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Bootstrapping: “The art of learning to do more with less.”

Bootstrapping, the Purest form of Entrepreneurship

Bootstrapping…bootstrapping…bootstrapping, it can be said that the purest form of entrepreneurship is bootstrapping.  During the prelaunch phase of a company and at times when access to business capital is difficult, bootstrapping is the way to go. To compete with existing businesses entrepreneurial firms face two major disadvantages: the burden of smallness and the disadvantage of newness. The reality means that the majority of start-up businesses and small businesses lack available resources to effectively compete (Winborg, 2009). Access to capital is a major issue for entrepreneurs. InexperienceBootstrapping, The Purest form of Entrepreneurship of many entrepreneurs has made it extremely difficult to obtain debt and equity when lack of a track record, reputation, or collateral for loans exists.  Starting with personal savings, followed by funding through family and friends, have been the main sources of finance for the vast majority of entrepreneurs. Engaging in “bootstrapping activities” is the way to go in operating the business.

Do not be discouraged with the thought of bootstrapping. There exist many great American bootstrapping success stories. A snippet include (Sherman, 2005):

Apple Computer. In 1976, Steve Jobs and Steve Wozniak sold a Hewlett-Packard programmable calculator and a Volkswagen van to raise $1,350. Through bootstrapping, the partners built the first Apple I personal computer in Job’s garage.

Hewlett-Packard Co.  Starting with $538 in 1938, Hewlett-Packards first client was fellow bootstrapper Walt Disney, who required sound equipment for the production of Fantasia in 1940.

Microsoft Company. With is high school sidekick (Paul Allan) and dropping out of Harvard University, Bill Gates moved into an Albuquerque hotel room in 1975 to start the company and write the programming language for the first commercially available microcomputer.

Nike Inc. William Bowerman and Philip Knight in the early 1960s sold imported Japanese sneakers from the trunk of a station wagon with startup costs of $1,000.

Lillian Vernon Corp. With her brainstorming idea of selling monogrammed purses and belts through the mail, Lillian Vernon established a mail-order company in 1951.  As a recent bride and four months pregnant, Lillian needed to earn extra money to support her new family. Society in the 1950s dictated that she stay at home for the duration of the pregnancy. A home-based business was her answer.  Lillian took $2,000 that her husband and she received as wedding gifts and designed a bag and belt set targeted at high school girls.  She manufactured the set through her father’s leather goods company. Than placing a $495, one-six-of-a-page ad in the September 1951 issue of magazine Seventeen the company generated $32,000 in orders by the end of the year.

The use of bootstrapping requires imaginative and parsimonious strategies for marshaling and controlling necessary resources. Think of bootstrapping from two perspectives:

1.    Raising money without the use of banks or investors.
2.    Gaining access to resources without the need for money.

First, entrepreneurs can raise money through the use of personal credit cards, cross-subsidizing from other businesses owned or through employment, reducing the time for invoicing seeking advanced payments and loans from friends and family. Entrepreneurs can hire temporary employees, share premises and/or employees with other entities, share or borrow the use of equipment, and obtain emotional support, skills, and knowledge from friends and family.

A key question that should be asked, “Do I need it or want it?”  In the event the entrepreneur needs a resource, try to use a bootstrapping technique to get it. If the entrepreneur wants a resource, defer the purchase. Preservation of cash is important.  This means controlling cost too.

Based on the writing of Oswald Jones and Dilani Jayawarna (2010) some bootstrapping techniques include:

•    Customer related

  • Receive payments in advance
  • Obtain advance payments
  • Increase invoicing
  • Select customers that pay on time

•    Delay payment

  • Negotiate payment conditions
  • Barter for goods and services
  • Lease rather than purchase

•    Owner related

  • Change salary payment period from weekly to bi-monthly
  • Use personal credit cards
  • Cross-subsidize with other businesses or employment
  • Fund through friends and family

•    Joint use

  • Borrow equipment from other companies
  • Use temperate employees or contractors
  • Share equipment, premises and employees

Simply put, bootstrapping is “entrepreneurship in its purest form” (Salimath & Jone, 2011). Overcoming resource constraints enables business operations to continue with the aid of external financial resources. Bootstrapping transforms human capital into financial capital also known as sweat equity that converts into bankable equity. It is about creating value that includes the idea of “meeting the need for resources without depending on long-term financing (debt or equity).  Bootstrapping is the strategy of necessity for entrepreneurs and not of choice.

For entrepreneurs that want to learn how to raising money for their business, push to following button:

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Sources:

Jones, O., & Jayanwarna, D. (2010). Resourcing new businesses: social networks, bootstrapping and firm performance. Venture Capital , 12 (2), 127-157.
Salimath, M. S., & Jone, R. J. (2011). Scientific entrepreneurial management: bricolage, bootstrapping, and the quest for efficiencies (Vol. 17). Orange, CA: Journal of Business & Management.
Sherman, A. J. (2005). Raising Capital (Vol. 2). New York, NY: AMCOM, 2. 30-33.
Winborg, J. (2009). Use of financial bootstrapping in new businesses: A question of last resort? Venture Capital, 11 (1), 71-83.

 

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Audit Reports vs. the Zone of Insolvency: How Valuable is an Audit Report to Investors When It Does Not Have Predictive Value Of Possible Insolvency?

Many strongly believed that, in large part, the success of the U.S. capital markets is due to the quality of the financial statements and the disclosure standards used by U.S. public companies (Smith, 2012).  However, an “audit expectation gap” exists (Gray et al, 2011) between users of the financial statements and the auditors in providing informative disclosures during the financial crisis.

Audit Opinions without Predictive Value

Throughout the financial crisis of 2007 through 2009, many unqualified (clean) audit opinions were issued to entities without including the conservative informative going concern modification (GCM) paragraph prior to filing bankruptcy, or being placed into receivership in the case of a bank, although accounting promulgation requires notification by the auditors’ to users concerning of the material risk of insolvency.

Audited financial statements must provide users both predictive value and feedback value; two primary ingredients that supports the decision usefulness qualities of financial statements. When an auditor issues an unqualified (clean) opinion, however it is determines that the entity face material risk of insolvency within 12-months of the audit report issuance date, a GCM paragraph must be included in the opinion. Under Generally Accepted Auditing Standards—AU Section 341(PCAOB, 1989), states that when an auditor has substantial doubt whether an audit client’s likelihood of continuing as a going concern for one year from the date of the audit, a GCM opinion is required (Hahn, 2011).

Unfortunately, this has not been consistently followed, which lessens the predictive value of financial statements.  Andersen (2011) examined 565 companies from 2002-2004—the post Enron era and the passage of the Sarbanes-Oxley Act of 2002 compared to 2000-2001 noting that auditors provided more conservative opinions when the profession is in the news headlines, however such conservatism declined in the following periods. In a complimentary study, this trend remained the same through 2008 (Feldmann & Read, 2010).  Carson et al (2012) found that half of the bankrupt companies in the U.S. had not received a going-concern uncertainty opinion prior to filing bankruptcy.

The audit reports of financial institutions during the banking crisis provided little warning that the global financial system was at risk as to the financial statements’ narrowness of the attestation assurance (The House of Lords, 2011) and those institutions operating in the zone of insolvency. Little research both in the U.S. and abroad have been conducted on whether auditors are, or should be, reluctant to issue going concern reports to financial institutions as to the self fulfilling notion of precipitating the bank’s failure by issuing a going-concern opinion (Carson et al, 2012).

One belief is the danger that an auditor issuing a going concern may undermine the institution’s confidence that may trigger a “run on the bank” (Shin, 2009). Others may believe that that because of the implied assurance by the U.S. federal government mitigated the need for a going concern paragraph (Lastra, 2008). According to Hull (2010), regulators are concerned with the systemic risks associated with banks as “a default by one bank may create losses at other banks” (page 84), and the prospects of “moral hazard” (page 52) whereas banks are considered “to-big-to fail” requiring the government to bail out the institution to protect the financial system. Determining whether the assumption that a going concern opinion precipitates unanticipated consequences and how, if at all, moral hazard affect audit opinions will be studied. Unfortunately, accounting literature as to whether auditors were reluctant in issuing going-concern opinions to financial institutions during the financial crisis is limited (Carson et al., 2012).

The concept of Zone of Insolvency is often cited in director fiduciary duty litigation cases following bankruptcy filings (Kandestin, 2007) and derivative actions for breach of fiduciary duty (Rothman, 2012). The zone of insolvency is defined under the U.S. Bankruptcy Code by not operationally meeting one of three solvency tests (Stearn & Kandestin, 2011): (1) the Balance sheet Test, which determines insolvency when the sum of the entity’s adjusted liabilities is greater than the sum of the entity’s property, as determined by its fair value, and taking into account contingent assets and liabilities, (2) the Cash Flow Test under Section 548—Fraudulent Transfers, which requires taking a forward-look at an entity’s ability to pay its debts as they come due, which includes subjective knowledge that the company has insufficient liquidity to satisfy its obligations, and (3) the Unreasonably Small Capital Test, which is based on case-law that the entity is unable to generate sufficient profits to sustain operations and unable to raise credit.

The accounting profession is at a quandary. How will the profession follow the accounting quality concept of predictive value for shareholders to make informative decisions without lighting the “fire” to the “gasoline” when an entity is “swimming” in the zone of insolvency? The accounting rules making bodies must decide what is best for the shareholders, the capital markets, and the banking system.

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For  a free online accounting mini course “Cracking the Accounting Code” designed for entrepreneurs go to http://AccountingMiniCourse.com

References

Anderson, K.L. (Sep 2011). The Effect of Hindsight Bias On Auditors’ Confidence In Going-Concern Judgments. Journal of Business & Economics Research 9.(9), pp. 1-11.

Carson, E., Fargher, N., Geiger, M., Lennox, C., Raghunandan, K. & Willekens, M. (2012) Auditor Reporting on Going-Concern Uncertainty: A Research Synthesis. Retrieved April 7, 2011, from Social Science Research Center http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2000496

Feet, J. (2012, Mar.). Turnaround Topics. American Bankruptcy Institute Journal. 16, pp. 70-71.

Feldmann, D.A. & Read, W.J. (2010, May), Auditor Conservatism after Enron. Auditing 29.(1), pp. 267-278.

Gray, G.L., Turner, J.L, Coram, P.J. & Mock, T.J. (2011, Dec.). Perceptions and Misperceptions Regarding the Unqualified Auditor’s Report by Financial Statements Preparers, Users, and Auditors.  Accounting Horizons 25.(4), pp. 659-684.

Harn, W. (2011). The Going Concern Assumption: Its Journey into GAAP. The CPA Journal, pp. 26-31.

House of Lords (2011). Auditors: Market concentration and their role. Select committee of economic affairs. 2nd Report of session 2010-2011. London: The Stationery Office Limited.

Hull, J.C. (2010). Risk Management and Financial Institutions, Boston, MA: Prentice Hall, (2nd Ed.), p. 52 and p. 84

Kandestin, C.D. (2007). The Duty to Creditors in Near-Insolvency Firms: Eliminating the “Near-Insolvency” Distinction. Vanderbilt Law Review 60.(4), pp. 1235-1272.

PCAOB (1989). The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern. Retrieved on March 28, 2012 from the Public Company Accounting Oversight Board from http://pcaobus.org/Standards/Auditing/Pages/AU341.aspx

Rothman, S.J. (2012). Lessons from General Growth Properties: The Future of the Special Purpose Entity. Fordham Journal of Corporate & Financial Law17.(1), pp. 227-260.

Shin, H.S. (2009, Winter). Reflections of Northern Rock: The Bank Run That Heralded the Global Financial Crisis. The Journal of Economic Perspectives 23.(1), pp. 101-119

Stearn, R.J. & Kandestin, C.D. (2011). Delaware’s Solvency Test: What Is It and Does It Make Sense? A Comparison of Solvency Tests Under the Bankruptcy Code and Delaware Law. Delaware Journal of Corporate Law 36.(1), pp. 165-187.

 

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Chapter 11 Bankruptcy: Know Fresh-Start Accounting in the Restructuring Process

Fresh-Start Accounting

Not since the Great Depression has the number of business bankruptcies been so prevalent. Bankruptcy is a dramatic experience. It is one thing reading about the recent large bankruptcies of AMR Corp., parent of American Airlines, Kodak, and MF Global Holdings. But for the business leader, understanding and planning a Chapter 11 bankruptcy to save their own company is a whole different “ball of wax.” Securing the professional advice from an accounting firm, not an individual practitioner is advisable. This is because several areas of specialization will be needed. A key question that will be asked is what the company will look like after all is said and done. After all the activities of debt restructuring and redistributing the ownership of the new company, accountants will use fresh start accounting, if it qualifies, to report the new balance sheet of the company. Because many business leaders are new to the process and never heard of fresh start accounting, and although the bankruptcy process and fresh-starting accounting are complex, a simplistic explanation of fresh-start accounting is attempted. Key expertise will be needed from the following areas that will effect the challenging bankruptcy process:

  • Bankruptcy and insolvency
  • Business valuations
  • Taxation
  • Accounting
  • Restructuring

What is Fresh Start Accounting?

Fresh-start accounting means, “the financial statements of the emerged from bankruptcy entity obtains a fresh presentation of its financial position with newly valued assets after the liabilities have been cancelled and/or adjusted.” Under certain conditions, it is recognized that the new users of the financial statements will be better served by re-valuating the balance sheet on a “fair value” basis after the confirmation of the bankruptcy. Accountants are required to follow promulgations of ASC 852 (formerly SOP 90-7) in establishing an opening balance sheet of the successor company.

Fresh start accounting benefits the new shareholders by creating a “clean” balance sheet and favoring a step up in the value of the assets. Business leaders can eliminate losses of the bankrupt company, which enables the new company to come out of bankruptcy stronger. Use of fresh-start accounting is not a standalone process. It is an integral part of the Chapter 11 reorganization procedure designed to create a solvent, operationally viable entity. Certain debts of the bankrupt company are restructured and/or discharged. Then, if the new company qualifies for fresh start accounting treatment, the balance sheet of the new company is reset.

Complexity of Fresh-Start Accounting

The American Institute of Certified Public Accountants developed strict rules for restating and a timeline for implementing fresh start accounting reporting. Determining the fair value of both tangible and intangible assets, the start date for fresh-start reporting, and the best practices in “push down” fresh start adjustments to subsidiaries and underlying ledgers must be understood. Valuation is most critical to the overall process. This can be an enormous burden on the financial, operational and systems teams as well as management. Completing this process will enable management to move forward and focus on the operations of the newly reorganized business.

Many attorneys and accountants boast having bankruptcy experience, however regarding fresh-start reporting, the requirements are beyond most of them. Practitioners and firms with experience in fresh-start accounting, along with other advisers will be needed to support the individual asset valuations to the company’s external auditors. Know that stakes are high; the situation tends to be demanding; and delays will come with penalties, which requires expertise in this area.

Criteria to Qualify for Fresh-Start Accounting

To qualified for fresh-start accounting two requirements must be met:

  1. The new company’s reorganization value must be less than the total claims and the post-bankruptcy petition liability, and
  2. The holders of the pre-bankruptcy confirmation-voting shareholders will receive less than 50 percent of the voting shares of the new emerge company.

These requirements were put into place to prevent solvent companies from filings and to prevent companies to exploiting the bankruptcy code to writing up the carrying value of the assets.

Pro Forma Fresh Start Reporting

The creation of a pro forma balance sheet using fresh start accounting includes two primary considerations:

  1. The recording of the pro forma effects as it relates to:
    1. Extinguish of debt
    2. Cancellation of the pre-bankruptcy common shares
    3. Estimation of the allowed settlement claims
    4. Issuance of the new capital (equity and debt)
    5. Adjusting the balance sheet items to the “fair value” the encompasses:
      1. Writing up and down the values of receivable, inventories, and fixed assets
      2. Adjusting and recording to the balance sheet any reorganization intangible assets
      3. Recording the present value of all surviving post-bankruptcy liabilities
      4. Adjusting any pensions and other post-retirement benefits
      5. Eliminating pre-bankruptcy retained earnings or deficits
      6. Cancellation of debt and any operating loss carry-forwards

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For free online accounting mini course “http://AccountingMiniCourse.com” designed for entrepreneurs go to http://AccountingMiniCourse.com

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Sample of Fresh Start Reporting

The following provides an example of Fresh-Start in practice:

Fresh-Sart Accounting Reporting
 

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Financial Risks that Can Lead to the “Zone of Insolvency” – Where are the Going Concern Opinions?

The 2007 credit crisis and the economic downturn revealed high-embedded financial risks of many entities that eventually led to significant bankruptcies. The high-embedded financial risks affected many entities ability to continue as going concerns because of the lack of liquidity and the availability of credit. So financial institutions such as Bear Sterns, Lehman Brothers, American International Group, and Washington Mutual all failed. With the inclusion of Fannie Mae, Freddie Mac, Citigroup and Bank of America, the U.S. government had to shore up the capital of systemically important institutions (“too big to fail”) with direct investments due to the high-embedded risks in the balance sheets of these institutions (Bair, 2010). What happened to the going concern assumptions by Auditors prior to the crisis? Nothing! Should not the risks of the valuation assertions of an entity’s balance sheet be measured and access for going concern issues if such risk can lead the entity into the “zone of insolvency”?

Using the going concern assumption is a fundamental principle in the preparation of financial statements by auditors. The assessment of an audit client’s ability to operate, as a going concern, is the responsibility of the client’s management, coupled with the appropriate applicable financial disclosure framework. The auditors must consider the appropriateness of the use of the going concern assumptions. The International Standard of Audit (ISA) No. 570, “Going Concern,” institutes the relevant requirements and guidance as to auditor’s consideration of the going concern assumption in the attestation report. According to IAASB (2011), “Auditors must remain alert throughout the audit for evidence of events or conditions that may cast significant doubt on an entity’s ability to continue as a going concern. We cannot stress enough the importance of professional skepticism and judgment in evaluating financial statement disclosures and the implications for the auditor’s report when a material uncertainty exists relating to events or conditions that, individually or collectively, may cast doubt on the entity’s ability to continue as a going concern.”

Consideration of the need for a going concern emphasis paragraph is a difficult matter of judgment. With the huge losses incurred by shareholders from impacted institutions, it creates a need for a heightened risk concern disclosure that would enhance the financial usefulness of the financial statements, especially after another high embedded risk bankruptcy, MF Global Holding, became insolvent in the fourth quarter 2011. Ironically in December 2011 (IFA, 2011), Professor Arnold Schilder, Chairman of the International Auditing and Assurance Standards Board (IAASB) sent a membership alert regarding going concern reporting, “… an entity may be experiencing a decline in its financial health, or may have material uncertainties arising from direct or indirect exposures to sovereign debt of distressed countries. Auditors are therefore encouraged to review the Alert and, importantly, the relevant requirements in the ISAs.” This alert came out after the MF Global holdings filing with its exposure to sovereign debt holdings.

Statement of Auditing Standards (SAS) No. 59 “The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern” requires auditors to evaluate conditions or events discovered during audit fieldwork that raise the validity of entities’ going-concern assumptions. For those auditors who are not satisfied with managements’ going-concern mitigation plans they are required to issue modified (unqualified) opinions. Unfortunately, auditors are not required to design audit procedures specifically to identify questions about the validity of an entity’s going concern assumptions unless issues were discovered contradicting the representation (Venuti, 2009).

Unfortunately the “expectations gap”[1] of auditing standards concerning the level of what a user envisions from audited financial statements and the anticipated performance by auditors of the financial statements continues to widen. SAS No. 59 superseded SAS No. 34 because of the perceived ineffectiveness of the old codification as to providing an effective warning of impending bankruptcies (Ojo, 2007). However the efficacy of even SAS No. 34 is questioned as none of the top ten 2011 bankruptcies received a going concern paragraph.

The fear that a going concern opinion can hasten the demise of a distressed company, which can lessen the chances that the client can receive fresh capital, is at the center of a moral and ethical dilemma. Should the auditor increase the pain of the troubled company or provide an unbiased opinion to stakeholders so that they can make informed decisions?  This is an open question.

The Solution

According to IAS 570, a detailed going concern analysis need not be required for an entity that has a history of profitability and access to financial resources. However with the most recent economic environment (the credit crisis and economic downturn) the landscape has changed. The validity of longstanding approaches no longer hold and undermines previous assumptions. Current economic uncertainties, issues around liquidity and credit risk create new assumptions. Therefore, auditors must approach an entity’s assumptions with the current market environment in mind. The solution is for auditors to supplement prior years reviews with robust analysis that deals with the current economic conditions.

Critical to this assessment, IAS 1 requires management to take, “into account all available informa­tion about the future, which is at least, but is not limited to, twelve months from the balance sheet date.” IAS 570 requires auditors to consider the same timeframe. But if the auditors feel that managements review time period is less than twelve months, the auditor is required to ask management to increase its review period up to one year after the balance sheet date. If management is unwilling to comply, the auditor is required to consider modifying the audit report as to a limitation to the audit scope period.

The auditor is required to assess management’s knowledge of event or conditions and related enterprise risks beyond the period of assessment as the significant doubt on the enterprise’s ability to remain as a going concern.

References

Bair, S. (2010). Speeches and Testimony Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation on Systemically Important Institutions and the Issue of “Too Big to Fail” before the Financial Crisis Inquiry Commission, Room 538 Dirksen Senate Office Building.

IAASB (2009). Staff Audit Practice Alert- Audit Consideration in Respect of Going Concern in the Current Economic Environment. International Auditing and Assurance Standards Board.

IFAC (2011). Economic Conditions Continue to Challenge Preparers and Auditors Alike; Focus Must Include Going Concern Assumption and Adequacy of Disclosures. Retrieved on February 5, 2012 from http://www.ifac.org/news-events/2011-12/economic-conditions-continue-challenge-preparers-and-auditors-alike-focus-must-i

Ojo, M. (2007). Eliminating the audit expectations Gap: Reality of Myth? Retrieved on February 6, 2012 from http://mpra.ub.uni-muenchen.de/232/MPRA Paper No. 232, posted 07. November 2007 / 00:53

Vanuti, E.K. (2009). The Going-Concern Assumption Revised: Assessing a Company’s Future Viability. Retrieved on February 5, 2012 from http://www.nysscpa.org/cpajournal/2004/504/essentials/p40.htm



[1] The “expectations gap” is the difference between what users of financial statements, the general public perceives an attestation to be and what the auditor claims is expected of them in conducting an audit.

 

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What is a Corporate Restructuring or Turnaround?

First, there is no hard rule or definition as to what constitutes a corporate turnaround or a corporate restructuring. The generic term is a company or firm or business unit that exhibits financial performance that in the foreseeable future, unless short-term corrective action is not taken, may fail. Let us say:

  • Corporate restructuring is a tactic used in an attempt to correct a declining financial situation or climbing out of insolvency.

A corporate restructuring or turnaround may be simply defined as a company’s existence is threatened as it moves from economic performance to decline or zone of insolvency. The decline or bankruptcy may take several years, however when extreme events take place, a shorter time frame may put the enterprise into peril.

In some circumstances the term may mean a financial restructuring by reorganizing and/or cleaning up the balance sheet using financing methods that changes the capital structure of the organization.

Surprisingly, a turnaround can be a situation where a company may exist without having a cash crisis. When measuring a company’s performance, as measured by return on capital employed, the turnaround candidate can be an organization that is performing below what is expected for a business in which it is engaged.  It is about recognizing that a company often displays symptoms of failure prior to any crisis beginning. It could be businesses with underutilized assets and poor management. Many companies have survived or stagnated for years in spite of ineffective management. If such stagnation does not change, the crisis situation will succeed because management has not taken the necessary steps to turn the situation.

Crisis situations are often in stable and mature industries and sometime with competitive advantages. Such companies are also firms that are closely held or family controlled. To avoid placing the enterprise in a crisis, it is about early instituting turnaround and restructuring strategies to avoid company trauma. Too often even a growth-oriented company that has grown too fast and is very profitable may experience a severe cash crisis. Alternatively, a company can report a loss in one year does not constitute a turnaround issue. Such a loss may be expected in executing a competitive strategy. However, a loss in one operating unit may place the whole company into a death spiral.

A company can become insolvent if management takes no corrective actions. Even external events may postpone the inevitability on insolvency, but it will not avert it. The outcome of management’s corrective action either will be successful or unsuccessful in which case the insolvency will lead the company into bankruptcy.

Generally, a corporation’s life cycle can be looked at as a humped curve of four stages. From (stage-1) start-up the company grows to a point of (stage-2) maturity then begins to (stage-3) decline until it reaches (stage-4) the zone of insolvency“. Not all businesses follow such life-cycle curve, since organizations can be reborn or transformed anytime. Some companies, in fact, institute competitive strategies that change the shape of the curve to an S-Curve to progression. The corporate turnarounds logically addresses two issues:

  • The measurement of a turnaround performance, and
  • The characterization of a turnaround cycle, which is the decline phase followed by a recovery phase.

Defining turnarounds on the basis of profitability (return of assets or return on investment) alone is problematic. The accrual quality of the turnaround company’s accounting may be low and result in manipulated earnings management. Companies gradually lose competitiveness, but this is often not reflected in deterioration in profitability. Rather, earnings flat line then plummet or the time lag between competitiveness and earnings improvement exist. With management’s “window dressing” a lag in indices showing a distressed state, the signals of impending trouble can be masked.

Simply put, the framework of the turnaround is to avoid the company moving into the “zone of insolvency” and then ultimately into bankruptcy. Taking proactive strategies to control the business is the objective.

Related Posts:

Corporate Strategies—Avoiding the Flawed Strategy

Strategy: Good Strategy or Bad Strategy? 5 Lessons to Follow

 

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Audit Risk: Surprise Bankruptcy Despite Financial Risks

The problem is the lack of issuing a going-concern uncertainty opinion prior to bankruptcy announcement to offset the “surprise” of signs of financial trouble. Generally publicly accessible negative information that acts as a signal of financial trouble mitigates the negative announcement effect of subsequent bankruptcy filings. Unfortunately, as in the case of the 2011 top 10 U.S. bankruptcies none of the audit reports accompanied a going concern opinion prior to filing. In particularly with public scrutiny of the audit profession in the light of high-profiled, alleged audit failures such as, Enron, Lehman Brothers, and now Olympus (Nakamoto, 2011), the problem questions the value-add of the audit function to society at large. Some would say, “the informational content of the going-concern opinion is not homogenous across the industry prior to bankruptcy filing.” Coupled with the fact that non-obvious distress signs of financial trouble prior to a filing (e.g., as firms being in default or showing deviated accounting ratios) those companies with embedded risks received clean opinions.

In a paper by Sengupta and Shum (2007), the researchers investigated whether auditors’ decisions can be explained by accrual quality[i]. Based on prior research, it was determined that a firm with prior accrual quality has associated higher fees, a heighten likelihood of receipt of a going concern opinion and greater chance of an auditor turnover based on using alternative measures of accrual quality. The study found that accrual quality is a proxy for a company’s information risk that is a basis for explaining decisions by auditors. Coupled with the fact that earnings management was found in the audits. accrual quality measures have also been suggested as a means of identifying earnings management using discretionary accrual and providing conflicting results. Evidence was gathered of the likelihood of earnings management affects auditors’ decisions adversely.

Since the collapse of Enron, auditors are now likely to issue a modified going-concern paragraph opinion according to a study by (Carey, Kortun, & Moroney, 2008). In the study, it found that comparing company failure rates subsequent to receiving a going concern modified audit opinion (type-1 error[ii] rate) in the pre- and post-2001 periods, the paper found a consistent type-1 error rate notwithstanding auditors issuing a greater number of going concern modified opinions. The outcomes provided an indication that auditors maintaining going concern reporting accuracy. Additionally, firms with large offices provide higher audit quality than small offices and there is a correlation to greater in-house experience due to more expertise in managing the audit (Yu, 2007).

In 2004 Sarbanes-Oxley Section-104 required PCAOB auditing firms to ‘‘to assess compliance with the Act, the rules of the Board, the rules of the Securities and Exchange Commission, and professional standards, in connection with the firm’s performance of audits, issuance of audit reports, and related matters involving issuers.’’ Gramling, Krishnan, and Zhang (2011) conducted a study as to whether following Section 104 identified audit deficiencies associated with a change in triennially inspected audit firms’ going-concern reporting decisions of financially distressed companies. Reviewing PCAOB inspection reports, the study indicated no audit deficiencies and provided only limited evidence of a change in the likelihood of issuing a going concern opinion.

The solution, short of promulgation by the accounting rules bodies, is drilling deeper into the value-at risk[iii] composition of the assets and liabilities of those companies’ balance sheets. Based on various potential scenarios i.e., a market decline of securities and the mark to market value of assets relative to liabilities, a going concern opinion should be issued and information provided if such risk appear plausible.  Such solution would have warmed stakeholders of Lehman Brothers, Beard Stearns, and AIG that the composition of these companies’ value at-risk financial positions posed high levels of risk, if the market went against them. The 2011 bankruptcy of MF Global may not have happened if management knew that the audit report would have informed shareholders of the company’s increased risk strategy to gain higher earnings. Externally, MF Global looked fine, however its composition of Greek sovereign debt relative to liabilities, posed high risk. When news of a possible Greek debt default, MF Global could not meet its cash collateral calls by its counterparties forcing it into bankruptcy.

References

Carey, P, J., Kortum, S. & Moroney, R. A., (2008). Auditors’ Going Concern Modified Opinions Post 2001: Increased Conservatism or Improved Accuracy. Retrieved on January 7, 2012 from http://ssrn.com/abstract=1309943

Gramling, A.A., Krishnan, J., & Zhang, Y. (2011).  Are PCAOB-Identified Audit Deficiencies Associated with Change in Reporting Decisions of Triennially Inspected Audit Firms? American Accounting Association, Pg 57-79

Nakamoto, M. (2011). Olympus Disclosure Shakes Auditors’ Reputations, Financial Times. Retrieved on January 11, 2012 from http://www.ft.com/intl/cms/s/0/b8aaffe0-0b8c-11e1-9861-00144feabdc0.html#axzz1jeGdZ5TH

Sengupta, P. & Shum, M. (2007). Can Accrual Quality Explain Auditors’ Decision Making? The Impact of Accrual Quality on Audit Fees, Going Concern Opinions and Auditor Change. Abstract retrieved on January 12, 2012 from http://ssrn.com/abstract=1178282

Yu, M.D. (2007). The Effect of Big Four Office Size on Audit Quality. Dissertation Abstracts International,  (UMI Number 3322756)


[i] Accruals quality measures the quality of the reported earnings and expenses.

[ii] Type I Error connotes a wrong decision that is made when a sample reject a true null hypothesis (H0) or called a false positive.

[iii] Value-at Risk is the loss in value that will not exceed some specified confidence level.

 

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Should Auditors Provide Going Concern Opinions for Firms with High Risk Balance Sheets?

With the formation of Sarbanes-Oxley and the Public Company Accounting Oversight Board (PCAOB) to monitor the activities of accounting firms audit of publicly traded companies, and despite Lehman Brothers, Bear Stearns and AIG, time has shown us that despite additional save guards it has not lessen the “surprise” of companies that received clean audit opinions filed for bankruptcy.  With no apparent signs of high risk, i.e., no mention of defaults or showing abnormal financial ratios, should those companies that have high level of embedded financial risks prompt auditors to issue a going concern opinion before the bankruptcy surprise? Hmmm…think of MF Global. This is a question that must be asked.

Generally publicly accessible negative information that acts as a signal of financial trouble mitigates the negative announcement effect of subsequent bankruptcy filings. But unfortunately, as in the case of the 2011 top 10 U.S. bankruptcies, none of the audit reports accompanied a going concern opinion prior to filing. In particularly with public scrutiny of the audit profession in the light of high-profiled, alleged audit failures such as Lehman Brothers, and now Olympus, the problem questions the value-add of the audit function to society at large. Some would say, “the informational content of the going-concern opinion is not homogenous across the industry prior to bankruptcy filing.” Coupled with the fact that non-obvious distress signs of financial trouble prior to a filing (e.g., as firms being in default or showing deviated accounting ratios) overall those companies with high-embedded risks received clean opinions.

Exhibit I

2011 Corporate Bankruptcy Ranking as of December 1st, 2011

COMPANY/BANKRUPTCY DATE

ASSETS

MF Global Holdings, Oct. 31

$40.541 billion

AMR Corp, Nov. 29

$25.088 billion

Dynegy Holdings, Nov. 7

$9.949 billion

PMI Group, Nov. 23

$4.219 billion

NewPage Corp, Sept. 7

$3.512 billion

Integra Bank Corp, July 30

$2.421 billion

General Maritime Corp, Nov. 17

$1.782 billion

Borders Group, Feb. 16

$1.425 billion

TerreStar Corp, Feb. 16

$1.376 billion

Seahawk Drilling, Feb. 11

$625 million

Source: BankruptcyData.com

In a paper by Sengupta and Shum (2007), the researchers investigated whether auditors’ decisions can be explained by accruals quality[1]. Based on prior research, it was determined that a firm with prior accruals quality has associated higher fees, a heighten likelihood of receipt of a going concern opinion and greater chance of an auditor turnover based on using alternative measures of accruals quality. The study found that accruals quality is a proxy for a company’s information risk that is a basis for explaining decisions by auditors. Coupled with the fact that earnings management was found in the audits. Accruals quality measures have also been suggested as a means of identifying earnings management using discretionary accruals and providing conflicting results. Evidence was gathered of the likelihood of earnings management affects auditors’ decisions adversely.

Since the collapse of Enron, auditors are now likely to issue a modified going-concern paragraph opinion according to a study by Carey, Kortun, & Moroney, 2008. In the study, it found that comparing company failure rates subsequent to receiving a going concern modified audit opinion (type-1 error[2] rate) in the pre- and post-2001 periods, the paper found a consistent type-1 error rate notwithstanding auditors issuing a greater number of going concern modified opinions. The outcomes provided an indication that auditors maintaining going concern reporting accuracy. Additionally, firms with large offices provide higher audit quality than small offices and there is a correlation to greater in-house experience due to more expertise in managing the audit (Yu, 2007).

In 2004 Sarbanes-Oxley Section-104 required PCAOB auditing firms to ‘‘to assess compliance with the Act, the rules of the Board, the rules of the Securities and Exchange Commission, and professional standards, in connection with the firm’s performance of audits, issuance of audit reports, and related matters involving issuers.’’ Gramling, Krishnan, and Zhang (2011) conducted a study as to whether following Section 104 identified audit deficiencies associated with a change in triennially inspected audit firms’ going-concern reporting decisions of financially distressed companies. Reviewing PCAOB inspection reports, the study indicated no audit deficiencies and provided only limited evidence of a change in the likelihood of issuing a going concern opinion.

So what is the possible solution? One possible solution, short of promulgation by the accounting rules bodies, may be to drill deeper into the value-at risk[3] composition of the assets and liabilities of those companies’ balance sheets. Based on various potential scenarios i.e., a market decline of securities and the mark to market value of assets relative to liabilities, a going concern opinion should be issued and information provided if such risk appear plausible.  Such solution would have warmed stakeholders of Lehman Brothers, Beard Stearns, and AIG that the composition of these companies’ value at-risk financial positions posed high levels of risk, if the market went against them. The 2011 bankruptcy of MF Global may not have happened if management knew that the audit report would have informed shareholders of the company’s increased risk strategy to gain higher earnings. Externally, MF Global looked fine, however its composition of Greek sovereign debt relative to liabilities posed high risk. When news of a possible Greek debt default, MF Global could not meet its cash collateral calls by its counterparties forcing it into bankruptcy.

References

Carey, P, J., Kortum, S. & Moroney, R. A., (2008). Auditors’ Going Concern Modified Opinions Post 2001: Increased Conservatism or Improved Accuracy. Retrieved on January 7, 2012 from http://ssrn.com/abstract=1309943

Gramling, A.A., Krishnan, J., & Zhang, Y. (2011).  Are PCAOB-Identified Audit Deficiencies Associated with Change in Reporting Decisions of Triennially Inspected Audit Firms? American Accounting Association, Pg 57-79

Nakamoto, M. (2011). Olympus Disclosure Shakes Auditors’ Reputations, Financial Times. Retrieved on January 11, 2012 from http://www.ft.com/intl/cms/s/0/b8aaffe0-0b8c-11e1-9861-00144feabdc0.html#axzz1jeGdZ5TH

Sengupta, P. & Shum, M. (2007). Can Accruals Quality Explain Auditors’ Decision Making? The Impact of Accruals Quality on Audit Fees, Going Concern Opinions and Auditor Change. Abstract retrieved on January 12, 2012 from http://ssrn.com/abstract=1178282

Yu, M.D. (2007). The Effect of Big Four Office Size on Audit Quality. Dissertation Abstracts International,  (UMI Number 3322756)

Footnotes



[1] Accruals quality measures the quality of the reported earnings and expenses.

[2] Type I Error connotes a wrong decision that is made when a sample reject a true null hypothesis (H0) or called a false positive.

[3] Value-at Risk is the loss in value that will not exceed some specified confidence level.

 

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