Chief Financial Officers are no strangers to a major flaw in Generally Accepted Accounting Principles (GAAP): it fails to recognize the investment characteristics of knowledge-based startups. As a result, these companies have had to rely on non-financial and non-GAAP metrics to tell their story, metrics that lack uniform standards.

As others have noted, GAAP, as a set of standards, was born in an era when production was the primary driver of profitability, and labor was viewed as replaceable and expendable. Although elements of intellectual capital existed, their significance was minimal compared to investments in production.

As the U.S. economy expanded and shifted to a global perspective, production was outsourced to lower-cost foreign manufacturers, and companies emerged that were largely knowledge- and service-based rather than production-oriented.

The stock prices of publicly traded knowledge-based companies have reached levels that cannot be explained solely by GAAP-based financial statements. The reason is that the large operating losses these companies incur when investing in talent are expensed in the current period, while their most important asset—the intellectual capital of their workforce—is not recognized until the company is acquired, at which point the excess paid to obtain that talent is recognized as goodwill.

Due to the limitations of existing GAAP, investors and analysts have adopted non-GAAP and non-financial metrics to evaluate company performance.

As these non-GAAP metrics proliferated, organizations such as the Sustainability Accounting Standards Board (SASB) emerged, aiming to standardize non-GAAP disclosures and ultimately establish a unified reporting system that integrates financial and non-financial data, potentially extending the audit function to the entire report.

However, as the U.S. Securities and Exchange Commission (SEC) demonstrated in itsrecent rulingrequiring expanded disclosures in Regulation S-K to include non-financial data in several areas, including human capital management (HCM), even regulators cannot decide what information filers should provide.

They only stipulate that such information must be material to understanding how workforce-related data affects company performance. Moreover, there is no requirement to present this information in monetary terms.

Consequently, human resources consulting firms quickly filled this guidance gap by proposing what HCM data should be provided, leading to what could be called a "kitchen sink" approach.

The SEC has also accepted that materiality varies by industry. For example, high turnover may be material in a publicly traded consulting firm but may be considered normal in the retail industry. SASB's industry-by-industry approach to standardization reflects this.

Intangible Assets as Expenses

I see no need to elaborate on why accounting standard setters decided to treat certain internally generated intangible assets as expenses, even when those expenditures are intended to generate future rather than current revenue, thereby meeting the technical definition of an asset.

Some internally generated intangible assets, such as patents, are already identifiable and separable, with a clear amortization period. These intangible assets are recognized as assets.

But what about the costs of developing intellectual capital, whether embodied in individual employees or collectively?

Standard setters have refused to capitalize labor expenditures because such "assets" are not identifiable or separable, lack an amortization basis, and there is no legal ownership to support capitalization.

This reservation was once reasonable because public policy—such as the Employee Retirement Income Security Act (ERISA)—actually encouraged labor mobility.

However, the economic environment has changed. Competition for talent in knowledge-based companies is intense, and given the substantial initial expenditures, retaining talent is critical for companies to recover their investments. Therefore, companies offer profit sharing, stock options, "Cadillac" fringe benefits, and other expensive incentives, yet GAAP treats these expenditures as period expenses.

I believe the original basis for expensing versus capitalizing has changed. Companies would not incur these HCM costs if they expected newly hired talent to leave; they are willing to bear the costs necessary to retain talent.

Will employees still leave early? Undoubtedly, but that is the exception rather than the rule. From a behavioral perspective, when senior management makes strategic decisions about the workforce, which has greater influence: financial information in internal accounting reports or non-financial metrics such as those proposed by SASB?

Regarding amortization, actuaries can estimate the average service life of pension and benefit plans, and these estimates could equally serve as an amortization basis, with immediate write-off as a loss if employees leave early.

Before environmental, social, and governance (ESG) investing became a focus, there were many proposals to include workforce investments under human resource accounting (HRA). The problem with many proposals was that the capitalized amounts were based on esoteric methods far removed from GAAP concepts.

What seems to have been forgotten is capitalizing human-resource-related original expenditures that meet the definition of an asset (intended to generate future benefits) and amortizing that asset over the expected service life of employees. Early departures would result in the unamortized balance being written off as a loss. (Tax treatment would remain under regular GAAP.)

Most HRA proponents consider this too simplistic and argue it fails to provide information about the value of the workforce in a going concern.

However, increases or decreases in the balance of this "asset" would clearly indicate whether investment is being made to grow or retain the workforce, and expressing this amount in traditional financial terms would become a common standard across all industry sectors. This differs from the industry-specific non-financial disclosures proposed by SASB.

Including these "assets" in GAAP-compliant financial statements would place the information under the audit function, a significant improvement over current non-financial disclosures that often originate from company press releases.

Critics of capitalizing and amortizing talent complain that deferring such costs would overstate income in the early stages of workforce development, but the opposite would occur if a company reduced its workforce investments.