Corporate Governance's Role in Mitigating Bankruptcy Risk: A Review

This literature review critically examines the role of corporate governance in reducing bankruptcy risk, emphasizing that financial statements alone are insufficient for investment decisions due to potential manipulations. It highlights the importance of evaluating key financial ratios like gross profit margin and debt-equity ratio, alongside critical financial indicators such as persistent negative cash flow and declining market share. The review discusses the Enron and HIH scandals, underscoring the need for auditor independence and ethical financial reporting. Furthermore, it identifies both financial (e.g., profit margins, cash flow) and non-financial indicators (e.g., employee satisfaction, customer loyalty) as crucial in assessing a company's financial performance and predicting bankruptcy risk. The paper concludes that strong corporate governance and comprehensive financial analysis are essential for mitigating bankruptcy risk and ensuring stakeholder confidence; students can find similar solved assignments and past papers on Desklib.

Running head: ROLE OF CORPORATE GOVERNANCE IN REDUCING THE
BANKRUPTCY RISK
Role of Corporate Governance in Reducing the Bankruptcy Risk
Name of Student:
Name of the University:
Author Note

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Role of Corporate Governance in Reducing the Bankruptcy Risk
Executive Summary
The aim of this literature review is understand the role of corporate governance in reducing
the bankruptcy risk. The paper explain that financial statement should not be relied solely by
the users in making their investment decision this is because some time financial statement
are window dress to attract more investment or with a aim to manipulate the share price of
the company. In this regards the users of the financial statement should evaluate the certain
key financial ratio like gross profit margin, debt equity ratio inventory turnover ratio. Certain
key financial indicator like persistent negative cash flow, negative profit, declining of the
market share of the company, loss key managerial personal. All these help the users in
evaluating the financial position of the company and making investment decision.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
Table of Contents
Introduction................................................................................................................................3
Discussion: financial statement analysis and the bankruptcy....................................................4
Enron Bankruptcy and Scandal..............................................................................................4
Bankruptcy of HIH.................................................................................................................6
Role of financial and Non- financial indicator of the firm in assessing financial performance 7
Financial indicator..................................................................................................................7
Non-financial indicators.........................................................................................................8
Conclusion..................................................................................................................................9
References................................................................................................................................11

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Role of Corporate Governance in Reducing the Bankruptcy Risk
Introduction
The purpose of this literature review is to critically examine the role of the corporate
governance in reducing the bankruptcy risk (Penman 2007). Corporate governance refers to
the method and approach in which a company is govern. It refers to the procedures by which
company are directed and managed. It means carrying on the business as per the direction of
the stakeholder (Mitchell et al. 2012).
Corporate governance confirms transparency which warrants strong and balanced
economic development. Corporate governance results in the interaction between the various
participants like shareholder, board of directors, company management (Tricker 2015).
Corporate government clearly distinguish between the owners and the manager. An
organization using the corporate governance ensures corporate success and economic growth.
Company following the corporate governance result in the positive impact on the share price
(McCahery, Sautner and Starks 2016).
Bankruptcy risk known as the probability that the company is incapable to meet its
debt liability (Altman, 1968). It is the possibility of the firm becoming bankrupt due to its
incompetence to service its debt. Bankruptcy risk of a business is known as the insolvency
risk.
Any business organization is at the verse of the bankruptcy due to only few factors
like liquidity shortage in the business because of the inadequate sales and high operating
expenses. It is very difficult for any business to come out of the insolvency. The proper
strategic planning can help the business in the overcoming the financial weakness position
(Claessens and Yurtoglu 2013).

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Role of Corporate Governance in Reducing the Bankruptcy Risk
Discussion: financial statement analysis and the bankruptcy.
Financial statement analysis has been a major tool for a long period to predict the
probability of the risk of bankruptcy, but with the emergence of the certain corporate scandal
has collapses the faith of the general masses on the presentation of the financial statement.
The famous corporate scandal which is popularly known as the Enron Scandal has collapses
the faith of the stakeholder on the analysis of the financial statement (Karl Greb 2013).
Enron Bankruptcy and Scandal
Enron was the American business company which was founded in 1985, whose main
business was in the energy, commodities and service industry (Markham 2015). The
company shown a tremendous growth between the year 1995 and 2000. Where the company
earning significantly grown from the 9 billion to 100 billion USD I, in the year 2001, it was
revealed that it was revealed that the company uses accounting manipulation in its books of
accounts to raise the share price in order to deceive the general public who have purchased
their share (Soltani 2014).
Enron financial statement were appearing confusing to the public because of the Company
had conceal the material misstatement in order to do unethical business practices and
misrepresent the actual earning of the company to indicate positive performance (Giannetti
and Wang 2016.).
Arthur Andersen which was one of the five largest audit and accounting firm in the world
after theBig4 Accounting firm (Agarwal, cooper 2017). The firm was the auditor of the
company and firm play a critical role in the concealing the manipulation done in the books of
account by the management of the Enron. The Enron scandal is considered as one of the
biggest audit failure in the accounting history (Ailon, G., 2015).

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Role of Corporate Governance in Reducing the Bankruptcy Risk
From accounting and auditing perspective Enron scandal was the result of the
significant accounting manipulation done by the organization, the two broad reason for Enron
bankruptcy can be given as follows (Mahama 2015)
Lack of truthfulness:
The management of the company in order to stay ahead of their competition from
their rival organization, had misused the accounting practices to deceive the financial
statement users.
Auditor conflict of interest:
Arthur Andersen was the auditor as well consultant of Enron, auditor lack of
independence and self-interest in the client business was the reason of the audit failure and
fraud happening.
Enron bankruptcy was the major accounting failure in the history.
Lack of truthfulness:
The management of the company in order to stay ahead of their competition from
their rival organization, had misused the accounting practices to deceive the financial
statement users.
Auditor conflict of interest:
Arthur Andersen was the auditor as well consultant of Enron, auditor lack of
independence and self-interest in the client business was the reason of the audit failure and
fraud happening (Altman, E.I., 1968).
From Enron scandal, following lesson can be drawn which can be useful to the auditor while
auditing the financial statement of an enterprise.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
An auditor while performing his duty should never compromise with his position i.e.
an auditor should be honest , sincere ,and must follow integrity while discharging his duty,
the auditor should be fair enough that is he should not allow the bias or any prejudice to
overlap its objectivity
Bankruptcy of HIH
The bankruptcy of HIH is well known to be the biggest company failure in Australia's
history. The liquidators of the company has accounted the total loss AUD 503 billion dollar
(Idowu Capaldi and Gupta, 2013).
There was a time when HIH was known to be the Australia largest insurance firms,
but the company in the later years after meeting its debt with the sale of the assets and after
the settlement of the claim the company is near to get insolvent. The director of the HIH
Rodney alder was sentenced to the jail 4.5 years of the prison on the 14 April 2005, the
directors of the company was charged on account of the manipulation of the company stock
market price in order to make profit with the price movement.
The director of the company was held responsible for the disseminating false
information to the public, the director of the company Rodney Alder try to lure the investors
to purchase the share of the company by making false and misleading statement in the news
report (Griffiths 2016).
From the scandal of Enron and HIH, following lesson can be drawn which can be useful to
the auditor while auditing the financial statement of an enterprise.
1. An auditor while performing his duty should never compromise with his position i.e.
an auditor should be honest , sincere ,and must follow integrity while discharging his

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Role of Corporate Governance in Reducing the Bankruptcy Risk
duty, the auditor should be fair enough that is he should not allow the bias or any
prejudice to overlap its objectivity(Rahmina and Agoes 2014).
2. Confidential: the auditor should always respect the confidentiality of any material
information which they have acquired during the audit of the business of the client
and an auditor should not disclose any such material information to any one without
the prior consent of the client (Rizvi,Razaque and cover 2016).
3. The auditor must ensure that the client has complied with all the applicable law and
regulation.
4. The auditor must check that all the commitment which are made by the client and the
contingencies have been disclosed properly.
5. The auditor must ensure that the management had not omitted any material
information while preparing the financial statement of the organization.
6. If any threat is found in financial statement of an enterprise while reporting, auditor
must ensure that appropriate action has been taken to eliminate such threat like
reporting such matter to the concerned authority or withdrawing himself from the
audit by giving proper reason to the concerned authority for his discontinuance.
7. The auditor must perform professional skepticism while performing the audit of the
account of an entity.
8. The auditor should Scrutinize the amount of loan from the books of accounts which
the company has obtained from the financial institution by paying a close look over
the bank details, examining the memorandum of association and article of association
and also evaluate whether such loan is taken by the company is within the permissible
limit as per the provision of the company act.
9. Auditor should verify the existence, ownership title, valuation of fixed assets and
should determine the nature and extent of liability.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
10. Auditor before performing audit should acquire the knowledge of client business in
order to discharge its duty in an efficient and effective manner.
11. Auditor should determine that that internal control within an organization operating
effectively such that audit risk can be reduced to an acceptable level.
From the analysis of the scandal mentioned above, it can be summarized that
shareholder of the company are the real business owner who provide the money to the
management of the company to do business, it is the responsibility of the company
management and the auditor that each and every rupee invested by the shareholder are
utilized by the business owner for the right purpose.
Role of financial and Non- financial indicator of the firm in assessing
financial performance
Financial indicator
These are known as the key performance financial indicator which are the quantifiable
parameter which a company uses to monitor its performance overtime (Tinoco and Wilson
2013). These parameter are used to evaluate the company progress in securing the
premeditated and the operational goals. These financial indicator also help the company in
identifying and comparing the performance the rival firm. Key performance indicator or the
financial indicators are also referred as the success indicator, it vary from the company to
company. Some of the important key performance indicator which a company must monitor
are as follows
 Gross profit margin: This ratio is important factor in evaluating the prices of the
product. This ratio says that price of the product should be properly valued such that it
covers the operating expenses.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
 Net profit margin: this ratio explain that the what percentage of the sale is your net
earnings, net profit formulae = net profit / total revenue
 Account receivable turnover the ratio is an important indicator in evaluating the
firm ability proficiently provide credit to the customer. The ratio represents the
number of times the business collects its average accounts receivable. A high turnover
ratio represent that the business ability to quickly recover its accounts receivable. On
the other hand this also represents that business has conservative credit policy and a
aggressive collecting policy.
 Current ratio: current ratio of the company signify the firm ability to pay short term
responsibility or those due within the one year.
 Operating cash flow: operating cash flow is a measure of the amount of cash
generated by a company normal business operation. As per the GAAP, which require
the public company to calculate the operating cash flow using the indirect methods.
 Working capital: working capital ratio measure the liquidity position of the firm,
which aims at assessing whether a business can pay its obligation. The ratio is also
known as current assets ratio, which is measures as the current assets divided by the
current liability. A working capital ratio less than 1 indicates that the company is
having liquidity problem. On the other hand, the ratio of 2 imply that the company is
having surplus cash to meet its obligation.
 Inventory turnover ratio: This ratio is an indicator of the company efficiency, this
ratio measure the number of times average inventory is turned or sold during a period.
This ratio is important to determine the company efficiency, the ratio has two main
component first is stock level and the second is the sale (Albring, Robinson, and
Robinson, 2014). If the company purchased large amount of inventory during the
year, this imply that the company has to drastically increase the sale component in

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Role of Corporate Governance in Reducing the Bankruptcy Risk
order to achieve the high turnover ratio. If the company cannot sale the greater
amount of the its stock then the company has to incur storage and other holding cost.
On the other hand sales have to match the inventory otherwise the inventory will not
turn effectively.
 Return on Equity(ROE)
Return on equity is the parameter of the financial performance which is determined by
dividing the net income by the shareholder equity. Sometimes return on equity is also
known as the return on the net assets. This ratio imply that how effectively the
company is utilizing the organization assets in order to generate profit of the firm. A
good or bad ROE depends upon what is the benchmarking in the industry.
Non-financial indicators
These are the metrics which are not measured in the monetary amount but it is of such
important they provide an insight into the business of the organization (Muscettola 2015).
Some of the important non- financial metrics are given below.
 Company reputation: The company reputation is an important non-financial
indicator which help the company stake holders like investor, lenders, banks and other
financial institution to evaluate the goodwill of the company in the market. These are
useful for the different stakeholder for different purposes like bank and financial
institution uses to assess the company reputation in the market to provide any kind of
financial assistance to the company.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
 Competitiveness: Competition for the business is important factor in determining the
entity strength, weakness, opportunity and threat. Which useful in assessing the firm
ability to compete against their rival.
 Innovation: Research and development of the company is an important factors in the
assessing the development happening within the organization, which are important in
determining business growth in the launching the new product and services.
 Brand preference: Business brand is not just a name but represent the value which
an organization provide to its customer. A brand comprises of the symbol or mark,
logo, name, word. Customer brand preference is an important factor as it represent the
face of the company through which the customer associates themselves.
 Customer loyalty and experiences: customer loyalty and experience towards the
business is important factor in determining the business. From investor point of view
people like to invest in the company which has the highest level of customer loyalty.
Conclusion
From the analysis of the report it can be concluded that the probability of the
bankruptcy of the firm cannot be solely determined by the analysis of the financial statement.
The financial statement which are prepared by the management of the organization cannot be
solely relied upon the by the investor for making the investment decision. As there may a
chances of the window dressing of the financial statement to attract the investor for making
the investment (Ailon, 2015).
Window dressing of the financial statement of the enterprise shall be done either to
lure the investor or to do any kind of fraud.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
There are certain indicator which help the users of the financial statement in
identifying and evaluating the entity financial position. Some of them are persistent negative
cash flow, negative profit, declining of the market share of the company, deterioration in the
physical facilities, low employee morale, uncompetitive product and services, changes
payment structure to the creditor from credit payment to cash payment, severity of
competition, unprofitable business, loss of key managerial position, high employee turnover,
assets liquidation, lack of financial assistance from the bank or any financial institution (Karl
Grebe, 2013).
If a user’s finds all these financial indication in a business, then it is possible that the
organization is moving towards its liquidation and bankruptcy stage. Certain key financial
ratio will also help the users in identifying the health of the company like gross profit margin,
current assets ratio, Debt to equity ratio, inventory turnover ratio. Apart from this it is also the
responsibility of the management of the organization and the auditor of a company to provide
the users true information about the company business and net financial position.

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Role of Corporate Governance in Reducing the Bankruptcy Risk
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Role of Corporate Governance in Reducing the Bankruptcy Risk
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