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In this Apr 2005 issue of On Target :
Reputation Risk Management : A new direction
for Management Accountants
The age of the corporation (since 1850) led to the enormous
emphasis on the determination of profit - hence the acceptance
of arbitrary cost allocations. Now the focus has widened.
Owners, investors, creditors, bankers, government now all need
leading indicators. Accounting - especially financial accounting
- is still preoccupied by lagging indicators.
Such a preoccupation with the past is akin to “navigating
by looking at the wake created by the ship”. This is only
possible, if one is sure one is going in the right direction,
and if one is sure there will be no unexpected ships, icebergs
and floating debris crossing the ship's path. Such a backward
looking preoccupation is unacceptable to corporate risk managers
who must look ahead to evaluate the impact of future conditions
on the continued viability of their organisation.
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.
When 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 ultimately traced to a defect
in an organisation’s products, services, information systems
or external auditors.
Consideration will, therefore, be given to the nature,
recognition, and measurement of information-era assets. The
engine(s) that drive information-era enterprises include
knowledge, innovation, communication, learning, and innovative
abilities. However, such assets are still systematically
excluded from our industrial-era balance sheets; thus
understating the total “capital” of the enterprise.
Therefore, currently “short-term monetary capital maintenance”
is the focus instead of "long-term comprehensive capital
maintenance”. This also provides temptation to managers to
reduce some of these assets for the sake of short-term earnings.
For example, in earlier times, advertising was seen as an
expense rather than a variable that enhances a Brand’s future
earnings potential (i.e. an asset). Thus there was a temptation
amongst managers to increase short-term profit by reducing the
advertising spent. Today’s managers may similarly reduce the
maintenance carried out on a tangible asset (e.g. aircraft), or
reduce the training given to a intangible asset such as a
knowledge worker (e.g. aircraft maintenance technician). If as a
consequence the aircraft crashes, this could irreparably damage
the reputation of the airline. In certain instances, such cost
savings (e.g. on safety equipment for workers) could result in
jail terms for directors.
Figure 1 below illustrates the issues involved. The available
tangible and intangible assets are the preconditions required
for the inducement of sales (the consequences). These
preconditions act via an intermediate variables of contextual
capability and brand capability (or organisational reputation)
to generate both present and future sales potential. The present
value of such sales potential is therefore the “value” of
the contextual capability that gives rise to the
brand/reputation capability. It is this brand/reputation
capability which must be managed.
[ Diagram Comes Here]
Considering Figure 1, it is important to contrast tangible
and intangible assets, contextual capability, brand (reputation)
capability and the resultant capability value. Assets are “what
one has”, much like a Ferrari racing car (tangible asset) or
Michael Schumacher’s driving skills (intangible asset).
Contextual Capability is what can be achieved in a particular
situation (or “what one can do”) when these asset categories
are combined in a contextual situation, i.e., win the World
Championship. Brand/Reputation Capability is the esteem
perception created in potential customers’ minds about the
Ferrari brand as a consequence of winning the world
championship. Capability Value is the economic value of the
capability (i.e. the current and future monetary value to
Ferrari via sales, having a Brand Reputation of winning the
formula one championship). Any diminution of that reputation due
to poor risk management techniques, ultimately results in the
diminution of an organisation’s value, and if this process
goes unchecked, or has a significant avoidable disaster, an
Enron type corporate collapse could result.
The ICMA has commissioned a project to test the proposition
that not only can risk be managed and valued, but also its
associated reputation value can be incorporated in the financial
statements. The outcome of the project is to provide 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, and hence value. Under such a valuation model,
consideration will be given to the approach that auditors can
take to determine an organisation's strategic capability of
sustaining and generating value via reputation enhancement.
Consideration will also be given to 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.
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