Question:
Discuss about the Accounting Theory and Current Issues for Capital market.
Introduction:
In the following solution to the case study of Karrick Gold and Copper Limited, different aspects of accounting are presented as per the International Financial Reporting Standards (IFRS) and International Accounting Standard (IAS). Controversy in regard to the consideration of historical cost or fair value of PP& E, non compliance of legitimacy, triple bottom line accounting approach for reliable and relevance of recording and reporting the financial statements.
Requirement A:
According to IAS 16 plant, property and equipment should be recorded at carrying amount, which is derived after measuring depreciation charges and impairment loss and after recognizing revaluation value (if any). Subsequently, IFRS requires every organization to record their fixed assets at fair value, as it will represent the reliable, true and fair view of financial statements of enterprise (Hall, Hunton and Pierce, 2015). Accounting Boards have taken this decision for the better and updated value of assets as per current market value should be presented in the books of accounts of companies so that the users of financial books can get true and fair value of the company. On the other hand historical cost gives the actual value of acquisition of the assets in the year it was acquired which does not show the current or updated value of assets today.
However, it has been a controversy since ancient times that whether the PP&E should be valued and reported at historical cost or fair value because some of the countries follow historical cost accounting while some follows fair value method. As a matter of fact, method of fair value accounting is comparatively challenging as it can be followed only if the fair value is reliable estimations are available. Whereas in maximum cases reliable availability for determining fair value estimates are not available unlike historical costs. Therefore historical costs after considering necessary adjustments for expenses like duties, registration fees, maintenance costs, charges for depreciation, revaluation adjustments or any other necessary adjustment is used to report the fixed assets by most of the organizations (Griffin and Wright, 2015).
In the given case of Karrick Gold & Copper Ltd, a mining organization listed in Australian Stock Exchange has been under operation in mining of gold and copper business in PNG has reported its plant, property and equipment at Net Book Value of $16.5 billion and it also requires one more costing $5.00 billion over the next seven years. As per the above discussions above pertaining to IFRS and IAS standards, KGC Limited should revalue its PP&E at fair value only if it is possible for the management to ascertain the reliable estimates. If such reliable data is not available then the management should value its PP&E at carrying amount with mandatory disclosures (Aobdia, Lin and Petacchi, 2015) in the following manner:
Historical cost of PP&E $xxx
Add: Duties & taxes $xxx
Maintenance cost $xxx
Repairing cost $xxx
Less: Accumulated Depreciation $xxx
Less/ add: Impairment $xxx
Net Book Value $16.5 billion.
Requirement B:
Replacement value is a value or cost that an enterprise would require to replace its assets as per its current worth. The method of determining such value of is provided in the IFRS as a measurement by comparing an estimated value of new asset with that of the asset to be disposed off according to current market structure and no depreciation to be charged on replacement value (Salotti and Carvalho, 2015). On the other hand, value in use represents a net present value of future cash flows or any other benefits in monetary term that the asset generates while being into use. Further, International Accounting Standard 36 on impairment of assets requires an entity to carry its Plant property and equipment either equal to or less than its recoverable value, which is measured as higher of (a) or (b):
In the given situation of Karrick Gold & Copper Ltd. (KGC Ltd), following information is given:
Net book value of plant property and equipment is $16.5 billion
Replacement value under current seven years of operation is $ 20.5 billion
Value in use given is $ 12.5 billion
Replacement value if contract renewed for ten years is $ 30.0 billion
To determine the true and fair value of plant, property and equipment of KGC Ltd, the principles and regulations of International Financial Reporting Standard and Generally Accepted Accounting Principles are required to be complied with (Nobes, 2015).
According to IAS on determining true and fair value of PP&E management is required to consider the reliable estimated value of its PP&E. Considering the books of accounts of KGC Limited, Net book value of PP&E given is less than the replacement value which is because in replacement value depreciation charge is not included whereas value in use which is net present value of cash flows is less than both the net book value and replacement value if the organization operates for seven years (Yao, Percy and Hu, 2015). However, if the contract is renewed for ten years, replacement value of PP&E would increase to $ 30.0 billion. Thus as per requirement of IAS and IFRS true and fair value would be the replacement value $ 20.5 billion which is higher than value in use and net book value with smaller amount if the operation of KGC Limited continues to seven years. While if the entity renew its contract for ten years then true and fair value would be net book value $ 16.5 billion as compared to ten years replacement value $ 30 billion because in mere three years rise in value by $9.5 billion ($30.0 billion- $20.5 billion) doesn’t seem to be fair according to the present market condition.
Requirement C:
Given that, KGC Limited operates its business in Star Mountain Range in PNG, which is an isolated place but has a wider variety of exotic plants and animals. The operating license of the entity will get expired in coming eight years for conducting its mining operations. Traditionally, presentation of financial statements under corporate accounting is being followed through ‘triple bottom line’ approach, which means the accounting for society, environment and finance (Souissi, 2016). This approach has been carried by most of the enterprises including corporate, non- profit organizations or small or medium sized entities as it gives a wider perspective to create greater business values. Considering this structure several merits and risks of KGC limited can be observed as follows:
Merits of KGC Limited:
Oligopoly competition: As the company is operating a large open cast gold and copper mine since 30 years in a region, which is isolated, number of its competitors in the mining industry is relatively lower (Takkar, 2015). There for the Karrick Gold and Copper Ltd can be referred under the definition of oligopoly industries and therefore sustainability and revenue generation or the organization becomes higher.
As there are less number of competitors in the mining industry with regard to the superior quality products, managers of KGC Limited claims that large deposits of good quality and quantity of silver and lead ore will be generated over the next eight years (Turker, 2015).
Employment: Since KGC Ltd has its manufacturing and trading unit settled in isolated region of PNG, where limited number of residents is available, the company has become a great source of employment to the laborers and employees (Bhaduri and Selarka, 2016). Citizens have the advantage of less travelling, sound remuneration or wage earnings, family participations etc along with the availability of education centers, healthcare centers.
Risks of KGC Limited:
Profitability: given that presently, KGC Limited is generating annual revenues of around $ 30 billion Australian Dollars with only seven years of ore reserves. This is a material risk that management need to take care profit element is the main source of business sustainability and growth. As per triple bottom line approach profit is an element of financial accounting, which is a vital element for any organization. In the absence of minimum requirement of reserves it becomes difficult to maintain the operation of the company (Gross, 2015). Therefore KGC Limited requires to focus and increase its revenue generation.
Unemployment: Society or people, another vital aspect of an organization require special attention. As discussed above, it is seen that KGC Limited offers great source of employment yet the present data about the participation rate of labour shows only 32 % and unemployment rate out of 32 % shows 45 %. However, the rate 45 % will rise to 95% if KGC Limited shuts off. So employment participation rate is major concern and risk for the company (Takkar, 2015).
Environment: The most important aspect in mining industry is to maintain environmental hygiene. As per the sources, KGC limited seems to violate and paying less responsibility towards maintaining the hygiene in the PNG region. Due to a collapse, 5 liters of ore- waste got dumped into the river which used to be a source of living for the local residents, KGC Limited failed to get the waste flushed out completely. As a result, environmental group claimed KGC limited to be irresponsible towards environment. As per triple bottom line approach, environmental measures are greenhouse gas emissions, waste amount to landfills, safety incident rate etc are required to be adopted by the entity (Zeff, 2016).
Requirement D:
Legitimacy or power is one of the most important aspects in an organization, which is defined as the right to govern by a group of people in form of Boards or institutions. Legitimacy gives the authority to the higher level so that there should be parity in maintaining its power in regard to following of different and mandatory requirements. In case of mining industry, category under which KGC Limited falls to, should strictly adhere to environmental and social issues which is regulated through Corporate Social Responsibility (CSR) legitimacy (Brief, et al. 2015). From the present structure of KGC Limited it can be framed that the company is maintaining its CSR for some aspect while for it is facing challenges to fulfill in some other matters:
In case of traditional land- owners, KGC Limited in PNG region had positively settled its royalties payment amounted to $ 4 billion for operating mining and processing of ores. Also, in case of government regulations of PNG, Karrick Ltd was regular in making payment of taxes amounted to $ 6 billion. However, in the eye of people of Australia, KGC limited apparently failed to comply legitimating under Corporate Social Responsibility (Salotti and Carvalho, 2015). According to the Australian group of people, KGC limited and its management stands irresponsible towards the environment because the management could not clean up the river water of PNG region which got polluted from the ore wastes and the same was a major source of living for the local villagers in form of drinking water, fishing, harvesting.
Requirement E:
Legitimacy of KGC limited towards the traditional land- owners and government has been complied with, except towards the society of Australia. As the management failed to spillage the ore wastes, Australian society contented the company to have lack of responsibility towards the environment, which is a vital aspect of an organization specially involved in mining industry. All the organizations/ enterprises works for the people, with the people and of the people hence it is the sole responsibility of industries to maintain safety measures keeping the environment and society clean and unpolluted (Yatsenko and Hritonenko, 2016). Failed to do so may put an enterprise at risk in terms of growth and sustainability and the same risk is flowing to the Karrick Limited. According to the given data, the operating current license is going to expire in the next eight years hence, management of the Karrick Ltd should strictly take steps to rectify its mistake.
The consequence that KGC Limited shall have to face for failing in compliance the legitimacy towards the environment would primarily be its sustainability and huge cost involvement towards the remedy (Aobdia, Lin and Petacchi, 2015). The estimated cost of spillage ranges between $6 billion to $60 billion, which would depend on the decision of the court ruling on the petition filed by the Australian ecological group.
Requirement F:
In order to maintain its sustainability and contention upon annual benefit on operations over mining and processing harm, KGC limited should restore its non- complied legitimacy in several ways. One of the ways is to get the river spillage at the earliest by putting more number of labour and equipments, which may involve high costs. Secondly, management of KGC limited can restore the legitimacy by installing polluted free water tanks for the local villagers as a temporary substitute to river water. Perhaps both the options will require high cost to the company but to maintain its reputation and to sustain in the industry the management is suggested to take either steps (Hall, Hunton and Pierce, 2015).
In this matter, the theory of stakeholder whose object is to consider the internal and external aspects between an enterprise and others, this involves identification and prioritization of interests for the society. One school of theory an entity is accountable and responsible for maintaining the society requirements in terms of hygiene along with the monetary benefits. Another theory contends that the companies specially engaging in the manufacture and operations of industry which pollutes the nature and society to a great extent should use the safety measures strictly so that extraction of greenhouse gas does not pollute the environment. Hence, KGC limited should consider and follow the necessary safety measures for the mineral and ore wastages and extracts (Salotti and Carvalho, 2015).
Requirement G:
The method to record and report the costs related to remedy of sludge spill in the General Purpose Financial Statements of KGC Ltd depends on the nature and category of the expenditure (Yao, Percy and Hu, 2015).
Method i) Full capitalization method: Under this method, cost of remedy shall be capitalized to the cost of the equipments and machinery used for conducting the remedial process (Gross, 2015). This method can only be used if KGC Ltd incurs its expenditure in buying the equipment while the cost of materials consumed should not be capitalized.
This method is advantageous for the company because it will enable to charge depreciation which would be a tax saving non cash flow transaction. On the other hand, disadvantage of this method is get a reliable estimate of the cost and bifurcation so that it does not affect the outcome of financial statement.
Method ii) Partial capitalization method: in this method management of KGC Ltd is required to segregate the cost incurred to buy the equipments as capital expenditure whereas other raw materials consumption cost, power costs to operate, labour costs as revenue expenditure which would be reported in the Income statement under the head Corporate Social Responsibility (Griffin and Wright, 2015).
The benefit of this method is that the clarification and true picture of expenses can be obtained while the disadvantage is to correctly bifurcate and allocation of capital expenditures.
Method iii) Full revenue method: Under this method, entire cost and expenditure regarding the remedial process is to be reported in the Income Statement under the head Corporate Social Responsibility (Hall, Hunton and Pierce, 2015).
One of the main advantages in this method is that no segregation of capital nature cost is required and hence becomes an easy way to allocate the costs. However, disadvantage is that the users of the financial statement would not get true and fair value of the event and proper disclosure will not be available.
According to our recommendation method ii) i.e. Partial capitalization method should be considered by the KGC Limited as it reflects the complete information and reported value of CSR remedial expenditure as an environmental measures in triple bottom line accounting approach.
Conclusion
The solution has dealt with accounting theory and current issues in compliance with IFRS and IAS, which represented the reporting valuation of PP&E of KGC Limited. Apart from this, various risks also been analyzed that KGC Ltd is currently facing in terms of non-compliance of legitimacy towards environment, unemployment risk. Recommendations and explanations for rectification of the said issues along with the various accounting options for recording and reporting its remedial expenditure has also been presented in the solution.
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