Risks of Fair Value Accounting

Question:

Describe about accounting theory and current issue.
 

a) Historical cost method of valuing assets records the value of the asset at the price at which it was acquired. Fair value accounting involves updating the value of assets regularly at the fair market prices by using current prices of comparable assets.

Whether or not the firms can estimate fair values accurately and without discretion is the main issue with fair value accounting. The estimation in fair value should be devoid of any “bias”. Generally fair value accounting aims to have the least discretionary values for recording the value of an asset. When identical positions trade in liquid markets that provide unadjusted mark-to-market values, fair value generally is the most accurate and least discretionary possible measurement attribute, although even liquid markets get values wrong on occasion. Fair values typically are less accurate and more discretionary when they are either adjusted mark-to-market values or mark-to-model values. (Scott, 2010)

The major risk of fair value accounting is that it can lead to dubious practises as evident from the historical misuse by US companies of this practise in 50’s and 60’s. There is academic research devoted to the fact that fair value accounting leads to a trade-off between two of the most important requisites of financial reporting i.e. “accuracy” and relevance”. (Ramanna, 2013)Whereas fair value accounting leads to an enhanced relevance ire’s adoption can also lead to loss in reliability. (Ryan, 2008)

Karrick Gold and Cooper Ltd(KGC) should not 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)

b) Given that the book value of plant property and equipment is currently 16.5 billion AUD. The value in use is 12 billion AUD if it lasts for seven years and 30 billion AUD if it lasts for an additional 10 years or a total of seventeen years. The replacement cost is 20.5 billion AUD. The task at hand is to determine what is fair and true value of the financial assets. As per IAS 13 fair and true value would be the replacement cost i.e. 20.5 billion dollars. IAS 13 is the accounting standard which lays down the framework for the fair accounting of financial assets.

c) The triple bottom line accounting is a new age approach to accounting which seek to dispel the notion that a successful company only needs profits to sustain its operations. Infect it is agreed upon by industry experts worldwide that suitability across all areas is the key to success for any business in the new millennium. The three variables within a Triple bottom line accounting are also called the three P’s i.e. people, planet and profit. 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) When a company incorporates triple bottom line accounting into its financial statements and annual reports it gives the users of financial statements more information about their activities apart from just its operations and financial performance.

Benefits and Challenges of Triple Bottom Line Accounting

For KGC Ltd. triple adopting bottom line accounting comes with both its merits and risks. 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. 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 KCG Ltd.  Stake holders like the employees and shareholders might be impressed with the social work done by KCG such as providing education to the local population and providing clean drinking water and raising the living standard of the population, since it gives them pride in being associated with a socially conscious organisation. However, the environmentalists are bound to be agitated by the environmental damage being done by KCG. 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. In a sense adopting triple bottom line accounting also gives them 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. 

d) Legitimacy of an organisation is determined by the fact whether it is acting in a manner which is desirable, proper and appropriate within some socially constructed system of norms, values, beliefs, and definitions.(Suchman, 1995) Of late legitimacy theory has become a much talked about theory in academic circles and its relevance cannot be overlooked in the voluntary social and environmental disclosures made by the corporations. In its simplest form legitimacy is a process through which an organisation gains approval of the various stake holder groups.(Tilling, 2010)

Generally, any organisation needs to maintain legitimacy in the eyes of major stake holder groups.  For any company including KCG maintaining legitimacy is essential since it ensures flow of capital, customers and labour availability all of which constitute what is a “must” for any organisation to sustain its operations. It also helps to avoid regulatory interference which is a must to maintain legitimate status. They can be summarised as the state, the public, the financial community and the media. Hence for KCG 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.

e) Yes, the legitimacy of KCG is definitely at risk. Their legitimacy is at risk from various stake holder groups mostly the Australian people and the media. The dumping of ore waste or sludge into the waste has led to a hue and cry among the Australian people who now believe KEG to be environmentally un responsible. These events are being communicated to them through the media who at some level also hold them wrong and illegitimate and that is why they are influencing the opinions of the people and the environmental groups in this vein. Of late the power the media has increasingly increased and as Tillings(2010) also stresses maintaining legitimacy in the eyes of media is equally essential as the other stake holder groups.

Relevance of Legitimacy Theory for Organizations

Should they lose legitimacy it will have far reaching repercussions on the operations of KCG. Should they lose legitimacy in the eyes of the Australian people they might not find the adequate funding required to sustain their operations. If they lose legitimacy 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. 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. 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 og the PNG Government.

f) That the legitimacy of KCG is at stake cannot be overlooked. The ways in which KCG can restore its legitimacy would involve image restoration. Image restoration is how a company tries to restore its image by the usage of symbols. In simpler words, when an organisation loses legitimacy stakeholder perception can be improved or restored by communicating messages to the audience which would have the result of pacifying them. These messages can have a tone ranging from denial to apology or from corrective action to intimidation. (Zaremba, 2014)

For KCG the correct course of action would be to take corrective measures to lessen the damage they have done and using the proper channels to communicate the message to their audience. An apology is also in order. 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” were considered insensitive by the various stake holder groups and did more damage to the reputation and legitimacy of KCG. The new course of action for image restoration would be to apologise for the sludge and the inappropriate comments made by the manager and to create awareness among the stakeholder groups regarding the initiatives undertaken in order to limit the damage caused. A good course of action can also be to undertake initiatives to preserve the various species which are a part of the ecology of the island.

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. Hence it is imperative that KCG manages to balance the needs of all the stake holder groups in a bid to attain a perception of legitimacy among all the stake holder groups. (Freeman, 1998)

g) 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. Right now since the cost of the damages are not known because a law suit filed by an Australian ecological group is pending in the court. The damages can range from 6 billion AUD to 60 billion AUD. Since the range is very broad it would be better to take a value which is in between. In this case an ideal value can be between 30-35 billion AUD as it as in between figures. 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 expense.

The pros of the first method are that it will not affect the cash flow while the negative is that would create a perception of an irresponsible organisation among stakeholder groups. The con of the second method is that it would affect cash flows and lower the profitability but the biggest positive is that would prove to be a damage control mechanism which would help the company regain stake holders confidence. In light of the recent events and the socio political environment in the region it is in the best interest of the company to opt for the second method. 

References

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

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

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.

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