Corporate Failure: Causes and Remedies

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Corporate Failure: Accounting and Auditing Resolution

Abstract: The Economic cost of business failure is relatively large, Government, providers of capital, as well as management and employees are severely affected. More critical are the reporting accountants who are likely to face potential litigation if their report failed to provide an early warning signal. The paper studies and makes a critical analysis on the concept, causes and resolution of business failure, with emphasis on auditing and accounting resolution option. The paper is purely analytical, as it utilizes previous studies to draw an inference. From the analysis it’s found that distress is mostly caused as a result of poor corporate governance. To stem distress and its debilitating effect, there is a need for the adoption of new audit framework which stresses on time limit of audit tenure with a client, forensic audit, retrospective audit procedure, and auditor’s skepticism. This will ensure and yield effective corporate governance that can curve and detect potential failure.

1.0 Introduction

Apart from profit making objective, all business concerns share one fundamental objective that is to remain as going concern. As businesses strive hard to perpetuate, one of the most significant threats irrespective of their size and nature of operation is illiquidity and insolvency. Extant evidence shows that in past decades business failures have occurred in higher rates than at any time.

It is also disinteresting to note that during 1990’s certain sectors of Nigerian economy, ranging from Small industrial businesses, financial sector (especially banking industry), and manufacturing sector of the economy has experienced overwhelming distress. This has eroded the confidence of general public in engaging on long term economic activities, there by dwarfing economic development. 2 of 17

The factors that led to business failure vary. While many economists attributed this phenomenon to high interest rates, recession, squeezed profit, macroeconomic instability, bad political atmosphere, excessive deregulation policies, dubious practices, heavy debt burden, and deteriorated financial discipline, among others. Recent studies associates failure to mismanagement and lack of good corporate governance.

Furthermore, industry specific characteristics, such as government regulation and the nature of operations can contribute to a firm’s financial distress. Studies of the pattern of business failure in the UK, US, Canada, and Australia found that small, private and newly founded companies with ineffective control procedures and poor cash flow planning are more vulnerable to financial distress than large well established public enterprises, [Star, 1990].This was also evident in Nigeria were by small businesses have an average live of 2-5 years, and most of failures in banking industry affected the so called third generation banks.

The economic cost of business failure is relatively large .Evidence shows that market value of the distressed firms decline substantially, [Warner, 1977].Hence the suppliers of capital, investors and creditors, government, as well as management and employees are severely affected by, from business failures.

The most critical cost is that threat to reporting accountants whom are also likely to face a potential law suit if they fail to provide an early warning signal through the issuance of qualified audit opinions [Zavgren, 1983]. 3 of 17

This disastrous effects forced government, investors and management to devised different strategy to remedy the scenario. From the academic world various efforts were made and still on to device and suggest ways to prevent failure as well as provide scientific models that can provide early warning signal of failure before it occurs. This write up seeks to make an exploratory discussion on why businesses failed? and How should failure be remedied? The Methodology adopted was purely utilization of library materials, therefore the paper is purely an analytical research effort, in which conclusion was based on achievable in which inference was arrived through available achievable literature on business failure.

The remaining paper proceeds as follows: conceptualization and forms of failures, Causes, Predicting, and remedies of failure, Section five discusses the remedies of failure and last section closed with Summary and Conclusion.

2.0 CONCEPTUALISATION

Corporation is an economic entity in which the ownership is separated from management. It’s an artificial being invisible, intangible and exist only by a mere contemplation of the law.

On the other hand Failure is a term used interchangeably with, distress, illiquidity, insolvency, persistent loss, Bankruptcy and winding up. These entire concepts could mean failure in one way or the other. From literal dimension failure stands for the inability for a concern to achieve its primary objective 4 of 17

“profit making” in the long run. It could also mean inability to generate adequate cash flow to retire due debts.

Thus, failure as applied to Business Corporation suggests, as the term is popularly used, as any situation from the mere inability to make profit, to complete dissipation of assets followed by bankruptcy and liquidation.

Authoritatively corporate failure stands different to many authors. According to

Calomiris and Gorton [1991] corporate failure connotes an unhealthy situation or weaknesses in an organization’s conditions which prevents the achievement of set goals and aspirations.

Komba [1991] perceives failure as an act of being unsuccessful in an attempt, cessation of normal operation or operating below normal official acceptable standards or to go bankrupt or become insolvent. Argenti [1976] views it as

“company whose performance is so poor that sooner or later it is bound to have to call in the receiver or cease to have or to go into voluntary liquidation, or which is about to do any of these, or has already done so”. Altman [1983] foresees it simply as inability of a firm to honor its obligation when due. Newton

[1975] a business is also known a failure when it can no longer meet the legally enforcement demand of its creation. Dun and Bradstreet [1974] define the term as “those businesses which ceased operation following assignment of bankruptcy, with a loss to creditors or where involved in court action such as reorganization or re arrangement. Relating to Banking, Ezeudoli[1997] & Ologun

[1994] view failure in the same way as, “the inability of a bank to meet its 5 of 17 obligations to customers, owners, economy occasioned by fault or weaknesses in its operation which renders it illiquid and insolvent.”

In whatever perspective failure is perceived it has common elements and process. That is, it is a process which begins with financial embarrassment degenerated into operational difficulties and ended in legal action. Corporate failure may not necessary mean cessation of operation and liquidation solely, but, when a concern fails to meet its obligation to its customers, management, shareholders, government and indeed economy in general.

For the purpose of this paper we take failure to cover failure to honor obligation

[financial], failure to operate successfully in the market place [operational] and failure to exist [legal].This will, however, give us a lead in easy diagnosing the root causes and remedies in both short and long run.

Stages in Financial Failure

From the work of Harold [1973], failure can be identified from the following stages:

Financial Embarrassment: This is a slightly degree of illness which if not remedied will lead to a more a serious disease of insolvency.

Financial Insolvency: This denotes a condition in which a concern finds itself in a situation where it can not meet its debts as they mature in the ordinary course of business. The essence of the trouble is the excess of immediately maturing liabilities over the means with which to meet them. 6 of 17

Total Failure: This arises when a concern has an excess of total liabilities over total assets, negative net worth.

Confirmed Insolvency: This indicates a failed condition of a firm, against which legal steps have been taken or which itself has taken a legal steps to satisfy claimant against its property.

These stages of failure should not be confused with causes of failure, is never a cause of failure, rather, a mere state of rung downward in the ladder of business failure.

3.0 CAUSES OF CORPORATE FAILURE

Corporate failure has been attributed to many factors which are categorized as

Exogenous and Endogenous. Those elements that are not directly under control of the failing concern are termed exogenous element these include basically:

Competition, the action of business circle, change in public demand, excessive regulations, and of recent the globalization threat. Many studies conclude, however, that fundamental to all causes of business failure is the human element, or especially the lack of good management and corporate governance

Harold, [1973], WorldBank,[1989], Nwachukwu,[1993] De Juan,[1987], Ozigbo

[1997], and Alashi [2003].

However, even the exogenous factors can have some indirect traces from poor management. Good management would plan and set all necessary system in motion, provide necessary foresight, initiate skills, and perseverance to adjust the affairs of a concern to meet it. 7 of 17

Conceding the truth of the basic factor of management, but recognizing also the fallibility of human judgment, the following may be listed as what we call fundamental causes of corporate failure:

Exogenous factors

Excessive competition: There is no threat no shock and no fear to a business than that of good product in the hand of a competitor. Competition has led so many firms to lose market to their rivals and subsequently close down.

Operation of the business circle: The business circle is generally considered to have four principal phases: prosperity, decline, depression and recovery. In periods of prosperity most companies are loaded with large inventories to meet the apparently continuing demands of their customers. When such inventories have to be sold at a loss during periods of declines or depressions many concerns are financially unable to stand the strains, and as a result more failures occur during depression than any other time.

Change in public demand: Shift in demand of a product by public as a result of technological advancements or arrival of better products may lead to a failure of a concern.

Casualties: This is what is otherwise call “act of God” an act of nature, may be a directly cause of failure. Earth quake, a tidal wave, flooding, crisis and other disturbances may ruin an enterprise and its practical possibilities of success.

Excessive Shift in government policy: Closely akin to act of nature are “acts of sovereign” Government can enact a law defining or prohibiting certain 8 of 17 economic activities or even bring stiff regulations, all these may spell doom an enterprise. Other example of legislative act sometimes leading to failure include: sudden burdensome taxes, minimum wage, the removal of tariff protection, an increase in tariff of essential materials. Also legislation in other country may lead to failure.

Socio economic and political unrest: The environment which a firm operates determines its life. In an environment that is characterized by: uncontrollable social unrest or the political atmosphere is not certain or there are persistent changes in macroeconomic policy will adversely affect the life of a business concern.

Endogenous factors

These are factors that are directly cause by management or weak corporate governance or mostly combination of the two, these are discussed below:

Mismanagement: Poor management due to selfish, greediness or lack of competency is charged with the responsibility of almost bases of failure discussed so far. More directly chargeable with management are certain other situations which may be set forth very briefly as follows:

Excessive expenses: this happened as a result of use of obsolescent machinery, antiquated production methods unprofitable sales, neglect of details and firm improper organisation. 9 of 17

Inadequate revenue: this arise out of competence in the sales department vis a vis quality of the product or services, pricing policy, and even from poor promotion.

Over capitalization: this can be traceable to promotion or later financing, perhaps to over expansion. The sales of corporation securities may have been poorly timed, the financial plan may be ill fitting, or subsidiaries or other units may have been acquired at unwarranted costs.

Excessive Floating debt: This could be induced through malfunctioning of the credit department, through expansion of the business without provision for adequate working capital, through the acquisition of fixed assets by short term notes, or even by the effect of inadequate banking facilities.

Unwise dividend policy: which often though not always goes hand in hand with inadequate maintenance, may so badly deplete the resources of a concern as to show the seeds of failure. Funds which should be used for maintenance or as reserves are sometime distributed to shareholders in order to make “good news” the good showing may later contribute importantly to poor showing.

Fraud and embezzlement: Fraud may arise in many ways. It may consist simply of embezzlement, which if very serious may set off spark of failure. . The sale of properties, directly or indirectly by directors or their associates to the corporation at highly inflated value may cause failure to the corporation.

Income smoothing: management oftenly engaged in income smoothing activities in order to post higher profit figure than expected, this will in turn earn 10 of 17 them reward and bonuses. Smoothing income in long run affects business operations and lead to failure.

Weak corporate governance: Corporations are artificial beings created by law. They hold assets, conduct transactions, and sue and be sued. The business of corporations is champion by board of directors appointed by owners.

Corporate Governance should provide a structure and processes within which shareholders, directors and management conduct a business of a concern with the ultimate aim and objective of realizing long term share holders’ value while taking into account interest of other stakeholders.

Therefore, good corporate governance demands not only transparency, accountability and probity but, also, a sense of conviction and commitment to ensure that the interests of all parties are protected. Weak corporate governance has contributed to many business failures, (George, 2002).

Accounting and auditing Problems

Lack of accountability in both performance and operations coupled with cut off of accounting processes, unsound internal control and inadequate safe keeping and security of documents has contributed to so many corporations to fail.

Furthermore, the inability of audit reports to provide early warning signal to owners and regulatory bodies has tremendously affect so many businesses, and questioned the integrity and adequacy of audit job in general.

The un restriction of client – audit time has led to impoverishing and corrupting auditors independence in Nigeria and world over. This has led to: 11 of 17

a) Failure of audit to deter and detect any fraudulent activities,

b) Failure of auditors to issue qualified audit reports of a failed concern,

c) Endorsement on erroneous profit figure, and

e) Issuing a clean report to general public on a distress concern.

4.0 SYMPTOMS OF FAILURE

Although “what is certain about the future always uncertainty”. Failure doesn’t happen overnight except that associated with a catastrophe which happened very seldom. Thus, failure is predictable before its happening, and the earlier it’s foreseen the more likely it can be prevent. Qualitative and quantitative models have been developed to predict failure and even discriminate the distress periods from healthy periods.

As inferred from the works of Ogunleye [1993], Donly, [2004] Imala, [2004] failure more specifically in banking sector manifest several symptoms, some at an early stage while others at a later stage. They enumerated these symptoms as follows:

a) Persistent lateness in submitting required return on account to regulatory

bodies.

b) Engagement in the falsification of returns, this serves as a more

discoverable evidence of financial distress.

c) Rapid staff turnover and /or frequent changes in top management.

d) Affliction with persistent liquidity problems. 12 of 17

e) Inability to meet obligations as at when due.

f) Frequent changes of auditors who refuse to compromise may also be a

symptom of financial failure.

g) Use of political influence.

h) Incessant complaint by customers.

i) Persistent adverse clearing position.

j) Borrowing at desperate rates.

k) Persistent contravention of laid down rules.

l) Window dressing of financial records

m)Persistent overdrawing of current account with CBN.

The above list is not exhaustive and not all the conditions are manifested out

rightly. However one or two of those conditions are always noticeable on

critical observation before degenerating into financial distress/insolvency.

Kunt, et al, [2004] opined that symptoms emanate when significant segment

of an organisation become illiquid or insolvent.

5.0. Failure Preventive measures:

Evidence from the literature and current studies from advanced economies reveals that there are certain critical factors that will prevents and minimize the frequent occurrence of corporate failure from accountant’s angle. These include:

New framework for the conduct of audit work

Evidence from report on corporate failure world over criticized the current framework of auditors work: Enron, Parmalat, WorldCom, Awa, HIH royal 13 of 17 commission and many Asian giants. In all the failure cases the auditors were charged with negligence and connivance with top management. This is influenced by fading away of professional quality of independence. In as much as

Auditors will compromise there independence, then the affairs of a corporation will be in jeopardy and is better for investors to revert back to proprietorship form of business.

Auditors’ independent is a requirement of the Auditing standard and professional ethics. Evidence from Enron case established loss of independent as a result of long term service of a client. O’Malley [2001] panel report in Enron’s case highlights the followings as a new framework to enhance audit work:

. Forensic Auditing: Forensic type field work phrase should be

introduced into the auditing process. The report is of the view that the

current auditing standard fell short of effectively deterring fraud or

significantly increasing the likelihood that the auditors would detect

material fraud. Largely because it fails to direct auditing procedures

specifically towards fraud detection.

. Auditor Skepticism: The second recommendation is on Auditors

skepticism where it has been noted that auditors should modify their

otherwise “neutral” concept of professional skepticism, and replace it

with presumption of possibility of management fraud during the

forensic audit phase. 14 of 17

. High quality Audit: The Audit should put more emphasis on the

performance of high quality audit in communication with top

management, performance evaluations, training and compensation

and promotion decision.

. Retrospective Audit Procedure: This involves investigating issues on

how accounting estimates and judgments in previously financial

statement were resolved.

. Interim period report: Another area which auditing procedures should

concentrate on is interim period reports, because many frauds are

initiated in interim periods. The main reason is that management can

influence the timing of the execution of some transactions, and their

recording in the accounts. This highlights the importance of tests for

transaction cut-off dates, especially at the end of quarterly, half-yearly

or annual periods.

. Audit committee: Audit firms should be required to discuss with audit

committee the entities vulnerability to financial reporting fraud and

exposure to asset misappropriation.

6.0 SUMMARY AND CONCLUDING REMARKS

The paper discusses failure its causes, precautions, and resolutions. We came to a Conclusion, that mismanagement of the affairs of a corporation epitomized by lack of attention to detail, lack of accountability of responsibility, operations and performance, unprofessional attitude of 15 of 17 reporting accountants, a lack of integrity in the corporate affairs internal process and system, poor and self decision making by those at the helm of affairs of a concern, coupled with macro economic and political instability are the major contributors to failure.

To stem corporate failure and its debilitating effects on the economy, proper effort should be made towards establishing and maintenance of a corporate culture that will relied upon a leadership equipped and able to establish a culture within the organization that would be able to recognize risk and take actions that would lead to prosperity. More importantly, new audit framework proposed in the work of [O’malle, 1991] should be enforced in practice and the existing audit tenure with a single client be limited to definite short period of time as oppose to current practice of indefinite time auditor client relationship.

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