00:00:00
financial accounting is not the same as internal accounting with its detailed categories of all costs and sources of
00:00:07
revenue for the purposes of our discussion here though what is important is the odd way
00:00:13
Financial Accounting treats employment costs as compared to other costs perhaps the best known example of this is
00:00:20
investments in equipment are treated as assets that can be paid for and depreciated over time as we get value
00:00:27
from them but investments in employees are treated as a current expense and must be paid in full in the year in
00:00:33
which they accrued even though we get value from them over time wages and salaries are seen as worse than other
00:00:40
current expenses because they are seen as fixed costs that somehow can't be cut
00:00:45
in downturns even though layoffs are commonplace welcome to the ripple effect the podcast
00:00:53
that takes you on a journey through the minds of work and faculty I'm your host
00:00:57
Dan Loney and in each episode we'll be diving deep into the inspiration behind
00:01:02
the groundbreaking research that Wharton professors have conducted and exploring
00:01:06
how their findings resonate with the world today we'll be covering a diverse
00:01:11
range of topics bringing you the latest insights and knowledge that you can apply to your life into work so get
00:01:17
ready to dive into new ideas with the ripple effect Peter great to have you here it's great
00:01:24
to see you again thanks for giving us a few moments today thank you Dan uh so this idea of financial accounting when
00:01:30
do you think it really has has kind of started and kind of gained traction so that you're seeing this impact around
00:01:38
companies right now you know one of the things that my father told me I should absolutely do is
00:01:45
take accounting classes and I never did so my knowledge of accounting is very much as a kind of outsider on this stuff
00:01:53
but I think there was a coming together of a couple of Trends so Financial Accounting my understanding of this
00:02:00
modern Financial Accounting begins with a Great Depression the creation of a security Exchange Commission efforts to
00:02:07
kind of standardize uh how financial accounting is done because you know if accounting is not consistent it's pretty
00:02:14
useless right and that has been in place for a while the Financial Accounting Standards Board
00:02:20
was created I think 1973 or so and they began to coordinate and consolidate the rules into clearer categories so they
00:02:29
could be used and then again in 2009 another effort in that so the standards the basic ideas of this are not new they
00:02:37
got started at a time when in most companies the big deal was Capital Equipment it was machine or even
00:02:44
manufacturing especially right so not too surprising that they focused on that and they didn't pay much attention to
00:02:51
human capital and the key distinction that they made was that something could be an asset if you own it
00:03:00
and then you could invest in it but only if you own it so once they thought about human capital
00:03:06
and they were not to my knowledge thinking about it at the time this was all promulgated
00:03:11
you know you don't own your employees so they can't be assets and you can't
00:03:15
invest in them because you can only invest in assets so that's been around for a long time what begins to change is
00:03:23
in the 1980s the rise of shareholder value as the new goal for companies they used to say
00:03:31
that the goal of companies was explicitly to balance the interests of the stakeholders and investors were one
00:03:38
but so were employees and so is the community around you and so were your customers when I first got to the
00:03:43
Wharton School that is how people thought about it right and how we taught it there was a academic Revolution on
00:03:51
that question that pushed sort of from the economics point of view the idea that really shareholders are the only
00:03:58
stakeholder and it was one of those battles that was one without a fight because we didn't actually teach
00:04:04
corporate governance here in most places so as it Advanced and finance became more important as investors became more
00:04:13
important and some of that happened when we started to get bigger institutional investors
00:04:19
you know groups like Calpers the California Pension Fund mutual funds like Vanguard and Fidelity these are now
00:04:25
huge investment blocks and particularly when they're buying the market average
00:04:30
right the idea that in the past is if they didn't like the way you were running their company they just dumped
00:04:34
the stock and move on you can't do that if you're trying to buy the market
00:04:38
average so you know a another development was this idea that the investors were pushing for this
00:04:46
shareholder value goal so once you had that we had Financial Accounting already which Drew this distinction between
00:04:54
human and physical assets there were no human assets right human capital broadly
00:05:00
defined and then the idea that shareholder value was really the big goal and then institutional investors
00:05:08
pushing that goal harder and harder all the time now we start to see some things change
00:05:14
and especially now that we start to see so many companies where the real value seems to be the people and so those
00:05:22
initial assumptions from you know the 1930s that people are not assets and they have no real value in
00:05:30
the finances of a company now starts to really bite because you have so many companies where the physical assets
00:05:36
don't matter and where investors are pushing harder on financial accounting outcomes because you know investors are
00:05:46
not trying to maximize current profits investors are trying to make money on future profits the value of the shares
00:05:55
is what will things look like in the future whether you're profitable today or not doesn't matter so much to them
00:06:02
so now we have to start thinking about what the rules of the game look like and like in sports
00:06:10
if you wanted to know how good a basketball team was you'd have to kind of Begin by understanding the game which
00:06:16
means understanding the rules on which it is played and financial accounting sets out the rules on which companies
00:06:24
are operating and what they're trying to do and those rules are financial accounting
00:06:29
and because of the quirks of the way it handles or doesn't handle human capital
00:06:34
we start to see bigger and bigger problems as human capital becomes in objective terms more important but in
00:06:43
financial terms still worthless and shareholder value based on financial accounting terms becomes the issue
00:06:51
so then with this shift especially in the last few years then the impact on the company and the
00:07:00
employee ends up being a pattern where you obviously don't want to see you go
00:07:06
down this pattern because as you and I have talked in a variety of different fronts in the past the value of the
00:07:12
employee really has a significant strength towards the company's you know bottom line benefit yeah and a lot of
00:07:19
our colleagues in strategy uh recognize that certainly the biggest uh benefit you've got the biggest
00:07:27
competency comes from the people and the way you manage them right and we have so
00:07:32
many companies like in the tech world where physical equipment doesn't matter
00:07:35
at all and it's all about intellectual horsepower and the ability to execute
00:07:40
things all those things are really kind of what matter and the investors have gotten onto this issue before anybody
00:07:50
else and their problem with financial accounting is they can't tell uh how valuable companies are because
00:07:58
they can't learn anything about its human capital because nothing about it is reported except for the total number
00:08:05
of employees you have but not the total number of workers so we'll come back to
00:08:10
that issue in a minute here right and it leads to all kinds of distortions as in
00:08:16
any situation where you measure only a few things and you leave out some important ones you're going to get
00:08:23
strange outcomes and that's what we get how then do you think this this shift
00:08:28
then potentially impacts how companies think about things like hiring and and where you know the the level of employee
00:08:39
involvement that they have within companies yes let's start with maybe the simplest
00:08:43
one let's talk about layoffs which if you think about it let's say our employees had asset value if you leave
00:08:51
the US accounting standards are different and some of those Accounting Standards do
00:08:57
allow employees to be assets so let's say we thought employees were assets and
00:09:01
head assets and we announced we're going to have a layoff and what layoffs meant
00:09:05
is we're just going to take those assets and we're going to push them out the
00:09:08
door you'd say that we're crazy right it's like okay we got a bunch of computers
00:09:13
here we're going to give them away we're just pushing them out the door it
00:09:15
wouldn't make any sense whatsoever and we see something like this if you see what's going on right now in the
00:09:22
tech industry especially but elsewhere you see companies that struggled like crazy to fill those positions and get
00:09:28
people and hold on to them and now they're dumping them and there's a pretty good bet that in six months
00:09:34
they'll be trying to get new employees back and in the current context unlike
00:09:40
you know the 1970s and before employees are not hanging around expecting to be rehired so you got to go back in and
00:09:46
hire people right so that's maybe the most obvious strange example when you come to hiring
00:09:53
you know the thing that employers measure in hiring is they measure the cost per hire perfectly sensible thing
00:10:01
to do the reason they measure that is those costs are ones that show up at least aggregated inside your financial
00:10:08
accounting and the other thing they worry about is cost sorry time to fill a vacancy those two things okay perfectly
00:10:16
reasonable what they don't measure is the quality of the higher which if you
00:10:21
think about it is exactly what you would think they would be looking at is how good are the people we're hiring
00:10:26
you know you could hire lousy people cheaply yeah right but if you look at what is reported in accounting and the
00:10:34
things that aggregate up that's your incentive uh hired cheaply uh don't
00:10:38
worry about whether they're any good or not right I mean it seems crazy but that
00:10:42
is literally what companies are doing the evidence on this is pretty overwhelming at least three different
00:10:48
surveys show that employers are not trying to assess the quality of the people they hire and they see them as
00:10:55
kind of interchangeable so you know one of the things that most all of us know is when you bring in somebody from
00:11:00
outside it takes a while for them to become productive compared to the people who are already there
00:11:06
there's no accounting for that I mean there's no literal accounting and there's no understanding of that either
00:11:11
so we're starting to see investors care about this a lot particularly when they
00:11:17
look at these Tech firms again because they can't figure out what the value is
00:11:21
and they would really like to know so take us into the the the structure of doing a book about this uh your book our
00:11:30
least important asset what was it that you have seen play out that have has really driven you to need
00:11:37
to do a book about this topic right now yeah well you know I think most people who are honest and kind of curious will
00:11:45
say that the book never turns out to be what you thought it was going to and you
00:11:50
probably know this about writing even writing papers you don't write the introduction until the thing is done uh
00:11:56
nor the conclusion because you don't really know what it's going to say so I
00:11:59
started out thinking I was going to write a book about how we actually manage employees
00:12:04
and that's different from what textbooks say like if you look at a textbook they'll talk about you know the issue of
00:12:10
hiring for example how you craft a job description and then you post a job ad and then you see who applies and then
00:12:16
you do these assessment tests and all this stuff right none of that really happens you know or rarely so the
00:12:23
evidence from the Census indicates the average person at least a couple years ago when they asked this question
00:12:28
reported that when they change jobs they were not looking for a job and they didn't really see a job ad somebody came
00:12:36
and got them we don't do any of those fancy testing of employees we typically
00:12:42
just rely on unstructured interviews which are pretty terrible as a way to hire especially when we get rid of
00:12:48
recruiters because they're expensive and we just push the task off onto Line
00:12:53
managers who aren't trained for this and they don't know what they're doing right
00:12:56
so I started to look at practices by practice to see how we're actually doing
00:13:00
on these things and it all seemed pretty lousy you know in ways that just wouldn't make sense to any of us if we
00:13:10
knew just a little bit about how employees actually operate so then I started to say why are they doing this
00:13:15
why do you see this same pattern everywhere and a simple description of this is It's the British phrase
00:13:21
Pennywise and pound foolish right so that is their squeezing costs on some costs and they're completely ignoring
00:13:29
other costs why is that and then I started to think about and look around to see what was driving this behavior
00:13:37
and you know the usual view we hear about shareholder values is they're just
00:13:41
trying to maximize profit so they're not paying attention you know to to anything
00:13:46
on the cost side but that's not true and part of the problem is we were kind of misled about what
00:13:53
companies do by our introductory economics classes which tell us that companies by definition are maximizing
00:14:01
profits okay what's a profit you just look at your revenue and you look at your uh costs and you subtract them and
00:14:07
that's your profit well that's not true at all uh anybody who sits down next to
00:14:12
an accountant for a while will get a half hour lecture as an introduction yes as to why that stuff is not so obvious
00:14:19
it's like thinking the game of basketball is simply about stuffing the ball in the hoop and stopping other
00:14:26
people from doing it and you would think well let's just tackle people which you
00:14:30
know does seem to happen in the NBA sometimes and let's just get a really huge guy standing of the basket and Pop
00:14:35
the ball you know you play it differently once you understand the rules right and so I ended up sort of
00:14:41
getting a sense of what the rules were big part of it is these Financial Accounting things there is another part
00:14:47
and that is in part because of the importance of investors and that shareholder perspective the people who
00:14:54
get to run companies now are different in systematic ways than they were a generation or two ago right they're much
00:15:01
more likely to be Engineers who come to these tasks with assumptions about human
00:15:07
behavior but also goals about optimization the data science world has given them lots of tools to optimize but
00:15:15
optimize you got to optimize on something and generally they optimize on minimizing the number of employees and
00:15:22
employment costs so that's what they end up driving and they haven't had as much
00:15:29
Management training most companies corporations got rid of that it used to be that you'd get hired you'd be put
00:15:34
into a management training program where they taught you all this stuff about managing people basically right right
00:15:41
and those are gone so we have a lot more CEOs famous ones in the tech world who never managed anything really they are
00:15:50
Engineers for the most part and you know their view about people was that they were not particularly important so that
00:15:57
that component of of the investor in this process we've obviously seen in in
00:16:04
the last few years how the investor and the employee have more of a voice in the
00:16:11
in what's going on in the company these days do they have enough impact where they're able to affect
00:16:18
change on on a topic like this on an issue like this on on that element of financial accounting yeah so the
00:16:25
investors you would think have the big hammer right because they're driving what uh executives are doing
00:16:35
um the accounting world and this is you know is an outsider to it but at least listening to our colleagues who are deep
00:16:41
into this the accounting world is astonishingly conservative it is Run for the most part by
00:16:49
associations of accountants and the Financial Accounting Standards Board sets the rules for accounting they are
00:16:57
overseen by another board which is not elected it's sort of that industry of
00:17:03
financial accounting but not Finance just Financial Accounting right the security exchange Community or Exchange
00:17:11
Commission has delegated the task of creating those rules to the Financial Accounting Standards Board and they
00:17:19
haven't been particularly concerned about what those rules do to the operation of companies right they have
00:17:25
been concerned about being consistent and the idea of valuing human capital is something that's kind of off the charts
00:17:33
for them it seems so weird so the investors have been pushing for a while to try to get more from companies on
00:17:40
this in terms of reporting they've been pushing security Exchange Commission
00:17:44
hard on this they haven't gotten very far yet so the little bit they got is in
00:17:50
2021 the security Exchange Commission required that companies report anything they thought was material about human
00:17:59
capital their human capital to their business but they get to pick what that is right and they get to pick what they
00:18:04
report and so what most of them report is just verbage about their principles so it's worthless if you're an investor
00:18:12
you don't learn anything from it so these investor groups are big and they still aren't getting very far which
00:18:19
shows you that this world of accounting standards is remarkably insular and I think everybody who looks at that is
00:18:28
struck by it and lots of people have thought about it so the investors can't
00:18:32
make much Headway on this at least not yet the employees have very low power the only Power employees ever really
00:18:39
have is if a lot of them are quitting right A lot of them were quitting that might be slowing down a bit now I'd say
00:18:48
the employers have largely resisted efforts to do make the changes that employees want so for example there's a
00:18:57
big concern now about mental health in the workplace many employers are responding to that which is a nice thing
00:19:02
but what they're responding to is helping you deal with the stress that we have created for you right they're not
00:19:09
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
00:19:17
that employers are willing to up wages enough to maybe clear the labor market for them and one of the reasons for that
00:19:26
again is that what investors see are the wage and salary costs that's a bad thing
00:19:31
they really don't like those because those uh look to them like fixed costs even though they're not fixed
00:19:38
historically they were more fixed and in economics we treated them as if they were fixed that is they couldn't go down
00:19:44
in a downturn in the business but of course they can and one more thing which is particularly quirky is the security
00:19:51
Exchange Commission requires that you report headcount which is the number of employees not the number of workers okay
00:19:59
so if you bring in contractors that doesn't count so if you'd like to make
00:20:04
your Revenue per employee or profit per employee jump up drop some of your employees and bring in non-employees to
00:20:12
do that work the denominator fall all suddenly you look wildly more productive and efficient and valuable so that's
00:20:19
another one of the quirks of this financial account well and I would think as well that when you talk about the
00:20:26
successes and failures that employees and managers have that that obviously has to factor into this as well because
00:20:34
the accountants are looking at the bottom line if you have projects that fail that's going to end up hurting your
00:20:40
bottom line and then that's going to have a downstream impact on who managers
00:20:45
are how many managers there are how many employees there are it's it's it is as
00:20:49
the title of our podcast is there is a ripple effect that plays out here yeah I think the investors would love to see
00:20:55
that the companies don't want to show them anything about their internal accounting right you know how are our
00:21:02
projects doing what is our turnover of employees by the way this is what the proposals the new employees sorry the
00:21:10
new proposals driven by investors in our accounting colleague Dan Taylor here in
00:21:15
our accounting department is one of those people is asking for the same thing I was suggesting independently and
00:21:21
that is let's ask companies to report turnover let's ask them to report how
00:21:26
much they spend on training investors can't see that right now training doesn't count as any kind of investment
00:21:32
because remember you can't invest in things that aren't assets your employees
00:21:35
aren't asset so you can't do that so I think you know there are pressures on
00:21:40
um to improve this but the resistance is so big so far not much is happening how you mentioned a moment ago about uh
00:21:49
the c-suite level uh impact uh how then does that impact the longer term decision process at the c-suite when you
00:21:59
have people that are in those roles that aren't really the ones that have made
00:22:04
those type of decisions in the past yeah I think that's uh that is a big issue and you know CEOs in particular
00:22:11
have a really difficult job and they can't know everything and they need people around them who can point out
00:22:19
those things you know that you're supposed to know they're not experts on
00:22:22
marketing they're not experts certainly on human resources very few anybody comes through that track and gets to the
00:22:28
top right so somebody has to kind of point this stuff out to them and make the arguments to them that hasn't been
00:22:36
happening I think over the last well since the 1980s basically the pressure has been on human resources to cut right
00:22:45
because that's what improves the company's Financial Accounting outcomes
00:22:50
and you know making an argument about why we really need to invest employees gets nowhere we're in a slightly
00:22:58
different moment now because now there are enough concerns about employees some of these under the ESG umbrella you know
00:23:07
social impact you should be nice to your employees some of it because frankly they're quitting and quitting is super
00:23:14
important even though in financial accounting it doesn't show up Anywhere But as a CEO you can't miss the fact
00:23:21
that a lot of your people are quitting and especially people close to you right so I think the you know again I think
00:23:29
the pressure is on to do something about this but the CEOs themselves don't really understand a lot of this stuff
00:23:36
they don't understand what the costs are of turnover most companies don't know
00:23:41
it's a little hard to figure this stuff out most of them are not trying I think
00:23:45
the human resource people understood that nobody really wanted to hear this stuff and they didn't want to get up on
00:23:51
a soapbox and make the case now it's easier to do right once you see that your positions are vacant and you're not
00:23:58
getting things done it's a little hard you know it's a little hard to miss that
00:24:02
there is one place where I think we are seeing particularly quirky decisions I think by employers and the c-suite
00:24:11
things and this is back to this optimization goal there are a lot of things that we have studied for a long
00:24:17
time and lots of evidence for that show that engaging employees in some decisions makes much better outcomes
00:24:24
they know things that are useful in the decision and they also care about it and
00:24:29
so more invested in it when they do it themselves a lot of that a lot of those practices are going away and being
00:24:35
replaced by software so here's an example let's set our work schedules we
00:24:40
have 10 employees in my office the work has to be covered the office has to be covered but people always have
00:24:45
emergencies and many of them have life concerns that they would like us to accommodate in some way well there's a
00:24:51
couple ways you could do that one of the ways which has worked extremely well is something just called
00:24:56
Flex time and flex time means that the employees get together and they work it out and they say Okay Dan's going to do
00:25:03
this on Monday he's got to come in a little late uh but I can cover that if he will cover this later it it takes a
00:25:10
little while to get good at this but it doesn't take long and it's quite
00:25:13
flexible right the other way you could do it is you could delegate it to software and software will make sure
00:25:19
that everybody has exactly the same number of hours everybody is treated equally but there's no flexibility in
00:25:25
that and employees don't like it because they have no say why would you go with
00:25:30
software when you could do this with employees and it's much simpler in the long run well because we want to be
00:25:37
optimal and getting employees to do this I don't know how to do that work with
00:25:43
employees so I'd like to just turn this over to software and let them do it so
00:25:47
we get a worst solution which is more expensive but it seems to fit this goal of optimization right so we're seeing
00:25:54
several of those situations play out in the workplace now Peter great to talk with you good luck with the book the
00:26:01
book is titled our least important asset Peter Capelli the Wharton School thanks
00:26:05
very much for coming in good thank you Dan thank you for listening to the ripple
00:26:10
effect we hope you found this episode informative and engaging don't forget to
00:26:14
subscribe and leave us a review so that we can continue to bring you the best Insight from the Wharton School
00:26:20
[Music]