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Contemporary Issues in Accounting, Special Topics in Accounting, MBA, University of Jordan
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  • 1. Solution Manual to accompany Contemporary Issues in Accounting Michaela Rankin, Patricia Stanton, Susan McGowan, Kimberly Ferlauto & Matt Tilling PREPARED BY: Michaela Rankin John Wiley & Sons Australia, Ltd 2012
  • 2. Chapter 13: Corporate Failure © John Wiley and Sons Australia, Ltd 2012 13.1 CHAPTER 13 CORPORATE FAILURE Contemporary Issue 13.1: Notopen and shut 1. Discuss how trade barriers may have contributed to the failure of the RedGroup. (J, K, AS) The RedGroup have blamed the collapse of the company partly on import barriers which protect local publishers. This means that when the company imports books they are subject to import duties which leads to the need to increase the retail price of books in the stores. This could have contributed to failure of the company as it means the entity is less competitive on price than online bookstores, with many consumers moving away from traditional bookstore shopping to purchase books online as a result of more competitive prices. 2. From the previous discussion, what other issues can the retail sector face which might lead to corporate distress? (J, K, AS) Increased competition from online bookstores, which have lower overheads and other costs could have lead to corporate distress. Bookstores in Australia are also subject to goods and services taxes, whereas stores operating internationally may be able to avoid these if they are selling online and delivering to Australia. The expansion of electronic books is also likely to have impacted on the book retail sector. 3. Outline some ways the sector could change its operations to sustain and compete in a global market where the internet dominates. (J, K, AS) Local retailers could expand their online presence to enable them to compete. This could mean moving warehousing offshore to countries where costs of products are lower, which would enable retailers to offer books at lower prices, and enable the company to avoid import taxes. Contemporary Issue 13.2: Penalties, enforcement keyto real reforms 1. The article highlights regulatory changes in the United States as a result of the GFC. Research the main outcomes from this legislation and document how this is anticipated to improve governance in the finance sector. (K, SM) The stated aim of the legislation is: ‘To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end "too big to fail", to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.’ Dodd- Frank Wall Street Reform and Consumer Protection Act.
  • 3. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 13.2 Some of the major outcomes of the legislation include: Two new agencies were created to monitoring systematic risk and clarify oversight of bank entities. Additional rules governing liquidation or bankruptcy of financial institutions were outlined. Reporting requirements of hedge funds have been expanded. A separate body has been set up to monitor the insurance sector Regulations increased accountability of swaps and credit derivatives, which were resulted in failure of some entities during the crisis. These must now all be traded centrally. Improvements to regulation of credit rating agencies and the asset-backed securitization process were also included. All of these reforms are anticipated to improve governance by expanding on regulatory oversight, and the requirements for reporting by financial institutions. They are designed to reduce systematic risk in the sector. 2. Outline the arguments both in favour of and against increasing regulation, given the extent of regulation already in the market. (K, SM) Arguments against increasing regulation include: there was already a broad range of regulations and governance measures in place to limit risk in the sector, yet it did not prevent the GFC. Companies that are going to ‘push the boundaries’ with respect to rules or commit fraud are likely to always do so, no matter what additional regulation is put in place. Arguments in favour of increasing regulation include: it will encourage entities to focus on risk taking and governance mechanisms and put in place policies to improve governance in this regard. Strong penalties are expected to deter any adverse behaviour.
  • 4. Chapter 13: Corporate Failure © John Wiley and Sons Australia, Ltd 2012 13.3 Review questions 1. What is corporate failure? Corporate failure can mean a range of things. It has been defined as a company filing for bankruptcy; delisting for a range of reasons; or liquidation. It could also include the appointment of a receiver or administrator to assist the entity to trade out of financial difficulties. 2. Articulate what is meant by bankruptcy and insolvency. In doing so, highlight the similarities and differences. Bankruptcy and insolvency are similar terms which may mean different things in different jurisdictions. For instance, in the US ‘bankruptcy’ refers to failure of a corporation, while this is referred to as insolvency in Australia, with ‘bankruptcy’ relating to individuals. As such, both terms are similar in that they refer to corporate failure, and are often used interchangeably. 3. What are four common causes of corporate failure? Common causes of corporate failure can include any of the following: a. Poor strategic decisions – failing to understand relevant business drivers leading to poor business strategic decisions b. Greed or the desire for power – leading to growth in the business that is unsustainable c. Overexpansion and ill-judged acquisitions – where costs can exceed benefits d. Dominant CEOs – who are not adequately managed or scrutinized by the board e. Failure of internal controls – may lead to failure to identify and manage operational risks f. Ineffective boards – where they do not operate independently of management 4. What external factors can influence corporate failure? External factors that can influence corporate failure include: changes in technology, recession, competitors’ actions, deregulation, changes in import protection in an industry or interest rate changes. 5. What internal factors can influence corporate failure? Internal factors the can influence corporate failure include: weak strategy, financial mis-management, or dysfunctional culture.
  • 5. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 13.4 6. Researchers and professionals have highlighted the importance of cash flow in avoiding corporate failure. Explain why this factor is important. There needs to be enough cash to pay staff and creditors, pay GST obligations, and other operating expenses. If a business cannot make these basic payments they are not going to be able to operate at the level to make sales. This will lead to staff leaving, suppliers refusing to provide stock, or demanding immediate payment where the business previously operated on more extended credit terms. 7. What direct costs can result from corporate failure? Direct costs that can result from failure include: expenses to hire lawyers and accountants, restructuring advisors or a range of insolvency practitioners. Additional interest on holding debt that cannot be discharged due to a lack of cash flow, or refinancing debt if covenants have been violated are also direct costs of insolvency. 8. What indirect costs can result from corporate failure? Indirect costs that can result from failure are difficult to identify. They can relate to reputation and opportunity costs. For example, some entities might suffer lost sales and profit as a result of customers choosing to avoid dealing with a company that is in receivership or is attempting to trade out of insolvency. Key employees or managers may also leave the organization. Lost opportunities can also arise because management focus on survival of the entity and are not focused on longer-term opportunities. 9. Discuss what financial indicators can be used by analysts to assist in predicting whether companies might be at risk of distress or failure. Analysts use a range of financial indicators, or ratios, to predict corporate failure. One of the most common models in this regard is the Altman Z-Score. Altman included five rations in his final model: working capital/total assets; retained earnings/total assets; earnings before interest and tax/total assets; market value of equity/book value of total liabilities; sales/total assets. Others stress the importance of cash flows. 10. What factors should investors look for to assess the likelihood of corporate failure? Explain how each might be related to the likelihood of corporate failure. Factors investors should look for to assess the likelihood of corporate failure include:  Poor cash flow, or no cash flow forecasts – inability to pay debts is one of the first signs of insolvency  Disorganized internal accounting procedures – a business cannot control what it cannot measure  Incomplete financial records – may be a sign that the business is attempting to cover up difficulties  Absence of budgets and corporate plans – no longer-term strategy might indicate a lack of direction and difficulties in managing for the short- term  Continued loss-making activity – will be difficulties operating into the future
  • 6. Chapter 13: Corporate Failure © John Wiley and Sons Australia, Ltd 2012 13.5  Accumulating debt and excess liabilities over assets – may be difficulties with cash flow going forward  Default on loan or interest payments – will have higher costs of debt and may not be able to borrow further funds to finance operations  Increased monitoring by financier – additional cost of debt and reporting requirements  Outstanding creditors of more than 90 days – indicative of cash flow problems  Installment arrangements entered into – indicative of cash flow problems  Loss of key management personnel – loss of confidence in the future direction of the business 11. Corporate governance has been highlighted as an important factor in alleviating the risk of corporate failure. Evaluate which aspects of corporate governance are likely to guard against corporate failure. Strong corporate governance that is likely to guard against failure will have the following characteristics:  Boards are active in setting and approving the strategic direction of the company  Boards are effective in overseeing risk and setting an appropriate risk level for the entity  Boards consist of independent directors, with audit, compensation and nomination committees made up completely from independent directors  Directors own an equity stake in the company  Director quality - At least one of the independent directors should have expertise in the entity’s core business, attend the majority of meetings and limit the number of boards they sit on  Boards should meet regularly without management present 12. What is the global financial crisis (GFC)? The global financial crisis (GFC) has been referred to as the worst financial crisis since the Great Depression in the 1920s. It commenced with a downturn in the US housing market, which created a liquidity shortfall in the banking system. This resulted in the collapse of a number of large financial institutions, a downturn in stock markets and the government bailout of banks in a number of countries. 13. How did the GFC start? The GFC is said to have started in the US housing sector. Leading up to the financial crisis there was a substantial increase in housing prices, with historically low interest rates. This created an environment which promoted borrowing, with lending standards relaxing and subprime mortgages increasingly being used. House prices started to decline towards the end of 2006, with significant defaults and foreclosures on mortgages following in early 2007. This coincided with an increase in interest rates and saw a number of financial companies filing for bankruptcy.
  • 7. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 13.6 14. Articulate the relationship between the housing sector and the finance sector. The housing sector and the finance sector are closely linked. The finance sector provides the funds for housing development and purchases, and hold mortgages over property as security on loans. In addition, research has shown that the end of major asset bubbles can also have a significant effect on other markets, such as the stock market. 15. How was the housing sectorso integral to the development of the GFC? The health of the housing sector is thought to be a critical indicator of the health of the economy in any company. The GFC was thought to have commenced with the increasing house prices – known as an asset bubble, and low interest rates. Borrowings increased and subprime mortgages were offered where funds were leant to parties with limited ability to repay. When the housing price bubble burst and house prices declined there was limited opportunity to repay mortgages and this resulted in an increase in default, and a reduction in cash flows to banks. 16. Why have Australian financial institutions been able to avoid the worst of the GFC? The Australian financial sector was protected to a certain extent as a result of strong prudential regulation of capital requirements. Further, government intervention to encourage spending served to ensure Australia avoided a technical recession.
  • 8. Chapter 13: Corporate Failure © John Wiley and Sons Australia, Ltd 2012 13.7 Application questions 13.1 Identify a delisted Australian company from the following website: www.delisted.com.au. Access the financial reports for the previous five years. Work in teams to determine and calculate a range of financial ratios which you could use to assess the evidence of financial distress that might have been evident to investors in the five years leading up to failure. (J, CT, SM) As a result of browsing the above website you should have been able to identify a large number of companies. One of these is A.B.C. Learning Centres Ltd, which collapsed in 2008. A search of the internet will provide access to annual reports on a number of websites. Alternatively they may be available through a range of databases normally held by university libraries, such as Aspect Huntley FinAnalysis or Connect 4. Share prices to calculate market value of equity can be downloaded from FinAnalysis if this is available to you under the ‘Charts and Prices’ tab. You could calculate the ratios used in the Altman’s Z-Score, in addition to a cash flow ratio such as operating cash flow ratio (cash flow from operations/total liabilities). For A.B.C. Learning these ratios for five years are as follows (note sales/TA has not been calculated as the firm was a service provider): Ratio 2007 2006 2005 2004 2003 Working capital/TA -26.11% 5.69% 3.21% 4.12% 1.28% Retained earnings/TA 4.24% 4.29% 4.68% 7.85% 9.14% EBIT/TA 7.13% 6.65% 6.40% 10.43% 12.12% Market value of equity/Book value of TL 1.32:1 5.88:1 2.89:1 5.67:1 4.45:1 CFO/TL 9.55% 20.8% 14.60% 17.81% 16.60% 13.2 You are interested in investing in shares in an Australian company but are worried the company might be in financial distress. Prepare a list of factors you might look at in deciding whether it might be considered to be a sound investment, or indicate potential distress. (J, K) This chapter highlights a range of factors that can be useful to assess an entity as a potential for investment, or to indicate potential distress. These include, but are not limited to:  A range of financial ratios as reflected in the Altman Z-Score
  • 9. Solution manual to accompany:Contemporary Issues in Accounting © John Wiley and Sons Australia, Ltd 2012 13.8  Cash flow forecasts  Budgets, corporate plans and strategies  Evidence of continuing loss-making activities  Ratio of liabilities to assets  Any evidence of default on loans or interest payments  Corporate governance quality reflected in board independence, board effectiveness and involvement in developing the strategic direction of the entity, share ownership by directors etc. 13.3 Access the Australian Prudential Regulation Authority (APRA) website. Document what rules and regulations it has in place to oversee governance of deposit institutions. Identify any proposals it is examining that may affect future governance requirements. (J, K) APRA has in place CPS 510 Governance, which sets rules and regulations for governance of deposit taking institutions. This prudential guideline is effective from 1 July 2012 and replaces APS 510.  The key requirements include:  Specific requirements relating to board size and composition  The requirement for the chairperson to be an independent director  An audit committee  Policies regarding board performance  The establishment of a remuneration committee  A remuneration policy  A dedicated internal audit function Proposed changes are identified in letters to deposit taking institutions. As a result of Basel Committee on Banking Supervision Pillar 3 disclosure requirements for remuneration being issued, there is anticipated to be changes to remuneration disclosure requirements – which are outlined in CPS 510. Consultation is to take place in the first half of 2012. Case study 13.1: ABC Learning ‘reliant’ on debt to cover cash shortfalls 1. Outline the importance of cash flow to ensuring the ongoing operation of a company. (J, K) Cash flow is essential to the ongoing operation of a company. Cash is needed to pay staff, pay GST obligations, debtors and other operational expenses. These expenses must be paid regularly and failure to do so will mean a business runs the risk of failure. 2. Discuss the corporate governance and board mechanisms that could have servedto limit the chances of corporate failure in the case of ABC Learning. (J, K) The board appears to not have paid adequate attention to strategy upon the acquisition of other companies. The board did not appear to effectively oversee risk levels. There was a lack of independence on the board. The board appeared not to question
  • 10. Chapter 13: Corporate Failure © John Wiley and Sons Australia, Ltd 2012 13.9 executives with regards to budget, cash flow and the source of cash to fund day-to- day operations. Case study 13.2: Company failures soar by 40 pc 1. Discuss how the GFC could have affected business health in New Zealand. (J, K) The GFC contributed to a recession in New Zealand, which led to increased unemployment, and declining orders and sales. As a result, businesses had problems with cash flow, and difficulties paying debt. The end result was an increase in liquidation or receivership in the country.
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