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Acknowledgement: This article is reproduced by kind permission of the Institute of Electrical Engineers. It appeared in their Engineering Management Bulletin.
There’s no accounting for skills It is frequently remarked by senior company representatives that their company’s greatest asset is its staff. How they know this is a mystery as there is no evidence of it in the company’s accounts. Indeed, if there was then perhaps downsizing would not be so popular: the shareholders would object to the assets being jettisoned in that cavalier fashion.
by John Locke
In today’s world of business, companies do not feel that they can put a monetary value on their staff or, more precisely, on their staff skills, nor does current accounting practice appear to provide a way to put this asset into the accounts. What is proposed in this article is one method of overcoming these difficulties, to the benefit of the shareholders and the staff alike, and to provide a monetary incentive for staff training.
The employment of expertise In employing a person, one does two things: one pays for their mental and manual skills and knowledge (which for the sake of brevity will henceforth be described in one word as expertise), and one pays for their time to apply this expertise. One will only employ those who can provide a net gain to the organisation. But there will be some who will contribute more than others; this depends on their level of expertise and the ability to apply it economically, i.e. within the shortest time and with the minimum of assistance. A machinist who can turn out 100 widgets an hour is worth more than one who can only make one an hour. Again, it would be of little use employing a mathematician who was unable to apply his expertise to a wide range of practical problems. We are therefore concerned with the intensity, the speed, the cost, and the breadth of application of this expertise in determining the worth of an employee to the organisation. In this context, the cost will be the salary/wages of the employee together with the other overheads and fixed assets which that employee absorbs in their work. Note that the cost is not the same as the worth of the employee.
Well, that didn’t take so very long!
The value of expertise Present accounting convention only allows for the cost of the employee to be shown in the accounts, but the worth of the employee is more than this, otherwise the organisation would soon become bankrupt. What is not shown in the accounts is the value of the expertise discounting the cost. This expertise, whether mental or manual skills or knowledge, is an asset and should be shown on the company accounts as such, but then we are back with the problem of valuing this asset. If we had to buy in this expertise from another company, we would have to pay more than the individual’s pay. The subcontracting company would probably charge twice that amount to cover their costs and to make a profit. This excess of buying-in cost over in-house pay is a good measure of the value of the ‘expertise’ asset when owned in-house although, strictly speaking, the value of expertise should equate to the average cost of acquiring it. In the simplest terms, pay as shown in overheads pays for the time during which the employees apply their skills, whereas the value of the expertise itself would appear as an asset. The two together add up to the ‘bought-in’ value. The implication is that the figure for pay should appear twice in the accounts, once as a cost for the employee’s time in applying their expertise and again, in assets, as the value of this expertise. This is one extreme, but at the other end of the scale one could judge the expertise to be worth what the employees would be given in severance pay at the time the accounts are made out. The characteristics of the expertise assets are that: (a) They tend to remain constant within a company that has a steady turnover.
(b) As the skills requirement within a company evolves then the existing expertise asset will depreciate without skills maintenance training. If the expertise requirement remains static, then the value of the expertise asset does not depreciate.
(c) Training to increase expertise within a company (upskilling) has the effect of increasing the value of the expertise assets.
(d) These assets are brought in by the employee and increased or maintained by training.
which time it can be withdrawn and taken elsewhere.
And, best of all, he works for peanuts!
Employee worth The expertise asset of a single employee is a measure of the wealth that each generates. Annually this amounts to a share of the total turnover. However each employee contributes a different share. Their annual pay must be a measure of this share which we will call their annual worth. If their pay is too small compared to their annual worth then the employee is likely to be poached by another company, whereas if it is too large then they will be driven harder within the company to make up the deficit, or be sacked. Introduced assets When a new business is started, the owner will introduce some assets into the business such as a car, a computer and some cash; but this is not all that is introduced, the owner will also introduce skills and intellectual property. These will be the idea behind the business venture and the manual and intellectual skills to carry it out. These ideas and skills are worth money: they have cost money to acquire and are marketable. The owner has therefore introduced into the business not only capital but also other assets. The balancing accounts are introduced assets and fixed assets, i.e. a transfer from the first to the second when the assets are introduced. Prudent accounting will show these introductions not as ‘introduced capital’ but as ‘introduced assets’ and will put a value on all of them. The value of introduced assets The value to be placed on intellectual property will be the amount that would have to be expended to buy it from someone else and the value to be placed on the manual and intellectual skills would be the amount that would have to be expended to acquire these skills. As discussed above, however, the figure of annual pay will be used as a starting point in the examples that follow. The distinction between property and skills in financial terms is that property is a one-off acquisition that depreciates with use and age whereas skills are acquired over a period and can appreciate with time and usage. What is more, every employee who is taken on brings with them skills that are an asset to the firm and are capable of generating revenue, otherwise they wouldn’t be employed. Revenue is generated from premises, equipment, consumables, materials and expertise. Consumers buy products because they do not have one or more of the tools, materials, knowledge, skills or time to make the item for themselves. Note that skills and knowledge lie over and above the time spent in applying them. If one accepts that the company is receiving the full value of an employee’s expertise after a year is past, then the expertise asset for that employee will have risen to that value at the end of the first year of employment. Strictly speaking, this rise will be exponential, but it will be easier to consider it to be linear for the present. Severance pay can be regarded as a repayment of part of this introduced expertise asset: a transfer of money to repay introduced assets, in the same way that introduced capital can be repaid.
Table 1 Annual turnover £1 million, fixed assets £200 000, cost of sales £300 000, overheads £350 000, wages/salaries bill £333000 included in the cost of sales and overheads given. Annual skills maintenance training bill £10000, upskilling bill £10000.
Note 1: The profit is higher by £10 000 because upskilling training has been moved from overheads to capital expenditure. Note 2: Assuming that none of the assets is a building.
Effect on the balance sheet Regarding introduced expertise as introduced assets will have a profound effect on the company’s balance sheet. It appears that tax regulations will allow ‘introduced skills’ to come under the tax category of ‘know-how’ for which there is a 25% capital allowance, decreasing. However, with suitable skills maintenance training, this asset does not depreciate. The cost of skills maintenance training is less than depreciation in that the training can be done in class sizes of up to 20 and for a few days a year only. If the skills maintenance training costs 1/12th of depreciation, then for a wages bill of £336 000, maintenance training could cost only £7000 while the know-how allowance is £84 000. ‘Introduced intellectual property’ can be included under know-how, copyright or patents tax categories, all of which are at present given capital allowances. As mentioned earlier, it would seem that introduced capital is overdue for a change to introduced assets since it already includes the introduction of fixed assets and liquid assets. As introduced assets, it would cover these together with introduced skills, intellectual property, copyright and patents that are brought, rather than bought in.
Example of the financial effects of introduced assets The effect on the company’s balance sheet can be seen from the example in Table 1. It can be seen that the introduced assets account increases the net worth of the company, decreases the tax on profits and increases the profit after tax. It will also convince the shareholders of the value of skills and training, and will put some logic into the levels of redundancy/severance payments for all levels of staff. The importance of a non-depreciating asset in reducing the tax burden is evident and, although the above may be an extreme example, the reduction in tax liability will still be significant. The inclusion of introduced goodwill and introduced intellectual property within the introduced assets account will have the same beneficial effects.
Making the changes fiscally neutral In this case, the decrease of tax is about 25% (or 5.6% of the wages bill). If the level of decrease of corporation tax throughout the country was about 20% this is likely to make the Inland Revenue and the Government somewhat unhappy unless there was some compensating effect. Taking the figures from ‘The United Kingdom National Accounts’, the Blue Book for 1995, we have the details shown in Table 2.
Table 2
The gains from providing the financial incentive to employment as described above are:
· personal income tax increase
· increase in employer and employee social security contributions
· reduction of unemployment pay paid
· reduction of income support paid
· reduction of housing benefits paid.
When these balance the loss to the Exchequer of corporation tax then the measures suggested are fiscally neutral. This occurs when (letting U = % decrease in unemployment and U x 2.59/25.4 = the increase in employment) 17341 x 20% = ((56378 + 41977) x U x 2.59/ 25.4) + (1360 ± 8000) x U or 3468 = 10029x U+9360x U Thus % reduction of unemployment = 17.9% and % increase in employment = 1.82% when fiscal neutrality is reached. From these figures, national unemployment should fall by a little above 460 000. In the company example shown above, if the wages bill is increased by 1.82%, it becomes £339 060. The skills asset becomes £349 060, capital allowances become £137275, taxable profit £222 735, tax £55 684, and profit after tax £304316, roughly the same as before without taking into account the increase in turnover that should occur with increased employment. With the financial incentives outlined above, this increase in employment should be possible as downsizing becomes a disadvantage to companies and their shareholders.
Conclusions 1 Changing the account ‘introduced capital’ to the more appropriate ‘introduced assets’ provides a clear path for accounting for intangible assets. 2 Once this path is opened, a value representing the skills of all members of staff can be shown in the accounts. The major argument will be on setting this value, but it is suggested that the starting point must be how much these skills would cost if bought in. 3 Skills are a non-depreciating asset; however, they can become outdated. Where this happens, they can be inexpensively brought up to date by either the normal process of self-improvement or by formal training. The asset can be appreciated in value by ‘upskilling’ training. 4 The tax advantages of non-depreciating intangible assets are clear and are covered by the present tax allowances for ‘know-how’. These tax advantages of up to 25% are an investment by the State in skills and employment. 5 The clear representation of skills, and other intangible assets, in company accounts allows for the correct valuation of companies as going concerns, bringing benefits to shareholders and staff alike. It will also show the true cost of downsizing. The prospects for change There is a growing, international groundswell, from the USA to Switzerland and from Sweden to Australia, for putting ‘the company‘s greatest asset’ (its staff skills) and other intangible assets into the company accounts. This article proposes a method whereby this might be achieved without a revolution in accounting practice nor in taxation rules. The adoption of these ideas depends on the accounting profession, on Government and on the companies themselves. The Accounting Standards Board has studied the ideas in this article in the course of its work in developing an accounting standard on Goodwill and Intangible Assets. A tax incentive for skills and employment is long overdue and the UK Treasury, and the Government, may be satisfied that, although the corporation tax take may decrease, income tax and social security contributions will increase and, at the same time, the costs of unemployment will decrease. As for companies, the prospect of reduced taxes and increased company worth might even engender a rush to adopt these principles!
© lEE: 1997
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