In a hypercompetitive job market where people are the ultimate prize, failing to manage human capital is a glaring risk.
CAEs need to understand the value of human capital and the risks involved in hiring, training, and retaining employees.
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Articles Judy Warner Dec 12, 2022
CAEs need to understand the value of human capital and the risks involved in hiring, training, and retaining employees.
Amid the “Great Resignation” and “quiet quitting” phenomena, employers are being reminded of the fragility of their relationships with their employees. In a tight labor market, failing to retain experienced, competent workers — and cover for them or replace them if they leave — contributes to higher operational and financial risks for all organizations. Even with signs of recession on the horizon, the U.S. unemployment rate in October remains low at 3.7%, according to the U.S. Bureau of Labor Statistics.
An estimated 85% of any organization’s costs are people related, according to PwC’s New Human Capital Disclosure Rules: Getting Your Company Ready. And talent management is the second highest-ranking risk — after cybersecurity — among the top 12 risks identified by The IIA’s OnRisk: A Guide to Understanding, Aligning, and Optimizing Risk 2022 report. Enter internal audit.
It’s now expected that CAEs understand the risks and value of this intangible asset. As companies compete to hire, retain, and train employees, internal audit can help by identifying patterns that indicate what is and isn’t working. Robert Lamp, a senior partner in the Global Financial Officer practice at Korn Ferry, views human capital management as an area where internal audit can be a strategic value differentiator for the business. “Internal audit’s role in tracking these trends often looks at movement in human capital from a productivity risk — tracing back commonly to enterprise risk management and perhaps broader cultural challenges.” Lamp says.
From the investors’ standpoint, there has been a dramatic change in the way work is valued. One proof point can be seen in the intangible asset value of the S&P 500. Intangible asset value was less than 20% in the 1970s and grew to an average of 84% by 2015, according to research conducted by Chicago-based intellectual property advisor Ocean Tomo, which was cited in a March 2019 recommendation by the U.S. Securities and Exchange Commission’s Investor Advisory Committee on Human Capital Management Disclosure.
The SEC working group includes former commission officials, academics, and market participants who believe human capital management disclosure is also a financial reporting matter, framing it as human capital accounting at a time when intangibles have become more prominent. Up until the new rule amendments in 2020, the SEC’s only human capital-related requirement was for companies to provide their employee count. Specifically, the principles-based rules passed under then-SEC Chair Jay Clayton require all U.S. publicly listed companies to disclose a description of their human capital resources, including any human capital management measures or objectives they use to manage operations.
Current SEC Chair Gary Gensler favors a rules-based approach. The view of labor as a material risk is leading the SEC to consider proposing rules for greater human capital management disclosure. So how soon could we see new disclosure rules? Recent acrimony over the SEC’s proposed climate-related disclosures could slow progress on additional human capital management-specific disclosures, experts on environmental, social, and governance matters say. The SEC rule proposal for human capital management disclosure is part of a broader trend in ESG reporting that has surged in recent years.
Globally, however, rules related to human capital management reporting have been advancing for years. European Union Directive 2014/95/EU is now in effect for 28 member states. The 2014 directive recommends the use of international standards for reporting purposes, which can include the ISO 30414: Human Capital Internal and External Reporting standards, according to a 2019 EY report, How and Why Human Capital Disclosures Are Evolving.
Disclosures aside, there are other factors at play. One is the changing demographics of the workforce — younger, more socially conscious generations of employees are in the workforce while baby boomers are supposed to be retiring or nearing retirement. But there’s a hitch. According to research published in September by the Nationwide Retirement Institute, 40% of workers 45 and older say they are pushing back their retirement plans because of rising costs, Bloomberg reports. Older workers are living longer while fertility rates around the globe are dropping, creating new tensions in labor markets.
All these factors combined led to the September New York Times article, “Making Sense of a Puzzling Jobs Market.” It reported that the U.S. job market is still strong despite a growing number of large companies reporting hiring freezes or layoffs. “We’re all waiting for the significant drop — the free fall — but that is not what we’re seeing,” said Becky Frankiewicz, North American president for ManpowerGroup, a global staffing agency. “As employment slows down in one industry, it picks up in another industry.”
Sioux Falls, S.D., exemplifies this strong labor market. Sioux Falls is forecast to be among the fastest-growing cities in the U.S. between now and 2060, according to Woods and Poole Economics, a Washington, D.C.-based economic forecasting firm. The city’s current population of 202,000 is expected to more than double to 438,400 over the next four decades. That growth creates talent challenges for companies like The First National Bank in Sioux Falls, a family-owned community bank established in 1885 that today boasts 18 branches serving the upper Midwestern U.S.
The bank’s internal audit function is approaching talent risk in two stages, says Seth Peterson, senior vice president and chief enterprise risk assurance executive. “First, through testing and interviews with management and the staff, we make sure that we have the talent that we need and that there’s resiliency and bench strength,” Peterson explains. “The second stage is to evaluate whether everyone has the talent they need to do their job today and what they will need to do their job tomorrow.”
Another key factor in talent management is a reckoning with systemic racism and inequality. Black Lives Matter and allied social movements have raised calls for greater employment and promotion opportunities for Black and Latino workers, with companies across industries pledging to ramp up their diversity, equity, and inclusion efforts.
To hold companies accountable, a group of academics, which include former SEC officials, filed a petition with the SEC in June proposing that the Commission “develop rules to require public companies to disclose sufficient information to allow investors to assess the extent to which firms invest in their workforce.” Among its recommendations is an accounting disclosure to describe the aspects of human capital that are considered expenses rather than investments. Investors and other stakeholders also have advocated that companies publicly disclose data from Equal Employment Opportunity-1 reports that describes the gender, race, and ethnicity of their employees across job categories.
An upcoming research report from The IIA’s Internal Audit Foundation and Deloitte will provide recommendations for how internal audit can review the DEI aspects of hiring and retention initiatives. DEI 101: Catalyzing an Inclusive Culture — Internal Audit’s Role in Recruiting, Retaining, and Developing Diverse Talent is the second in a three-part series.
The talent risks arising from a strong labor market and the likelihood of a recession next year are even more reason for CAEs to be on top of their game. “When internal audit finds issues with the way things are being done, the root cause is most likely a people problem — not enough people, or the wrong people, or people without the appropriate skills, experience, and competence,” says Norman Marks, an advisor on risk, internal audit, and corporate governance in San Jose, Calif. “Talent management feeds into all of this.”
Organizations should view talent as a systemic risk, according to Patrick Lee, senior advisor to KPMG’s Board Leadership Center. He notes that management disclosure committees — a recommendation that publicly listed companies have these committees stems from the U.S. Sarbanes-Oxley Act of 2002 — should include the chief human resources officer and the head of sustainability, in addition to the CAE, chief legal officer, and chief risk officer.
SEC recommendations notwithstanding, proactive companies voluntarily report in advance of regulations. This applies to human capital management, as well — particularly in the current talent market.
“A lot of companies say employees are their most valuable asset,” Lee says. “What employees and investors are saying is ‘prove it.’” Managing talent risk will be complicated by the triple impact of a bear stock market, inflation, and recession fears, he adds, which will likely affect employee retention and recruitment strategies.
Regardless of macroeconomic machinations, CAEs have an important role to play at the intersection of data analysis and human capital management. Internal audit will need to optimize its data capabilities to provide greater data analysis and insights on all aspects of talent management while ensuring that related talent systems and processes are compliant and assumptions about them are valid (see “KPIs for Talent Management,” below). “Internal audit needs to work with the board and management to establish first quantitative risk-appetite tolerances against which enterprise risks and controls, including those related to human capital, can be audited, measured, and reported,” says James Lam, a risk consultant in Wellesley, Mass. and board member of RiskLens Inc.
With employee salaries, benefits, and recruitment often an organization’s single largest line-item expense, it stands to reason that executive management and the board should understand the effectiveness of their human capital programs and optimize the return on investment, says New York-based data scientist Dr. Solange Charas, founder of HCMoneyball. This is where human capital analytics tie in.
Cloud-based tools transform human capital data into standardized metrics that CEOs, chief financial officers, and others can use to calculate the material impact of human capital investments on financial outcomes. Charas applies finance principles to value human capital and quantify its impact on a company’s profitability. Her research shows that businesses that use human capital analytics are 25% more profitable than competitors that don’t use it.
Where does internal audit fit into the formula? “What internal audit can provide is the data analysis to inform management about the efficiency of budget allocations to human capital,” Charas says. She explains that in 2020 the SEC reclassified human capital costs from an expense to an investment in an intangible asset, dramatically changing how companies manage and measure human capital performance. At the time, “workers were considered dispensable, replaceable, or like commodities,” she says. “Now we have this new context for understanding human capital, and like any other investment, investors will require some threshold level of return on that investment. Quantifying the material impact of human capital is the only way to measure return and determine human capital’s contribution to sustainable corporate performance.”
Analytics are a valuable tool for assessing talent issues, says Uday Gulvadi, managing director in the disputes, compliance, and investigations group at global investment bank Stout in New York. Gulvadi conducts audits of staffing, senior management succession planning and transition, and talent retention and attrition. Some of that assessment is a blend of art and science, Gulvadi says. “This is a relatively new area for internal audit,” he explains. “I expect there will be greater standardization in tools and techniques in the coming years given the recognized importance of human capital management.”
If knowledge is power, then a regular human capital audit can provide insights that are nuclear in their value-creating potential. From the smallest one- or two-person audit function to the best resourced Fortune 500 company, there exists the ability to capture and analyze data. Good, consistent data analysis can provide insights on employees — everything from their satisfaction with their job to their productivity.
Where to begin? Start with benchmarks:
Arguably, the two most important key performance indicators, according to experienced HR consultants, are the overall cost of human capital, and its return on investment. Other KPIs include:
Sources: ClearPoint Strategy, Datapine, HCMoneyball
Business is full of uncertainty. What remains certain is the CAE’s role in making the unpredictable more predictable. Lee advises CAEs to be laser focused on talent as a risk interconnected with many other risks such as cybersecurity and ESG. “The employee empowerment movement shows no signs of slowing down and greater employee leverage should cause all companies to reevaluate work/life balance, flexible work arrangements, and opportunities for key talent to advance and share their knowledge,” he says.
Lee notes that given the growing fusion of risks today, organizations can no longer manage risk in silos. “Having the right talent is critical to mitigating and managing every risk any organization faces,” he says.