Proceedings of the 3rd European Conference on Intellectual Capital

Krishanthi Ganga Vithana et al.
force and his natural and acquired skills” (p. 104). Thus, <strong>the</strong> accounting concept <strong>of</strong> “service potential”
is used as <strong>the</strong> principle to calculate HC. According to <strong>the</strong> Lev and Schwartz’s (1971) arguments, even
though <strong>the</strong> current spending on employees will not have a direct influence over <strong>the</strong> service potential <strong>of</strong>
<strong>the</strong> employees, <strong>the</strong> special programmes and <strong>the</strong> spending associated with those, e.g. employee
induction, training and development, might increase <strong>the</strong> service potential <strong>of</strong> employees as such
expenditures are made with <strong>the</strong> expectation <strong>of</strong> future pr<strong>of</strong>it. Although a rough general understanding
<strong>of</strong> <strong>the</strong> concept HC exists, a universally accepted and widely applicable definition does not.
3. Human capital accounting
Measuring <strong>the</strong> HC <strong>of</strong> firms has been <strong>the</strong> interest <strong>of</strong> economists and accountants due to <strong>the</strong> concern
on <strong>the</strong> potential impact <strong>of</strong> ignoring HC in financial decisions. This has led to <strong>the</strong> development <strong>of</strong> <strong>the</strong>
new field Human Resource Accounting which is defined as “<strong>the</strong> process <strong>of</strong> identifying and measuring
data about human resources and communicating this information to interested parties” (American
accounting association, 1973 p.169).
Relying on <strong>the</strong> assumption ‘if some thing can be measured, it can be managed’, researchers have
made several attempts at measuring <strong>the</strong> HC <strong>of</strong> firms at different levels using different approaches
such as direct measure <strong>of</strong> HC (Brummet et al 1968; Lev and Schwartz, 1971; Flamholtz, 1971;
Flamholtz, 1972a; Flamholtz, 1972b; Flamholtz, 1972c) or measuring HC as efficiency indicators
(Pulic, 1998; Chan, 2009a; Chan, 2009b ; Chen et al, 2005; Tan et al, 2008; Nazari and Herremans,
2007). Understanding <strong>the</strong> difficulty <strong>of</strong> linking human capital with financial accounting and reporting
through hard accounting numbers, researchers have fur<strong>the</strong>r explored <strong>the</strong> potential <strong>of</strong> accounting for
employee wealth as a provision <strong>of</strong> s<strong>of</strong>ter accounting information (Roslender and Dyson, 1992;
Roslender, 1997; Roslender and Fincham, 2001). These research findings are explained below
mostly in chronological order, emphasising <strong>the</strong> <strong>the</strong>ories developed and <strong>the</strong> subsequent modifications
<strong>the</strong>reafter.
The arguments on HC valuation were initiated in <strong>the</strong> fields <strong>of</strong> economics (Becker, 1962) and
accounting (Brummet et al., 1968) in terms <strong>of</strong> <strong>the</strong> value creation for firms through people. Identifying
<strong>the</strong> inadequacies <strong>of</strong> <strong>the</strong> conventional accounting practice in treating human resources <strong>of</strong> firms
specially in <strong>the</strong> accounting and financial reporting process, Brummet et al., (1968) have proposed to
treat <strong>the</strong> outlays for human resources as “capital ra<strong>the</strong>r than consumption” or as “asset ra<strong>the</strong>r than
expenses” especially due to <strong>the</strong> future services potential <strong>of</strong> employees. In this research multiple
techniques including, acquisition cost (<strong>the</strong> historical cost), replacement cost (<strong>the</strong> cost to replace firm’s
existing human resources and <strong>the</strong> economic value (<strong>the</strong> present value <strong>of</strong> <strong>the</strong> portion <strong>of</strong> firms future
earnings attributable to human resources) have been proposed to measure HC (Brummet et al.,
1968). Though <strong>the</strong> method has particularly been generalised for management, to what extent this
model is applicable considering <strong>the</strong> entire workforce as well as marginal benefit over <strong>the</strong> cost <strong>of</strong> <strong>the</strong>
practice still remain questionable.
Flamholtz (1971), focusing upon measurement <strong>of</strong> an individual’s value to a firm, has proposed a
normative model for <strong>the</strong> economic valuation <strong>of</strong> people based on individuals as individuals become <strong>the</strong>
primary focus in many <strong>of</strong> <strong>the</strong> organizational decisions such as selection, training, allocation
(placement), job design, promotion, compensation etc.. Under this <strong>the</strong> expected service life <strong>of</strong> a
person states in terms <strong>of</strong> service level and <strong>the</strong> service group has been taken into account and have
estimated <strong>the</strong> present monetary equivalent <strong>of</strong> <strong>the</strong> expected services as <strong>the</strong> HC value <strong>of</strong> an individual.
Lev and Schwartz (1971) proposed ano<strong>the</strong>r model for individual valuation in which <strong>the</strong> aggregate
value <strong>of</strong> HC is <strong>the</strong> sum <strong>of</strong> <strong>the</strong> values <strong>of</strong> <strong>the</strong> individuals calculated using <strong>the</strong> accounting concept <strong>of</strong>
“service potential” as <strong>the</strong> principle. The sums <strong>of</strong> discounted future earnings <strong>of</strong> <strong>the</strong> employees
according to <strong>the</strong> earnings pr<strong>of</strong>ile <strong>of</strong> each have been treated as <strong>the</strong> HC <strong>of</strong> <strong>the</strong> firm. However, <strong>the</strong> uses
<strong>of</strong> current data on earning distribution classified by age, education, skill etc., as well as problems such
as <strong>the</strong> use <strong>of</strong> prevailing interest rate, inability to determine <strong>the</strong> expected service life, retirement age,
and accidental loss <strong>of</strong> employees due to death or chronic illness, lead to pragmatic difficulties in
estimating <strong>the</strong> HC <strong>of</strong> <strong>the</strong> firm. In a commentary article, <strong>the</strong> work <strong>of</strong> Lev and Schwartz (1971) has been
criticised for <strong>the</strong> lack <strong>of</strong> relevance and utility to decision makers by Flamholtz (1972c) emphasising
that significant applications and implications for management and investors has not been considered
by Lev and Schwartz (1971). In response, Lev and Schwartz (1972) note <strong>the</strong> non-existence <strong>of</strong> a well
defined and empirically valid set <strong>of</strong> decision models used by investors. They fur<strong>the</strong>r elaborated that
due to <strong>the</strong> absence <strong>of</strong> such a formal model it has been impossible to define precisely <strong>the</strong> role <strong>of</strong> HC
information in financial decision making. The lack <strong>of</strong> a valid decision model to employ HC and a
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