Tuesday, October 14, 2008

Strategic Finance Notes - 4

Q.14 Explain the concept of Human Resources Accounting.
Ans Human Resource Accounting (HRA):
HRA as an approach was originally defined as the process of identifying, measuring and communicating information about human resources in order to facilitate effective management within an organisation. It is an extension of the accounting principles of matching costs and revenues and of organizing data to communicate relevant information in financial terms.

The accounting of human resources can be seen as just as much a question of philosophy as of technique. This is one of the reasons behind the variety of approaches. It is further underlined by the broad range of purposes for which accounting human resources can be used. For example, it can be used as an information tool for internal and/or external use (employees, customers, investors, etc.) and as a decision-making tool for human resource management.

The reasons for developing HRA methods can be summarized in the following six points:
· Inadequacy of traditional balance sheets in providing sufficient information on enterprise performance,
· Measuring problems deriving from the valuation of human resources,
· Redistribution of social responsibilities between the public and private sectors,
· Security versus flexibility in employment,
· Improved human resource management,
· Formal learning versus in-firm competency acquirement.

The Policy Dimension
The focus on HRA in enterprises has lead to a growing interest by stakeholders who have started to identify and formulate their positions. The main stakeholders, such as the enterprises, investors, employees, trade unions and governments, are therefore gradually becoming aware of the potential of HRA, albeit from different perspectives.

The basic questions in this perspective are:
· Should HRA be mandatory for enterprises alongside financial statements, i.e. should law and/or social partner agreements regulate HRA?
· If mandatory, what kind of information should be included in such statements?
· If voluntary, how to secure the interests of, say the employees, at enterprise level?

If, and this is still a big if, the public sector, nationally or internationally, decides to promote HRA, three ways forward can be identified:
· The voluntary market-based method i.e. develop a consistent framework which can be operational across sectors and countries and promote this through a rewarding and image campaign,
· The voluntary rewarding method, i.e. develop a consistent framework supported by rewarding mechanisms once it is introduced and approved at enterprise level,
· The compulsory method i.e. identify disclosure of human resources as a societal concern and prepare international regulations.

HRA is not a new issue in economics. Economists consider human capital as a production factor, and they explore different ways of measuring its investment in education, health and other areas. Accountants have recognized the value of human assets for at least 70 years. Research into true human resource accounting began in the 1960s.

Performance Ratios/Indicators for HRM
What data might we use when accounting for human assets?
· FTEs – Full time equivalent staff
· Headcount (H) e.g. total FTEs at month end
· Revenues(R) – total operating income (total sales)
· Expenses (E)- Operating expenditure exac. Tax, interest and extraordinary items
· Profit-R Less E
· Cash Like rewards (C)- emoluments: salaries, wages, overtime, bonuses, commissions, including NI contributions.
· Benefits (B) –other rewards which may or may not be taxed as “benefit in kind” – cars, pensions, company loans etc.

Staffing Performance Indicators
1. Sales per employee – indicates general employee productivity. Compare SPE this year over last year and with SPEs of rival organisations. Their turnover may be smaller but they may have a better SPE.
H may increase if the business expands. Was the growth was worth it (SPE)?
2. Recover Rate Aggregate compensation and benefits then divide by revenue. LRR compares staffing costs with revenues delivered. Are we obtaining better or worse returns on each RR of staff expenditure? A decreasing RR is desirable.
RR = (C+B)/R
Unravelling influences on RR can be difficult e.g. is it the staff turnover or a new marketing approach or manufacturing plant? The impact on additional investment should show through in RR later – revenue increases whilst staffing costs fall.
3. Utilisation % - can be applied e.g. to a consultancy company or school whose main business is allocating or selling the time of its staff. We assume that an increase in U% is desirable – is this always the case?
U%= R/(C+B)
R (revenue) can be substituted by another measurable output e.g. wagons delivered, dustbins emptied, examination results (points). Calculation must include staff costs of the whole business unit – direct and support staff.
4. Profit per Head like RoCE, shareholders and business analysts may use profit per head or profit before tax per head to focus on employee related costs and returns.
PpH= P/H
A firm’s PpH rating may highlight under-achievement and profit potential when compared to industry competitors. Corporate preditors may be attracted.
5. Compensation per Re. Profit. This evaluates profit against cost/employee rather than headcount. Interpretation can be difficult. CpP can swing with profits e.g. where there are close links between profits and staff compensation (profit related bonuses).
CpP= (C+B)/P
CpP is negative where a firm is making a loss. What if CpP is a small positive number and CpP a small negative number? CpP may indicate that better management could improve cost-effectiveness or controls.
6. Personnel services expenses (PSE). What are the total operating expenses of the personnel/HRM section.
7. Personal Services Headcount (PSH) – total FTE for the personal/HR section in the calculation period.
8. Personal Service Cost %. (PSC) Divide PSE by total operating expenses (E) to identify rends and to influence budgeting processes.

Q.15 What are the various models and theories for valuation of shares and goodwill?
Ans Theories for valuation of Shares:
a) Value of assets: In this approach the focus for the valuation of the shares will be on the assets. The net value of the assets, i.e. the value of the assets less the liabilities will be used. For computation of valuation of shares, the total value of all the assets will be divided by the total number of shares.

But in this approach,
i) Non trading assets should be included
ii) If the company is having outstanding preference shares, their value should be deducted to calculate the net asset available to the equity shareholders.
iii) There may a lot of intangible assets in the balance sheet like preliminary expenses, deferred revenue expenditure, discount on issue of shares/debenture etc. These should normally be excluded from the value of total assets.

This approach has certain limitations.
Firstly the book value of the assets is directly dependent on the accounting policies followed by the company. This is more so in the area of booking depreciation, methods of provisioning adopted by the company, and valuation of inventory.

Second, in the valuation of intangible assets, there are no standard procedures. This is for intangible assets like goodwill, patents etc.

b) Realizable or liquidation of value:
To overcome some of the limitations in the book value approach, here the value of assets is taken to be the market value. Thus the value chosen is the one which can be had by selling the assets. It is also known as the liquidation value. This may be estimated for the company as whole, as it would be misleading or even irrelevant to look at individual assets. The value would be equivalent to estimated net amount that will be received by sale of assets less liabilities.
The method is as follows
Net Estimated value of assets = Estimated market value of assets – Liabilities
Value of the share = Net Estimated value of assets/ Number of Equity shares

c) Replacement or reproduction value:
In this approach, we move away from both the book value as well as the market value. Instead, we focus on the assumption that if the assets were to be replaced or reproduced all over again, what will be the value required. Thus the value of assets is taken to be on the basis of replacement cost rather than historical cost and market value. This replacement cost is estimated by competent authorities, like chartered engineers, other competent authorities. Again, there is and most likely a possibility that the replacement value may differ from authority to authority depending on the process, competency in valuing all the assets, person related factors and the assumptions that they make.
The method is as follows
Net Replacement value of assets = Estimated replacement value of assets – Liabilities
Value of the share = Net replacement value of assets/Number of equity shares
Some of the limitations:
First- replacement value of certain assets that are no longer available, or of an older technology may not be possible.
Second- estimating impact of depreciation on the replacement cost is difficult.

d) Yield/Earnings Approach: This approach assumes that the investors are interested in the income an investment would generate in the future. Often past earnings and income also have a bearing on the expected income in the future. Then the priced- i.e. the valuation of the share that they are prepared to pay depends upon the dividends, which they are expected to earn.
As such the value of share is calculated as:
Price = Rate of dividend x paid up value of share/ Normal rate of return

Goodwill is the value or the amount of reputation/standing/credibility of the business in respect of additional profit expected in future over and above the normal level of profit earned by a company – normally in the same class of business.

i) Super Profit Approach: In this approach, the future expected profits of the company are compared with normal profits, had their not been goodwill. There would some adjustments to be made for known factors affecting the profitability. Normal profit indicates the profit, which would have been earned by an average firm without goodwill. Normal profits can be calculated by multiplying the average capital employed by the average rate of return. The difference between future expected profit and normal profit is in the form of super profits, which is the measure of extra profits earned by the firm due to goodwill. Goodwill is calculated by multiplying the super profit by the certain number of years. The number of years to be taken into account would differ from investor to investor, from company to company and also would differ from industry to industry. It is a highly judgmental. Normally 3 to 5 years are considered.
ii) Capitalisation Method: Total value of the business is calculated using the actual average profits after taking into account all factors based on normal expectation. The value of the goodwill is the difference between capitalized value and the net assets of the business.

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