a6l clqrcc*, bka oc(digilib.library.usp.ac.fj/gsdl/collect/usplibr1/index/... · 2009-10-19 ·...

I ' THE UNIVERSITY OF THE SOUTH PACIFIC

t r LIBRARY Author Statement of Accessibility- Part 2- Permission for Internet Access

Name of Candidate : A 6 L cLqrcc*, b k a

Degree : h 4 e g oC( ~ - c e

Department/School : ~ C L o o l A' ACCWY) & V q

~nstitution/university : ~ln\Ve~sl& E K c 5:~ cc Thesis Title : P~MLSC: CX Eat o w 9 5 c-n+ & a C L 5

Date of completion of requirements for award : 6 13 101

1. I authorise the University to make this thesis available on the Internet for access by USP authorised users.

2. I authorise the University to make this thesis available on the Internet under the International digital theses project

Signed: s Date: \3 !3 lo?

Contact Address Permanent Address

Analyses of Earnings Management Practices

in State Owned Enterprises

Case Studies of the Housing Authority and

the Fiji Electricity Authority

by

Asha Shyreen Lata

A thesis submitted in partial fulfillment of the requirements for the

degree of Master of Commerce in Accounting

School of Accounting and Finance

Faculty of Business and Economics

The University of the South Pacific

Suva, Fiji

March 2007

© Asha Shyreen Lata 2007

ii

DECLARATION OF ORIGINALITY

I, Asha Shyreen Lata, declare that this thesis is my original work and, to the best

of my knowledge, does not contain any material(s) used from elsewhere.

However, where materials have been borrowed, due acknowledgement has been

rendered in an appropriate manner.

----------------------------------

Asha Shyreen Lata

March 6, 2007.

iii

ACKNOWLEDGEMENT

I would like to express my gratitude to the several people who have assisted me

in completing this thesis. I gratefully acknowledge the continuous support and

guidance provided by my supervisors, Associate Professor Arvind Patel and

Professor Michael White, throughout the period of study. Their critical

comments and suggestions on all aspects of the thesis were very useful. I also

acknowledge the two examiners, Professor Howard Davey and an anonymous

examiner, for reviewing this thesis.

I also wish to thank Mr. Parmesh Chand, the Chief Executive Officer of the

Ministry of Public Enterprises and Public Sector Reform and his staff members

for providing relevant information about the organisations on a timely basis. I

am equally thankful to Mr. Narendra Prasad, the former Chief Executive Officer

of the Housing Authority for providing pertinent information about the

Authority.

I am appreciative to my husband, Mr. Rup Singh, for providing editorial

support. His assistance was useful in improving the general structure of the

thesis. I am also grateful to the University of the South Pacific for providing

financial support to complete the study. Finally, I sincerely acknowledge my

family for their moral support, understanding and encouragement during the

completion of my thesis.

iv

DEDICATION

To my parents and the God Almighty

v

ABSTRACT

Earnings management practices lower the quality of financial reporting as they

are often used to obscure the true performance of businesses. This study analyses

the possibilities of earnings management in the two statutory organizations in

Fiji, the Housing Authority and the Fiji Electricity Authority, over the period

1990 to 2004. The results suggest that the entities may have practiced earnings

management by using provisions, amortization and depreciation, revaluation,

capitalisations and misclassification of government grants. These practices were

largely the result of professional judgment and flexibility permitted by the

accounting standards, although, there were a few cases, which occurred due to

non-compliance with generally accepted accounting practices. Further, agency

relationships provided several economic incentives to misreport the financial

outcome, such as reflecting performance of the incoming Board and/or

government, converting debts into equity, satisfying debt covenants and

attracting outside financiers. These findings are consistent with the a priori

expectation derived from studies of earnings management that such practices

arise because of flexibility in accounting standards and agency relationships.

vi

TABLE OF CONTENTS

Contents Page No.

Title Page i

Declaration of Originality ii

Acknowledgement iii

Dedication iv

Abstract v

Table of Contents vi

List of Tables and Figures x

List of Abbreviations xii

Chapter One

Overview of the Thesis

1.1 Introduction 1

1.2 Background 2

1.3 Justifications and contributions of the study 3

1.4 Objectives of the study 5

1.5 Organisation of the thesis 5

Chapter Two

Understanding Earnings Management Behaviour

2.1 Introduction 6

2.2 Why does earnings management occur? 6

vii

2.2.1 Managerial compensation effects 7

2.2.2 Borrowing cost effects 8

2.2.3 Equity offerings 9

2.2.4 Management buyout 10

2.2.5 Meeting analysts’ expectations 11

2.2.6 Reduce(increase) regulatory costs( benefits) 11

2.3 How does earnings management occur? 13

2.4 Conclusion 16

Chapter Three

Earnings Management in State Owned Enterprises

3.1 Introduction 17

3.2 Institutional background 17

3.3 Possibilities of earnings management in SOEs

3.3.1 Economic incentives 21

3.3.2 Accounting regulation 23

3.3.3 Cultural influences 25

3.4 Conclusion 27

Chapter Four

Methodology

4.1 Introduction 28

4.2 Empirical models of earnings management 28

4.3 Data 32

4.4 Research Method 32

4.5 Overlap between the two approaches 39

4.6 Conclusion 41

viii

Chapter Five

Evidence of Earnings Management Practices in the Housing Authority

5.1 Introduction 42

5.2 Overview of the Housing Authority

5.2.1 Background 42

5.2.2 Lending activities 45

5.2.3 Accounting environment and financial performance 47

5.3 Possible instances of earnings management

5.3.1 High provision for write downs of developed lots in 1988 to 1991 48

5.3.2 Capitalisation of administration expenses 54

5.3.3 Deferred interest expense 60

5.3.4 Changes in accounting policies for provision for doubtful debts 67

5.4 Conclusion 80

Chapter Six

Evidence of Earnings Management Practices in the Fiji Electricity Authority

6.1 Introduction 81

6.2 Overview of the Fiji Electricity Authority

6.2.1 Background 81

6.2.2 Electricity generation 84

6.2.3 Accounting environment and financial performance 85

6.3 Possible instances of earnings management

6.3.1 Capitalisation of research and development costs 86

6.3.2 Revaluation of fixed assets 94

6.3.3 Classification of government grants 96

6.3.4 Capitalisation policies 101

6.3.5 Changes in depreciation rates 103

6.4 Conclusion . 112

ix

Chapter Seven

Conclusions and Limitations

7.1 Conclusions 113

7.2 Limitations of the study 116

Bibliography 118

Appendices

1 Checklists 124

2 Current interest rates offered by different financial institutions 130

3A Financial indicators of the Housing Authority 131

3B Financial indicators of the Fiji Electricity Authority 132

x

LIST OF TABLES AND FIGURES

Tables Description Page No.

2.1 The Relationship between Accounting Philosophy and GAAP 14

3.1 List of State Owned Enterprises 18

3.2 Financial Performance of State-Owned Enterprises 20

5.1 Interest Rate Spread of the Housing Authority and the

Commercial Banks 46

5.2 Operating Costs of the Housing Authority and the

Commercial Banks 46

5.3 Auditors Remuneration 47

5.4 Developed Lots Inventory 49

5.5 Abnormal Items 50

5.6 Financial Indicators of the Housing Authority Before and After the

Transfer of Rental Operations (As a percentage of total assets) 52

5.7 Inventory Days 56

5.8 Effects of Capitalising Administrative Costs on Profits 57

5.9 Amortisation of Deferred Interest Expense 63

5.10 Components of Total Expenses in 1993 63

5.11 Interest Expense 64

5.12 Loan Liabilities in 1992, 1993 and 1994 ($000s) 65

5.13 Interest Expense on New Loans Raised During 1992, 1993

and 1994 65

5.14 Discretionary Expenditure 71

5.15 Profits in 1995 and 1996 (as a percentage of assets) 72

5.16 Profitability and Equity Position of the Housing Authority 76

xi

5.17 Effects of Change in Accounting Policy at the Housing

Authority in 1999 78

5.18 Summary of Earnings Management Evidence in the

Housing Authority 80

6.1 Research and Development Cost ($000s) 87

6.2 Capital Works In Progress in 1984 89

6.3 Amortisation of Training Expenses 91

6.4 Effect of Cost Capitalization on Return on Fixed Assets 93

6.5 Effects of Revaluation in 1992 94

6.5 Effects of Misclassification of Deferred Income 99

6.7 Combined Effects of Revaluation and Classification of

Deferred Income 100

6.8 Total Expenses and Profits of the Fiji Electricity Authority 102

6.9 Depreciation Expenses and Profits of the Fiji

Electricity Authority 104

6.10 Summary of Earnings Management Evidence in the Fiji

Electricity Authority 112

xii

LIST OF ABBREVIATIONS

ADB Asian Development Bank

CSA Commercial Statutory Authorities

FASs Fiji Accounting Standards

FEA Fiji Electricity Authority

FIA Fiji Institute of Accountants

FNPF Fiji National Provident Fund

GAAP Generally Accepted Accounting Principles

GCC Government Commercial Companies

HA Housing Authority

IASs International Accounting Standards

NBF National Bank of Fiji

PRB Public Rental Board

RBF Reserve Bank of Fiji

SOEs State Owned Enterprises

Analyses of Earnings Management Practices in SOEs

1

CHAPTER ONE

OVERVIEW OF THE THESIS

“I fear that we are witnessing an erosion in the quality of earnings and therefore the quality of financial reporting.

Managing may be giving way to manipulation; integrity may be losing out to illusion”

Levitt 1998, the former Chairman of Securities and Exchange Commission.

1.1 Introduction

The issue of earnings management has been widely researched and found to be

pervasive in the private sector in many developed economies (DeFond and Jiambalvo,

1994; Teoh et al., 1998; Beneish, 2001; Barton and Simko, 2002 and Krishnan, 2003).

However, little work has been done in the context of developing economies and the

public sector. It will not be clear as to how pervasive the phenomenon of earnings

management really is until the analysis is extended to developing economies and to

public sector entities. This thesis has been undertaken to make a contribution to address

this lacuna. It constitutes an endeavour to identify and analyse possible instances of

earnings management in the public sector of a developing economy, namely Fiji. The

study focuses on two State Owned Enterprises (SOEs) - the Housing Authority and the

Fiji Electricity Authority. At the outset, this thesis can only suggest that there may of

evidence of earnings management in these entities. This introductory chapter begins

with some background information on earnings management and then proceeds to justify

the purpose of the study and its contributions to the literature. Further, the chapter

outlines the research objectives and presents the layout of the thesis.

Chapter 1: Overview of the Thesis

2

1.2 Background

Corporate collapses such as Enron, Qwest, Xerox, WorldCom and HIH Insurance reflect

the failure of conventional accounting and auditing practices. The demise of Arthur

Anderson has further questioned the integrity of financial reporting. Such failures raise

concern about financial reporting, auditing, corporate regulations and the accounting

profession as a whole. Thus, as Fraser and Ormiston (2001:25) state,

The sharper and clearer the picture presented through the financial data and the

closer that picture is to the financial reality, the higher is the quality of financial

statements and reported earnings.

In an effort to improve the quality of financial reporting, the international accounting

profession has taken a number of steps. These include improving the audit committees’

strength and independence, pushing for greater focus on auditor independence and

increasing the review of filings submitted by public companies to detect earnings

management (Behn et al., 2002).

Earnings management is not a new phenomenon. It has received attention from

regulators, practitioners and the media. Several studies strongly suggest that earnings

management is becoming a common practice in firms (Healy, 1985; McNichols and

Wilson, 1988; DeFond and Jiambalvo, 1994; Natarajan, 1999; Nelson et al., 2002;

Beneish and Vargus, 2002 and Palliam and Shalhoub, 2003). As one of their major

findings, the Sponsoring Organisations of the Treadway Commission concluded that

more than 50% of the financial reporting frauds that took place among the USA public

companies over a period from 1987–1997 involved overstatement of revenue (Palliam

and Shalhoub, 2003).

In the literature, earnings management is also referred to as creative accounting,

income/earnings smoothing, financial engineering and cosmetic accounting. It occurs

when managers use judgment in financial reporting and in structuring transactions to

alter financial reports with intentions of either misleading stakeholders about the


3

underlying economic performance of the company or to influence the contractual

outcomes that depend on reported accounting numbers (Healy and Wahlen, 1999).

Opportunities for these practices arise because accounting standards allow for flexibility

and judgment in selecting the reporting methods, estimates and disclosures that reflect a

firm’s economic conditions (Vinciguerra and O’Rielly, 2004). Thus, it becomes

important to study earnings management as such practices obscure the firm’s intrinsic

value.

1.3 Justification and Contributions of the Study

Studies on earnings management has mainly focused on the developed economies, such

as the USA, UK, Canada and some continental European countries. In developing

countries, however, such studies are rare and to date, none has been undertaken in the

Pacific Island Economies. As institutional and regulatory differences exist between

developed and developing countries, it is difficult to extrapolate findings/evidences from

one to another. With this gap in the literature, this thesis attempts to examine earnings

management practices in two SOEs in Fiji, which has a relatively weaker financial

regulatory environment than the developed countries. Unlike the USA, Australia and

New Zealand, the accounting standards in Fiji do not have a legal backing.

Consequently, a weaker regulatory environment would permit higher levels of

manipulation.

Furthermore, Fiji is no exception when it comes to failures in financial reporting. An

excellent example is the economic losses incurred when the state owned bank, National

Bank of Fiji (NBF), collapsed. Grynberg et al. (2002) provide a comprehensive insight

into the collapse of the NBF. They describe the NBF’s case as the "largest known

financial scandal in the history of Fiji and the Pacific Islands". According to them, the

bank's failure resulted from corruption, mismanagement and improper accounting

practices. For instance, loans were advanced without adequate security followed by lack

of monitoring of these loans. These peaked in 1996 when bad and doubtful debts

Chapter 1: Overview of the Thesis

4

amounted to $220 million, representing 8% of Fiji's GDP. The NBF failed despite

regulations and monitoring by the Reserve Bank of Fiji (RBF), the Auditor General and

the Ministry of Finance. Its failure emphasised the need for good financial disclosures,

sound corporate governance and robust banking supervision.

The literature on earnings management heavily concentrates on the private sector while

little is known about the prevalence of such practices in different institutional

environments. SOEs, an important sector, particularly in the developing countries, have

been examined in a few studies only (Likerman, 1983 and McInnes, 1990a and 1990b).

Many large organizations in Fiji are state owned, hence substantial investments are made

to these entities. Despite their importance, earnings management in SOEs has been

largely overlooked. Consequently, this study attempts to extend the existing earnings

management literature by exploring two SOEs in Fiji.

Studies on earnings management have mainly used quantitative techniques, the most

common being the variants of the accruals models. However, these models are

constrained by measurement error and their use is limited to the developed countries that

can meet the data requirements (see discussions in Chapter 4). In contrast, this study

examines earnings management using a different approach, viz, the checklists designed

by Mulford and Comiskey (2002). It may be noted that this is a pioneering attempt to

explore earnings management using the qualitative method in the case of a developing

country.

The study is useful to the Fiji Institute of Accountants, the accounting standard setting

body in Fiji, as it identifies

• the specific accounting standards that are used to practice earnings management;

• the extent to which managers misuse accounting discretion and judgment permitted

by the standards and

• the specific accruals that are commonly used to employ such practices in the

aforesaid entities.


5

Finally, the study has implications for the auditors of the two entities and the auditing

profession as a whole. The findings would indicate if their audit procedures are adequate

to identify earnings management practices and the areas which require more scrutiny.

1.4 Objectives of the Study

The objectives of this thesis are two-fold. Firstly, it attempts to identify the presence of

earnings management behaviour in the two aforesaid SOEs in Fiji. Secondly, the study

aims to determine the motivations for such practices.

1.5 Organisation of the Thesis

This thesis comprises of seven chapters. The current chapter is an overview of the thesis.

A brief survey of earnings management literature is in Chapter Two. Chapter Three

describes Fiji's SOEs and discusses the possibilities of earnings management in these

entities. Chapter Four outlines the methodology adopted in the study and justifies the

choice of the qualitative approach over the well-known accruals models. The next two

chapters analyse and discuss the results of earnings management in the two entities and

conclusions and limitations are stated in the final chapter.

Chapter 2: Understanding Earnings Management Behaviour

6

CHAPTER TWO

UNDERSTANDING EARNINGS MANAGEMENT BEHAVIOUR

2.1 Introduction

This chapter presents a brief survey of the earnings management literature. It

concentrates on two major issues; why earnings management occurs and how it is

possible in the presence of accounting regulation.

2.2 Why Does Earnings Management Occur?

The agency theory has been used to explain earnings management behaviour. According

to Jensen and Meckling (1976), an agency relationship is a contract under which one or

more persons-the principal(s), engage another person-the agent, to perform some service

on their behalf that involves delegating some decision making authority to the agent. If

both parties are utility maximisers, it is reasonable to believe that the agent will not

always act in the best interest of the principal. Agency problems arise because of

asymmetric information between the two parties, where the management possesses a

more complete set of organizational information relative to the current and potential

stakeholders. Proprietary costs of disclosure, accounting rules and other institutional and

contractual constraints suggest that there is restriction on total communication

(Richardson, 2000). Thus, when management does not communicate all information,

conflict exists between the privileged agents and the remote body of stakeholders.

Richardson provides empirical evidence that information asymmetry is a necessary

condition for earnings management. Using a broad sample of firms, he finds a positive

relationship between the levels of information asymmetry and earnings management.


7

This is justified on the basis that when information asymmetry increases, stakeholders

may not have the necessary information to see through the manipulation of earnings.

Alternatively, an environment with a high level of information asymmetry suggests that

stakeholders do not have sufficient resources, incentives or access to relevant

information to monitor management’s actions, which can also give rise to earnings

management. Thus, it is both logical and inescapable that management behaviour will be

self-serving within the agency relationship (Amat and Gowthorpe, 2004). Hence, agency

theory is a solid framework for understanding earnings management as it provides the

agents with economic incentives to manipulate the financial results. The following

section describes the major incentives found in the literature.

2.2.1 Managerial Compensation Effects

One of the most common incentives for earnings management is the manager’s

remuneration package. The employment contract of management often includes

accounting based constraints that determine compensation opportunities, such as annual

salary increases, management bonus, performance evaluation, reaching targets set in the

compensation contracts. It is logical that where management's remuneration is based on

the level of profits, they will manipulate it either to increase or smooth their income.

Healy (1985) is among the first to propose this argument. His study shows how upper

and lower bounds on executive bonus packages encourage managers to make

discretionary accounting accruals in a strategic manner. A common form of

compensation contract specifies the minimum level of profits to grant bonuses. Hence,

such contracts provide incentives for income-increasing or income-decreasing earnings

management depending on the actual level of profits attained in a particular period.

Using accruals and changes in accounting procedures, Healy finds that as long as profits

fall within the minimum and maximum boundaries, managers choose income-increasing

accruals. However, when earnings are above the maximum level, managers tend to move

towards income- decreasing accruals.


8

Using a sample of 102 firms for the period 1980-1990, Gaver et al. (1995) extend

Healy’s study by examining the relationship between discretionary accruals and bonus

plan bounds. Contrary to Healy, they find that when earnings before discretionary

accruals are below the lower bound, managers select income-increasing discretionary

accruals (and vice versa). They believe that these results are more consistent with

income smoothing hypothesis than with Healy's bonus hypothesis. However, they do not

rule out the mechanical selection bias in portfolio formation as an alternative

explanation for their results.

Guidry et al. (1999) test and validate Healy’s hypothesis by examining business-unit

managers. They use business unit-level data as this reduces the aggregation problem that

arises from firm-level data. Also, as managers will be paid bonuses based solely on

business-unit earnings, the confounding effects of long-term performance and stock-

based incentive compensation will be absent. Guidry et al. find that business-unit

managers manipulate earnings to maximize their short-term bonuses.

2.2.2 Borrowing Cost Effects

Debt contracts provide another incentive for earnings management. These contain debt

covenants, which are described by Mulford and Comiskey (2002) as stipulations

included in debt agreements designed to monitor corporate performance. For example, a

lender might instruct that a certain value for an accounting ratio be maintained or impose

limits to investing and financing activities. Violating the covenants could result in the

lender increasing the interest rate, requiring additional financial security, or in extreme

cases, calling for immediate repayment. Therefore, debt covenants provide incentives for

earnings management either to reduce the restrictiveness of accounting based constraints

in debt agreements or to avoid the costs of covenant violations (Beneish 2001).


9

Studies investigating the debt covenant hypothesis postulate that managers have

incentives to make financial reporting decisions that reduce the likelihood of violating

debt covenants. Using a sample of USA firms that actually violated their lending

covenants, DeFond and Jiambalvo (1994) find that firms accelerate earnings one year

prior to the violation. They interpret this behaviour as evidence of earnings management

by firms that are close to violating their lending covenants. Sweeney (1994) also finds

that covenant violators manipulate earnings, but in the year(s) following rather than prior

to the violation. This behaviour suggests that earnings are not managed specifically to

avoid violating a lending contract but to reduce the likelihood of violating them in the

future. In order to provide large-sample tests of the debt covenant hypothesis, Dichev

and Skinner (2002) use a database of private lending agreements for USA firms. They

find an unusually small number of loans with financial measures just below covenant

thresholds and an unusually large number of loans with financial measures at or just

above covenant threshold. They provide strong evidence that managers take actions to

avoid debt covenant violations.

2.2.3 Equity Offerings

Issuing shares provide a direct incentive to manage earnings since firms that report a

higher earnings power tend to witness a favourable effect on share prices. From the

firm’s perspective, a higher share price implies an increase in its market valuation and a

reduction in cost of capital. As Dechow and Skinner (2000) state, to the extent that

managers can increase reported earnings without being detected, they can improve the

terms of the public offer, providing direct monetary benefits to themselves and their

firms. Studies examining this incentive test whether managers manipulate earnings in

periods prior to initial public offers (IPO) and seasoned equity offers. The IPO process is

susceptible to earnings management since the information is highly asymmetrical

between the investors and IPO issuers. As there is no previous price on the market,

manipulating earnings would increase its introductory price. Using a sample of 1649

IPO firms in the USA, Teoh et al. (1998a) examine the relationship between


10

underperformance of IPOs in the subsequent periods and earnings management. They

find evidence that issuers with unusually high accruals in the IPO year experience poor

stock returns in the three years thereafter and conclude that the underperformance is

largely the result of earnings management in the IPO year. Similarly, Rangan (1998) and

Teoh et al. (1998b) provide evidence that earnings are managed at the time of seasoned

equity offerings. Their studies show that at the time of the issue, firms report unusually

high earnings due to unusually high accruals. However, in the subsequent years, they

report poor earning performance. Both studies find strong association between the extent

of earnings management and subsequent stock returns.

2.2.4 Management Buyout

In the previous section, it was noted that upward earnings management is practiced at

the time of equity offerings. However, earnings are managed downwards in the case of a

management buyout. The management is faced with a conflict in such a situation. They

have a fiduciary duty to the shareholders to get the best price for the firm. However, as

buyers, managers would not want to pay a high price. Therefore, they have an incentive

to report reduced earnings prior to the buyout. As earnings information play an

important role in valuation of management buyouts, DeAngelo (1986) claims that

management of buyout firms would understate earnings. She uses a sample of 64 New

York and American Stock Exchange companies over the period 1973-1982, whose

managers proposed to buyout the firm. However, DeAngelo finds little evidence of

earnings management by examining the changes in accruals. In support of her finding,

she asserts that shareholders carefully scrutinize financial statements to detect any

manipulation by the management. A similar study was undertaken by Perry and William

(1994), using a larger sample of 175 management buyouts during 1981-88. By

examining discretionary accruals, they provide convincing evidence of income-

decreasing earnings management prior to a buyout.


11

2.2.5 Meeting Analysts’ Expectations

Financial analysts or the management often forecast the entities expected earnings prior

to its financial year-end. Studies have examined whether earnings are managed to meet

these expectations. Among other things, DeGerorge et al. (1999) examine if companies

manage earnings to meet analysts’ earnings forecasts. They use a large sample of USA

firms over the period 1974-1996 and find that firms report abnormally high earnings just

to meet or exceed the analysts’ forecast. Kasznik (1999) investigates whether managers

who issue annual earnings forecasts practice earnings management to meet their

forecasts. Using 499 firm-years (366 firms) with management earnings forecasts issued

between 1987 and 1991, he provides evidence that when earnings are below

managements' forecasts, positive discretionary accruals are used to manage earnings

upwards.

2.2.6 Reduce (Increase) Regulatory Costs (Benefits)

Regulatory considerations can also induce firms to misreport financial performance.

Firms that are vulnerable to anti-trust investigations/other adverse political consequences

or seeking government subsidy/protection have incentives to manage earnings to appear

less profitable. Jones (1991) examine whether regulatory scrutiny increases the

likelihood of earnings management by firms benefiting from import relief assistance,

such as tariff increases and quota reductions. Empirically examining 23 firms from 5

different industries that are investigated by the United States International Trade

Commission, Jones finds convincing evidence that the firms practiced income-

decreasing earnings management during the investigation period in order to qualify for

the import relief assistance. Cahan (1992) investigates the effects of monopoly related

antitrust investigations on firms reported earnings. He uses a sample of 48 firms that

were investigated for monopoly related violations by the USA’s regulatory agencies

between 1970 and 1983 and finds that firms under scrutiny reported income-decreasing

discretionary accruals in the investigation years.


12

To conclude the discussion on earnings management incentives, it is appropriate to note

that the presence of earnings management will depend not only on the incentives for

such practices, but also on internal and external control procedures. These could include

entity's internal governance structure, previous accounting decisions made by the firm

that limit future discretionary choices and the costs imposed on the entity when earnings

management is revealed (Becker et al., 1998).

Furthermore, of the incentives discussed above, some are income-increasing incentives

while others are income-decreasing. In reality, entities can face multiple incentives at the

same time. If all motivate the management of earnings in an upward or downward

direction, then the number of incentives present does not matter as they will lead to

either income-increasing or income-decreasing earnings management. However,

incentives of opposing directions are impossible to pursue simultaneously. In such

circumstances, the management would seek to manage other aspects of the financial

report. A similar observation was also made by Mr. Prasad, the former Chief Executive

Officer of the Housing Authority, during an interview, see quotation below:

You will find in the Fiji context that each stakeholder is maximising their relative

utility in the final outcome of the reported results. And more often than not, for

each to keep their position, a consensus is reached and justified before the final

figures are reported.

Such a scenario was noted while analysing the Fiji Electricity Authority (see Chapter 6

for detailed discussion). In 2004, it wanted to attract external financiers and at the same

time increase electricity tariff rates. In order to achieve the former objective, the FEA

had to report increased earnings while the later required evidence of reduced

profitability. Therefore, in such cases, one needs to clearly understand the incentives and

their effects in order to see through the manipulations.


13

2.3 How Does Earnings Management Occur?

Annual financial reports contain a wealth of information that could be used by various

stakeholders for different purposes. Despite its importance, the preparers of financial

reports enjoy considerable latitude when reporting transactions. Accounting standards

allow scope for flexibility and judgment in preparing financial reports. Healy and

Wahlen (1999) argue that accounting standards must allow these so that management

can convey information to the stakeholders about the entity's performances. On the other

hand, given that auditing is imperfect, corporate insiders can also abuse this flexibility to

hide the true performance and achieve a desired earnings figure.

According to Mulford and Comiskey (2002) and Fraser and Ormiston (2001), one of the

ways of practicing earnings management is through a firm’s selection policies that are

employed to present financial reports. They further state that the selection and

application of generally accepted accounting principles (GAAP) is flexible, leaving

room for exercising professional judgment in several cases. Upon reviewing the

corporate financial reporting practices, Loomis (1999, c.f. Brewer et al., 2002:2) asserts

that

…managing earnings is the fundamental motivation for many accounting frauds.

Missing earnings estimates by even a penny is interpreted as an important failure, in

part because managers have so many earnings management tools at their disposal.

The gaps and flexibility in the accounting standards allow a greater variety of accounting

results. Findings of Nelson et al. (2002) point out that earnings management occurs in

several accounting areas such as revenue recognition, business combination, intangibles,

fixed assets, investments and leases and the most frequently identified is reserves. These

practices can include accounting treatments that are intentionally aggressive,

conservative or fraudulent financial reporting. The former two treatments are within the

boundaries of accounting standards while fraudulent financial reporting is outright

violation. Dechow and Skinner (2000) argue that a within-GAAP choice can be

considered earnings management only if it is used to obscure the true economic position


14

of the entity. They further argue that to determine whether a particular choice is earnings

management or a legitimate managerial judgment hinges on managerial intent. The

following table illustrates how the accounting philosophy and GAAP interact to create a

range of accounting policy choices.

Table 2. 1 The Relationship between Accounting Philosophy and GAAP

Accounting philosophy

“Conservative” accounting

“Neutral” accounting

“Aggressive” accounting

“Fraudulent” accounting

Relationship with GAAP

Within GAAP Violates GAAP

Impact

Examples Accounting policy changes

-overly aggressive recognition of provisions or reserves -overstatement of restructuring charges and asset write-offs.

-earnings that result from a neutral operation

-understatement of bad debts provision -drawing down provisions or reserves in overly aggressive manner

-recording sales before realisable -recording fictitious sales -backdating sales invoices -recording fictitious inventory

“Real” Cash Flow Choices

-delaying sales -accelerating R&D or advertising expenditures

-postponing R&D or advertising expenditures; -accelerating sales

(Adapted from DeChow and Skinner 2000 and Auditing and Assurance Standards Board 2001.)

Amat and Gowthorpe (2004), Brewer et al. (2002), Healy and Wahlen (1999) and Blake

et al. (1998) discuss several potential areas for earnings management resulting from the

accounting standards. Based on their studies, these areas can be grouped into the

following categories:

1. Management exercises judgment in order to estimate several future economic events.

These events include the expected lives and salvage values of long-term assets,

obligations for pension benefits and other post employment benefits, deferred taxes,

and losses from bad debts and asset impairment. McNichols and Wilson (1988)

examine the discretionary and non-discretionary elements of bad debts provisions

Tendency to understate earnings and overstate liabilities

Tendency to overstate earnings and assets


15

and found evidence of earnings management by firms with unusually high or low

earnings.

2. Managers can report the same economic transactions using a range of acceptable

accounting methods. For instance, non-current assets can be depreciated using

straight line or accelerated depreciation method. Likewise, inventory could be valued

using First In First Out or weighted average methods or borrowing costs can be

treated as part of the cost of the asset or an expense. Schipper (1989) points out that

the effects of these changes can easily be identified in the year of change but it is less

readily discernible thereafter.

3. Management exercise judgment when evaluating whether a transaction meets the

criteria for a particular accounting treatment. For example, for an item to be

extraordinary (when this was permitted by GAAP), it has to be both unusual and

infrequent.

4. Management can decide the timing of genuine transactions in order to give the

desired impression. That is, they can make or defer expenditures, such as research

and development, advertising or maintenance.

5. Management can choose how to structure corporate transactions so that the financial

statements can be manipulated. For example, in a sale and leaseback arrangement,

the sale proceeds of the asset could be artificially increased or decreased, with an

equivalent adjustment to related rental payments. Another possibility relates to

equity investments, which can be structured to avoid or require consolidation.


16

2.4 Conclusion

In an environment where the users and preparers of financial reports have asymmetric

information, the agency relationship and the flexibility permitted by the accounting

standards can be used to explain the presence of earnings management. The principal-

agent relationship provides the agents with economic incentives to practice earnings

management and flexibility in accounting regulation provides the management avenues

to manipulate the financial outcome. Therefore, it can be concluded that managers face a

wide variety of financial reporting situations in the real world and a correspondingly

wide variety of opportunities and methods to misreport the financial performance of

their organisations.


17

CHAPTER THREE

EARNINGS MANAGEMENT IN STATE OWNED ENTERPRISES

3.1 Introduction

The chapter begins with a general introduction of the SOEs in Fiji. It then discusses the

possibilities of earnings management in these types of entities by relating the economic

incentives identified in the previous chapter, reviewing their accounting environment

and evaluating the influence of cultural factors.

3.2 Institutional Background

Every economy has SOEs to control certain economic activities. These entities engage in

the provision of essential utilities and services such as electricity, aviation, housing and

seaports, to name a few. SOEs are an essential part of Fiji's economic environment as

many of the largest organisations in Fiji are state owned. These entities are large

consumers and producers of resources in Fiji's economy hence provide essential

products and services. This study concentrates on state owned enterprises that are fully

owned by the government. These enterprises are divided into two major categories,

Government Commercial Companies (GCC) and Commercial Statutory Authorities

(CSA). The following table lists the SOEs in Fiji and the year when they were

established.

Chapter 3: Earnings Management in SOEs

18

Table 3. 1 List of State Owned Enterprises

Government Commercial Companies Commercial Statutory Authorities

Airports Fiji Limited (1998) Civil Aviation Authority of Fiji Islands (1997)

Fiji Broadcasting Corporation Limited (1997) Fiji Electricity Authority (1966)

Fiji Hardwood Corporation Limited (1998) Housing Authority (1958)

Fiji Shipbuilding Corporation Limited (2001) Maritime and Ports Authority of Fiji (1998)

Food Processors Limited (2003) Public Rental Board (1989)

Ports Terminal Limited (1997)

Post Fiji Limited (1996)

Rewa Rice Limited (1960)

Unit Trust of Fiji (1976)

Viti Corps Corporation Limited (1995)

Yaqara Pastoral Company Limited (1973)

(Adapted from Ministry of Public Enterprises and Public Sector Reform Annual Report 2003)

These entities are administered by the Ministry of Public Enterprises and Public Sector

Reform. The Ministry monitors compliance with the financial reporting and disclosure

requirements of the Public Enterprise Act 1996. The Boards of GCCs are directly

responsible to the Minister for Public Enterprises for their performances while CSAs

report directly to their respective line ministries who appoints their Boards (such as the

FEA reports to the Minister responsible for energy and the HA to the Minister

responsible for housing). These entities are liable to report regularly and be accountable

to their respective authorities. The Public Enterprise Act is intended to improve their

accountability to the government and the public. The Act requires these entities to

submit the following documents to the Minister:

� half-yearly report within two months after the end of the first half of the year or

later after consulting the Minister responsible;

� draft annual report and the unaudited financial statement within three months

after the end of each financial year and

� annual report with audited financial statements within five months after the end

of each financial year.


19

The SOEs financial accounts are audited annually in accordance with the provisions of

the Companies Act and any other legal requirements. They prepare a Corporate Plan,

which specifies forecasts relating to the current and the following financial year's profit

and loss account, balance sheet, sources and applications of funds, cash flows and a

statement of the assumption on which the forecasts are based. The respective Boards

ensure that the entities act in accordance with their Corporate Plan. Additionally, each

SOE prepares a Statement of Corporate Intent. This is an annual document summarising

the main elements of the SOE's Corporate Plan and other matters set out in the Public

Enterprise Act. The Statement lists the financial and non-financial performance targets

for the relevant year. Furthermore, all SOEs prepare an Employment and Industrial

Relations Plan, which articulates the major employment and industrial relations issues

for the entity.

The government provides equity and debt finance to SOEs but receives returns only

from profitable ones. As of 2002, the government required the SOEs to achieve a 10%

benchmark required rate of return on shareholders funds, which is used as a financial

performance indicator for successfully operating SOEs. Government also provides

substantial amount of grants to SOEs. Not only this, as the owner, the government is

often explicitly required to guarantee loans for these enterprises. Although SOEs

generate revenue for the government and are a major source of employment for the local

population, many enterprises often incur large losses. According to the Minister for

Commerce, losses from SOEs are around $20 million a year, including forgone revenue

(Ministry for Commerce, 1998). He further states that if CSAs had paid income tax on

profits between 1988 and 1995, government would have received an additional $50

million. The financial performance of the GCCs and the CSAs over the recent years is

reflected in Table 3.2.


20

Table 3.2 Financial Performance of State Owned Enterprises

2001 2002 20031

Net Profit Before Tax ($m)

GCC 2.36 2.07 1.00

CSA 2.66 2.05 7.55

Total Assets($m)

GCC 330.51 358.17 391.85

CSA 702.91 748.37 758.84

Return on Assets (%)

GCC 2.87 3.88 2.19

CSA 0.67 1.86 2.14

Shareholders Funds($m)

GCC 107.01 294.68 308.13

CSA 359.69 477.38 487.89

Return on Equity (%)

GCC 9.43 6.43 4.44

CSA (2.63) 1.89 2.29

(Adapted from Ministry of Public Enterprises and Public Sector Reform Annual Report 2004)

The major factors contributing to the poor performance of most SOEs are identified by

the Ministry of Public Enterprises and Public Sector Reform as follows:

� multiple and often conflicting objectives such as commercial, social and

regulatory;

� there is lack of commercial orientation;

� continued reliance on government for financial support;

� lack of accountability on performance leading to a lack of incentive for improved

efficiency;

� government intervention in the decision making for public enterprises;

� protection from competition so there is lack of incentive for improving

performance and

� with regard to the FEA, meeting universal service obligations2.

(Ministry of Public Enterprises and Public Sector Reform Annual Report, 2000:6)

1 Figures beyond this are not available. 2 This is an additional item added to the list as FEA used this factor to justify its reduced profitability (see Chapter 6).


21

3.3 Possibilities of Earnings Management in SOEs

3.3.1 Economic Incentives

While Chapter 2 discussed several economic incentives for earnings management in the

private sector, the following section aims to relate those incentives to the SOEs in Fiji.

Although, management compensation is one of the common incentives in the private

organisations, it is not highly prevalent in the public entities. However, in order to

improve performance, some SOEs have implemented performance based contracts, for

instance, the Housing Authority in 1993. Therefore, the executive management of these

entities have incentives for earnings management. Further, the extent of the borrowing

cost incentive in the public sector is not very clear. No doubt, SOEs require large

amount of debt finance from the local as well as international lending agencies, who

would impose certain debt covenants. However, in most of the cases, government

guarantees the debt of these enterprises. For instance, contingent liabilities of

government in relation to government guarantees of SOE borrowings were $213 million

in 2004 (Parliamentary Paper, 2005). These entities may not worry if they violate the

debt covenants. Alternatively, the government as the guarantor of debts may exert

pressure on them to meet the covenants. Therefore, it is not clear if the borrowing cost

would provide an incentive to the SOEs for earnings management.

The incentive of equity offerings does not exist in the SOEs; but only in the publicly

listed firms. Although, management buyout is not a common practice in Fiji,

government considers it as one of the methods for privatising SOEs3. For instance, there

was an attempt of a management buyout of Rewa Rice Limited in 1999 when the

government was planning to sell off its shares. However, the management's offer was

declined. Thus, management buyout is an option, but it has never occurred for an SOE in

Fiji.

3 Other methods of privatisation include the sale of shares or assets, leasing and outsourcing.


22

Of the incentives discussed in the previous chapter, the one that is highly relevant to

Fiji’s SOEs is that of reducing regulatory cost or increasing regulatory benefit. These

enterprises rely heavily on government assistance, such as grants, subsidies and/or

government guarantees on loans. Therefore, it is expected that SOEs would be inclined

to report conservative earnings so that they can qualify for government grants/assistance.

Pathik's study in 1999 supports this argument. One of her findings was that in the year

the government was planning to withdraw their financial assistance, the Housing

Authority misclassified government grant in its financial reports. As a result of the

misclassification, the Housing Authority was able to report lower earnings as it feared

that large profit would provide the needed rationale to the government to withdraw their

assistance. This is an example of a SOE reporting conservative earnings in order to

continue receiving government grants.

Apart from the private sector incentives, there could be other incentives present in the

SOEs, which may drive them towards earnings management. One of these could be for

purposes of job security. These enterprises are generally characterised as poor

performing entities and therefore, the management is often pressured by the key

stakeholders to perform and failing to do so could cost them their jobs. There have been

instances where the management had been sacked because of poor performance, such as

in Airports Fiji Limited and Fiji Electricity Authority. Thus, to retain their jobs, the

management has the incentive to manipulate financial performance of the organization.

A contrasting feature of the SOEs to the private sector is their social obligations in

addition to the financial objectives. Social objectives would provide reasons to report

conservative earnings, as reporting higher than average profits would instigate a public

scrutiny. Moreover, SOEs that intend to increase the tariff rates (unit cost of supplying

the commodity) would not want to show high profits. For instance, the Fiji Electricity

Authority planned to raise their tariff rates but they could not justify the increase with

high profits as this will be objected by the public (see Chapter 6 for details). Finally,

entities would attempt to manage earnings downwards when there are strong trade

unions. Trade unions with strong negotiating powers will demand wage increments


23

when the entity continues to report high profits. Apart from these general incentives,

there could be other entity-specific incentives to practice earnings management, which

would be known by investigating the individual organizations.

3.3.2 Accounting Regulation

The Fiji Institute of Accountants (FIA) was established in 1972 under the provisions of

the Fiji Institute of Accountants Act with the objective of registering accountants and

regulating the practice of accountancy in Fiji. The FIA Council appoints various

committees, one of which is Accounting and Auditing Standards Committee, responsible

for issuing accounting and auditing standards4. This Committee promulgates Fiji

Accounting Standards (FASs) that serve as the basis for preparing financial statements.

The institute is a member of the International Accounting Standards Board (IASB) and

the International Federation of Accountants, and therefore, the Institute's standards are

highly influenced by these governing bodies. Over the period 1976 to 1998, the FIA had

issued 28 standards that were largely based on International Accounting Standards

(IASs). However, Australian and New Zealand accounting standards were also adapted

when these were seen to be relevant to the Fijian society5. In early 1999, the Council

decided to adopt the IASs as the basis for a completely new set of FASs. Consequently,

a two-year comparative review began in November 1999, which concluded that FIA

would apply all extant IASs numbered 1-31 with the exception of IAS 12 with effect

from 1 July 2002. IAS 12 and 32-39 were regarded as guidance standards6. Furthermore,

in order to achieve international standards in accounting, the FIA will be adopting

International Accounting and Financial Reporting Standards (IFRS) from 1st January

2007. The adoption was initially set for January 2006 but was deferred when the Council

4 Detail explanations of the standard setting process in Fiji are provided in Chand (2003) and Pathik (1999). 5 These include FASs 2, 7, 8,12,14,17, 101, 102 and 103. Since 2002, only FASs 101, 102 (now withdrawn) and 103 were drawn from Australia and New Zealand. 6 FASs 15, 19 and 26 also had guidance status.


24

realised that a longer lead time was required to obtain IFRS compliant comparative

figures than was first thought7.

Thus, the accounting standards applied in Fiji are almost entirely based on IASs, which

provides flexibility in financial reporting. Also, it is worth pointing out that IASB

applies principle-based approach in standard setting process. Consequently, the FAS

requires the accountants to exercise professional judgment. One such example is the

accounting standard on leasing that requires the accountant to use qualitative

benchmarks to distinguish between operating and financing lease instead of quantitative

guidelines. Furthermore, IASs are developed mainly on the basis of accounting

standards that prevail in the developed countries of the UK and USA. Therefore, if the

IAS or equivalent in these countries provided opportunities to manage earnings then the

use of the same standards is also likely to enable such behaviour in adopting countries,

like Fiji.

The Surveillance Panel of the FIA is responsible for monitoring compliance with the

accounting standards. However, so far there has been minimal effort to enforce

compliance. This is firstly because the law does not mandate the accounting standards so

on several occasions, the Panel’s observations are ignored. Further, the Panel cannot

always access all the reports they wish to review. The existence of such behaviour is

perhaps a useful insight into ambivalence within the profession as on one hand the

profession enforces compliance and on the other hand it is not helping to achieve the

desired goal. Secondly, the committee mainly has to rely on volunteer members. This

problem is further compounded as the country loses qualified skilled personnel through

emigration. Also, most of the members who possess the necessary expertise are

precluded from the membership into the Panel due to their workplace associations.

Earnings management practices mainly occur within the boundaries of accounting

standards so if the Panel is weak in monitoring compliance, it would be weaker in

detecting manipulations. This provides additional opportunities for earnings

management in Fiji. 7 IFRS 1 First-Time Adoption of International Financial Reporting Standards requires the compilation of an IFRS compliant balance sheet two years prior to formal adoption.


25

Barton and Simko (2002) argue that although generally accepted accounting practices

require managers to make numerous judgments and assumptions to report their firm's

performance, managers do not have unlimited discretion to do so. The accounting

regulators such as the Securities and Exchange Commission and the Financial

Accounting Standards Boards, along with professional bodies like the American Institute

of Certified Public Accountants, provide rigorous guidelines and oversight. On the

contrary, Fiji does not have such bodies that would limit managers' use of discretion.

This suggests that there is even higher scope for earnings management in Fiji.

3.3.3 Cultural influences

The environment in which businesses operate consists of four elements: legal, political,

economic and cultural (Miroshnik, 2002). Culture is “the collective programming of the

mind which distinguishes the members of one human group from another” (Hofstede

1980: 25, c.f. Greer and Patel, 2000). Different cultural environments differ in their

norms and behaviour. According to Dressler and Carns (1969), culture allows us to

communicate with others through a common language. It gives us standards for

distinguishing between conditions such as what is right or wrong. It makes it possible to

anticipate how others in our society are likely to respond to our actions. (c.f. Miroshnik,

2002).

Studies have recognised the importance of cultural factors in shaping a country’s

accounting system (see Fechner and Kilgore, 1994). Some have argued that accounting

in fact is determined by culture. Accordingly, Hines (1992) states that accounting

language is a reflection and social production of a particular set of cultural values and

conceptions of reality (c.f. Greer and Patel, 2000). Culture tends to influence the

accounting standard setting process, behaviour of entrepreneurs and managers,

accountability issues, alternate accounting controls and many others.


26

Hofstede’s (1980) predominant approach has identified four distinct cultural dimensions.

These include Uncertainty Avoidance, Power Distance, Individualism and Masculinity.

Uncertainty Avoidance measures the extent to which people in a society feel threatened

by ambiguous situations, and the extent to which they try to avoid these situations by

providing greater career stability, establishing more formal rules and rejecting deviant

ideas. It reflects the willingness to undertake risks and the preference for security. Power

Distance relates to the degree to which cultures accept a more autocratic structure or the

degree to which participation is favoured. It measures the extent to which the less

powerful members of societies accept the unequal distribution of power. The

Individualism dimension addresses the issue of interdependency between a society and

its individuals. It measures the extent to which people feel they are supposed to take care

or be cared for by themselves, their families or organizations they belong to. It considers

the relative importance placed on the individual as opposed to the group. Masculinity

measures the extent to which a culture is conducive to dominance, assertiveness and

acquisitions of things. It considers the relative importance placed on income recognition

and advancement.

Countries can be differentiated on the basis of the cultural dimensions identified by

Hofstede. Although these dimensions are diminishing, Chand (2003) argues that there

exist cultural differences between Fiji and the developed countries. The dimension that

differentiates Fiji from the developed countries and has implications for earnings

management is power distance. Relative to the countries like the UK and USA, Fiji is

considered to be a large power distance society. This implies that the Fijian society

accepts the hierarchical order in which everybody has a place and they do not require

justification. Thus, the management knows that financial reports prepared by them

would be accepted as given without questioning. Hence, the cultural value of large

power distance reduces the chances of detecting any creative accounting practices.

Similarly, Chand and White (2006) argue that in general Fiji society exhibits large

power distance. However, contrary to their expectation, they found that accountants are

comfortable in making judgments. Their results are surprising as it is not a consistent

behaviour given a range of cultural factors. Nonetheless, they suggest that the


27

accounting community is 'accultured'. That is, it has its own professional culture rather

than the culture of the various ethnic groups they are drawn from. There is, therefore, a

possibility that instances of earnings management will not be challenged in Fiji,

irrespective of whether the accountant's judgments has been exercised to facilitate or

inhibit it.

3.4 Conclusion

There are possibilities for earnings management in Fiji’s SOEs. Although, the economic

incentives are not the same as in the previously examined publicly listed companies,

there exist incentives in the SOEs that could drive them towards earnings management.

Further, the weak accounting regulation and the cultural influences produce an

environment that is conducive to earnings management.

Chapter 4: Methodology

28

CHAPTER FOUR

METHODOLOGY

4.1 Introduction

This chapter briefly reviews the empirical models used in the literature to identify

earnings management practices and evaluates their applicability to Fiji. It then justifies

and explains the research method employed in this thesis.

4.2 Empirical Models of Earnings Management

Earnings management has been empirically investigated in many studies using the

variants of the accruals models (see Phillips et al., 2003; Frankel et al., 2002; Beneish

and Vargus, 2002; Heninger, 2001; Natarajan, 1999 and Dechow et al., 1995)8. The

traditional models by Healy (1985) and DeAngelo (1986) are simple since total accruals

are used to measure earnings management. The Healy Model assumes that earnings are

manipulated in a systematic manner over the years. Therefore, it calculates non-

discretionary accruals9 using the average of total accruals scaled by lagged total assets

during the estimation period. The DeAngelo Model calculates non-discretionary accruals

by taking a ratio of lagged total accruals to lagged total assets on the assumption that

non-discretionary accruals are constant. However, Kaplan (1985, c.f. Dechow et al.,

1995) strongly objects to this assumption and suggests that the very nature of accrual

accounting dictates that the level of non-discretionary accruals varies in response to

changes in the economic conditions.

8 Dechow et al. (1995) and Bartov et al. (2000) provide a detailed discussion of these models. 9 Total accruals is the difference between earnings and net operating cash flows. Discretionary accruals is the difference between total accruals and nondiscretionary accruals.

Analyses of Earnings Management Practices in Fiji's SOEs

29

Consequently, the Jones Model (1991) (JM, henceforth) relaxes this assumption by

controlling for the variables that cause changes in non-discretionary accruals. The

controlling variables are revenue and gross property, plant and equipment. Revenue

controls the economic environment of an entity as it is an objective, although not

completely exogenous, measure of the entities operations before managers’

manipulation. Gross property, plant and equipment controls for the portion of total

accruals related to non-discretionary depreciation expense. Instead of using total

accruals as a measure of earnings management, the JM decomposes total accruals into

discretionary and non-discretionary components, where the former are used to explain

earnings management. The calculation of discretionary accruals is a two-step procedure.

The first step is to estimate the non-discretionary component of total accruals using the

following equation:

tt

t

t

t

tt

t

A

PPE

A

REV

AA

TA εααα +

+

∆+

=

−−−− 13

12

11

1

1 (1)

where

tTA = total accruals

1−tA = total assets

tREV∆ = change in revenue

tREC∆ = change in net receivables

tPPE = gross property, plant and equipment

t = time subscript

The second step is to compute the error term from the above equation, the difference

between total and non-discretionary accruals, which represents the discretionary

accruals. Positive (negative) error term means income-increasing (decreasing) earnings

management.


30

Subramanyam’s (1996) study shows that the cross-sectional JM is better specified than

its time-series counterpart (c.f. Krishnan, 2003). He finds that in the cross section model

the accuracy of the estimated coefficients is higher due to a large number of degrees of

freedom. Moreover, cross sectional models do not impose a requirement for long series

of data, hence, it yields a lower risk of survivorship bias relative to a time series model.

The JM is further modified by Dechow et al. (1995) to improve the predictability of

discretionary accruals. The Modified Jones Model (MJM, henceforth) is specified as

follows:

tt

t

t

tt

tt

t

A

PPE

A

RECREV

AA

TA εααα +

+

∆−∆+

=

−−−− 13

12

11

1

1 (2)

where

tREC∆ = change in net receivables

The only difference in this model compared to the JM in (1) is that the change in

revenue is adjusted for the change in receivables in the event period. While the JM

assumes that no discretion is exercised over revenue, MJM assumes that all changes in

credit sales results from earnings management. This is because it is easier to manage

earnings by exercising discretion over credit sales revenue than cash sales. Thus, the

MJM assumes that the change in revenue less the change in accounts receivable is free

from managerial discretion.

Bartov et al. (2000) evaluated the ability of seven accruals models to detect earnings

management and concluded that the cross sectional JM and the cross sectional MJM

outperform their time series counterparts10. However, these observations are naïve in

light of recent developments in time series techniques such as unit root and

10 The models they examined include the DeAngelo Model, Healy Model, JM (time series and cross sectional), MJM (time series and cross sectional) and Industry model.


31

cointegration, which are on the forefront in applied econometrics. Furthermore, the cross

sectional approach is not entirely free from shortcomings.

The major criticism of the accruals models is the degree of sophistication involved in

separating discretionary and non-discretionary accruals. The models reflect

measurement error, which arises partly because of the misclassification of non-

discretionary accruals as discretionary accruals (see Bernard and Skinner, 1996).

Findings of Dechow et al. (1995) and Guay et al. (1996) suggest that the discretionary

accrual from the JM is imprecise due to the large variation in estimated coefficients.

Nevertheless, recent studies (Krishnan, 2003; Heninger, 2001 and Teoh et al., 1998)

continue to employ the JM and MJM, despite their limitations.

The methodology adopted in this thesis can be distinguished from earlier studies. Instead

of using the empirical models, it employs a qualitative approach, which is discussed in

Section 4.4. The choice of the methodology, however, was not made on the merits and

de-merits of the two methods but on its applicability to Fiji’s environment.

Unfortunately, the lack of quality and consistent data for Fiji does not permit a reliable

statistically based study to be undertaken. It should be noted that the smaller the sample

size, the greater the impact of one particular observation on the coefficient estimates.

Meeting the data requirement is not a problem for developed countries as the size of

such economies, together with the number of entities and age of entities, provide the

model with the required data. Even the cross sectional models, which require fewer data

points than time series models, cannot be applied in Fiji. Cross sectional models requires

a minimum of six observations within each group in each year. In Fiji's case, if the

entities in the sample were grouped, there would hardly be six entities of similar nature

in one group. Further, consistent data on all entities for the same sample period are

hardly available as most of these organizations fail to produce annual reports.

A similar situation was also faced by Liu and Lu (2003), when examining earnings

management in another developing country, China. Instead of discretionary accruals,

they use total accruals as a proxy for earnings management because they argue that there


32

is no reliable model to estimate discretionary accruals in the Chinese listed companies.

Consequently, Liu and Lu conclude that a well-received model in the developed

countries may not be applicable in other economies without some adjustments.

4.3 Data

The required data for this study are primarily collected from the published annual reports

of the entities. Many of the SOEs do not produce annual reports every year but only

prepare financial statements. While this is sufficient for empirical models, the qualitative

approach requires the financial data together with the narrative information in annual

reports. Thus, to be taken in the sample, the chosen entities should publish their annual

reports periodically. Furthermore, the investigation period is 1990 to 2004 as it is

believed that the time frame is large enough to furnish the necessary materials that

would be needed to undertake this study. Therefore, the entities selected should be in

operation over this period. Of the 16 SOEs in Fiji (see list on page 17), only four meet

these criteria - the Fiji Electricity Authority, Housing Authority, Public Rental Board

and the Unit Trust of Fiji.

Given that the qualitative approach employed in this study has not been widely

employed in previous studies, it is important that more than one case is used so that the

applicability of the approach can be tested. Robson (2002) points out that a common

misconception for using more than one case study is for the purpose of gathering a

‘sample’ to make generalization about the ‘population’. However, more than one case is

used not to make a statistical generalization but analytic generalisation. They are chosen

to demonstrate that the methodology can be applied to cases in general, rather than to a

single instance. Thus, it is possible to study all the four entities as they would provide

better results. Nonetheless, knowing that a case study requires an in-depth examination

of the chosen organization, four cases would become unmanageable and beyond the

scope of this thesis. In light of these factors, two cases will be used in this study.


33

A review of the annual reports of Unit Trust of Fiji shows that there is not much scope to

identify the possibilities of earnings management as there are not many accounts listed

in the financial statements. So this entity is eliminated. The Housing Authority and

Public Rental Board are similar organisations as both are involved in the housing

market. Also Public Rental Board was established by taking over some of the functions

of the Housing Authority. Therefore, it is better to study the larger organization of the

two, which is Housing Authority. After eliminating Unit Trust of Fiji and Public Rental

Board, the two entities chosen are Housing Authority and the Fiji Electricity Authority.

It should also be noted that out of the four, these are the two largest entities, in terms of

total assets and turnover. Hence, they make appropriate cases to be studied.

4.4 Research Method

Each organization's annual report over the review period was thoroughly read in order to

understand their operations, organisation structure, accounting environment and

products and services. Subsequently, the checklists developed by Mulford and Comiskey

(2002) were applied to detect instances of earnings management, which provide a useful

and practical classification scheme to do so without employing empirical modeling.

They state that such a scheme assists the financial report readers to be more focused in

their search for items that may indicate that the reported results may not be true. Mulford

and Comiskey provide the following categories to detect earnings management:

(i) Recognising premature or fictitious revenue

(ii) Aggressive capitalisation and extended amortisation policies

(iii) Misreported assets and liabilities

(iv) Using operating cash flow to detect earnings management

Based on these categories, they prescribe a guideline in the form of checklists. The

checklists, constructed after considering the international collapse of a number of

organisations, provide a list of items that should be considered in detecting earnings


34

management. These checklists are appended in Appendix 1 and are briefly described

below.

Checklist 1 is based on recognising premature or fictitious revenue. Given the

importance of revenue items in the income statement, it cannot be denied that they are

the most obvious items subject to manipulation. For the purpose of detecting earnings

management, it is not important to identify the difference between premature and

fictitious revenue as both lead to misreported results. Checklist 1 is divided into three

parts; revenue recognition policy, physical capacity and accounts receivables.

In order to identify possible earnings management practices related to revenues, one

needs to understand the entity’s revenue recognition policy. Detailed information on this

is provided in the notes section of the annual report and a careful examination of this

would be useful. To assist in identifying premature and/or fictitious revenue, one also

needs to consider the physical capacity of the entity to generate revenue, which is the

focus of the second part to the checklist. Analysing the physical capacity could indicate

whether the entity has the capacity to generate the reported revenue. Possible measures

of revenue per physical capacity could include revenue per employee, revenue per dollar

of property, plant and equipment or revenue per total assets.

Generally, with fictitious or premature revenue, there would be no associated cash

inflow. Accordingly, a balance sheet account is increased and an obvious one is accounts

receivable. Thus, one needs to be mindful of unusual increases in accounts receivable as

these accompany questionable revenue. However, knowing that readers would look for

such relationships, managers may use other balance sheet accounts as a potential storage

for misreported revenue. These could be property, plant and equipment and prepaid

expenses11. Therefore, the final section of the Checklist 1 analyses accounts receivables

and other asset accounts.

11 It should be noted that this evidence would be available only if it had escaped the notice of the auditors. If auditors had already sighted this trend, they could have taken appropriate action(s).


35

Checklist 2 focuses on an entity’s capitalisation and amortisation/depreciation policies.

The first part of the checklist analyses the capitalisation policies as they have direct

effects on earnings and assets. Some useful analytical tools that could identify

aggressive capitalisation policies include:

1. Review of the entity’s capitalisation policy

2. Carefully consider what the capitalised costs represent

3. Analyse whether the entity has been aggressive in its past capitalisation policy

4. Search for costs capitalised in stealth

In order to find out whether the entity is taking an aggressive approach of capitalising

costs, it would be useful to compare their capitalization policy with that of the

competitor's and the industry's. Although it is useful to compare with competitors, it is

possible that the competitors are also aggressively capitalising costs. Furthermore, if it

was found that the entity had adopted an aggressive capitalisation policy in the past, then

it is reasonable to assume that it will continue to practice this in future. Thus, caution is

required while examining capitalised costs. Needless to say, entities that have been

aggressive in capitalising costs will seek to mask their actions. Therefore, it is important

to go beyond the accounting policy notes and the capitalised expenses to several other

accounts reported in the balance sheet, such as accounts receivable, inventory, prepaid

expenses, property, plant and equipment and other assets. To detect if aggressive

capitalised costs have been transferred to these accounts, it is worthwhile to examine the

relationship of these accounts to revenue and their rate of change relative to that of

revenue.

The other section of checklist 2 deals with extended amortisation and depreciation

policies since these areas have potential scope for manipulation. In order to detect

extended amortisation and/or depreciation policies, the checklists provide two useful

steps. Step 1 calculates average amortisation period for the entity’s depreciable asset

base. The direct approach to determine extended amortisation/depreciation period is to

check the disclosure of the useful lives of non-current assets. This disclosure, however,


36

in many instances is vaguely stated. For example, the Housing Authority disclosed the

following in its Annual Report (2004:38):

NON CURRENT ASSET USEFUL LIVES

Building 28 - 66 years

Plant and equipment 3 - 5 years

This piece of information makes it difficult to identify either what was the

amortisation/depreciation period or whether the disclosed years had been used. In light

of this problem, an alternative would be to compute the average

amortisation/depreciation period of the entity's collective depreciable base. Step 2

searches for extended amortisation periods in prior years as entities found to be behaving

as such in the past are likely to leave themselves open to such problems in future as well.

Checklist 3 identifies any misreported assets and liabilities as these have direct links

with earnings. The first part of the checklist analyses assets that are not subject to annual

amortisation/depreciation, such as accounts receivable and inventory. Assets subject to

periodic amortisation/depreciation have been excluded as they were examined in the

earlier checklists.

As noted in Checklist 1, premature and/or fictitious revenue improperly accumulates

accounts receivable. Consequently, it grows faster than revenues, yielding accounts

receivable days much higher than normal for the entity. However, even when revenues

are properly recognised, earnings could still be temporarily increased. This could be

achieved through an improper valuation of accounts receivable, as these are reported in

the balance sheet after adjusting for provision for doubtful debts. Entities that want to

misreport earnings to suit their objectives could manipulate the provisions.

Another asset account is inventory, the cost of unsold goods reported in the balance

sheet, which upon sales is transferred to the income statement. Misreported inventory

could lead to misreported cost of sales and therefore misstated net income. There are a


37

number of ways to manipulate inventory. A direct approach is to misreport the physical

quantity of inventory while the second is to misreport its dollar value without altering

the physical count. The third is to postpone a needed or make an early write-down for

inventory. No matter how this is done, the same steps could be used to detect

manipulation. For example, with these anomalies, there would be an unexplained change

in inventory that outweighs the change in revenue. Moreover, inventory turnover days

will reach levels that are different from the competitors and other entities in the industry.

Checklist 3 then proceeds to examine liabilities such as accrued expenses and accounts

payable. To identify misreported accrued expenses, it is important to carefully review

the trends in such accounts. A useful approach is to compare the growth rate in accrued

expenses with that in revenue. For instance, if revenue increases faster than accrued

expenses, it implies that accrued expenses could be undervalued. Another useful test is

to compare selling, general and administrative expenses as a percentage of revenue with

prior periods. It needs to be considered whether an improvement in the expense ratio

reflects true operating efficiencies or a failure to accrue operating expenses properly.

Accounts payable increases mainly due to credit purchase of inventory. Often when

accounts payable are misstated, so is the inventory purchase. Hence, these lead to

misreported cost of goods sold and net profit. To detect unusual or unexpected changes

in accounts payable, it is useful to compute accounts payable days. Unexpected changes

in gross profit margin may also be an indicator that an inappropriate adjustment was

made to accounts payable. However, if the misstatement in accounts payable and

inventory purchases are of an insignificant magnitude, the effect on accounts payable

days and gross margin may not be noticeable. Therefore, a more useful tool would be to

compare the growth rate in accounts payable with that in inventory.

The fourth checklist deals with how the cash flow from the operating activities could be

used to detect earnings management practices. In order to carry out a thorough

examination of such practices, one has to study the entity’s cash generating abilities. It is

generally agreed that operating cash flow is a key indicator of the entity’s ability to


38

generate sustainable cash. Managing reported earnings do not change operating cash

flow therefore examining the relationship between earnings and operating cash flow is

helpful. To use operating cash flow, one needs to eliminate nonrecurring cash items.

Such items include income taxes on items classified as investing or financing activities,

cash effects of purchases and sales of trading securities for non-financial entities,

capitalised expenditure and other nonrecurring cash flows. Cash flow from operating

activities is not useful on its own but when it is used in conjunction with income from

continuing operations adjusted for nonrecurring events. Using these two variables, the

adjusted cash flow-to-income ratio is calculated in the following manner:

Adjusted cash provided by continuing operations

Adjusted cash flow-to-income ratio =

Adjusted income from continuing operations

This ratio is useful in identifying discernible trends over a period of time. A decrease in

the ratio indicates that earnings are growing faster than operating cash flows. Such an

outcome necessitates a closer examination to determine the underlying reasoning, using

the steps outlined in earlier checklists. It could be possible that management may have

employed earnings management practices to temporarily boost earnings. On the other

hand, an increase in this ratio caused by an increase in operating cash flow in excess of

an increase in earnings also needs to be investigated. Such an outcome may be the result

of management employing income-decreasing earnings management practices.

The above-discussed checklists would identify any unexplained, unusual behaviour,

which would then be analysed on a case-by-case basis. Analysis will involve checking

whether the item is consistent with generally accepted accounting practices and if it was

motivated by any incentives.


39

4.5 Overlap Between the Two Approaches

Through the scrutinisation of the accruals model and the preceding in-depth analysis of

the qualitative approach, it can be seen that the two approaches overlap. Although, the

two methods approach earnings management differently, the variables used in the

models are similar. To illustrate this, the MJM is reproduced here.

tt

t

t

tt

tt

t

A

PPE

A

RECREV

AA

TA εααα +

+

∆−∆+

=

−−−− 13

12

11

1

1 (2')

On the left-hand side of the above equation is total accruals, which according to the

existing literature can be calculated in one of the following ways:

1. Total accruals = net income before _ net cash flows

extraordinary items from operations

2. Total accruals = change in current assets - change in current liabilities - change in

cash + change in short-term debt – depreciation

3. Total accruals = - (decrease in accounts receivable + decrease in inventory +

increase in accounts payable + increase in taxes payable + net

change in other current assets + depreciation)

The variables that are used to calculate total accruals are also used in the checklists. The

first way of calculating total accruals uses net income before extraordinary items and net

cash flows from operations. These two variables are used in the checklist 4 to calculate

cash flow-to-income ratio. Furthermore, items such as accounts receivable, inventory,

accounts payable are used in the third checklist, which analyses misreported assets and

liabilities. Depreciation expenses are also used in the qualitative method, specifically in

the checklist 2.


40

The right-hand side of the equation considers three important variables, revenue,

receivables and property, plant and equipment. The qualitative method also uses the

same variables; revenue figures to identify any premature and fictitious revenue and

property, plant and equipment to detect if the entity had the physical capacity to generate

the reported revenue. Receivables are used on both sides. It is used on the left-hand side

to calculate total accruals and on the right as an independent variable. The qualitative

method analyses receivables to determine its trends over the years and its relationship

with revenue.

Furthermore, the qualitative models not only analyses the same variables but also

considers all other factors that affect a particular variable. This is highly informative and

useful. The empirical models fail to grasp the complexities of accruals actual behaviour.

For instance, they concentrate on the dollar value of revenue only, but the qualitative

approach analyses revenue values, revenue recognition policy, credit policy, related

party transactions and the physical capacity to generate the reported revenue. It could,

thus, be said that the checklists analyse all the aspects of a particular variable.

Additionally, this method assists in identifying the specific accruals used to manage

earnings, which cannot be obtained using the accruals models as it aggregates the effects

of all accruals.

However, the qualitative approach to earnings management has equally, if not more,

significant weaknesses than accruals models. Firstly, this method has not been

extensively used in the literature since it was recently developed. Hence, there is a lack

of practical guidance and means of comparison. Secondly, while accruals models

objectively determine the presence of earnings management, results from the qualitative

approach are subjective to the interpretation of data based on the researcher’s ability.

The qualitative method will not yield a numerical value, on which to base and compare

results. It provides detailed information that should be interpreted cautiously. Thirdly,

this method is only useful in providing indications of earnings management rather than

providing direct documentary evidence. Finally, it could be possible that the qualitative

method may not be able to identify all instances of earnings management in the two


41

entities, particularly those which were more creatively practiced. Nonetheless, it is

useful, in cases when the accruals models cannot be applied due to data limitations,

particularly in developing countries such as Fiji.

4.6 Conclusion

The accruals models for detecting earnings management cannot be used in Fiji due to

data limitations. As a result, this thesis employs the checklists designed by Mulford and

Comiskey to identify possible instances of earnings management in the two SOEs. It is

worth pointing out that studying earnings management is a difficult task, no matter

which method is applied. Given the qualitative nature of the study, all instances are

analysed on a case-by-case basis. The following two chapters provide details of this

analysis of the two entities.

Chapter 5: Evidence of Earnings Management Practices in the HA

42

CHAPTER FIVE

EVIDENCE OF EARNINGS MANAGEMENT PRACTICES IN

THE HOUSING AUTHORITY

5.1 Introduction

This chapter explores earnings management practices in the first entity, the Housing

Authority (HA). It begins with an overview of the HA, which provides a brief corporate

background and describes its lending activities and the accounting environment within

which it operates. It then proceeds to identify and analyse the possible instances of

earnings management and the economic incentives that may have motivated these

manipulations over the review period.

5.2 Overview of the Housing Authority

5.2.1 Background

In the mid 1950s, the government realised that housing demands by low-income earners,

particularly in the greater Suva area, had far outgrown the available accommodation.

There were concerns that the projected demand for housing in the future could not be

entirely met by the private builders. Therefore, a resolution was passed in the Legislative

Council in September 1955 calling for the establishment of a statutory authority to deal

with these housing problems. Subsequently, the HA was established in 1955 under cap.

267 of the Housing Act and became an operating entity in 1958. The responsibilities of

the Authority were based on recommendations of a report prepared after studying low

cost housing in the West Indies. The report made recommendations on the approach to


43

public housing that was best suited to Fiji. These recommendations formed the substance

of the policy on which the Authority commenced with its housing programmes12.

The HA launched its first scheme, the Cash Loan Scheme, in October 1958. It provided

loans to the low-income group living in Suva and Lautoka to buy, build, extend or

substantially alter their houses. The loans were advanced to people, who were on regular

employment with average weekly income of less than $24. Towards the end of the year,

the HA diversified into building houses under its Home Purchase Plan. In 1964, the

Rental Flat Scheme was introduced to assist people who could not meet the loan

repayments under the Cash Loan Scheme or the House Purchase Plan. This scheme

operated on rental subsidy, where the tenants contributed 15% of their gross weekly

income towards the rent while the difference between the economical rent and the

tenant’s contribution was subsidised by the government13.

The HA was on a verge of financial collapse in the late 1980s. Consequently, with the

assistance from the Asian Development Bank (ADB) and World Bank, a team of experts

were engaged to study the functions and financial and administrative problems of the

Authority. On the basis of their findings, the HA developed a major Revitalisation Plan,

which involved restructuring of its rental housing program, finances and operations and

taking corrective actions to turn the HA into a viable and dynamic entity. The Plan was

implemented from the beginning of 1989 as the government amended the Housing Act to

allow for the establishment of Public Rental Board (PRB) to take charge of the HA’s

rental operations. A special project team was appointed to implement the transfer of

assets and liabilities to PRB and assist this new entity to take charge of its

responsibilities. Following the transfer of rental operations, the HA developed its own

corporate plans and established and documented its objectives. Its new role was defined

as follows:

12 The government sent Mr. Bain to the West Indies to study their public housing programmes. The details of his recommendations are explicitly described in the HA’s 2001 Annual Report. 13 Economical rent is the level of repayment to meet the loan uplifted to build the unit.


44

…to produce and finance through long-term mortgages, shelter for families who

would not otherwise have available to them the kinds of living accommodation they

would both desire and afford (The HA Annual Report, 1989:10).

The Design and Build programme was introduced in 1992 to cater for the increased

housing demands. This was a major change from the previous practices where the

contractors had to build houses as per HA's standard designs. With the new system, the

builders tendered their own designs and were required to complete the houses within

four months from the award of a contract. This system contributed to greater efficiency

in the HA’s construction activities. In 1996, there was a turnaround in the HA's status as

it was declared a CSA, which required it to operate on commercial basis and provide

returns to the government. While pursuing commercial objectives with a major focus on

profit, the HA developed and constructed houses that were affordable but of poor

quality. Defective houses led to difficulties in sales and customer dissatisfaction.

Following complaints from a number of tenants about the quality of houses, the

Authority paid for their repairs and maintenance. The HA began outsourcing the

designing and building activities from 1997 so that it could concentrate only on the

production of land lots and providing home loans. With the initial vision to provide

affordable housing to the middle and low-income earners, the HA has in recent years

expanded its target market by providing mortgage financing to high-income earners as

well.

The HA Board comprises of a Chairman and five other members, all appointed by the

Minister for Housing. The Chief Executive of the HA is an ex-officio member to the

Board. Over the study period, there have been many changes in the Board’s

composition. All executive management appointments in the recent years have been

conducted through a transparent recruitment process and appointees were allocated jobs

within a competency-based framework. A job evaluation exercise was undertaken in

2003 to appropriately remunerate all staff and for the first time in HA's history, the

wages and salaries for its entire staff came on par with the market.


45

5.2.2 Lending Activities

Providing home loans is one of the core activities of the HA. The financial products of

this package are cash loans, house sale, land sale and village scheme. Cash loans are

provided for purposes of house repairs, fencing, personal or family commitments. Since

1998, new products such as soft loans, home comfort loans and quick loans were also

included in this package. The HA faces stiff competition from other institutions that also

provide home loans. For instance, in 1999 the HA's average lending rate was 9.71%

while the commercial banks charged an average rate of 7.59%. This resulted in a

massive loss of performing customers to its competitors. Most of these customers were

from middle-income level with no arrears and with repayments made directly from

salary deductions, implying that the HA lost customers who were less risky. Also, the

high interest rates become unsustainable to low-income earners who do not qualify for

commercial bank loans. Consequently, loans began to fall into arrears and contributed

towards high level of non-performing loans for the Authority, which averaged around

20% of total mortgage portfolio.

In order to competitively serve its client base, the HA has to be attractive in terms of its

lending rate. This is quite challenging for the Authority as it faces difficulties in

lowering the rate of interest. One of the major contributors of the high interest rate

charged by the HA is its borrowing cost. Table 5.1 compares the interest rate spread of

the HA with commercial banks. Commercial banks have higher interest margin than the

HA despite charging a reasonably lower lending rate. This is achieved due to its lower

average cost of borrowing as the commercial banks are able to source funds at a

significantly lower rate than the HA.


46

Table 5.1 Interest Rate Spread of the HA and the Commercial Banks (%)14

Year HA All Commercial Banks

Average Lending Rate

Average Borrowing

Rate Spread

Average Lending Rate

Average Borrowing

Rate

Spread

1999 9.71 6.81 2.90 7.59 1.69 5.90

2000 9.59 7.74 1.85 7.49 1.81 5.67

2001 9.65 6.72 2.94 7.51 1.54 5.96

2002 7.53 5.63 1.90 6.77 1.12 5.66

2003 7.43 5.51 1.91 6.74 0.88 5.86

2004 7.69 5.19 2.50 6.62 0.89 5.73

(Adapted from Jayaraman and Sharma 2003, the HA Annual Reports 1999-2004 and author’s calculations)

Additionally, given the nature of its business, the HA’s operating costs are relatively

higher than its competitors. This is clearly reflected in Table 5.2, which shows that

operating expenses per dollar of income is around 80% for the HA when compared with

50% for commercial banks.

Table 5.2 Operating Costs of the HA and the Commercial Banks

Year HA All Commercial Banks

Income $000

Operating Expenses $000

Operating Expenses Per

Income %

Income $000

Operating Expenses $000

Operating Expenses Per

Income %

1998 8252 6671 80.84 134218 71435 53.22

1999 9517 7081 74.40 153296 85866 56.01

2000 6526 4965 76.08 157671 81948 51.97

2001 9389 8088 86.14 153821 81739 53.14

2002 7886 6478 82.15 152589 81605 53.48

2003 8157 6418 78.68 170496 85016 49.86

2004 9601 6169 64.25 184377 91938 49.86

(Adapted from the HA Annual Reports 1998-2004, RBF Annual Reports 2002 and 2004 and author’s calculations)

Despite high borrowing and operational costs, the HA reduced its lending rate from

11.5% to 6% for all new low-income customers in late 1999 and beginning 2000, this

was extended to all low-income customers (new and existing). The reduction in the rate

was a result of a government directive and an undertaking to the Authority to secure

cheaper funds. The government provided grants to the HA to compensate for the loss in

14 Interest rate spread = Interest earned __ Interest paid

Average interest earning assets Average Borrowings


47

income resulting from reduced interest rates. Still faced with intense competition, the

HA launched its "Moving on Package" in September 2001, in which interest rates for the

first year were further reduced to 5.99% and 8.35% for all new and existing customers,

respectively. With the introduction of the "Sapphire Package” in 2003, the HA further

lowered the lending rate to 4.45% for the first two years and 7.99% thereafter. Although,

the HA have been able to compete with other lending institutions in the recent years, this

has been possible with the continued financial assistance from the government.

Appendix 2 details the current lending rates of HA and its competitors.

5.2.3 Accounting Environment and Financial Performance

The HA introduced accrual accounting system in 1993 and by the end of 1994 all

transactions and financial reports were prepared on this basis. The financial reports were

audited by the Auditor General until 1989 and since then, KPMG was responsible for its

external audit functions. The KPMG also provides non-audit services since 1995. Table

5.3 illustrates the fees paid to KPMG for auditing and non-audit services.

Table 5.3 Auditors Remuneration

Year Audit fees/ Total fees

(%) Non-audit fees/ Total fees

(%)

1995 62.16 37.84

1996 50.00 50.00

1997 47.73 52.27

1998 30.30 69.70

1999 54.29 45.71

2000 86.36 13.64

2001 86.36 13.64

2002 21.84 78.16

2003 46.43 53.57

2004 86.67 13.33

(Adapted from the HA Annual Reports 1989-2004 and author's calculations)


48

When the same auditor provides both audit and non-audit services, auditor independence

is doubtful. According to section 201 and 202 of the Sarbanes Oxley Act 2002, an

auditing firm can only provide non-audit services together with audit services without

obtaining any prior approval, as long as non-audit fees is less than 5% of total fees.

Table 5.3 illustrates that KPMG's income for non-audit services is significantly higher

than 5%. Given that auditors were not rotated from 1990, it is important to check if

there was rotation of audit partners. However, it is hard to determine as the reports were

signed off by the institution rather than the individual partner. These factors, therefore,

suggest that auditor independence is questionable at the HA.

The HA's total assets increased from $85.29 million in 1990 to $158.70 million in 2004,

growing at an annual average rate of 4.96%. Their debt to equity ratios were quite high

in the early 1990s but it worsened in the later part of 1990s when it became negative.

This was due to large accumulated losses included in equity. The conversion of $44

million debts into equity in 2002 returned HA to a net assets position. After reporting

consecutive losses in the 1980s, 1992 was the first year when the HA showed an

operating profit of $43 million. It continued to report marginal profits for few years, but

losses were again reported from 1998. However, the HA reverted to a net profit from

2001. Abnormal items were quite frequently reported in its financial accounts. These

financial data are provided in Appendix 3A.

5.3 Possible Instances of Earnings Management

5.3.1 High Provision for Write Downs of Developed Lots in 1988 to 1991

The inventory of the HA is categorised into developed lots, unsold properties and work-

in-progress. From 1988 to 1991, there were unusual increases in the provision for write-

down of developed lots, as shown in Table 5.4 below.


49

Table 5.4 Developed Lots Inventory

Year Beginning Balance ($000s)

Provision for write-down ($000s)

Ending Balance ($000s)

Write-down/ developed lots (%)

1985 3726 0 3726 0

1986 2661 0 2661 0

1987 6738 63 6675 0.9

1988 9916 1561 8355 15.7

1989 9727 2063 7664 21.2

1990 13207 3012 10195 22.8

1991 10039 1756 8283 17.5

1992 9155 0 9155 0

1993 11695 0 11695 0

1994 10819 0 10819 0

1995 8170 163 8007 2

1996 7756 506 7250 6.5

1997 9417 362 9055 3.8

(Adapted from the HA Annual Reports 1985 – 1997 and author’s calculations)

The HA values inventory at cost but when the net selling price is lower than the cost, the

cost is written down to its net realisable value. This implies that from 1988 to 1991, the

selling price of developed lots was lower than the cost, hence the large write-downs.

Accordingly, there is a need to ascertain why the selling price was lower than the cost of

developed lots in these periods. However, no information was available in the annual

reports to explain the large write-downs in inventory, apart from the Board Chairman’s

comments. He stated the following about the HA’s operating performance:

…the Housing Authority has progressed quite satisfactorily over the past three

years. From an operational deficit of $1.144 million in 1989 and $2.216 million in

1990, this deficit has been reduced to $479,000 in 1991. However losses due to

abnormal items specifically with relation to on-going re-negotiation of high interest

Fiji National Provident Fund loans and write-offs due to past over expenditure on

land development have put the 1991 loss at $1.898 million compared to $1.141

million for 1990 and $4.088 million for 1989. (The HA Annual Report, 1991:4).

The above statement indicates that the HA had over-spent on land development

activities in the previous years so in 1991, it wrote off these development costs. Table


50

5.5 illustrates the items related to developed lots that were reported as abnormal in the

Income Statement.

Table 5.5 Abnormal Items15

Year Item $000s % of Income % of

Inventory

1987 Provision for write-down of development cost and unsold lots

1037 54.44 5.51

1988 Provision for write-down of development cost and unsold lots

2196 115.70 11.05

1989 Provision for write-down of development cost & unsold lots

1641 41.65 8.98

1989 Development cost written off 1303 33.07 7.13

1990 - - - -

1991 Development cost written off 889 21.29 5.94

1991 Provision for unsold land written back (722) (17.29) (4.83)

(Adapted from the HA Annual Reports 1987 – 1991 and author’s calculations)

In 1991, development cost of $0.89 million, representing 21% of income, was written

off. Costs written down and costs written off are two separate items and each has

different accounting treatment. The former is the expected loss in value of inventory

while the latter is the actual loss. When inventory is written down, a provision account is

created and when inventories are written off, there is a direct reduction to the value of

inventory. The corresponding debits in both the cases will still be reflected in the Income

Statement. Furthermore, costs written down and costs written off were only reported as

abnormal items while no such expenses were reported in the normal operating section of

the financial statements. Therefore, the Chairman’s statement only explains the write-

offs of the development cost and not inventory written down.

Based on the reason for the write-offs, it could be argued that from 1987 to 1989 (see

Table 5.5), the HA may have provided for the write down anticipating the loss that

would be incurred due to high expenditure on developed lots. The 1989 and 1991 values

suggest that an additional write-off was needed when these lots were actually sold off.

This means that the provisions made in the earlier years were not sufficient. Under/over

provisioning does not in itself point towards earnings management, but its magnitude

15 Note that the provisions shown in the table includes the provision for developed lots and work-in-progress. This will explain the high write-down in 1987 even though Table 5.4 shows a provision of only $63,000.


51

may do so. The under-provision was substantial, such that when the additional write offs

of $1.30 million in 1989 and $0.89 million in 1991 were made, they were treated as

abnormal items.

As a result of over-expenditure on developed lots, the HA wrote off these expenses in

1991. In light of this, it is interesting to note that the provision for developed lots was

written back during the same year. Writing back of provisions is not unusual. Prudent

accounting practices should lead to consistent, but not excessive provisioning. Write

backs will arise as uncertainties resolve themselves. Therefore, it is not the write back

but its magnitude that is important. A large write back suggests deliberate over

provisioning and hence an attempt of earnings management. Therefore, it is essential to

consider if the write back related to a specific year or to several years. However, this

was not possible to verify from the available data. Also, there were no further write

backs of provision after 1991.

The property market boomed in the early 1990s so the write back may simply be a

reflection of this optimism. It would certainly explain the zero provisioning in 1992 to

1994 and the higher inventory levels. The property market slumped in 1995 and HA

resumed provisioning at that time. Therefore, the economic factors explain the pattern in

HA's provisioning for developed lots except the high provisioning from 1988 to 1991,

which is hard to justify. As high provisioning reduces earnings, there is a need to

identify if there was any possible reason(s) for the HA to manage earnings downwards

during these periods.

The HA was plagued with financial losses in the 1980s largely due to its subsidised

rental program. Its rental operations imposed significant costs threatening its viability.

There was poor loan management, lending terms did not take into account the cost of

funds and the HA had to meet the debt service costs of the loans that were acquired to

build the rental estates. Immediately after the military coup of 1987, the borrowing rate

in the local market had sky-rocketed. This led the HA to seek cheaper sources of finance

from the ADB and World Bank, who stipulated that loans would only be given if the


52

rental element was separated from the HA's operations. Therefore, the deficit laden

rental operations were transferred to the newly created Public Rental Board (PRB) in

May 1989. Negotiations with the ADB were concluded in December and the loan

agreement was signed in early 1990. The agreement with World Bank was delayed due

to issues over the lending terms but was eventually signed in 1991. Separating the rental

operations proved to be advantageous to the HA as it enabled the Authority to meet the

guidelines of the loan requirements. When the PRB was created, the following items

were transferred from the HA:

Assets $11.14 million

Liabilities $19.37 million

Accumulated losses $11.89 million

Revaluation Reserve $ 3.39 million

Table 5.6 shows the performance of the HA in years before and after the transfer of the

aforesaid assets and liabilities to the PRB.

Table 5.6 Financial Indicators of the HA Before and After the Transfer of Rental

Operations (As a percentage of total assets)

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994

Total Equity

13.56 9068 1.86 (3.73) 3.04 2.00 0.93 1.91 3.37 3.78

Total Liabilities

86.44 90.32 98.14 103.73 96.96 98.00 99.07 98.09 96.63 96.22

Interest Income

7.94 7.79 7.08 7.00 8.82 8.28 8.54 6.86 6.88 7.09

Total Income

10.52 9.71 9.29 9.55 12.65 11.84 12.40 12.41 11.85 11.78

Interest Expenses

7.67 7.88 7.31 7.65 8.20 8.28 7.58 6.93 6.09 5.80

Total Expenses

12.34 12.27 12.14 12.87 13.94 14.44 12.95 12.37 11.44 11.33

Net Profit (1.75) (2.60) (8.01) (5.52) (4.62) (1.34) (2.19) 0.23 0.40 0.45

(Adapted from the HA Annual Report 1985-1994 and author's calculations)

It is noted that the HA's financial position and performance improved following the

transfer of rental operations. The equity position increased to $3.04 million in 1989

compared to a negative balance of $3.73 million in the previous year. Return on assets

also improved from negative 4.62% in 1989 to 0.23% in 1992.


53

There were expectations from the government and the offshore lending agencies that

following the transfer, the HA would be able to operate on a profitable basis (Sharma

2000). The Authority was aware that it would have to meet these expectations. One way

to report improved performance in subsequent years is to report major losses in the

current period. It seems that the HA has behaved in this manner. By excessive

provisioning in years prior to and in the year of separation, the HA reported poor

profitability. Given the nature of its rental operations, there is no doubt that the HA was

making losses. Nevertheless, it is argued that by creating unusually large provisions, the

HA exaggerated its unprofitable position. Furthermore, when the assets and liabilities

were transferred to the PRB, $11.89 million of accumulated losses were also transferred.

Although, the HA states that the transfer related to the rental operations only, it may be

possible that this contained losses pertaining to non-rental operations. No matter how

carefully any transfer of business operations is made, it will be arbitrary to some extent.

Therefore, it seems that the HA was able to shed its unprofitable operations to the PRB

and part of its balance of accumulated losses.

There was an additional possible economic incentive to manage earnings downwards in

the early 1990s. The Japanese Grant provided five experts to the HA to strengthen its

institutional capability and train the local staff to undertake the responsibilities. The

grant provided expatriate consulting services in the fields of physical planning, project

management, procurement, corporate planning, accounting and information systems.

The HA was required to have these experts in place before the loans from World Bank

and ADB became effective. The recruitment process began from January 1989 and all

experts were hired by the end of the year. These consulting services were valued at

$183,000 in 1989, $673,000 in 1990 and $332,000 in 1991. The Board Chairman made

the following comments on these services:

Despite the major changes and obvious benefits that have resulted over the 12

months to December 1990 arising out of institutional factors, due to complicated

skills involved and the need for comprehensive training for the authority's

employees, it is desirable, indeed necessary, that in the meantime, the institutional

consultancies continues and support through the funding of these consultancies be


54

sustained, to prevent the process from reversing on itself at this delicate and early

stage. (The HA Annual Report, 1990:2).

This shows that HA not only wanted to continue receiving the consultancies but also it’s

funding. High provisioning would assist the Authority in reporting lower profits hence

they could continue to benefit from the assistance. If HA had reported high profits then

perhaps it would still have received the consultancies, but it may have not been in the

form of grant. Rather, the HA would have had to finance them.

To conclude, it was found that unexplained large provisions were created in 1988 - 1991

period. The analysis suggests that this may have been done to exaggerate the poor

performance of the HA so that in the subsequent periods the financial performance

reported are relatively better. This is argued on the basis that there were general

expectations from key stakeholders that the HA would reflect improved performance

following the transfer of rental operations. Hence, it seems that the HA managed

earnings downwards during these periods. Furthermore, the need to continue receiving

funds for consultancies may have provided an additional incentive to practice downward

earnings management.

5.3.2 Capitalisation of Administration Expenses

The HA reports work-in-progress inventory at the lower of cost or net realisable value.

The cost of work-in-progress includes capitalised indirect administrative costs, which

are incurred as a result of land development and house construction, and development

interest costs of the funds used to finance the development up to the time of completion.

Capitalising interest expense is not an uncommon practice as FAS 23 Capitalisation of

Borrowing Costs allows an entity to do so. The concern here is of capitalising

administrative expenses. According to FAS 11 Accounting for Construction Contracts16,

16 Reference is made to FAS 11 because apart from the lending activities, the HA is also involved in construction activities.


55

costs such as general administration and selling costs, finance costs, research and

development costs and depreciation of idle plant and equipment that is not used on a

particular contract are examples of costs that relate to the general contract activity but

cannot be related to specific contracts. Paragraph 19 of the standard further states that

these costs are usually excluded from accumulated contract costs because they do not

relate to reaching the present stage of completion of a specific contract. However, in

some circumstances, general administrative expenses, development costs and finance

costs are specifically attributable to a particular contract and are sometimes included as

part of accumulated contract costs.

Capitalising costs rather than expensing postpones the recognition of expense. As a

result, current period’s expense will be reduced and earnings will rise. Since the

accounting regulation permits the capitalisation of administrative expenses in certain

circumstances, if an entity is capitalising this expenditure, it is possible that they are

attempting to boost current period earnings. Consequently, it is possible that the HA

interpreted this paragraph of FAS 11 to suit its own convenience rather than to generally

reflect economic reality!

Capitalising administrative expenses to work-in-progress has two effects on profits.

First, when the costs are capitalised, the current period earnings will increase. Secondly,

these capitalised costs will be expensed when the work-in-progress inventory is

completed and sold, upon which, it will be expensed through cost of sales. Thus, in the

subsequent periods, cost of sales will increase leading to a reduction in earnings. In

order to determine when these costs would be expensed, the following table calculates

inventory days, using all three categories of inventories- land, houses and work-in-

progress


56

Table 5.7 Inventory Days

1989 1990 1991 1992 1993 1994

Sale of land & houses 3276 3428 4203 6673 13390 21014

Cost of sales of land & houses

2978 2776 3503 5264 10775 17835

Inventory 14004 12679 12266 20558 23914 22899

Inventory days 1716 1667 1278 1425 810 469

(Adapted from the HA Annual Reports 1989–1994 and author’s calculation)

The calculation yields significantly large number of inventory days. For instance, in

1989, it took HA almost five years to sell inventory. This seems unrealistic as when an

entity has such high inventory days it will not continue with annual production activities.

The HA, however, had continued with its land development and construction activities.

Using inventory days to ascertain the timing of expense recognition for the capitalised

costs would therefore be impractical. Thus, the narrative information provided for land

development and construction activities during the years was used in this analysis. As

there is no consistency in the type and extent of information provided in this form, the

study had to rely on whatever information is made available. Based on the narrative

information, it was found that it took HA an average of two years to complete individual

projects and sell them off. Table 5.8 depicts the profits that were reported after

capitalisation and the profits that would have been reported if the HA had not capitalised

these expenses.


57

Table 5.8 Effects of Capitalising Administrative Costs on Profits

(Adapted from the HA Annual Reports 1989–1994 and author’s calculations)

Table 5.8 firstly shows the actual profit as reported in the financial statements that is

achieved after capitalising administrative expenses. It then reverses the effect of

capitalisation to calculate the profits without capitalized costs. To do that, capitalised

costs are subtracted from profits since capitalisation has increased current period

earnings. Once the work-in-progress inventory is completed and sold, capitalised costs

would be expensed through cost of sales. So the table adds back cost of sales to profit.

As it takes two years time to expense the deferred costs, the table shows that the amount

capitalised in 1989 is expensed in 1991. Capitalised costs in other years are also

expensed in similar time interval.

The amount of administration expenses capitalised was reported in the financial

statements only until 199417. However the accounting policy note continued to state that

work-in-progress included capitalised administrative expenses. This implies that HA had

continued to capitalise administrative expenditure even though the amount capitalised

was not disclosed from 1995 onwards. Consequently, the table could not be extended

beyond 1994. The effect of capitalisation on profits was more observable in periods

17 Capitalised administrative expenses were not explicitly reported prior to 1989 as the format in the presentation of information had changed after the transfer of rental operations.

Profits with capitalisation

Reversal effects - Profits without capitalization

Year Net Profit $000s

NP/Equity (%)

Capitalised administrative

costs ($000s)

Subtract capitalised costs from profits $000s

Add back cost of sales to profits $000s

NP/Equity (%)

1989 (4088) (151.86) 86 (4088) - 86 = (4174)

(4174) (155.05)

1990 (1141) (67.04) 76 (1141) - 76 =

(1217) (1217) (71.50)

1991 (1898) (236.07) 415 (1898) - 415 = (2313)

(2313) + 86 = (2227)

(276.99)

1992 248 12.09 576 248 - 576 =

(328) (328) + 76 = (252)

(12.28)

1993 518 12.02 575 518 - 575 =

(57) (57) + 415 = 358

8.30

1994 687 11.81 676 687 - 676 =

11 11 + 576 =

587 10.09


58

1992 to 1994. Capitalisation improved the profitability position of the HA from a

negative return on equity of 12.28% to positive 12.09% in 1992. Further, in 1993 and

1994, it increased the returns from 8.30% to 12.02% and 10.09% to 11.81%,

respectively. Given that capitalisation resulted in increased profits, the following section

examines if there was any possible incentive(s) for reporting higher earnings during

these years.

The Rabuka government, which came into power in 1992, placed a lot of emphasis on

public sector reforms as a means of bringing efficiency in the operations of SOEs. In

line with the government's reform agenda, the HA's focus changed as it prepared for

privatisation. The Authority began to pursue commercial activities with a view of

making profit. Taking into account the changes that took place in the government, it

could be argued that the newly elected government wanted to reflect its performance

through the performance of the HA, which is its public sector housing institution.

Furthermore, there were major changes in the HA's Board membership in 1993 as four

out of the six board members were replaced during the year. Accordingly the Board,

with a majority of new members, may have also wanted to reflect their performance to

the government and other stakeholders. Thus, the incentive to report high profits in 1993

may have also originated from the HA’s Board.

Additionally, the HA introduced performance based contracts at the senior executive

level in June 1993. Management was exposed to a contractual system where appraisal

techniques and indicators were used to facilitate this exercise. All staff in executive

positions was put on three-year contract and the renewal of their contracts was based on

the achievement of the set targets and objectives for each position. The annual bonus of

the senior executives was also based on the achievement of those targets. The annual

report indicates that

the movement of salaries for these positions therefore will be relative to the

productivity of the incumbents and in turn will be reflective of the overall

financial performance of the Authority. (1993:10).


59

Performance indicators, comprising of both financial and non-financial, were used as a

measure of the achievement of the targets. They enable managers to evaluate in

numerical terms the extent to which their actions have led to improvement in services

offered. The Chief Executive and the General Manager establishes the targets for the

respective departments while the Board Chairman and the Chief Executive sets for the

Chief Executive. Each division has its own targets to achieve, against which the

managers were evaluated. For instance, the Collection Department had a target

collection policy and the Sales Department performance indicators encompassed

cumulative actual and cumulative target sales of land and houses. Similarly, the

performance of the Lending Department was judged through the volume of loans

approved and the average loan processing time relative to the predetermined monthly

targets.

The annual year-end bonus for managers, which was a component of their salary, was

awarded if the set targets were met. Furthermore, renewal of their contract was subject

to the successful achievement of the targets over the current contract period. When the

targets are not achieved, a review is carried out to determine the underlying reasons.

After a thorough investigation, the targets are reviewed or reduced so that they are

attainable. KPMG also checks the targets from time to time to establish its feasibility.

From the time contractual system was introduced, the employment contracts were taken

seriously by the management. Sharma (2000) reports that one of the managers left the

institution in the year in which the contract was actually introduced as he was unhappy

with the new system. It seems that performance based contracts provided incentives to

manage earnings upwards in order to qualify for annual bonuses and continuity of

employment. However, it is difficult to clearly establish the link between the targets and

performance given that in some instances where the targets were not achieved, they were

reduced.

To sum up, it was found that capitalisation resulted in higher profits in the years 1992 to

1994. In fact 1992 was the first year in which HA reported a profit after years of losses.

The analyses suggest that the possible motive to report high earnings may have come


60

from three sources. First, there was a newly elected government in 1992 that was in

favor of reforming the public enterprises. Performance of public enterprises is often seen

as a reflection of the performance of government. Second, the majority of the Board

members were replaced in 1993. They would also want to reflect their good

performance. Finally, performance based contracts were introduced in 1993. This system

provides an incentive to the management to report high earnings in order to qualify for

the annual bonuses and to retain their employment. Capitalising administrative costs is

allowed by the accounting regulation so the practice by the HA is not questionable.

Nonetheless, capitalisation significantly improved the HA’s financial performance in

early 1990s and there were several incentives for the HA to report higher earnings. Thus,

it seems that the deferral of administration expenses was used for earnings management

purposes.

5.3.3 Deferred Interest Expense

In the 1990s, the HA negotiated with the Fiji National Provident Fund (FNPF), their

major financier, to reduce the high lending rates. The following contingent liability was

reported in the Annual Report:

Early in 1990 the Authority negotiated with FNPF to reduce high interest rates on

loans taken out during the years 1983 to 1986. The Authority was advised by FNPF

that it had agreed to the reductions and to make repayments based on the reduced

interest rates, which occurred from December 1990. The Authority's solicitors were

in the final stages of amending the loan covenants when advice was received from

FNPF in March 1991 that their Board had not formally approved the renegotiated

interest rates. The Authority had previously taken up interest at the negotiated rates.

If the renegotiated rates are not approved by FNPF, additional interest of $677,000

will be payable each complete year. In respect to 1990 $188,000 will be payable.

(1990:15).


61

As no formal approval was received for the negotiated rates by 1991, there was an

additional interest payable as at December 31 1991 amounting to $1.18 million to the

FNPF. This was reported as an abnormal item in the Income Statement. This implies that

it was only in 1990 and 1991 that HA recorded interest payable to FNPF at the reduced

rate. The matter was resolved in 1991 by expensing the additional interest payable.

In 1992, the HA recognised Deferred Interest Expense of $7.56 million as an asset. The

same amount was also found under its Loans Liability in 1992 and it was stated that

$7.56 million is the unexpired portion of differential interest on FNPF loan that would

be converted into 10-year bonds in 1993. From 1995, the annual reports began to state

the following:

The deferred interest expense relates to differential interest on rescheduled FNFP

loans. The deferred interest is amortised over a period of 10 years.

During 1992, the FNPF decided to reschedule the loans advanced to the HA. If the

FNPF reduced the interest rate, it would lose the entire amount of $7.56 million.

Accordingly, the FNPF decided that the HA will continue to pay interest at the lower

negotiated rate and the difference in interest payable between the normal and the

reduced rate will be converted into 10-year bonds in 1993. The following disclosures

were found in the FNPF's annual reports.

…Also excluded from the investments are the unpaid portion of nine HA loans

totaling $7,564,354 which were converted to 10-year zero rated bonds during the

1992/199318 financial year (1993:27).

…Also excluded from the investments is the differential interest totaling $7,564,354

for the unexpired portion of nine rescheduled HA loans, converted to 10-year zero

rated bonds during the 1992/1993 financial year (1995:21).

This provided further information that the differential interest was converted into zero-

rated bonds. Thus, the HA will benefit as they will continue to pay interest at the lower

rate and the differential interest will be paid collectively in the tenth year without further

18 The financial year-end for the HA is 31 December while for the FNPF it is 30 June.


62

interest accruing over the ten year period. As a result, the HA was able to conserve its

cash flows. Although, the FNPF will still receive its income at the end of the ten-year

period, it will lose as the delayed cash flows would impact, albeit marginally, on its

reinvestment capacities. The differential interest was finally paid in 2002.

Deferred interest expense is an example of a deferred debit, which is reported as asset in

the balance sheet. Henderson and Peirson (2002) and Goodwin and Howieson (1999)

argue that accountants are so anxious to correctly match revenues with expenses that

they end up creating deferred debits and credits. They state that these accounts fail to

meet the definitions of assets and liabilities. However, Sprouse (1966) argues that some

deferred debits and credits are assets and liabilities. Therefore, it is important to find out

if the deferred debit reported by the HA is actually an asset. The Framework for the

Preparation and Presentation of Financial Statements (FIA, 2001) defines assets as

resources controlled by the enterprise as a result of past events and from which future

economic benefits are expected to flow to the enterprise. The future economic benefit

from the deferred interest expense relates to the difference in the interest expense that

the HA will save each year for the next ten years. The deferred debit arose from the past

event when the FNPF actually decided to reschedule the loans. Through the legal

contract of converting the differential interest into bonds, the HA also has control over

these benefits. Consequently, the deferred interest expense reported by the HA does

meet the definition of an asset. After discussing the nature of deferred interest expense,

the following section focuses on its subsequent amortisation.

Table 5.9 shows how the HA expensed $7.56 million over the 10 years. The table shows

that the pattern in which the HA has expensed the deferred debit does not constitute any

systematic method. Further, in 1993 there was an anomaly in the amount amortised as

the amortisation rate, being 31%, was the largest over the entire ten year period. The

amount amortised of $2.38 million was even greater than the abnormal item of $1.18

million reported in 1991 Annual Report, which related to two years of additional interest

expense payable.


63

Table 5.9 Amortisation of Deferred Interest Expense

Year Deferred Interest

Expense ($000s)

Amortisation Expense ($000s)

Amortisation Expense/ Deferred Interest Expense (%)19

Return on Assets (%)20

1992 7564 0.23

1993 5188 2376 31.41 0.40

1994 4832 356 4.71 0.45

1995 4504 328 4.34 (1.43)

1996 4175 329 4.34 (3.37)

1997 3870 305 4.03 0.07

1998 3239 631 8.34 0.10

1999 2394 845 11.17 (2.15)

2000 1549 845 11.17 (0.27)

2001 704 845 11.17 0.31

2002 0 704 9.31 0.31

(Adapted from the HA Annual Reports 1992 - 2002 and author's calculations)

Over the amortisation period of 1993 to 2002, no separate disclosure was made for the

amortisation expense either in the Income Statements or in the disclosure notes for

expenses. From 1994 to 2002, it was not possible to identify where the amount is

aggregated as it was not large enough to be separately identifiable. It may be possible to

do this for 1993 given the magnitude of the amortisation. In 1993, the following

categories of expenses were shown in the Income Statement and their corresponding

values.

Table 5.10 Components of Total Expenses in 1993

Item $000s

Interest on Loans 7794

Operating Cost 5584

Provisions 965

Bad and Doubtful Debts 300

(Adapted from the HA Annual Report 1993)

Table 5.10 is used to explain the costs with which the amortisation expense is

aggregated. The expenses categorised as Provisions and Bad and Doubtful Debts are

19 This ratio is calculated as the amortisation expense for each year divided by the initial amount recognised as deferred interest expense of $7.56 million. Thus, the ratio gives the amortisation rate. 20 Return on equity could not be used because for several years the HA was faced with negative equity balance, hence the ratio would not give a meaningful explanation.


64

eliminated as the amount for these categories of expenses, $965,000 and $300,000,

respectively, is lower than the year's amortisation expense of $2.37 million. The next

category to consider is Operating Costs. All items in this category cost less than $2.37

million except for wages and salaries of $3.46 million. Therefore, this category is also

eliminated. The analysis now suggests that the amortisation expense is almost certainly

included with Interest on Loans. This implies that the amount of interest expense

reported in the Income Statement included the amortisation of deferred interest expense.

Table 5.11 illustrates the interest expense with and without amortised costs.

Table 5.11 Interest Expense

Year Interest Expense

Including Amortisation Interest Expense

Excluding Amortisation

($000s) % of Borrowings ($000s) % of Borrowings

1990 7377 9.47 7377 9.47

1991 7603 9.77 7603 9.77

1992 7941 8.21 7941 8.21

1993 8442 7.37 8442 - 2376 = 6066 5.30

1994 9792 7.03 9792 - 356 = 9436 6.77

1995 11476 7.43 11476 - 328 = 11148 7.22

1996 12547 7.92 12547 - 329 = 12218 7.71

1997 12358 7.95 12358 - 305 = 12053 7.75

1998 12546 8.11 12546 - 631 = 11915 7.70

1999 10336 6.94 10336 - 845 = 9491 6.38

2000 11585 7.70 11585 - 845 = 10740 7.14

2001 10079 6.74 10079 - 845= 9234 6.17

2002 7827 6.09 7827 - 704 = 7123 5.54

2003 7118 5.49 7118 5.49


The above table first shows the interest expense on long-term loans as reported in the

financial statements. It then subtracts the amortisation expenses from the interest

expenses to calculate interest expenses excluding the amortised charges. This represents

the interest payable at the negotiated rates. An examination of the interest payable at the

negotiated rates suggests that the interest expense as a percentage of total borrowings is

gradually declining, except for 1993. The interest expense over total borrowings in 1993

was relatively lower at 5.30%, which seems not to be in line with the general trend. It is,

therefore, argued that given the interest payable excluding the amortisation was low in


65

1993, the HA amortised a larger amount of the deferred interest expense in that year to

smooth its total interest expense payable and consequently its profits.

As it was found that interest expense excluding amortisation was relatively low in 1993,

an attempt was made to identify its possible reason. The following table presents the

Authority’s loan liabilities from 1992 to 1994.

Table 5.12 Loan Liabilities in 1992, 1993 and 1994 ($000s)

1992 1993 1994

Opening balance 75348 91820 109614

New loans 12138 21034 28457

10 year zero rated bond 7564

Principal repaid (3230) (3240) (2701)

Ending balance 91820 109614 135370

(Adapted from the HA Annual Reports 1992 - 1994)

Table 5.12 shows that the outstanding loan balance had increased over the three years.

Accordingly, the interest expense on these loans would also increase. The table shows

that in each year, new loans were undertaken and repayments were made for existing

loans. New loans raised were relatively higher than repayments, implying that interest

expense in 1993 and 1994 should be increasing. To ascertain the interest expense on the

new loans undertaken in each of the three years, the following calculations are made.

Table 5.13 Interest Expense on New Loans Raised During 1992, 1993 and 1994

1992 1993 1994

Loan $000

Interest rate %

Interest expense $000

Loan $000

Interest rate %


Loan $000

Interest rate %


1437 8.5 122.15 3034 8.5 257.89 6957 8.50 591.35

3580 8.02 287.12 4000 7.875 315.00 10000 7.50 750.00

1500 8.075 121.13 6000 7.45 447.00 7000 7.60 532.00

320 8.12 25.98 1800 7.35 132.30 4500 8.00 360.00

500 8.36 41.80 4000 7.82 312.80

2100 7.8 163.80 2200 8.375 184.25

2701 9.00 243.09

$12138 $1005.06 $21034 $1649.24 $28457 $2233.35



66

While drawing up Table 5.13, it was assumed that all new loans were undertaken from

the beginning of the year, so the interest expense represents interest for 12 months. For

1992, interest rate on the amount borrowed from the FNPF of $2.70 million was not

provided in the annual report. Consequently, it was assumed that the interest rate was

9% as the annual report had stated that the interest rate on all loans during the year

varied from 6.5% to 9.0%.

Based on the calculations above, it was expected that interest expense (excluding

amortisation) would have increased by approximately $1.65 million and $2.23 million in

1993 and 1994, respectively. Referring back to Table 5.11, it was seen that interest

expense (excluding amortisation) did increase in 1994 from $6.07 million to $9.44

million. However, this does not hold for 1993. Although, Table 5.13 shows that interest

should have increased over the year in 1993, Table 5.11 shows that interest as reported

in the Income Statement has actually reduced. One could argue that perhaps this was the

outcome of the rescheduling of the FNPF's loans as the FNPF had agreed to reduce the

rate. If this was the case then 1994's interest expense should have also been reduced.

But, as it was found, the 1994's amount in Table 5.11 and 5.13 reconciles. Therefore, no

reasonable explanation could be obtained for the low interest expense reported

(excluding amortisation) in Table 5.11.

In conclusion, it is argued that the actual amortisations do not conform to any

identifiable pattern. The amortisation of the deferred expense seems to suggest that it

was used as a smoothing device, particularly in 1993. Interest expense prior to the

inclusion of the amortised charge was relatively low, hence amortising a significant

amount brought the interest expense in line with the general trend. In the earlier section

on capitalisation of administration expenses, it was argued that the HA practiced upward

earnings management in years 1992-1994 while this section implies that a substantial

amortisation made in 1993 reduced earnings. Both the sections discuss items that are

highly dependent on management's discretion as managers can certainly predetermine

the likely effects of amortising a certain amount of deferred assets and/or capitalising a

certain portion of administrative expenses. The year 1993 was an opportune time for the


67

HA to amortise a significantly large amount as even after amortising deferred debit of

$2.38 million, it was still able to provide 0.40% return on assets compared to 0.23% in

the previous year.

5.3.4 Changes in Accounting Policies for Provision for Doubtful Debts

Over the review period, there were two occasions when the HA revised its accounting

policies pertaining to the provision for doubtful debts. The first revision was made in

1995 and the accounting policy note on doubtful debts was provided as follows:

During the year, the Authority adopted a policy of creating specific provisions for

doubtful debts on non-performing debtors accounts. In addition a general provision

of 1% of the total debtors portfolio not covered by the specific provision is brought

to account. In the past, provision for doubtful debts was calculated on an assessed

mathematical formula. The level of general provision is determined having regard

to economic conditions and general risk factors. The financial effect of this change

in the method of calculating provision for doubtful debts is a charge of $2,702,000

to the profit and loss account. (The HA Annual Report, 1995:25).

Prior to 1995, the HA provided for doubtful debts by using an assessed mathematical

formula21. Following 1995, it began to create specific and general provisions. With the

change in accounting policy, there was a significant increase in the provision for

doubtful debts. This increase was reported as an abnormal item in the Income Statement,

explaining that it was an impact arising from a change in accounting policy.

Consequently, the HA incurred a net loss of $2.39 million in 1995 compared to an

operating profit of $0.69 million in the previous year. On this performance, the Board

Chairman made the following comment:

The Housing Authority has recorded a net loss of $2.393 million for the year ending

31 December 1995. A loss was inevitable after the adoption by the Housing

21 Details of the formula are not provided in the annual reports but may be obtained from the HA.


68

Authority Board of new accounting policies in the preparation of the 1995

Accounts. The changes in policy, in particular for the Provisioning for Doubtful

Debts, adopt practices that are acceptable and in line with industry standards. (The

HA Annual Report, 1995: 8).

The HA Board justified the change on the grounds that the new practice was acceptable

and in line with industry standards. Under Section 14(3) of the Banking Act 1995, as part

of the minimum rules for the conduct of banking business by licensed financial

institutions, the RBF provided guidelines for classifying loans and creating provisions

for impaired assets in 199622. The guideline states the following regarding provisions:

(Licensed Financial) Institutions are required to maintain a prudent level of general

provisions against losses not as yet identified on the good part of the portfolio as

well as specific provisions against reasonably anticipated losses on poor quality

assets and all specifically identified losses on impaired assets. Any understatement

of the level of provisions required may result in an institution's capital and profits

being overstated which could lead to a lack of certainty of the institution's on-going

solvency. (RBF Policy Statement No. 3, 1996:7).

The change in the HA's accounting policy for the provision of doubtful debts was in line

with the accepted practice of the licensed financial institutions as these institutions

created general and specific provisions. Thus, the HA's decision to change the

accounting policy is not questionable as it shows that they are moving in line to the

general industry practice. However, the concern here is the timing of the change. Why

did HA decide to adopt an accounting practice similar to the licensed financial

institutions in 1995? It surely cannot be because of the minimum guidelines of the

Banking Act as this came into effect from the following year. Additionally, the guideline

does not apply to the HA since it is not a licensed financial institution so it is not even

obliged to follow these guidelines. It is a non-bank financial institution, regulated by its

individual statute and not by the RBF.

22 Licensed financial institutions include commercial banks, credit institutions and insurance companies.


69

Interestingly, the policy change was first advised by their external auditors in 1991 but

its discussion and review had been deferred till 1995. The Chairman admitted the

following in the Annual Report:

Deferring the discussion and review of the Housing Authority's accounting

practices since 1991 means that the picture presented in our Annual Accounts for

the past few years have been misleading as a measurement of our performance

(1995:8).

It is not understood why the HA deferred the revision of its accounting policies when it

knew that the existing policy was giving a misleading picture. One should bear in mind

that a change in accounting policy does not automatically improve the economic reality

of the report. Indeed the motive for the change made in 1995 is not undertaken to better

reflect economic reality, but to bring the Authority into line with the rest of the industry.

The following section considers whether there was any possible motive for the change in

policy.

With the existing government’s public sector reform policy, the HA's operations since

1992 has been production driven and it was mainly satisfying the needs of the middle-

income customers. A large number of families in the low-income group were regularly

dispossessed of their houses through mortgagee sales. These families not only lost their

personal savings but also their retirement funds with the FNPF. In light of this, the

Board directed that there be a change in focus from the beginning of 1995 as it felt that

unless this change was made, evictions would continue. The HA commenced the year by

focusing on both the middle and low-income earners. The Authority suspended its

design and build scheme during the year in order to re-align their focus to their target

market as the houses constructed under this scheme proved to be unaffordable to its low-

income clients.

However, the change resulted in conflict within the HA so the Government sanctioned a

Special Inquiry into the affairs of the HA. The committee of the Special Inquiry was

headed by the former secretary to the Public Service Commission, Winston Thompson.


70

The recommendations (of the Thompson Report) were aimed at bringing about

stability in management of HA, reducing the costs of its products and making

housing more affordable to low income earners, improving the delivery of services

to the clients and bringing about general efficiency in the execution of its functions

(The Fiji Times, October 1996:4 ).

Cabinet accepted the findings and recommendations of the Thompson Report. Its

acceptance reconfirmed government's commitment to the HA realising that its original

key objective is to serve the middle and low income earners.

If the HA had not changed their accounting policy, they would have reported a profit of

$0.31 million compared to a loss of $2.39 million. A profit would have not looked good

for the HA when so many of its customers were facing hardship by losing their houses

and savings that were used for financing. Accordingly, the net loss lent legitimacy to the

HA's operations. The government's acceptance of the committee of Special Inquiry’s

findings suggests that Government realised the problem and resolved that the HA should

not depart from the social objectives of providing affordable housing to the low and

middle-income earners. Therefore, this license from the government might have

provided further incentive to the HA to change its accounting policy and to report a net

loss in 1995.

Furthermore, in 1996 KPMG were commissioned by the Ministry of Housing and the

Ministry of Finance to undertake a special audit. Engaging KPMG to undertake a special

audit is odd in itself as KPMG was already providing a significant amount of non-audit

services together with their audit work. This special audit would have been more

appropriately and independently undertaken by another firm, although it does not seem a

matter, which the HA has ‘managed’. The purpose of the audit was to ascertain the HA's

true financial status, including the quality of its assets. On this special audit the Board

Chairman made the following comment:

As a result (of the special audit), the Authority introduced a more realistic and

prudent accounting policy. A consequential increased allocation for provisions


71

gives a much more reliable representation of the Authority's financial position. (The

HA Annual Report, 1996:4).

According to the HA, the provisions were included in the accounts in line with a more

prudent accounting approach, which compares loan balances against current market

value of assets. The Board argues that this approach ensures that the balance sheet

reflects the state of the HA's finances more accurately. The special audit resulted in an

increase in the provision for doubtful debts, repairs and maintenance and stock write-

down. The following table shows the trend in these expenses over the years.

Table 5.14 Discretionary Expenditure

Year Provision for Doubtful

Debts Provision for Repairs and Maintenance

Stock Write down

Net profit

$000s % of

Receivables $000s

% of Stock & PPE23

$000s % of Stock

$000s % of Assets

1992 395 0.55 132 0.49 0 0.00 248 0.23

1993 300 0.34 34 0.11 0 0.00 518 0.40

1994 963 0.97 57 0.18 0 0.00 687 0.45

1995 3522 2.84 0 0.00 163 0.75 (2393) (1.43)

1996 3302 2.49 1017 3.83 977 5.26 (5695) (3.37)

1997 1542 1.18 455 1.76 170 0.95 115 0.07

1998 1421 1.00 135 0.77 130 1.34 160 0.10

1999 5836 4.09 0 0.00 777 12.90 (3400) (2.15)

2000 1993 1.41 120 0.91 0 0.00 (432) (0.27)

2001 783 0.54 2245 17.50 355 9.49 518 0.31

2002 870 0.54 150 1.16 287 7.56 538 0.31

2003 968 0.64 0 0.00 41 0.59 771 0.43

2004 1365 0.96 224 1.05 250 2.18 2067 1.30

(Adapted from the HA Annual Report 1992-2004 and author's calculations)

In December 1996, all new members were appointed to the HA Board, including the

Chairman. At the senior management level, the general manager positions were reduced

from five to only three. The Board Chairman commented as follows, regarding the new

Board’s role:

23 Repairs and maintenance are usually carried out for property, plant and equipment. However, the HA paid for these expenses upon receiving several complaints from the customers about the defective houses.


72

1996 at the Housing Authority can best be described as a year of resolving

problems, introducing change and laying the foundation for future reorganisation.

The new board appointed in December 1996, is now firmly embarked on a new

course which will see the Authority emerge as a viable, efficient and innovative

commercial enterprise. It will be profit driven, dedicated to supplying affordable

and acceptable housing and enabling more and more people to own homes. (The

HA Annual Report, 1996:4).

As the HA was declared a CSA from 1996, the new Board was expected to lead the HA

towards a profit-driven institution. The following table compares the Authority’s

profitability position in 1995 and 1996.

Table 5.15 Profits in 1995 and 1996 (as a percentage of assets)

1995 1996

Total Revenue 19.23 17.23

Total Expenses 19.04 17.86

Profit before abnormal items 0.18 (0.63)

Abnormal items (1.61) (2.74)

Profit after abnormal items (1.43) (3.37)

(Adapted from the HA Annual Reports 1995 and 1996)

Table 5.15 shows that in 1995 the HA’s operating profit before abnormal items was

0.18% of total assets while in 1996 it was negative 0.63%. As is evident from the above

table, the operating loss in 1996 was due to reduced revenue. Given the Board and the

senior management’s profit driven objectives, an operating loss of 0.63% would reflect a

poor performance of the new team, especially when a profit was reported by its

predecessor. Hence, the effects of the special audit in 1996 proved to be an advantage to

the Board and management as the operating loss before abnormal items have been

overshadowed by the losses incurred through abnormal items.

There was yet another change in the accounting policy for provision for doubtful debts

in 1999. This time the change was in the definition of non-performing loans. When this

policy was first changed in 1996, a non performing loan was classified as one on which


73

interest was in arrears for six months or more. In 1999, this was reduced to three months.

Thus, all loans where the interest was in arrears for three months or more was

considered to be a non-performing loan.

An interesting point was discovered when reviewing the explanation for the change in

this accounting policy. The annual report stated that the first change in the accounting

policy for the provisioning of doubtful debts was made in 1996. This implies that in

1995, the HA created specific and general provisions and then in 1996, it classified a

non-performing loan as one in which interest was in arrears from six months or more.

Although, the accounting policy note on provision for doubtful debts in 1995 stated that

HA created specific provisions for non-performing loans, it did not provide any

information in its disclosure notes on the definition of non-performing loans.

This change increased the non-performing loans portfolio by approximately $24.40

million. Once a loan is deemed to be non-performing, interest revenue will cease to be

recognised on them. Thus, the Authority lost about $2.60 million of interest revenue.

Given that non-performing loans have increased, so will its related provision for

doubtful debts. The Chairman attributed the year's net loss to the change in accounting

policy as reflected in the following statement:

For the year the Authority has recorded a loss of $3.4 million as against

$159,899 profit recorded in 1998. This loss was inevitable because of the

introduction of new accounting policies relating to Provisioning for Doubtful

debts and Stock Write-downs. (The HA Annual Report, 1999:3).

Similar to the justification given in 1995, the HA again argued that the revision in 1999

conformed to commercial and international practices. The Board Chairman's comment

on the issue of change in accounting policy was as follows:

…the Authority proceeded to again redefine its accounting policy relating to the

booking of Provision for Doubtful Debts. These policy changes were not only

prudent but also necessary as it conformed to commercial and international

accounting practices. (The HA Annual Report, 1999:3).


74

FAS 30 Additional Disclosure by Financial Institutions was first issued and was

effective for accounting periods beginning on or after 1 January 1999. According to

paragraph 55 of the standard,

Loans or similar facilities which have not been operated within key terms for at

least 90 days and for which the recovery of all amounts of principal and interest

is not regarded as probable are classified as non-accrual loans.

…90-day threshold period of non-compliance with key terms is based on industry

practice.

The HA’s decision to change the definition of non-performing loans was in line with the

requirements of FAS 30. The standard does state the 90-day threshold period for

classifying loans as non-accrual (non-performing). Hence, the change made by the HA is

not questionable. However, one cannot overlook the possibility that the HA could have

exaggerated the effects of the policy change. The subsequent discussions will illustrate

that the events that took place in years surrounding the year of change could possibly

have provided the incentive to the HA to reduce earnings.

Excessive provisioning often leads to write-back in subsequent years. Upon reviewing

the financial accounts, no such write-backs were found. Alternatively, there would be

reduced provisioning in the future periods. Table 5.14 shows the provision for doubtful

debts over the years as reported in the Income Statement. Given that from 1999, loans

were classified as non-performing three months sooner, it is expected that the doubtful

debts should be more than what was provided for prior to the change. The values in the

table show otherwise. The provisions after the change is relatively lower than the

previous years’ provisions. One could argue that the HA may have taken steps to reduce

the non-performing loans and hence its provisions. However, there is no evidence of

such measures being implemented by the HA.

Further support of the argument that the HA may have exaggerated the effects of the

change comes from the stock write-downs. The Chairman stated that the operating loss

was inevitable due to changes in accounting policies for both, provision for doubtful


75

debts and stock-write downs. Although the change for provision for doubtful debts was

explained, no explanation was given for the change in stock write-downs anywhere in

the report. Yet, a perusal of the expenses reflects a major movement in the account

balance from the previous year as shown in Table 5.14. The table shows that apart from

major increase in the provision for doubtful debts in 1999, stock write-downs

represented 13% of stock, being the largest over the review period. In fact, when the

accounting policies were changed in 1996 and 1999, stock write-downs had increased.

Thus, the trend in the provision for doubtful debts and the stock write-down in 1999

supports the argument that the HA may have increased the provisions.

A possible incentive to manage earnings downward could be the need to convert the $44

million ADB and World Bank debts into equity. From as early as 1999, the HA had

commenced discussions and made submissions seeking government approval for the

conversion. A comprehensive review was conducted in 2001 to assess the financial

performance of the Authority and to determine the factors that would contribute to its

continued financial viability. One of the findings of the review is given below.

The review indicated that unless Housing Authority's debt to Government in respect

of ADB/World Bank loans acquired for the low income housing projects 1990-1994

were converted to equity, (the) Housing Authority would remain unviable. The

Board made representation to the Government in this regard. (The HA Annual

Report, 2000:8).

The review clearly pointed out that for the Authority to continue as a viable institution,

these loans had to be converted into equity. The change in accounting policy in 1999 had

worsened the profitability of the HA and consequently deteriorated the equity balance.

The following table shows the profits and equity position of the HA over the years.


76

Table 5.16 Profitability and Equity Position of the HA

Year Net Profits Accumulated Profits Total Equity

$000s % of Assets $000s % of Assets $000s % of Assets

1990 (1141) (1.34) (12444) (14.59) 1702 2.00

1991 (1898) (2.19) (14342) (16.57) 804 0.93

1992 248 0.23 (14094) (13.09) 2052 1.91

1993 518 0.40 (13576) (10.61) 4311 3.37

1994 687 0.45 (12889) (8.38) 5819 3.78

1995 (2393) (1.43) (15282) (9.13) 3426 2.05

1996 (5695) (3.37) (20977) (12.42) (2219) (1.31)

1997 115 0.07 (20862) (12.52) (2104) (1.26)

1998 160 0.10 (20702) (12.31) (1944) (1.16)

1999 (3400) (2.15) (24102) (15.25) (5344) (3.38)

2000 (432) (0.27) (24534) (15.17) (4364) (2.70)

2001 518 0.31 (24016) (14.48) (3846) (2.32)

200224 538 0.31 (23478) (13.34) 38464 21.85

2003 771 0.43 (22707) (12.78) 39235 22.09

2004 2067 1.30 (20640) (13.01) 41302 26.03


In fact, the HA had already begun to receive financial assistance from the government in

1999 in regards to its negative equity position. Quoting the Board Chairman,

The government provided a grant of $2 million to improve Housing Authority's

negative equity position and to offset reduction in income arising out of the

implementation of new policies (The HA Annual Report, 1999:3).

The above observation implies that government had realised the negative equity position

of the Authority hence provided assistance. Also, the Labor government that came in

power in 1999 had put a halt to the privatisation policy. This means that the HA would

now possibly be able to receive grants from the government, which was ceased by the

previous government.

The HA reduced its lending rate for low income customers in September 1999 so the

government provided assistance to the HA through a grant of $2 million. The purposes

of the grant were to improve the Authority's financial position and assist in reducing

24 The positive balance for capital and reserves from 2002 is reflective of the ABD and World Bank loans converted into government's equity contribution.


77

interest rates to customers. The entire amount was reported as an abnormal item in the

Income Statement. The grant was reported in accordance with FAS 20 Government

Grants (issued in 1992).

Government grants are rarely gratuitous. The enterprise earns them through

compliance with their conditions and meeting the envisaged obligations. They

should therefore be taken to income and matched with the associated costs which

the grant is intended to compensate (paragraph 8b).

In certain circumstances, a government grant may be awarded for the purpose of

giving immediate financial support to an enterprise rather than as an incentive to

undertake specific expenditures. Such grants may be confined to an individual

enterprise and may not be available to a whole class of beneficiaries. These

circumstances may warrant taking the grant to income in the period in which the

enterprises qualifies to receive it, as an abnormal item if appropriate, with

disclosure to ensure that its effect is clearly understood (paragraph 14).

The above two sections from FAS 20 justifies why the grant was reported in the Income

Statement as an abnormal item. Further, the accounting policy note on Government

Grants stated:

Government grants are recognised in the profit and loss statement over the periods

necessary to match them with the related costs that they are intended to compensate

(The HA Annual Report, 1999:17).

This implies that the entire amount that was received from the government in 1999 was

matched with its related expenses during the same year.

Eventually in October 2002, the Parliament approved to convert the $44 million owed to

the ADB and World Bank into government equity. This moved the HA’s negative equity

position of $3.8 million in 2001 to a positive position of $38 million in 2002. However,

this financial assistance from the government came with certain conditions. The HA and

the Government signed a Memorandum of Understanding, to ensure good corporate


78

governance and the financial viability of the HA in the future. As part of these

conditions, the Board is now accountable for good corporate governance through the

Minister for Housing and the Minister for Public Enterprise. In order to ensure this, the

HA created a Corporate Governance Division, headed by the Manager Corporate

Governance. The division's responsibility is to monitor and report on the progress of the

HA's Annual Work Plan on a quarterly basis and ensure that the performance

benchmarks agreed upon, under the respective divisions are met.

Changing the accounting policy had a substantial effect on the HA's net profits and the

equity balance. Table 5.17 demonstrates the effects of changing the accounting policy in

1999. As it is argued that the HA may have exaggerated the effects, the table also takes

into account the large increase in stock write down.

Table 5.17 Effects of Change in Accounting Policy at the HA in 1999

Change in

Accounting policy No Change in

Accounting policy

$000s % of Assets $000s % of Assets

Interest income 13893 8.79 13893 + 2600 = 16493 10.43

Profit before abnormal items

(1416) (0.90) (1416) + 2600 + 777 =

1961 1.24

Abnormal items (1984) (1.26) (1984) - 4291 = 2307 1.46

Profit after abnormal items

(3400) (2.15) 1961 + 2307 = 4268 2.70

Accumulated profits (24102) (15.25) (20702)25 + 4268 =

(16434) (10.40)

Equity (5344) (3.38) (5344) - (24102) + (16434) = 2324

1.47

(Adapted from the HA Annual Report 1999 and author's calculations)

With the change in the definition of non-performing loans, the HA lost about $2.60

million of interest income. Hence, if the change was not made, the HA would have

earned $16.49 million of interest income. Adding back the $0.78 million of stock write

down to income yields an operating profit before abnormal items of $1.96 million. In

order to determine the profit after abnormal items, the provision for doubtful debts of

$2.31 million is added back to yield $4.27 million. Thus, the table shows that presently

the net profit of the HA is negative 2.15% of total assets. If the policy were not revised,

25 This is the beginning balance for accumulated profits


79

the net income would be much higher at positive 2.70%. Additionally, after the change

in accounting policy the equity position deteriorated to a negative 3.38% from positive

1.47%. The negative equity position was the major concern that the HA was indeed

using when making requests to the government to convert the debts into equity. Had the

accounting policy not changed, it would be less likely that the government would agree

to the conversion.

Table 5.17 presents the calculations with and without the change in accounting policy.

With FAS 30 being effective from 1999, the HA had to make the change. As it is argued

that the HA may have exaggerated the effects of provisioning, this could not be

incorporated in the above table. The extent of exaggeration is impossible to determine.

Nonetheless, the table shows that if the HA had not changed its accounting policy; it

would have made an operating profit of $4.27 million. This profit would have been

achieved despite that HA had reduced its lending rate. As already been noted, a high

possible reported profit is politically unacceptable in view of the Authority's social

objective. Therefore, the HA may not want to report high profits irrespective of

government policy and management incentive schemes. This proves to be another

incentive for exaggerating the effects of accounting policy change and reporting a loss in

1999.

In conclusion, it is argued that the actual change in accounting policy did not reflect an

attempt of earnings management. However, the timing of the change in 1995 is

questionable and it seems that the HA may have exaggerated the effects of the policy

change in 1999. While analysing the change in policies it was found that several possible

incentives existed that could have driven the change. These incentives include the need

for the incoming board and management to reflect improved performance, the non-

financial or social objectives of the HA and the conversion of debts into equity.


80

5.4 Conclusion

The in-depth analysis of the information obtained from the HA's annual reports and

other relevant documents suggests that there may be evidence of earnings management

practices in the relevant years. Table 5.18 summarises the evidence in light of the

possible incentives for its practice.

Table 5.18 Summary of Earnings Management Evidence

Year Event Incentive

1988 - 1991 Provision for write-down of inventory

Meeting stakeholders expectations and continue receiving funds for consultancies

1992-1994 Capitalising administration expenses

Reflect performance of the new government and new Board and introduction of performance based contracts

1993 Amortisation of deferred interest Smooth the trend in interest expense

1995 Provision for doubtful debts Social obligations

1999 Provision for doubtful debts Converting debt into equity

Four major possible instances of earnings management practices were identified and

these related to the provisioning for inventory, capitalised administrative expenses,

amortisation of deferred interest expense and changes in accounting policies for

provision for doubtful debts. To support the presence of such practices, analysis

indicates that there were several incentives for these events. These include the need to

meet expectations of the stakeholders, reflect performance of new government and the

incoming board and management, for annual bonuses and continuity of employment, to

satisfy the social objectives of HA and to convert debt into equity.

Analyses of Earnings Management Practices in Fiji’s SOEs

81

CHAPTER SIX

EVIDENCE OF EARNINGS MANAGEMENT PRACTICES IN

THE FIJI ELECTRICITY AUTHORITY

6.1 Introduction

This chapter analyses earnings management practices in the second organization, the Fiji

Electricity Authority (FEA). It begins by providing a brief corporate background of the

Authority, reviews its sources of electricity generation and describes the accounting

environment within which the FEA operates. The chapter then proceeds to identify and

analyse the possible instances of earnings management in light of the economic

incentives.

6.2 Overview of the Fiji Electricity Authority

6.2.1 Background

The FEA was established under the provisions of the Electricity Act 1966, which

constituted it to provide and maintain a power supply that is financially viable,

economically sound and consistent with the required standards of safety, security and

quality. When the Authority commenced operations on 1 August 1966, it was only

responsible for supplying electricity to Nadi, Lautoka and Levuka. Fiji’s biggest

consumer of electricity, Suva, was not under its jurisdiction. The Authority realised that

until it incorporated Suva within its market, its development would not proceed on a

satisfactory basis. In 1978, the FEA eventually acquired the assets of the Suva City

Council's Electricity Supply and became responsible for supplying electricity to Suva.

Subsequent to the acquisition, the Authority’s customers increased from 13,400 to

Chapter 6: Evidence of Earnings Management Practices in the FEA

82

32,000, a massive increase of 140%, and it evolved from being a regional to a national

entity. The rationale for taking over the Suva supply was that the Monasavu Hydro

Electric Scheme (discussed below) would only be financially viable if the FEA had a

larger customer base.

Fuel prices increased in the early 1970s due to the world oil crisis, making the

conventional diesel generators a very costly source of power generation. The

Government decided that hydro power was a viable option as it was expected to free Fiji

from some of the price fluctuations and other problems associated with an unstable oil

market. The government implemented the Monasavu Hydro Electric Scheme to generate

electricity. The FEA was given the responsibility for implementing this first hydro

scheme. Two out of the three stages of the scheme were completed in the second half of

1983 so the FEA began generating hydro electricity from October of that year. Since

then, electricity needs for Viti Levu have been met through hydro generated energy.

Diesel power stations were relegated to a standby role and were mainly used to supply

electricity in other areas of Fiji.

The Monasavu Hydro Electric Scheme saves the country over $40 million annually in

foreign currency and guarantees a secure source of supply through utilisation of a local

natural resource. The Chief Executive of the FEA stated in the 1991 Annual Report that

apart from the savings in foreign exchange, the Monasavu Hydro Electric Scheme had

met FEA’s expectations in operational efficiency. It exposed the Authority’s workforce

to state of the art technology that improved the employees' professional skills. Although

this scheme is an economic success, it represents a severe burden for the FEA in terms

of loan repayments as the total cost of financing the project was $240.50 million

(Parliamentary Debates 2003). The FEA had to borrow large sums of finance from

offshore lenders, such as the ADB ($28 million), Commonwealth Development

Corporation ($25 million), European Investment Bank ($34 million) and World Bank

($28 million) to fund the project26. The costs of servicing these foreign debts placed the

FEA into a difficult financial position, as around 40% of its revenue was used for paying 26 $73 million was borrowed from local lending agencies through bond issues while the remainder was financed by the government.


83

interest. The 33% devaluation of the Fiji dollar in 1987 (17.75% in June and 15.25% in

October) increased the Authority's debt by $69 million, thus compounding its

difficulties.

In 1993, the FEA management prepared a corporate plan to give the organization its

planned direction and future development strategies. After intensive consultations and

discussions, the plan was adopted in 1994. It set out the philosophies for guiding the

FEA into corporatisation, placing customer satisfaction at the forefront of its corporate

objectives. In 1997, the FEA was declared a Reorganisation Enterprise by the

Government and was to be split into three government commercial companies, each

responsible for Generation, Transmission and Distribution of power. The government

planned to partially privatise the Generation and Distribution companies by allowing a

strategic investor to bring in new technology, ideas and expertise while the third

company was to remain fully owned by the government. However, the restructuring plan

was reversed in 1999 by the new Labour government and the three companies instead

became three business units and two support divisions. They were placed under one

organisation, the FEA, which remained fully owned by the government.

The FEA Board comprises of a Chairman, Deputy Chairman and five other members, all

appointed by the minister responsible for Energy. The Chief Executive is an ex-officio

member and is responsible for the management and execution of the FEA's policies.

There were three occasions over the review period, where a new Board was appointed,

the most recent one being in 2001. Apart from this, the Board turnover was relatively

stable.


84

6.2.2 Electricity Generation

Although, the hydro generation began operating efficiently since its inception, there was

a relative fall in its production capacity due to severe dry conditions and growing

consumer demand. The Monasavu dam reached a critically low level in 1992 due to the

prolonged drought which necessitated the use of supplementary diesel generators at

additional costs. Further, the consumer demand in Viti Levu had exceeded the long-term

average energy production capacity of the Monasavu Hydro Electric Scheme. The FEA

anticipated that if demand increases as expected, it will have to increase the use of diesel

generators to meet the hydro shortfall, which will significantly increase the FEA’s

operating expenditure. In light of this, the FEA commenced developing further hydro

generation as well as other alternatives (discussed below) to replace costly diesel

generators. In addition to supply issues, the FEA introduced Demand Side Management

programme in 1996 to help its customers, particularly industrial, to reduce their

maximum demands and thereby save on charges and improve their loading pattern. The

concept of Demand Side Management supplements the supply side planning activities

and presents new options to the Authority while trying to meet the demand in a cost

effective and efficient manner.

The FEA also explored the possibilities of environment friendly forms of power

generation. It pursued works on solar energy generation and in late 1997 installed a trial

10kW solar panel in Lautoka. As the solar energy production increased over the years, it

began to receive positive attention, particularly in light of ever increasing fuel costs. The

FEA intended to develop solar energy on a large scale so a feasibility study was

undertaken at Yaqara. Further, the FEA is embarking on a wind farm project in

Sigatoka. The Authority has already acquired the land from Native Land Trust Board on

a 50-year lease and expects to commission the project by mid 2006. Studies are also

underway for the development of wind farms in other parts of Viti Levu, Vanua Levu

and Ovalau. On its quest for renewable energy development, the FEA signed a joint

venture agreement with Australia based Pacific Hydro Limited, one of the largest

renewable energy companies in Australia. The FEA is jointly developing two hydro


85

projects worth $18 million with the Australian company. Currently, the FEA is

embarking on a plan of becoming a 100% renewable energy utility by 2011.

The FEA was seriously affected by the El Nino weather pattern that caused another

prolonged drought in Fiji in 2003. The Monasavu dam was below the minimum safe

operating level. The condition deteriorated in 2004 as Monasavu experienced the lowest

rainfall over the past 24 years. The FEA carried out a long-term plan, which showed that

the existing power capacity would not be able to meet electricity demand unless a new

power supply is developed by 2006. The FEA signed a 20 year energy conversion

agreement with Telesource (Fiji) to operate and maintain its diesel power stations at

Vuda and Kinoya. Telesource played an important role in the energy crisis of 2003 in

locating and helping to negotiate rental terms that brought the 38 generator sets required

to cover the shortfall in hydro generated electricity. There are three independent power

producers currently operating in Fiji, viz Fiji Sugar Corporation, Tropik Woods and

Emperor Gold Mines. They produce electricity for their own use and sell the surplus to

the FEA. A new Power Purchase Agreement was signed with Tropik Woods in 2004 to

increase their production for the FEA.

6.2.3 Accounting Environment and Financial Performance

The FEA prepares its financial reports on the basis of the FASs and Electricity Act 1966.

The IASs are also used where the Fijian counterpart does not provide adequate guidance.

From the beginning of the review period to 1994, the FEA’s financial accounts were

audited by Coopers & Lybrand while from 1995-1997, PriceWaterhouse took over the

audit responsibilities. With the merger of the two audit firms, the FEA's accounts were

audited by PricewaterhouseCoopers from 1998. The auditors' remuneration averages

around 0.04% of the FEA's income. Although there has been some rotation of the audit

firms over the review period, it is hard to determine if there was any rotation of the audit

partners, as the audit reports are signed off by the audit firm rather than the partner.


86

The FEA's total assets increased from $337.39 million in 1990 to a peak value of

$526.96 million in 1996. Subsequently, assets declined to $452.12 million in 2004. Its

equity position was negative since 1987 but turned positive in 1991. This, however, was

achieved through profits and not capital injections. Equity was still low at $13.41

million, with a debt to equity ratio of 25:1. Following the revaluation of assets in 1992,

equity increased significantly and since then it has averaged around $283.30 million.

The FEA reported an average operating profit of $16.91 million from 1991-1999.

However, a loss was reported in 2000, which was largely due to the political crisis in the

country. The Authority returned to operating profits from 2001 but these were relatively

lower than what was being reported prior to the crisis. The return on equity in the 1990s

averaged around 7% and was reduced to 1% in the early 2000. Apart from the activities

related to its normal operations, abnormal items during the 1990s were quite frequently

reported in the statement of financial performance. These indicators are appended in

Appendix 3B.

6.3 Possible Instances of Earnings Management

6.3.1 Capitalisation of Research and Development Costs

The review of the FEA’s financial reports revealed that it has capitalised research and

development costs (R&D). The accounting policy it adopted is given below followed by

Table 6.1, which depicts the annual movements in the FEA's R&D over the relevant

periods.

Research and development costs are carried forward as an asset where future

benefits are expected. Amortisation will be effected against future income after

commercial production commences. Research and development expenditure which

no longer satisfies this criterion is written off against revenue. (The FEA Annual

Reports, 1985-1992).


87

Table 6.1 Research and Development Cost ($000s)

Year Beginning Balance

Increase During The Year

Amounts Written Off

Ending Balance

1985 3418 628 0 4046

1986 4046 498 413 4131

1987 4131 245 1461 2915

1988 2915 119 257 2777

1989 2777 19 24 2772

1990 2772 7 449 2330

1991 2330 7 372 1965

1992 1965 2 1967 0

(Adapted from the FEA Annual Reports 1985 -1992)

With this capitalisation, it is important to review the requirements of the accounting

standard. FAS 9 Accounting for Research and Development Activities (paragraph 3)

differentiates between research and development phases in the following manner:

Research is the original and planned investigation undertaken with the hope of

gaining new scientific or technical knowledge and understanding.

Development is the translation of research findings or other knowledge into a plan

or design for the production of new or substantially improved materials, devices,

products, processes, systems or services prior to the commencement of commercial

production.

Further, according to paragraph 15 of FAS 9, the costs of research and development

include the following:

a) the salaries, wages and other related costs of personnel engaged in research and

development activities

b) the costs of materials and services consumed in research and development

activities

c) the depreciation of equipment and facilities to the extent that they are used for

research and development activities

d) other costs related to research and development activities, such as the

amortisation of patents and licenses.


88

The accounting standard requires R&D to be expensed in the period in which they were

incurred. However, development costs can be capitalised provided all the following

criteria according to paragraph 17 of FAS 9 are met:

a) the product or process is clearly defined and the costs attributable to the product

or process can be separately identified;

b) the technical feasibility of the product or process has been demonstrated;

c) the management of the enterprise has indicated its intention to produce and

market, or use, the product or process;

d) there is a clear indication of a future market of the product or process, or if it is to

be used internally rather than sold, its usefulness to the enterprise can be

demonstrated; and

e) adequate resources exist, or are reasonably expected to be available, to complete

the project and market the project or process.

Even after meeting the above criteria, all development costs still cannot be capitalised.

Only those costs, which can reasonably be expected to be recovered from related future

revenues, are deferred (paragraph 18). So the accounting regulation allows an entity to

capitalise development costs only and not the costs incurred for undertaking research

activities. Therefore, it is important to ascertain whether the capitalisations made by the

FEA relate only to development costs or it includes costs incurred for research activities.

This is discussed in the following section.

FAS 9 requires the following disclosures to be made for R&D:

i. The total of research and development costs, including the amortisation of

deferred development costs, charged as an expense

ii. The movement in and balance of unamortised deferred development costs

iii. The basis, proposed or adopted, for the amortisation of the unamortised balance


89

Along with the above disclosure requirements, paragraph 14 of FAS 9 states that:

Further information which might usefully be provided could include a general

description of the project, the stage which the project has reached and the estimate

future costs to complete it.

Although it is not mandatory, FAS 9 considers it useful that entities provide a general

description of the research and development project. However, the FEA’s annual reports

failed to do so. Thus, it is hard to verify for which product (or process) the research and

development project was undertaken. Also, the reports did not disclose the cost

components of the research and development activities, making it impossible to verify if

all the listed criteria in FAS 9 have been met. Further, R&D prior to 1985 was not

separately listed in the statement of financial position. Rather, it was aggregated with

capital works in progress. Capital works in progress represents expenditure in respect of

labour, material, services, an appropriate proportion of overheads and interest on

borrowings for specific capital works which were incomplete at balance date. It is

impossible to disaggregate the figures for R&D from capital works as the way the

information is presented does not permit to do so. Thus, the initial capitalisation of R&D

is unknown. The following table lists the capital works that were in progress in 1984.

Table 6.2 Capital Works In Progress In 1984

Items $000s

Building 481

Investigation 210

Plant, Machinery & Equipment 361

Reticulation 1623

Power Development 46159

Total 48834

(Adapted from the FEA Annual Report 1984)

Total capital works in progress in 1984 were $48.83 million, which includes $3.42

million of R&D (see Table 6.1). Therefore, the research and development activities

relates to one or a combination of assets in Table 6.2. One of the items listed as part of

capital works was ‘Investigation’. This item was first reported in the statement of

financial position in 1983, where $98,687 was shown under fixed assets and $32,713


90

was reported as capital works in progress. In the following year, the amount reported

under fixed assets was transferred to capital works in progress. This item was not

reported in capital work in progress in the subsequent years. An item termed as

‘Investigation’ seems more likely to be the costs undertaken for research activities.

Hence, its inclusion as part of capital works suggests that the FEA has capitalised costs

incurred for research activities.

Moreover, the review of the FEA’s individual capital works revealed that for years up to

198327, they primarily related to the Monasavu Hydro Electric Scheme and following

that, it related to extension of transmission lines and telecommunications systems and

building/relocating new power stations and substations. This clearly shows that all

capital works for the FEA relates to assets that have long economic lives. Regardless of

whether the research and development expenditure relates to the Monasavu Hydro

Electric Scheme or other projects, it should have been amortised using a longer

economic life. The lives of the FEA’s assets range from 20-80 years (excluding motor

vehicle and furniture and fittings). Hence, if the capitalised R&D includes development

costs, it should have been amortised for at least 20 years. Referring back to Table 6.2, it

can be seen that this is not the case. There had been nominal capitalisations of R&D

from 1987 and large write offs. It is also noted that prior to 1987, annual capitalisations

exceeded write-offs. It can be clearly seen from the table that the write offs seem to be

discretionary, rather than based on any policy. Following a review in 1992, the FEA

expensed the remaining balance of R&D. There has been no further research and

development expenditure reported in FEA's financial accounts. The analysis so far

suggests that the capitalised R&D does include costs incurred for research activities.

During the same periods, FEA also capitalised training expenses. These expenses were

initially treated as part of capital works in progress in 1983 while from the following

year, it were separately reported as an intangible asset. The following policy note was

provided in its annual reports:

27 Although, the Monasavu Project was fully completed in 1986, all major works were completed in 1983 and the FEA began to generate hydro energy from that year.


91

During the construction of Monasavu Hydro Scheme $3,787,769 of training

expenses was capitalised, giving rise to an intangible asset in the books of the

Authority. This intangible asset is being amortised over 5 years. (The FEA Annual

Reports, 1984 - 1987).

Table 6.3 shows how training expenses of $3.79 million was amortised over the years.

Table 6. 3 Amortisation of Training Expenses

Year Amortisation Expense

($) Amortisation Expense/Initial Amount Capitalised (%)

1984 757554 20.00

1985 757000 19.99

1986 757600 20.00

1987 1515615 40.01

(Adapted from the FEA Annual Reports 1984 -1987 and author’s calculations)

Even though the FEA had adopted a policy of amortising training expenses over five

years, the expenses were fully amortised in the fourth year. In 1987, the FEA wrote off

the unamortised balance for training expense, as stated in the following policy note:

…however, the Authority views this benefit as fully realised and has amortised an

amount of $1,515,615 in 1987 to bring the balance to nil. The effect of this change

in policy is to increase operating loss by $758,015. (The FEA Annual Report,

1987:21).

The generally accepted accounting practices do not allow an entity to capitalise training

expenses. Further, it was noted that the FEA wrote off two years’ amortisation expense

in 1987. The Authority justified this on the grounds that the benefit from capitalising

training expenses was fully realised in the fourth year. This is purely an act of

management judgment, which would be difficult to question. The large write off of

training expenses was accompanied with a first time significant net write off of R&D.

The 1987 annual report was reviewed to find out the reason(s) for the large write-offs of

R&D and training expenditure. Apart from the suspension of capital works (which may

explain the large write off of R&D), there was no other relevant information provided,

which could explain them.


92

Capitalisation of research and training costs are not permitted by the accounting

standards. By overstating its assets, the FEA was able to defer the recognition of its

expenses. There were unusually large write offs of these expenses in 1987, as it was an

opportune year to for the FEA to write off unwanted debits it has treated as assets. As a

result of political coups and devaluations, the readers would have expected substantial

losses during the year and may not be expected to question possible manipulations in

intangibles. Non-compliance with generally accepted accounting practices does not

necessarily constitute earnings management. It could be possible that the accountants

lacked understanding of the requirements of the accounting regulation on this aspect

therefore, making this a genuine case. However, one cannot overlook the possibility of

opportunistic behaviour. Therefore, it is important to determine if there was any

incentive for deferring these costs. This is discussed in the following section.

As part of the terms and conditions of the loans, the lending agencies required the FEA

to provide a return of 8% on currently valued fixed assets (the FEA Annual Report

1984). Table 6.4 depicts the return that the FEA was able to achieve by deferring the

recognition of research and training costs. The return is calculated using operating

profits before financing charges. The second last column shows that in the 1980s, except

for 1984, the FEA was not able to achieve the 8% return required but was close to the

value. It is important to calculate what the returns would have been had these costs not

been capitalised. However, this cannot be calculated with precision due to several

reasons. Firstly, the FEA calculated the above ratios by using separately maintained CPI

adjusted book values so the denominator in the calculation is unknown. Secondly, as

earlier mentioned, it could not be ascertained when R&D was first capitalised. Finally,

although it has been found that R&D capitalized does include research costs, the

component of each is impossible to determine. Keeping these factors in mind, the last

column of Table 6.4 calculates the approximate returns. As expected, there is a

noticeable effect in 1983, as this was the year when training expenses were first

capitalised. The return in fixed assets after capitalising training expenses yields 7.27%.

Had this cost not been deferred, the returns would have been 1.97%. In both cases, the

covenant is violated but the return without capitalisation is substantially lower than the


93

required return. Therefore, it can be argued that research and training expenses were

capitalised either to meet or smooth the return on fixed assets.

Table 6.4 Effect of Cost Capitalisations on Return on Fixed Assets

Year

R&D capitalised (amortised)

$000

Training Exp

capitalised (amortised)

$000

Profit with Capitalisation

$000

Profit without

capitalisation $000

Return with capitalisations

%

Return without

capitalisations %

1983 3788 5198 1410 7.27 1.97

1984 3418 (758) 21290 18630 11.98 10.48

1985 628 (757) 21223 21352 5.8 5.84

1986 85 (758) 27774 28447 6.17 6.37

1987 (1216) (1516) 31519 34251 6.53 7.27

1988 (138) 9669 9807 7.74 7.77

1989 (5) 29736 29741 7.35 7.35

1990 (442) 34352 34794 7.21 7.30

1991 (365) 40179 40544 8.01 8.08

1992 (1965) 40050 42015 8.1 8.50

(Adapted from the FEA Annual Reports 1983 -1992)

Studies have clearly shown that debt covenants are one of the strongest incentives for

earnings management in the private sector. Accordingly, one might argue that as FEA's

debts are guaranteed by the government, observing the terms of a debt covenant cannot

be an incentive for manipulation of profits. It cannot be denied that the presence of

government guarantees weakens this incentive in FEA. However, it can also be argued

that government as a guarantor can pressure FEA to satisfy the covenants. Therefore, in

FEA's case, the pressure to report certain numbers in the financial reports comes more

from the government than meeting the lenders terms. There are occasions where the

FEA has been penalized for not meeting the covenants. The penalties were in the form

of government declining to guarantee further debts and lenders not allowing the raising

of further long- term funds. In conclusion, the analysis indicates that the capitalisation of

research and training costs may have been undertaken with earnings management intent,

since it helped the FEA to meet the covenant set by the lenders.


94

6.3.2 Revaluation of Fixed Assets

Fixed assets of the FEA were revalued on 1 January 1992 by independent valuers. The

existing use value was selected for most of its assets as recommended by its valuers,

except for motor vehicles and furniture and fittings. These two classes of assets were not

revalued due to their more frequent renewal and as any difference between the revalued

and written down values were deemed to be immaterial. The revaluation resulted in an

increase in the value of fixed assets by $164.08 million and the corresponding credit was

made to a newly created Asset Revaluation Reserve. There was a consequential increase

in depreciation of $3.39 million during the year, which was reported as an abnormal

item in the Income Statement. Table 6.5 illustrates the key items of the financial

statements that were affected by the revaluation in 1992.

Table 6.5 Effects of Revaluation in 1992

With Revaluation Without Revaluation

Balance Sheet Accounts ($000s)

Capital 74845 74845

Accumulated Losses (58007) (58007) + 3394 = (54613)

Asset Revaluation Reserve 164076 0

Other Reserves 23455 23455

Total Equity 204369 43687

Fixed Assets 483418 483418-164076 = 319342

Total Assets 509885 509885-164076 = 345809

Profit and Loss Accounts ($000s)

Depreciation expenses 12657 12657 - 3394 = 9263

Net profit 15107 15107 + 3394 = 18501

Debt to Equity Ratios

Total debt Total equity

305,516,000 204,369,000

= 1.49:1

305,516,000 43,687,000 = 6.99:1

Long-term debt Total equity

213,287,000 204,369,000

= 1.04:1

213,287,000 43,687,000

= 4.88:1

(Adapted from the FEA Annual Report 1992 and author’s calculations)


95

The revaluation exercise significantly improved the FEA's equity position from $43.68

million without revaluation to $204.37 million, representing an increase of almost 370%.

Further, the higher equity balance helped FEA to reduce the debt to equity ratios. Total

debt to equity ratio fell from 6.99:1 to 1.49:1 and long-term debt to equity ratio also

moved in the similar manner from 4.88:1 to 1.04:1. The following comments were made

by the General Manager Finance in relation to the revaluation exercise:

As a result of continuing profitability and the benefits of the asset revaluation

exercise, the Authority's debt to equity ratio as reflected in the audited published

accounts has now reached a commercially acceptable level. This ratio stands at

60/40 and is equivalent to the accepted industry norm. By excluding all short term

funding in accordance with World Bank and other overseas lending criteria, the

ratio is closer to 50/50. (The FEA Annual Report, 1992:27).

Although, the revaluation reduced the FEA's net profit by 18% through additional

depreciation charges, it proved to be beneficial as it aligned the debt to equity ratios of

the FEA to a commercially acceptable level and within the guidelines set by the offshore

financiers. While the FEA borrows from the local as well as overseas financiers, during

these periods offshore loans were quite substantial, around 50% of total borrowings.

With the exception of the loan from Suva City Council, all of the FEA's indebtedness is

guaranteed by the government, which makes the FEA a less risky borrower to its

lenders. However, even when government guarantees the loans, the FEA still has to

meet the covenants set by the lending agencies, as discussed in the earlier section.

As part of the covenants, the offshore lending agencies required the Authority to

maintain a debt to equity ratio of 3:1 (The FEA Annual Report, 1984). The devaluations

of 1987 resulted in $99.17 million of unrealized foreign exchange losses, which

consequently eroded the equity position of the Authority through accumulated losses.

Since then, the equity position of the FEA had been negative and it was unable to meet

the debt to equity covenant. Although, capital contributions were made by the

government, they were insufficient to offset the deteriorated equity balance. The analysis


96

shows that the revaluation exercise not only improved the equity balance but also

assisted the FEA to meet the covenant of 3:1 debt to equity ratio.

Moreover, from 1992 the FEA adopted a policy of revaluing its assets every five years.

The next valuation was to be undertaken in 1997 but was deferred due to the Authority's

anticipated corporatisation. Despite the FEA's policy, it has never undertaken a

revaluation exercise in the past 12 years since 1992. It is worth noting that reporting

entities in Fiji generally face real problems in revaluing assets as it is a costly exercise28.

The deferral of subsequent valuation and the associated costs of revaluation further

support the argument that the revaluation in 1992 was undertaken with an opportunistic

intent. The frequency of the revaluation is dependent on the movements in the fair

values of non-current assets (FAS 16, paragraph 32) and not the need to improve the

equity position of an entity. Therefore, the analysis indicates that the revaluation in 1992

may have been used as an earnings management tool to improve the deteriorating level

of equity position and to meet the debt covenants. This argument is strengthened in the

following section, which looks at the classification of government grants by the FEA.

6.3.3 Classification of Government Grants

Deferred income of the FEA relates to grants-in-aid, representing the fair value of non-

monetary assets received in the form of grants. These were materials received from the

overseas government, particularly the Chinese government29. These were received

through a bilateral procedure, where the overseas government provided the materials to

the FEA through the Fiji government. These grants were not in the form of cash. From

1995, deferred income also includes ‘Government and FEA Contributions for Rural

28 The cost of valuation in Fiji is as follows: valuation of $10,000 = $100 + total expenses valuation of $10,000 to $50,000 = $220 + $2 for every $1000 + total expenses valuation of $50,000 to $250,000 = $620 + $1.50 for every $1000 + total expenses (These figures were obtained from Mr Hassan, who is a registered valuer in Suva.) 29 This information was supplied by the former Chief Executive of the FEA, Mr., Nizam-Ud Dean, who has been with the Authority since the late 1980s.


97

Electrification’, which are cash contributions made by each towards rural electrification.

As advised by the Ministry of Finance, the FEA converted a $5.50 million government

loan into equity in February 1990. The Ministry later discovered that this transaction

was not approved in the parliament in 1990 so the House of Representatives passed a

motion in February 1996 to convert the Loan into a Government Grant for Rural

Electrification instead of loan to equity conversion. This represented the Government's

contribution for rural electrification. Since the conversion of debts into equity was not

approved by the Parliament in 1990, the FEA was liable for interest on the loan from

1990 to 1996. On the request of the Government, the FEA contributed the equivalent

amount of interest forgone towards Rural Electrification, which represented FEA's

contribution.

The FEA reported deferred income as part of equity for years prior to 1995 while from

the following year it was reported as a non-current liability. This reflects inconsistency

in reporting government grants. Alternatively, the nature of the grants may have changed

from 1995 hence the differing treatments. Apart from the above described fact about the

FEA's grants, there was no information disclosed in the annual reports suggesting that

the nature of grants had changed. Also, the accounting polices relating to government

grants during the concerned periods remained unchanged as given below:

Grants in aid received in kind have been recorded as deferred income which is

recognised in the Income Statement on a systematic and rational basis over the

useful life of the assets. (The FEA Annual Reports, 1990-91).

…grants in aid and assets acquired at no cost to the Authority are capitalised and

progressively recognised as Other Income on the basis of the average lives of the

assets to which the grants were deemed to relate. (The FEA Annual Reports, 1992-

96).

Given the inconsistency in the classification of grants and the absence of any

explanation to prove otherwise, it is important to ascertain which of the two


98

classifications (equity or liability) is correct. According to FAS (IAS) 2030 Accounting

for Government Grants and the Disclosure of Government Assistance, there are two

accounting treatments of government grants; the capital approach and income approach.

Under the capital approach, the grant is taken directly to the equity section of the

balance sheet while the income approach requires the grant to be taken to income on a

systematic basis. As grants-in-aid relates to assets, FAS 20 further states the following

about grants relating to assets:

Government grants, including non-monetary grants at fair value, should not be

recognised until there is reasonable assurance that (i) the enterprise will comply

with the conditions attaching to them, and (ii) the grants will be received. They

should not be credited to shareholder's interests. (Paragraph 37)

Government grants should be recognised in the income statement over the periods

necessary to match them with the related costs which they are intended to

compensate, on a systematic basis. (Paragraph 38)

FAS 20 requires non-monetary grants to be accounted for using the income approach. It

is further stated in paragraph 39 that grants related to assets should either be presented as

deferred income (liability) or deducted from the carrying amount of the asset. The nature

of FEA’s grants requires it to apply the income approach. Thus, its treatment from 1995

is correct while in the earlier years it resulted in non-compliance with FAS 20. It should

be noted that accounting standards were revised in 1996, but there was no change in

FAS 20. Hence, the differing treatment could not be the result of change in accounting

practice. As indicated earlier, non-compliance with accounting standards does not

always constitute earnings management. It could be possible that the FEA made a

genuine error in classifying government grants. It is worth pointing out that the

misclassification did not occur in a single but a series of years. With due respect, the

auditors should have been able to spot this error. Their failure to do so suggest either the

audit team was lax or they "condoned" the accounting treatment. Also, during the years

of misclassification, the same firm audited their accounts and the correct approach was

applied when there was a change their auditor. In light of this, the FEA's 30 FAS 20 was issued in 1992 and was identical to IAS 20. In the absence of any national accounting standards on government grants prior to 1992, the FEA relied on IAS 20.


99

misclassification seems more to be opportunistic rather than a general error in practice.

This undoubtedly seems to be a case where the FEA has stretched the limits of generally

accepted accounting practices to the extent that it actually led to non-compliance. It

should, however, be noted that the misclassifications did not affect profits. In both the

treatments, grants were amortised to the Income Statement. The following table

illustrates the effects of reporting government grants as equity in years prior to 1995.

Table 6.6 Effects of Misclassification of Deferred Income

Year Deferred Income Taken To Equity Deferred Income Taken To Liability

Equity $000s

Total Debt To Equity Ratio

Long-Term Debt To

Equity Ratio

Adjusted Equity $000s

Total Debt To Equity Ratio

Long-Term Debt To

Equity Ratio

1990 (3929) (86.86) (61.24) (3929) – 1911 =

(5840) (58.77) (41.53)

1991 13407 24.52 18.32 13407 - 4891 =

8516 39.18 29.42

1992 204369 1.49 1.08 204369 – 12077

= 192292 1.65 1.21

1993 224677 1.29 0.94 224677 – 12781

= 211896 1.43 1.06

199431 241995 1.11 0.99 241995 – 13125

= 228870 1.23 1.10

(Adapted from the FEA Annual Report 1990-1994 and author’s calculations)

Table 6.6 shows that the misclassification of grants improved the equity balance of the

FEA, which consequently affected its debt to equity ratios. Applying the capital

approach improved the total debt to equity ratios and long-term debt to equity ratios.

Hence, the motive behind the misclassification was to improve the equity position of the

FEA. In the earlier section, it was found that the FEA revalued its assets in 1992 and this

section revealed that it misreported government grants as equity instead of liabilities in

years prior to 1995. It seems that both these events were undertaken with a view to

improve the FEA's equity position and consequently the debt to equity ratios. Table 6.7

shows the combined effects of revaluation and misclassification of government grants.

31 The table is not extended beyond 1994 as grants were correctly reported from 1995.


100

Table 6.7 Combined Effects of Revaluation and Classification of Deferred Income

Scenario 1 No Revaluation and Deferred Income is Reported as Liability

Year Equity ($000s)

Non-Current Liabilities ($000s)

Total Liabilities ($000s)

Total Debts to Equity

Long-Term Debts to Equity

1989 (7756) 258943 342294 (44.13) (33.39)

1990 (5840) 242545 343234 (58.77) (41.53)

1991 8516 250528 333669 39.18 29.42

1992 31610 233425 317593 10.05 7.38

Scenario 2 No Revaluation and Deferred Income is Reported as Equity

Year Equity ($000s)





1989 (5832) 257019 340370 (58.36) (44.07)

1990 (3929) 240634 341323 (86.87) (61.25)

1991 13407 245637 328778 24.52 18.32

1992 43687 221348 305516 6.99 5.07

Scenario 3 Revaluation and Deferred Income is Reported as Equity

Year Equity ($000s)





1989 (5832) 257019 340370 (58.36) (44.07)

1990 (3929) 240634 341323 (86.87) (61.25)

1991 13407 245637 328778 24.52 18.32

1992 204369 221348 305516 1.49 1.08


The table presents three scenarios. Scenario 1 analyses the effects if there were no

revaluation and deferred income was reported as a liability. In the second scenario, again

there is no revaluation but deferred income is now classified as equity. The third

scenario describes what actually happened at the FEA and the values for this scenario

are directly taken from its financial statement. It presents a case of a revaluation and

deferred income being reported as equity. It was impossible to extend the table beyond

1992 since the full effects of a revaluation cannot be determined precisely in the future

years. Given that revaluation results in increased depreciation expense in the current

year as well as in the subsequent years, the extent of the increase in depreciation expense

in subsequent years cannot be determined.


101

In 1989 and 1990, the FEA had a negative equity position hence the debt to equity ratios

in these years are not really meaningful. The difference in the ratios is more observable

in the remaining years. In scenario 1 with no revaluation and deferred income correctly

reported as a liability, the total debt to equity ratio and long-term debt to equity ratio was

the highest of all the three scenarios. By reporting deferred income as equity, the FEA

was able to reduce the ratios in scenario 2. Although, the ratio was reduced, it was still

high when compared with industry standards and those set by the overseas lenders.

Hence, the revaluation exercise in the third scenario produced the lowest debt to equity

ratios, which were now within the industry and overseas lenders' standards. The

combined analysis illustrates that the FEA had intended to reflect an improved debt to

equity ratios. This was initially achieved by classifying deferred income as equity and

the subsequent revaluation activity further strengthened the financial position. Hence,

the revaluation and the misclassification of government grants might be a possible case

of earnings management at the FEA.

6.3.4 Capitalisation Policies

The cost of the FEA's fixed assets includes the cost of all materials, direct labour and

associated overheads. Over the review period, there were two occasions where the FEA

changed the policy of capitalising overheads to property, plant and equipment. The first

change was made in 1994 where certain overheads, which could not reasonably be

identified as forming part of the cost of purchase or acquisition of an asset or of bringing

it to its working condition were expensed from 1 January. These overheads were

previously capitalised to property, plant and equipment. Two years later, the FEA ceased

to capitalise administrative salaries and motor vehicle operating costs to the acquisition

cost of property, plant and equipment. The FEA stated that by expensing these costs

from 1996, they were able to reflect actual operating expenditure. It should be noted that

neither of the two changes was done retrospectively. The changes increased the FEA's

operating expenses by $0.90 million and $2.50 million in 1994 and 1996, respectively.

These are reflected in Table 6.8. In 1994, the operating expenses represented 74% of


102

income and in 1996 it increased to 78%. Higher operating expenses reduced FEA’s

profits during the concerned periods.

Table 6.8 Total Expenses and Profits of the FEA

Year Total Expenses Profit

$000s % of Income $000s % of Assets

1992 36907 68.29 17294 3.39

1993 39636 68.75 18189 3.53

1994 45260 73.80 16379 3.21

1995 48343 70.97 20470 3.92

1996 56116 78.20 17320 3.29

1997 55605 76.60 18408 3.68

1998 63472 74.91 21256 4.27

1999 83378 90.23 9028 1.87

2000 93694 107.64 (6647) (1.40)

2001 97971 99.97 31 0.01

2002 110886 96.70 3787 0.83

2003 125204 97.96 2609 0.57

2004 119449 92.77 9306 2.06


Given the changes in the capitalisation policies, it is important to find out the

requirements of the accounting standard on this aspect. FAS 16 Accounting for Property,

Plant and Equipment (paragraph 11) states that

the cost of an item of property, plant and equipment comprises its purchase price,

including import duties and non-refundable purchase taxes, and any directly

attributable costs of bringing the asset to working condition for its intended use; any

trade discounts and rebates are deducted in arriving at the purchase price.

Examples of directly attributable costs are:

a) site preparations;

b) initial delivery and handling costs;

c) installation costs, such as special foundations for plant;

d) professional fees


103

The accounting standard further states that

administration and other general overhead expenses are not a component of the

cost of property, plant and equipment, unless they can be specifically related to the

acquisition of the asset or bringing it to its working condition ( Paragraph 13).

Paragraph 13 illustrates an example of accounting regulation that allows management to

apply discretion and flexibility in financial reporting. According to the accounting

standard, the capitalisation or current expensing of administration and other general

overhead expenses is dependent on whether these expenses were related to the assets

acquisition or bringing it to its working condition. This criterion is available to the

preparers of financial reports so that the economic reality of the transactions can be

reported. However, in the presence of economic incentives, the same condition can be

used to misreport the reality. The FEA used this condition to justify their policy change

by stating that these costs are expensed as these are not specifically related to the assets

acquisition. On the surface of it, it seems that the policy change was made to reflect

economic reality. Knowing that the determination of whether an expenditure is an asset

or an expense can have a significant effect on the entity’s operating results, it could also

be possible that the policy change was an attempt of earnings management. This

possibility is supported by the fact that there were incentives for the FEA to report

reduced earning in these periods. These incentives will be discussed in the next section

together with the changes in depreciation rates as these changes would appear to have

been made for same reasons.

6.3.5 Changes in Depreciation Rates

During the review period, there were two occasions where the FEA changed the

depreciation rates for fixed assets. The first revision was in 1999 when the FEA began to

apply tax depreciation rates, which were higher than the previously applied rates.

Although the rate had varied, the method of depreciation remained unchanged as straight

line. The depreciation rates were changed for the new assets as well as assets acquired


104

earlier than 1 January 1999. As a result, depreciation expense increased by $21.16

million during the year. As changing depreciation rates have on-going effects, the FEA

has managed to increase its depreciation expenses in the future periods as well. The

following table illustrates the Authority's depreciation expenses and its impact on

profits.

Table 6.9 Depreciation Expenses and Profits of the FEA

Year Depreciation Profit If the rates were not changed

$000s % of PPE $000s % of Assets Depreciation $000s

Profit $000s

1992 9263 1.87 17294 3.39

1993 13671 2.64 18189 3.53

1994 14118 2.68 16379 3.21

1995 14309 2.66 20470 3.92

1996 14484 2.67 17320 3.29

1997 14538 2.64 18408 3.68

1998 14391 2.56 21256 4.27

1999 36095 6.31 9028 1.87 14467 30656

2000 35733 6.22 (6647) (1.40) 14535 14551

2001 35902 6.03 31 0.01 15056 20877

2002 41030 6.39 3787 0.83 16257 28560

2003 43301 6.52 2609 0.57 16791 29119

2004 20260 3.02 9306 2.06 16970 12596

(Adapted from the FEA Annual Reports 1992-2004)

The profits reduced to 1.87% of assets in 1999 when compared to 4.27% in the

preceding year and the FEA attributed this to the change in depreciation rates. The

following statement was made by the Authority on its financial performance:

Net profit before abnormal items and income tax decreased from $21.3 million to $9

million in the current year. This was due mainly to a change in accounting policy

when FEA adopted tax depreciation rates from 1 January 1999. The Authority

considered it prudent to adopt tax depreciation rates because it reflects a more

realistic life of the fixed assets and FEA became a taxable entity from 1 January

1998. (The FEA Annual Report, 1999:22).


105

Table 6.9 also illustrates the depreciation expenses and profits that would have been

reported if the rates were not changed. Depreciation rates are calculated using an

average rate of 2.53% of gross property, plant and equipment.32 It is evident from the

table that the change in rates has significantly affected FEA’s profits. Depreciation rates

were changed for two reasons; prudence and the FEA’s taxable status. According to

FAS 1 Disclosure of Accounting Policies, prudence is one of the factors that govern the

selection and application of accounting policies. Paragraph 8(a) of the standard states

that:

Uncertainties inevitably surround many transactions. This should be recognised by

exercising prudence in preparing financial statements. Prudence does not, however,

justify the creation of secret or hidden reserves.

Upon selecting and applying accounting policies, entities need to exercise prudence. The

FEA asserts that by employing tax depreciation rates, it would be able to reflect a more

realistic life of its fixed assets. This reason seems to be justifiable as long as the FEA

had not used it for the purpose of creating hidden reserves. Nonetheless, it should be

noted that tax depreciation rates are arbitrary and apply to certain types of assets rather

than to industries. It is impossible for tax depreciation rates to fairly reflect the

economically useful life of an asset. As they are often structured to provide investment

incentives, tax depreciation rates may not be specifically related to the assets economic

lives. Further, being a taxable entity does not oblige it to adopt depreciation rates used

by the tax authorities; it can still employ the accounting rates. Hence the FEA’s reason

to adopt tax depreciation rates due to its taxable status seems to be neither necessary nor

justifiable. The increase in depreciation rates and changes in capitalisation polices in

1994 and 1996 discussed earlier seem to be related. As a result of all the three changes,

the FEA’s expenses (depreciation and operating) increased resulting in reduced

profitability. There were possible motives for the FEA to report reduced earnings during

these periods.

32 This average is computed using 1992 to 1998 values in Table 6.9 since the FEA changed the format of presenting its fixed assets and their corresponding depreciation charges. Unlike in the previous years, from 1999, the Authority ceased to separately disclose its individual assets.


106

The FEA was involved in a long running debate with the government over their tax

status. Since inception it has been exempted from tax in pursuant to section 17(25) of the

Income Tax Act. However, the Income Tax (Amendment) Decree repealed the FEA’s

tax exempt status from 1 July 1992 given that the FEA was expected to be corporatised

in the near future. The FEA made submissions to the appropriate Ministries for an

extension of the tax exempt status, back dating from 1 July 1992 to 31 December 1996.

In light of this, the FEA did not adopt tax effect accounting and had not provided for any

taxes payable on its profits during these periods. If the FEA's submissions had not been

accepted, its tax payable from 1 July 1992 to 31 December 1996 would have been

expected to be $23 million (Parliamentary Debates, 2005). As a result of this, the

auditors had raised a matter of emphasis when signing off the 1996 financial statements.

The FEA argued that its operational costs made it difficult to cope with the universal

service obligations that they are undertaking33. The cost of these services is an average

of $25 million per year. Although the Public Enterprise Act requires the government to

reimburse the universal service obligation costs to the FEA, such costs have not been

refunded. The Authority argues that it was able to afford the universal service obligation

in the past when it was exempted from paying tax and dividends to the government. This

has changed as it is now required to pay taxes and provide dividends. Further, the FEA

as a commercial statutory authority is required to earn the government a target return on

equity of 10% from 2002.

The FEA’s Board Chairman asserted that as long as the government reimburses these

costs, the Authority could earn the benchmark return:

The government as its right as a shareholder, expects a 10% return on investment

(ROI) from all CSA, like FEA. This is not an unreasonable demand. In terms of

profit, it means that FEA should be making over $30m a year. In other words, if the

Government were to reimburse for its social obligation cost as intended under the

Public Enterprise Act, then its financial performance is right on track with the

current reforms. The government will need to seriously consider reimbursing FEA 33 As a universal service obligation, the FEA subsidises power to rural areas in Viti Levu as well as the entire islands of Vanua Levu and Ovalau.


107

for these social obligations subsidies if it insists on this return benchmark. If not, it

will have to allow an increase in tariffs. (The FEA Annual Report, 2002:9)

In September 2002 the Cabinet finally decided to extend the FEA’s tax exempt status

from 1 July 1992 to 31 December 1996. It was also decided that the FEA’s universal

service obligation be recognised as its annual 'social' dividend to the government.

Although, the recognition of the universal service obligation cost as a social dividend is

a relief to the FEA to some extent, the Authority still argues that:

…if it (universal service obligation costs) were part of the profit, it would mean that

we would have to pay well in excess of 90% of our profit as a dividend. For such a

capital intensive industry, this, as a dividend policy is financially unsustainable and

untenable. (The FEA Annual Report, 2003:10)

The above discussion highlights that the FEA sought to extend its tax exempt status and

reimbursement of universal service obligations costs. The decision would be made by

the government so the financial performance of the FEA has to be reported such that it

can make a justifiable case to the government. An entity with marginal or reduced

profitability has a high chance of getting a favorable response in contrast to an entity

with a series of high reported profits. The changes made to the capitalisation policies in

1994 and 1996 have led to a continuous reduction in earnings. The increase in the

depreciation rates from 1999 further reduced profitability (see Table 6.9). Therefore, the

analysis indicates that the changes to the accounting polices may have been used as an

earnings management device since the changes have undoubtedly assisted the FEA to

make a permissible case to the government.

There was yet another change in the depreciation rates in 2004. Following a

comprehensive review of the remaining useful lives of its asset base, the FEA adopted

new depreciation rates from 1 January 2004. These rates were lower than the previously

used tax depreciation rates and for most of the assets, were the same as the ones that

were applicable prior to 1999. By applying lower depreciation rates, the FEA was able

to reduce its depreciation expense from 6.52% of gross property, plant and equipment in


108

2003 to 3.02% in 2004 and return on assets increased from 0.57% to 2.06% (Table 6.9).

The FEA again attributed the year's profit to the changes in depreciation rates. The

Chairman of the Board indicates:

Whilst it (the FEA) recorded a headline operating profit before tax of $9.3m, this

has really been the result of a significant reduction in depreciation charges due to

lower accounting depreciation rates used for 2004 (The FEA Annual Report,

2004:7).

When the depreciation rates were increased in 1999, the FEA argued that this was

undertaken to reflect a more realistic life of its fixed assets. It then believed that the

fixed assets had a shorter useful life. When reducing the depreciation rates in 2004, the

Chief Executive of the FEA argued the following:

Operating profit before tax is $9.3m. This would have been a loss of $13.7m if the

depreciation rates used by FEA for accounting purposes were not revised

downwards. Lower accounting depreciation rates were adopted by FEA in 2004

following a comprehensive review of the remaining useful lives of its existing asset

portfolio. Previously higher depreciation rates allowed by the Income Tax Act for

tax depreciation purposes have been used for accounting purposes also. Given the

longer useful lives of FEA’s assets such as hydro dams, generators and plant and

equipment, the Board considered that the lower accounting depreciation rates will

reflect fair and more reasonable financial statements as required under the current

financial reporting standards. The effect on the income statement is a reduction in

the depreciation charge of $23m. (The FEA Annual Report, 2004:17).

The reduced depreciation rates were justified by the FEA on the grounds that lower rates

reflected a fair and reasonable financial statement. It now believed that its fixed assets

had longer lives. It was also noted that the new rates resulted in $9.30 million of

operating profit before tax. If FEA had continued to use the higher tax depreciation

rates, it would have ended up with a major loss of $13.70 million. On the basis of the

Chief Executive’s statement, one can argue that the FEA had not wanted to report a


109

material operating loss. This argument is further supported by the fact there were

possible incentives for the FEA to report high earnings in 2004.

The FEA has been operating at near full capacity since the mid 1990s and the demand

for electricity has also been escalating. In order to meet electricity demand, the FEA

argues that it needs to undertake capital investment of $500 million. Its surpluses have

clearly been inadequate to finance the investment needed, hence it requires external

funding. In order to attract outside financiers, the FEA needs a healthy financial

performance and position. By reducing the depreciation rates in 2004, the FEA was able

to avoid reporting significant losses as a loss making entity would fail to attract potential

investors.

To further improve its operating results, the FEA intended to increase the electricity

tariff rates. Since the 10% increase in tariff in 1991, there has been no other increase in

the rate and the FEA contends that its current tariff structure would not attract investors.

The Board Chairman argued that

...the tariff structure that prevailed at the beginning of 2004 is inadequate to

provide the necessary cash flows for FEA to fund building new power capacity.

Also, the tariff rates were considered too low to attract private investors and

independent power producers as there were not enough economic returns to such

investors. Therefore one of the main objectives of FEA was to achieve an

appropriate increase in tariff rates which have not increased since 1991 and in fact

have reduced three times, in 1996, 1997 and 1998. (The FEA Annual Report, 2004:

9-10).

However, the increase in tariffs would be decided by the government on

recommendations of the Commerce Commission so in the second half of 2004, the FEA

made a submission for a substantial increase in electricity tariff to the Commission34.

The Commission reported that

34 The Commerce Commission is an independent statutory body, established under the provision of the Commerce

Act 1998. The Commission promotes effective competition and informed markets, encourages fair-trading, protects


110

In its submission, FEA requires up to $500 million to meet new capital

investment to cater for the increased power capacity and to achieve 10% Return

on Shareholders Fund (ROSF) in line with the Public Enterprise Act. (The

Commerce Commission Report, 2004:3).

According to the Commerce Commission’s Report, the FEA proposed three major

reasons, amongst others, for the increase in tariff. Firstly, the FEA argues that the higher

prices would provide new capacity to meet new investment. It states that unless it

installs new power capacity, there would be power shortages after 2006. Based on past

trends, it anticipates that growth in future electricity demand would not be met by

current capacities and its diesel generators are already 30 years old and are becoming

unreliable. Secondly, it argues that the current tariff is inadequate to meet new funding

and ROE of 10%. In order to increase its power capacity, it would need to undertake

substantial borrowing, which would increase its debt level and interest rates. These

finance charges would not enable the FEA to meet the 10% bench mark return. The FEA

argues that the tariff increase would bring it closer to meeting government’s ROE,

maintaining acceptable debt levels as well as meeting new investment requirements.

Finally, of the $500 million capital investment needed, the FEA expected that

Independent Power Producers (IPPs) would contribute $150 million. The FEA argues

that the current tariff structure would not attract IPPs as it would fail to provide the

return that they would require to invest. Thus, higher prices would encourage IPPs.

When making a case to the Commission, the FEA reviewed its accounting policies and

decided, inter alia, to revalue its non-current assets.

The FEA points out in its submission that it has revalued its non-current assets.

In so doing, it increases the denominator in the ROSF calculation, thus driving

up the tariff required to secure the 10% required by the government. (The

Commerce Commission Report, 2004:14)

consumers and businesses from restrictive trade practices and control prices in regulated industries and other markets where competition is lessened or limited.


111

A revaluation requires the recognition of a Revaluation Reserve as part of equity. Given

that the valuation of non-current assets will increase, depreciation expenses will also

increase, which would then reduce the profits of the FEA. So revaluation will increase

the equity and reduce profit, thus reducing the ROE. Hence, the profit figure will have to

rise proportionately in order to achieve the 10% target return. Revaluation increases the

denominator in the ROE calculation, which requires the tariff increase to earn the 10%

return. Thus, the proposed revaluation may have helped to influence the Commission's

decision in FEA's favour.

The Commission subsequently approved the increase in electricity tariff rates in

November 200435and was implemented from 1 January 2005. The reduced depreciation

rates and the approved increase in electricity tariff rates helped to strengthen the

financial performance and position of the FEA. As matters transpired the FEA secured

concessionary funding from the Fiji National Provident Fund of $230 million supported

by a government guarantee. The proposal to revalue non-current assets was

consequently shelved.

Jones (1991) study shows that when organizations expect to receive assistance from the

government, they are likely to report reduced earnings. Similarly, when the FEA makes

its case for an increase in its price, it is expected that they would have also behaved in

the similar manner. Therefore, one would argue that reducing depreciation rates does not

help but contradicts the normal expectation. In order to reconcile this, one needs to

clearly understand FEA’s situation. Since 2004, the FEA’s main objective was to obtain

external funding, for which it has to report higher profits. Higher prices assist in

reporting more profits but government would not approve the increase when high profits

are reported. Thus, the FEA used other arguments (as discussed above) to get the

approval from the government.

35 The approved increases in electricity tariff rates were 3.30% in 2005, 3.20% in 2006 and 3.10% in 2007 for domestic customers. The Commission also approved increases in electricity tariff rates of 6.90% in 2005, 6.45% in 2006 and 5.70% in 2007 for commercial and industrial customers and the Maximum Demand tariff customers.


112

Therefore, it seems that the reduction in depreciation rates may have been used to

manage earnings upwards as the FEA wanted to attract external financiers. The FEA’s

submission to the Commerce Commission further supports the argument as higher tariff

rates would increase its profitability. Not only this, the FEA used the revaluation

proposal to receive favourable response from the Commission.

6.4 Conclusion

From an in-depth analysis of the information obtained from the FEA's annual reports

and other relevant documents, it seems that there may be evidence of earnings

management practices in the FEA. Five possible instances were identified and these

related to the capitalisation of research and training expenses, revaluation of non-current

assets, classification of government grants, changes in capitalisation policies and

changes in depreciation rates. Table 6.10 summarises the evidence and the incentives for

its practice.

Table 6.10 Summary of Earnings Management Evidence

Year Event Incentive

1985 to 1992

Capitalisation of research and training costs

Avoid reporting large expense in a single year and to meet the debt covenant

1992 Revaluation of non-current assets Improve the equity position and meet the debt covenant set by the offshore lenders

Prior to 1995

Deferred income was reported as equity instead of liability

Improve the equity position and the debt to equity ratios

1994 and 1996

Ceased to capitalise certain overheads to property, plant and equipment

1999 Adopted higher tax depreciation rates

To make a case to the government to extend the tax exempt status and reimburse the cost of universal service obligations.

2004 Adopted lower tax depreciation rates To attract external financiers

Several incentives seem to be present during the times of these earnings management

practices. These include the need to improve the equity position of the Authority, to

meet the debt covenants, extend its tax exempt status, re-imbursement for the universal

service obligation costs and to attract potential investors.


113

CHAPTER SEVEN

CONCLUSIONS AND LIMITATIONS

7.1 Conclusions

The unexpected collapses of large corporations reflect erosion in the quality of financial

reporting. Earnings management is one of the contributing factors as it is used to

manipulate the true and fair view of the entity. The review of the related literature shows

that earnings management arises because of two broad reasons. Firstly, accounting

standards provide considerable discretion and flexibility to the preparers of financial

reports. Secondly, agency relationships provide economic incentives to the agents.

Considerable attention has been devoted to earnings management issues in the

developed countries, largely focusing on the publicly listed companies. Conversely,

studies in developing countries are rare. Therefore, the primary objective of this thesis is

to find evidence of earnings management in commercial statutory bodies of Fiji. Due to

the inapplicability of the widely used accruals models, the study applied the checklists

designed by Mulford and Comiskey (2002) to identify and analyse the possibilities of

earnings management practices in two SOEs over the period 1990 to 2004.

The findings of the study indicate a number of possible earnings management practices

in the organizations. In the HA, these were related to:

i. provisioning of inventory,

ii. capitalisation of administrative expenses,

iii. amortisation of deferred interest expense and

iv. changes in accounting policies for provision for doubtful debts.

The HA increased the provision for write-downs of inventory in the late 1980s and

transferred part of the resultant losses to the PRB. Higher provisions assisted HA to meet

the stakeholders’ expectations of reporting improved performance after the separation of

Chapter 7: Conclusions and Limitations

114

rental operations. Furthermore, by capitalising administrative expenses, the HA was able

to report increased profitability in the early 1990s. Higher reported profits reflected

better performance of the new government and the Board. Performance based contracts

were also implemented during this period, which are argued to have provided added

incentives to the management to report improved performance.

The HA recognised deferred interest expense in 1992, which was amortised over a ten-

year period. Its recognition is not questionable but its subsequent amortization seems to

be opportunistic as the trend in the amortisation expense suggests that it was used as a

smoothing device. This was particularly evident in 1993 when a large amount was

amortised to smooth the HA's interest expense. The final evidence relates to the changes

in accounting policy for provision for doubtful debts. There were two occasions over the

investigation period, when the policy was changed and in both cases the change was

justified on the grounds of prudence and conforming to industry standards. However, the

timing of the change in 1995 was questionable while in 1999 it was argued that the HA

may have exaggerated the effects of the policy change. The change in policies increased

the doubtful debts expenses, resulting in reduced earnings. It seems that the events that

took place in years surrounding the policy change, such as achieving its social objectives

and the need to convert debts into equity, may have led the HA to practice downwards

earnings management.

The analysis of the second entity, the FEA, revealed the following possible earnings

management practices:

i. capitalisation of research and training expenses,

ii. revaluation of non-current assets,

iii. classification of government grants,

iv. changes in capitalisation policies and

v. changes in depreciation rates.

The FEA capitalised research and development expenditure from 1985 to 1992, which

included costs incurred during the research phase. During the same period, it also


115

deferred training expenses. Capitalisation of these costs is not permitted by generally

accepted accounting practices, hence, it can be argued that FEA has possibly practiced

earnings management with the incentive to meet debt covenant set by its lenders. The

majority of these costs were expensed in 1987, as it proved to be an opportune time.

Furthermore, the FEA misclassified government grants as equity instead of liabilities in

years prior to 1995 and revalued its non-current assets in 1992. It seems that these events

were undertaken with similar intentions. As a result of the two devaluations, the FEA’s

net worth has been negative since 1987, which prevented it from meeting the 3:1 debt to

equity ratios imposed by the offshore financiers. Although, misclassification of grants

improved the equity position, it had insignificant influence on debt to equity ratios. The

subsequent revaluation further improved the equity balance and the ratios. Hence, the

two events improved the deteriorated equity balance and aligned debt to equity ratios to

a commercially acceptable level and those required by the lending bodies.

From 1994 and 1996, the FEA began to expense certain overheads that were previously

capitalised, resulting in higher operating expenses. Additionally, the FEA increased the

depreciation rates from 1999 by adopting the higher tax depreciation rates. These policy

changes are related and seem to be undertaken for similar reasons as they resulted in

reduced profitability. Lower reported earnings assisted the FEA to justify its case to the

government when requesting for an extension of their tax exempt status and

reimbursement of universal service obligation costs. The government subsequently

extended the FEA’s tax exempt status and universal service obligations costs were

acknowledged as the 'social' dividend. Finally, it was found that the FEA reduced the

depreciation rates from 2004 so that it could attract external finance for its capital

investment. This argument is further strengthened when the FEA made a submission to

the Commerce Commission for an increase in electricity tariff rates and used the

proposed revaluation to influence the Commission’s decision in their favour. The

increase in the tariff rates was subsequently approved by the Commission. Lower

depreciation rates and higher tariff rates strengthened the financial performance of the

FEA, enabling it to receive concessionary external funding.

Chapter 7: Conclusions and Limitations

116

The possible evidence of earnings management was more clearly observable in the FEA

than the HA. The results indicate that multiple earnings management practices were

undertaken for similar reasons at the FEA while the HA used a single event at a

particular time. The results illustrate that the key accounting areas used by two entities

for these practices were provisions, amortization and depreciation rates, capitalisation

policies, revaluations and classification of government grants. All these practices were

within the boundaries of generally accepted accounting practices except for the

classification of grants and capitalisations of research and training expenses. It should be

noted that the analysis only suggests that earnings management may be practiced in

these organizations. Overall, the findings are consistent with a priori expectation that in

the presence of agency relationships and flexibility in accounting standards, earnings

management practices will exist. These observations suggest that apart from the

presence of earnings management in publicly listed companies, it can also be practiced

in statutory organizations. However, these observations should be interpreted in light of

the following limitations.

7.2 Limitations of the Study

Earnings management practices are normally examined using variants of accruals

models, which require large samples of data. Accordingly, these models are confined to

the developed countries, where data is readily available. In small developing countries,

such as Fiji, the limited number of reporting entities does not permit the application of

the widely used statistical models. Therefore, the study had to pursue with a qualitative

case study method of investigation. This is the major drawback of this study. Moreover,

the entities examined are government owned, where the public is privy to certain

documents/data. If these were made available, it would have added more validity to the

findings of this study. Further, given the scope of the thesis, only two entities were

reviewed. Had more entities been included, the confidence in the obtained results would

be higher.


117

Even though, the qualitative approach is less powerful than the accruals models, it

certainly provides indications of earnings management. It should be noted that this is a

pioneering attempt and can be used as a guideline by other researchers who may explore

earnings management practices in countries where the accruals models are inapplicable.

If data permits, a promising avenue for future research would be to compare the results

obtained using the accruals models with the qualitative approach to ascertain the degree

of similarities in the results obtained by the two methods.

Bibliography

118

BIBLIOGRAPHY

Amat, O. and Gowthorpe, C. 2004. Creative accounting: nature, incidence and ethical issues.

Working paper, Spain.

Australian Accounting Research Foundation. 2001. Earnings management: audit considerations

& issues. Auditing & Assurance Alert 10, Auditing & Assurance Standards Board.

Barton, J. and Simko, P. The balance sheet as an earnings management constraint. The

Accounting Review. Vol. 77(supplement), pp. 1-27.

Bartov, E., Gul, F. and Tsui, J. 2000. Discretionary accruals models and audit qualifications.

Journal of Accounting and Economics. Vol. 30(3), pp. 421-452.

Becker, C., DeFond, M., Jiambalvo, J., and Subramanyam, K. 1998. The effect of audit quality

on earnings management. Contemporary Accounting Research. Vol. 15 (1), pp. 1- 24.

Behn, B., Nagy, A. and Riley, R. 2002. The association between stock/compensation mix and

earnings usefulness. Working paper, Tennessee.

Bernard, V. and Skinner, D. 1996. What motivates managers’ choice of discretionary accruals?

Journal of Accounting and Economics. Vol. 22(1-3), pp. 313-325.

Beneish, M. 2001. Earnings management: a perspective. Managerial Finance. Vol. 27(12), pp.

3-17.

Beneish, M. and Vargus, M. 2002. Insider trading, earnings quality and accrual mispricing. The

Accounting Review. Vol. 77(4), pp. 755-791.

Blake, J., Clarke J. and Gowthorpe C. 1998. The ethics of accounting regulation. In Gowthorpe

C., and Blake J. (eds.). Ethical Issues in Accounting. London.

Brewer, B., Angell, R. and Mautz, R. 2002. The proliferation of “special” accounting items: a

threat to corporate credibility. Southern Business Review. Vol. 28(1), pp.1-10.

Cahan, S. 1992. The effect of antitrust investigations on discretionary accruals: a refined test of

the political cost hypothesis. The Accounting Review. Vol. 67(1), pp. 77-95.


119

Chand, P. 2003. Relevance of International Accounting Standards to developing countries: the

case for Fiji. Unpublished MA thesis, The University of the South Pacific.

Chand, P. and White, M. 2006. The influence of culture on judgments of accountants in Fiji.

Australian Accounting Review. Forthcoming.

Commerce Commission. About us. www.commcomm.gov.fj/

Commerce Commission. 2004. Price Determination on the Fiji Electricity Authority's proposal

for tariff increase.

DeAngelo, L. 1986. Accounting numbers as market valuation substitutes: A study of

management buyouts of public stockholders. The Accounting Review. Vol. 61(3), pp.

400-420.

DeChow, P. and Skinner, D. 2000. Earnings management: reconciling the views of accounting

academics, practitioners, and regulators. Accounting Horizons. Vol. 14(2), pp. 235-250.

DeChow, P., Sloan, R. and Sweeney, A. 1995. Detecting earnings management. The Accounting

Review. Vol. 70(2), pp. 193-225.

DeFond, M. and Jiambalvo, J. 1994. Debt covenant violation and manipulation of accruals.

Journal of Accounting and Economics. Vol. 17(1-2), pp. 145-176.

Degeorge, F., Patel, J. and Zeckhauser, R. 1999. Earnings management to exceed thresholds.

Journal of Business. Vol. 72(1), pp. 1-33.

Dichev, I. and Skinner, D. 2002. Large-sample evidence on the debt covenant hypothesis.

Journal of Accounting Research. Vol. 40(4), pp. 1091-1123.

Fechner, H. and Kilgore, A. 1994. The influence of cultural factors on accounting practice. The

International Journal of Accounting. Vol. 29, pp. 265-277.

Fiji Electricity Authority. 1983-2004. Annual Reports.

Fiji Institute of Accountants. 1995. Fiji Accounting Standards. Suva, Fiji.

Fiji Institute of Accountants. 2001. Fiji Accounting Standards. Suva, Fiji.

Fiji Institute of Accountants. 2001. Framework for the preparation and presentation of financial

statements. Suva, Fiji.

Fiji National Provident Fund. 1993 and 1995. Annual Reports.

Bibliography

120

Frankel, R., Johnson, M. and Nelson, K. 2002. The relation between auditors fees for nonaudit

services and earnings management. The Accounting Review. Vol. 77 (supplement), pp.

71-105.

Fraser, L. and Ormiston, A. 2001. Understanding financial statements. Prentice Hall, Inc.; New

Jersey.

Gaver, J., Gaver, K. and Austin, J. 1995. Additional evidence on bonus plans and income

management. Journal of Accounting and Economics. Vol. 19(1), pp. 3-28.

Goodwin, J. and Howieson, B. 1999. In Leo, K. and Radford, J. (eds.) Financial Accounting

Issues. John Wiley & Sons, Australia.

Greer, S. and Patel, C. 2000. The issue of Australian indigenous world-views and accounting.

Accounting, Auditing and Accountability Journal. Vol. 13(3), pp. 307-329.

Grynberg, R., Munro, D. and White, M. 2002. Crisis: the collapse of the National Bank of Fiji.

University of the South Pacific Book Centre, Suva, Fiji.

Guay, W., Kothari, S. and Watts, R. 1996. A market-based evaluation of discretionary- accrual

models. Journal of Accounting Research. Vol. 34(supplement), pp. 83-105.

Guidry, F., Leone, A. and Rock, S., 1999. Earnings-based bonus plans and earnings management

by business-unit managers. Journal of Accounting and Economics. Vol. 26(1-3), pp.

113-143.

Healy, P. 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting

and Economics. Vol. 7(1), pp. 85-107.

Healy, P. and Wahlen, J. 1999. A review of the earnings management literature and its

implications for standard setting. Accounting Horizons. Vol. 13(4), pp. 365-383.

Henderson, S. and Peirson, G. 2002. Issues in financial accounting. Pearson Education

Australia.

Heninger, W. 2001. The association between auditor litigation and abnormal accruals. The

Accounting Review. Vol. 76(1) pp. 111-126.

Housing Authority. 1985– 2004. Annual Reports


121

Jayaraman, T. and Sharma, R. 2003. Why is interest rate spread high in fiji? results from a

preliminary study. Fijian Studies: A Journal of Contemporary Fiji. Vol.1 (1), pp.75-104.

Jensen, M. and Meckling, W. 1976. Theory of the firm: managerial behaviour, agency costs and

ownership structure. Journal of Financial Economics. Vol. 3(4), pp. 305-360.

Jones, J. 1991. Earnings management during import relief investigations. Journal of Accounting

Research. Vol. 29(2), pp. 193-228.

Kasznik, R. 1999. On the association between voluntary disclosure and earnings management.

Journal of Accounting Research. Vol. 37(1), pp. 57-81.

Krishnan, G. 2003. Audit quality and the pricing of discretionary accruals. Auditing: A Journal

of Practice and Theory. Vol. 22(1), pp. 109-126.

Levitt, A. 1998. The numbers game. Unpublished remarks. Available at

http://www.SEC.gov/news/speech/spch220.txt.

Likerman, A. 1983. Evidence on accusations of manipulating profitability: adjustments for

inflation by nationalised industries 1976-81. Accounting and Business Research. Vol.

14(53), pp. 29-34.

Liu, Q. and Lu, Z. 2003. Earnings management to tunnel: evidence from China’s listed

companies. University of Hong Kong, Hong Kong.

McInnes, W. 1990a. A longitudinal study of accounting changes: The UK Gas Industry 1969-

1974. Accounting and Business Research. Vol. 20(80), pp. 315-327.

McInnes, W. 1990b. Further evidence on accounting choices: The South of Scotland Electricity

Board, 1978-1988. Accounting and Business Research. Vol. 20(81), pp. 57-66.

McNichols, M. and Wilson, G. 1988. Evidence of earnings management from the provision for

bad debts. Journal of Accounting Research. Vol. 26(supplement), pp. 1-31.

Ministry of Public Enterprises and Public Sector Reform. 2000-2004. Annual Reports.

Ministry for Commerce, Industry, Cooperatives and Public Enterprises. 1998. Towards a Better

Fiji: The Public Enterprise Reform Programme.

Miroshnik, V. 2002. Culture and international management: a review. The Journal of

Management Development. Vol. 21(7), pp. 521-544.

Bibliography

122

Mulford, C and Comiskey, E. 2002. The financial numbers game: detecting creative accounting

practices. John Wiley & Sons. Inc., USA.

Natarajan, R.1999. Earnings based compensation schemes and discretionary accrual and

expenditure decisions over CEO tenure. Managerial Finance. Vol. 25(9), pp. 89-118.

Nelson, M., Elliot, J. and Tarpley, R. 2002. Evidence from auditors about managers and auditors

earnings management decisions. The Accounting Review. Vol. 77(supplement), pp. 175-

202.

Palliam, R. and Shalhoub Z. 2003. The phenomenology of earnings management within the

confines of agency theory. International Journal of Value Based Management. Vol.

16(1), pp.75-88.

Parliament of Fiji. 2003 and 2005. Parliamentary Debates (Hansard).

Parliament of Fiji. 2005. Accounts and Finance for the year ended 31 December 2004.

Parliamentary Paper No. 80.

Pathik, K. 1999. The standard setting process in Fiji and the level of compliance. Unpublished

MA thesis, The University of the South Pacific, Fiji.

Perry, S. and William, T. 1994. Earnings management preceding management buyout offers.

Journal of Accounting and Economics. Vol. 18(2), pp. 157-179.

Phillips, J., Pincus, M. and Rego, S. 2003. Earnings management: new evidence based on

deferred tax expense. The Accounting Review. Vol. 78(2), pp. 491-521.

Rangan, S. 1998. Earnings management and the performance of seasoned equity offerings.

Journal of Financial Economics. Vol. 50(1), pp. 101-122.

Reserve Bank of Fiji. 1996. Guidelines for loan classification and provisioning for impaired

assets. Banking supervision policy statement number 3.

Reserve Bank of Fiji. 2001. Guidelines for loan classification and provisioning for impaired

assets. Banking supervision policy statement number 3(revised).

Reserve Bank of Fiji. 2002 and 2004. Annual Reports.


123

Robson, C. 2002. Real world research: a resource for social scientists and practitioner

researchers. Blackwell Publishers, UK.

Richardson, V. 2000. Information asymmetry and earnings management: some evidence. Review

of Quantitative Finance and Accounting. Vol. 15(4), pp. 325-347.

Schipper, K. 1989. Commentary on earnings management. Accounting Horizons. Vol. 3(4), pp.

91-102.

Sharma, U. 2000. Management accounting and control system changes: a case study of the

Housing Authority of Fiji. Unpublished MA thesis, The University of the South Pacific,

Fiji.

Sprouse, R. 1966. Accounting for what-you-may-call its. The Journal of Accountancy. Vol.

122(4), pp. 45-53. In Keller, T. and Zeff, S. (eds.) Financial Accounting Theory Part II:

Issues and Controversies. 1969. pg 367-379.

Stolowy, H. and Breton, G. 2000. A framework for the classification of accounts manipulations.

Working paper, HEC School of Management.

Sweeney, A. 1994. Debt covenant violations and managers’ accounting responses. Journal of

Accounting and Economics. Vol. 17(3), pp. 281-308.

Teoh, S., Welch, I. and Wong, T. 1998a. Earnings management and the long-run market

performance of initial public offerings. The Journal of Finance. Vol. 53(6), pp. 1935-

1974.

Teoh, S., Welch, I. and Wong, T., 1998b. Earnings management and the long run

underperformance of seasoned equity offerings. Journal of Financial Economics. Vol.

50(1), pp. 53–100.

The Government of Fiji. Public Enterprise Act, 1996.

Wise, M. 1996. HA close to objective. The Fiji Times. 127th year (288) Oct 16, pp.4.

United States of America. 2002. Sarbanes-Oxley Act.

Vinciguerra, B. and O’Rielly, M. 2004. An examination of factors influencing managers and

auditors assessments of the appropriateness of an accounting treatment and earnings

management intentions. American Business Review. Vol. 22(1), pp. 78-87.

Appendix

124

APPENDIX 1 CHECKLISTS

Checklist 1 Premature or Fictitious Revenue

What is the entity’s revenue recognition policy?

1. Before delivery or performance

a. Is it really earned?

2. At delivery or performance

a. Is there a right of return or price protection?

i. Has the entity provided adequately for returns or price adjustments?

3. After delivery or performance and full customer acceptance

Was there a change in the revenue recognition policy?

1. Did the change result in earlier revenue recognition?

Are there any unusual changes in revenue reported over the years?

1. What is the revenue for each year over the investigation period?

2. Does any one year show unusual activity not explained by economic factors?


125

Checklist 1 Continued

Does the entity have the physical capacity to generate the revenue reported?

1. What is revenue per appropriate measure of physical capacity for each of the last ten years?

a. Possible measures of revenue per physical capacity:

i. Revenue per employee

ii. Revenue per dollar of property, plant and equipment

iii. Revenue per dollar of total assets

Are there signs of overstated accounts receivable or other accounts that might be used to

offset premature or fictitious revenue?

1. Compare the percentage rate of change in accounts receivable, property, plant and equipment

and other assets with the percentage rate of change in revenue for each year.

a. What are the implications of differences in the rates of change in these accounts and revenue?

2. Consider whether unexplained changes in other asset or liability accounts might be explained

by premature or fictitious revenue.

3. Compute accounts receivable days for each year.

a. What are the implications of changes noted in accounts receivable days over the investigation

period?

Appendix

126

Checklist 2 Capitalization and Amortization Policies

PART 1 Detecting Aggressive Capitalization Policies

For cost capitalization generally:

1. What are the entity’s policies with respect to cost capitalization?

a. Is the entity capitalizing costs that should be expensed?

b. Does the entity expense more, taking a more conservative approach?

c. Are capitalized costs increasing faster then revenue over lengthy periods?

Has the entity shown evidence in the past of being aggressive in its capitalization policies?

Is there an example of prior year write down of capitalized costs that should not have been

capitalized?

Has a regulator forced a change in accounting policies in the past?

Has the entity capitalized costs in stealth?

Examine unusual changes in and relationships with revenue of the following: accounts

receivable, inventory, property, plant and equipment and other assets.

PART 2 Amortization Policies

Has the entity selected extended amortization and depreciation periods for capitalized

costs?

1. How does the calculated average amortization period for long-lived assets compare with

competitors or other entities in the industry?

Consider the extended amortization periods in the following situations:

1. Entity’s industry is experiencing price deflation

2. Entity is in an industry that is experiencing rapid technological change

3. Entity has shown evidence in the past of employing extended amortization periods

a. Is there an example of a prior year write down of assets that became value impaired?


127

Checklist 3 Misreported Assets and Liabilities

Detecting overvalued/undervalued assets

Accounts receivable

1. Compare the percentage rate of change in accounts receivable with the percentage rate of

change in revenue for each year.

a. What are the implications of differences in the rates of change?

2. Is the allowance for doubtful accounts sufficient to cover future collection problems?

a. Compute accounts receivable days for each year.

i. Is the trend steady, improving or worsening?

3. Have economic conditions for the entity’s customers worsened recently?

a. Are entity’s sales declining?

b. Are there other general economic reasons to expect that customers are or may be having

difficulties?

4. Are sales growing rapidly?

a. Has the entity changed its credit policy?

i. Is credit being granted to less creditworthy customers?

b. Have payment terms been extended?

Inventory

1. Are inventories overstated due to inclusion of nonexistent inventories or by the reporting of

true quantities on hand at amounts that exceed replacement cost?

a. Compute gross margin and inventory days for the last ten years

i. Is the trend steady, worsening or improving?

b. Do ongoing entity events and fortunes suggest problems with slackening demand for the

entity’s products?

i. Are sales declining?

ii. Have raw material inventories declined markedly as a percentage of total inventories?

Appendix

128

Checklist 3 continued

c. Are prices falling, suggesting general industry weakness and an increased chance that

inventory cost may not be recoverable?

d. Is the entity in an industry that is experiencing rapid technological change, increasing the risk

of inventory obsolescence?

e. Has the entity shown evidence in the past of inventory overvaluation/undervaluation?

i. Is there an example of a prior year write-down of inventory that became value impaired?

Detecting overvalued/undervalued liabilities

Accrued expenses payable

1. What is the trend in accrued expenses payable?

2. Compare the percentage rate of change in accrued expenses payable with the percentage rate

of change in revenue for each year.

a. What are the implications of differences in the rates of change?

3. Does an improvement in selling, general and administrative expense as a percentage of

revenue reflect true operating efficiencies?

Accounts payable

1. Compute accounts payable days for each year.

a. Is the trend steady, worsening or improving?

2. Was there an unexpected improvement/decline in gross profit margin?

3. How does the percent change in accounts payable compare with the percent change in

inventory?


129

Checklist 4 Using Cash Flows To Detect Earnings Management Practices

Isolate nonrecurring cash inflows and outflows, including:

1. Income taxes paid or recovered on transactions classified as investing or financing activities,

including:

a. gain or loss on sale of assets, investments or businesses

b. extraordinary items

c. changes in accounting principle, if any

2. Cash flow from the purchase and sale of trading securities

3. Capitalized expenditures that should be expensed as incurred

4. Nonrecurring cash income and expense

5. Significant isolated events leading to changes in operations-related assets and liabilities,

including:

a. special inventory reduction sale outside normal channels

Compute adjusted cash flow provided by continuing operations

1. Adjust reported cash flow provided by operating activities for identified nonrecurring cash

flow items.

Compute adjusted income from continuing operations

1. Adjust reported income from continuing operations for nonrecurring items of income and

expense

Compute the adjusted cash flow-to-income ratio

1. Adjusted cash flow provided by operating activities divided by adjusted income from

continuing operations.

a. Compute for several years

b. Examine results for discernible trend.

Appendix

130

APPENDIX 2

Current Interest Rates Offered by Different Financial Institutions

Institution Rate36

Home Finance Company 8.65% fixed for first 6 months, 10% variable thereafter

Westpac Banking Corporation 8.4% fixed for 1 year, 10.25% variable thereafter

Colonial National Bank 9.40% fixed for 1 year, 10.25% variable thereafter

ANZ 8.25% fixed for 1 year, 10.25% variable thereafter

Fiji Development Bank Variable rate 8.95%

Housing Authority 3.99% fixed for 18 months, 7.99% variable thereafter

(Adapted from the financial institutions)

36 These rates are effective August 2006 after the RBF increased its policy indicator rate in June from 3.25% to 4.25%. However, HA's rates remained unchanged.


131

APPENDIX 3A

Financial Indicators of the HA

Year Assets

$m

Equity

$m

Liabilities

$m

Operating

Income37

$m

Debt to

equity

Current

ratio

ROE

%

1990 85.29 1.70 83.59 (2.22) 49.11 1.93 (130.20)

1991 86.55 0.80 85.75 (0.48) 106.65 1.44 (59.58)

1992 107.70 2.05 105.64 0.04 51.48 1.73 2.10

1993 127.98 4.31 123.67 0.52 28.69 2.07 12.02

1994 153.74 5.82 147.92 0.69 25.42 2.15 11.81

1995 167.32 3.43 163.90 0.31 47.84 3.35 9.02

1996 168.92 (2.22) 171.14 (1.07) (77.13) 1.59 47.99

1997 166.55 (2.10) 168.65 0.12 (80.16) 1.08 (5.47)

1998 168.13 (1.94) 170.08 (0.77) (87.49) 0.61 39.40

1999 158.06 (5.34) 163.40 (1.42) (30.58) 1.02 26.50

2000 161.77 (4.36) 166.14 (1.96) (38.07) 0.83 44.84

2001 165.87 (3.85) 169.71 0.45 (44.13) 0.65 (11.80)

2002 176.05 38.46 137.58 0.54 3.58 1.08 1.40

2003 177.62 39.24 138.39 0.77 3.53 1.07 1.97

2004 158.70 41.30 117.39 2.07 2.84 1.23 5.00

(Adapted from the HA Annual Reports 1989-2004 and author's calculations)

37 This represents income before abnormal items.

Appendix

132

APPENDIX 3B

Financial Indicators of the FEA

Year Assets

$m

Equity

$m

Liabilities

$m

Operating

Income38

$m

Debt to

Equity

Ratio

Current

Ratio

ROE

%

1990 337.39 (3.93) 341.32 (3.38) (86.92) 0.23 85.97

1991 342.19 13.41 328.78 13.84 24.52 0.32 103.25

1992 509.89 204.37 305.52 17.29 1.49 0.31 8.46

1993 515.23 224.68 290.56 18.19 1.29 0.34 8.10

1994 509.53 242.00 267.53 16.38 1.11 0.85 6.77

1995 522.51 240.87 281.64 20.47 1.17 1.56 8.50

1996 525.96 259.61 266.35 17.32 1.03 1.33 6.67

1997 500.47 277.61 222.85 18.41 0.80 0.45 6.63

1998 497.61 299.78 197.83 21.26 0.66 0.55 7.09

1999 482.08 318.17 163.91 9.03 0.52 1.61 2.84

2000 473.28 315.91 157.37 (6.65) 0.50 0.33 (2.10)

2001 470.07 319.46 150.61 0.03 0.47 0.99 0.01

2002 456.70 324.91 131.79 3.79 0.41 2.21 1.17

2003 459.92 330.14 129.78 2.61 0.39 3.47 0.79

2004 452.12 325.38 126.74 9.31 0.39 1.89 2.86

(Adapted from the FEA Annual Reports 1990-2004 and author's calculation)

38 This represents income before abnormal items and income tax.

a6l clqrcc*, bka oc(digilib.library.usp.ac.fj/gsdl/collect/usplibr1/index/... · 2009-10-19 ·...

Documents