Topic A

Abstract

The bankruptcy of the firms has become a major hurdle in the growth of the economies. To
forecast the bankruptcy of a firm, analysis of financial statements has always been a major tool.
These financial statements were very important until some corporate scandals revealed that this
analysis is no more the most reliable source to predict the risks of bankruptcy. To clear the
views whether corporates should depend on financial statements alone, a study in form of essay
is presented here. A quantitative analysis is done with examples from journals that clarifies the
problem of bankruptcy prediction. After analysing, it has been found that the modern methods
such as option valuation approach are much more effective in estimating bankruptcy. A novel
rule-based system is also proposed to solve the problem of prediction of bankruptcy of the
firms. These will help the corporates and economies.

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The recent financial crisis has increased the cases of bankruptcies of the businesses and that
has opened a new area of research which should provide new methods to predict bankruptcies
of firms. There is need to overcome the old methods of bankruptcy prediction by using financial
statements. The information of a firm that is available publicly when combined with financial
statements provides data set of property, income and financial position of the company. This
data set from financial statements is converted into financial indices by analysts and useful
information is extracted from them. The analysis of this data including financial statements
such as balance sheet, cash flows, statement of income, statement of change in equity is also
used to predict the bankruptcy of a firm. The most popular bankruptcy model, value-based,
generally used is the one that already exists from long time (developed by Altman in 1968) and
is dependent on financial indices (Gissel, Giasomino and Akers, 2007). A single, predictive
value is calculated and used to categorize the company according to the performance as good
or bad (Reizinger-Ducsai, 2016). More than 100 such models are crafted form the time when a
bankruptcy prediction model was first time scripted by Fitzpatrick (1932) in his paper
(Bhandari, 2014).

The bankruptcy predictions have a principle effect on the decisions related to lending and the
sustainability of a firm in terms of risk management (Jo, Kim and Shin, 2015). The question
arises here is that whether these financial ratios derived from the financial statements of a firm
can really predict the bankruptcy (Adnan Aziz and Dar, 2006)? The answer to this question is
‘not always’ because what happened in the past is not necessarily going to happen in future. If
a company is facing problems today and performing badly, it doesn’t mean it won’t perform
well in the future. Suppose the reason for bad performance today is lack of funds but tomorrow
the company may get sufficient funds and it can perform well. The vice versa is also true for
this situation. It is also true that these ratios are very useful in predicting bankruptcy but only
if the numbers used are true. It depends upon the company to present correct or incorrect
numbers in front of stakeholders. Besides this there are also many corporate scandals from the
past that proves financial statements are not reliable to predict the bankruptcy risk of a firm.

The financial and income elements that were used in the past were unable to provide the real
content and potential falsity of the underlying economic events. The accounting loopholes and
poor financial reporting provides an opportunity to show the company as better performing
despite being in loss. One such example from history is “Enron Scandal”. The scandal came
into light in 2001 and at that time, it was the biggest audit failure in the history of America.
Some executives from the staff used accounting loopholes, poor financial reporting and special

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purpose entities to hide the debt of billions of dollars that emerged from failed projects and
deals. The Chief Financial Officer along with executives misled the Board of Directors of
Enron and auditing committee on the high-risk accounting practices. They also pressured the
audit company to ignore these issues. This scandal when publicized led to the bankruptcy of
Enron. The shares of company that achieved a high of US$ 90.75 per share in middle of 2000
fell to less than US$ 1 by the end of November 2001. The company faced a lawsuit from
stockholders as well as lost billions of dollars because of plummeting stocks in the share market
(En.wikipedia.org, 2017). After that many other scandals were in news that proved it is not safe
to completely rely on the financial statements of a firm for predicting bankruptcy. Whether it
was from insurance sector, telecommunications, energy, retail or banking, every scandal was
demanding new methods to predict bankruptcy (En.wikipedia.org, 2017).

In today’s world, survival methods are applied. Option valuation approach is one of them where
variability of stock prices is considered. When a firm’s assets reach a significant low level in
comparison to the liabilities that it has, then it is assumed that the firm is on the verge of default
(Structural Models of Credit Risk, n.d.). This happens under structural models. Various models
such as neural network models are tested for predicting bankruptcy. These modern methods
are no more dependent on the annual accounts of the company. They have moved beyond the
events like judgements, duration, bad media, payment incidents and payment related
experiences from creditors. In 2013, Jackson and Woods provided best discussion of the
literature available till now. They evaluated 15 popular models ranging from the univariate
models of Beaver, multidimensional models of Altman and Ohlson to the most recent
techniques that includes option valuation approaches. It was found that option valuation
approach easily outperforms the earlier available models that depend mostly on the accounting
numbers (En.wikipedia.org, 2017).

One other study in 2013 by Zhang, Wang, and Ji was done to predict the bankruptcy of a firm.
They proposed a novel rule-based system to solve the problem of bankruptcy prediction. There
are four stages in this process: first one is sequential forward selection by which most important
features are extracted; secondly a rule-based model is opted that fits in the given data set by
presenting physical meaning to it; thirdly, a Genetic Ant Colony Algorithm (GACA) was
introduced. A new algorithm was formed by incorporating fitness scaling strategy and the
chaotic operator with GACA named as fitness-scaling chaotic GACA (FSCGACA) and was
utilized to get the optimum parameters from the rule-based model. Lastly, to enhance the

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generalization of the model, the stratified K-fold cross-validation technique was used
(En.wikipedia.org, 2017).

The purpose of the essay was to discuss whether the financial statements are efficient or
inefficient in prediction of bankruptcy of a firm. From a very long time, financial statements
were used for bankruptcy predictions but there were some loops in the accounting system that
were misused. Sometimes, the companies knowingly present the wrong figures and misled
everyone associated with the company. Other times it is done by the financial executives and
other team members who tweaks the financial statements and the distressed assets of the firm
and makes them look like well performing. When these scandals were exposed, it was
discovered that there is a need to bring new innovative techniques to predict bankruptcy, a new
area for research was opened. Many studies have been done till now and some methods such
as option-valuation approach and rule-based systems have emerged as a boon to the corporates.
These techniques have become more reliable processes to predict the bankruptcy of a firm.
Now, the failure of prediction by depending on financial statements can be ruled out.

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References

Adnan Aziz, M. and Dar, H. (2006). Predicting corporate bankruptcy: where we stand?.
Corporate Governance: The international journal of business in society, 6(1), pp.18-33.

Bhandari, S. (2014). Two Discriminant Analysis Models of Predicting Business Failure: A

Contrast of the Most Recent with the First Model. American Journal of Management, 14(3),
pp.11-19.

En.wikipedia.org. (2017). Bankruptcy prediction. [online] Available at:

https://en.wikipedia.org/wiki/Bankruptcy_prediction [Accessed 1 Jun. 2017].

En.wikipedia.org. (2017). Enron scandal. [online] Available at:

https://en.wikipedia.org/wiki/Enron_scandal [Accessed 31 May 2017].

En.wikipedia.org. (2017). List of corporate collapses and scandals. [online] Available at:
https://en.wikipedia.org/wiki/List_of_corporate_collapses_and_scandals [Accessed 1 Jun.
2017].

Gissel, J., Giasomino, D. and Akers, M. (2007). A Review of Bankruptcy Prediction Studies:
1930-Present. Journal of Financial Education, 33, pp.1-42.

Jo, N., Kim, H. and Shin, K. (2015). Bankruptcy Type Prediction Using A Hybrid Artificial
Neural Networks Model. Journal of Intelligence and Information Systems, 21(3), pp.79-99.

Mansouri, A., Pirayesh, R. and Salehi, M. (2009). Audit Competence and Audit Quality:
Case in Emerging Economy. International Journal of Business and Management, 4(2).

Reizinger-Ducsai, A. (2016). Bankruptcy prediction and financial statements. The reliability

of a financial statement for the purpose of modelling / Predykcja bankructwa a sprawozdania
finansowe. Wiarygodność sprawozdań finansowych dla potrzeb modelowania. Prace
Naukowe Uniwersytetu Ekonomicznego we Wrocławiu, (441).

Structural Models of Credit Risk. (n.d.). 1st ed. [ebook] pp.41-54. Available at:
https://www.fields.utoronto.ca/programs/scientific/09-10/finance/courses/hurdnotes2.pdf
[Accessed 1 Jun. 2017].