Arguments developed by Rucinski, (2008) indicate that financial statement is perceived as a collection of reports about a financial organization results. As a result, Rucinski (2010) argues that financial statements are useful in determination of ability of business to generate cash, determine if business is able to pay its dues, keep track of financial results, derive ratios and also aim at investigating the details which concerned business transactions. But, the main idea of this topic is showing that financial statements have proved to be inefficient in bankruptcy prediction. The terms bankruptcy refers to a situation where a company is unable to settle its liabilities and hence a company are termed to be bankrupt.
For years we have witnessed firm fall as a results of prediction in financial statement inefficiencies in predicting the escalating factors to bankruptcy. From what can be observed firms such as Enron fell because of financial manipulations by the officials leading to bankruptcy, on the other hand Lehman Brothers failure was as a result of poor financial statement observation where they borrowed a lot of money and invested more in housing sector. From these two cases, it is clear that financial statement inefficiencies led to bankruptcy of these firms. Therefore, this shows that financial statements are in need of new approaches to cope with bankruptcy prediction.
We understand that when predicting a firm’s bankruptcy through financial statement, the key indicators used in the prediction are the financial ratios. Financial ratios tend to be important elements in prediction of the greater picture but they tend to be inefficient when taken alone and in absolute comparison without the use of additional information. Hence, financial statements via financial ratios prove to be worthless in prediction because its difficult risk wise outside the company to look for particular attention in ration analysis. Fitzpatrick (1931) perceives that for years he has seen companies with good economic resources and fairly good financial ratios fall all over sudden, this mainly is as a results of lost equilibrium due to lack of care details in the treasury. Therefore, it is difficult for firms to use ratios such as number of customers, individual risk, debt maturity and liquidity of customers. Hence, the reason as to why firms are recommended to use agency cost of managerial information. Here, the agency cost of managerial information tends to be resourceful because of its ability to manage implications, examine data and integrate it in a wider context. Hence, consideration of the business becomes a reality and there will be ease predictability of financial ratios.
An argument by (Ohio State Bar, 2007) is that when a number is divided by another number we get a ratio. Therefore, the significance of ratios emerge from the actual number of inputs are kept in the ratio. Therefore, even if financial ratios developed from the company statements are true the actual figures are the key determinants in showing that this is the true actual figure. Therefore, we could perceive that Weule et al (2007) argument shows that financial numbers used of development of financial statements (ratios) are resourceful in decision making. But, Ohio State Bar (2007) argues that when predicting a firm’s actual position and predicting any instance of bankruptcy management should not solely rely on financial ratios. But, there is the need of them developing a multi-dimension through the use of balance scorecard concept developed by Kaplan and Norton. The adaptation of this method tends to provide analytics solutions which act helpful in the identification of the hidden information. Hence, we could perceive that the balance scorecard tends to be unique in its own way because of its analytical capability in development of financial information and predicting bankruptcy instances.
Based on our discussion some firms have fallen because of using financial statements in determination of their actual bankruptcy levels. The process of predicting bankruptcy situation tends to be different in each firm, even if the provided information is true, for instance if a firm receives donations or governments grant support on the business capital. All this has an influence on some of the ratios. Hence, the question developed here is getting to know how well the firm and comparison of the accounts are throughout the years. Since, financial statements aren’t adequate enough in development of these predictions there could be the introduction of use balance scorecards as indicated above to deal with all these challenges (Ekvall & Smiley, 2007). At times there exist excellent financial indicators in financial statements, but the performance levels tend to be low the vice versa can also happen. Hence, companies that have implemented the balanced scorecard step are likely not to suffer from failure of bankruptcy predictions because if the financial statements become inefficient there is support of balance scorecard in the process of prediction. Therefore, showing that ratios shouldn’t be recorded and interpreted blindly, but there is the need of integrating other methods into the system to avoid instances of actual bankruptcy in a firm (Ohio State Bar, 2007).
Newton (2009) argues that there exist many distorting factors in financial statements (ratios) they include; accounting rules being different from a single company to another making it hard to understand what one is looking for, ratios developed on historical cost tend to have a less meaning this is because one can’t predict bankruptcy based on historical cost, it is obvious that in earnings there is a positive cash flow, at the end of ratios it shows what happened at the best evolution until the initial point, there are industry averages mear, there exist no benchmark for any ratios to compare to Newton (2009). One ration that tends to amuse me is the leverage ratio which is based on book value. Come to think of why do we have a complete capital structure theory if we want to measure debts based on our book value. Perhaps, it would be vital to have this entire fine along your WACC which is optimal. Hence, it is recommended there be a market value which leverages enough in a firm.
It obvious that most accountants would claim that financial statement (ration) analysis prove to be significant in bankruptcy prediction. But truth of matter is that accountants have shifted their focus from this historical type of analysis. Most of them tend to not only focus on the financial statements alone but also look at the market values and cash flow which tends to be a relevant item in the valuation of analysis (Weule et al, 2007). At times bond pricing tends to act as the best predictor of any default risk (bankruptcy). Hence, this proves that the existence and development of ration in financial statements based on historical cost and accruals can’t lead to any accurate conclusion in prediction of risks.
In conclusion, this paper provides an in-depth analysis of why financial statements can’t and shouldn’t be solely used in the prediction of bankruptcy. Our introduction definition of bankruptcy tends to be a situation where firms are unable to pay off their due, hence making them sell of part of their assets or a firms operations come to a halt (Rucinski, 2008). Therefore, our argument tends to focus mostly on inefficiencies of financial statements in predicting a firm’s accurate position. Hence, it’s clear from our argument that firms could consider using methods such as balance score card to avoid blind interpretation, there could also be the use of multi-method approach which develops more focus on effective prediction on the actual firm’s position and account records.
Ekvall, L. L. W., & Smiley, E. D. (2007). Bankruptcy for businesses: the benefits, pitfalls, and alternatives : steps to take to avoid bankruptcy, non-bankruptcy alternatives, and the new bankruptcy code for a business. [Irvine, CA], Entrepreneur Press.
Fitzpatrick, P. J. (1931). Symptoms of industrial failures as revealed by an analysis of the financial statements of failed companies, 1920-1929. Washington, D.C., Catholic University of America.
Newton, G. W. (2009). Bankruptcy and insolvency accounting. Volume 1, Volume 1. Hoboken, N.J., John Wiley & Sons.
Ohio State Bar Association. (2007). Financial statements workshop: understanding financial statements and tax returns in bankruptcy and domestic cases. Columbus, OH, Ohio State Bar Association CLE Institute.
Rucinski, K. L. (2008). Understanding financial statements and tax returns in bankruptcy and domestic cases. Columbus, OH, Ohio State Bar Association CLE.
Weule, B., Warburton, W., & Brading, R. (2007). The bankruptcy handbook. Annandale, N.S.W., Federation Press.