Approaches for Predicting Corporate Bankruptcy

Question: Describe about the Approaches for Predicting Corporate Bankruptcy. Answer: Abstract The report explores about financial statement analysis and how it is not the only approach to rely to predict financial crisis by exploring the examples of Lehman Brothers, WorldCom and Enron. How Lehman Brothers breached US standard for leverage ratio, how WorldCom window dressed its financial statements and how did Enron deceive its shareholders all is explained in the given repot below. Further, report will give an idea that there are certain non-financial approaches available like corporate governance and support the argument by discussing corporate governance. Introduction Financial statement analysis is an essential skill in a variety of occupations including investment management, corporate finance, commercial lending and the extension of credit. (Alvarez, Fridson 2002). On elaborating the term financial statement analysis, it is analysis of various financial terms like ratios, cash flows, balance sheet of the firm to know the strengths and weakness of the firms in terms of finance. The major objective of the report is to give an idea about how financial statement analysis determines the bankruptcy of firm through various methodologies. Further to bring in view that financial statement analysis is not the only approach to predict bankruptcy of firms by enlightening the financial crisis of three major economic scandals like Enron, WorldCom, Lehman Brothers and discussing non-financial approach like corporate governance. Further, describing the corporate governance and how corporate governance help in predicting financial distress. To summarize, we say that we support the argument that financial statement analysis is not the only approach available there are various non-financial approaches like corporate governance is there and same should be applied by corporates to predict financial crisis. Further discussion is also done regarding composition of board of directors, segregation of duties of board of directors and proportion of independent directors. Financial statement analysis not the only approach for predicting bankruptcy From the view of financial statement analysis, it is the process of reviewing and analyzing a companys financial statement to make better economic decisions. It includes balance sheet, cash flow statements, and a statement of change in equity. To describe failure of corporates two technical words are insolvency and bankruptcy. A firm is considered as insolvent whenever its book value of assets is less than those of its liabilities. In this case a company is considered insolvent when it files for bankruptcy in court. However, as per economic conception, insolvency is defined as failure to repayment of debt, inability to pay dividends etc. In this situation a firm can or cannot lead to judicial proceedings (Levratto, 2013). On the note of discussing the major corporate scandals Enron, WorldCom and Lehman Brothers, the major reason of their bankruptcy was misinterpreted financial statements. Major cause for the collapse of Lehman Brothers was extending subprime mortgage loans to customers, who were otherwise not extended due to poor credit score. But, due to boom in 2007 Lehman extended these kinds of loans. Thus, two major blunders identified were one Lehman has no accurate future projections and secondly, even if management was known about possible changes, they were busy in increasing shareholders wealth. Another financial fraud which appeared was its leverage ratio was 31:1 which was against the set U.S. regulations of not more than 15:1.This high leverage ratio raised a question on the liquidity of Lehman Brothers. Another major financial fraud made by Lehman Brothers was repurchase agreement transactions (repos). REPOS denote percentage of assets sold in comparison to cash received. Lehman showed r epos of 105 and 108 which means assets sold were 5% and 8% more than cash received, thus it was window dressing of financial statements to deviate shareholders of the company. However, on various other aspects Lehman Brothers auditors Ernst Young defended quoting that the international accounting standards supported company transactions. (Gyamfi, 2016). Similarly, in case of fall of Enron also basic fundamental principal of preparing financial statements was not followed i.e. true and full disclosure of facts. Enron executives never disclosed to its employees about selling of stock, it was only when Enron bankruptcy news evolved employees came to know about companys selling out the stocks. Also, it was seen that failure of Enron was due to massive accounting errors like enhancing accounting for special purpose vehicles and strengthening internal accounting system. (Li, 2010). WorldCom was again involved in questionable accounting practices. WorldCom has huge amount of contractual ob ligations and when went under reconstruction it was found that vendors, creditors would not be able to generate revenues. Thus, again a big financial fraud was there. (Gertmenian and Chuvakhin, 2003). Thus, with this discussion we can say that financial statement analysis is not the only option available to predict the bankruptcy of corporates. With discussing above financial frauds, we analysis that not only quantitative factors considered but also qualitative factors. With considering qualitative factors along with quantitative factors for credit risk analysis it helps to correctly classify the companies. Qualitative factors or non- financial factors are generally selected with the help of management discussions and business policies. However, corporate governance is a good qualitative factor. Corporate Governance is the structure that is intended to make sure that right questions asked and that checks and balances are in place to make sure that the answers reflect what is best for the creation of long term, sustainable, renewable value. (Minow, and Monks, 2011). Corporate Governance include large number of variables like Board of Directors characteristics, Board Committee, internal control factors, shareholders influence on Board of Directors. As financial scandals were increasing over number of years, the requirement to consider non- financial factors and provide an interaction between financial and non-financial factors became important. From early eighties only discussion regarding corporate governance and its influence in financial distress or bankruptcy are there. In corporate governance, conflicts arise among shareholders and management regarding assigning of roles. Basically, it is ethical conflicts among management and shareholders as in case of financial distress management prioritize their personal aim rather than overall companys objective. Now, there are two ways to analyze financial distress from corporate governance point of view. Firstly, firms with high ownership concentration are likely to have high financial distress and secondly, firms with high board ownership have less risk to financial distress. Firm having high institutional ownership they try to focus more on long term benefits rather than short term benefits as management do. However, if there is high ownership of institutional investors they try to control the management. Coming on second aspect that is where there is high board ownership. With respect to board it is seen as ability of directors to act efficiently, has been regarded as major factor in determining corporates financial distress. Thus, if a company has poor or weak board of directors, it increases the opportunity of management controlling shareholders and extracting money from shareholders. Thus, as per corpor ate governance board of directors should have independence. This independence can be defined as separating the role of chairman, chief executive directors, and independent directors. In separating the roles of chairman and chief executive directors is to ensure the effectiveness and independence of the board. However, other theories say that instead of separating the role of chairman and chief executive officer it should be accumulated in one power i.e. CEO, so as to reduce the cost and to avoid conflicts of interest. Apart from segregating the role of chairman and CEO another aspect is to increase the proportion of number of independent directors in board. Independent directors are basically directors who have no financial interest in company. Their work is to monitor the directors and to avoid selfish motive of management so that they can work in the interest of the shareholders. However, proportion of independent directors depends on the size of the board. A board having large si ze with less number of independent directors is likelihood of having more financial distress due to imbalance in board and conflict of interest, while a firm having smaller board size and large number of independent directors increases transparency of corporates thus preventing corporates from financial distress. However, corporate governance mechanism, ethics code, legal system to predict financial distress varies according to the country. Example of this is Spain. In Spain, corporate governance methodology was different regarding ownership concentration, unitary board system and voluntary good corporate governance practices lead agencies to conflict of financial distress. Thus, we can support argument that beyond financial statement analysis also there are non-financial factors to predict bankruptcy of corporates. (Elshahat, Elshahat, Rao, 2015). Conclusion On concluding the above discussion we see that financial statement include balance sheet, cash flow statement, and ratio analysis. For long time corporates were relying on financial data for predicting the corporates financial position. However, with major scandals like Enron, WorldCom, and Lehman Brothers who all were involved in financial frauds through window dressing their financial statements brought out an argument that whether financial statement analysis is the only approach to predict corporates financial situation. On, further study we support the argument that financial statement analysis is not the only approach to rely upon. Various journal articles supported the arguments and concluded that while analyzing corporates position not only financial aspects but also non-financial aspects should be considered. One of such non-financial aspect is Corporate Governance which focus not on financial aspect of the firm but it is basically considering management, board of directors and their influence in board and level of independence We further concluded that firm having small board size with large number of independence directors, will be less exposed to financial distress as there will be consistent monitoring over board of directors by independent directors. Thus, we support the argument that corporate should consider other aspects to predict bankruptcy of corporates. References Alvarez, F., and Fridson, M.S. (2002) Financial statement analysis: A practitioners guide. 3rd ed. New York: John Wiley Sons. Elshahat.I., Elshaht.A., Rao.A. (2015) Does Corporate Governance Improve Bankruptcy Predicition. Academy of Accounting and Financial Studies Journal 19(1). Gretmenian, L.W., and Chuvakhin, N.V. (2003) Predicting bankruptcy in the WorldCom age. Graziadio business Review, 6(1). Gyamfi, M.A. (2016) The Bankruptcy of Lehman Brothers: Causes, Effects and Lessons Learnt, Journal of Insurance and Financial Management, 1(4), p.132-149. Li, Y. (2010) The Case Analysis of The Scandal of Enron. International journal of business management, 5 (10). Livratto.N. (2013) From failure to corporate bankruptcy- a review. Journal of Innovation and Entrepreneurship, Available from DOI:10.1186/2192-5372-2-20. (Accessed on 05-10-16) Minow.N. and Monks, R.A.G. (2011) Corporate Governance. 5th ed. United States: John Wiley Sons.