Introduction to Compensation and Benefit Design: Applying Finance and Accounting Principles to Global Human Resource Management Systems
This introductory chapter examines how finance and accounting principles apply to compensation and benefit program design. The discussion analyzes the current connections and proposes various connection enhancements. In this chapter, you also learn the terms commonly used with regard to compensation and benefits. The chapter also proposes modifications to the accounting process to accommodate a revised classification of compensation and benefit cost outlays and transactions. Thus, the chapter lays the foundation for the finance and accounting analysis of compensation and benefit transactions.
The words cost and expense are often used interchangeably. Are human resource (HR) outlays costs or expenses? What is the difference? Where in the accounting structure and system can one find HR expenditures? Are the current classifications within the accounting framework appropriate? What changes can one anticipate in the current expense/cost classification resulting from the changes in how work is currently done and how it will be done in the future? These and other questions need to be answered before discussing the various specific techniques and analytical mechanisms within the finance and accounting structure that affects HR management (and specifically compensation and benefits).
In this chapter, after answering some critical questions posed here, the basic flow of compensation and benefits outlays,1 as defined by HR departments, is traced through the accounting framework and structure.
The Cost Versus Expense Conundrum
The words cost and expense are used interchangeably in accounting. But a cost incurred can be an asset or expense depending on the timing of accounting transactions and the concept of periodicity.
Especially in transactions like the acquisition of a physical asset, the cost classification can become an important decision. When a physical asset is acquired, many costs might be involved (for example, purchase price, freight costs, and installation costs). So, the accountant has to decide which cost to include as an asset and which costs to expense immediately. Those costs that are expensed immediately can be called revenue expenditures. And costs that are not expensed immediately but are included in asset accounts are referred to as capital expenditures. Some firms call these expenses operating expenses (OPEX) and capital expenses (CAPEX). You’ll read more about these classifications later in this chapter.
An expense is, in actuality, a cost used up while producing the sales revenue for the business. In other words, expenses are those monetary outlays that flow through to the income statement. In contrast, costs that have not been used up remain a cost and are reported on the balance sheet as an asset. Expenses are those costs that are necessary to make sales within a specific period. A company can incur a cost and spend cash to pay rent in advance for a six-month period, for example. On the day this transaction is made, however, a debit entry is made to an asset account called Prepaid Rent. Only after a month is over and the premises have been occupied for that month does an expense transaction occur, and for that month only; five months of the cost incurred for prepaying the rent stays on the balance sheet as an asset.
Let’s take another example. Suppose a restaurant is gearing up for a Christmas banquet for a big corporate event. The owners go out and buy nonperishable restaurant supplies such as napkins and so forth. The cost of this cash purchase is $5000. Now let’s suppose they use up 30% of these supplies for this big corporate banquet. In this case, $1500 is classified as an expense for that period (the month and year when financial statements are prepared) and the remaining $3500 will still be a cost but will be reported on the balance sheet as Restaurant Supplies (an asset). In this case, this cost—an outlay of cash—is both an asset and an expense.
Now, suppose that a business buys a piece of land to build a factory. The cost of that land never becomes an expense. That cost continues to be classified as an asset (because land is never depreciated).
If a hospital buys an MRI machine, any cash or credit purchase is first carried as an asset on the balance sheet. Then, after that, a periodic depreciation expense is recognized in the income statement. So, here again, the entire cost of that MRI machine is not an expense at the time of purchase. Instead, the expense is spread over the useful life of the MRI machine. As a matter of fact, the historical cost of acquiring the MRI machine is always shown on the balance sheet. Depreciation taken each period is recorded as a period expense and also recorded as a contra-asset in an account called accumulated depreciation.
Now consider manufacturing businesses: Cost outlays within a given period for direct materials, direct labor, and manufacturing overhead directly used in making products that were sold within that specific time period are considered expenses for that period and are termed cost of goods sold . Cost of goods sold flows into the income statement and is matched with revenue earned during that period. But direct materials, manufacturing overhead (which includes indirect labor), and direct labor remaining in finished goods or in work in process are considered assets. Therefore, here again, not all costs are expenses. Some are assets (balance sheet), others are expenses (income statement). So, in current accounting practice, some employee monetary outlays are assets, some are expenses.
Furthermore, other transactions in a manufacturing company are considered selling, general, and administrative expenses for a specific period. Compensation outlays for the truck driver who delivers materials to the factory are considered expenses for a period. In contrast, electricity used in the factory might be either an asset or an expense depending on whether manufacturing overhead, including factory electricity, is assigned to products as cost of goods or as work in process inventory or finished goods inventory. But all electricity used in the administrative offices is considered an expense for a particular period.
Adding to the confusion, let’s consider monetary outlays for research scientists. Suppose that a firm buys a laboratory machine for a research lab. The cost of this machine might be $20,000, with an additional $5,000 expense for installing the machine. As of the date the firm acquires this machine, the accounting system increases an asset account by debiting that account with the total purchase cost of the machine plus all costs necessary to make the machine ready to use. And then the accountant periodically records a debit entry to a depreciation expense account spread over the useful life of the machine, using an acceptable depreciation schedule. This expense is then reported in the income statement, matching it against the current period revenue.
If the same firm were to hire a research scientist during the same period, however, the costs that the firm incurred to hire that scientist—recruitment advertising, search fees (which can be quite large), interviewing costs, and other hiring costs—will all be currently expensed and reported in the income statement. This can lead to a distortion in income measurement because the research scientist’s service will extend over more than one year. But currently, the accounting rules require that all the HR cost outlays be expensed during the current period.
Compensation-related outlays for these scientists are all considered expenses for the current period. In accounting systems, though, the cost outlays for physical products (the machines the scientists use) are considered assets and are expensed only over a period of time (their useful life).
The issue of reporting intangibles also needs to be discussed in connection with the recording of HR outlays. Under current accounting standards, intellectual property that an employee brings and utilizes within the employment setting is not considered a recognizable asset. The current accounting system records as assets only certain other intangibles such as copyrights, patents, and trademarks. The irony is that the intangibles are the outputs of the employees with specifically valuable intellectual property.
In many cases, a big difference can exist in book value versus market value of the assets. For example, in a recent year Google had stockholder equity of $22.7 billion, whereas its market value during the same period as determined by multiplying Google’s market price of its shares by the number of outstanding shares was about $179 billion. Such a wide difference undermines financial reporting. It can be assumed that most of this big difference results from nonrecognized intangibles. And one of the biggest intangibles is the value of Google’s human assets. Part II of this book discusses this concept in greater detail.
So, one can safely say that confusion abounds within current accounting standards frameworks as to how and where HR monetary outlays are classified in accounting systems.