: “The skills, knowledge, and experience possessed by an individual or population, viewed in terms of their value or cost to an organization or country.”

The SEC defines Human Capital as: “Human capital can be considered the collective knowledge, skills, and experiences of the workforce that powers economic growth."

Since 2017, the SEC has been collecting public comments and recommendations on how publicly traded companies should disclose Human Capital management policies and performance. A range of stakeholders, investors, unions, academics, and more, have been making the case for years that publicly traded companies should be more transparent about their relationship with their employees. You can read all of the public comments here.

“It's just time to acknowledge that people are not widgets.” - Former SEC Chairman Jay Cayton (8/26/2020)

In 2020, the SEC announced the requirement of human capital disclosures for the first time. Former SEC Chairman Jay Clayton, mandated that publicly-traded companies must describe all material Human Capital resources, measures and objectives.

In the August 2020 announcement, the SEC didn’t specify how companies must report these resources, measures and objectives, but rather it gave companies broad discretion to convey what they considered material and important for investors to know. So for the past four years, companies have enjoyed a lot of discretion as they met this requirement.

We’re seeing the SEC get more specific about the kind of disclosures that are required. In September 2023, the SEC’s Investor Advisory Committee (IAC) voted to support a recommendation that publicly-traded companies disclose specific information related to their human capital management practices in their annual 10-K filings. We’ll be interested to see how the final disclosure requirements relate to the IAS recommendations.

The IAC recommended the following Human Capital disclosures:

Employee headcount, broken down by full-time, part-time and contingent workers
Employee turnover
Total cost of people spend, broken down by compensation type
Workforce demographic data
Discussion of how labor practices, compensation incentives, and staffing fit within the firm’s broader strategy

What does today’s Human Capital reporting look like?

In John Deere’s 2023 Annual Report, known as the 10-K, the company’s Income Statement line item of Sales, General & Administrative (SG&A) did not break out Human Capital as a separate line item.

In John Deere’s Business Section, written in paragraph form, the company devoted 17 paragraphs to Human Capital and noted its corporate motto of, “We run so life can leap forward” inspires its workers. It went on to speak about training employees on this code of conduct, having employees certify their code of conduct training, and the use of a scorecard to measure and innovate on worker safety. The company also noted that it supports 13 Employee Resource Groups (ERGS) and recruits employees from a diverse set of colleges, universities, and associations.

Very few risks were mentioned nor was there much mention of non-risk items beyond the ERGs and recruiting. The one risk that caught our attention was John Deere’s reporting of a lack of guarantee to renew collective bargaining agreements. 34% of its U.S. employees are covered in collective bargaining agreements, so this is surely material.

The two metrics discussed in the Human Capital business section are related to worker safety and injuries. The company noted A) a total recordable incident rate of 2.08 and B) a lost time frequency rate of 0.65.

For all of our excitement about what could be in the Human Capital discussion section, John Deere’s Human Capital discussion left us wanting more.

Questions we had:

What is the gender, racial and ethnic breakdown of its employees?
How much money, in total and per employee, is devoted to Learning & Development (L&D)? How does the company allocate L&D among employees?
How much money does the company invest in employees’ physical and mental well-being?
Which Human Capital metrics (HCM) does the company believe effectively explain employee contribution?
As a heavy machine manufacturer, does the company expect human capital, as a percentage of market value, to increase or decrease over the next 5-10 years?

Why now?

When former Chairman Jay Clayton announced the new Human Capital disclosure rule, he cited a 300% increase in human capital over the past 30 years. Modern companies acknowledge that their successes and failures are due not only to strategy and market conditions, but also to their employees’ contributions.

To put this statistic into greater relief, Ocean Tomo published research (below chart) showing 90% of the S&P 500’s market value of S&P 500 comes from intangible assets, which for most companies is Human Capital. In other words, in the 1980s and before, the majority of a company’s value was derived from physical assets like real estate and machinery. But in the information age, company value is derived from employee contribution.

Ocean Tomo's Intangible Asset Value Market Value Study (2022)

“The proposed rules would require disclosure about a registrant’s workforce and compensation policies, practices, and workforce stability.” - Gary Gensler (April, 2021)

How will the addition of Human Capital reporting change internal company operations?

We believe the following people will find the SEC’s Human Capital reporting valuable and may experience a meaningful change in their work:

L&D advocates and practitioners
Champions of Human Capital best practices
Job seekers searching for employers supporting professional development
Anyone who wants to learn about a publicly-traded company’s culture
Leaders driving their company toward a public offering
Recruiters utilizing Human Capital to achieve a competitive advantage
Did we miss anyone? Who else should be added to this list?

Additionally, we can imagine that work will change as a result of the new SEC Human Capital disclosures. As these standards mature, we anticipate the following internal changes:

HR budgeting process
Increased CEO & CFO involvement and judgment of Human Capital related decisions
Determining how HR and Finance departments approve training and hire contractors
Measuring employee buy-in for L&D and other learning opportunities
Tracking L&D outcomes in order to create new and sophisticated Key Performance Indicators (KPIs)
What changes do you foresee?

The new SEC Human Capital disclosures obviously impact the Finance and Human Resource departments, but they less obviously affect all of the other company departments. As a result, we expect to see changes in the way that HR makes decisions and how many stakeholders are involved in those decisions. Plus, we contend that most medium and large-sized private companies will begin reporting on Human Capital topics in the coming years.

We believe Human Capital reporting is just as interesting to potential employees as Environmental & Sustainability reporting

How can we effectively measure the value of an organization’s Human Capital?

For many private companies, Human Capital will be treated the same way as the environment and sustainability–a chance to discuss and put metrics to a company’s values and priorities. Plus, any privately-held company preparing for an IPO will start to test metrics and a narrative message that aligns with company strategy.

Intuitively we can agree that engaged employees are more efficient than disengaged employees, we want resilient rather than feeble teams, resourceful rather than unresourceful, inspired versus apathetic, and solution-oriented employees are more effective than task-oriented employees.

The good news is that in the past twenty-five years there’s been ample research proving what we suspect about company outcomes for those that support professional development. Below is a list of some of our favorite data relating to the business impact of Human Capital investment.

Company financial performance: In 2023, The McKinsey Global Institute published research analyzing the largest 1,800 global companies, companies with annual revenue over US$100M, and looked at their investment in employee professional development. The highest professional development spenders made up the top decile of the 1,800 employers that achieved economic profitability, with a return, versus their peers, on invested capital of 4.3x, and a ratio of economic profit to revenue of 4.2x. Source here
Customer Service costs: In 2000, Dr. Ann Bartel audited case studies focused on the return on investment for employee training. She cited 1994 research from Jack J. Phillips showing that International Oil Inc.’s investments in customer service training led to a 500% reduction of customer service costs. Source here Human Capital return on investment: The Conference Board published research in 2021 showing that organizations that use Human Capital Analytics (HCA) in their processes have an approximately 270% higher level of return on every $1 invested in Human Capital compared to organizations not using HCA. Source here
Market returns: Dr. Laurie Bassi published a 2004 Harvard Business Review (HBR) piece showing data from three equities portfolios made up of companies investing in employee development at twice the industry norm. These higher investing companies outperformed the S&P 500 the next year by 17% to 35% (range is due to three portfolios). Source here

How can we effectively and ethically measure the value of an organization’s Human Capital?

When we discuss “Human Capital” in this article, also sometimes referred to as “Human Asset Accounting” or “Human Resource Accounting,” we are referring to an organization’s workforce. We are not discussing the value or measurement of a human. Rather, “Human Capital” refers to the value employees and their work bring to their employer’s operations, profitability, and innovation. In our minds, the best rule of thumb for understanding Human Capital is the collective impact an organization’s employees have on the company.

Human Capital Metrics

Within finance, metrics are a commonly-used tool to simplify and standardize information and report on relationships. Right now Human Capital metrics are not part of SEC’s recurrent disclosure requirement, but it does appear there’s growing consensus on the most appropriate financial metrics that companies should use. As of this writing, we don’t know if the below metrics will ultimately gain a consensus view, but it’s worth noting which financial relationships one large asset manager thinks are the most important for understanding human capital risks.

Schroders Asset Management published a set of key Human Capital Metrics via a publicly available report called, Schroders Human Capital Management Research Summary, link here. Below are their four key metrics, along with definitions. To delve deeper into the calculations, please refer to the report.

HCCF- Human Capital Cash Flow “Provides the cost of Human Capital, both immediately and over the long run on a fully-loaded basis. This gives us an understanding of the total investment cost of a firm’s Human Capital.”

HCROI - Human Capital Return on Investment “Explains the fully costed return on monies spent investing in people. This represents the leverage on pay and benefits used to identify the benefits of Human Capital management.”

EEVA - Employee Economic Value Added “Estimates the value employees derive from working at a given organization, adjusted for approximate corporation tax. Used to compare against economic value added to proxy gain-sharing between labor and capital.”

ROPACE - Return on People Adjusted Capital Employed “Allows for the adjustment of Balance Sheet, Profit & Loss (P&L) and Cash Flows to reflect Human Capital as an asset. Allows us to see a fully-loaded return on all types of Human Capital cost, including carving out employee "expense" versus "investment.”

How will these disclosures change the role of Human Resources? How can organizations proactively address these changes?

Chief Executive Officers (CEO) determine broad company goals, and HR leaders translate those goals into processes and budgets. This is typically how People-related work has flowed inside companies. Now that Human Capital resources must be reported, it strikes us that there are two decision-makers involved in Human Resources: Finance and the HR Departments.

We can imagine a world in which the Finance Department will be a participant in translating company goals into HR action. In fact, we can’t imagine a scenario where Finance won’t want to be involved in some of the HR decisions.

No matter how exactly the responsibilities shake out, it's clear to us that going forward HR and Finance will work together to determine the most impactful Human Capital processes. HR leaders are steeped in the research of supporting people, and they can translate goals into action. Some of the more statistically-gifted HR leaders may already have information on the relationship of inputs, effects and interventions they can bring to conversations with the Finance Department.

Do CFOs agree with our ideas? Terawatt is currently conducting a survey on how CFOs view Human Capital, and one of the questions we ask them is how they believe Human Capital operations should be handled. Once we have the CFO perspective on the best way forward, we’ll share with you.

Key Takeaways

Human Capital relevance will continue increasing, not only in public companies but as part of the evolving corporate culture and its relationship to stakeholders. Regulatory bodies will strengthen the reporting and intensify scrutiny. Talents (particularly the younger generations) will review Human Capital disclosures as part of their research before joining any company. What company would you choose to work with? A) A big corporation with a market capitalization value of US$50B showing acceptable Human Capital KPIs, orB) A smaller corporation with a market capitalization of US$7B that shows positive Human Capital KPIs (particularly in terms of employee engagement and team collaboration)?
Measuring intangible assets and their impact is challenging, nevertheless sensible approximations and trend analyses can offer valuable information.At the same time it's important to give ethical consideration to the creation of numbers to describe human work product in order to protect workers’ dignity and contribution. To give you a flavor of the implications of measuring Human Assets, we created a table to translate the relationship of fixed assets to the questions surrounding human work contribution.
Human Capital attention and responsibility will spill outside HR: During the last decades of the 20th century, individual career development rested mostly in the HR department within L&D, its specialty. Later, that responsibility moved towards the managers and then to the individuals. We often heard the motto, “Your career, your responsibility.”

As we move from traditional shareholder capitalism (focused solely on profits and dividends) to stakeholder capitalism (focused on serving all shareholders and society), we see this responsibility spreading to more internal leaders with an emphasis on a new actor: the CFO.

We can envision a host of related articles:

The role of the CFO as we foresee it,
More aspects of ethically measuring Human Capital,
Specific KPIs and how to calculate them, and
How companies can prepare for Human Capital reporting
Future implications for A.I., employee longevity, and any intent to measure Individual Human Capital
If the above topics appeal to you, let us know your comments, questions and suggestions and we will bring them into the discussion.

Key Links

2020 G&A Institute Flash Report https://www.ga-institute.com/russell-1000.html

Since 2017, the list of comments regarding human capital submitted to SEC https://www.sec.gov/comments/4-711/4-711.htm

2020 SEC announcement on Human Capital https://www.sec.gov/news/public-statement/clayton-regulation-s-k-2020-08-26

2024 SEC press release on Climate Related Disclosures https://www.sec.gov/news/press-release/2024-31

John Deere 2023 10-K https://www.sec.gov/ixviewer/ix.html?doc=/Archives/edgar/data/0000315189/000155837023019812/de-20231029x10k.htm

Ocean Tomo chart of human capital as a percentage of market value https://oceantomo.com/intangible-asset-market-value-study/

Introduction to Sustainability Reporting What is Sustainability Reporting? - ESG | The Report https://www.esgthereport.com

Shroders Human Capital Management Research Summary’s human capital metrics https://www.schroders.com/en-us/us/institutional/insights/human-capital-management-research-how-people-are-our-greatest-asset/

The McKinsey Global Institute Research on the company effects of employee professional development https://www.mckinsey.com/mgi/our-research/performance-through-people-transforming-human-capital-into-competitive-advantage#/

Conference Board research on Human Capital investment https://www.conference-board.org/topics/human-capital-benchmarking/accelerating-value-by-using-HCA

Jack J. Phillips, published in Handbook of Training Evaluation, (1994) cited by Anne Bartel in 2000 https://www0.gsb.columbia.edu/faculty/abartel/papers/measuring_employer.pdf

Dr. Lauri Bassi, Training return on investment https://www.mcbassi.com/documents/HCMPredictsStockPrices.pdf and https://hbr.org/2004/03/hows-your-return-on-people

SEC’s expected clarification on Human Capital, April 2024. Exact date TBA

About the Authors

Eduardo Villegas, PCC Mission – Eduardo Villegas Oficial

Eduardo’s vision is expanding the perspective of leaders, from first-time managers to C-suite executives, to amplify their positive impact. After 25+ years of international corporate exposure leading finance teams, he transitioned to a full coaching practice focused on leadership. Eduardo was born in Caracas and has an accounting degree from Universidad Nacional Abierta in Venezuela, a master's degree in Economics from Universidad Francisco Marroquin in Guatemala, and finance and leadership executive training at Harvard, Tulane, and Boston University Schools of Business. Eduardo is a Professional Certified Coach by the ICF.

Francie Jain, Terawatt

Francie believes supporting people to achieve their potential creates a ripple effect in every community. After a career in alternative asset marketing, she became obsessed with professional development for individuals. She founded Terawatt to make it easy to be great. Francie earned an AB from Princeton University and an MBA from The University of Chicago Booth School of Business.