Do you sometimes say, “Our people are our most valuable asset”? What exactly do you mean by that? Some big-company CEOs repeat that phrase as if it were a mantra but then cut expenses by letting people go. Can you imagine a company downsizing or laying off any other asset—just putting it out on the street in hopes that it will walk away?
From a commonsense perspective, employees are assets. Their knowledge and their work bring value to a company. When one company acquires another, the value of employees is recognized as part of the goodwill.
Otherwise, though, the value of employees doesn’t show up on the balance sheet. There are two reasons:
Employees do create an expense: payroll, in one form or another, is often one of the biggest items on the income statement. But the phrase about employees being the most important assets has more to do with a company’s culture and attitudes than it does with accounting. Some organizations really do seem to regard employees as assets. These companies train their people, invest in them, and take good care of them. Other companies focus on the expense angle, paying their people as little as they can and squeezing as much work out of them as possible. Is the former strategy worth it? Many people (including ourselves) believe that treating people right generally leads to higher morale, higher quality, and ultimately higher customer satisfaction. Other things being equal, it boosts the bottom line over the long term and thus increases a business’s value. Of course, many other factors also influence whether a company succeeds or fails. So there’s rarely a one-to-one correlation between a company’s culture and attitudes (on the one hand) and its financial performance (on the other).
When a company buys a piece of capital equipment, the cost doesn’t show up on the income statement; rather, the new asset appears on the balance sheet, and only the depreciation appears on the income statement as a charge against profits. You might think the distinction between “expense” (showing up on the income statement) and “capital expenditure” (showing up on the balance sheet) would be clear and simple. But of course it isn’t. Indeed, it’s a prime canvas for the art of finance.
Consider that taking a big item off the income statement and putting it on the balance sheet, so that only the depreciation shows up as a charge against profits, can have the effect of increasing profits considerably. WorldCom is a case in point. A large portion of this big telecom company’s expenses consisted of so-called line costs. These were fees it paid to local phone companies to use their phone lines. Line costs were normally treated as ordinary operating expenses, but you could argue (albeit incorrectly) that some of them were actually investments in new markets and wouldn’t start paying off for years. That was the logic pursued by CFO Scott Sullivan, anyway, who began “capitalizing” his company’s line costs in the late 1990s. Bingo: these expenses disappeared from the income statement, and profits rose by billions of dollars. To Wall Street, it appeared that WorldCom was suddenly generating profits in a down industry—and no one caught on until later, when the whole house of cards collapsed.
WorldCom took an overaggressive approach toward capitalizing its costs and wound up in hot water. But some companies will treat the occasional questionable item as a capital expenditure just to pump up their earnings a little so that the bottom line looks better to lenders and potential investors. Does yours?