"Kind word and a gun"

Many HR don't realise it but their world changed - and there will be no going back.The change starts with publicly traded companies in the USA, but soon all other organisation both profit and non-profit will benefit from it. This change starts the era of transparency and accountability.

Requirement to disclose human capital information

The U.S. Securities and Exchange Commission mandated human capital disclosure by all companies selling securities in the United States. The rule is effective in November and there is no grace period. Even if your companies isn't traded in the U.S. markets and doesn't have the plans to do so, this change is both good and bad news for all HR professionals.

A bit of context

Let's start with a bit of history. The SEC was founded in 1934 to bring order to securities trading. It is hard to believe, but before that companies could issue and sell stocks, bonds and derivatives without providing any information. The SEC required companies to provide investors with basic information (e.g. balance sheet and income statement).

The rules evolved over time but not much. The last significant requirement was introduced in 1977 - the SEC published a list of 12 items that companies needed to disclose along with their financial statements: product or service offered, seasonality, source of raw materials and competitive conditions etc. The one and only one item related to human capital: the number of employees.

Increase in value of intangible assets

The world has changed and in 2015 SEC introduced a new set of rules. These new rules are based on three conclusions SEC experts derived from years-long research. First, the pace of change rendered any prescriptive lists obsolete. Second, in most companies value is added not through manufacturing operations, so what worked for manufacturing wouldn't work for services. Third, the primary driver of value in most companies is human capital, not physical assets. More here).

In 1975, 83 percent of the value of the companies in the S&P 500 list could be explained by the value of the physical assets on their balance sheets. This was not so different from 1934, when this was almost 100%.

In 2015 only 16% of the value of the companies in the S&P list could be explained by its physical assets on their balance sheets. The 84% is now explained by human capital.

Human capital is the primary driver of value and thus the stock price in most companies. And yet the balance sheet continues to be about physical capital. The companies still need to disclose just one item in human metrics, and not very informative one - the number of employees.

New rules

The SEC viewed a problem and decided to act. For three years they held consultations with experts and other stakeholders and in August 2020 published the rule called "Modernization of Regulation S-K". It governs public disclosure by companies for their initial security offerings (S-1 reports) as well as quarterly (10-Q reports) and annual (10-K) financial releases.

The SEC also changed its approach from prescriptive to material. It means that companies must disclose all material information about their business any investor would want to know before buying or selling a security. So if the information is important, it is better be disclosed, otherwise the SEC take administrative measures or worse -

shareholders can take legal action for your failure to disclose material information.

Your CEO, CFO and risk officer might be not very keen to be exposed to this type of risk.

Information on Human Capital

The SEC recognises the new role of human capital as the primary driver of value, so it required the disclosure of all material human capital information. As the chair of the SEC, Jay Clayton, said "I have never encountered a company where human capital was not material". The clear signal was also supported by the comments that the SEC expects disclosure around employee attraction, development and retention, at a minimum. However, no clear metrics were provided.

Not just HR metrics are to be disclosed.

Just like in financial reports quarterly and annually reports should contain detailed explanations.

For example, if you share your employee engagement metrics and they get worse, you need to explain why this happened and what you would do about it. HR professionals are also required to comment on HR initiatives like purchasing new software, implementing new approaches to performance management etc. So it's not just a formal page, it would a series of pages scrutinised and read by wide investor and shareholder community.

ISO 30414:2018

It is very impressive, isn't it? That's not all. The SEC has not provided any metrics, but he International Organization for Standardization (ISO) has in their December 2018 Guidelines for Internal and External Reporting.

The Guidelines suggest a total of 59 metrics for organizations, which are of interest for both employees and investors.

ISO recommends 10 metrics for reporting by small/medium organizations and an additional 13 for public reporting by large organizations - understanding that burden of reporting is greater for smaller organisations.

The 10 metrics for all-sized organizations include total workforce cost, human capital ROI, Earnings before interest and taxes (EBIT) per employee, turnover rate, total development and training cost, and percentage of employees who have completed compliance training. The 13 additional metrics for larger organizations include diversity by age, gender and disability, leadership diversity, leadership trust, time to fill vacant positions and time to fill critical vacant positions, and percentage of positions filled internally and percentage of critical positions filled internally.

Other metrics in L&D are also recommended by ISO - percentage of employees who receive training, percentage of leaders who receive training, percentage of leaders who receive leadership development and average hours of training per year.

"Kind word and a gun"

«You can get much further with a kind word and a gun than you can with a kind word alone.» — Al Capone

So in short Human Resources reporting is now part of compliance and information reported bu HR professional should be material. Otherwise the company might be sued by investors and employees.

So, "kind words" - that people are the most important assets in most organisations are now supported by "guns" - requirements to disclose material HR information in the form of ISO 30414:2018 and SEC Guidelines. The next steps are logical - HR professionals would not only be held responsible for inputs (e.g.how much is spent on leadership training) but also on outputs (how money spent on leadership training impact the bottom line).

This was the main bottleneck in most businesses. In huge companies the management only reported on material assets. Balance Sheet and Income Statement can only provide information on what was done. Financial reports can't help stakeholders evaluate opportunity costs. Now metrics on Human Capital can help to achieve it and provide more data on how companies are actually managed.

Next time, we discuss what can be done to make Human Capital reporting work in your company.

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