Managerial incentives behind fixed asset revaluations: evidence from New Zealand firms.

AuthorSeng, Dyna
PositionReport
  1. INTRODUCTION

    The revaluation of fixed assets has become a common practice in Australia and New Zealand (i). While New Zealand Financial Reporting Standard FRS-3 (ii) "Accounting for Property, Plant and Equipment" requires historical cost to be used for reporting non-current assets, it does allow the alternative treatment of revaluing assets to fair value (iii) at regular intervals. Why, then, have asset revaluations been allowed in New Zealand and elsewhere? The purpose of undertaking asset revaluation is to provide more relevant information about an organisation's financial position to users of financial statements. In most countries, however, whose accounting rules allow revaluation of assets, the decision to revalue assets is optional upon manager's discretion. The considerable inconsistency among the timing, frequency, and methods of revaluation practice raises the question as to whether the "relevance" is the sole reason of companies' asset revaluation decisions (Lin and Peasnell, 2000a). Positive accounting theory suggests that managers' choice of accounting methods may be influenced by economic incentives.

    Earlier research (e.g. Strong and Meyer, 1987; Brown et al., 1992; Francis et al., 1996; Cotter et al., 1998; Holgate and Ghosh, 2000) revealed that a firm's decision as to whether or when to revalue fixed assets could be partially explained by management incentives relating to commercial or political influences. It was found that upward revaluations were used to reduce contracting costs, political costs, and information asymmetries. This study attempts to investigate the underlying management incentives of the voluntary upward fixed asset revaluation behaviour of New Zealand listed companies. The results provide little evidence to support the hypotheses that the asset revaluation activities of New Zealand companies are motivated by contracting costs, information asymmetry or other opportunistic incentives. This study also examines the regularity and the valuation methods of companies' revaluation practice. It reveals that some New Zealand companies choose to disclose the current values of fixed assets in the notes to annual reports rather than to recognise them in the balance sheet. Cotter (1999) argued that a perceived benefit of disclosing rather than recognising these current values is a more conservative and, therefore, more credible balance sheet.

    The next section addresses the prior literature and hypothesis development. In section 3 the research design is developed while section 4 presents the results of univariate and multivariate tests. The discussion of the results is provided section 5 and the last section contains the conclusions.

  2. PRIOR LITERATURE AND HYPOTHESIS DEVELOPMENT

    Accounting standards provide companies some flexibility in choosing from alternative accounting methods when dealing with accounting issues that are complex and uncertain. Fixed asset revaluation is one of the areas that granted such discretion. The amount of revaluation can be either increments or decrements. This study investigates only the upward asset revaluation. Traditional financial reports prepared under the historical cost accounting method are criticised for its lack of relevance to users of those financial reports. An asset revaluation modifies original historical costs of assets to current market value, therefore providing more up-to-date value of a firm's assets to users (Brown et. al, 1992). Earlier research by Brown et al. (1992), Lin and Peasnell (2000a and 2000b) documented three potential benefits of upward fixed asset revaluation. These are the reduced debt contracting costs, the decreased profit and therefore lessened political attention, and the reduced information asymmetry regarding future prospects of the firm.

    2.1. Contracting Factors

    Fixed asset revaluation may affect a firm's power in negotiating debt contracts with debtholders. Two main contracting factors that were examined in previous studies are leverage level and declining cash flows from operations.

    2.1.1 Leverage Level

    It is well recognised that technical default on covenants in debt agreements is costly and negatively affects shareholder wealth. Brown et al. (1992) argued that either the technical violation of accounting-based debt covenants, or a high level of leverage on balance sheet, would result in costly debt repayment or an increase in future renegotiation costs to the firm. Beneish and Press (1995) stated three principal consequences of technical default following renegotiation process: additional covenants, increased interest rates, and reduced allowable borrowing. Whittred and Chan (1992) and Smith (1993) further argued that the existence of tight debt limit would restrict a firm's investment opportunities, as highly profitable projects might be passed over due to restriction in the firm's borrowing capacity. Therefore, a firm's management tend to choose an accounting method that helps the firm to reduce these contracting costs associated with the firm's gearing and debt covenants (Whittred and Zimmer, 1986).

    Since an upward revaluation of fixed assets would increase the book value of total assets and the asset revaluation reserve, the firm's debt-to-asset or debt-to-equity ratios would be improved. Given a strong balance sheet position, lenders would be willing to loosen debt restrictions or reduce interest charges. It was, therefore, argued that firms are more likely to undertake assets revaluation when the leverage level is high in their balance sheets (Lin and Peasnell, 2000a).

    A number of researchers have found a positive relationship between Australian firms' revaluation action and their financial leverage as well as debt covenants (Brown et al., 1992; Whittred and Chan, 1992). Easton et al. (1993)'s survey of Australian firms reported that the primary motive of revaluation was to present true and fair financial statements, and the second was to loosen debt constraints and enhance financial flexibility. Lin and Peasnell (2000a and 2000b) carried out revaluation studies in the U.K. using two different samples, and the results of both studies supported their hypotheses that there was a positive relationship between the upward revaluation action and firms' gearing and debt covenants. It is thus expected that firms with high leverage may tend to use upward asset revaluation to expand asset base, reduce debt ratio, and therefore restore firms' borrowing capacity. Hence, a positive relationship is predicted between firms' leverage and the incentive to revalue their fixed assets.

    H1: Firms with higher level of leverage are more likely to revalue their fixed assets.

    2.1.2 Declining Cash Flows From Operations

    A firm's borrowing capacity depends not only on existing leverage but also on the firm's ability to repay debt. Declining cash flows from operations may cause debtholders to be concerned with the firm's liquidity. An Australian study by Cotter and Zimmer (1995) argued that an upward revaluation would signal a higher value of the firm's collateral assets, which may help to convince debtholders about the firm's ability to repay debts through the potential to realise the firm's assets at a higher market value. Therefore, upward revaluations would restore firms' borrowing capacity. They proposed that firms with declining cash flows are more likely to revalue their assets in the current year. The results of their study generally supported this argument. However, Cotter (1999) used this variable again, but found no significant relationship between this variable and the decision to revalue. She explained that it was because of the changed institutional setting of Australia. The closer relationship between firms and their bankers has made it unnecessary to use costly revaluations to reduce debt contracting costs. It is predicted that firms declining operating cash flows is positively related to the upward asset revaluation decision.

    H2: Firms experiencing declining in cash flows from operations are more likely to revalue their fixed assets.

    2.2 Political Factor

    It was believed that a firm's size was an important factor related to the revaluation decision. Previous studies suggested that governmental price controls have focused more heavily on large firms than on small ones because large firms are perceived to have greater freedom from regulations, and are more likely to take price leadership roles (Lin and Peasnell, 2000a). Unions may also pay more attention to large firms and demand higher salaries from these firms (Brown et al., 1992). In order to reduce adverse political influence, firms tend to avoid reporting excessively high profits (Standish and Ung, 1982). An upward asset revaluation can be an effective way to reduce reported profit through increased depreciation charges on the asset revaluation increments, and it is therefore expected to mitigate the political pressures faced by larger firms from government or unions (Lin and Peasnell, 2000a). Therefore, it is expected that there is a positive relationship between firm size and the revaluation decision.

    H3: Larger firms are more likely to revalue their fixed assets.

    2.3 Information Asymmetry

    The presence of information asymmetry in accounting generally refers to the situation where external users of the financial reports cannot obtain full information about the firm due to the disparity between the reported information and the true economic reality of the firm (Brown et al., 1992). Factors that affect the degree of information asymmetry are expected to influence the management's decision as to whether and when to revalue the firm's assets. These factors include prior revaluation, fixed asset intensity, growth options, takeover offer and bonus issue.

    2.3.1 Prior Revaluation

    As revaluation is costly, a firm may not choose to revalue its assets every year. Instead, the firm might delay exercising revaluation to a later time when the revaluation is...

To continue reading

Request your trial

VLEX uses login cookies to provide you with a better browsing experience. If you click on 'Accept' or continue browsing this site we consider that you accept our cookie policy. ACCEPT