ACCOUNTING FOR PRE-PRODUCTION COSTS IN THE AUSTRALIAN EXTRACTIVE INDUSTRIES

ACCOUNTING FOR PRE-PRODUCTION COSTS IN THE AUSTRALIAN EXTRACTIVE INDUSTRIES Peter G Gerhardy Senior Lecturer in Accounting School of Commerce The Flinders University of South Australia SCHOOL OF COMMERCE RESEARCH PAPER SERIES: 98-2 ISSN: 1441-3906 Abstract This paper examines the method used to account for pre-production costs by companies in the Australian extractive industries Within a costly contracting framework, hypotheses on factors motivating the treatment chosen to account for these costs are developed and tested Specifically, the relationship of debt contracting, political sensitivity, income diversification, engineering risk and auditor effect variables to three alternative continuous measures of the accounting treatment are tested While, overall, traditional costly contracting and political sensitivity explanations of accounting choice not appear to hold well, the findings suggest that the ability to explain observed variation in accounting treatment is dependent upon the definition of pre-production costs considered – particularly whether development costs are included with the early pre-production costs relating to explanation and evaluation Further, the results are affected by whether amortisation is included in the measure of pre-production costs written off Some support is found for an effect on the treatment of early stage pre-production costs of the company auditor’s expressed preference for capitalisation of such costs Evidence is also found to support the proposition that, at the time of the study, those companies in the gold mining sub-sector of the extractive industries were subject to the effects of political sensitivity, related to the impending removal of concessional taxation arrangements Some support for a relationship between leverage and the proportion of pre-production costs written off directly to the profit and loss statement is also evident 1 Introduction This paper examines the method used to account for pre-production costs by companies in the Australian extractive industries Availability of choice for this accounting policy has continued despite the introduction of Australian accounting standard AAS dealing with the matter in 1976, and companies have and continue to utilise this ability to make a choice in relation to the treatment of pre-production costs adopted in practice (see for instance, Ryan, Heazlewood and Andrew, 1977, 1980; Ryan, Andrew, Gaffikin and Heazlewood, 1990, 1993; Ryan and Heazlewood, 1995, 1997; Gerhardy, 1998) Costly contracting theory is used as the basis for explaining companies’ accounting choices Hypotheses relating to factors motivating the treatment chosen to account for pre-production costs in the Australian extractive industries are developed and tested within this framework This paper adds to the literature on accounting method choice within the Australian institutional framework Its particular contribution to the area is twofold First, it examines companies within a particular sector of the economy, namely the mining sector, which has often been regarded as being subject to differing influences and incentives, particularly in relation to the political sensitivity of firms within the sector (see for example, Bowen, Noreen and Lacey, 1981, pp 168-9).1 Supporting the importance of taking a single industry approach to accounting choice studies, Aitken and Loftus (1994, p 2) suggest ‘that future developments in this research will depend upon the eventual accumulation of research results across a number of separate industries’ The second significant difference between this and many accounting choice studies conducted to date relates to the measurement of accounting treatment adopted The majority of studies in the area have adopted a dichotomous measure of accounting policy This paper suggests that surveys of practice which attempt to categorise the choice of treatment for pre-production costs into discreet The possibility of differing influences on sub-sectors of the extractive industries, particularly those in the gold mining and petroleum sub-sectors, is discussed below Exceptions to this include Aitken and Loftus (1994) who measure the dollar effect of policy choices, and Walker (1988) whose approach has been adopted and modified in this paper categories represent a major understatement of the variation found in practice It therefore utilises an alternative continuous measure of the accounting treatment adopted In addition to extending the scope of Australian research within the contracting cost framework, the study is timely from the point of view of the usefulness of its results to standard setters Watts and Zimmerman (1986, p 14) argue: Positive accounting theory is important because it can provide those who must make decisions on accounting policy (corporate manages, public accountants, loan officers, investors, financial analysts, regulators) with predictions of, and explanations for, the consequences of their decisions The Australian standard setters have recently indicated that extractive industries accounting represented a high priority project, with the expectation that a discussion paper on the issue would be prepared in the not too distant future, to be followed by an exposure draft and finally a revised accounting standard (AARF & AASB, 1996, p 16) In addition, at its April 1998 meeting the International Accounting Standards Committee (IASC) placed on its agenda a new project dealing with the Extractive Industries A Steering Committee for the project was appointed in July, with the first major step in the process to be preparation and issue of a discussion paper by the end of 1998 (IASC, 1998) Given the current program to harmonise Australian and International accounting standards, this move by the IASC suggests that the Australian standard setters will soon commence their foreshadowed reconsideration of this country’s extractive industries standards Thus, this study is able to provide further insights into this issue, particularly in relation to the factors that may be associated with a preference for a particular treatment of pre-production costs Prior research conducted within the contracting cost framework has indicated three significant motivations operating on firms’ accounting method choices, namely management compensation contracts, debt constraints and political sensitivity Due to measurement difficulties the influence of the first of these factors, the existence of management compensation contracts tied to earnings, is not investigated in this study The influence of both debt constraints and political sensitivity are investigated in detail In addition, the effects on accounting treatment of two factors hypothesised on the basis of ex ante efficient contracting arguments, namely income diversification and engineering risk, are investigated Finally, the existence of an auditor effect on accounting method, as hypothesised by Deakin (1980), is investigated in the Australian context The remainder of this paper is organised as follows The next section briefly outlines the possible methods of accounting for pre-production costs, and the position adopted by the Australian regulators in relation to this accounting choice Flowing from this, the need for a continuous measure of the accounting treatment adopted is explained In Section the formal hypotheses are developed Section provides details of the research methods utilised in the study, with the results being presented and discussed in Section The final section summarises the major findings and discusses the implications of the study Accounting for Pre-production Costs The fundamental issue distinguishing the different methods of accounting for pre-production costs in the extractive industries relates to the choice of cost centre to be used in accumulating such costs for external reporting purposes There exist a large number of possible cost centres, varying greatly in their size, which could be used to accumulate pre-production costs Lourens and Henderson (1972, p 54) indicate that the cost centre can ‘be as small as an individual mineral deposit, mine, quarry, well, lease or reserve, or it can be as large as several leases, areas, a State, or an entire country’ Effectively the choice of a different cost centre leads to the choice of a different method of accounting for pre-production costs While numerous possible cost centres implies equally numerous methods of accounting for pre-production costs, Table summarises four of the major methods available; viz., the full cost, area of interest, successful efforts and expense methods [INSERT TABLE ABOUT HERE] As can be seen from the table, the full cost method is conceptually the opposite of the expense method This is by virtue of their adoption of extreme positions as to the cost centre used to accumulate pre-production costs Both the successful efforts and area of interest methods lie between the two extremes, with the distinction between the two being less than clear It has for instance been suggested that the area of interest method is a particular variety of the successful efforts method, with the cost centre defined as an area of interest (Henderson and Peirson, 1995, p 772; Whittred, Zimmer and Taylor, 1996, p 395) Heazlewood (1987, p 30) on the other hand suggests that the area of interest method lies between the full cost and successful efforts method in view of the fact that the former ‘could result in more expenditure being capitalised than under the successful efforts method in any given geological area’ Davison (1979, pp 22-23) and Wise and Wise (1988, p 30) express a similar view Whichever view is accepted, it is suggested that while Table describes four particular methods of accounting for pre-production costs, this number belies the wide variety of possible methods which could be used to account for pre-production costs in the extractive industries, given that the outcome for the two intermediate methods will be dependent upon how the cost centre is defined In the Australian regulatory context the essential accounting requirements relating to preproduction costs are contained in paragraphs 10-12 of the current version of Australian Accounting Standard AAS 7.3 Paragraph 10 deals with accounting for pre-production costs incurred in the earlier pre-production stages of exploration and evaluation, and states that: Costs arising from exploration and evaluation related to an area of interest shall be written of as incurred, except that they may be carried forward provided that rights to tenure of the area of interest are current and provided further that at least one of the following conditions is met: (a) such costs are expected to be recouped through successful development and exploitation of the area of interest, or alternatively, by its sale; and (b) exploration and evaluation activities in the area of interest have not at reporting date reached a stage which permits a reasonable assessment of the existence or otherwise of economically recoverable reserves, and active and significant operations in, or in relation to, the area of interest are continuing (emphasis added) This paragraph clearly provides a choice of accounting methods for exploration and evaluation costs While initially it appears to require the expense method, whereby all such costs are written off to the profit and loss statement as incurred, it goes on to add that the costs may be capitalised, subject to one of the stated conditions being met This approach is described as the ‘area of interest method’ (AAS 7, para 16) Whittred, et al (1996, p 395) suggest that the conditions under which Approved accounting standard AASB 1022 was issued in 1989, giving legislative force for companies to the accounting requirements contained in AAS Since this study refers to accounting practices of mining companies prior to the release of AASB 1022, reference will be confined to the AAS series standard The accounting requirements of the two standards are the same this area of interest method may be applied allow ‘the option of deferral even in those cases where the feasibility of operations … has not yet been established – all that is required is that rights to tenure of the area of interest are current and that the actual and significant operations (not defined) are continuing in that area’ In addition to having an explicit choice between use of the expense and area of interest methods, the ‘area of interest’ is so broadly defined in geological terms that a wide variety of possible cost centres may be adopted for the purpose of accumulating pre-production costs On this point AAS (para 18) admits that during the earlier pre-production stages ‘an area may be difficult to delimit’ Similarly, Davison and Lourens (1978, p 34) note that in formulating the Australian accounting requirements ‘the critical size of the area of interest was, unavoidably, left undefined in an operational manner, thus permitting a wide variety of options in practice’ (emphasis added) Thus, the available treatments of exploration and evaluation costs are much broader than simply a dichotomous choice between two methods, being highly dependent upon how the area of interest is defined Exploration and evaluation comprise the initial and generally higher risk pre-production phases in the extractive industries Accounting for costs incurred in the remaining two pre- production phases, development and construction, also require consideration Costs incurred in the latter construction phase generally are in the nature of expenditure on fixed assets and therefore, as recognised in paragraph 12 of AAS 7, are subject to the accounting requirements of Australian Accounting Standard AAS 4, Depreciation As such, construction costs are not considered further in this study In addition, Walker (1988, p 40) suggests that an argument can be put for excluding development costs when considering accounting for pre-production costs, on the grounds that ‘development typically relates to the preparation of the deposit or field for commercial production and as such will take place after it has been determined that the exploration has been successful’ This is reflected in the accounting treatment required by AAS (para 11) for such costs, which ‘shall be carried forward to the extent that [they] … are expected to be recouped through successful exploitation of the area of interest, or alternatively, by its sale’ The choice of methods available for exploration and evaluation costs is not available when accounting for development costs As such, they may be argued to be different in nature to the costs incurred in the exploration and evaluation phases, and not subject to managerial discretion It could however be argued that to exclude development costs would unduly bias the study since they represent an extra degree of freedom for managers in determining the amount of preproduction costs to carry forward/write off Since, as recognised by Henderson and Peirson (1995, p 773), ‘Frequently, the boundaries between these phases are unclear as the … phases often occur simultaneously in the same area’, consideration of development costs adds a further dimension to managements’ decisions on the accounting treatment to be accorded pre-production costs The significance of this distinction is investigated in this paper by conducting tests which both include and exclude development costs The above discussion suggests that specifying the dependent variable in this study as dichotomous, or even as polychotomous, would not accurately represent firms’ accounting treatments of pre-production costs A refinement of Walker’s (1988) continuous proportionate measure is used to represent the accounting treatment of pre-production costs The specification of this dependent variable is fully discussed in Section Hypothesis Development Research conducted within the contracting cost framework utilises the contracting and political processes as the basis for investigating firms’ choices amongst accounting alternatives This section develops hypotheses relating to the influence of two motivations derived from the framework, namely debt constraints and political sensitivity Also derived from contracting theory, hypotheses predicting engineering risk and income diversification as factors influencing the accounting In addition, a practical argument in favour of considering development costs in this study is the frequent practice of companies whereby all non-construction pre-production costs are included in the balance sheet as a single figure, not allowing in such cases the distinction of development costs from exploration and evaluation costs treatment of pre-production costs in the Australian extractive industries are developed Finally, Deakin’s (1980) auditor effect hypothesis is investigated in the Australian regulatory context 3.1 Debt Constraints The general hypothesis that the closer is a business to breaching an accounting based debt constraint the more likely is management to adopt accounting methods that increase profit has been well documented in contracting cost theory and related empirical studies (see for instance Watts and Zimmerman, 1986, pp 257-259) This strategy is adopted by management in order to loosen such covenants and therefore reduce the probability of a breach, and the incurrence of the consequential costs The most commonly used proxy for closeness to debt covenant default in prior studies has been a leverage ratio.5 Whittred and Zimmer (1986) and Stokes and Tay (1988) provide evidence of the use of various types of restrictive covenants in trust deeds supporting listed public debt issues by Australian companies Both studies indicate that most commonly such covenants are specified in terms of liabilities to total tangible assets Whittred and Zimmer (1986, p 27) suggest that exclusion of intangibles means that for a number of accounting choices, including inter alia., the treatment of pre-production costs, to a large extent ‘the choice of capitalizing or expensing cannot affect a firm’s proximity to a leverage constraint’ This would seem to suggest that the general hypothesis outlined above would not hold in the current study Despite this argument, two factors suggest that investigation in this study of the relationship between leverage and the choice of accounting treatment for pre-production costs is warranted First, both of the surveys mentioned investigated only public debt agreements The current study suggests that public debt is seldom used in the Australian extractive industries, with only one company included in the study having such debt outstanding It is possible that covenants in private debt agreements differ from those for public debt issues In addition, Whittred and Zimmer’s (1986) survey includes only one company with a stock exchange industry classification indicating involvement in the extractive industries, As recognised by Press and Weintrop (1990, p 65) such proxies for closeness to breach of covenants are used because of the high cost of gaining access to actual contracts with none of the companies in Stokes and Tay’s (1988) survey being involved in the pre-production stages of the extractive industries Thus, to draw the conclusion that pre-production costs are routinely precluded when specifying leverage constraints in debt agreements may be somewhat premature In addition, Press and Weintrop (1990) found evidence in the US context of an association between firms’ level of leverage and closeness to debt constraints Based on the above, and recalling that capitalisation of pre-production costs will have the effect of reducing the probability of breaching a debt covenant specified in terms of the debt to equity ratio, the following hypothesis is tested: H1: The ratio of debt to equity will be positively correlated with capitalisation of pre-production costs A further ratio often specified in debt covenants is the level of interest coverage As observed by Bowen, Noreen and Lacey (1981, p 167), ‘Some debt agreements prohibit the firm from issuing new debt unless a minimum prescribed ratio of income to interest charges is maintained’ Whittred and Zimmer (1986, p 25) provide evidence of the use of such interest coverage constraints in Australia, although they were found in only 33 per cent of the debenture trust deeds they examined The potential difficulty of leverage ratios being unaffected by the method of treatment of pre-production costs if intangible assets are excluded in the specification of the constraint does not apply to constraints specified in terms of interest coverage This therefore suggests a possible observable relationship between the interest coverage ratio and the accounting treatment of pre-production costs in the Australian extractive industries Specifically, capitalisation of pre-production costs in preference to writing them off will have the effect of increasing the level of interest coverage above what it would be under the alternative, thereby reducing the probability that the firm will violate such a constraint Thus the lower the level of coverage the more likely is the firm to capitalise such costs The following hypothesis is tested: H2: The interest coverage ratio will be positively correlated with writing off or expensing of pre-production costs 3.2 Political Sensitivity Contracting cost theory establishes a link between the political sensitivity of firms and their accounting method choices, hypothesising that the more politically sensitive is a firm the more likely is management to choose income reducing accounting methods Traditionally studies investigating political sensitivity have adopted firm size, measured in various ways, as the proxy for political sensitivity.6 Malmquist (1990, p 181) provides an additional ex ante argument as to why firm size may be related to the accounting method choice of US oil and gas companies He argues that while choosing to capitalise pre-production costs rather than write them off has the effect of decreasing variance in reported profits, the effectiveness of this strategy reduces as firm size increases He argues that larger firms will have a greater number of drilling projects, which leads to a ‘portfolio effect’, by diversifying away variance due to drilling risk Thus, for such firms the necessity to capitalise pre-production costs to reduce earnings variance is diminished Conversely, the potential exists for smaller firms to gain much in the way of variance reduction by adopting a policy of capitalisation, since they are less likely to have the number of separate drilling projects required to gain variance reduction from the ‘portfolio effect’ This ex ante efficiency argument implies, as does the ex post political sensitivity argument outlined previously, that firm size will be correlated positively with the expensing of pre-production costs Revenue and total assets have been the two most frequently adopted proxies for firm size in prior accounting choice studies In their study Deegan and Hallam (1991, p 11) adopt what they consider to be an alternative and preferable measure of firm size, viz., net profit after tax and before extraordinary items They base their preference for this measure on Watts and Zimmerman’s (1986, p 239) view that a firm’s accounting earnings are ‘a better proxy for the negative/positive corporate wealth transfers [than] firm size (total sales or assets)’ Thus, substituting a net profit Lim (1996) provides a comprehensive review of the literature relating to the political sensitivity/costs hypothesis The concept of drilling or engineering risk and its likely effect on accounting treatment of pre-production costs in the extractive industries is discussed further in Section 3.3 below 30 5.3.3 4RWRITEOFF3 The final dependent variable used in the study differs from the first only in that it excludes amortisation of pre-production costs from the numerator, providing arguably a finer measure of preproduction costs written off The results for the base regression are reported in Panel C of Table 11 While overall the model remains insignificant, the model performs best using this version of the dependent variable vis-à-vis the other two versions already discussed In this case the coefficients for LNLEVERAGE and GOLD are both of the expected sign and significant at the 5% level These results are consistent with those of the univariate tests reported earlier, and suggest that more highly levered companies tend to write off a lesser proportion of pre-production costs incurred directly to the profit and loss statement Further, firms involved in the mining of gold also tended, in 1986, to write off a greater proportion of such costs direct to the profit and loss statement, offering support for the proposition that such firms were, at that time, a politically sensitive sub-group of companies in the extractive industries Where LNASSETS is used as the proxy for political sensitivity LNLEVERAGE and GOLD maintain significant coefficients with p = 0.10 and p = 0.052 respectively, with PETROL also having a significant positive coefficient with p = 0.10 When LNREVENUE is used as the political sensitivity proxy only GOLD has a significant coefficient with p = 0.065 Where large absolute values of interest coverage are coded as plus or minus 50, LNLEVERAGE has a significant coefficient at p = 0.023, and the coefficient of GOLD remains significant with p = 0.053 The interest coverage coefficient is significant (p = 0.013) but of the wrong sign Including only those companies for which interest coverage is defined reduces the number of companies used to estimate the model to 88 Here, in addition to the coefficient for GOLD being significant at p = 0.053, PETROL has a significant positive coefficient with p = 0.085 As with the other dependent variables, this model was retested to control for error in measuring the AUDITCAP variable by using only the 81 companies with auditors other than KMG Hungerfords and Peat Marwick Mitchell and Company Little change in the results occurred, except that p values for those 31 coefficients that were significant when all companies were used were consistently slightly higher, and thus somewhat less significant Conclusions This study examines explanations for variation in the treatment of pre-production costs by companies in the Australian extractive industries It finds that the ability of the hypothesised explanations to account for the observed variation is dependent, to some extent, upon the definition of pre-production costs considered, particularly whether development costs are included with the early pre-production costs relating to exploration and evaluation Further, the results are affected by whether amortisation is included in the measure of pre-production costs written off This suggests that the availability of a choice of accounting treatment for early pre-production costs, but not for development costs, may create differing incentives for companies’ treatment of costs incurred in different phases of operations As such, accounting standard setters in the impending review of the extractive industries standard may wish to consider the desirability of maintaining such differential treatments across different pre-production phases Further, the fact that only 37 per cent of companies in the study provided sufficient information to separate exploration and evaluation costs from total pre-production costs suggests that consideration ought to be given of whether the standard’s disclosure requirements are adequate to meet the needs of financial statement users In summary, the results provide limited support for some of the factors hypothesised to affect the accounting treatment of pre-production costs adopted No support for interest coverage, nor traditional political sensitivity proxies (PROFIT, ASSETS and REVENUE), as influences on the accounting treatment is found A significant negative correlation was found between the political sensitivity proxy TAXRATE and both dependent variables incorporating all pre-production costs, namely WRITEOFF1 and WRITEOFF3 The reason for the unexpected direction of this relationship may lie in consideration of potential or future political costs relative to companies’ extant political sensitivity Companies with high effective tax rates are already subject to high political costs, and as such the potential for further such costs to be imposed in the future may be 32 regarded as low Such companies may therefore have little incentive to adopt profit decreasing accounting practices On the other hand, lowly taxed firms may be seen as potential targets for politically motivated wealth transfers in the future, since they could be argued to be ‘under taxed’ in some sense Such firms therefore have an incentive to adopt income decreasing accounting methods to reduce their extant political visibility Such an explanation is consistent with the observed negative association between the TAXRATE variable and the proportion of preproduction costs written off The results of this study also suggest that when only early stage pre-production costs are considered (WRITEOFF2) the accounting treatment of such costs appear to be influenced by whether the company’s audit firm has expressed a preference for capitalisation of pre-production costs It seems that, in relation to costs incurred in the more risky early stages of exploration and evaluation, companies are either likely to be advised by their audit firm or have selected an audit firm which favours their preferred treatment of such costs This result only occurred when error in the AUDITCAP variable was controlled for by excluding those companies audited by the two firms which merged into KPMG Peat Marwick Hungerfords The study also finds evidence that when all pre-production costs are considered (WRITEOFF1 and WRITEOFF3) companies involved in the gold mining sector of the extractive industries tended to write off (and/or amortise) a greater proportion of such costs than companies which were not This supports the proposition that such companies were attempting to protect their privileged position in relation to the taxation treatment of income generated from gold mining operations In contrast, there is no strong evidence to suggest that companies in the petroleum sector took actions consistent with the predicted sensitivity caused by the impending introduction of the resource rent tax It is possible that by 1986 introduction of the tax was regarded as a ‘foregone conclusion’, and so action to reduce political visibility by affected companies was expected to be ineffective and therefore unnecessary This is consistent with the suggestion by Walker (1988, p 23) that the timing of such political factors needs to be identified She suggests that in this case it is difficult to determine in which year or years, 33 from its first proposal in 1975 up to its introduction, the resource rent tax was likely to affect the accounting treatment adopted Finally, there is support for a relationship between companies’ degree of leverage and the proportion of pre-production costs written off directly to the profit and loss statement (WRITEOFF3) More highly levered companies tend to write off directly to the profit and loss statement a lower proportion of pre-production costs It was suggested that such action might be undertaken in an effort to loosen debt covenants To determine the plausibility of such an explanation, and given that only one company in the study had public debt on issue, further research into the nature of covenants in private debt agreements of companies in the extractive industries in needed Overall, traditional costly contracting and political sensitivity explanations of accounting choice not appear to hold well in the case of pre-production cost accounting in the Australian extractive industries It seems that the mining sector may be subject to differing influences and incentives to those that have been found to apply in studies which have ranged across numerous industries Further, it appears that incentives may apply differently to different sub-sectors of the extractive industries In the case of political sensitivity, this is likely to be highly dependent on economic and political conditions at the time of the study – those in the gold sub-sector in 1986 appear to have been influenced by political visibility considerations, while those in the petroleum sub-sector were not Further investigation of the operation of differential incentives across the subsectors of the extractive industries would shed further light on this issue References Australian Accounting Research Foundation (AARF) (1989), Statement of Accounting Standards AAS 7: Accounting for the Extractive Industries, November AARF and AASB (1996), 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other costs written off as incurred All pre-production costs expensed as incurred Relative Asset Effect Highest Intermediate Intermediate (between full cost and expense methods; dependent on choice of cost centre) Lowest (none) Relative Profit Effect Highest in early years Intermediate Intermediate (between full cost and expense methods; dependent on choice of cost centre) Lowest in early years Table Numbers of Extractive Industries Companies with 1986 Annual Reports on the AGSM Annual Report File but Excluded from the Study, by Reason for Exclusion Total extractive industries entities with 1986 annual reports on the File Less: 123 Excluded companies by reason for exclusion Foreign currency financial statements Trusts Investment companies No 1986 annual report Incomplete data In rehabilitation phase 1986 report covers 18 months Total excluded 19 Total companies included in study 104 Table Dependent Variables Label WRITEOFF1 Definition Exploration, evaluation and development costs written off and amortised during the year/(Closing balance of exploration, evaluation and development costs carried forward as at the end of the year + Exploration, evaluation and development costs written off and amortised during the year) WRITEOFF2 Exploration and evaluation costs written off during the year/(Closing balance of exploration and evaluation costs carried forward as at the end of the year + Exploration and evaluation costs written off during the year) WRITEOFF3 Exploration, evaluation and development costs written off during the year/ (Closing balance of exploration, evaluation and development costs carried forward as at the end of the year + Exploration, evaluation and development costs written off during the year) Table Independent Variables Label LEVERAGE (H1) INTCOVER (H2) PROFIT (H3) TAXRATE (H4) PETROL (H5) Predicted Sign Definition – Book value of debt/Book value of total equity as at the end of the period + Net profit before extraordinary items, interest and tax/Interest expense for the year + Net profit before tax and extraordinary items for the year + + GOLD (H6) + ENGNRISK* (H7) EXTRALNS (H8) AUDITCAP (H9) – AUDITEXP (H9) + – + Tax expense for the year/Net profit before tax and extraordinary items (0,1) dummy variable = if the company is involved in the petroleum (oil and/or gas) sector of the extractive industries, = otherwise (0,1) dummy variable = if the company is involved in the gold sector of the extractive industries, = otherwise Exploration, evaluation and development costs incurred during the year/Book value of total equity at the end of the year Revenue from industry segments other that those directly related to the extractive industries/Total revenue for the year (0,1) dummy variable = if the company is audited by a firm expressing a preference for carrying forward of pre-production costs, = otherwise (0,1) dummy variable = if the company is audited by a firm expressing a preference for the immediate write off of pre-production costs as incurred, = otherwise * Where the dependent variable under consideration is WRITEOFF2 this variable is replaced by ENGNRISK2, defined as the ratio of exploration and evaluation costs incurred during the year, to the book value of total equity at the end of the year Table Choice of Audit Firms by Sample Companies Firm Companies Audited Audit Firm Preference No % Firms Making Submissions to the AARF Peat Marwick Mitchell & Co Coopers & Lybrand Price Waterhouse Ernst & Whinney Arthur Young KMG Hungerfords Pannell Kerr Forster Deloitte Haskins & Sells Touche Ross Arthur Andersen & Co Hendry Rae & Court Duesburys Total Firms Making Submissions Firms Not Making Submissions to the AARF Bentley & Co Nelson Wheeler Other Total C N N N N C C C N C N C 15 14 13 7 3 85 14 13 13 7 3 83 N N N 12* 104 12 102** C = expressed preference for capitalisation of pre-production costs N = neutral on treatment of pre-production costs * Includes 12 separate accounting firms each acting for a single sample company ** Greater than 100% due to rounding of individual percentages Table Descriptive Statistics - Untransformed Variables Panel A: Independent Variables WRITEOFF1 WRITEOFF2 WRITEOFF3 N 104 38 104 Minimum 0 Maximum 1 Mean 0.1352 0.2065 0.0966 Standard deviation 0.1987 0.3308 0.2023 Skewness 3.074 1.724 3.400 Kurtosis 10.270 1.548 11.821 Kolmogorov-Smirnov Z statistic 2.530 1.926 3.228 (2-tailed p) (