Managerial Finance For Financial Stability For Stakeholders

Critical Analysis of Need for New Approach for Bankruptcy Predictions by Corporates

Describe about the Managerial Finance for Financial Stability for Stakeholders.

Financial statements of a business corporation represent its financial stability to the stakeholders. The financial position of a firm is determined on the basis of its financial statements that are used to forecast its future growth position. The financial statements facilitate investors and analysts to predict the future growth performance of a firm and thereby take effective decisions for investing in the firm. The comparison of financial statements such as balance sheet, income and cash-flow statement of a business firm is used by the decision-makers internally and externally to examine its present and predict the future performance (Laitinen, and Suvas, 2013). However, the occurrence of many corporate scandals such as Enron, Worldcom and Lehman Brothers has revealed that financial statements are not reliable for estimating the bankruptcy risk of a corporation. The corporate scandals have aroused the need of new approach for bankruptcy prediction of firms (Kennedy, 2012). In this context, the present essay examines the usefulness of financial statements for predicting a firm bankruptcy and the need of new approach to estimate the possibility of its default.

Critical Analysis of Need for new approach for bankruptcy predictions by Corporates

Financial statements have long been used for developing an insight into the financial position of a business corporation by decision-makers. The information provided by financial statements is not reliable as was revealed by the corporate scandals of Enron, Worldcom and Lehman Brothers. These corporate scandals are regarded as largest accounting frauds in the history causing major financial losses to the investors. The accounting frauds can be regarded as the use of false and deceptive accounting practices intentionally by a business firm in order to obtain the likely results of enhanced financial performance. The common approaches that are used by the business firm in improving the appearance of financial statements are overstating revenues by showing future expected sales, understating expenditure, inflating net worth of assets and hiding financial obligations (Rezaee and Riley, 2011). Enron Corp collapse was revealed when it filed for bankruptcy in the year 2001 before which the company was recognised as a highly successful innovative and best managed business in the US. The main reason for the collapse of the company was its fraudulent accounting practices through which the company used to claim more profit in its financial reports than its actual profitability. The company had created its ‘special purpose entities’ for preventing significant losses from appearing on its financial statements. The losses incurred by its special purpose entities were not consolidated with the company’s financial statements. Thus, the company used to provide false financial information to the investors and analysts through its financial reports. The investors and financial analysts could not predict the possibility of default risk of the company that was revealed by its bankruptcy filing causing major financial losses to the shareholders (Johnson, 2003).

New Approaches for Bankruptcy Prediction of Firms

Similarly, the corporate scandal of Worldcom occurred due to the mis-representation of information in the financial statements of the company. The internal audit of the firm has revealed that about $3.3bn in its profits are improperly recorded between the years 1999-2002. The company had held these profits as reserves and intentionally inflated them for increasing its profitability. The main reason for the collapse of the company was its acquisition strategy which created a debt of about $41 billion (Chuvakhin and Gertmenian, 2003). The company improperly reported its accounting debt in the financial statements through fake entries. However, the company financial condition became doubtful when it failed to secure new source of financing from the banks as it possess less than $300 million cash. The investors, analysts and public were shocked by the bankruptcy of Worldcom as its reported profits in the financial statements were suddenly transformed into losses. The fake accounting policies of the company were revealed during its internal audit and the company was heavily charged for the fraud by the Securities and Exchange Commission (Helwege, 2009).

In this regard, the case of Lehman Brother’s filing for bankruptcy in the year 2008 was largest in history. It has about $639 billion in assets and $ 619 billion in debt and as such its bankruptcy surpassed of Enron and Worldcom. It was regarded as one of the largest U.S. investment bank at the time of its collapse with workforce of about 25,000 employees. The collapse of Lehman Brothers was mainly attributed to the U.S. housing boom in the period of financial years 2003 and 2004 (McDonald and Robinson, 2009). The investment bank used to provide low-interest rates mortgage lending that increased its revenue generation at a faster growth than other businesses in investment banking. The firm recorded revenue of about $146 billion in the year 2006 that is about 10% increase from the previous year 2005. Lehman’s stock started to decline with the rise of credit crisis and bursting of housing bubble. The revenue generated was further used to increase the house prices and increase in interest rates for mortgages repayment. The borrowers were unable to repay the loans that caused the bursting of housing bubble causing bankruptcy of Lehman Brother’s.  The financial statements of Lehman Brother have depicted increasing profits from the year 2005-2007 with suddenly turning bankrupt in the year 2009. Thus, the case also reflected that financial statements are not trustworthy source for investors and analysts to predict the financial position of a firm (McDonald and Robinson, 2009).

The Importance of Economic and Institutional Factors in Bankruptcy Prediction

The occurrence of all these corporate scandals have raised the need of other approaches besides relying on financial statements for estimating the present and future growth financial performance of a firm. As such, the investors and analysts are largely incorporating the use of other innovative approaches for examining the firm bankruptcy. The prominent techniques used for estimating the financial performance of business corporations is data envelopment analysis (DEA) and production function-based economic performance evaluation (PEFP) (Vav?ina et al.,  2013). These new approaches for estimating the bankruptcy prediction of firms has not yet been validated for use in financial sector but investors and analysts are increasingly adopting the use f these methods for estimating the possibility of default of firms. Both the methods assess the firm’s bankruptcy by quantifying its financial distress. The methods assess the relative efficiency of a firm through the help of a mathematical formula that helps in bankruptcy assessment through the use of financial ratios. A new approach that can be used for analysing bankruptcy of the business entities is Altman Z-score model. The model estimates the possibility of default of the firms through assessing its insolvency, leverage, liquidity and solvency. Zeta model is also used for bankruptcy assessment of firms through quantifying the financial distress trough the use of mathematical models.  In addition to this, the economic and institutional factors should also be analysed by the investors and financial analysts in bankruptcy prediction. The economic factors such as interest rates, monetary and fiscal policy and the overall industry performance can provide valuable insights for predicting bankruptcy of a firm (Vav?ina et al., 2013).

The accounting fraud is very difficult to be predicted by the financial investors by solely relying on the information obtained from the financial statements as evident from the occurrence of corporate scandals discussed above. As such, the financial statement fraud can significant damage the retirement and educational savings of people. In this context, the implementation of horizontal and vertical analysis can prove to be very useful for the investors and financial analysts for financial statement fraud detection. Vertical analysis involves examining and analysing each and every entry in the income statement as a percentage of total revenue and comparing it with the previous results (Almsafir et al., 2015). The sudden increase in the revenue generated reflects a risk in the business operations of the business entity. Moreover, the investors can select a benchmark from the financial statements such as total assets for monitoring the deviations in it on yearly basis. Similarly, horizontal analysis involves identifying the variations in percentages of the base year figures in financial statements signifying the need for future analysis. The technique of logistic regression approach is also proving to be highly useful for identifying the financial distress of corporations. It involves the use of regression analysis for predicting bankruptcy possibility of a firm. Thus, it can be said that use of improper accounting procedures by business firms around the world for developing financial statements is causing the need of these new approaches to examine their present and future financial performance. This is necessary to protect the hard earn money of investors from any potential damage by investing in the business corporations (Almsafir et al., 2015).

Conclusion

Thus, it can be summarised FROM the above overall discussion that financial statement frauds are on increase in the business corporations around the world as can be seen from the case of Enron, Worldcom and Lehman Brothers. There is high need for incorporation of new approaches such as DEA, regression analysis, horizontal and vertical analysis for estimating the financial performance of a business firm besides relying only on the information provided by financial statements. 

References

Almsafir, M. et al. 2015. Transparency and Reliability in Financial Statement: Do They Exist? Evidence from Malaysia. Open Journal of Accounting 4, pp. 29-43.

Chuvakhin, N. V. and Gertmenian, L.W. 2003. How to determine when it is safe to grant credit. Worldcom Ethics Case Study 6(1), pp. 1-6.

Helwege, J. 2009. Financial Firm Bankruptcy and Systemic Risk. [Online]. Available at: https://www.bankofcanada.ca/wp-content/uploads/2010/09/helwege.pdf [Accessed on: 8 October 2016].

Johnson, C. 2003. Enron’s Ethical Collapse: Lessons for Leadership Educators. Journal of Leadership Education 2(1), pp. 45-56.

Kennedy, K. 2012. An Analysis of Fraud: Causes, Prevention, and Notable Cases. Honors Theses, pp. 1-48.

Laitinen, E.K. and Suvas, A. 2013. International Applicability of Corporate Failure Risk Models Based on Financial Statement Information: Comparisons across European Countries. Journal of Finance & Economics 1(3), pp. 01-26.

McDonald, L. and Robinson, P. 2009. A Colossal Failure of Common Sense: The Incredible Inside Story of the Collapse of Lehman Brothers. Random House.

Rezaee, Z. and Riley, R. 2011. Financial Statement Fraud Defined. John Wiley & Sons.

Vav?ina, J. et al. 2013. New Approaches For The Financial Distress Classification In Agribusiness. ACTA UNIVERSITATIS 4(XI), pp. 1177-1182.