In the complex world of financial accounting, employees aren’t counted as corporate assets. Wharton’s Peter Cappelli explains why that’s a mistake.
This special series of the Ripple Effect podcast features leading Wharton faculty authors in lively, fast-moving conversations about their research and latest business books.
The Consequences of Prioritizing Company Shareholder Value
Dan Loney: When did financial accounting start to gain traction with companies?
Peter Cappelli: One of the things that my father told me I should absolutely do is take accounting classes, and I never did. So, my knowledge of accounting is very much as an outsider, but I think there was a coming together of a couple of trends. Modern financial accounting begins with the Great Depression, the creation of the Securities and Exchange Commission, and efforts to standardize how financial accounting is done, because if accounting is not consistent, it’s pretty useless.
The Financial Accounting Standards Board was created in 1973 or so, and they began to coordinate and consolidate the rules into clearer categories so they could be used. In 2009, there was another effort in that. The standards or basic ideas of this are not new. They got started at a time when, in most companies, the big deal was capital equipment. It was machinery, manufacturing especially. It’s not too surprising that they focused on that and didn’t pay much attention to human capital. The key distinction they made was that something could be an asset if you own it and could invest in it — but only if you own it.
What begins to change is in the 1980s, the rise of shareholder value as the new goal for companies. They used to say that the goal of companies was explicitly to balance the interests of the stakeholders. And investors were one, but so were employees, and so was the community around you, and so were your customers.
When I first got to the Wharton School, that is how people thought about it and how we taught it. There was an academic revolution on that question that pushed, from the economics point of view, the idea that shareholders are the only stakeholder. It was one of those battles that was won without a fight, because we didn’t actually teach corporate governance here in most places. As it advanced and finance became more important, as investors became more important — and some of that happened when we started to get bigger institutional investors. Groups like CalPERS, the California Pension Fund; mutual funds like Vanguard and Fidelity, these are now huge investment blocks. And particularly when they’re buying the market average. The idea in the past is that if they didn’t like the way you were running their company, they’d just dump the stock and move on. You can’t do that if you’re trying to buy the market average.
So, another development was this idea that the investors were pushing for this shareholder value goal. We had financial accounting, which already drew this distinction between human and physical assets. There were no human assets, human capital broadly defined. The idea that shareholder value was really the big goal, and then institutional investors (were) pushing that goal harder and harder all the time. Now we start to see some things change, especially now that we start to see so many companies where the real value seems to be the people.
Those initial assumptions from the 1930s, that people are not assets and have no real value in the finances of a company, now start to really bite because you have so many companies where the physical assets don’t matter, and where investors are pushing harder on financial accounting outcomes. Investors are not trying to maximize current profits. Investors are trying to make money on future profits. The value of the shares is, “What will things look like in the future?” Whether you’re profitable today or not doesn’t matter so much to them.
Now we have to start thinking about what the rules of the game look like. In sports, if you wanted to know how good a basketball team was, you’d have to begin by understanding the game, which means understanding the rules on which it is played. And financial accounting sets out the rules on which companies are operating and what they’re trying to do. Because of the quirks of the way it handles or doesn’t handle human capital, we start to see bigger and bigger problems, as human capital becomes, in objective terms, more important, but in financial terms still worthless. And shareholder value, based on financial accounting terms, becomes the issue.
Loney: With this shift, does the impact on the company and the employee become a pattern where you don’t want to see yourself go down this path because the value of the employee really has a significant strength towards the company’s bottom line?
Cappelli: Yes, and a lot of our colleagues in strategy recognize that certainly the biggest benefit you’ve got, the biggest competency, comes from the people and the way you manage them. We have so many companies, like in the tech world, where physical equipment doesn’t matter at all. It’s all about intellectual horsepower and the ability to execute things.
The investors have gotten onto this issue before anybody else, and their problem with financial accounting is they can’t tell how valuable companies are because they can’t learn anything about its human capital, because nothing about it is reported except for the total number of employees but not the total number of workers. We’ll come back to that issue in a minute. It leads to all kinds of distortions. As in any situation where you measure only a few things and you leave out some important ones, you’re going to get strange outcomes, and that’s what we get.
Examining Current Flaws in Hiring and Management Practices
Loney: How do you think this shift impacts how companies think about hiring and the level of employee involvement?
Cappelli: Let’s start with maybe the simplest one. Let’s talk about layoffs. Let’s say our employees had asset value. If you leave the U.S., accounting standards are different, and some of those accounting standards do allow employees to be assets. So, let’s say we thought employees were assets and had assets, and we announce we’re going to have a layoff. What layoffs mean is we’re just going to take those assets and push them out the door.
You’d say they were crazy. It’s like, “OK, we’ve got a bunch of computers here. We’re going to give them away. We’re just pushing them out the door.” It wouldn’t make any sense whatsoever. If you see what’s going on right now in the tech industry especially and elsewhere, you see companies that struggled like crazy to fill those positions and get people and hold onto them, and now they’re dumping them. There’s a pretty good bet that in six months, they’ll be trying to get new employees back. In the current context, unlike the 1970s and before, employees are not hanging around expecting to be rehired.
The thing that employers measure in hiring is they measure the cost per hire — a perfectly sensible thing to do. The reason they measure that is those costs are ones that show up, at least aggregated, inside your financial accounting. And the other thing they worry about is time to fill a vacancy — perfectly reasonable. What they don’t measure is the quality of the hire, which is exactly what you would think they would be looking at. How good are the people we’re hiring?
You could hire lousy people cheaply. If you look at what is reported in accounting and the things that aggregate up, that’s your incentive. Hire cheaply, don’t worry about whether they’re any good or not. It seems crazy, but that is literally what companies are doing. The evidence on this is pretty overwhelming. At least three different surveys showed that employers are not trying to assess the quality of the people they hire, and they see them as kind of interchangeable.
One of the things that most all of us know is when you bring in somebody from outside, it takes a while for them to become productive, compared to the people who are already there. There’s no accounting for that. There’s no literal accounting and no understanding of that. We’re starting to see investors care about this a lot, particularly when they look at these tech firms, again because they can’t figure out what the value is, and they would really like to know.
Loney: Your book is Our Least Important Asset. What have seen play out that has driven you to write a book about this topic right now?
Cappelli: I started out thinking I was going to write a book about how we actually manage employees that’s different from what textbooks say. If you look at a textbook, they’ll talk about the issue of hiring, for example, how you craft a job description and then you post a job ad, and then you see who applies, and then you do these assessment tests and all this stuff. None of that really happens, or rarely.
The evidence from the census indicates the average person reported that when they changed jobs, they were not looking for a job, and they didn’t really see a job ad. Somebody came and got them. We don’t do any of that fancy testing of employees. We typically just rely on unstructured interviews, which are pretty terrible as a way to hire, especially when we get rid of recruiters because they’re expensive. And we just push the task off onto line managers who aren’t trained for this, and they don’t know what they’re doing.
I started to look at practice by practice to see how we were actually doing on these things, and it all seemed pretty lousy in ways that just wouldn’t make sense to any of us if we knew just a little bit about how employees actually operate. I started to say, “Why are they doing this? Why do you see this same pattern everywhere?” A simple description of this is the British phrase, “Penny wise and pound foolish.” They’re squeezing on some costs, and they’re completely ignoring other costs. Why is that?
I started look around to see what was driving this behavior. The usual view we hear about shareholder values is they’re just trying to maximize profits, so they’re not paying attention to anything on the cost side. But that’s not true. Part of the problem is we were misled about what companies do by our introductory economics classes, which tell us that companies by definition are maximizing profits. OK, what’s a profit? You just look at your revenue, and you look at your costs, and you subtract them, and that’s your profit. Well, that’s not true at all. Anybody who sits down next to an accountant for a while will get a half-hour lecture as an introduction as to why that stuff is not so obvious.
I ended up getting a sense of what the rules were. A big part of it are these financial accounting things. There is another part. Because of the importance of investors and that shareholder perspective, the people who get to run companies now are different in systematic ways than they were a generation or two ago. They’re much more likely to be engineers who come to these tasks with assumptions about human behavior but also goals about optimization. The data science world has given them lots of tools to optimize. You’ve got to optimize on something, and generally they optimize on minimizing the number of employees and employment costs. That’s what they end up driving, and they haven’t had as much management training. Most companies, corporations, got rid of that. It used to be that you’d get hired, you’d be put into a management training program where they taught you all this stuff about managing people, and those are gone.
We have a lot more CEOs, famous ones, in the tech world who never managed anything, really. They are engineers for the most part, and their view about people was that they were not particularly important.
Increasing Employee Engagement and Influence
Loney: We’ve obviously seen in the last few years how the investor and the employee have more of a voice in what’s going on in the company these days. Do they have enough impact to effect change on a topic like this?
Cappelli: You would think the investors have the big hammer because they’re driving what executives are doing. The accounting world is astonishingly conservative. It is run for the most part by associations of accountants, and the Financial Accounting Standards Board sets the rules for accounting. They are overseen by another board, which is not elected.
The Securities and Exchange Commission has delegated the task of creating those rules to the Financial Accounting Standards Board. And they haven’t been particularly concerned about what those rules do to the operation of companies. They have been concerned about being consistent, and the idea of valuing human capital is something that’s kind of off the charts for them, it seems so weird. So the investors have been pushing for a while to try to get more from companies on this in terms of reporting. They’ve been pushing the Securities and Exchange Commission hard on this. They haven’t gotten very far yet.
In 2021, the little bit they got is that the Securities and Exchange Commission required that companies report anything they thought was material about their human capital to their business. But they get to pick what that is. And they get to pick what they report. What most of them report is just verbiage about their principles. It’s worthless if you’re an investor. You don’t learn anything from it. These investor groups are big, and they still aren’t getting very far, which shows you that this world of accounting standards is remarkably insular. And I think everybody who looks at that is struck by it.
The investors can’t make much headway on this, at least not yet. The employees have very little power. The only power employees ever really have is if a lot of them are quitting. A lot of them were quitting. That might be slowing down a bit now. I’d say the employers have largely resisted efforts to make the changes that employees want. For example, there’s a big concern now about mental health in the workplace. Many employers are responding to that, which is a nice thing. But what they’re responding to is helping you deal with the stress that we have created for you. They’re not trying to deal with the stress per se.
As we know, wages are lagging inflation by a lot, so it’s not that employers are willing to up wages enough to maybe clear the labor market for them. And one of the reasons for that again is that what investors see are the wage and salary costs. That’s a bad thing. They really don’t like those because those look to them like fixed costs even though they’re not fixed. Historically, they were more fixed than in economics. We treated them as if they were fixed; that is, they couldn’t go down in a downturn in the business. But of course they can.
And one more thing, which is particularly quirky, is the Securities and Exchange Commission requires that you report headcount, which is the number of employees, not the number of workers. So if you bring in contractors, that doesn’t count. If you’d like to make your revenue per employee or profit per employee jump up, drop some of your employees and bring in non-employees to do that work. The denominator falls. Suddenly you look wildly more productive and efficient and valuable. That’s another one of the quirks of this financial accounting.
Loney: I would think that when you talk about the successes and failures that employees and managers have, that obviously has to factor into this because the accountants are looking at the bottom line. If you have projects that failed, that’s going to end up hurting your bottom line, and that’s going to have a downstream impact on who manages. There is, as the title of our podcast is, a ripple effect that plays out here.
Cappelli: Yes, I think the investors would love to see that. The companies don’t want to show them anything about their internal accounting. How are our projects doing? What is our turnover of employees? Investors can’t see that. Right now, training doesn’t count as any kind of investment because you can’t invest in things that aren’t assets. Your employees aren’t assets. We can’t do that. I think there are pressures on to improve this, but the resistance is so big, so far not much is happening.
Loney: How does that impact the longer-term decision process at the C-suite when you have people in those roles who aren’t really the ones who have made those types of decisions in the past?
Cappelli: Yes, I think that is a big issue. CEOs have a really difficult job, and they can’t know everything. They need people around them who can point out those things that you’re supposed to know. They’re not experts on marketing. They’re not experts on human resources. Very few, if anybody, comes through that track and gets to the top. Somebody has to point this stuff out to them and make the arguments to them. That hasn’t been happening.
Since the 1980s, the pressure has been on human resources to cut because that’s what improves the company’s financial accounting outcomes. Making an argument about why we really need to invest in employees gets nowhere. We’re in a slightly different moment now because now there are enough concerns about employees, some of these under the ESG umbrella, social impact. You should be nice to your employees. Some of it is because, frankly, they’re quitting, and quitting is super important even though in financial accounting it doesn’t show up anywhere. But as a CEO, you can’t miss the fact that a lot of your people are quitting, especially people close to you.
Again, I think the pressure is on to do something about this, but the CEOs themselves don’t really understand a lot of this stuff. They don’t understand what the costs are of turnover. Most companies don’t know. It’s a little hard to figure this stuff out. Most of them are not trying. I think the human resources people understood that nobody really wanted to hear this stuff, and they didn’t want to get up on a soap box and make the case. Now it’s easier to do. Once you see that your positions are vacant and you’re not getting things done, it’s a little hard to miss that.
There is one place where I think we are seeing particularly quirky decisions by employers and the C-suite, and this is back to this optimization goal. There are a lot of things that we have studied for a long time, and lots of evidence for, that show that engaging employees in some decisions makes much better outcomes. They know things that are useful in the decision, and they also care about it and are more invested in it when they do it themselves.
A lot of those practices are going away and being replaced by software. Here’s an example: Let’s set our work schedules. We have 10 employees in my office. The office has to be covered, but people always have emergencies, and many of them have life concerns that they would like us to accommodate in some way. There are a couple of ways you could do that.
One of the ways that has worked extremely well is flextime, which means that the employees get together and work it out. The other way you could do it is delegate it to software. Software will make sure that everybody has exactly the same number of hours, everybody is treated equally, but there’s no flexibility in that, and employees don’t like it because they have no say. Why would you go with software when you could do this with employees, and it’s much simpler in the long run? Well, because we want to be optimal, so I’d like to just turn this over to software and let them do it.
So, we get a worse solution, which is more expensive, but it seems to fit this goal of optimization. We’re seeing several of those situations play out in the workplace now.