Accounting dissertation introduction example

CHAPTER 1

INTRODUCTION

1.1 Introduction

In many emerging markets, capital market is one of the most significant tools to measure the economic growth. Stoica(2002) disclosed that a good capital market is an efficient economic mechanism that organizes the monetary resources between the money providers and the users. Effective mobilization and allocation of fund enable businesses to sustain its growth and development in a country such as the stock market, which promotes capital efficiency to ensure optimal output (Osinubi,2000). The weight of capital market has driven many professionals and academicians; accountants, economists and technologists to document numerous empirical capital market issues. By using quantitative or qualitative analysis, study on capital market covers a wide range of concerns concentrating on the security prices, business failure, company performance and future cash flow (Subrahmanayam, 2010).

The most popular theme in capital market studies for the new millennium is predicting the corporate failure or financial distress. Studies on corporate failure prediction have been perceived by the government and private companies. As a great cost burden due to the corporate failure affects many individuals; the government is concerned with its total impact on the country’s economy and society, whilst private companies are interested with its corrective and preventive actions (Andreer, 2005).

Beaver (1966) has defined corporate failure as the inability of the firms to meet their financial obligation as they mature, while Elam (1975), described it as the occurrence of a firm’s total liability exceeding the fair values of its asset. Corporate failure has been known to be defined in numbers of ways, but mainly it refers to the insolvency of a firm. Yusof (2008) identified corporate failure as a synonym with failure to meet financial obligation, debt reorganization, applying bankruptcy protection or even business termination.

The study of corporate failure was started in the mid 1960’s by William H. Beaver (1966) and Edward I. Altman (1968). As Beaver (1966) claimed that financial statements are the successful bankruptcy predictor by using the univariate analysis. On the other, hand Edward Altman (1968) reviewed the work of other scholar by combining various financial ratios known as The Z-score model (a multivariate analysis). It was reported The Z- score as a better predictor for corporate failure although it has to put up with certain limitations. Since then, a great number of failure prediction models have been established using different types of approaches and frameworks.

Besides prediction model, corporate failure can also be traced through several failure signals at any level of business cycles. Sori, Hamid & Nasir (2005) concluded that, corporate failure is not a sudden event but a cumulative penalty of unsolved hassles. This claim was also supported by Ahmad, Halim, Hamzah and Husni (2008), who revealed in their study that, economical factors, financial factors, marketing deficiencies, corporate fraud and human error were the logical factors that expose a business to the corporate failure.

The incidences such as long period’s poor performance, insufficient company’s cash, (Ahmad et al.,2008; Sori et al.,2005), high leverage, bad management, new company (Sori et al,2005; Andre and Kaplan, 1998; Heng et al.;1995; Kharbanda and Stallworthy, 1985; Argenti, 1976), competition (Heng et al.;1995) creative accounting (Sori et al,2005) fraud, unstrategic location, and economic downturn condition (Andre and Kaplan, 1998; Kharbanda and Stallworthy, 1985; Argenti, 1976) are among the potential indicators that leads to business failure. Failed companies are frequently associated with the initial defects in their management which lead to poor decision making and finally causing financial deterioration and insolvency. It was suggested that a company’s management should forecast any declining activity and resolve the situation so that early actions can be taken as a precaution (Andreica, Andreica, & Andreica, 2009).

In Malaysia, there is a great numbers of companies grounded with the aims of making profit and struggling in intense competition. Table 1.1 shows the summary of percentage for Malaysian companies wounded up from 2006 to 2009 compared to newly registered companies issued by the Companies Commission of Malaysia (CCM). It proved that the percentage of post failure anxiety has increased for years.

Table 1.1

Statistics of Malaysian’s Registered Companies and Winding Up

Year Registered companies Wound up Companies %

2006 756,245 955 0.13

2007 799,582 1276 0.16

2008 841,205 1450 0.17

2009 882,843 2013 0.23

SSM report 2006 – 2009

Note. The percentage is calculated by dividing the numbers of winding up companies over registered companies.

Malaysian stock market is known as Bursa Malaysia and it is governed by the Securities Commission (SC) while Malaysian companies are bound under Companies Act 1965 and administrated by CCM. According to section 218(2) of the Companies Act 1965, insolvency occurs when a company is unable to pay debts and it affects the allocation of the company to the external administration.

In Malaysia, according to section 182-192 of the Companies Act 1965 there are three types of external administration which are the receivership; providing a way for creditors to securely receive their money; scheme of arrangement involves structured proposal by the company to re-negotiate or reschedule its debts and other contractual agreements with the creditors and winding up imply an insolvency practitioners selling off the company’s asset and distributing the proceeds among the company’s creditors which finally resulted to dissolve the company (Sulaiman, Bidin, Hanrahan, Ramsay, & Stapledon, 2008). Malaysian listed companies are temporarily suspended and given a chance to restructure by Bursa Malaysia and SC instead of filing for bankruptcy (Haat et al., 2005).

Currently, there are almost 1000 companies listed at Bursa Malaysia, however, only several are financially sound. These listed companies must fulfill Bursa Malaysia’s Listing Requirements. Both company’s financial position and business direction can change to either end of the extremes fail or success. Therefore Bursa Malaysia has issued a Practice Note 17/2005 (PN 17) in managing those companies that are in a financially sound position or absent of a core business or has failed to meet minimum capital or equity (not less than 25% of the paid up capital. Companies that are categorized under PN17 (Prior to 2005, it was classified under PN4) have to reorganize and recover the company by presenting their proposal to the Bursa Malaysia in maintaining their listing status.

Paragraphs 8.04(2) of the Listing Requirements under Practice Notes 17/2005 amended 2009 states that, public listed company which triggered any one or more of the following prescribed criteria can be a signal to be listed under PN17:

(a) the shareholders’ equity of the listed issuer on a consolidated basis is 25% or less of the issued and paid-up capital (excluding treasury shares) of the listed issuer and such shareholders’ equity is less than RM40 million;

(b) receivers or managers have been appointed over the asset of the listed issuer, its subsidiary or associated company which asset accounts for at least 50% of the total assets employed of the listed issuer on a consolidated basis;

(c) a winding up of a listed issuer’s subsidiary or associated company which accounts for at least 50% of the total assets employed of the listed issuer on a consolidated basis;

(d) the auditors have expressed an adverse or disclaimer opinion in the listed issuer’s latest audited financial statements;

(e) the auditors have expressed a modified opinion with emphasis on the listed issuer’s going concern in the listed issuer’s latest audited financial statements and the shareholders’ equity of the listed issuer on a consolidated basis is 50% or less of the issued and paid-up capital (excluding treasury shares) of the listed issuer;

(f) a default in payment by a listed issuer, its major subsidiary or major associated company, as the case may be, as announced by a listed issuer pursuant to Practice Note 1 and the listed issuer is unable to provide a solvency declaration to the Exchange;

(g) the listed issuer has suspended or ceased –

(i) all of its business or its major business; or

(ii) its entire or major operations,

for any reasons whatsoever including, amongst others, due to or as a result of –

(aa) the cancellation, loss or non-renewal of a license, concession or such other rights necessary to conduct its business activities;

(bb) the disposal of the listed issuer’s business or major business; or

(cc) a court order or judgment obtained against the listed issuer prohibiting the listed issuer from conducting its major operations on grounds of infringement of copyright of products etc; or

(h) the listed issuer has an insignificant business or operations

1.2 Problem Statement

Corporate failures are perceived as development problem for economic environments (Altman et al., 1979). Opoku (2011) reported that, the world corporate failure rate is increasing due to the economic deceleration resulting from the 2007 credit crunch that have affected the United States’s housing sector. On the other hand, the Deputy Chief Executive Officer (CEO) of CCM Rokiah Mohd Noor states that 11,631 registered companies in Malaysia recorded losses which lead to bankruptcy in the first six months in 2010, surpassing the total of 11,409 companies in 2009 (The Star online, 15 August 2010). Rokiah also revealed that, the failed company has increased due to the increasing numbers of companies registered with CCM and failing due to internal; individual problems or companies as a whole rather than current economic factors. Thus, it shows Malaysia has an exceptional basis for the corporate failures. This disclosure also calls for a need to provide the corporate failure alarm in order to sustain the Malaysian economic development.

In the developed countries, companies’ performances are evaluated using different models. These models are useful information-gathering facility for the shareholders and potential investors, thus allowing them to make efficient decision. The documented findings on corporate failures from developed countries contribute to the firm’s failure characteristics. Nevertheless, the findings mentioned above are inappropriate for Malaysian companies. These are due to the variations in the market composition, political atmosphere, social economics features, rules and law provision and execution as well as the accounting standards used in Malaysia.

In Malaysia, studies on the prediction of bankruptcy and financial distress among companies have received the scholars’ attention. Yet, the differences among these studies are its argumentation regarding definitions of financial distress, the methodologies that had been used and the sectors that the companies were listed. For instance study performed by Fauzias and Chin, (2001) applied in manufacturing companies, on the other hand Zulkarnain and Karbhari (2004) focused on mixed industry. Low et al. (2001) defined the failure term based on section 176 Companies Act 1965 whereas Tew and Enylina, (2005), and Mohmad Isa et al., (2005) defined companies under PN4 Bursa Malaysia as the distress companies. Low et.al (2001) employed logit analysis statistical towards mix sample while, Zulkarnain and Karbhari,( 2004), and Chin, (2005) employed the same multiple discriminant statistical approach.

However, it is vital to further scrutinize the topic due to the following reasons. Firstly, although the studies on this dynamic financial distress have been conducted in many countries for several years, there is no solid guidance or definite theory underlying the selection of the appropriate ratios to be used (Yap, Yong, & Poon, 2010). Furthermore, the absence of conformity regarding the selection ground for the ratio promotes more study on predicting corporate failure. Therefore, the previous researchers claim the prediction approval by presenting reasonable degree of predictive accuracy. As a result, none of them argued that neither the model nor the selected ratios are the best. Abdullah and Nasir (2004) disclosed that, most of the studies on evaluating the firm performance using accrual and cash flow measures are inclusive throughout countries and time.

Prior studies of predicting corporate bankruptcy and financial distress using ratio analysis have selected the financial ratios from the company financial statements. The facts about the ability of the balance sheet, income statement or cash flows statement in providing accurate inferences on a company’s financial condition are not questionable but the analyses depended on only the cash flow statements or the accrual statements i.e. the balance sheet and the income statement, may be misinterpreted and ambiguous. Studies by Viscione (1985), Bowen & Daley (1986), Deachow (1994) and Cotter (1996) have given recognition to the fact that accrual data i.e. the balance sheet and the income statement are the best predictor while Baever (1966), Deakin (1972), Lee (1982), Casey & Bartezak (1985) and Low et al. (2001) have shown that promoting cash flow information is a more significant predictor.

Those researchers who supported accrual accounting claims that accrual statement provides better indicator of the company’s capability in generating current and future desirable cash flows (Habib, 2008). Viscione (1985), revealed that the prediction using cash flow can be manipulated. Viscione argument has been supported by Bowen & Daley (1986) as they pointed out that cash flow is just a secondary source in making decisions. In Malaysia, several studies have also agreed with the function of accrual in predicting the company performance as suggested by Mohd, Li & Sanda(2001) and Zulkifli (2001).

There is a contradiction against the famous belief that earnings are not an illustration of the actual cash that a firm may create over a given time period (Ibbarra, 2009). The cash Flow is considered as the best served information due to its ability to portray the company’s ability to survive with the absence of any innumerable issues. Negative signal will reveal if most cash is derived from financing activities with the tendency of defaulting debt is higher.

Subsequently the significance of cash flow has been endorsed by other studies such as Deakin (1972), Lee (1982), Casey & Bartezak (1985) and Low et al.(2001). The benefits of the cash flow as bankruptcy’s predictor have been recognized and reported in the financial literatures. Based on empirical evidence, the analysis of Laker Airways cash flow from its operation showed that the potential failure of the company can be discovered three years prior the crash.(Lee,1982).

This paper depicts a dynamic prediction model by establishing a hybrid bankruptcy model. Pan (2010) used the term hybrid in his study on predicting the stock price where by combining principal component regression (PCR) model and general regression neural network, Pan tried to solve the multicolinearity issues. In this study, hybrid means the combination of accrual and cash flow based ratio in predicting the corporate failure. Ratio used in this study represented the most popular ratio’s clusters which are liquidity, profitability, solvency and asset efficiency. The idea comes from the statement by Carslaw & Mills (1991) who claims that the integration of cash flow and accrual data would provide a superior measure of performance. The summarization of problem statement is being illustrated in Figure 1-1

Figure 1-1 Problem statement framework

1.3 Objective of the study

Main Objectives

The main objectives of this study is to develop the corporate failure prediction model for Malaysian companies associates the accrual based and cash flow based ratio.

Specific objectives

Specific objectives of this study are as follows:

a. To examine the relationship between accrual based and cash flow based ratios for each category

b. To examine the significant relationship of the financial ratios(selected in this study) as the corporate failure predictor.

c. To examine the accuracy of the failure prediction model for Malaysian companies from one year up to five years prior to failure.

1.4 Scope of the study

This study covers the companies which have been listed as PN 17 companies in 2010 representing the failure companies. In addition, the companies which are not listed in PN17 are also being selected as non failure companies. The selection of the non failure is based on the similarities of industry registered under Bursa Malaysia Berhad. The scope of the study is restricted to five years; 2005 to 2009, mainly with the hope that the ratio model may provide an alarm signal of the failure prior three to five years of their failure.

1.5 Significance of the study

Financial distress can trigger bankruptcy while bankruptcy can cause enormous damages to shareholders and stakeholders if left unattended. In fact, developing the company financial distress and bankruptcy benchmark is very important. The benchmark will help to initiate the awareness of the stakeholders. In developing a reliable benchmark of financial distress, obtaining the bankruptcy information is very crucial. The truth and sufficient information will give the company and its stakeholder to the correct direction.

Currently, financial statement is the main information regarding the company’s financial strength and performance and the use of ratios to predict financial variables and performance is believes one of accounting evolution (Giacomino, Don, Mielke, & David, 1993). Moreover, the evolution in the accessibility of data and arithmetical techniques facilitate the corporate failure prediction development.

By having an appropriate knowledge about the corporate failure, managers and other stakeholders may have an exposure regarding their business challenges in the future. Subsequently, it will help the manager to distribute the resources effectively and conduct their undertaking efficiently. These are among the important strength of ‘good companies’ as most of failed companies are misallocation of their available resource (Aharony,1980)

As a result, the impressive ability of the business and its manager in dealing with the business future challenges can boost the company’s profit along with minimizing the company’s cost. This in turn will benefit the owners and shareholders as it will have a positive effect in raising the value of their shares.

As the potential investors, bankruptcy information can be one of the tools used in selecting their investment. They may use this predictor model to evaluate and monitor the performance of the stock. They will also be able to access their potential returns that reflect with the risk to be suffered.

While from a lender’s point of view, obtaining superior understanding about factors affecting company distress and bankruptcy, specific risks for the company can be accessed. As the creditors are concerned with the burden of unhealthy loans and the premium value needed to accept those threat, while lenders want to borrow at lowest promising rates.

As for Government, detecting the business failure helps the government to provide some remedial actions since those failures are connected with several parties and great numbers of costs. Besides that, the government is concerned with the total impact towards the country’s economy and social as a whole.(Andreer,2005)

The benefits of corporate failure prediction discussed in this study are beneficial to many parties. Perhaps, by having greater number of corporate failure study in Malaysia it will help to identify and constructs Malaysian failure company characteristics.

1.6 Contribution of the study

This paper attempt to contribute another dimension of analyzing the company financial distress warning signals for Malaysian company using a hybrid approach; combination between accrual based and cash flow based ratio. By using this hybrid approach, the users of financial statement can maximize the usage of all the information disclosed by the company. In this study, a new variable, return on invested capital (ROIC) has been introduced and tested. Clausen & Hermansen(2011) demonstrate ROIC is more persistent measurement tool in evaluating company performance. ROIC also has been reported as an important indicator of company valuation (Silverstein, Johnson and Mizrakjian,1996; Jiang & Koller,2007)

1.7 Organization of the study

The remaining of this paper has been organized in the following manner:

Chapter two presents reviews of the literatures on bankruptcy and corporate failure prediction and past studies on using the accrual and cash flow as the failure predictor in general as well as in Malaysia.

Chapter three discusses the development of hypotheses to be tested in this study, the selection of sample firms, the data collection, the variables and their measurements, and finally, the regression model employed.

Chapter four presents the descriptive statistics of the variables used in this study, the analysis and findings of the regression models, and a summary of the results.

Finally, Chapter five concludes the study, and includes limitations of the study as well as suggestions for possible future research.

1.8 Summary of the Chapter

This chapter discusses the current corporate failure prediction environment and related issues arose such as an exceptional factor for Malaysia, numerous model used, unguided failure term definition and the argumentation on accrual and cash flow ratios.

This chapter also discusses the aim of the study on the development of the corporate failure prediction model for Malaysian companies. Three specific objectives which have been identified were also discussed.

Since the definition of the failed company used is referred to PN17, this chapter also discusses the criteria’s of the listed company to be classified as PN 17 companies. In Malaysia, there is a distinctive definition between bankrupt, restructured and winding up companies.