August 1, 2022

More financial information about human capital? FASB looks to require disaggregation of expenses on the income statement

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In June, the Working Group on Human Capital Accounting Disclosure, a group of ten academics that includes former SEC Commissioners Joe Grundfest and Robert Jackson, Jr. and former SEC general counsel, John Coates, submitted a rulemaking petition requesting that the SEC require more disclosure of financial information about human capital. According to the petition, there has been “an explosion” of companies “that generate value due to the knowledge, skills, competencies, and attributes of their workforce. Yet, despite the value generated by employees, U.S. accounting principles provide virtually no information on firm labor.” (See this PubCo post.) The Group may be about to have its wishes granted—at least in part—but not by the SEC. Rather, the FASB is hard at work on a project to disaggregate income statement expenses, and high on all of the FASB board members’ lists was the need to separately disclose labor costs/employee compensation. Of course, as reported by Bloomberg (here and here), there has been a push for disaggregation of expenses on the income statement since at least 2016, but in 2019, the FASB voted (5 to 2) “to put its once-high priority financial reporting project on pause.” It’s been quite a lengthy pause, but, in February 2022—perhaps hearing the call from investors and others—the FASB decided to restart work on the project to “improve the decision usefulness of business entities’ income statements through the disaggregation of certain expense captions.” It seemed from the FASB Board discussion that the Board members were favorably inclined to proceed with a disaggregation requirement—especially with respect to labor costs.

[Based primarily on my notes, so standard caveats apply.]

Currently, companies typically include in their income statements expense captions for selling, general and administrative (SG&A) expenses, cost of services and other cost of revenues, and cost of tangible goods sold. Total compensation costs are rarely disclosed—only about 15% of companies disclose that data, according to testimony at the SEC’s Investor Advisory Committee. In February, the FASB considered several potential approaches to addressing the topic through various disaggregation principles and quantitative thresholds, and determined to conduct outreach. At the meeting on July 27 (see the Board meeting handout, beginning p. 6), the Board discussed the feedback received through its outreach efforts, as well as potential approaches to disaggregation. As to principles-based approaches that were considered, the FASB Chair wryly observed that employing a one-size-fits-all principle sounds great until they try to write it and see if anyone can understand it. The feedback from the outreach was mixed, with preparers generally advocating flexibility and lamenting the cost and challenges of implementation, particularly with regard to inventory (“because it may be challenging to disaggregate costs after they have been capitalized into inventory”). In contrast, investors typically advocated for disaggregation, with some expressly urging disclosure of specific expenses, such as labor, particularly in light of inflationary trends, as well as the shift in the economy from corporate value based on tangible to intangible assets.

SideBar

At a recent meeting of the SEC’s Investor Advisory Committee, a panel addressed presentation of non-traditional financial information. The Committee member moderating the panels on this topic began by emphasizing the importance to investors of high-quality, decision-useful information to “understand and assess a company’s business, risks and prospects, to make critical decisions about how and where to direct capital. It is thus critical that this information remain both relevant and reliable. As the sources of value and risk have shifted over the past several decades, investors’ informational needs have necessarily evolved.” In 1973, 83% of the market cap of the S&P 500 was in physical assets—property, plant and equipment. In the midst of this “fourth industrial revolution,” more value resides in intangible assets, such as knowledge-based assets. Now, 90% of the market cap of the S&P 500 is in intangible assets. In light of this shift, do we need to rethink the type of information that is included in financial statements? Are investors getting the information they need? What types of financial information, she asked, are now relevant for investors? (See this PubCo post.)

Similarly, the Working Group petition (referred to above) assessed that companies’ value is increasingly derived from intangible assets, such as intellectual property and human capital, rather than tangible assets, such as property, plant and equipment. According to the petition, in 1975, intangibles represented just 17% of the value of companies in the S&P 500; in 2020, intangibles represented 90% of the S&P 500 market value. That trend is illustrated by the growth of the healthcare and information technology industries, both of which depend heavily on human capital and now together represent about a third of the market cap of the S&P 500. Yet the accounting rules are still fashioned around corporate value as structured in the 1930s, when the first accounting standard-setter was created. For example, current accounting standards treat investments in capital expenditures as assets on the balance sheet to be depreciated over time, while investments in R&D are typically treated as expenses, not assets, and reduce net income in the current period. Similarly, labor appears as an expense that reduces net income, but, the petition observes, labor costs are typically included as part of administrative expenses, and only 15% of companies even separately disclose their labor costs. “These legacy rules,” the petition concludes, “do not reflect the current reality that the largest firms add value through internally developed intangible assets such as human capital[,]… leaving investors without information necessary to accurately value the firms that they own.”

The petition advocated, among other reforms, that labor costs be required to be disaggregated in the income statement, allowing investors to determine the proportion of COGS, R&D and SG&A attributable to labor costs and thus to better understand the contribution of workers to the company and the dependence of the company on its employees. The petition maintained that, for companies that report losses, investors “need information on product margins to estimate future profitability. To do that, investors need detailed information on operating costs, the most important of which is labor, to predict future margins and to determine what portion of cash outflows reflect investment. Without this information, it is difficult, if not impossible, to reliably value these firms, or to stress-test the market’s valuations of a firm using fundamental analysis.”

In the discussion, one Board member suggested that this project on disaggregation could be the most significant that he’s worked on, with substantial benefits to users. He thought that, although companies may be reluctant, they typically do have the necessary information about these costs because they often provide the information on analyst calls, especially recently in the context of the impact of inflation. He thought disclosure of the information was necessary to understand margin structure and would enable better forecasts, increasing market efficiency as result. Another Board member advocated looking at costs incurred for items that are capitalized and breaking out SG&A. According to another Board member, there’s one type of cost that every company has, and that’s labor, adding that information about labor costs has been widely requested by investors. He agreed with the concept of making disclosure of certain costs explicit; in addition to labor, he would include amortization and depreciation, as well as, adding a little accounting humor, material, “where material is material.” Another Board member added that the FASB should acknowledge that there will be incremental systems costs and audit costs, but she believed that the benefits outweighed these costs. She also suggested that the FASB look at splitting off selling expenses in SG&A. The Chair of the FASB echoed the views of others, indicating that he too favored the hybrid approach.

At this point, a loose consensus appeared to form around a two-pronged hybrid approach (somewhat similar to the approach being taken by the IASB): a prescriptive component that would require disaggregation of some specific costs, including labor, depreciation and amortization and, in some cases, materials or purchases; and a principles-based component for disaggregation of other costs, which might involve management judgment or a quantitative threshold or backstop. More elusive perhaps may be a simple approach to addressing inventory and capitalized expenses. The staff plans to perform analysis and develop alternatives for discussion at a future Board meeting. Clearly, there’s still a way to go here, but the project does appear to be moving forward. Separately, the FASB is working on a proposal to require more granularity about segments.

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