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Fair Value Accounting

Discuss about the Fair-Value Accounting for Accounting and Public Policy.

a) Accounting standards across the world, AASB included (Australian Accounting Standards Board) give two methods for recognising the value of an asset. One is the historical method and the other is the “fair value” method. Historical cost method involves recording the value of the asset at its historical cost or the price at which it was acquired whereas the fair value method involves revaluing the asset to its current market price at regular intervals obtaining the price from that of a similar and comparable asset.

At the outset, fair value method looks the more superior method of valuing an asset, however there are issues which arise when a company values asserts according to this method. The first and the biggest issue is whether companies can employ discretion while valuing the assets at fair value. (Scott, 2010) A fair value of an asset should be devoid of any “bias” and that is what fair accounting aims for as well; to have the least discretionary values as recorded values of assets in the financial assets’ (Financial Accounting Standards Board) prescribes a three level hierarchy for the fair valuation of an asset. The main problem arises when a company or an auditor has to value an asset according to specifications.

There is enough evidence in corporate history that fair value accounting can lead to dubious practises and mislead the users of the financial statements. One of the major exploiters of this method was the US behemoth Enron who misused it and reported the gain arising from revaluation as business gains thus misleading one and all about the financial health of the company.  (Benston, 2006) Academic literature seems to be divided on their views regarding the benefits of fair value accounting. While there is no doubt that fair value is more “relevant”, the fact that it is not always “reliable” also cannot be overlooked. Hence it adoption leads to a trade-off where one has to choose one quality over the another. (Ramanna, 2013)So any company while adopting fair value needs to keep in mind that while assets valued at “fair value” would be more relevant but they aren’t necessarily reliable. (Ryan, 2008)

As explained immediately in the paragraph above for the given scenario Karrick Gold and Copper Ltd(KGC) faces the same conundrum that every company would while deciding on whether or not to use the fair value accounting to value their plant property and equipment. Since it is not possible to determine the fair value of the plant, property and equipment reliably and the IAS 16.31 clearly states that the revaluation model should be used only if the fair value of the asset less depreciation and impairment can be measured reliably. (Deloitte, 2012) For their case, it must be opined there are so many uncertainties that loss of reliability must take precedence over increased relevance.

Process of Valuing Assets at Fair Value

b) We are given three different values of the plant property and equipment of KGC Ltd. One is the book value of the PP&E which is recorded as 16.5 billion AUD. Now also given that valuation would be 12 billion AUD if it lasts for seven years and the value is expected to increase by 2.5 times to 30 billion UAD should the life exceeds by an additional 10 years. Further, the replacement cost is given as 20.5 billion AUD. From the following data the fair and true value of the financial assets is to be determined. The IAS 13 which is the standard and lays down the framework for valuing assets at fair value gives three methods or approaches while valuing assets at fair value. These three methods are the cost approach, the income approach and the valuation approach. For the given scenario cost approach would be the best fit and most suited. As per IAS 13 “cost approach” fair and true value would be the replacement cost i.e. 20.5 billion dollars. The standard prescribes that the fair value of a non-financial asset takes into account a market participants ability to gain economic gains from the highest and best possible use of the asset. In that sense one would estimate the fair value to be 30 billion but the standard also adds that the best possible use is subject to physical, legal and financial constraints. Since the legal aspects of KGC are not clear as there are lawsuits pending and there is uncertainty regarding its operations in every sense be it economic or political as deduced from the information given, based on the standard and the information in hand 30 billion dollars cannot be decided upon as the fair value.

c) The triple bottom line accounting or 3BL as it is also called is a financial reporting approach which is gaining prominence in recent times. It can be called a new age approach to accounting which not only seeks to measure the financial performance of a company through conventional variables such as revenues. profits and earnings per share but also seeks to measure a company’s performance across aspects other than profit. Sustainability in operations and social existence have been agreed upon by industry experts as key parameters that will define success of organisations in the new millennium. Hence the triple bottom line accounting measures three p’s which are “profit” “planet” and “people”. It is aptly summed up as a “concerted effort to incorporate social, economic and environmental considerations into a company’s evaluation and its decision making processes.” (Wang & Lin, 2007) Review of financial performance and operations are what a company normally publishes in their annual reports but of late companies have taken to make their stake holders aware of the initiatives undertaken by them other than the prescribed operations. A lot of companies in fact publish sustainability reports other than their annual reports.

Triple Bottom Line Accounting

For any company triple bottom line accounting comes with its share of pros and cons. And the same is applicable for KGC Ltd. as well. KGC can communicate to their stake holders by the means of their sustainability reports the initiatives they have undertaken and the positive impact their presence has had on the people living in the Star Mountains Range and the people employed with them. The given information clearly mentions that they are a major employer of the region as well as provide a lot of facilities like schools, clean drinking water and others which go a long way in improving the life of the local population. It is widely believed and proven as well that stake holders have a feeling of pride in being associated with a socially relevant and aware organisation. Even the employees have a sense of pride in being associated with a company who is doing good for the society. It raises the reputation of the organisation and there is enough academic research which corroborates that reputation of a firm builds value. (Weber Shandwick, 2015) While their contribution to the lives of the inhabitants of the island is undeniable, the damage their presence is doing to the environment is also hard to cover up in spite of their claim that their presence in Star mountains does more good than harm to the inhabitants and the ecological system there. A typical sustainability report requires a company to report the environmental activities and investments they have undertaken in order to offset the harm from one of their primary activities. This especially is pertinent for oil and mining companies like KGC Ltd. The environmentalists are bound to be agitated by the environmental damage being done by KGC. The dumping of sludge into the pond which caused serious water and ground pollution and the asymmphetatic attitude of the manager after the occurrence are something which would be very difficult to cover up for KGC. Until this point while KGC was not performing on the “planet” front they were at least performing on the “people” front. However, what this spill did was cause harm to the people as well because the pond they polluted was the only water source for two villages for purposes such as farming, drinking and hunt. A different point of view of looking at things would be that adopting triple bottom line accounting would give KGC Ltd. an opportunity to communicate to these groups if they have under taken any initiatives to lessen the damage caused by them. In that sense triple bottom line accounting becomes a damage control mechanism.

Benefits and Drawbacks of Fair-Value Accounting

d) Legitimacy is how a company gains the approval of the various stake holder groups by acting in a manner which is accordance within “some socially constructed system of norms, values, beliefs, and definitions”.(Suchman, 1995) All the organisation are continuously striving for legitimacy in a bid to remain sustainable.(Tilling, 2010) Legitimacy theory has been discussed upon in academic research as the main driving force behind voluntary social disclosures.

It is important here to address the question as to why the companies strive for legitimacy. It can be answered by the argument that every organisation needs to maintain legitimacy in the eyes of major stake holder groups in order to be competitive and survive since a legitimacy in the eyes of various stake holder groups ensures flow of capital, customers and labour availability all of which constitute what is a “must” for any organisation to sustain its operations. Just like for any company for KGC too maintaining legitimacy is essential and the Australian people, the land owners and the PNG government are the most important stake holder groups in whose eyes they would always want to maintain their legitimacy. Should any stake holder group withdraw their support it would become difficult for KGC to sustain its operations.

e) Right now KGC is at a juncture where it faces legitimacy issues with the various stake holder groups. Because they are operating in an ecologically and socio politically sensitive environment they were always vulnerable to scrutiny from environmental groups and socially conscious investor groups but with the recent incident where their gross carelessness has led to tremendous damage to the environment and well-being of the people their legitimacy has come under further stress from all quarters. The legitimacy is essential for KGC in case of all stake holder groups particularly, the media as it is them who shape the reactions of other stake holder groups as well. The increased role of media in establishing the legitimacy of a firm has been acknowledged in the academic world.(Tilling, 2010) The dumping of ore waste or sludge into the waste has led to a hue and cry among the Australian people who now believe KGC to be environmentally un responsible. Should they lose legitimacy in the eyes of the Australian people they might not find the adequate funding required to sustain or expand their operations. If they lose legitimacy the socially conscious shareholders might start selling their stocks which might lead to loss in market capitalization and devaluation of the company since they are listed on the Australian Stock Exchange. There are several instances in corporate history where a company has had to lose share holder confidence when its less than desirable business practices came in the eye of shareholders. Should the land owners start considering the company as no longer legitimate they might reconsider the leasing of the land and would want to take back the land. The socio political environment within the region also need to be keep in context. It is mentioned that the police actions by the Indonesian army may spill into the PNG portion of the Star Mountain Range. In wake of such circumstances KGC would want protection from the PNG government which it might not have access should they further lose legitimacy in the eyes of the PNG Government. Hence as explained in the previous paragraphs for a company to attract resources necessary for its survival legitimacy is essential and if it does legitimacy, the survival becomes extremely difficult

Legitimacy in Corporate Decision-Making

f) The dumping of the sludge has led to the loss of legitimacy of KGC in the eyes of the various stake holder groups which include the Australian people and the local land holders respectively. In the aftermath of the incident the irresponsible comments made by the manager of the mines came across as highly in sensitive and damaged the reputation and consequently the legitimacy even more so. For damage control KGC has to indulge in image restoration activities which would involve restoring image by use of symbols. When an organisation loses legitimacy they want to pacify shareholders through communication of messages or through actions in a bid to lessen their distrust for the company. The tone of these messages can have a tone which could range from apologetic to intimidatory. (Zaremba, 2014)

For KCG the right way forward would be as described above and what tone they chose to communicate their message is highly critical. Communication would be such that it reflects the companies and the managements sincerity and remorse for their actions rather than of denial and indifference. In that sense the statement issued by their manager might have been a step in the right direction had it been different in its tone and approach. Instead what it did was to further the damage as the statements such as” dilution is the solution to pollution” and at “sea the sludge will be highly diluted” were considered insensitive and indifferent by the various stake holder groups and reflected quite the opposite of what it should have reflected. The correct way would be to issue a sincere apology and make sure that the stake holder groups are made aware of the initiatives being undertaken by the company to correct its mistakes.

Stakeholder theory in its basic form suggests that a firm must seek to maximise profits and the welfare of the stock holder subject to social or moral constraints. (Freeman, 1998) Then there is a stake holder theory which stresses that a major objective of the firm [is] to attain the ability to balance conflicting demands of various stakeholders in the firm. (Laan, 2009) Whenever a company makes voluntary disclosures they are seen as mechanisms to gain legitimacy. As Laan (2009) rightly points out any organisation including KGC faces a paradox as to which stake holder group it places higher in its hierarchy of perceived importance. Here KGC can chose to manipulate what image they want to build based on which stake holder group they want to appease more.

g) The cost that KGC might incur to clear the damages arising from the sludge spill is uncertain at this time. Subject to a pending lawsuit in an Australian court, damages can range from 6 billion to 60 billion AUD. Reporting for an environmental liability reporting is an area which is highly judgemental and comes with its share of pitfalls, traps and nuances. (PriceWaterhouse Coopers, 2014)  One way through which KGC can record the cost of harm done through sludge spill is by recognising it as contingent liability and creating a provision for it. Since the range is very broad it would be better to take a value which is in between. The net effect on the financial statements would be that the decided upon value would be deducted from the income statement as an expense possibly under the head “environmental damage account” and will feature on the balance sheet under non-current liabilities as estimated liability. The second method through which KGC can record the cost of harm done is by actually spending the amount in the rehabilitation of the surrounding area without waiting on the verdict of the lawsuit and actually classifying the money spent as an operating expense. (Ernst and Young, 2010)

Accounting for environmental damages as already explained is an area where company gets judged and hence KGC already under scrutiny must be careful in choosing the method which improves their image would be a better choice. From the company’s profitability point of view, the first method is better as the company can wait for the verdict and instead chose to do do nothing, however that would further prove damaging to their already suffering reputation. The second method involves cash flow and would result in probable short term losses but would enhance company’s reputation proving to be a damage control mechanism. As explained earlier it would be a positive image building exercise thereby enhancing their legitimacy as well which has already been established as essential for a company’s survival.

References

Benston, G. J., 2006. Fair-value accounting: A cautionary tale. Journal of Accounting and Public Policy, Volume 25, pp. 465-484.

Deloitte, 2012. IAS 16 — Property, Plant and Equipment, s.l.: Deloitte.

Freeman, R., 1998. Stakeholder Theory of the Modern Corporation, s.l.: s.n.

Laan, S. V. D., 2009. The Role of Theory in Explaining Motivation for Corporate Social Disclosures: Voluntary Disclosures vs ‘Solicited’ Disclosure. Australian Accounting Business and Finance Journal, 3(4).

Ramanna, K., 2013. Why “Fair Value” Is the Rule. Harvard Business Review, March.

Ryan, S. G., 2008. FAIR VALUE ACCOUNTING:UNDERSTANDING THE ISSUES RAISED BY THE CREDIT CRUNCH, s.l.: s.n.

Scott, I. E., 2010. Fair Value Accounting: Friend or Foe?. William and Mary Business Law Review, 1(7).

Suchman, M. C., 1995. Managing Legitimacy: Strategic and Institutional Approaches. Academy of Management Journal, 20(3), pp. 571-610.

Tilling, M., 2010. Refinements to Legitimacy Theory in Social and Environmental Accounting, s.l.: s.n.

Wang, L. & Lin, L., 2007. A Methodology Framework for the Triple Bottome Line Accounting and Management of Industry Enterprises.. International Journal of Production Research, 45(5), pp. 1063-1088.

Weber Shandwick, 2015. The CEO Reputation Premium: Gaining Advantage in the Engagement Era, s.l.: Weber Shandwick.

Zaremba, A. J., 2014. Crisis Communication: Theory and Practice. s.l.:Routledge.

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