It’s almost unbelievable that human capital is not recognised on the balance sheet. Today, when it universally recognised that people are the most important part of a company, we still don’t recognise human capital as an asset on the balance sheet due to accounting principles and regulations.
We still don’t capitalise staff salaries or any likewise expenditure when it is clearly obvious that expenditure on staff has an enduring benefit that extends way into the future. Training expenditure will give staff skills that will help them become more effective employees, and make them able to serve the company better. There is definitely a value to people.
Don’t get me wrong, I am not saying that accounting statements need to be overhauled to start capitilising staff salaries and the like. But what I am saying is that when analysing a company, and working out the net asset value, or return on assets ratio, one must take into account the value of one of the most valuable unrecognised assets – the value of its people.
To try and get a value for such an intangible asset is almost impossible to gauge. The value will change from company to company and from industry to industry. For technology companies it may not be as material, where the profit driver may be a website, or a system. But in most companies, such as a bank or a retail company, this value would be very large. Where service is the source of revenue, the company will rely on it people to bring in the bacon, while a company that sells a product will rely less on its people. However there is no such company that can run profitably without effective people. There can be a situation where a company has such poor service that you could say that their people are a liability to the company.
So again, when analysing a company, take into account the value of its management, its people, its expenditure on training, its recruitment process, etc etc. Recognise the value of a companies workforce.
Benjamin Graham, the investment guru, tells it as it is: "An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative". In his book, the Intelligent Investor he differentiates between an "investor" and a "speculator". Investors are long term buyers of shares, while speculators are simply trying to make a "quick buck".
But what character traits do the best investors have in common?
Contrarians - The best investors are contrarian thinkers, always thinking out-the-box and trying to buck the trend, as opposed to going with the trend.
Patient - Patience comes with this key, and long term patient investing is necessary to become a successful investor.
Good versus evil - Another trait that a good investor will have is the ability to distinguish between good and bad. Some things like a "50% increase in HEPS" seems to be good news to most, but the good investor can analyse more deeply than that and distinguish how good, or how bad information is.
Risk - An understanding of risk is a vital component of a good investor. A good investor can determine how risky an investment is, and what the required relative returns are. A return of 100% sounds great, but what was the related risk?
While I was driving home today a strange scenario came into my mind. If Wits University asked me to give all the first year accounts students an introduction to accounting, what would I say?
So while cruising through the streets of Johannesburg, I saw myself standing there in front of a few hundred aspiring and undecided students...
Accounting is the language of business. To understand how a business works, you have to understand how it runs, and how it is communicated. If you decided to backpack through France, and could not speak a word of French you would struggle to make it very far. Similarly, if you try to analyse a company without understanding how the annual financial statements are drawn up, you will struggle to page through a company's results.
When I was in second year I was deciding whether to study finance or accounts and so I did both courses in second year. After passing both courses, I decided to do accounting. Even though I was more interested in finance, I thought that if I truly wanted to value and evaluate companies I would have to learn the language of the companies I was looking at. Many people think that if they do finance they can learn how to analyse companies, how to choose between different investments, and which stocks to pick. But I don't think you can just learn how to analyse a company unless you understand the fine details that make up that accounting system. When I got to 3rd and 4th year accounting, one of the four subjects is called Management Accounting and Finance. Half the course is finance and that pretty much sums up how small a section finance is of this business language called accounting.
While I do not think finance is a small part of the accounting system, I do believe that to truly evaluate and value companies, a thorough knowledge of the accounting system, the accounting rules, the tax figures, the corporate and tax legislation, the systems and controls of an enterptise etc. is essential. It is very hard to blindly believe what the accountant has prepared in front of your eyes and without the accounting knowledge it is hard to make fundamental investment decisions. Creative accounting is prevalent throughout the world - there are many Enron disasters out there - and to see through the fraud it is essential that you can understand the fraudster's language. I have personally been burnt when I invested in a small South African IT company called CS Holdings who fraudulently misstated its figures. Maybe if I understood accounting then like I do now, I may have picked up the fraud. But the point is that it is not only about finding the fraud in financial statements. It's about understanding the basic accounting system that creates these financial statements.
So therefore, I would have to conclude that if you are interested in going into business, or just investing in businesses, accounting is a useful and essential tool that will always help you in your business success and career.
