Human Resource Accounting

Human Resource Accounting Meaning, Definition

Table of Contents:-

  • Meaning of Human resource accounting
  • Definition of Human resource accounting
  • Objectives of Human Resource Accounting
  • Process of Human Resource Accounting
  • Methods of Human Resource Accounting
  • Importance of Human Resource Accounting
  • Issues/Problems of Human Resource Accounting

Meaning of Human resource accounting 

Human resource accounting is a system of accounting that considers human resources a valuable asset. It includes a record of all financial expenditures related to human resources, including wages, salaries, training costs, and more, in the books of accounts. The value of human resources is also recorded in the books of accounts, just like other physical possessions. Assessment, budgeting and reporting the cost of human resources helps the organization accurately document its assets and, thus, is a mandatory part of every business association. Any organisation’s financial report depends entirely on the cost of the workforce working in that organisation.

Definition of Human resource accounting

Flamholtz states, “Human resource accounting is the measurement of costs and value of the people for the organisation”.

According to the American Accounting Association Committee, “Human resource accounting is the process of identification and measuring data about human resource, and communicating this information to interested parties”.

As per R. L. Woodruff, “Human resource accounting is an attempt to identify and report investments made in human resource of an organisation that are presently not accounted for in conventional accounting practice”.

According to Stephen Knauf, “Human resource accounting is the measurement and quantification of human organisational inputs such as recruiting, training experience and commitment”.

Objectives of Human Resource Accounting

Human resource accounting has the following objectives:

1) It enables the organization to plan a projected budget for human resource expenses well in advance, covering acquisition costs, expansion costs for human assets, training expenses, salaries, and wages, among others.

2) Once management possesses quantitative information about the organization’s human assets, they consider it an integral component of all decision making processes. This fosters an enhanced managerial ideology as the organization gains clarity about the economic impact of human resources.

3) It allows management to assess whether the available human resources are being utilized optimally, ensuring the workforce is utilized efficiently and preventing labour exploitation within the organization.

4) The HRA system enables organizational management to evaluate employees based on performance and standards, providing incentives accordingly.

5) Human resource accounting is one of the most effective methods for measuring an organization’s expenditures on human resources and determining the precise value of these resources. All decisions regarding the workforce in a particular organization are based on HRA.

6) To estimate the value of human resources, an organization must adhere to specific principles and procedures established by the human resource department standards.

7) In the event of any impending changes in the value of human assets within an organization. HRA signals the management in advance so that appropriate measures can be taken to preserve the organization’s most valuable human assets.

Process of Human Resource Accounting

Management must follow a specific process to implement human resource accounting. The procedure is as follows:

Step 1: HR Accounting Objectives

Every organization must define a set of objectives, which serve as the foundation for the human resource accounting system. These objectives include establishing a problem-free budgeting system, determining the cost of human resources, and providing accurate information about the value of human resources for optimal utilization by management. This information is gathered from various departments within the organization. All departments involved in human resource management must clearly outline their functions, decisions, and the rationale behind them. Once this information is provided, it becomes easier to define the objectives of the human resource accounting system.

Step 2: Developing HRA Measurements

There are primarily two methods for making HR accounting measurements:

  1. Management can choose one specific measurement method or use several methods.
  2. Both monetary and non-monetary methods can be used as standards for measuring the cost, value, or both of human resources. Before implementing any of these methods, their consistency and validity must be evaluated.

Step 3: Developing HR Accounting Database

The human resource accounting system relies on various factors, such as time management sheets, the cost of each employee, and various psychological factors. These factors form the database for the HRA system. In some cases, restructuring the organization’s accounting system may be necessary to classify human resources costs separately. This categorization should be based on monetary aspects, such as staffing and training and non-monetary elements, such as employee behaviour and character assessment.

Step 4: Pilot Testing the System

After achieving the first three steps systematically—setting objectives, developing dimensions, and establishing an adequate database—the next step is pilot testing the accounting process. Pilot testing involves pre-checking the system’s functionality before fully integrating it into the organization. Management’s coordination and cooperation throughout the pilot testing process are essential for its success.

Step 5: Implementing the Human Resource Accounting System

This is the final step of the human resource accounting process. The organization introduces the entire workforce to the new accounting system during this stage. Employees are informed about the importance and various methods of HRA and how it can benefit them. Responsibilities for managing the HRA system are assigned to deserving candidates. The HRA system can be easily modified and improved to adapt to changing organizational requirements. Regular reviews are essential for the smooth functioning of the HRA system, as they prepare the system to adjust to the organization’s evolving needs.

Methods of Human Resource Accounting

Different methods contribute to the human resource accounting system. These methods can be categorised into two major categories:

1) Monetary Measurement Methods: These methods aim to measure the value of people as organizational resources in monetary terms. Employee performance, the number of promotions and transfers, worker productivity, and profits generated by an employee for the organization are some ways to measure the value of an employee in financial terms.

2) Non-Monetary Measurement Methods: These methods encompass aspects of human resources that cannot be quantified monetarily but have financial implications for the organization. For example, employee behaviour, performance, development, attendance, dedication, and ability to achieve organizational goals. All these factors play an essential role in assessing employee values and can also be used to estimate the potential monetary benefits for the organization in the future.

Monetary Measurement Methods

Monetary measurement methods are as follows:

  1. Replacement Cost Method
  2. Capitalisation of Salary Method
  3. Economic Valuation Method
  4. Reward Valuation Method
  5. Return on Efforts Employed Method
  6. Historical Cost Method
  7. Opportunity Cost Method
  8. Adjusted Discounted Future Wages Method

1) Replacement Cost Method

This method, introduced by Rensis Likert and Eric G. Flamholtz, calculates the value of employees in an organization by assessing the costs involved in replacing current employees with new staff. According to this method, management determines the expenses incurred if other suitable and qualified individuals replace current employees. Recruitment, training, selection, and development costs are also considered. Unlike the historical cost method, which focuses on the historical value of employees, this method is based on the developmental expenditures of employees.

2) Capitalisation of Salary Method

Developed by Schwartz and Lev in 1971, this method is also known as the present value of future earnings model. According to them, a close relationship exists between an employee’s salary and their value to the organisation. This method is based on two assumptions: firstly, that an employee’s future earnings can be used as an alternative for their present value, and secondly, that the employee will continue with the organisation until retirement. The technique involves the following steps:

  1. Categorising employees into groups based on age, experience, skills, etc.
  2. Calculating the annual income of each group of employees, and
  3. Assessing the present value of each group’s future income using the appropriate discount rate.

Many renowned organisations such as Cement Corporation of India (CCI), Steel Authority of India (SAIL), Bharat Heavy Electricals Ltd. (BHEL), Southern Petrochemicals Industrial Corporation Ltd. (SPIC), Infosys, etc., have adopted this approach for the valuation of HR.

3) Economic Valuation Method

The economic valuation approach is another method that can be used to evaluate the cost of human resources working in an organization. This method calculates future earnings that employees can generate during their tenure. This cost is then subtracted from the expenses incurred for various functions such as recruitment, selection, training, etc. The result obtained from this calculation represents the economic cost of the employees.

4) Reward Valuation Method

Introduced by Flamholtz, the reward valuation method is considered an improved version of the capitalization of the salary method. This method finds the possibility of an employee leaving the job before retirement or in the event of their death and the potential changes in their role throughout their professional career. According to this method, an employee’s current and actual value is based on the expected realizable value of the employee. The assumption underlying this expected likely value is that there is no direct correlation between the total cost incurred on an employee and their value in the organization at a specific time. The value of an employee can be determined by assessing the current value of the services they can provide in the future during their employment in the organization.

5) Return on Efforts Employed Method

The organization’s benefit or return entirely depends on the efforts made by its employees. This method entails measuring the gains that employees provide to the organization regarding profits, productivity, etc. This type of valuation considers factors such as designation, experience, skills, etc.

6) Historical Cost Method

Brummet, Flamholtz, and Pyle developed the historical cost method. Historical cost refers to the expenses incurred in acquiring and developing human resources over time, which are then aggregated to determine the actual cost of HR as an asset and estimate the depreciated cost of human resources. Under this method, human resources are treated similarly to physical assets. Just as the cost of a physical asset is reduced when any part of it expires, a portion of an employee’s value is depreciated each year as an expense against the profits earned. Expenses incurred for recruitment, training, development, promotion, etc., are considered investments in HR and are gradually reduced each year until the employee leaves the organization.

7) Opportunity Cost Method

This method was developed by Hekimian and Jones, who observed the inclination of various managerial employees to hire a large number of people and enhance the investment base. The opportunity cost approach emphasizes the significance of human resources, as it is grounded in the ‘opportunity cost’ concept of economics. There is a direct correlation between the scarcity of human resources and the opportunity cost. Neither surplus employees nor top-level employees incur opportunity costs. Therefore, the opportunity cost method does not apply to all human resources.

8) Adjusted Discounted Future Wages Method

Introduced by Hermanson, this method involves adjusting an employee’s compensation value to align it with their value within the organization. The discounted future wages are adjusted by an efficiency factor, which determines the relative effectiveness of the organization’s human resources. The following steps are involved in measuring the worth of human resources according to this method:

i) First, the wages and salaries of all employees at various hierarchical levels are calculated for the subsequent five years.

ii) Then, the present value of the salary and wage payments at the rate of return is calculated.

iii) The average efficiency ratio for a specific period, typically the past five years, is determined.

iv) Finally, the present value of the future services of the organization’s human capital is calculated by multiplying the discount value (step ii) by the organization’s efficiency ratio (step iii).

The efficiency ratio can be calculated using the formula given below:

Efficiency Ratio = Actual Average Earnings of the Organization / Normal Earnings of the Organization

If Efficiency Ratio = 1: The organization’s average rate of return equals the economy rate of return, indicating that the value of HR is equivalent to the industry’s value.

If Efficiency Ratio > 1: The organization’s returns exceed its average earnings, suggesting that the value of the human resource surpasses the industrial average.

So, If the Efficiency Ratio < 1: The organization’s returns are lower than its average income, indicating that the value of the human resource is less than the industrial average.

Non-Monetary Measurement Methods

Non-monetary measurement methods are as follows:

  1. Performance Evaluation Methods
  2. Potential Assessment
  3. Skills Inventory
  4. Attitude Measurement
  5. Subjective Expected Utility

1) Performance Evaluation Methods

Another way to evaluate human resources is based on performance. Two methods for performance evaluation are as follows:

i) Rating: This method involves setting a scale to assess a worker’s performance. Ratings are assigned to employees based on their intelligence, professional knowledge, interpersonal proficiency, and ability to judge situations.

ii) Ranking: In this method, individuals are evaluated based on one or more criteria. The ranking is considered another form of rating. For instance, ranking can be utilised when an evaluator assesses workers based on their leadership qualities.

Types of procedures for ranking include:

a) Simple Ranking: This is the most straightforward procedure in which the evaluator ranks employees based on specific dimensions, from highest to lowest. For example, in terms of punctuality, the most punctual employee is given the highest rank, while the frequently late employee is given the lowest rank.

b) Alternative Ranking: This method selects one employee with the highest value and one with the lowest value, repeating the process for each employee. This makes the ranking method reliable and straightforward.

c) Paired Comparison: In this method, each employee is compared with every other employee, enabling ranking based on these comparisons. This approach facilitates the selection of the best employee from the group.

2) Potential Assessment

Potential assessment, as the name suggests, involves evaluating the capabilities of an organization’s human resources for the future. The primary approach for assessing potential is the trait approach, which focuses on identifying the traits required for a particular job position and determining their degree of presence in the workers. As an individual’s development depends on their potential, potential assessment plays a critical role in calculating the non-monetary value of human resources.

3) Skills Inventory

A skills inventory records an individual’s capabilities, classifying employees based on their skills. Evaluating employees’ behaviour and skills is the most straightforward method. These abilities are assessed according to employees’ qualifications, acquired training, gained experience, and other additional talents. Based on their potential, assessments are made regarding how long their services can be optimally utilized.

4) Attitude Measurement

Attitude reflects one’s personality. Organizations employing attitude measurement techniques can quickly gauge their employees’ perspectives, such as job satisfaction, happiness with working conditions, salary expectations, and overall job satisfaction. These are questions that can be answered by evaluating employee attitudes. Through the study of attitudes, management can also gain insights into the feelings of their employees. One standard method of assessing employee attitudes is the questionnaire method, where employees can respond to various questions with options such as:

  1. Excellent
  2. Good
  3. Average
  4. Below Average

5) Subjective Expected Utility

This concept of ‘subjective expected utility’ consists of two additional concepts: utility and subjectivity. Firstly, utility refers to the value of any resource or its usefulness for its user. Secondly, subjectivity pertains to an individual’s viewpoint regarding the likelihood of any event. There are various psychophysical methods to calculate utility and subjective probability.

These methods include ranking, paired comparison, and magnitude estimation. The magnitude estimation method involves assigning numbers to indicate the magnitude of a property. If a property is set to a zero number, it suggests that the value of the property is nil, but if the assigned number is high, it signifies that the property has a high value.

Importance of Human Resource Accounting

With time, HRA has gained significant importance in almost all organisations. Its importance is discussed below:

1) Helps in Calculating ROI

HRA is an accounting system that identifies the expenditure made on an organisation’s human resources. Once the investment is calculated, an organisation can ascertain the exact Return on Investment (ROI) by calculating the profits. This helps management determine how much they should spend on human resources to achieve maximum ROI.

2) Ascertains Negative Effects of Programs

The HRA system also helps management determine the adverse effects of various programs running in an organisation.

3) Sign of Good Health of the Organization

HRA serves as an indicator of the well-being of any organisation. The investment made in human resources helps measure potential future profits.

4) Helps in Determining Recruitment Needs

HRA reports provide insights into the chances of returns and the required expenditure on the organisation’s workforce. If profits are high, the demand for recruiting new employees increases, while if no profits are gained, no further recruitment takes place. These decisions are based on information provided by HRA.

5) Facilitates Scheduling and Implementing HR Policies

The HR policies of an organisation, including those regarding functions such as promotions, training, demotion, and transfer, are crucial for smooth operations. An organisation’s Human Resource Accounting system controls these policies’ proper scheduling and implementation.

6) Motivates Employees

Employees become motivated to improve themselves when they understand their value per the organisation’s HRA system. The investment made in them inspires them to increase their output proportionally.

7) Improves Decision-Making Process

Human Resources Analytics (HRA) serves as a central hub for obtaining information regarding the actual value of human resources. This information aids management in making appropriate decisions regarding organisational issues.

Issues/Problems of Human Resource Accounting

Though there are many advantages of HRA, there are also certain disadvantages. Some of them are as follows:

1) Trade Union Resistance

Estimating the value of human resources may lead to resistance from union leaders and industrial conflict. This opposition may arise due to bias on the part of management while estimating the value of human assets. Thus, before introducing HRA in an organisation, all employees and leaders must be made aware of the importance of HRA and how it can benefit them.

2) Lack of Perfect Knowledge about Future Receipts of HR

The future is unpredictable and full of uncertainties. An investment made will be profitable. Therefore, sometimes, evaluation on an imaginary basis poses an excellent problem for the HRA system. Thus, there needs to be more perfect knowledge regarding the future earnings of any organisation.

3) Variety of Methods Creating Confusion

Many methods can be used to calculate the cost incurred on human resources. This variety of methods can lead to misunderstandings, so management should choose a specific process to evaluate HR costs to avoid uncertainty.

4) Uncertainty about Continuance of Employees

Unlike machinery, one cannot expect the workforce to stay within the organisation for a lifetime. Circumstances may occur that cause employees to leave their jobs. Thus, the stability of an employee in any organisation is still being determined. However, this uncertainty increases vacancies in the organisation, troubling the estimation of human resource accounting and further disrupting the organisation’s operations.

5) Non-availability of Standards

The leading problem organisations face is the need for proper standards to evaluate the cost incurred on human resources. The Institute of Chartered Accountants of India (ICAI) should formulate specific criteria to measure the value of human assets.

6) Expense

It should be cost-effective when introducing HRA in an organisation. This system is useless if its adoption affects the organisation’s profit. Therefore, the expenditure on this system should be sensible. Otherwise, it may incur additional costs to the organisation.

7) Results in Dehumanization

If human asset valuation is not done correctly, it may result in workforce exploitation. The evaluation conducted by Human Resource Accounting should benefit the organisation without showing favouritism towards employees at their expense.

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