Human Resource Accounting

Human resources are considered as important assets and are different from the physical assets.
Physical assets do not have feelings and emotions, whereas human assets are subjected to
various types of feelings and emotions. In the same way, unlike physical assets human assets
never gets depreciated.

Therefore, the valuations of human resources along with other assets are also required in order
to find out the total cost of an organization. In 1960s, Rensis Likert along with other social
researchers made an attempt to define the concept of human resource accounting (HRA).:

1. The American Association of Accountants (AAA) defines HRA as follows: ‘HRA is a

process of identifying and measuring data about human resources and communicating this
information to interested parties’.

2. HRA as ‘accounting for people as an organizational resource. It involves measuring the costs
incurred by organizations to recruit, select, hire, train, and develop human assets. It also
involves measuring the economic value of people to the organization’.

3. According to Stephen Knauf, ‘ HRA is the measurement and quantification of human

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

Need for HRA:

The need for human asset valuation arose as a result of growing concern for human relations
management in the industry.

Behavioural scientists concerned with management of organizations pointed out the

following reasons for HRA:
1. Under conventional accounting, no information is made available about the human resources
employed in an organization, and without people the financial and physical resources cannot
be operationally effective.

2. The expenses related to the human organization are charged to current revenue instead of
being treated as investments, to be amortized over a period of time, with the result that
magnitude of net income is significantly distorted. This makes the assessment of firm and inter-
firm comparison difficult.

3. The productivity and profitability of a firm largely depends on the contribution of human
assets. Two firms having identical physical assets and operating in the same market may have
different returns due to differences in human assets. If the value of human assets is ignored, the
total valuation of the firm becomes difficult.

4. If the value of human resources is not duly reported in profit and loss account and balance
sheet, the important act of management on human assets cannot be perceived.

5. Expenses on recruitment, training, etc. are treated as expenses and written off against
revenue under conventional accounting. All expenses on human resources are to be treated as
investments, since the benefits are accrued over a period of time.
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.

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.

• Providing cost value information about acquiring, developing, allocating and

maintaining human resources.

• Enabling management to monitor the use of human resources.

• Finding depreciation or appreciation among human resources.

• Assisting in developing effective management practices.

• Increasing managerial awareness of the value of human resources.

• For better human resource planning.

• For better decisions about people, based on improved information system.

• Assisting in effective utilization of manpower.

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.

The main benefits of Human Resource Accounting are:-

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

valuable 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.

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

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.

HR Accounting provides a basis for planning of physical assets vis-a-vis Human Resources
and 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

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

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:

HRA is yet to gain momentum in India due to certain difficulties:

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

2. There are no standardized procedures developed so far. So, firms 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 far from possible.

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

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