Mohammad Talha Awan Q1)

Corporate Finance

TP021713

One of the major issues that aroused debates amongst scholars and management academics were determining the principals or factors that led to corporate failure or success (meaning why some organizations prosper while others collapse). Analysts are tempted to look for methods of predicting corporate failure since large companies collapsed unexpectedly such as Lewiss (1991), Enron (2001), WorldCom (2004). Before we discuss the causes of failure, it is better to understand what corporate failure basically means. It has no particular meaning, but refers to a situation where a company ceases to exist due to instability or incapability of making profits to support day to day operations. This may result due to incompetence, lack of management skills, poor corporate governance, or economic instability. Failure rates are also influenced by the condition of the business life cycle, economical performance and also macro-economic policies. According to a research only one-third of the companies in UK are still in business and the annual business failure rates vary pro-cyclically through the business cycle. In 1980, there were 8 business failures per 1000 operating companies, whereas in 1990 the figure reached 25 failures per 1000 operating companies. Therefore there is evidence showing us that an increasing trend is being experienced in the number of corporate failures. Business failure is a concern which is not only of academic interest; such information is an important factor in the decision making of banks, investment analysts, credit rating agencies, insurers, factors and any company engaged in extending and managing trade credit (Liu, Wilson, 2002).

Symptoms of Corporate failure: 1) Low profitability 2) High gearing 3) Low liquidity When one of the above characteristics starts to appear, it indicates that the company is headed towards corporate failure. A downwards trend in profitability will raise concerns about how long the company will be able to tolerate loses and return on capital below cost of capital. In such cases the business tends to survive by increasing its funds and working capital through loan

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Corporate Finance

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financing, which in return will increase the companys gearing. When this happens, the company faces a worsened situation where they are forced to use low declining profits to finance increasing amounts of interest on loans taken. Eventually confidence in the company starts to diminish due to low profits and lower liquidity, which results in shareholders withdrawing due to fall in share prices. In such scenarios the company either gets taken over or goes bankrupt if situation is much worsened.

Possible causes of corporate failure: Technological changes: competition has led to changes from traditional methods to development of new technology. By using advanced technology innovation can be achieved and also helps in reducing cost of production, giving the firm advantage against its competitors in pricing and production output. Firms that are not able to adapt to technological changes will face serious problems such as high cost of production which will force the firm to sell products at high prices as compared to competitors and eventually will result in loss of market and sales. This kind of situation was faced by Kodak that was known as Google of its time, it was also well known for its innovation and carried the slogan You press the button, we do the rest. It accounted for 90% sales of film and 85% of camera in America itself. But then digital photography took-over film and smartphones replaced cameras; according to BBC news, experts said that Kodak took too long to move from its traditional film business to digital cameras leading to downfall of its profits and losing market share. Recently reported, the company suffered a third-quarter loss of $222m, which is the ninth quarterly loss in three years. (The Economist) The problem could be avoided if in 1992 the company would have granted permission to launch the worlds first consumer digital camera that Kodak produced said the former vice president Don Strickland (BBC News).

Limited working capital: changes in working capital leads to poor liquidity as the organization has insufficient fund to cover up their day to day expenses. Businesses that

Mohammad Talha Awan

Corporate Finance

TP021713

are less diversified or those who rely on few major customers, usually face liquidation problems as losing one of the customers can cause cash flow problems. There might also be a chance that the major customer might get bankrupt and the company will end up losing most of it sales and unable to recover its debts. Selling all goods on credit and allowing debtors a long credit period are also one of the reasons as to why firms are not able to manage sufficient working capital to meet their daily expenses. The company might be generating high sales for the month, but actually they wont be receiving any cash as all goods were sold on credit and payments are to be received in the upcoming months creating a shortage of finance in the current month.

Macro-economic conditions / breakdown: changes in macro-economic policies or economic breakdown are one of the major reasons as to why many corporations fail. During recession or economic crisis the level of activity is reduced along with the purchasing power of consumers, which results in lower demands for firms and has a negative effect on their sales and performance. This is a situation that is unpredictable and cannot be avoided by corporations; the only thing they can manage is the survival of the business until the economy stabilizes. After the global financial crisis that heated up in 2002, many corporations faced bankruptcy due to economic instability in the US. In 2008 two of the major corporations in USA faced bankruptcy and were bailed out by the government; i) American International Group: on 4 different occasions the government attempted to support and aid AIG from collapsing. A sum of $128billion was injected from the Federal Reserve and Treasury for preventing liquidation of the company. ii) Citigroup: the government has already invested up to $45billion out of the total $280billion that it has promised to inject for limiting the losses of the group as whole. The US government also aided the bailout of GM and Chrysler which amounted up to $22billion. Due to such economic conditions many corporations worldwide face corporate failure and the chances of survival are usually less. (ProPublica)

Mohammad Talha Awan

Corporate Finance

TP021713

The factors that usually worsen the economic conditions of a country are high interest rates, which tend to decrease the lending power or consumption level of businesses and consumers at the same time. Firms would now have to pay huge amount of interest on debts which will increase their gearing ratio and increase the cost of production. On the other hand consumers will face a loss in their consumption power due to high prices and fewer goods will be purchased. In such situations firms cannot increase their lending and suffer cash flow problems which then lead to fewer opportunities of finance or investment; hence leading to corporate failures. (Young, 1995) also argues that changes in interest rates above expected level is the fundamental cause of corporate liquidation in periods of rising debts. Managerial problems: Management plays an important role in determining the efficiency and success rate of a business. Firms facing inadequate internal control or lack of managerial skills are not able to manage resources well and thus result in corporate failure. Often managers are not able to capitalize the opportunities the environment has to offer or remain unaware of the threats approaching the business. Agency problems Managers working under different departments may not have the quality to work together. With each department having dispersed objectives, they will be working for their own gain and not towards the goals of the company, which in return will be bringing failure in the company. WorldCom being a relevant example, where financial and legal tasks were scattered all over other countries and communication between departments was extremely poor. Over-expansion and Diversification CEO of a company is usually thrived to expand the business and achieve rapid growth for their own personal benefit rather than working towards the objective set for the company. They may try to increase the company status and their pay by mergers and expanding the business. Problem of such over-expansion arises when the company fails to focus on its core product, which guarantees proper income and use its resources on new business field that they dont understand well. It was reported in (Hanan Luss, 1982) that during over-expansion the existing capacity exceeds the growing demand at any point in time, creating extra storage and facility costs that are not being utilized and thus raises the cost of production. WorldCom is an example

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Corporate Finance

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which displays how the managers did not understand how the over capacity would influence the company profits and were unaware of the risks.

Lack of CG (Corporate Governance):

Implementation of good corporate

governance in an organization is very essential since the number of fraud cases are increasing on yearly basis. After the scandal of Enron and WorldCom, various governments have been keen on encouraging the concept of corporate governance to protect the interests of the shareholders. Management fraud can cause a corporate to fail as they might be consumed by personal greed and would manipulate financial records to fool the shareholders about the actual financial position of the business. These fraudulent acts or mismanagement are due to lack of control in an organization (Corporate governance), and will lead to serious problems such as loss of revenue or decrease in corporate efficiency. Considering the above causes of Corporate Failure, it can be concluded that although economic factors such as interest rates and inflation are unpredictable and impossible to control, an organization can still survive depending on other factors such as good corporate governance, maintaining skilled managers, and managing efficient working capital. Therefore corporate failure cannot be termed as tragic incident but rather it depends on the structure and management of the organization.

Q2) Following the huge scandals of WorldCom and Enron, the SEC (security exchange commission) came across another major scandals in 2002 as Xerox was accused of improperly classifying $6billion worth of revenue, which led to an overstatement of $2billion in earnings. At first when the SEC began investigation in April (2002), it was stated that only half the amount which is $3million formed part of manipulation. But after charging the producer of photocopier with a fine of $10 million and conducting further audit, it was revealed that the manipulation was being done over the past 5 years and amounted up to $6billion in revenue (World Socialist Web Site).

Mohammad Talha Awan

Corporate Finance

TP021713

Xerox is a multinational company which manufactures and sells a wide range of black-white and colored printers, photocopiers, digital production printing presses etc. Xerox established itself as the master of xerography machines, but the high profit margins from its copiers blinded the management from identifying the true potential of this technology, which the other companies capitalized. Xeroxs market share rapidly started fading by 1982, as companies such as Canon started out-performing them in copier sector (Daft, 2009). Around 1997 Xeroxs performance started improving drastically under the supervision of Chairman and CEO (Paul Allaire), who was elected in 1990. Share prices started increasing as well as profits, but these results were just illusionary as Xerox was using creative accounting practices to mislead the shareholders and potential investors into luring in more investment in the business. Along with CEO (Allaire), the top management was also involved in conducting fraudulent activities by manipulating accounts and profits, so that the gap could be closed between actual and budgeted amounts (Lowenstein, 2004). When the SEC began their investigation and filed a case against Xerox in New York, they found out 2 basic types of manipulation. The first one was not including part of revenue in the balance sheet and storing it, where it was released when they suffered losses or at time of crisis in order to boost incomes in a particular quarter. The second method was what accounted for most of the fraudulent earnings acceleration of income was achieved by stating short term equipment rentals as long term leases. According to the GAAP (Generally accepted accounting principles), the entire value of the long term lease can be recorded as revenue during the first year of agreement. As a result the company was able to create an illusion, showing that the financial position was substantially better than they really were (World Socialist Web Site). Xerox charged with allegations without denying agreed to paying $10million penalty which is the largest fine SEC has imposed for an accounting fraud. The interesting part in this case was that KPMG, the audit company responsible for auditing Xeroxs financial statements was working for the firm over 30 years, which is illegal and does not satisfy the financial reporting standards. Not only did KPMG work with Xerox that exceeded a period of 3 years, but they were also able to form a relationship with the company, where along with top management of Xerox they manipulated data and did not report any fraudulent activities. (The Guardian)

Mohammad Talha Awan

Corporate Finance

TP021713

In 2005 the SEC announced that KPMG agreed to pay $22.5million for its connection with Xerox in conducting fraud and misstating financial statements from 1997-2000. (U.S Securities and Exchange Commission) The reason for Xeroxs failure might be seen as a scandal which resulted due to manipulation of accounting data and wrongly overstating its assets, but in actual the cause of its failure could be seen long back where Xerox developed innovative techs during the digital age but failed to capitalize them. Not only were they not able to capitalize but their market share for copiers also started drastically falling as Canon and Ricoh were able to sell copiers at a price that cost Xerox to produce it. According to (Daft, 2009), while Xerox was sluggish along selling copy machines, younger and potential companies were developing PARC technologies into incredible money-making goods and services Xerox was once well known for its quality and dedicated employees, with a corporate structure that influenced and emphasized on fairness, loyalty and employee participation. This motivational structure was offset by the top management, whose poor decision making cost the company its market share. The compensation paid to managers was directly related to their ability of achieving company targets, which led them to manipulate records in order to close the gap between actual and budgeted targets. To prevent the scandal the board could have simply presented the truth above all and acted ethically while financial reporting. Independent directors must have been appointed in order to analyze and guide the board through tough times and to ensure that duties are being performed properly as scheduled. According to (Lowenstein, 2004) Xerox was in desperate need to change its organizational structure as it influenced the managers to act according to their free will, doing unethical activities. The investigation at Xerox revealed that the organizational culture was driven up to the point where directors were hesitant in questioning the management and that was in their best interest. Due to the implementation of Sarbanes Oxley Act, Annie Mulcahy became the new CEO of Xerox and managed to stabilize the system and corporate structure by replacing the companys accounting team and closed down all loss making operations to reduce the debt. She communicated and implemented ethical values and outsourced most of its production so that the

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Corporate Finance

TP021713

company could focus mainly on innovation and betterment of its services. Mulcahy was keen not to cut down on research and development as the company needed to keep intact with its core technological innovation to gain back the market share. The change in leadership and compliance with good Corporate Governance was what Xerox needed which was effectively delivered by Mulcahy and as a result sales rose to more than $17 billion in 2007. (Daft, 2009) Other factors that could prevent Corporate Failure: Appointing non-executive directors plays an essential role in every organization as they are not entitled to work under the companys payroll and are not answerable to management except shareholders. They will monitor the role or duties of executive management and provide solution to problems; as they are not directly related to the company, they tend to be unbias when making decisions.

Focusing on research and development will allow an organization to generate new idea and innovative products that can outperform the competitors.

Presence of Audit committee will help prevent fraudulent activities such as misstating the financial reports and create an environment where discipline is followed and actions controlled.

It can be deducted that directors of a company play an important role in reducing corporate failure, providing that they abide to the rule. An Organizations success is based on its culture that is built on foundation of accountability and ethical values.

Mohammad Talha Awan

Corporate Finance

TP021713

References: Daft, R. L. (2009). Organization theory and design (10th Ed.). Mason, OH: South-Western Cengage Learning. Lowenstein, R. (2004). Origins of the crash: The great bubble and its undoing. New York: The Penguin Press. Young, G (1995), Company Liquidations, Interest Rates and Debt, The Manchester School. Hanan Luss (1982), Operations Research and Capacity Expansion Problems: A Survey, INFORMS. Jia Liu, Nick Wilson, (2002),"Corporate failure rates and the impact of the 1986 insolvency act: an econometric analysis", Managerial Finance.
The Economist, Technological change: The last Kodak moment? [ONLINE] Available at: http://www.economist.com/node/21542796. [Accessed 21 May 2012] BBC News - Kodak may face cash crisis if patent sales fail. [ONLINE] Available at: http://www.bbc.com/news/technology-15585158. [Accessed 21 May 2012] ProPublica, History of U.S. Govt Bailouts. [ONLINE] Available at: http://www.propublica.org/special/government-bailouts. [Accessed 21 May 2012] World Socialist Web Site, Xerox restates billions in revenue: yet another case of accounting fraud. [ONLINE] Available at: http://www.wsws.org/articles/2002/jul2002/xero-j01.shtml. [Accessed 21 May 2012] The Guardian, Xerox in $2bn scandal | Business. [ONLINE] Available at: http://www.guardian.co.uk/business/2002/jun/29/2?INTCMP=SRCH. [Accessed 21 May 2012] The Guardian, Xerox hit by fresh scandal. [ONLINE] Available at: http://www.guardian.co.uk/business/2002/jun/28/5?INTCMP=SRCH. [Accessed 21 May 2012] U.S. Securities and Exchange Commission, KPMG Pays $22 Million to Settle SEC Litigation Relating to Xerox Audits. [ONLINE] Available at: http://www.sec.gov/news/press/2005-59.htm. [Accessed 21 May 2012]