Bakruptcy predictions: Analysis
Nowadays, numerous companies are involved in different business activities and credit transactions. Managers of all levels, shareholders, investors and financial institutions pay much attention to bankruptcy predictions to make relevant business decisions and avoid financial losses. Since 1960, analytics make predictions on the grounds of financial ratios. This approach has numerous issues and deficiencies the current work will discuss. The precise analysis and understanding of weak sides of using financial statement analysis as the major instrument to predict the probability of bankruptcy enables one to understand why companies need new approach for making these predictions.
Necessity of Making Relevant Predictions Concerning Companys Bankruptcy
The bankruptcy prediction is extremely important for managers of all levels to make effective and efficient business decisions. This information is also relevant for investors because they need to assess risks in order to avoid significant losses. Financial institutions are also highly interested in relevant bankruptcy predictions of companies because these institutions need to assess and judge the future of a firm before extending loans (Mokjopadhyay, Tiwari & Karmaker 2012, 71). The erroneous credit decisions can lead to loss of interests of principals and enormous credit risks (Mokjopadhyay, Tiwari & Karmaker 2012). Inability to predict financial crisis leads to failure to use existing financial resources and investment opportunities properly for the mitigation of negative impact of this crisis on companys performance and financial positions of investors (Ahmadi, Amjadian, & Pardegi 2012). These statements form the understanding that correct bankruptcy predictions are extremely important for companies, stakeholders, and financial institutions.
The Application of Financial Statement as an Approach for Bankruptcy Prediction
Since the middle of 1960, the predictions concerning possibility of companies bankruptcies were made by using financial statements ratio (Wahlen, Baginskim & Bradshaw 2015). The examples of the following financial indicators were taken into consideration: net income, depreciation, total liabilities, total assets, total debts, net working capital, current assets, current liabilities, etc. (Wahlen, Baginskim & Bradshaw 2015). These indicators provide understanding of the past performance of the company. This approach is considered to be rather convenient for managers and investors in setting performance targets and planning templates (Sultan 2014).
Issues of the Current Application of Financial Statement as an Approach for Bankruptcy Prediction
Application of financial statement has the following issues: missing data, deterioration, using of various accounting options for same transactions, misreporting, enormous effect of changeable financial policies and companys financial managemment, inadequate disclosure, performance of adjustments, and dependence of interpretation on professional abilities of an analyst. The variety and significance of these issues make it evident that the companies should change their approach in determination of default possibilities.
Accountants of medium- and small-size companies can be influenced by the problem of missing data, i.e. the absence of necessary financial information that is necessary for making relevant predictions (Zhou & Lai 2015). This means that the information available in financial statements is incomplete for making bankruptcy predictions, which happens because of inefficiency of financial management system.
Deterioration of Financial Information
Financial statements provide information about the past financial performance of the company (Sultan 2014). They are usually prepared for the financial year or quarters and become available for the public some months later. Financial ratios can provide incorrect picture of the future because the past financial information not always indicates the further companys performance. This is why the information for financial statement cannot effectively depict the current and future companys performance and determine the possibility of bankruptcy.
Various Accounting Options for Same Transactions
Today, there are various accounting options for representation of same transactions. In fact, there is no objective income (Pascan 2010, p. 186). The grounded analysis of past and current financial performance and development of relevant predictions concerning the possibility of bankruptcy can be made only after precise studying of accounting policies of the company (Pascan 2010). However, the information presented to the public rarely provides the sufficient understanding of this policy.
Misreporting of Financial Information
The relevance of the information presented in the financial statements is questioned because of the issue of misreporting of financial data. This issue is based on one of the main principles of financial accounting that is matching (Kurt 2011). This principle undermines the idea that fixed manufacturing costs are incurred as part of the process of generating or productivity (Kurt 2011, 2). This means that direct and indirect costs of inventory production are matched against financial revenues, which are obtained from the sale of companys inventory (Kurt 2011). In other words, accountants may knowingly raise the production of inventory in the disproportion of the anticipated growth of its sales. They will remove fixed cost on the balance sheet where they would be marked as unsold inventory (Kurt 2011). The example of such fixed costs is depreciation. The additional attention should be paid to varying nature of changes in profits. They may be based on changes in amount of sold commodities or on changes in per unit cost. These discrepancies may have the enormous impact on the assessment of financial ratios and predicting further companys performance.
The accuracy of bakruptcy predictions based on financial statements can be lowered due to inadequate disclosure of financial data. For example, in Australia, some companies do not publish funds statements, and try to provide insufficient information about sales and costs, and diversify the information about vairious production lines (Davis 1976). During the analysis of financial ratios and predicting companys performance in the future, not all the finacial particularities are taken into account.
The Influence of Changeable Financial Policies
One more barrier to relevant prediction of bankruptcy is represented by changeable accounting policies and discretions provided by various regulatory institutions. For example, enormous discretions in accountability giving management the ability to hide or omit key information are provided by GAAP reporting rules (Kurt 2011, 3). This means the data in financial statements does not fully reflect the real companys performance. This is why predictions about possible bankruptcy made on the grounds of this data will be erroneous.
Effect of Companys Financial Control
Predictions concerning companys bankrupcy based on the data presented in financial statement may be also significantly affected by the internal control over financial reporting realized in the company. For example, inventory turnover ratios for the companies that have insufficient inventory-related materials is rather low (Feng et al. 2015). Such companies report inventory impairments more frequently than the companies that have more efficient inventory control. Companies that remediate material insufficiency connected with tracking inventory usually show higher inventory turnover rates, raised sales, increased operating cash flow and significantly higher gross profit. These statements are considered to be important for the discussion of the chosen topic, because inventory transactions are reflected in balances presented in financial statements (Feng et al. 2015). Thus, ineffective internal control lowers the reliability of analysis of financial statements and predictions made on the grounds of these statements.
Necessity of Adjustments
Companies need new approach to bankruptcy prediction because the making such predictions by using financial ratios requres application of numerous adjustments. These adjustment are represented by the presence of nonrecurring and nonoperating items in long-term analysis and their absence in short-term analysis; necessity to make restatement of depreciation, inventory valuatio and fixed assets on common basis during changing of an accounting technique; necessity to change the accounting treatment of such items as lease premiums, bank overdraft, intangible assets, contingent liabilities, and expenditures of a capital nature (Davis 1976).
The ratios should be considered in some particular context. Their calculation is relative to their interpretation (Davis 1976, 15). Predictions depend greatly on the professional knowledge, skills, and abilities of anslysts.
To summaize, the current work provides the general discussion of the necessity of relevant bankruptcy predictions for managers, stakeholders and financial institutios. The major approach to this predictions was defined. Its issues are the following: missing data, deterioration, application of various accounting options for same transactions, misreporting of financial data, significant influence of changeable financial policies and poor financial control, inadequate disclosure, necessity of adjustments, and dependence of interpretation on professional abilities of analysts. The discussion of these issues explains why the approach based on the analysis of companies financial statements is imperfect. Companies should apply new approaches for the determination of the possibility of their default.
Order a College essay paper from a professional academic writer!