Showing Your Talent

People and culture are long-term strategic imperatives, according to the report, Executive Perspectives on Top Risks for 2023 and 2032, by Protiviti and NC State University’s ERM Initiative. In fact, finding and keeping talent is the top risk looking out 10 years. In the workplace, the expected impact of artificial intelligence, automation in all its forms, and other technologies are such that significant efforts will be necessary to teach employees the skills needed to fulfill the value proposition of these technological investments. This makes the future of work, and by extension, talent and culture, a defining business priority.

Given these market realities, it is hardly surprising that organizations committed to reporting on and acting upon sustainability and ESG matters are expected to disclose information on human capital objectives and measures that are integral to managing their business. Investors know that talent wins and that leads to the presumption that companies offering the best prospects for performance are certain to be the ones with superior strategies for acquiring, developing, and retaining talent. 

With regard to the social factor, board members and C-suite leaders, including CAEs, should take note: More human capital reporting and disclosures are coming. This presents key priorities for internal audit leaders to increase their relevance and deliver greater value to their organizations.

Human Capital Reporting Is Evolving

Over the last 30 years, as markets placed increasingly higher values on intangible assets, interest in emphasizing public reporting on such assets has escalated. Human capital represents the most important enterprise asset a company possesses. As the old adage asserts, an organization is only as good as its people.

To that end, standard-setters and regulators have weighed in with guidance on human capital reporting. In 2019, the International Organization for Standardization (ISO) provided reporting recommendations with the publication of ISO 31044: Human Resource Management – Guidelines for Internal and External Human Capital Reporting. As the first international standard designed to provide a clear view of human capital contributions, it offers guidance on such areas as organizational culture, recruitment and turnover, productivity, health and safety, and leadership. 

In the U.S., the Sustainability Accounting Standards Board (SASB) published a framework on human capital in 2020 with an emphasis on labor practices, employee health and safety, and employee engagement, diversity, and inclusion. The SASB, now a part of the International Sustainability Standards Board overseen by the International Financial Reporting Standards Foundation, created standards across 77 industries, covering the distinctive sustainability opportunities and risks within each industry. 

But standards, unlike rules, are not enforceable in the context of public reporting on human capital matters. In 2020, the U.S. Securities and Exchange Commission (SEC) issued a rule requiring companies to report on human capital metrics. The rule mandated this disclosure to the extent it is material to an understanding of the registrant’s management of the business taken as a whole. 

Of note, the SEC did not offer an operational definition of human capital, nor did it explain what was meant by the contextual reference to managing the business. No doubt this leaves many preparers confused as to exactly what is required, while it also arguably offers organizations some flexibility in developing their disclosures. 

Earlier this year, the EU enacted the Corporate Sustainability Reporting Directive (CSRD) to modernize and strengthen the EU’s Directive on Non-Financial Reporting. The CSRD requires information on social responsibility and treatment of employees, respect for human rights, and diversity on company boards. It augments existing requirements pertaining to diversity issues, employment and working conditions, trade union relationships, remuneration systems, training and career management, and health and safety matters. 

And the EU is not done. Sector-specific reporting criteria are expected down the road. As for the U.K., midsize to large companies must disclose their employee engagement practices and the ratio of CEO pay to median employee income (which is also required in the U.S.). 

Countries in other parts of the world also require social disclosures, some of which include human capital themes. In addition, there are other market-driven frameworks that touch on human capital, such as the Global Reporting Initiative, which covers topics such as recruitment and retention, labor and management relations, health and safety, training and education, diversity, and pay equity. 

What does all of this mean? Human capital disclosures have become a fixture in corporate reporting. While prescriptive requirements have been trending, there remain flexibility and a foundation in principles-based frameworks that allows the leaders of publicly listed companies to use their best judgment as to what and how much to disclose on material topics. To that point, a review of proxy disclosures reflects significant latitude among reporting companies in terms of topics covered, depth of coverage, and length. However, the market can expect more specific requirements as regulators review disclosure practices and institutional investors and other stakeholders offer feedback regarding their expectations.

Where Internal Audit Adds Value

Internal audit’s opportunity to add value begins with understanding management’s process for managing and reporting on human capital. 

Management Process: Set the right tone, inculcate the right culture, and formulate a winning strategy. This starts at the top with the board and executive management. An effective advocate for the preservation of talent and culture should have a seat at the table. 

The Opportunity: Internal audit can evaluate the extent to which human capital objectives, goals, and measures are integrated into the business. For example, are they:

• Linked to the organization’s overall corporate vision, mission, and strategy? 
• Supported by initiatives pertaining to talent acquisition, development, and retention; succession planning; appropriate training programs; building resilience into the culture; and management of diversity, equity, and inclusion initiatives?
• Integrated into management’s performance expectations and compensation? 

Internal audit should assess whether the chief human resources officer has appropriate stature in the organization. For example, there should be evidence that senior leadership and the board are leveraging the chief human resources officer position to derive the greatest value from the organization’s talent investments to support the business. In addition, internal audit should evaluate whether the human resources function is evolving to focus more broadly on people and culture and positioning talent management as a differentiator in the marketplace.  

Management Process: Identify the right metrics to manage the human resources strategy. This is about focusing on the metrics used to manage human capital, as used by decision-makers and provided to the full board at an appropriate level, not merely to meet disclosure requirements. For example, for electronic manufacturing services, the SASB standards recommend several metrics, including the number of work stoppages, total days idle, and the total recordable health and safety incident and near-miss frequency rates for employees and contractors. These are examples of metrics that drive managerial decisions and are used to shape the goals and expectations of the human resources function. 

The Opportunity: Internal audit can assess whether the metrics selected are consistent with metrics recommended by applicable frameworks and used by competitors in the industry. It can evaluate management’s materiality assessment in determining the appropriate topics for human capital disclosure purposes, as well as compare the company’s reporting and reported results against its peers.

Management Process: Determine an effective measurement approach. As with financial data, the underlying data feeds and information sources used in the measurement process supporting human capital reporting must be factual and verifiable. Once the metrics for the dashboard are determined, the necessary processes and information systems should be designed to collect, verify, and present the underlying data. Sources of input and data should be automated, with sufficient transparency allowing traceability back to the source. Managers should use the dashboard to drive internal outcomes and support stakeholder messaging. 

The Opportunity: Internal audit can evaluate the measurement methodologies and the veracity of data sources, as well as the efficiency of the approach. For example, where does the data reside? Are the data feeds automated and measurement processes centrally located, or does data need to be compiled from various locations manually? Another area to assess is the reliability of the dashboard in reporting progress on achieving human capital goals. 

Management Process: Evaluate disclosure controls. The design and operating effectiveness of disclosure controls and procedures related to human capital reporting should be assessed periodically to provide assurance that all information reported externally is complete, accurate, and timely. As a result of the U.S. Sarbanes-Oxley Act of 2002, the CEO and chief financial officer (CFO) of U.S.-listed companies sign a certification in the company’s management report that asserts, among other things, that the disclosure controls are effective for this purpose. 

The Opportunity: This area presents one of the best uses of internal audit. This assessment could entail a review of the current state of the design effectiveness of disclosure controls in place for human capital measures and a determination of additional controls needed to meet reporting requirements. It should include an assessment of controls needed to ensure human capital metrics are calculated consistently. 

Among other queries, internal audit can determine if changes to the underlying methodology have occurred and, if so, whether they are disclosed. Internal auditors can get useful direction on evaluating disclosure controls within COSO’s new supplemental guidance, Achieving Effective Internal Control Over Sustainability Reporting: Building Trust and Confidence Through the COSO Internal Control–Integrated Framework, released in March. 

Management Process: Create the human capital report to support regulatory requirements. In preparing the human capital portion of the organization’s sustainability report, the appropriate stakeholders should be involved to ensure the right narrative. While the CFO typically is involved with the human capital reporting process, the chief human resources officer is responsible for providing the data used to create the metrics and reports. Chief human resources officers have limited experience quantifying and validating measures presented to regulators and shareholders. This dynamic necessitates effective collaboration with the CFO to quantify the links between human capital investments and performance and profitability. It may entail input from investor relations, legal, IT, and other functions.

The Opportunity: Internal audit can review this collaborative, cross-functional process. They can also look at the efficiency of the processes for incorporating human capital information into the annual reporting and the results of comparisons of company disclosures to those from other organizations that contain the strongest links between human capital strategies and business outcomes.

Management Process: Tell the right story linked to the strategy. The narrative to the company’s stakeholders should be supported by reliable data. It should help outsiders understand management’s rationale behind key decisions and, more importantly, how the approach to human capital enhances business performance. If management is able to advance a narrative about meaningful human capital programs as a demonstration of corporate values, human capital reporting introduces an opportunity for companies to differentiate themselves in the market and influence employees, customers, and other stakeholders. 

The Opportunity: This area has several opportunities for focused internal audit inquiries:

• Has management set market expectations that they are confident the company can deliver?
• Are the human capital objectives and metrics included in corporate sustainability reports also shared consistently through other venues, such as earnings calls, marketing materials, onboarding materials for new hires, social media, the corporate website, and reports to regulators, lenders, and rating agencies?
• Is the company maximizing the impact of human capital reporting on employees, customers, and other stakeholders from a reputation and brand image standpoint?

A More Agile Culture

As stakeholder focus on the role of human capital in underpinning and enhancing long-term value grows, there may be opportunities to improve the value of human capital disclosures. Corporate reputations are at stake, as the penalties for misleading disclosures can be severe. 

It is significant that the Executive Perspectives on Top Risks survey also points to resistance to change as a formidable cultural issue and an obstacle to long-term success. A trust-based, transparent, and diverse culture is needed to break down the barriers of resistance and enable organizational preparedness, agility, and decisiveness. Accordingly, internal audit can deliver value by supporting human capital initiatives through its proven risk-and-control mindset and methodologies.