HumanResource

Accounting

Advances in Concepts,Methods and Applications

Third Edition

Human Resource

Accounting

Advances in Concepts, Methods and ApplicatioRS

Third EditioD

by

Eric G. Flamholtz

.... " Springer Science+Business Media, LLC

Library of Congress Cataloging-in-Publieation Data

Flamholtz, Erie. Human resouree aeeounting : advances in eoneepts, methods, and

applieations I Erie G. Flamholtz. - 3'd ed. p. em.

lncludes bibliographieal references and index. ISBN 978-1-4613-7940-9 ISBN 978-1-4615-6399-0 (eBook) DOI 10.1007/978-1-4615-6399-0 1. Human eapital-Aeeounting. 1. Title.

HF5681,H8F55 1999 658.3-DC21 99-23037

CIP

Copyright CI 1999 by Springer Seience+Business Media New York Originally published by Kluwer Academic Publishers, New York in 1999 Softcover reprint ofthe hardcover 3rd edition 1999 Ali rights xeserved. No part of this publieation may be reproduced, stored in a retrieval system or transmitted in any form or by any means, mechanieal, photo-eopying, recording, or otherwise, without the prior written pennission of the publisher, Springer Seience+Business Media, LLC.

Printed on acid-free paper.

This book is dedicated to myfamily and one specialfriend:

~ Pearl Flamho/tz

.¢. Alexander Flamholtz (In memoriam)

.¢. Yvonne Randle

~ Laurie Flamholtz

~ Carl Flamho/tz

~ Robert Flamholtz

~ William Rossien (In memoriam)

~ Edith Rossien (In memoriam)

~ Stanley Rossien

~ Hilda Rossien

And

~ Diana Troik

Contents•••••••••••••••

The Author ix

Preface xi

Introduction: The Development and State of the Art of Human ResourceAccounting 1

Part I: Role of Human Resource Accounting 7

1.

2.

Uses for Managers and Human Resource Professionals

Uses in Corporate Financial Reporting

9

29

Part D: Accounting for Buman Resource Costs 53

Part ill: Accounting for Human Resource Value

3.

4.

5.

6.

7.

8.

9.

10.

Measuring Human Resource Costs: Concepts and Methods

First-Generation Accounting Systems for Human Resource Costs

Second-Generation Accounting Systems for Human ResourceCosts

Determining Human Resource Value: Concepts and Theol}'

Monetary Measurement Methods

Nonmonetary Measurement Methods

First-Generation Accounting Systems for Human Resource Value

Second and Third-Generation Accounting Systems for HumanResource Value

55

79

119

157

159

179

219

231

249

Part IV: Applications and Implementations 283

Annotated Bibliography

11.

12.

13.

14.

Designing and Implementing Human Resource AccountingSystems

Applications for Improving Management, Training, and PersonnelDecisions

Developing an Integrated Systems

Recent Advancement and Future Directions in Human ResourceAccounting

285

299

321

349

359

Notes

Index

377

385

The Author•••••••••••••••

Eric G. Flamholtz is professor of Management the Anderson Graduate School ofManagement, University of California, Los Angeles. He has also served asVice-Chainnan of the Anderson Graduate School of Management, and Director ofthe Accounting-Information Systems Research Program, and Assistant Director ofthe Institute for Industrial Relations where he was head of the Center for HumanResource Management Flamholtz has taught courses in a variety of areas, includingaccounting - information systems, human re~ource management, planning and

control systems, managerial decision making, and entrepreneurial management Heis also the President ofManagementSystems Consulting Corporation, aLos Angelesbased consulting practice which he co-founded in 1978.

Flamholtz received his Ph.D. degree from the University of Michigan, where heserved on the staff of the Institute for Social Research under the direction of RensisLikert His doctoral dissertation, 'The Theory and Measurement of an Individual'sValue to an Organization," was co-winner of the McKinsey Foundation forManagement Research Dissertation Award. Flamholtz also received an MB.A fromWashington University in St Louis, and an undergraduate degree in economics andaccounting from Hunter College.

Flamholtz has also served on the faculties at Columbia University and theUniversity ofMichigan and has been a faculty fellow at Price Waterhouse & Co. Hehas broad interests in management and has done research on a variety ofmanagement topics, ranging from accounting and human resource management toorganizational development and strategic planning. Flamholtz has conductedresearch projects for the National Science Foundation, the National Association ofAccountants, and the U.S. Office of Naval Research.

The author of more than one hundred articles and chapters on a variety ofmanagement topics, F1amholtz published the flI'st edition of this book, which isconsidered the standard for the field, in 1974. In addition, Flamholtz has authoredseveral other books, including How to Make the Transition from anEntrepreneurship to a Professionally Managed Firm, Growing Pains, The InnerGame of Management (co-authored), Effective Organizational Control, andChanging the Game: Managing Organizational Transformations of the First,Second, and Third Kinds (co-authored).

As a consultant, F1amholtz has extensive experience with firms ranging fromentrepreneurships to members of the New York Stock Exchange and the Fortune500. He has also presented seminars and management development programs fororganizations in Europe, Mexico, Australia, Singapore, the Philippines, and thePeople's Republic of China, as well as throughout the United States.

Preface••••••••••••

The United States is currently undergoing a fundamental transfonnation from anindustrial to a seIVice-based economy.! This transfonnation, which began around the eOOof World War II, has led to changes in the composition of the labor force, affecting thevarious sectors in which people are employed and also the types and levels of skills thatare in demand.

At present ours is rapidly becoming a mowledge, or infonnation based economy,requiring "high-teclmology services" from people who are highly.trained and educated aswell as experienced in their fields. Engineers, computer programmers, softwaredevelopers, medical technicians, lawyers, and university professors all qualify ashigh-tech selVice personnel Thus, the economy is increasingly composed ofwhite collar,teclutical, professional personnel

Growing Recognition of the Importance of Human Assets

Whereas physical capital was of utmost importance in the economy of the past, thedistinctive feature of the emerging economy is an increasing emphasis on human andintellectual capital-the knowledge, skills, and experience of people. Given the growingimportance of human capital and intellectual property as detenninants of economicsuccess at both the macroeconomic and enterprise levels, it should also be clear that thenature of investments made by firms needs to shift to reflect the new economic realities.Specifically, if human caPital is a key detenninant of organizational success, theninvestments in training and development ofpeople also become critical.

A related attribute is the relative costliness of developing human capital; significantinvestments are required by individuals and the organizations that employ themOrganizations spend money to recruit, select, hire, and train employees, and this moneyrepresents an investment in people. Organizations often spend more on investments inpeople than on investments in equipment. For example, if an organization purchases amicrocomputer to use in word processing, it may spend $3,000 to $5,000. If theorganization wishes to hire a senior vice-president for manufacturing, it may have toinitiate a nationwide search for the individual, advertise the position in newspapers, incurthe expense of bringing possible candidates to visit its facilities and be intelViewed, andeven pay an executive search finn 30 percent of the manager's first year's compensation.The investment in this executive can amount to $20,000 to $50,000 or more. Yet WIderpresent accounting conventions, the microcomputer would be treated as an asset while theinvestment made in acquiring the executive would be treated as an expense and chargedagainst the current period's revenues. 1bis is clearly a distortion of income measurementbecause no finn would make such substantial investments in a person wtIess he or sherepresented ''human capital"- an asset with expected future benefits.

xii Human Resource Accounting

Impetus for Development of Human Resource Accounting

Since the 1960s a growing body of research, experiment, and theory has attemptedto develop methods of accounting for an organization's human assets. This researchis the outgrowth of recognition that human assets and human capital playa greaterrole in our economy today than in the past.

Under ttaditional agricultural and industrial economic structures where the extent ofhuman capital was significantly less than it is today, the theories and methods ofaccounting did not treat either people or investments in people as assets (with theexception of slaves, who were viewed as property). However, with the increasingimportance of human capital to the economy as a whole, as well as to individualfirms, a great deal of research has beer. directed toward developing concepts andmethods of accounting for people as assets. This field, described below, has come tobe known as human resource accounting.

Human resource accounting (HRA) has been defmed by the American AccountingAssociation's Committee on Human Resource Accounting as "the process ofidentifying and measuring data about human resources and communicating thisinformation to interested parties. ,,2 It involves measuring the costs incurred bybusiness firms and other organizations to recruit, select, hire, train, and develophuman assets. It also involves measuring the economic value of people toorganizations. In brief, it involves accounting for people as organizationalresources, for managerial as well as fmancial accounting purposes.

HRA is, at least in part, a recognition that the skills, experience, and knowledge thatpeople possess are assets that can be termed "human capital." This concept is thebasis of the economic theory of human capital. Theodore Schultz, who received aNobel Prize for his work on this theory, stated that "laborers have becomecapitalists not from a diffusion of the ownership of corporation stocks as folklorewould have it, but from the acquisition of knowledge and skill that have economicvalue."3 In a review of the history of the development of the economic theory ofhuman capital, Kiker indicated that early economists who recognized that humancapital exists included Petty, Say, Senior, List, Von ThunOD, Roscher, Walras,Fischer, and Adam Smith.4 The two methods used by economists to measure humancapital were based on cost-of-production and capitalized-eamings procedures.

Human resource accounting has also developed from a parallel ttadition inpersonnel management known as the "human resources school," which is based onthe premise that people are valuable organizational resources and, therefore, oughtto be managed as such. Personnel theorists such as Odiorne and organizationalpsychologists such as Likert have treated people as valuable organizationalresources in their work.s For example, in his book The Human Organization: ItsManagement and value, the late noted organizational theorist Rensis Likert statedthat "every aspect of a firm's activities is determined by the competence, motivationand general effectiveness of its human organization." 6

Preface xiii

There is also support among some of the early accounting theorists for treatingpeople as assets and accounting for their value. even before the nature of oureconomic structure changed and human capital increased in importance. Forexample. DR Scott noted that "a trained force of teclutical operatives is always avaluable asset."? Similarly. W. A Paton stated that "in a business enterprise aweU-organized and loyal personnel may be a much more important asset than astock of merchandise." 8

In addition to academic theorists, practicing managers have also recognized theimportance of human assets for quite some time. For example, the 1966 annualreport of Uniroyal stated that "our prime resource is people. [We are] essentially acollection of skills-the varied expertise of our 68,000 employees. , .Uniroyal basplants and has capital, but most ofall, it has people. ,,9

Taken together, these various streams of thought all lead to the conclusion thatorganizations possess valuable assets in the people who are in their employ-thatthe people themselves are a form of capital, human capital. During the 1960s, thisrecognition led to academic research and business development of concepts andmethods of measuring the cost and value of people as organizational assets. to thedevelopment of the field known as human resource accounting.

The foundation for this new field was laid between 1967 and the early 1970s. ht1974, I published the first book dealing with this emerging area, Human ResourceAccounting. It was intended to present the state of the art of the field. The existenceof that book as well as the research on which it was based evidenced the growingrecognition of the importance of human resources, and, in turn, the need to developmethods of human resource accounting.

Extent of Change in This Edition

The present edition, which is a descendant of the original 1974 edition and thesecond edition, which followed in 1985, has been substantially revised and updatedto reflect the current state of development in the field of human resourceaccounting. The foIlowing paragraphs highlight major changes to the currentedition:

• Chapter 10 has been revised and expanded to include both second and thirdgeneration accounting systems for human resource value. and presents two casestudies to illustrate the material.

• Chapter 13 includes some new cases, which are intended for illustrativepurposes as weIl as for use in class room settings.

• Chapter 14 presents recent progress in the theoretical and practicaldevelopment ofHRA-related concepts. theories, and methods.

• The annotated bibliography has been updated and expanded to reflectdevelopments and activity within HRA since the publication of the second

xiv Preface

edition. Thus, the annotated bibliography now provides a comprehensivereview of literature related to the field

The purpose of these changes has been to emphasize the usefulness of lIRA,especially for human resource professionals, and to improve the overall structureand presentation of the entire book.

Purpose of This Book and Oveniew of the Contents

This book presents the current state of the art of human resource accounting. Itsgoals are (I) to examine the concepts and methods of accounting for people ashuman resources; (2) to explain the present and potential uses of HRA as a tool forhuman resource professionals, line managers, and investors; (3) to describe theresearch, experiments, and applications of human resource accounting inorganizations; (4) to consider the steps involved in developing a human resourceaccounting system; and (5) to identify some of the remaining aspects of HRA thatrequire future research.

Part One provides an introduction and overview of human resource accounting forprofessionals in the field, managers, and external users. Chapter One examines wayshuman resource professionals as well as line managers can use HRA. It includes anexample that illustrates how a human resource accounting system can work forhuman resource professionals and line managers. The chapter examines the dualrole of HRA as a paradigm to guide thinking about human resource management aswell as a technology for measuring human resource cost and value so that they canbe used as components in decisions to acquire, develop, allocate, conserve, andutilize people as organizational resources.

Chapter Two deals with the uses of human resource accounting by external users­stakeholders who are not members of an organization. For example, it examines therole of human resource accounting for investors in publicly held corporations. Thechapter addresses the fundamental issues involved in accounting for human assets incorporate financial reports, including the limitations of conventional financialstatements that do not include human assets, and how human assets can be reportedin financial reports.

Part Two deals with accounting for human resource costs. Chapter Three presentsthe concepts and methods for measuring human resource costs and examines thefoundation of human resource cost accounting. It explains the basic accountingconcepts of costs and introduces the human resource accounting concept of humanresource costs. It presents models for measuring the original and replacement costof human resources.

Chapters Four and Five examine the actual systems of measuring and accounting forhuman resource costs that have been developed by organizations. Chapter Fourpresents the first generation of human resource cost accounting systems, which weredeveloped prior to 1974, including systems by a professional athletic organization, a

Preface xv

manufacturing company, a CPA finn, and an insurance company. Chapter Fivepresents the second generation of systems of accounting for human resource costs,including applications by one of the ten largest U.S. banks and the U.S. Navy.

In Part Three, we deal with accounting for human resource value. Chapter Sixexplains the economic concept of human resource value and presents methods ofaccounting for it. It presents models to explain the nature and determinants of anindividual's as well as a group's value to an economic organization.

Chapter Seven deals with the measurement of the economic value of humanresources in monetary terms. It presents a model for the measurement of humanresource value and explains what is required for the application of that model inactual organizations. It also consid~rs the conditions under which this model cannotbe applied and the alternative models that can be used in such circumstances. Itdeals with the methods of measuring the value of individuals, groups, and the totalhuman organization.

Chapter Eight presents methods for measuring the economic value of people asorganizational resources in nonmonetary terms. It deals with circumstances underwhich nonmonetary measurement of human resource value is appropriate as well asthe methods that can be used in such measurement.

The next two chapters in Part 'Three, Chapters Nine and Ten, present the first andsecond generations of systems that have been developed to account for humanresource value. Chapter Nine describes the first published attempt to develop asystem of accounting for the value of people as organizational resources. Itexamines the reasons for the organization's interest in developing a system ofhuman resource valuation, the nature of the system developed, and how it was used.Chapter Ten presents two research studies to measure the value of human resourcesacquired in an acquisition of one company by another. It examines the need tomeasure the value of people as organizational assets for purposes of calculatingcorporate income taxes, and presents the model developed. It also illustrates howthe model was actually applied.

Part Four of the book deals with the design and application of human resourceaccounting. Chapter Eleven examines different types of HRA systems as well as thesteps involved in developing a system. Chapter Twelve examines three majorexamples of the application of human resource accounting in managementdecisions. The rust involves the use ofHRA in costlbenefit analyses. In particular, itfocuses on the use of measurements of the value of executive time in decidingwhether to acquire corporate aircraft rather than use commercial transportation. Thesecond involves the use of HRA cost information in making personnel layoffdecisions. The third application deals with the use of human resource accounting toevaluate the return on investment from management development programs.

Chapter Thirteen presents a case study of the development of an integrated HRAsystem by one of the leading certified public accounting rums in the United States,Touche Ross & Company. I am working with the firm to develop the system on an

xvi Preface

experimental basis. It represents the first reported attempt by any major organizationto devise and implement a system for measuring human resource cost and value.

Chapter Fourteen discusses recent advancements and future directions of HRA. Itdeals with the implications of lIRA for understanding the effects of thetransforming economy on stock prices, financial statements, and related financialmeasurements. It also cites some recent experiments and applications of lIRA infinancial reporting, which have occurred in Europe during the past few years.

Intended Audience

This book provides a comprehensive review of the state of the art of humanresource accounting. It is intended for a variety of different groups that possess apresent or potential interest in lIRA.

Human resource professionals, such as personnel managers and directors of humanresource management, are the primary audience for this book. Given the emergingrole of human resource professionals as advisers to senior line management withrespect to human resource issues, this book is designed to provide a powerfulanalytical tool to assist in making decisions about personnel management It alsoprovides a technology for measuring human resource cost and value that will assistprofessionals in the field in translating management decisions into monetary terms.

Another major audience for whom this book is intended includes CPAs and lawyerswho are taxation specialists, corporate acquisition specialists, and chief financialofficers of corporations. This group will be especially interested in the tax aspects ofhuman resource accounting. This book will be particularly useful for those who areconcerned with acquisitions of firms that largely comprise human assets. It will alsoserve as a handbook for developing potential services for clients.

This book is also intended for senior managers of all organizations, especially onesthat are progressive in their concern for people as organizational resources. For suchcompanies, human resource accounting represents the next logical step indeveloping concepts and tools to assist in the effective management of theorganization's most valuable asset-its people.

In addition, professors of human resource management and accounting will fmd thebook of interest in terms of its applications for theory, research, and teaching. Caseshave been appended to each chapter that may be used to illustrate concepts andmethods and in connection with assigrunents to students.

I hope this book will make a contribution to the field of human resource accountingand prove a practical tool for human resource professionals, senior managers,accountants, investors, organizational psychologists, corporate acquisitionspecialists, and others who are interested in improving the management of our mostvaluable resource- people.

Preface

Acknowledgments

xvii

My interest in human resource accounting began when I was a doctoral student atthe University of Michigan, where I studied in the Graduate School of BusinessAdministration and was employed as a researcher in the Institute for SocialResearch (ISR). I am especially indebted to R Lee Brummet (now Ross GrahamWalker Professor at the University of North Carolina), who first interested me inthis area and later served as a member of my dissertation committee. I am also verymuch indebted to the late Rensis Likert, who was director of ISR during my years atMichigan. Rensis Likert was one of the earliest advocates for the development ofhuman resource accounting, and research support for my doctoral studies carne fromhis discretionary funds as director of ISR. I am also indebted to Lee Danielson, whoserved as chainnan of my dissertation committee, and to George Odiorne, EdwardMiller, and Meyer Ryder, who were also members of that committee.

After leaving Michigan I joined the faculty of the Anderson Graduate School ofManagement at the University of California, Los Angeles, where I have found avery supportive environment for research in human resource accounting under fouroutstanding deans: George Robbins, Harold Williams, John Buckley, and Clay LaForce. The first edition of this book was written while I was on the accountingfaculty of the Graduate School of Business at Columbia University. My colleaguesat Columbia, including Gordon Schillinglaw, Carl Nelson, Sandy Burton, andRashad Abdel-Khalik, were very supportive during that period.

Throughout the development of the research leading to this book, as well as duringthe preparation of the manuscript itself, I have benefited from the assistance ofmany individuals and organizations. In addition to the contributions previouslyacknowledged in the first edition and the second edition, I wish to express mygratitude for the direct or indirect assistance of several individuals andorganizations: Richard A Kaumeyer, Jr., was a co-researcher for the studyconcerning the bank in Chapter Five. The U.S. Office of Naval Research (ONR)provided financial support for two human resource accounting research projectsunder my direction at the Center for Human Resource Management of the Instituteof Industrial Relations, University of California, Los Angeles. I would like toacknowledge the role and assistance of George Geis in the ONR project as well. Iam also indebted to D. Gerald Searfoss of Touche Ross & Company ( now part ofDeloitte & Touche), who was the catalyst for the human resource accounting projectdescribed in Chapter Thirteen as well as its coauthor. Special acknowledgment ismade to Russell Coff and Yvonne Randle, who were then both doctoral students inthe Graduate School of Management, University of California, Los Angeles, andwho assisted with the preparation of Chapter Twelve. Russell Coff also assisted inthe preparation of Chapter Thirteen, and co-authored the article on which the secondresearch study reported in Chapter Ten is based. In addition, George Geis, RichardPerle, and Diana Ho were part of the research team that assisted me in the originalresearch that underlies the first case study in Chapter Ten.

The word processing and preparation of the manuscript for this book were doneprimarily by the operations support staff of ManagementSystems Consulting

xviii Preface

Corporation, including Amanda Rose and Nahn Jiminian. Amanda was responsiblefor checking and correcting the fmal manuscript Her thoroughness and care isappreciated very much.

Portions of this manuscript were used in my various courses at the Graduate SchoolofManagement, University of California, Los Angeles, including courses on humanresource management for the MBA and executive MBA programs and a seminar onhuman resource accounting. Participants in these classes provided constructivefeedback to me. In addition, I am also grateful to the faculty and Ph.D. students ofthe Personnel Economics Institute of Stockholm University, Sweden, for theirinterest in my work, and for the opportunity to present seminars at their institutionas well as for the fme contribution to Human Resource Accounting that they havemade individually and collectively. Special acknowledgement must be made to Jan­Erik Grojer, U1f Johanson, Hunter Mabon, and Birgitta Olsson (all faculty membersat Stockholm University) and Bo Hansson (ph.D. student). I also wish to thankAnthony Hopwood, founder and editor of Accounting, Organizations, and Society,and Marc Epstein, founder and editor of Advances In Management Accounting fortheir interest in and support of Human Resource Accounting as well as my researchover the years.

I would like to thank Diana Troik, Executive Vice-President ofManagementSystems Consulting Corporation, for her help with both the first andsecond editions, as well as the numerous conversations we have had over the yearson Human Resource Accounting.

I am also very grateful to Yvonne Randle, Vice-President of ManagementSystemsConsulting Corporation and Lecturer at the Anderson School of Management,UCLA, for assistance in revising the second edition. She assisted with severalaspects of its preparation. Similarly, I am very grateful to Erica Main for assistancein the preparation of this third edition. She coauthored Chapter 14, prepared theupdated revision of the annotated bibliography and assisted with other aspects of thecurrent edition, including a final review of the entire manuscript

I also wish to acknowledge Kluwer Academic Publishers for publishing this thirdedition of Human Resource Accounting. The second edition has been out of printfor several years, but I have continued to receive inquiries about the availability ofthe book. This new edition makes the book available to the next generation of thoseinterested in Human Resource Accounting.

Although I acknowledge with gratitude the contributions of all the people citedabove, I remain responsible for the book and its remaining imperfections.

Los Angeles, CaliforniaEric G. Flamholtz