SEC Requires New Human Capital Disclosures

I have long advocated for greater disclosure of information on intangible assets in company financial reports. Specifically, the MD&A (Management Discussion and Analysis) section of SEC-required financial statements should require more qualitative disclosure of intangibles. This would allow for more information on intangibles while sidestepping the difficult problem of assigning a financial value to the asset.

Earlier this year, the SEC took a major step forward in that direction by finalizing a rule amending Regulation S-K to require disclosure of information on a company’s human capital. [It should be noted that this new rule, which took effect November 9, makes a number of changes beyond disclosure of human capital.]

The rule takes a principles-based approach to disclosure rather than a prescriptive approach. This means that the requirement is for general disclosure of material information rather than requiring specific types of information. The rule requires a “description of the registrant’s human capital resources, including the number of persons employed by the registrant, and any human capital measures or objectives that the registrant focuses on in managing the business (such as, depending on the nature of the registrant’s business and workforce, measures or objectives that address the development, attraction and retention of personnel).”

The key point is that whatever human capital metrics or other information the company uses to manage must be disclosed.

While this may sound vague, the new rules won’t operate in a vacuum. For example, as one commentator points out, there are already International Standards Organization (ISO) recommendations for human capital metrics, such a development and training costs, and turnover rates. Not surprisingly, accounting/consulting firms (such as PWC) also have approaches to help companies decide what and how to disclose.

Some argue that the SEC should have gone farther to require more disclosure on Environmental, Social, and Governance (ESG) issues. It should be noted that the two Democratic members of the SEC voted against the new rule because the changes didn’t go far enough – in both the scope of the ESG items covered and the lack of any prescriptive requirements. This may foreshadow additional action by the SEC in this area, especially given the incoming Biden Administration. I suspect, however, the SEC will want to see how the new requirements actually work before making any changes. I also suspect, however, that this is just the beginning of additional disclosures in company’s MD&A filings.

Early innovation at Amazon

But not what you think.

This insight is from a review (by James Ledbetter) of a new book collected writings by Jeff Bezos:

Bezos and his wife initially packed up Amazon orders while kneeling on a concrete floor. His idea for improvement was kneepads; when an employee suggested packing tables, Bezos declared him a genius. “The next day I went and bought packing tables and doubled our productivity,” he writes.

Score one for the importance of business process innovation!

October was a “so-so” month for intangible employment

This morning’s employment data from BLS for October is better than expected but still rather disappointing (even though the unemployment rate dropped significantly). Employment rose by 638,000 compared to the 600,000 economists expected. Almost all of that growth was in tangible producing goods and services industries. Similar to the previous months, increases occurred in industries where there is physical presence with customers, specifically Accommodation & Food Services and Trade, Transportation & Utilities.

On the intangible-producing side of the economy, employment in Professional & Business Services expanded at a healthy rate. Almost every other industry grew only very modestly, if at all. But once again, there was a large drop in government employment offsetting most of the gains.

I’ll repeat myself from the last two months. Once again, under normal circumstances this would be a positive increase. However, in the age of COVID-19, this is only a modest rebound in employment. And keep in mind the worrisome trend of furloughed workers being permanently let go.

Much more needs to be done.

Trade in Intangibles – Sept 2020

Earlier this year I posted an analysis of how the then-new pandemic economic shock was affecting our intangibles trade surplus. Back the, IP trade was affected but other sectors only suffers slightly. With all the ups and downs of the past 6 months, it is time for an update based on BEA’s latest trade data for September.

Overall, the intangibles trade surplus has rebounded somewhat since hitting bottom in April. While not yet back to January’s level, it is at least closer to the pre-pandemic trendline. This is being driven by Business Services and Financial Services which dropped in the beginning of the pandemic and are beginning to rebound slightly. Maintenance & Repair Services and net revenues from Intellectual Property Products also took a hit at the beginning of the pandemic but have flatten rather than rebounding. Telecommunications, Computer & Information Services remained flat for the past year or so. Insurance Services and Personal, Cultural & Recreational Services continued their steady decline.

A closer look at specific industries reveals a more nuanced and worrisome picture.

First, there is a new sector added to this analysis: Personal, Cultural, and Recreational Services (see more detailed discussion below on BEA’s revisions to the data). Two points to make here. One, the balance of trade in this category has seen a 5-year steady and dramatic decline. Two, trend was not substantially interrupted by the pandemic. The pandemic caused a slightly turnaround as exports saw a blip in the summer rebound. But exports have flattened recently and imports have continued a steady rise.

The trade surplus in Maintenance and Repair services took a nose dive at the beginning of the pandemic and has not yet begun to recover as exports remain stuck at a lower level.

Our surplus in Intellectual Property also seems stuck at a lower level as payments out (imports) grew at about the same as revenues received (exports). As I noted back in December, the trade surplus in IP products has been declining for almost a decade as revenues (export) have remain essentially flat while payments (imports) have grown.

The pandemic seems to have had little impact on our trade deficit in Insurance Services. But that is not good news as the trendline continues to go straight down with imports climbing and exports declining slightly over the past few years.

The picture for Financial Services is somewhat better. Exports are rising while imports are flat.

The case is similar for Business Services with the surplus rebounding as exports grew faster than imports.

For Telecommunications, Computer, and Information Services, the pandemic had almost no net impact on the trade surplus as exports and imports first dropped and recovered at the same amount. This flat level, however, interrupted a 5-year trend in growth in the trade surplus in this sector.

NOTE: As part of its annual revision, BEA has updated the categories it uses to collect services trade data. As mentioned above, this includes creating a new category called Personal, Cultural, and Recreational Services. This category consists of the following subcategories (some of which were previously included in the Intellectual Property and Business Services categories:

  • Audiovisual services, which covers production of audiovisual content, end-user rights to use audiovisual content, and outright sales and purchases of audiovisual originals
  • Artistic-related services, which includes the services provided by performing artists, authors, composers, and other visual artists; set, costume, and lighting design; presentation and promotion of performing arts and other live entertainment events; and fees to artists and athletes for performances, sporting events, and similar events
  • Other personal, cultural, and recreational services, which includes services such as education services delivered online, remotely provided telemedicine services, and services associated with museum and other cultural, sporting gambling, and recreational activities, except those acquired by customers traveling outside their country of residence

BEA also created a new category called Construction Services separating the data out from the existing Business Services category. Since this category seems to cover physical construction activities, I have decided not to include it as an intangible creating activity, similar to how we treat the Travel and Transportation categories.

For more information, see the BEA article “Preview of the 2020 Annual Update of the International Economic Accounts.”

Learning from an innovation failure

Over at Digital Tonto, Greg Satell has an interesting analysis of why the streaming service Quibi failed. He points out four major flaws: too much money; no hair-on-fire use; no addressing the key bottlenecks; and, not having an adaptable strategy.

I won’t address the “too much money” issue – one that says you need to keep the company lean. I will accept his argument that “limiting the amount of money you have around forces people to face up to problems and solve them,” although my experience has been seeing undercapitalization as the problem.

The other three I think fall into the cardinal principles of innovation: experiment, expand, adapt. The three work together. What Satell calls the “hair-on-fire use case” is having a must use. Rather than identify the largest addressable market, you look for a problem with an immediate need. You use this market to refine and further develop the innovation and follow a flexible strategy to take advance of what you learn (including new opportunities).

This is a variation of what we used to call the “thin opening wedge.”

The process of learning and adapting based on real-time market information is key to success. It is almost axiomatic in innovation research that the first iterations of a new technology are inferior to the existing technology – except in one crucial characteristic. In the case of semiconductors, their advantage over vacuum tubes was in weight and power requirements. The need for low weight and energy in space and defense uses overcame the higher cost. These early markets provided not only a source of funding for further development of the technology (both product and process). They also provided a beta test function that generated important information.

Expanding and adapting is the other key. For example, look at Apple. The iPod was a cute device for music lovers (especially teenagers). It replaced the Walkman with much easier to use technology (digital rather than audio tape) both for play back (no need to carry and change tapes) and for song acquisition (via download). That was the thin opening wedge to a much more powerful platform: the iPhone. Once the iPod was married to a cell phone, the possibilities exploded. Not only was it a voice communications tool (the phone), it was a digital communications device and a digital interconnection device (email, web browsing, GPS, and all those apps).

Remember that Airbnb started out as a means to people to identify places to crash for the night. Uber was an on-demand sedan service. Amazon was a book seller based on the arbitrage between publishers’ prices and the retail bookstore prices. Each of these expanded by using the infrastructure (physical and organizational) created to service that first market.

Tied into this process of experimenting, expanding and adapting is making sure you are focusing on the right questions. Satell notes that successful innovations address the hard problems first. These are the bottlenecks that will cause the innovation to be an also-ran in a crowded field. The example he uses is Tesla and battery technology. Electric vehicles have been around since the dawn of the automobile age. In a more recent (relatively speaking) case, in the late 70’s / early 80’s I worked on a technology assessment of electric vehicles for Detroit Edison (and was licensed to drive their test vehicles – modified VW Rabbits with a ton of batteries in the back). Our conclusion was not surprising: limitations of battery technology would keep EVs in niche markets such local delivery vehicles with limited range, limited speed and the ability to recharge overnight. But even in that market, there was no great advantage for EVs over gasoline powered vehicles. Satell notes that Tesla’s breakthrough was to combine an improved, good-enough batter technology with a niche market of affluent consumers who would pay for the cache of an eco-friendly car.

In conclusion, let me just note that each of these examples of successes illustrate the principles of experiment, expand, adapt. Satell’s analysis of the failure of Quibi provided a useful counterpart to the success stories. Since the mantra of innovation includes learning from failure, I hope would-be entrepreneurs will take the lessons Satell provides to heart.