Managerial Finance: Financial Statement Analysis and Bankruptcy Prediction in a Firm

3Managerial Finance

Managerial Finance: Financial Statement Analysis and Bankruptcy Prediction in a Firm

Abstract

In this study, the bankruptcy risk of business enterprises was reviewed. The primary purpose of this paper is to present the supportive arguments of evidence that financial statements are declining in their predictive value. Based on the risks of manipulations of information and fraudulent activities that are associated with corporate financial statements, the paper argues that a new methodology for predicting the risks of business bankruptcy should be developed to replace the use of financial statements, which has proved to be ineffective.

Managerial Finance: Financial Statement Analysis and Bankruptcy Prediction in a Firm

Predicting failure in business is one of the major activities that most enterprises give much attention. It involves assessing the operation indicators of the firm to establish and anticipate risks or variables that can lead to the bankruptcy of the enterprise. While evaluating the financial conditions of a firm, financial statement analysis and reporting is a tool that has employed to communicate the actual financial status and position of the firm. Financial statements have long been used as the valid indicator of the financial performance and position of a firm. However, this method has been associated with instances of fraud and other scandals making it unreliable tool for assessing the risks of business insolvency. Additionally, financial statements have undergone changes, which have raised debates of its reliability to predict failures in business. This paper seeks to assess the reliability of financial statement analysis as a tool to predict the probability of bankruptcy of firms and the necessity of other approaches in place of this method.

Accounting entails identifying, evaluating and communicating financial and other economic information to users for decision-making purposes. Abdullah et al. (2015) explain that financial statement is a form of a counting that organises the purported information into balance sheets, trial balance and cash flow statements amongst others that users use to make investment and operation decisions in a firm. However, Danilov (2014), Abdullah et al. (2015) and Monem (n.d.) claim that the reliability of the data that financial statements communicate rely on different factors, which can result in incorrect information if not considered adequately. The authors argue that these factors include accounting standards involved, corporate governance, internal and external control, and ethical practices.

Corporate governance, external and internal controls and ethical practices are some of the factors that determine the nature of the information that financial statement analyses communicate. Financial statement analysis has proved to be profoundly affected by the lack of effective communication strategies and skills amongst different management and departments in a firm. According to Abdullah et al. (2015), poor communication of information across different departments has resulted in incorrect information communicated to users by financial statements.

Also, corporate governance and ethical practices are other factors that impact the reliability of financial statement analysis as an instrument for predicting failure or bankruptcy in a firm. Different corporate scandals have been associated with misconducts of the management of a firm; some managements tend to communicate incorrect information in the financial statements to attract potential investors while retaining the existing ones (Thurasingam & Sivanandan 2012). This unethical practice has resulted in the insolvency of many corporates firms, such as One-Tell, rendering financial statement unreliable.

Additionally, different companies employ different methodologies and accounting standards of analysing financial information. Lack of a universal standard and method of analysis of financial data has resulted in manipulation of the information that financial statements communicate to the users. Vrentzou (2011) explain that the use of different methods of analysis and accounting standards has provided room for fraudulent activities in many firms, which most of them have collapsed while other are battling risks of bankruptcy.

Besides, different public companies have different opinions of what to or not to include while conducting financial analysis and preparing a financial statement. A report by MPS/CPA states that a new accounting standard has been established to be used universally in place of the different firm-based methods of analysis that many enterprises have been using. This rule was set up to account for some of the key indicators of financial performance and position of that many firms tend to leave out while preparing their financial statements. The new accounting standard recommends the inclusion of lease and other associated financial elements, alongside their treatment in financial analysis. Most firms do not include lease information while analysis their financial reporting. However, the treatment and effect of a lease in financial statements haves raised opposition from most public firms. Therefore, this renders financial statement unreliability for predicting bankruptcy in business.

Moreover, information that financial statements communicate concerning the financial position and status of a firm is also dependent on the auditing activities that the company carries out. In most cases, the information is affected by the inherent risk, control risks, and detection risks. As Monelos et al. (2011) argue, financial statement analysis at the level of auditing has also contributed to bankruptcy in many firms. The authors explain that the information that the auditors communicate to the investors and other users in their reports are always influenced by the nature of the relationship with the company. Also, the level of knowledge that the auditor has about the financial information of the company, which is also dependent on the ability of the firm to communicate freely and openly, affects the financial reporting.

Therefore, transparency of different stakeholders of a firm is questionable in most enterprises. Alongside poor communication of financial information across the departments of a company and poor corporate governance, unethical conducts have adversely affected the level of transparency and reliability of information that financial statements communicate to the users and the public. These have resulted in a failure of financial statements to predict bankruptcy adequately. Manipulation of the information contained in these declarations; as a result of fraudulent activities; has also rendered financial statements analysis unreliable as a tool for predicting business financial failure and insolvency, since the statements do not present the actual financial status of the firms.

In conclusion, financial statement analyses are subject to transparency issues associated with poor communication skill amongst other internal and external controls and poor corporate governance. Also, unethical conducts and fraudulent activities of manipulation of financial information as well as poor analysis and accounting methods are some of the issues that affect the reliability of financial statement analysis as an instrument for predicting financial failure and bankruptcy in a firm. Therefore, considering all the challenges associated with financial statement analysis, as discussed above, different approaches should be established and adopted to effectively assess, evaluate and communicate the financial performance of firms. These strategies should consider effective communication of financial information within the firm, efficient method of analysis and accounting that incorporates all the relevant financial elements, and fraudulent activities detection and prevention, amongst others.

Reference List

Abdullah, ZI, Almsafir, M.K. & Al-Smadi, AA, 2015. Transparency and Reliability in Financial Statement: Do They Exist? Evidence from Malaysia. Open Journal of Accounting, Vol. 4, 29-43.

Danilov, KA, 2014. Corporate Bankruptcy: Assessment, analysis and prediction of financial distress, insolvency, and failure. (Master Dissertation)

Monelos, P, Sanchez, C.P. & Lopez, MR, 2011. A model to forecast financial failure, in non-financial Galician SMES. Finance and Management Information System Research Group, University of A Coruna.

Monem, R, n.d. The One-Tel Collapse: Lessons for Corporate Governance. Department of Accounting, Finance, and Economics, Griffith University.

Thurasingam, A.S. & Sivanandan, P, 2012. Generation Y’s perception towards law and ethics. Journal of Advanced Social Research, Vol. 2, 52-66.

Vrentzou, E, 2011. The Effects of Internal Financial Reporting Standards on the Notes of Auditors. Managerial Finance, Vol. 37, 334-416.