Auditor Independence Corporate Governance And Corporate Bankruptcy: Lessons From Australian Companies

Analyzing Corporate Bankruptcies in Australia

Question:

Discuss About The Auditor Independence Corporate Governance?

The incidence of corporate failure is on the rise and in order to retain the confidence of the investors it becomes imperative to analyse the underlying reasons and thereby provide recommendations to avoid future bankruptcies. On the surface, the trigger for bankruptcy and subsequent liquidation is essentially the outstanding liabilities whose quantum far exceeds that of the available asset. However, the real cause in most of cases lies elsewhere which actually leads to the problem of the liabilities increasing to such an extent. Very rarely is this a short term phenomenon and usually the business inches towards bankruptcy in the long run. In order to analyse the role of liabilities in corporate bankruptcy, some actual corporate bankruptcies witnessed in Australia have been analysed so as to bring clarity on the matter besides offering recommendations for the future.

In order to analyse the given problem, three cases have been selected to shed light on the various aspects that led to bankruptcy and to narrow down any common aspect which is noticeable in each of these cases. The three companies are ABC Learning, HIH Insurance and One Tel which essentially belonged to different sectors and have undergone bankruptcy in the first decade of the 21^st century.

The company came into existence in the late 1980’s but post listing on the ASX, it shot into prominence owing to the ambitious plan for expanding the reach. In a short time period only, the company was able to scale the spread of ABC centres across various geographies in a bid to deliver superior returns to shareholders. However, the expansion strategy had one crucial flaw which was in the form of lowering service quality as the management seemed so obsessed with scaling the reach that quality took a back seat. As a result, the very strategy that was to deliver superior returns for shareholders destroyed their wealth (CPA, 2012).

The business started operations in 1968 but the growth phase of the company happened only post 1990. The company acquired a number of companies as it not only enhanced the geographical presence but also the insurance products on offer. The net result of this strategy was that by the turn of the century, the company had more than 100 subsidiaries with foray in different insurance segments coupled with geography. However, the company became bankrupt owing to the huge insurance contracts related liabilities. But, details revealed later clearly indicate that these were on account of imprudent risk management practices and concealing of the same through quid pro quo relation with the external auditor. This ensured the continuance of faulty business practices to such a period when there was no turning back (Mak, Deo & Cooper, 2005).

ABC Learning

The company emerged as a prominent telecom player before filing for bankruptcy on account of huge business losses. However, this was not sudden and could be attributed to faulty sales penetration policy which led to huge losses which were then concealed through shoddy corporate reporting practices. To the external users, only the rise in market share and the subscriber base was highlighted and the losses were not reflected. As a result, the company management continued with the aggressive expansion policy which essentially contributed to the losses which became so large and eventually sustainable leading to company filing for bankruptcy (Monem, 2009).

When the company listed, it started expanding the presence of centres and announced an expansion plan which the management implemented with success and the stock price rose. However, in a bid to expand, the management lost the major strength of the company which was the quality of services. There was in increase in the complaint level which was faced due to lack of staff and hence the reputation of the company suffered. However, the management did not address these issues (Arens et. al., 2013).  The sole concern of the management was to carry ahead with setting up more centres without considering the falling service standards and the overall impact on the brand. The company also acquired certain businesses so as to provide an entry into new markets. However, this intrinsically incorrect business strategy essentially backfired when the financial crisis began and the company had to file for bankruptcy (Kaplan, 2011). The downfall of the company could be attributed to the falling quality standards, shifting customer loyalty coupled with lapse in corporate governance issues and corporate reporting. An instance of shoddy corporate governance practice relates to favour in terms of lucrative maintenance contract and sponsorship being extended to a relative of a particular director. These instances lead to fall in investor confidence and filing of bankruptcy (CPA, 2012).

The company after the humble beginning made attempts to expand the business of the company through expansion strategy post 1990. With regards to business expansion, there is always the increased risk which need to be taken into consideration and the management is expected to take prudent actions to keep liabilities within control. However, the management at HIH insurance did not manage the risks and had to pay the price for this huge expansion by declaring bankruptcy (Mak, Deo & Cooper, 2005).  The insurance business is inherently risk and the various steps should be taken by the management taking into cognizance the associated business risk (Gay & Simnett, 2012). However, this is found missing here as for enhancing the customer case in a new market (USA), the premiums were kept at so low level that the underlying risk become very high and thus, huge losses were sustained which could have been avoided through prudent management action. Besides, the acquisition strategy of the company was also flawed as apparent from the acquisition of FAI where due diligence was lacking and high premium was paid which put further strain on the business (Mirshekary, Yaftian & Cross, 2005).  Further,  instead of following the provisioning norms for limiting underwriting risk, the management adopted the more risky and unsustainable reinsurance model and ventured into insurance of planes and ships which Is considered higher risky. Also, on account of quip pro quo relation with the external auditor, these glaring efficiencies were never brought to light and hence bankruptcy was inevitable for the company (Mak, Deo & Cooper, 2005).

HIH Insurance

The key deficiency with One Tel was also a flawed management decision to expand business which taking the bottomline into consideration and then using the shoddy reporting practices and internal controls to hide the impact of these.  As a result of the falling standards of corporate reporting, the internal and external decision making suffered since the financial statements could not be trusted. A contributory factor to this was that the internal controls were compromised by the top management and information was only selectively captured. The interest of the management only was solely on the subscriber base increase without considering if the shareholder wealth is being created by this practice or not. The losses arising from this strategy were concealed so that no external user could object (Gilbert, Joseph & Terry, 2005).

In relation to financial performance reporting, the comparison drawing was virtually impossible in an environment where the accounting policies had become so volatile. The sole concern for the choice of the accounting policies was that a stable performance could be presented to the shareholders which provide support to the share price. Hence, there was frequent switching of the applicable accounting policy so as to suit the agenda of the management and they had absolute control on the results reported as the independence of the external auditor was severely compromised. As a result, the faulty policies continued unabated amidst falling corporate governance norms and the only way for this to stop was the losses to become so huge that it virtually becomes impossible to conceal leading to bankruptcy which is what essentially transpired (Monem, 2009).

A common theme which is observable in all the above bankruptcy cases is the failure on part of the management in terms of wrong business strategy and then taking inappropriate (and at times illegal) measures to conceal the disastrous results of the same.

Take for instance, ABC Learning where the management focus was essentially restricted only to expansion without taking requisite measures to stop the downfall in quality. It should have been obvious to them that such a strategy was not sustainable as essentially this would lead to erosion of brand, reputation and profits. However, the management made no attempts to rectify the issue at hand and instead compounded the problem by concealing the effect of such a policy. As a result, there was systematic deterioration of the financials which the management was aware but the failure on their part was the prime reason for the liabilities becoming so huge that liquidation was the only choice left for the company (Bhagat & Bolton, 2008).

One Tel

For HIH Insurance, the ambitious expansion policy with minimal risk containment led to the downfall of the company. The management desired to venture into highly risky avenues in the insurance business and deployed aggressive premium pricing on one hand while on the other their risk management strategy was inherently wrong and inconsistent with the industry practice of deploying provisioning norms. Further, the decisions were taken without adequate consultation and due diligence and the impact of the same were concealed with the help of compromised independence of the external auditor. As a result, the business became a virtual time bomb and eventually exploded resulting in business liquidation (Mirshekary, Yaftian & Cross, 2005).

Further in relation to One Tel also, a similar observation can be made where an expansion of subscriber base was implemented in manner which led to huge losses but the management made no attempts to alter the strategy and instead tried to portray the strategy as a success. This ensured that they continued with the policy which eventually led to mounting losses and subsequent business failure (Brown & Caylor, 2009).

The research that has been conducted using the three companies clearly indicate that the business failure is not the result of mounting liabilities but rather the wrong decisions taken by unethical management which have continued with the faulty practices for long by compromising the corporate reporting and corporate governance measures. Hence, the emphasis needs to be on ethical management for which the accountability of the top executives needs to be fixed which to an extent has been catered to by the enactment of Corporations Act 2001 which enlists the directors’ duties and also imposes punishment for violation of these (Arens et. al., 2013). Also, the improvement in corporate governance is essential so that the corporate disclosures and internal control mechanism can be strengthened. Two essential parameters in this regards are expanded role of non-executive directors and also ensuring the independence of the external auditor (Gay & Simnett, 2012).  This would go a long way in ensuring that bankruptcy is not caused as the faulty business practices are brought to light on time. In the Australian context, measures have been taken to ensure the above two through CLERP reforms (Clout Chappelle & Gandhi, 2009).  

Conclusion

In accordance with the above discussion, that the actions of the management coupled with weak corporate governance norms seem to be responsible for the bankruptcy of business. This is the reason which effectively leads to mounting liabilities and eventually liquidation of business. The management strategy pursued in all the discussed cases was driven by the short term purview and did not aim at creating long term value for the shareholders. Also, the weak corporate governance norms and internal controls allowed the management to collude with the auditor leading to the concealment of all wrong policies till the time the losses become very huge. Prudent corporate governance measures coupled with higher auditor independence and higher accountability of directors would ensure that the incidence of these frauds tends to decrease and various steps have been taken by the government and regulators in this regard.

References

Arens, A., Best, P., Shailer, G. and Fiedler,I. (2013). Auditing, Assurance Services and Ethics in Australia, 2^nd eds., Sydney: Pearson Australia

Bhagat, S. and Bolton, B. (2008), ‘Corporate Governance and Firm Performance’, Journal of Corporate Finance, Vol.14, No.3, pp. 257-273.

Brown, L and Caylor, M. (2009), ‘Corporate Governance and Firm Operating Performance’, Review of Quantitative Finance and Accounting, Vol. 32, No. 2, pp. 129-144.

Clout, V, Chappelle, E and  Gandhi, N (2013), ‘The impact of auditor independence regulations on established and emerging firms’, Accounting Research Journal Vol. 26, No. 2, pp. 88-108

CPA (2012).  ABC learning collapse case study., CPA Website, [online ] Available at https://www.cpaaustralia.com.au/professional-resources/education/abc-learning-collapse-case-study  [Accessed September 14, 2017]

Gay, G. and  Simnett, R. (2012), Auditing and Assurance Services in Australia, 5^th eds., Sydney: McGraw-Hill Education

Gilbert, W., Joseph J. and Terry J.E (2005), ‘The Use of Control Self-Assessment by Independent Auditors’. The CPA Journal, Vol. 3,  pp. 66-92

Kaplan, R.S. (2011). ‘Accounting scholarship that advances professional knowledge and practice’. The Accounting Review, Vol. 86, No.2,  pp. 367–383.

Mak, T., Deo, H. and Cooper, K. (2005), ‘Australia’s Major Corporate Collapse: Health International Holdings (HIH) Insurance ‘May the Force Be with You’, Journal of American Academy of Business, Vol. 6, No.2, pp. 104-112.

Mirshekary, S., Yaftian, A. and Cross, D. (2005), ‘Australian Corporate Collapse: The Case of HIH Insurance’, Journal of Financial Services Marketing, Vol. 9, No.3, pp. 249-58.

Monem, R. (2009), The Life and Death of OneTel, Griffith University, [online] Available at https://www98.griffith.edu.au/dspace/bitstream/handle/10072/42673/74746_1.pdf [Accessed September 14, 2017]