Corporate failure prediction methods - Essay Example

ACC4240: REVISION QUESTIONS By of the of the School ACC4240: Revision Questions 1. Corporate failure prediction methods (a) Altman’s Z-score The method offers one of the means that can be used to predict the failure for corporates. It can be used to determine if a firm is likely to go bankrupt within a period of two years. The Z-scores can be applied in the prediction of corporate nonpayment of firms as well as offering an easy method for determining the financial challenges that firms undergo. This method is more accurate since it uses easy to calculate accounting ratios. The Altman Z-score can be obtained using the following formula: Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E Where: A = Working Capital/Total Assets B = Retained Earnings/Total Assets C = Earnings Before Interest & Tax/Total Assets D = Market Value of Equity/Total Liabilities E = Sales/Total Assets Any score that falls below 1.8 is an indication that the company is headed for bankruptcy, scores above 3.0 indicates no likelihood of bankruptcy. (b) Taffler’s Z-score This version of Z score uses a combination of four ratios in its analysis of the corporate failure. It is accurate since it uses easy ratios. The method can be expressed as follows; Z = 3.2 + 12.18 X1 + 2.5 X2 - 10.68 X3 + 0.0289 X4 where: X1 = Profit before tax / current liabilities X2 = Current assets / total liabilities X3 = Current liabilities / total assets X4 = No-credit interval in days = (Liquid current assets / daily cash operating expenses) (c) Argenti’s model This is a qualitative model of predicting corporate failures. The process argues that failure follows a sequence beginning with defects, mistakes and symptoms of failure. If the total score is less than 25, then the company is not facing an imminent danger but if its greater than 25 then the company is headed for failure. Defects greater than 10, means that the management is likely to make mistakes leading to failure. Models Strengths Weaknesses (a) Altman’s Z-score (i) Uses financial data of the company which are more accurate. (ii) The method can be used to compare the performance of different companies. (i) The method is based on historical data which may not portray the actual trend. (ii) Interpretation relies of scores relies on past studies (iii) It has no conceptual base (b) Taffler’s Z-score (i) The method applies the use of many ratios hence more accurate in its predictions. (ii) the unusual ratios used are more accurate than the normal ratios (i) It uses very unusual ratios (ii) Interpretation is on past study which may not be accurate. (iii) Relies on historical data that may not portray the actual trend. (c) Argenti’s model (i) Better inputs lead into better and reliable results. (ii) Gives more accurate results since it applies many data. (i) Results are as good as the inputs into them. (ii) Requires large amount of information which may be lacking. (iii) Is based on subjective judgment of the experts. Fair Value Accounting Vs Historical Cost Accounting Fair value accounting refers to a financial reporting method under the Generally Accepted Accounting Principles (GAAP) the method allow companies to measure as well as report the value of assets and liabilities on the basis of their actual or estimated fair market prices. Some of the advantages of fair value accounting include the fact that it provides a more accurate valuation of assets and liabilities. Therefore, it accurately relates the value of assets and the market price. The method also limits a company’s ability to manipulate its reported net income hence leading to the portrayal of true income. It is timely in nature owing to the fact that it reports gains or losses on assets in the period that they occur. One of its disadvantages is that it may adversely affect the market conditions in a negative way. The lower value of an asset after revaluation may lead into a fall in the prices of all related assets thus affecting the market negatively. The method may also result into a number of challenges to firms as well as to the users of the reported financial information. The market conditions in which a given asset and liability is traded may fluctuate in many occasions and become more volatile in some situations (Cooper, 2007, 17-18). On the other hand historical cost accounting is a technique that values assets and liabilities at the price paid during its acquisition. Revenues, assets and expenditures are recorded based on their time of acquisition. The fact that accountants are usually reluctant to price assets based on their market value, offers an opportunity to apply the use of historical cost method. Accountants must always guard the integrity of their data against internal modifications and manipulations which makes this method more advantageous than its alternatives. The method provides managers with a number of key alternatives in the recognition, reporting and measuring of economic information thus helping them to forecast future operational costs using past data. The figures used in this approach are very reliable and readily available to the users of the final information. (Barth, 2007, 17-18) Some of its weaknesses include the fact that the method only generates interest in cost allocations and not in the value of assets since ti does not recognize the current market value. Another limitation is that it does not factor in inflation. It is heavily relies on the assumption that the currency in which the transactions were conducted initially will remain stable over the entire period. The method cannot be used to make accurate comparison of corporate performance of several firms. Conclusion It is realized from the above information that Fair value method is mostly applied in many companies due to its many advantages but on the same scale, historical cost accounting method has also not disappeared from its uses owing to the fact that each method has got its own flaws and strengths. Most users of accounting information are used to historical method and are very reluctant to accept new techniques such as fair value despite their advancements. Therefore, accounting bodies need to come up with a system that will harmonize both the approaches in order to block the division that has been caused. Bibliography Accounting and Business Research Special Issue: International Accounting Policy Forum. pp. 17-18. 2007 Discussion of ‘Standard-setting measurement issues and the relevance of research’ by Stephen Cooper Accounting and Business Research Special Issue: International Accounting Policy Forum. pp. 17-18. 2007 Standard-setting measurement issues and the relevance of research by Mary E. Barth BARTH, M. E. (2007). Research, standard setting, and global financial reporting. Hannover, MA, Now Publishers. GREAT BRITAIN. (2011). Auditors: market concentration and their role : 2nd report of session 2010-11. Vol. 2, Vol. 2. London, Stationery Office. Lecture_6_-_multi-variat_corporate_failure_prediction_models_1_.pptx fair_value_accounting_solutions_2_.doc Read More