Corporate Failure

Question: Do you think that it is possible to predict corporate failure from financial reports? Explain your answer.

Answer:

It is not always possible to predict corporate failure and potential bankruptcies of public companies based solely on the financial reports. Normally, financial reports yield correct information and working results; they also indicate a true status of the strength and weakness of the company concerned. However, there are instances when duly audited financial reports fail to reveal the real position. There may be several reasons for the same including the practice of creative accounting, and thereby misrepresenting the accounting data, which erodes the value of financial reports and reduce their credibility in the eyes of the general public.

The collapse of Hanis Scarfe Holdings Ltd in the month of April, 2001 is a classical example of such an unfortunate accounting practice. Hanis Scarfe Holdings Ltd established in 1850 as a proprietorship firm and with a history of more than 150 years, had continued to flourish. By 1995, the focus of the company has shifted with ambitious expansion plans (Annual Report 2000). However, within next 6 years the company’s fortunes changed and it suddenly failed in April, 2001. This came as a surprise as the

Annual Reports of the company for several years in a row, right from 1997 to 2000, did not reveal any disturbing trends. Financial analysis and analysis of major accounting ratios did not reveal any significant negative trends and they revealed that everything was normal; profitability ratios, efficiency ratios, financial stability ratios (both long as well as short term) and the cash flow ratios had

remained stable and in certain instances even exhibited improvements. For example, cash flow on operations ratio had improved during the period 1997 to 2000 from 1.7 in 1997 to 7.67 in 2000. Likewise, return on investment ratio had remained over 12; asset turnover ratio had remained over 1.70

during each of the year from 1997 to 2000. (Source: data derived from annual reports 1991 to 2001).  Several other financial ratios conveyed the same story of strength and robustness. Despite this, the company tumbled in April, 2001. Upon an examination by Ernst & Young in 2001, a number of accounting malpractices were noticed though the Annual Reports for last six years did not reveal any negative features (Dunphy & Hay, 2001, p. 6).

This position revealed disturbing trends in accounting practices, and the inability of the auditors to correctly interpret the accounting data. It also indicated deficiencies in the regulatory framework and the shortcomings in the Australian Auditing & Accounting Standard.  The failure of Hanis Scarfe Holdings Ltd point to a peculiar position: the financial ratios may indicate a robust picture whereas the real position may be different. Even the auditors sometimes fail to detect the element of falsification introduced in the accounts. The company’s officials, particularly if the top management consents or directs, are susceptible to pressure, and may make wrong entries to give a picture which may be completely different from the real position and profitability of the company  (Acquaah-Gais2ie0 03,p . 3). In the ultimate analysis, the financial reports generally reveal the real position of a company, but it may sometimes hide more than it reveals. Therefore, it is not always possible to predict corporate failure based on financial reports. It is always advisable to look beyond the financial reports and examine certain other aspects of company’s management style like constitution of its audit committees; its style of corporate governance; and the transparency of its management including accounting practices and the reputation of members of its top management team. At the same time, audit should not concentrate only on figures and accounting entries, but should be more analytical in its approach. Financial ratios if combined with the aforesaid may perhaps be a better tool to predict the possibility of collapse of a company.

Bibliography

Dunphy,B & Hay, A 2001,’Corporateg ovemance- liability issuesa risingo ut of directors

responsibilitiesv’,i ewed7 January2 004,< www.claytonutz.com/downloads,lD=unphyHay >

Acquaah-GaisieG, A 2003, ‘Minimising corporatec ollapsest hrough stakeholdear ctivism,,

CorporateM isconducte Zine,vol. 1, iss. l, viewed2 1 April2004, < www.lawbookco.com.aul

academic/corporate-Misconduct-ezine/trltemsl/-afir ticlesa.s p >

Annual report-see Harris Scarfe Holdings Ltd 1995_2000