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

Solution manual to accompany: Contemporary Issues in Accounting

CHAPTER 13
CORPORATE FAILURE

Contemporary Issue 13.1: Not open 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 key to 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.

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 Chapter 13: Corporate Failure

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.

© John Wiley and Sons Australia, Ltd 2012 13.2

Solution manual to accompany: Contemporary Issues in Accounting

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.

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 Chapter 13: Corporate Failure

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

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Solution manual to accompany: Contemporary Issues in Accounting

 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.

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 Chapter 13: Corporate Failure

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 sector so 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.

© John Wiley and Sons Australia, Ltd 2012 13.6

Solution manual to accompany: Contemporary Issues in Accounting

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
-26.11% 5.69% 3.21% 4.12% 1.28%
capital/TA

Retained
4.24% 4.29% 4.68% 7.85% 9.14%
earnings/TA

EBIT/TA 7.13% 6.65% 6.40% 10.43% 12.12%

Market value
of
1.32:1 5.88:1 2.89:1 5.67:1 4.45:1
equity/Book
value of TL

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

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 Chapter 13: Corporate Failure

 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
served to 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

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Solution manual to accompany: Contemporary Issues in Accounting

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.

© John Wiley and Sons Australia, Ltd 2012 13.9