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‘People are our number one asset’. A phrase used so many times that it could be considered a corporate cliche, reused again and again in annual reports and investor presentations until we become almost numb to the phrase.
But what does this really mean? Well, it’s actually a powerful truth that exposes an interesting debate within the accounting community. If people are the biggest asset in a business… why aren’t they shown on the balance sheet?
In this article, we’ll explain exactly why top talent such as a star CEO is not ‘capitalised’ on the balance sheet, but we’ll also explain some curious exceptions to this rule. Yes, indeed there are some scenarios in which the value of people actually are presented within the assets of a business – but it’s probably not how you think.
Can you show the staff as asset as an asset on company financial statements?
The simple answer is no. A company cannot capitalise salary or recruitment costs as an asset on the balance sheet.
These costs are instead treated as expenses in the income statement because they directly (and contractually) relate to the service provided by an employee for a specific service period. After that service period expires, an employee is at liberty to leave the company (subject to a notice period) and therefore a company cannot be said to ‘control’ the future value created by an employee at any one time. Control is a necessary element of the definition of an asset under International Financial Reporting Standards (IFRS) and therefore it fails this first hurdle.
The exception to the rule: how can talent be shown as an asset in financial statements?
We’ll explain two scenarios in which the value of talent is included in a balance sheet, but we’ll build to the answer in stages because this is a technical accounting topic.
The full market value of a business reflects the talent of its staff and management. For evidence of this phenomenon, look no further than Berkshire Hathaway, the investment conglomerate managed by Warren Buffet. Trades at a premium to book value due to the premium that investors place on his ability. The premium reflects the additional value that investors believe he’ll continue to create in the future.
Market value becomes a book value through acquisition accounting
When a group acquires a business, they will pay a market price. This will become the historical cost of the acquisition, and therefore that value will, by default, need to be reflected as an asset in the company financial statements of the parent, and the consolidated group financial statements. If you’re interested in learning more about consolidated financial statements in general, the RSM Global houses hundreds of technical articles written to help accountants get the insights they need.
In practice, firms conduct a ‘fair value’ exercise that guides management on how to allocate the full purchase price across the individual assets and liabilities acquired. However, this usually leaves a large, apparently unexplainable gulf between the fair value of all the tangible assets acquired, and the purchase price paid.
This is not controversial, as it is very typical for the enterprise value of a company to greatly exceed the book value of its buildings, equipment, IT and vehicles. Why? Because value is usually obtained by discounting the anticipated future profits of the business, which is a completely different basis to simple cost accounting. Consider that a corporation like Alphabet Inc will generate more profit each year than it even has tangible non-current assets, and you will begin to understand why companies typically pay a large margin above and beyond the net assets of a business to acquire it.
What happens with the balancing figure? It needs to go somewhere. After pulling out any intangible assets that could possibly be associated to the valuation, such as brand, order book, customer lists, any leftover value is labelled as ‘Goodwill’.
Goodwill is effectively a catch-all term for ‘the amount we paid to acquire a business that cannot be specifically linked to a tangible or separately identifiable intangible asset’. In many cases though, it might as well be called ‘the value of talent acquired’ as this is often the reality of what it represents as IFRS 3 — Business Combinations does not allow this as an intangible asset.
