This thesis investigates the financial reporting incentives for prediscovery costs in the Australian mining industry. The aim of the study is to explain variations in the accounting treatment of such costs by reference to (1) the levels of exploration risk faced by individual firms and (2) the tax minimisation incentives of a subsection of the industry. Exploration risk is depicted as the probability that the firm will fail to make an economically viable mineral discovery.
Australian exploration firms frequently conduct their activities via holdings of partial interests in a portfolio of exploration projects. Such a portfolio approach mitigates exploration risk, since it improves the likelihood that the firm will earn a share in at least one viable discovery. However, the levels of exploration risk attaching to each portfolio is firm-specific and will be determined by management, with the tacit approval of shareholders. Exploration risk will therefore vary across firms.
High levels of exploration risk exacerbate the inherent conflict of interest between the shareholders and the risk averse managers of the firm. Hence, where shareholders prefer to pursue a high risk exploration strategy, there will be a greater need for incentive structures to encourage risk-taking by managers. A central proposition of this study is that the choice of accounting method for pre-discovery costs is a means of providing such incentives. Specifically, capitalisation policies, which shield reported earnings and other financial statement metrics from the effects of exploration risk, are likely to be used where the firm is a high risk explorer. Institutional factors suggest four indicators for exploration risk; extent of offshore hydrocarbon exploration, corporate form and type of shares issued, the existence of foreign control and the use of project debt.
For many years in Australia, the profits from the sale of gold were income tax exempt. During the test period used in this study, this exemption was under review by the Federal government. The profitability of the gold industry was central to that review process. Firms which earned gold revenues therefore had incentives to adopt income-minimising accounting techniques to justify the continuance of their tax free status.
Both pooled and cross-sectional data analyses were undertaken on a sample of 120 companies for the 1985 and 1986 financial years. A maintained argument in this study is that Australian regulations allow wide intra-method discretion in the accounting treatment for pre-discovery costs. Accordingly, the reporting choice is measured as a continuous variable, rather than a classification based on firms' publicly asserted accounting policies. Pooling of the 1985 and 1986 data sets reduces any random fluctuation present in the crosssectional data for this variable.
The results support the proposition that exploration risk influences the accounting choice for pre-discovery costs. In both the univariate and multivariate tests, all four risk proxies are positively associated with capitalisation policies. Tax minimisation incentives are also an important determinant where the firm is earning gold revenues. Such firms are more likely to use expensing methods for prediscovery costs. Overall, the findings indicate that firms choose the accounting method for pre-discovery costs in view of its incentive and political consequences.