Q&A: Global HR authority Prof Peter Cappelli on how the pressures of financial accounting are undermining human capital practices

A comprehensive and thought-provoking stock-take of the modern workplace by the Wharton expert to explain the puzzling reasons behind practices such as layoffs, training spend, and more.

Prof Peter Capelli is a global trusted figure who we've all referenced at some point to manage workplace issues - from leadership development and labour market analyses, to managerial pay structures and strategic talent management. 

Presently the George W. Taylor Professor of Management at The Wharton School and Director of Wharton’s Center for Human Resources, Prof Cappelli (pictured above, and below on the right) is also a regular contributor to Wall Street Journal. 

He has recently released his latest book, Our Least Important Asset: Why the Relentless Focus on Finance and Accounting is Bad for Business and Employees, where he argues that financial accounting problem account for many puzzling practices in contemporary management--employers' emphasis on costs per hire over the quality of hires, the replacement of regular employees with "leased" workers, the shift to unlimited vacations, and the transition of hiring responsibilities from professional recruiters to more expensive line managers.

Financial accounting views employee costs as fixed costs that cannot be reduced and fails to account for the costs of bad employees and poor management. The simple goal of today's executives is to drive down employment costs, even if it raises costs elsewhere. In the process, employers undercut all the evidence about what works to improve the quality, productivity, and creativity of workers.

HRO's Aditi Sharma Kalra (pictured below on the left) grabs the opportunity to learn from Prof Cappelli's experience and research in this exclusive interview, where we touch on issues such as:

• Why companies employ fewer people even though it’s not prudent,
• Detriments of companies not investing in management training for new managers,
• Evaluating recruiting costs—penny wise, pound foolish: why line managers should not be leading the hiring process,
• How corporate fixation with shareholder value maximisation has turned employees from a perceived asset to a liability, 
• Financial accounting’s fundamental flaws in dealing with human capital.

Read on for the thought-provoking interview excerpts: 

Q You've noted that companies make several mistakes when it comes to managing their talent. They often take a very narrow or a short-term view of their talent. So what are some of the puzzling practices that you've identified in contemporary management?

You always hear people complain about businesses and say that, they're only interested in money, etc. – and that's fine. But what I find most puzzling is that they're doing things which are not economically efficient and are basically costing them money.

For example, when they lay people off even while they know they're going to have to hire back people, but they can't hire the people that they just let go because they cut all ties with them. Meanwhile, they don't fill vacancies because they think that saves them money, after which they hold wages down and they can't fill positions.

Then, they think that it saves them money when they replace regular employees with leased employees, even when the total typical hourly cost of that is higher.

Similarly, when businesses are hiring, they focus intently on the cost of hiring. But they don't look at the quality of the candidates that they are hiring. It just doesn't seem to make any sense.

Sometimes the story you get, is that they're so caught up with finance that they just don't understand the other things about business. But these are things that are not rocket science to understand. You would think you could just measure them and see, like if you can't fill positions, don't you think there is obviously something wrong?

So, in my research, I was trying to figure out why this was happening.

Q Well you mentioned as part of your research that there is a relentless focus on financials and accounting, and this is actually proving to be a danger for workforce development. Especially in cases where companies are laying off full timers and replacing them with less experienced part timers or contract workers, where the hourly cost works out more expensive.

So could you share for us what are the flaws in the logic of financial accounting that you've observed, especially when it comes to dealing with human capital issues on the balance sheet?

Well, firstly, financial accounting differs a little around the world. The model that we use in the US, which has driven a lot of accounting around the world, involves the Generally Accepted Accounting Practices (GAAP) and are developed by the Financial Accounting Standards Board (FASB), which is commissioned by the Securities and Exchange Commission (SEC), which is the very top of the food chain as a government-appointed agency and a regulator.

So the problem is that financial accounting begins with the assumption that there are assets (which you own) and there are non-assets (things you don't own). Employees are not considered assets because you don't own them. Even if they're locked in as a contract, they have no value in the accounting books – similar to, say, a professional sports team.

That's the beginning of the problem, because it also means that, when you’re laying people off, it does not suggest that you're losing any assets – unlike, say computers, which you wouldn’t just unplug and put out on the streets.
But when it comes to people, companies do this. And the reason they do it is because people don't have any asset value in accounting.

Which also means that you can't treat or think of training as an investment. And while we use that phrase all the time, it's not literally true, because if you don't own employees, you can't invest in something which is not an asset.

Meanwhile, in HR, we think of training as an investment. It pays off over time, it improves performance, and overall, your human capital gets better – in contrast to physical capital which depreciates.

Yet, you can't invest in employees, because accounting treats it like a cost – akin to office furniture or coffee – so there’s no place you can report training spend in financial accounting. Even if investors wanted to know about it, they wouldn't be able to find it anywhere.

So you know from there, there's just all kinds of things that accumulate.

Another one, which is very important is that, financial accounting reports performance on a per employee basis, so if you cut the number of employees, your performance looks much better. That way, to cut employees without stopping work, is to substitute regular employees for leased workers and contractors because they don't count as part of your headcount. So suddenly you look wildly more valuable and you haven't done anything except taking your regular workers and replacing them with more expensive ones.

Basically, the fact is that financial accounting is organised around physical capital, and it just can't handle any of the important aspects of human capital.

Q It definitely sounds like it's time for an overhaul in terms of the accounting standards that we've upheld all of these years, and even looking at accounting for human capital differently.

Pulling some of the practices that you've highlighted in the book, one of them is, the employer’s emphasis on cost per hire, and why it doesn't make sense for companies to replace employees (full- or part-timers) with non-employees (such as leased employees or contractors).

So, why are companies employing fewer people, even though it is not prudent in the long run?

Well, because they are driven by investor pressures which have increased over the last 30 years or so. One of the questions people would ask is, well, accounting has always been like this, so why is this now suddenly a big problem?
It's not suddenly a big problem, but it's gotten to be a bigger problem because investors have become more important and all investors see about a company is its financial accounting. Financial accounting aggregates things into big buckets, which is why training is never a separate item.

This is a problem especially in software and tech companies where the assets are really all the programmers, but the investors can't tell anything about what those companies are worth, so they end up with very peculiar financial positions.

So to the point you made earlier, it is time to change this. The investor community has been leaning on the government and employers hard to try to get them to report more information because they've got the problem where a company’s share price goes through the roof, but if you look at the value, it looks like they have no assets.

From the FASB’s perspective, the general sense is they just can't budge. They've had this system for generations now, and they don't want to play around with it because it seems to work for the accountants. So the solution seems to be to lean on the SEC to require different reporting from companies. You could require for example, that companies report their training spending. You could also require that they report their total labour spending so that you don't have any big advantage just by shifting from employees to non-employees.

There's just a couple of things like that that would alter the incentives which are there now to undervalue human capital and to make these decisions, which are penny-wise and pound-foolish.

Most of the book is driven by that discussion, but there is another set of arguments about top executives and where they come from these days. Basically, the story is that they don't understand fundamentally what the value of good employees is. And the I think the reason is that their backgrounds are increasingly technical.

Say, they disproportionately come now from engineering. Engineering has got a rigorous way of thinking about things, but it's about optimisation fundamentally, which is really about cost minimization, which is what you see in accounting, mainly the different cost aspects. So when they think about employees, their goal is minimum costs and you end up with bizarre decisions.

To take another example, when it comes to hiring, the goal is to try to get good hires and try to do it as cheaply as possible. Well, one of the things that has happened is that, at least in the US, they've been cutting back on recruiters. Recruiters are experts on hiring, so why would you come back on recruiters? Well, companies are push hiring costs and decisions onto line managers. Even though line managers are more expensive than recruiters. So you are taking this task that used to be done by cheaper people with expertise, and you’re lumping it on to this group of people (line managers) who are more expensive and don't know what they're doing. How does that possibly make sense?

The other general thing that we notice about the current generation of leaders is that they are sort of a throwback to an earlier generation of scientific management believers, in terms of the time and motion studies, and technology is basically allowing them to do that. So stopping short of an engineer standing there with stopwatches, they're reintroducing all this optimisation stuff and taking power and discretion away from employees.

If we've learned anything in the last generation or two about management, it is that empowering employees really works, partly because they care more about the work, they take it more seriously.

And now they're doing the opposite. They're taking away the authority of teams and individuals, and imposing engineering-based software solutions and things like that on them. And that’s because of the ideology in which they were trained to think. They haven't seen a lot of management. In fact, 58% of US managers have said they had no training before they became supervisors.

So management is debased in some ways. When you combine managing people with the financial accounting problems, then you start to see how we can just go systematically off the rails and engage in practices that just do not make any sense.

Q Thanks for bringing up the point on line managers and the resourcing issues around them, and frankly, I don't think line managers have the bandwidth to take on recruiting.

Could you help us identify the most important skills for new managers that they need to be trained on to become successful line managers?

Fundamentally they need to understand more about human behaviour.

There's a belief at the top of many organisations that incentives are the answer to every problem. And in some ways, that's because the way executives tend to be managed as if they are robots, it's all managed by compensation and incentives and that doesn't work that well for regular employees.

Part of the reason is that incentives are usually pretty tiny because you don't want to spend much money on them, and the things that do matter a lot are cheap but are ignored. Things like employee involvement, which drives commitment and other sorts of outcomes. It’s not rocket science.

Q As we look ahead to solutions, could you share with us what in your view is a good systemic approach to talent management that could actually enhance long-term success for companies both from the point of view of a CFO but also from the point of CHRO?

One of the problems with alternative reporting, as our accounting colleagues tell us, it just has never worked. And the reason is because companies don't want to report bad news.

If things are not required, they don't want to report them because they understand, even if they report good news next year, they'll be expected to report the same information the year after. And if the numbers look bad next year, they'll be in trouble. Even if they just don't report it, then they are in trouble as well. Because then investors will assume that the reason you're not reporting is because things are really bad.

The SEC has already passed regulation requiring that US employers report on human capital issues that are material to their business. You might say, that sounds very nice, except they get to pick what is material and they get to pick what is reported. So it's kind of the opposite of accounting, where you’ve got standard definitions and standard measures so that you can compare over time, and you can compare across companies.

So what do you do? If you were, let's say, the HR leader of a company, we can’t really expect to be enlightening the CFOs to these challenges, because their scorecard is just different. But the board and the CEO can be enlightened, right? And for them, the ultimate goal later on in a company is performance, which is improved by efficiency and effectiveness. Even if your immediate financial accounting scores don't look so good, if you are more efficient in the longer run, you will be more profitable and all things will look better.

Thus, the goal in part for HR people is to advocate for that position. Some of it is simply explaining to the board and to the CEOs how expensive some of these things are, for example, when you lay off a bunch of people. There is now pretty good research evidence showing that if you lay people off, which is the advice that some finance people might give (“cut early and cut hard”), the evidence is that that is the worst thing you can do because business picks up at some point.

And the deeper you've cut, the harder it is to start back up – not just in terms of the administrative costs of replacing a body, but the turnover costs of lost productivity, lost performance effects on peers, etc. You saved cost, but you really get killed on revenue on the other side. Being able to explain things like turnover costs is really big for HR leaders. We have to advocate, and provide evidence as a way to do that.

Q I think that's very motivating for HR professionals to really take the stance and advocate for what is the progressive thing to do and it will help us further the profession in the future. Thank you for your time on this interview, Prof Cappelli!

Lead photo / Provided