THE EFFECT OF ESTIMATES IN FINANCIAL STATEMENTS BY ELIZABETH JOHANNA RAUBENHEIMER DISSERTATION SUBMITTED IN ACCORDANCE WITH THE REQUIREMENTS FOR THE DEGREE MAGISTER IN ACCOUNTING IN THE FACULTY OF ECONOMIC AND MANAGEMENT SCIENCES (CENTRE FOR ACCOUNTING) AT THE UNIVERSITY OF THE FREE STATE STUDY LEADER: PROF. HA VAN WYK BLOEMFONTEIN MAY 2008 TABLE OF CONTENTS PAGE CHAPTER 1 INTRODUCTION AND BACKGROUND 1.1 INTRODUCTION .............................................................................. 1 1.2 PROBLEM STATEMENT ..................................................................... 3 1.3 OBJECTIVES OF THE STUDY ............................................................ 7 1.4 SCOPE OF THE STUDY ..................................................................... 8 1.5 RESEARCH METHODOLOGY .............................................................. 8 1.5.1 Literature study ............................................................................... 8 1.5.2 Empirical study ................................................................................ 9 1.6 CONTENTS OF THE STUDY .............................................................. 9 1.7 CONCLUSION ................................................................................ 11 CHAPTER 2 ACCOUNTING ESTIMATES IN FINANCIAL STATEMENTS 2.1 BACKGROUND ............................................................................... 12 2.2 GENERALLY ACCEPTED ACCOUNTING PRACTICE ............................. 12 2.2.1 Introduction .................................................................................. 12 2.2.2 Building blocks of financial statements ............................................ 13 2.2.3 IFRSs in South Africa ..................................................................... 17 2.3 DEFINING ACCOUNTING ESTIMATES .............................................. 18 2.4 POSSIBLE INCREASE IN ALLOWED ACCOUNTING ESTIMATES .......... 20 2.5 INCREASES IN “ESTIMATE” HITS BETWEEN 2003 AND 2004 ............ 21 2.5.1 IFRS 1 (AC 138) ............................................................................ 23 2.5.2 IAS 36 (AC 128) ............................................................................ 23 2.5.3 IFRIC 1 (AC 434) ........................................................................... 26 2.5.4 IAS 38 (AC 129) ............................................................................ 26 2.5.5 Conclusions on “estimate” hits between 2003 and 2004 .................... 28 2.6 INCREASES IN “ESTIMATE” HITS BETWEEN 2004 AND 2005 ............ 29 2.6.1 IFRS 2 (AC 139) ............................................................................ 30 2.6.2 IFRS 4 (AC 141) ............................................................................ 32 i TABLE OF CONTENTS (continued) Page 2.6.3 IFRS 7 (AC 144) ............................................................................ 32 2.6.4 Revised standards analysed ............................................................ 33 2.6.4.1 IAS 1 (AC 101) ..............................................................................35 2.6.4.2 IAS 8 (AC 103) ..............................................................................36 2.6.4.3 IAS 19(AC 116) and IAS 41 (AC 137) .............................................. 37 2.6.4.4 IAS 39 (AC 133) ............................................................................37 2.6.5 Conclusions on “estimate” hits between 2004 and 2005 .................... 38 2.7 FAIR VALUES IN ACCOUNTING STANDARDS .................................... 39 2.8 FREQUENCY OF USE OF ESTIMATES IN FINANCIAL STATEMENTS ..... 43 2.9 THE NATURE OF ACCOUNTING ESTIMATES. .................................... 48 2.10 CONCLUSION ................................................................................ 50 CHAPTER 3 CREATIVE ACCOUNTING 3.1 INTRODUCTION ............................................................................ 52 3.2 DEFINING EARNINGS MANAGEMENT AND CREATIVE ACCOUNTING .. 52 3.3 CONDITIONS AND MOTIVATION FOR CREATIVE ACCOUNTING ........ 56 3.3.1 IFRSs as an underlying condition for creative accounting .................. 56 3.3.2 Motivation and incentives for the practice of creative accounting ....... 58 3.4 CREATIVE ACCOUNTING PRACTICES .............................................. 61 3.5 EVIDENCE OF THE EXISTENCE OF CREATIVE ACCOUNTING ............. 64 3.5.1 Evidence from the SEC ................................................................... 64 3.5.2 Evidence from recent financial disasters .......................................... 65 3.5.2.1 Enron Corporation .........................................................................66 3.5.2.2. WorldCom Inc. ..............................................................................66 3.5.2.3 Parmalat .......................................................................................66 3.5.2.4 Leisurenet .....................................................................................66 3.5.3 Evidence from academic research ................................................... 67 3.6 CAN USERS IDENTIFY CREATIVE ACCOUNTING PRACTICES? ............ 69 3.7. CONSEQUENCES OF THE USE OF CREATIVE ACCOUNTING ............... 71 ii TABLE OF CONTENTS (continued) PAGE 3.8 FRAUDULENT FINANCIAL REPORTING ............................................ 73 3.8.1 Creative accounting and fraud – comparing definitions ..................... 74 3.8.2 Motivation for fraudulent financial reporting ..................................... 77 3.8.2.1 Conditions .....................................................................................78 3.8.2.2 Corporate structure........................................................................79 3.8.2.3 Choice ..........................................................................................80 3.9 CONCLUSION ................................................................................ 81 CHAPTER 4 PREVENTION AND DETECTION OF CREATIVE ACCOUNTING 4.1 INTRODUCTION ............................................................................ 83 4.2 PUBLIC TRUST .............................................................................. 83 4.3 CORPORATE REPORTING SUPPLY CHAIN ........................................ 86 4.4 COMPANY EXECUTIVES AND BOARD OF DIRECTORS ....................... 89 4.4.1. System of Internal controls ............................................................. 92 4.4.2. Corporate governance .................................................................... 94 4.4.2.1 Board composition .........................................................................97 4.4.2.2 Remuneration ...............................................................................98 4.4.2.3 Audit committee ............................................................................99 4.4.2.4 Code of ethics ............................................................................. 100 4.5 INTERNAL AUDIT FUNCTION........................................................ 102 4.6 INDEPENDENT AUDITORS (EXTERNAL AUDITORS) ........................ 106 4.6.1 Objective .................................................................................... 107 4.6.2 Approach .................................................................................... 110 4.6.3 Audit Standards ........................................................................... 111 4.7 INFORMATION DISTRIBUTORS .................................................... 115 4.8 THIRD PARTY ANALYSTS AND INVESTORS .................................... 115 4.9 STANDARD SETTERS ................................................................... 117 4.9.1 IAS 1 (AC 101) ............................................................................ 120 4.9.2 IFRS 7 (AC 144) .......................................................................... 121 iii TABLE OF CONTENTS (continued) PAGE 4.10 MARKET REGULATORS ................................................................. 123 4.10.1 Companies Act ............................................................................ 123 4.10.2 The JSE ...................................................................................... 124 4.11 ENABLING TECHNOLOGIES .......................................................... 125 4.12 CONCLUSION .............................................................................. 126 CHAPTER 5 EMPIRICAL STUDY OF FINANCIAL STATEMENTS 5.1 INTRODUCTION .......................................................................... 128 5.2 SCOPE OF EMPIRICAL RESEARCH ................................................. 129 5.3 PERCENTAGE OF TOTAL ASSETS AFFECTED BY ACCOUNTING ESTIMATES ................................................................................. 130 5.3.1 Introduction and Methodology ...................................................... 130 5.3.1.1 Aveng Ltd (Aveng) ....................................................................... 131 5.3.1.2 Basil Read Holdings Ltd (Basread) ................................................. 132 5.3.1.3 Group Five Ltd (Group 5) ............................................................. 133 5.3.1.4 Murray and Roberts Holdings Ltd (M&R-HLD) ................................. 135 5.3.1.5 Wilson Bayly Holmes Ovcon Ltd (WBHO) ....................................... 136 5.3.2 Summary: Percentage of assets affected by accounting estimates ... 137 5.4 REFERENCE TO “ESTIMATES” IN THE FINANCIAL STATEMENTS ..... 140 5.4.1 Introduction and methodology .....................................................