The research question investigated is “Do managers of Australian firms use upward asset revaluations to reduce debt contracting costs?” Much work in the accounting choice literature is premised on a relation between debt contracts and accounting policies. In particular, prior research using sample periods from the 1970s and early 1980s, provides evidence that asset revaluations are used to reduce the costs of debt contracting (see Whittred and Chan, 1992; Brown, Izan and Loh, 1992; and Cotter and Zimmer, 1995). However, considerable changes to the institutional setting have occurred in the past decade. These institutional changes include increased regulation of asset revaluations and disclosures, changes in the macroeconomic environment, and changes in the Australian debt market. Particularly, there has been a shift in emphasis from public to private debt. The relationship between asset revaluations and debt contracting is examined in the current setting. Following Watts and Zimmerman’s (1990) suggestion that research into the relationship between firms’ contracts and their accounting policy choices will be improved by the use of more refined measures of contracting variables, the research commences with an investigation of the terms contained in recently issued debt contracts. Accordingly, this thesis contains two phases. Part A comprises an investigation of the covenants and accounting measurement rules typically contained in the recent debt contracts of listed Australian firms, with an emphasis on the role of asset revaluations. Part B then uses the outcomes of this investigation to determine the refined measures of debt contract terms used in testing hypotheses about the current relationship between asset revaluations and debt contracting. Part A establishes the current dominance of bank loan financing, along with a dramatic decline in the use of public debt. Details of the terms typically contained in bank loan agreements, particularly those relating to asset revaluations, are then investigated using a questionnaire survey of senior corporate bankers and analysis of a small sample of actual contracts. Outstanding public debt contracts are also analysed and compared with private debt contracts. The results of this phase of the research indicate that leverage covenants are the most widely used accounting based covenant in the bank loan agreements of listed Australian firms. In addition, interest coverage, current, tangible net worth, and prior charges ratios are all frequently used. Covenants tend to be less restrictive for larger firms than for smaller firms, and more restrictive for mineral producers than for industrial firms. Covenants contained in bank loan agreements tend to be more restrictive than those contained in convertible note trust deeds. In addition to providing important data for part B, the results of this phase of the research address an important gap in our knowledge about the terms contained in recently issued public and private debt contracts of listed Australian firms. Part B develops hypotheses based on the assumption that the costs of revaluing will be incurred when they are expected to be less than reductions in the costs of debt contracting derived from the revaluation. Due consideration is given to the likelihood that at least some of these costs have changed since prior research was conducted. In addition to the arguments presented in prior asset revaluations research, the expected costs of default on debt contracts, and the accounting discretion available to managers, are investigated as determinants of asset revaluation accounting choices. Predictions are made in relation to the likelihood of revaluation, the choice of valuer type, and whether to recognise or merely disclose new valuations of land and buildings. Interestingly, the results of prior research do not replicate in the current setting. Further analysis shows that differences in results are not due to differences in research methods between the current and prior research. In order to further examine the potential impact of changes to the institutional setting, a series of interviews with Chief Financial Officers is undertaken. The conclusion drawn from this additional analysis is that the relatively closer relationship between firms and their bankers has caused many firms to choose footnote disclosure of undervalued assets in preference to recognising an upward asset revaluation in the balance sheet. Overall, the results indicate that, when investigating the relationship between firms’ contracts and their accounting policy choices, a consideration of the way that contracts are negotiated and monitored is potentially more important than the use of refined measures of contract terms.

The revaluation of non-current assets has become an accepted accounting practice in many countries including the United Kingdom, Australia and New Zealand. This practice has implications for the external auditor who must decide whether to accept a valuation as reasonable and how much evidence to collect to support the decision. This thesis represents the first study to examine audit decision making in this area. Because of the absence of prior research, a series of structured interviews was undertaken with audit partners to identify the main audit issues. The results of these interviews, together with the relevant literature, were used to identify some of the factors that may impact on audit judgments concerning revalued assets. Hypotheses were developed and two complementary experiments were designed to test them. These were based on the premise that client management may be motivated to revalue in order to improve the appearance of the balance sheet, thereby increasing the inherent risk of misstatement. A 2 x 2 between-subjects design was used for both experiments, and the dependent variables measured were estimates of the planned audit hours to be spent on the revalued assets and likelihood judgments that the valuations would be accepted as reasonable. Experiment One considered the situation where auditors are faced with two conflicting risks which are likely to exist simultaneously in the audit environment. These were the threat of litigation arising from the client's breach of a debt covenant and the risk of losing the client. The study examined auditors' responses to high and low levels of these risks on the audit of revalued owner-occupied property and an investment property. For the planned audit hours, results indicated a strong interaction effect between the two factors, with auditors planning to spend significantly more time on the audit of revalued assets when both the risk of breaching a debt covenant was high and the risk of losing the client was low. Similar results were found for the likelihood judgment that the valuations would be accepted as reasonable, except that for the investment property the results were only marginally significant. Experiment Two examined the impact of a proposal to issue shares to the public and the competence of the independent valuer on the audit of four classes of non-current assets. Results indicated that auditors would plan to spend longer on the audit of revalued assets when the client proposed to make a share issue and also when the competence of the valuer was lower. They were also less likely to accept the valuations as reasonable in these cases. However, an interaction effect between class of asset and competence of the valuer indicated that concern with some aspects of the evidence could override subjects' sensitivity to the competence of the valuer. An additional finding was a significant experience effect for the likelihood judgments, based on the number of audits, in which subjects had been involved, that had included asset revaluations. More experienced subjects were more likely than less experienced subjects to accept the valuations as reasonable.