The Valuation And Reporting Of Reputation Risk Management Capability

Abstract

The Financial Statements prepared and audited in today’s economic environment can be traced to the industrial era, when tangible assets such as machinery were the engines of growth. In this era, financial accountants endorsed or invented rules based on the historical cost doctrine that yielded values which had no counterparts in commercial reality – often book valuations were sheer fictions, and thus managing the risk associated with those valuations became a meaningless exercise. This was especially the case when intangible assets such as an organisation’s Brand Equity and Reputation were kept off the Balance Sheet, thus making the valuations even more fictitious. This has resulted today in knowledge-economy companies reporting book values widely divergent of market values. These fictitious financial reports were then audited, and the auditors were paid well by the preparers of the statements to hold that the statements gave a true and fair view of the state of affairs of the company. When some of these companies failed spectacularly due to the mismatch between commercial reality and reported values, the reason for failure was pinpointed to the irreparable damage to the company’s reputation due to the lack of adequate risk management procedures, resulting in a failure traced to an organisation’s products, services, information systems or external auditors. Since the spectacular collapses of Enron and WorldCom in the international stage, many countries have introduced either mandatory or voluntary corporate governance procedures. In the USA, SOX 404 makes mandatory the reporting of all significant risks in a company’s annual reports, albeit outside of the financial statements, as an off-balance sheet item. This paper argues that the overriding reason for governance is ultimately the safeguarding of an organisation’s reputation, and that this requires an integrated approach where the ‘accountees’ (corporations), and its investors and regulators are provided with appropriate information by the ‘accountors’, i.e. the accounting profession. It also argues that although the current professional accounting standards result in financial statements that are not adequate for the proper governance, an integrated approach can be taken where reputation risk can not only be managed and valued; it can also be incorporated in these financial statements. The paper provides a valuation model based on the premise that risk management should not be based on what the organisation has, but instead what the organisation can do, i.e. its capability to manage and enhance its reputation in order to ultimately generate incremental future cash flow. It then suggests an approach that auditors can take to determine its strategic capability of sustaining and generating value via reputation enhancement. Finally, the paper considers the role of the Risk Manager, and how an empowered open-book approach to communicating and financial reporting can provide significant motivational benefits in risk reduction and reputation enhancement that ultimately result in increased value.