Notable by its absence: significant HR information frequently is missing from corporate annual...

If 15 percent of a public company's buildings burned to the ground one year, it would make sense for the company to disclose that fact in its annual report. Investors, after all, would want to know about the status of the company's sizeable capital investment.

What makes much less sense,

And Haig Nalbantian a principal at Mereer Human Resource Consulting in New York, says investors want such information.

"We think that investors implicitly recognize" that human capital management (HCM) has value, says Nalbantian--one of the authors of a new study about the inclusion of HCM information in the annual reports of top companies in the United States and United Kingdom. "Now is the time for organizations to recognize this. When they are able to secure that advantage, they need to help investors clearly understand and appreciate it."

Organizations that use this information to show that their expert human capital management affords them a competitive advantage may be more likely to attract investors, Nalbantian says. Those that do not may prompt investors to place their funds elsewhere.

Plenty of Platitudes, Few Hard Numbers

Currently, many top corporations include some mention of HCM information in their annual reports. However, that information is frequently cursory and superficial.

"Too often, the only things about people in the annual report have been the photos," notes Ilene Gochman, central division leader of organizational effectiveness and national practice leader of organization measurement for Watson Wyatt Worldwide in Chicago.

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That's a view borne out by the research of Nalbantian and fellow Mercer Human Resource Consulting Principal Rick Guzzo. The pair scoured each Fortune 100 company's 2003 and 2004 annual reports--documents that can run 50-plus pages and often contain scores of complexly worded footnotes--for any information related to compensation, benefits, recruiting, training and development, succession planning, workforce composition issues (such as diversity) and organizational culture (such as discussions of employee surveys).

They found that 90 percent of the annual reports studied contained some mention of the company's workforce--but most of those mentions included little or no discussion of where HCM fits into the company's business strategies and most contained no numerical measurements related to the workforce whatsoever.

When Nalbantian and Guzzo analyzed the breadth and depth of the HCM information available in these annual reports, they found four different levels. (See the table below.) Only 14 percent of companies reached the highest level by providing at least one hard indicator of workforce performance, such as a specific number about turnover rate or scores from employee surveys. (For examples of this level of disclosure, see "Level-4 Disclosure," below.)

Nalbantian acknowledges that providing at least one hard indicator is not a terribly stringent standard. He also emphasizes that more progress is possible and necessary in this area, and he describes a fifth level of disclosure that would report on direct links between employee metrics and financial metrics. Some companies already gather such figures, but few--if any--report those links.

For example, a few years ago First Horizon National Corp., a Memphis, Tenn.-based regional bank, enlisted Mercer Human Resource Consulting to help mine its workforce data. The resulting analysis suggested that by boosting the average tenure of customer-facing employees by one year, the company could increase revenue per customer by $15 million per year.

And in 2003, U.K.-based Standard Chartered Bank reported that its retail branches shown in surveys to have highly engaged employees enjoyed several eye-opening advantages over branches with less engaged employees. Branches with highly engaged workers chalked up 100 percent higher profit margin growth and 74 percent higher growth in deposits.

(For an additional example of a company working to link HCM metrics to financial performance, see "Measuring the Value of HR" on page 44.)

Those are the sorts of links between workforce measures and performance measures that Nalbantian and Guzzo have in mind when they describe a mission to alert companies and investors that "there is mutual advantage in providing better and more focused disclosure in this all-important area."

Yet many factors make the inclusion of HCM data in annual reports an uphill battle, for the moment.

The Problem with Annual Reports

Although a company's annual report remains one of the only viable vehicles for providing HCM information to investors and potential investors, the report's very nature--part balance sheet, part glossy marketing pitch--also makes it an imperfect vehicle for HCM-related reporting.

Michael Thomsett, author of Annual Reports 101: What the Numbers and the Fine Print Can Reveal About the True Health of a Company (AMACOM, 2007) and a former corporate accountant, notes that the dual nature of annual reports leads to conflicting objectives. "One [objective] is to disclose financial information," he explains, "and the other is to gloss over how bad it is.... As a general rule, companies tell as little as possible about the bad news and try to make the bad news look good. I think there is a conflict between what we as investors would like to see in an annual report and what executives want to disclose in a report."

That conflict often results in confusion and narrative gaps from year to year.

One reason for relatively incomplete data or explanations of company activity is that in the post-Sarbanes-Oxley era, many companies are leery of providing any information they are not required to report. (And while the U.S. Securities and Exchange Commission--which regulates the financial statements U.S. public companies produce--has occasionally mentioned intangible valuations, it has shown no signs of requiring any sort of human capital measures in financial statements.)

"I can hear the accountants saying, 'We don't want to disclose anything we don't have to disclose because that can be used against us,'" says Thomsett.

In fact, over the past few years, shareholder letters from the annual reports of a number of Fortune 500 firms have generally become less clear and more confusing, says Laura Rittenhouse, president of investor relations firm andBEYOND Communications Inc., in New York.

Each year, Rittenhouse ranks shareholder letters from a cross-section of Fortune 500 companies' annual reports, based on the degree to which they effectively address employees and employee concerns. Her analysis of reports from 2002 to 2005 identifies several trends, including:

* The number of CEOs writing clear and candid shareholder letters declined substantially from 2002 (when 57 percent of the letters received top marks for candor) to 2005 (when only 24 percent received top marks for candor).

* The vast majority of shareholder letters do not connect to themes and ideas expressed in letters from the prior year, which, Rittenhouse says, can damage employee trust She notes that when the importance of multiyear initiatives are emphasized in one annual report and then ignored in subsequent annual reports, employees are less likely to buy into future strategic initiatives.

What's more, such missed opportunities to communicate company vision and strategy can negatively affect employees as well as investors. Rittenhouse and other notable figures--including Jack Welch and Warren Buffet--firmly believe that employees represent an annual report's primary audience. Annual reports that fail to address employee concerns effectively, Rittenhouse explains, create a risk for losing top talent and alienating long-term investors, whom she says heavily weigh the health of an organization's culture in their investment decisions.

Yet many annual reports fail to address employee concerns in any significant way, and others actually downplay the important role that employees play in executing company strategy. For example, Rittenhouse's research found that in 2004 shareholder letters, only 22 percent of CEOs thanked employees--a decline from 28 percent in 2002.

Her research also shows a rise in annual report language that objectifies employees and their contributions. Examples include a 2004 shareholder letter in which Humana's CEO noted that the health care company expected "to use our product mix diversification"--not its employees--"to expand our medical provider network and create new growth opportunities." And Wachovia's "strong balance sheet," rather than its employees, was responsible for driving results in 2003. Such language, Rittenhouse says, gives credit to an inanimate object--the balance sheet--rather than the employees whose performance produced the figures on the balance sheet.

Additionally, several companies informed readers that they had achieved "reductions in head count" (or, sometimes, reductions in "salaried head count" or "general and administrative expense reductions"). While these layoffs may have been necessary, the dehumanizing characterizations of them were not--and they did little to inspire employee or investor trust.

(For more, see "Don't Forget About Employees" on page 55.)

A Dearth of Data

Another factor delaying the inclusion of HCM information in annual reports is a dearth of good data and the fact that many companies are still wrestling with ways to prove HR's value to the bottom line.

"Right now, we're trying to grasp the 'Holy Grail' by determining how talent is directly linked to financial value at the end of the day," says John Gibbons, senior research adviser for The Conference Board's management excellence practice in New York. He also notes that while more HR executives are being held accountable for delivering on bottom-line results at their companies, "the process for doing that has not yet matured."

A new working group at The Conference Board called "evidence-based human resources" seeks to help organizations establish a valid link between human capital and financial metrics, Gibbons explains. Other research and consulting firms, such as Mercer and Watson Wyatt, also have made recent progress in linking human capital measures and performance metrics. Yet the degree to which those links are established, measured and managed at individual companies varies widely.

For example, Nalbantian notes that one of the world's top banks recently established a workforce analytics group because its chairman "got so exasperated that something as basic as annual head count differed depending on whom he asked."

Guzzo agrees: "Too often, there is incoherence with respect to internal [HCM] reporting," he says. "It's difficult to tell a story to the outside world and investors if you don't have your house in order."

And some investors may be a tough audience for HCM information even if companies do have their HCM reporting ready. "Some institutional analysts are going to say, 'Why do we want to see that? It doesn't affect the P/E [price-to-earnings] ratio and the return on sales,'" notes Thomsett.

That will almost certainly be the case with investors who hold investments for shorter periods of time--like the hedge funds whose purchasing power and influence has grown enormously in the past five years. Hedge fund managers with investment horizons of 14 months or less are unlikely to care about links between, say, workforce productivity and shareholder value, or between average tenure and profitability growth--factors that take more than a year to bear fruit, say experts.

Yet close to half of all investors retain at least some interest in the long-term health of companies, says Rittenhouse. "While astute investors may not be interested in specific human resource programs, they are believers in the importance of healthy corporate cultures," she adds.

Change in the Air?

There are a number of compelling forces at work that suggest that most of the obstacles preventing widespread disclosure of human capital information can be overcome.

First, the ever-increasing availability of data and growing sophistication of business software suggest that it will become increasingly easier to measure and monitor human capital information.

Second, there is growing evidence that traditional forms of accounting and financial reporting have not kept pace with the transition from an industrial economy to an economy bulging with knowledge workers--and that valid HCM data is needed to fill the void. In fact, research indicates that only a small portion of a company's market value--as little as 28 percent--is captured by the information in the balance sheet, writes Michael Echols in his book Competitive Advantage from Human Capital Investments (Tapestry Press, 2006). Echols is vice president of strategic initiatives with Bellevue University in Omaha, Neb.

Wells Fargo Chairman and CEO Richard Kovacevich made the same point in his 2004 letter to shareholders: "GAAP [Generally Accepted Accounting Principles] does not recognize the value of intangible assets that a knowledge-based company such as Wells Fargo generates internally--such as the loyalty and relationship levels of our team members and customers."

Third, smart companies won't just wait for investors to demand HCM-related disclosures but will start including human capital information in annual reports because it makes business sense. Guzzo believes companies that elect not to disclose these measures "are going to be quickly surpassed by companies that recognize the power of telling credible and coherent stories to investors about how they are in command of the totality of their business enterprise."

After all, if a company developed a new product or secured a new patent, it would communicate that competitive advantage to shareholders. So, too, should companies inform investors whenever they have "developed policies, procedures and mechanisms that allow them to extract a premium from their workforce that competitors cannot," says Nalbantian.

Fourth, the law of supply and demand may soon require much more precise disclosures of people costs. "The question of how to attract and retain talent is becoming very difficult," notes Echols, who recently assisted a large government agency in assembling a demographic plan. "The demographics are grim."

Even more important is the potential skills gap facing many employers. Those who can attract and retain workers who possess needed skills in a business environment that is changing at an increasingly faster pace will hold a definite edge--one that investors should want to know about.

What To Say About People

Given these factors, what sorts of workforce or HCM information should CEOs and HR executives consider including in annual reports? Experts who study annual reports and HCM recommend mentioning:

Training and tuition reimbursement costs. "Most companies don't even know how much they spent on training last year," notes Echols. By contrast, corporate financial statements contain the exact amount companies invest in buildings and other tangible assets each year.

Citing estimates from IBM and Eduventures, a firm that provides information services on the U.S. education market, Echols pegs the total corporate investment in training and tuition reimbursement at about $100 billion annually. That makes General Electric's $1 billion investment in training--a figure CEO Jeffrey Immelt disclosed in his 2005 "stakeholder" letter--extremely impressive.

Recruiting costs. This measure reflects the degree to which an organization is developing talent internally. "If recruiting costs are escalating at a rate of 20 percent to 30 percent per year, while a competitor's recruiting costs are only escalating 2 percent or 3 percent per year, that's an important piece of financial delineating information," says Echols.

Annual turnover rate. This measure helps illustrate the degree to which the company's investments in training, tuition reimbursement and recruiting bear fruit. "I get zero return on my investment from all those people who depart the company," notes Echols.

Succession planning. The succession planning processes at clothing retailer the Gap are so effective that the company "almost never has to go outside the organization for a management job in their field organization," Gibbons notes. "And almost never is there a gap between the person leaving the job and the person taking over the job.... As a member of the board of directors or a shareholder, I would want to know that."

Formal customer service improvement efforts. Annual report and human capital experts most frequently mention the application of Six Sigma to customer service efforts as ripe information to include in annual reports. "Six Sigma is a way to quantify changes in performance," notes Thomsett. "You can put a number on it." (For more information, see "Six Sigma in Sight" in the March 2004 issue of HR Magazine.)

For example, if a Six Sigma effort coincided with a 30 percent improvement in customer satisfaction and a noticeable bump in stock price, Thomsett says, "that would be very exciting to see." (For more information on HR's role in boosting customer service, see "Building Service with a Smile" in the November 2006 issue of HR Magazine.)

What the Future Holds

The degree to which future annual reports excite investors and employees depends heavily on human resource executives. If annual reports are to include more sophisticated links between workforce investments and financial performance, data will need to be mined and analyzed--and CEOs and other annual report authors will need to be convinced of the value of reporting on those links.

"HR executives will have to make the case to colleagues in other functions and to executive leadership as to why this is so important," Nalbantian adds. "If they start to make that case with stronger, firmer metrics that tell the story of human capital, I think you will start to see a change in HR's role. It's part of the evolution of this function."

ERIC KRELL IS A BUSINESS WRITER BASED IN AUSTIN, TEXAS, WHO COVERS HR AND FINANCE ISSUES.

RELATED ARTICLE: Level-4 Disclosure

New research from Mercer Human Resource Consulting indicates that 14 percent of Fortune 100 companies include at least one hard number related to workforce performance in the shareholder letters with their annual reports. The following three excerpts are examples of that type of disclosure:

From Wells Fargo, 2004: "In recognition of our team's outstanding performance and their key role in achieving these great results, we committed to a special, one-time contribution in shares of Wells Fargo common stock of 1 percent of their pay to the 401(k) account for every eligible team member (up to a maximum of $750), for a total of $44 million."

From PepsiCo, 2005: "Since 2000, the percentage of women in management positions in the United States has risen from 20 percent to 25 percent. The number of people of color in management positions has climbed from 15 percent to almost 22 per-cent-we made a gain of about 2 points of growth in 2005 alone. This change in the workforce has contributed to our growth through product ideas, greater insights about consumers, and connections into growing urban and ethnic communities."

From General Electric, 2005: "The final imperative--and maybe the most important--is to use our size to develop great people in a strong culture. Developing and motivating people is the most important part of my job. I spend one-third of my time on people. We invest $1 billion annually in training to make them better.... I spend most of my time on the top 600 leaders in the company. This is how you create a culture. These people all get selected and paid by me."

RELATED ARTICLE: Don't Forget About Employees

Laura Rittenhouse, president of investor relations firm andBEYOND Communications Inc., in New York, believes that employees--many of whom are also shareholders--represent a key audience for annual reports.

But many companies don't seem to target their annual reports to that audience. Rittenhouse's annual analysis of shareholder letters that appear in the annual reports for Fortune 500 companies (she studies a cross-section of those companies to cover a broad range of industries and sizes) indicate that most of the companies studied:

* Do not empathize with employees.

* Do not consider employees as the principal corporate stakeholders.

* Fail to recognize employees as essential to company success.

* Fail to mention any programs that support employees in their daily work.

Companies that fail to recognize employees sufficiently in the shareholder letter miss "a huge opportunity to reinforce cultural norms, to provide strategic direction, to communicate excitement about the future, to highlight problems that need collective solutions, and to motivate employees to achieve important operational and financial goals," Rittenhouse notes. She adds that "astute investors ought to carefully note which companies are missing out on these opportunities."

(For a list of companies that do a good job of addressing employees, see the online version of this article.)

Online Resources

See the online version of this article at www.shrm.org/hrmagazine/06December for additional material, including:

* A video interview on HR information in annual reports with Edward Lawler, distinguished professor and director of the Center for Effective Organizations at the Marshall School of Business, University of Southern California.

* A list of companies that do a good job of expressing information for an employee audience in their annual reports.

* A report by the Task Force on Human Capital Management, a U.K. effort to standardize human capital measurement in annual reports.

* The basic format for corporate annual reports.

* A previous HR Magazine article about Six Sigma and HR.

* A previous HR Magazine article about HR's role in building great customer service.

Human Capital Information Appearing in Fortune 100 Annual Reports

                                                     Percentage of
Breadth and Depth of                                 Fortune 100 Annual
Workforce Disclosure  Description of Disclosure      Reports

Level 1               Boilerplate disclosure that    25%
                      each year reproduces
                      "platitudes" about the
                      importance of the workforce
                      or specific qualities, such
                      as diversity; no statements
                      about specific workforce
                      policies, practices or
                      processes.
Levels 2 and 3        Philosophical statements       61%
                      about workforce objectives;
                      some descriptions of policies
                      and practices; the level of
                      detail separates Level 2
                      (less explicit) from Level 3
                      reports, which were roughly
                      equal in number.
Level 4               Contains at least one hard     14%
                      indicator of workforce
                      performance, such as turnover
                      rate, total investment in
                      training, percentage of pay
                      that is variable, or an
                      engagement score from an
                      employee survey.