Discuss About The Increasing Incidence Companies Liquidated?

Real Life Cases of Business Liquidation

Question:

Discuss About The Increasing Incidence Companies Liquidated?

Ever since the dawn of the 20^th century, there has been a rise in the business liquidation which is not limited to Australia but is essentially a worldwide trend. As a result, this topic has gained immense attention in the recent times which poses question over the reason which is responsible for the same. In line with the basic understanding of bankruptcy, the immediate reason is almost always overwhelming liabilities which cannot be met with the existing asset on the balance sheet of the company which essentially forces the business to file for bankruptcy leading to liquidation of business. However, beneath the overwhelming liabilities lie the various causes which pose a bigger threat and need to be guarded against. To aid in this process, real life cases involving the bankruptcy in recent times have been discussed. These include One Tel, ABC Learning along with HIH Insurance.

Even though the company had existence since 1988 but it came into limelight from 2001 onwards when in a matter of a few months, the geographical presence and the concentration of centres grew. Further, a crucial aspect of this expansion strategy was acquisitions of various day care canters. As the company expanded operations across geography, a major issue it faced was in the form of falling quality. This was on account of the staff shortage which increased the overall dissatisfaction of the customers with the services of the company centres. It would have been expected that the company would have corrected these issues through increased staff so that there is a positive feedback from customers (Arens et. al., 2013).  However, the management was more concerned with geographical expansion to cash in on the subsidy provided by the government related to day care.  Hence, the number of centres grew with little focus on the level of quality of services being delivered and the financial viability of these centres. Besides, the management resorted to misrepresentation in terms of corporate reporting and hence formed a quid pro quo relationship with the auditors (Pitcher Partners). Also, there were significant related party disclosures that were not captured in the financial statements (Kaplan, 2007). This led the external users to be misguided and the stock soared nearly 10 times after it was listed in 2001. Clearly this conduct was unethical on part of the management and amounts to violation of fiduciary duties of agent (Gay and Simnett, 2012).

Causes of Business Liquidation

There were severe lapses in corporate governance framework which enabled the management to misrepresent the performance of the company and continue with their faulty practices. While sound corporate governance measures are imperative in order to ensure that there are internal reporting mechanisms which tend to complement the external auditor (Kaplan, 2011). In case of ABC Learning, the internal mechanisms were compromised and also there were no attempts to maintain the independence of the external auditor. The external auditor on their part never questioned the explanation provided by the management in relation to the swelling intangibles which formed about 70% of the total assets. Further, lucrative contracts were given to the relatives of the top management which clearly amounts to nepotism and hints towards ineffective internal control mechanisms (CPA, 2012).

On the basis of the support from the revenues provided by the government and rising share price, the company was able to assume huge loans from leading bank such as Commonwealth Bank of Australia and in the year of their failure had about $ 1 billion outstanding debts. Further, about 70% of the assets of the company were in the form of intangible assets which were actually not there. As much as 40% of the day care centres had been loss making from several years but the management continued with these so that the share price can be jacked up which can be used for raising incremental capital (Arens et. al., 2013). However, the financial stress and liabilities of the company was exposed when in 2007-2008, the auditor was changed to E&Y and it disclosed questionable practices and hinted that the loss for the year would be greater than the cumulative profit minted by the company. This essentially led to insurmountable liability for the company as there was massive write off of assets particularly intangibles (CPA, 2012).

Even though the company came into existence in 1968, but the growth trajectory really started in the last decade of the 20^th century when the company aggressively went on an acquisition spree which led to growing number of subsidiaries as the company ventured into all different forms of insurance coupled with larger geographical presence in a bid to expand business. Investigations into the matter highlighted the reporting lapses coupled with a faulty business model which were the main culprit. The nexus between the management and auditor made it worse and hence the flawed practices kept on stretching to a point where bankruptcy became inevitable. Also, the management was charged with stock market manipulation, dishonest conduct and dissemination of false information (Mak, Deo & Cooper, 2005).

Lapses in Corporate Reporting and Governance

It is noteworthy that a high intrinsic risk is found in the insurance business and therefore while attracting new customers, the premiums should be decided keeping in mind the underlying risk However, HIH in a bid to attract more customers and increase the market share launched in USA with premiums that were so low that there were increasing liabilities. Also, the management decision to use the reinsurance model also compounded the problem coupled with acquisitions that did not make much financial sense. Further, hefty premiums were paid which further aggravated the financial position of the company and reflect at the poor conduct of the management (Mirshekary, Yaftian & Cross, 2005). 

The above wrongdoings by the management of the company could be sustained only because of the lack of sound corporate governance. One of the first ones relates to the compromised independence of the external auditor (Arthur Anderson). There was a mutual understanding between the management and the external auditor whereby the external auditor issued an unqualified audit report and the management in turn gave lucrative business consulting contracts to Arthur Anderson. As a business consultant also, Arthur Anderson never indicated the additional risks associated with reinsurance model (Mak, Deo & Cooper, 2005). Besides, in 2000, the independence of the board was comprised when three ex-partners at Arthur Anderson were appointed at the board of HIH Insurance. Also, the audit committee in place did not have a single non-executive independent director thus ensuring that the internal reporting was compromised (Mirshekary, Yaftian & Cross, 2005).

Considering the nature of the insurance business, financial stress in the balance sheet is not unexpected. However, even in the heydays, the company’s financial position was dubious since despite have assets worth $ 8 billion, the net stood at $ 133 million and hence even minor fluctuations could potentially be disastrous for the company. Then in 2001, the company posted a loss of over $ 800 million for the six months ending on December 31, 2000. As a result, attempts were made to save the company through receivership but in vain. Later the liquidated appointers put the loss for the company at $ 5.3 billion. Thus, the company has since become a run-off which is managing the claims arising from the insurance contracts and does not take any new business (Mak, Deo & Cooper, 2005).

The core issue with the company which culminated in bankruptcy were essentially the imprudent business policies. As a result, in a bid to register rapid growth, the company witnessed huge losses which were concealed through incorrect reporting which eventually led to bankruptcy when the losses become unsustainably huge (Monem, 2009). The top management had the sole concentration towards increasing the subscriber base irrespective of the underlying financial cost involved and thus they made sure that the losses incurred were not represented as part of the financial reports so that the strategy could be continued (Gilbert, Joseph & Terry, 2005). However, the actual financial results were never reported by the management. Also, the CEO tweaked with the composition of the board and key internal committees so that two particular non-executive directors with whom the CEO had close connections always were members which amounts of dereliction of duty in light of the duties for directors bestowed by Corporations Act 2001 (Brown and Caylor, 2009).

Financial Stress and Imprudent Business Policies

The critical issue in relation to One Tel which pushed the company towards liquidation was the lapse in corporate reporting coupled with lack of sound corporate governance practices. The information that was contained in the management reports was not verified by the executives and as a result, there was deterioration of decision making both internally as well as externally. The internal control mechanisms with regards to audit were farce and hence there was fraudulent reporting in the internal books which had presence of only limited entries (Bhagat and Bolton, 2008). Also, for representation of company’s performance, there was no consistency of underlying financial policies and hence the results for two consecutive years were not comparable. The accounting policy was used based on the underlying business environment so that the performance could be moderated and the stock performance can be ensured. This resulted in the financial performance of the company appearing very consistent giving the impression of stability in business. In the whole financial misrepresentation, the independence of the external auditor, the board and the key internal committees was compromised so that the CEO can misrepresent the financial statements (Monem, 2009).

The financial stress for the company is visible from the period 1998 to 2000 i.e. before the liquidation period when the reported financial performance of the declined in stark contrast to the telecommunication industry which had improved result during this period. However, from a marginal profit in 1998, the company made a loss of around $ 291 million in 2000 which marked the demise of the company. Further, in the same year, the company had to spend $ 523 million for purchasing spectrum. Despite the losses, the CEO kept on deriving fat salary with bonus of upto $ 10 million. There were last moment attempts to provide funding to the company but on account of glaring errors in financial reporting, it could not go through and company became bankrupt (Monem, 2009).

It is evident from the analysis carried out in relation to the recent bankruptcy that the failure of business is more attributed to failure of corporate governance and reporting norms rather than the huge outstanding liabilities. As a result, it is imperative that a more active role in the board decisions need to be played by executive directors who in turn also constitute various committees for internal control (Gay & Simnett, 2012).  Further, a pivotal role in bringing any financial misreporting or any faulty business practice that poses serious risk to light is played by the external auditor who needs to be independent of the influence of the management. In the aftermath of the above bankruptcies, various provisions have been introduced to ensure the same in the form of CLERP 9 and Ramsay report recommendations (Clout Chappelle & Gandhi, 2009).  Further, the duty of the directors have been outlined in pivotal statute such as Corporations Act 2001 and violation of the same can potentially attract both civil and criminal liabilities. It is expected that steps such as these which ensure accountability and transparency would go a long way in prevention of corporate frauds and related bankruptcies (Arens et. al., 2013).

Conclusion

Based on the discussion carried out above, it is apparent that on the face of the bankruptcy, it is liquidation that prima facie seems as the contributing factor. However, deeper introspection of the circumstances and the contributory factors would indicate that the liabilities were essentially the result of faulty corporate governance setup under the control of an unethical management running in collusion with the auditor. Typically, the management are driven by short term incentives and hence aim to achieve growth without considering sustainability and in the process increase the liability to such an extent that the business revival becomes impossible. It is essential that the corporate governance norms need to be improved coupled with auditor independence and greater role for non-executive directors as these steps would ensure that the wrongdoing by the management would come to light and rectifying measures could be taken on time to prevent bankruptcy

References

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

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

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

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.

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 12, 2017]

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.

.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.

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.

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 12, 2017]