Accounting Measures Of Corporate Liquidity Leverage And Costs Of Financial Distress Finance Essay - Free Essay Example

Sample details Pages: 19 Words: 5683 Downloads: 9 Date added: 2017/06/26 Category Finance Essay Type Analytical essay Did you like this example? John, Teresa A. Financial Management. Tampa: Autumn 1993. Vol. 22, Iss. 3; pg. 91 Abstract (Summary) The costs of financial distress are those resulting from the costs of asset restructuring or the costs of informal or formal debt restructuring. The costs of financial distress will have important implications for the liquidity and leverage policies of a firm. When the costs of financial distress are high, the firm may maintain a larger fraction of its assets as liquid assets or be cautious in taking on debt. Based on a simple model of financial distress, a positive relationship between the optimal liquidity maintained by a corporation and the costs of illiquidity of its assets is postulated. These costs include costs of distressed asset sales and loss of going-concern value in liquidation. Some new proxies are proposed for the costs of illiquidity and the indirect costs of financial distress. The study sample consists of 223 major US corporations with an average annual liquidity ratio of 6.3% in the period from 1979 to 1981.   Ãƒâ€šÃ‚ »   Jump to indexing (documen t details) Full Text  (5708   words) Copyright Financial Management Association Autumn 1993 * A general view of financial distress is that it results from a mismatch between the currently available liquid assets of a firm and its current obligations under its hard financial contracts. Mechanisms for dealing with financial distress rectify the mismatch by either restructuring the assets or restructuring the financing contracts, or both. The costs of financial distress are those resulting from the costs of asset restructuring (converting illiquid assets to liquid ones) or the costs of informal or formal debt restructuring. The costs of financial distress will have important implications for the liquidity and leverage policies of a firm. In particular, when the costs of financial distress are high, the firm may maintain a larger fraction of its assets as liquid assets and/or be cautious in taking on debt (hard contracts). In this study, I analyze the relationship between the costs of financial distress and (i) the corporate liquidity policy, and (ii) the leverage policy of a firm. Liquid assets constitute a considerable portion of total assets and have important implications for the firms risk and profitability. For instance, Baskin [6] reports that among his sample of 338 major U.S. corporations, 9.6% of invested capital was held in cash and marketable securities in 1972. In our sample of 223 major U.S. corporations, the average annual liquidity ratio was 6.3% in the period 1979-1981. Kallberg [19] documents that top managers pay a lot of attention to management of corporate liquidity. In his book on liquidity management, Kallberg [19] provides six stages of decreasing liquidity as follows: (i) meeting current obligations from current cash flows, cash balances and short-term investments; (ii) using short-term credit; (iii) careful management of cash flows, e.g., through management of credit policy and inventory levels; (iv) renegotiatio n of debt contracts; (v) asset sales; and (vi) bankruptcy. This scheme suggests a direct link between liquidity policies pursued by management and costs of financial distress. Using various proxies for the different direct and indirect costs at various stages of financial distress, its relationship to corporate liquidity is examined. Although several measures of corporate liquidity have been suggested, I focus on the accounting measures of liquidity, such as the liquid ratio. A second response to high financial distress costs is to limit the use of debt financing. Although the inverse relationship between bankruptcy costs and leverage has been studied previously, I will propose new measures of asset illiquidity and indirect bankruptcy costs in exploring the relationship between leverage and the costs of financial distress.(1) The remainder of the paper is organized as follows. In Section I, a simple model of dealing with financial distress is used to develop testable relationship s between (i) distress costs and corporate liquidity policy, and (ii) distress costs and corporate leverage. Several proxies for different components of financial distress are developed in Section I.C. Methodology and data are described in Section II. Results are presented in Section III. Section IV concludes. I. DEVELOPMENT OF HYPOTHESES A. A MODEL OF FINANCIAL DISTRESS The financing contracts of a firm can be loosely categorized into hard and soft contracts. An example of a hard contract is a coupon debt contract which specifies periodic payments by the firm to the bondholders. If these payments are not made on time, the firm is considered to be in violation of the contract and the claimholders can seek specified and unspecified legal recourses to enforce the contract. Common stock and preferred stock are examples of soft contracts. Here, even though its claimholders have expectations of receiving current payouts from the firm in addition to their ownership rights, the le vel and frequency of these payouts are often policy decisions made by the firm. These payouts can be suspended and/or postponed, if the liquid resources remaining in the firm after satisfying the claims of the hard contracts are not sufficient. The assets of a firm also have a natural categorization based on liquidity. Cash or cashlike (marketable) securities are liquid assets. Long-term investments (such as plant and machinery) which may only produce liquid assets in the future may be called illiquid assets. The above categorizations of the financing contracts of a firm and its assets give rise to a natural definition of financial distress. A firm is in financial distress at a given point in time when the liquid assets of the firm are not sufficient to meet the current liquidity requirements of its hard contracts. Since financial distress results from a mismatch between the currently available liquid assets and the current obligations of its hard financial contracts, mecha nisms for coping with financial distress involve correcting the mismatch by either increasing the liquidity of the assets (through asset sales) or decreasing the hardness of the debt contracts (through debt renegotiation). The total costs of accomplishing this through a combination of asset restructuring and/or debt restructuring, through formal mechanisms (e.g., Chapter 11 bankruptcy procedure) or through informal mechanisms (e.g., private debt workouts), constitute the costs of financial distress.(2) For a recent survey of the literature on financial distress and mechanisms for dealing with it through asset and/or debt restructuring, see John and John [16]. B. TESTABLE HYPOTHESES Given the above characterization of financial distress, a firm with high costs of financial distress will reduce its exposure in two ways: (i) increase the liquid component of its assets, and (ii) reduce the extent of its hard contracts (such as debt). This immediately leads to the following hypothe ses: H1 : The proportion of total assets invested by a firm in liquid assets (e.g.,cash and marketable securities) will be increasing in its costs of financial distress. H2: The proportion of debt in the capital structure of a firm will be decreasing in its costs of financial distress. In the following section, I will develop various proxies for the costs of financial distress. C. PROXIES FOR COSTS OF FINANCIAL DISTRESS Empirical proxies for the costs of financial distress are developed based on the simple economic model of coping with financial distress presented in Section I.A. Since financial distress is resolved through asset restructuring (asset sales or other liquidations) and/or financial restructuring (private or formal debt renegotiations), the costs of these different mechanisms of resolving distress will represent financial distress costs. First, let us consider the liquidation costs which are the costs incurred when assets are sold to raise cash and rem edy distress.(3) The most important cost of liquidation is the destruction of going-concern value that occurs when assets are sold to pay down debt. This loss of value will be greater for intangible assets and assets that generate firm-specific rents (e.g., growth opportunities, managerial firm-specific human capital, monopoly power, and operating synergies whose value depends on the firms assets being kept together). Financial distress will be relatively more costly for firms whose assets are more intangible or firm-specific (see John and Vasudevan [18] and Shleifer and Vishny [28]). The ratio of the firms market value to the replacement costs of its assets, defined as Tobins q, is used as a proxy for the loss of going-concern value due to asset sales (see Lindenberg and Ross [21]). Replacement costs approximate what the firms assets could be sold for piecemeal, and are positively correlated with the liquidation value of the asset. Firms with a higher market value/replacement costs ratio will have higher costs of asset liquidations. Therefore, Tobins q ratio (equal to market value/replacement costs) will be used as a proxy for the loss of going-concern value in asset sales and premature liquidations associated with financial distress. For several reasons, assets are more likely to be sold when debt is restructured in Chapter 11 rather than privately. First, automatic stay gives the debtor more power over the disposition of the firms assets, by enjoining creditors from exercising their nonbankruptcy right to sue the firm and seize collateral. Asset sales that would normally be in violation of the firms debt covenants will be allowed if the firm can convince the bankruptcy judge that such sales are necessary for the continued operation of the business. Second, since the debtor can undermine the value of lenders collateral and grant new lenders superpriority standing, fully secured lenders will in general prefer liquidation over reorganization. This may creat e additional pressure for asset sales in bankruptcy. In Chapter 11, creditors can initiate asset sales by making a motion to sell before the court. In addition, Chapter 11 cases can be converted into Chapter 7 liquidations. For a sample of Chapter 11 filings in the Southem District of New York (including nonpublic firms), White [34] finds that onethird either end up in Chapter 7 or as liquidating reorganizations. The fraction of bankruptcies converted to Chapter 7 liquidations is smaller (only five percent) in the sample studied in Gilson, John, and Lang [13]. Finally, purchasing assets from a financially distressed firm is less risky in Chapter 11, because asset sales are executed by a court order and are thus free from legal challenge. In addition, assets that are purchased from an insolvent firm that subsequently files for Chapter 11 may have to be retumed as a voidable preference or fraudulent transfet Given the costs incurred if an asset sale is later challenged or canceled, potential purchasers of an asset will prefer to deal with firms in Chapter 11. Titman [30] and Titman and Wessels [31] have argued that the costs of liquidation are higher for firms that produce unique or specialized products. Their workers and suppliers often have job-specific skills and capital, and their customers find it difficult to find altemative servicing for their relatively unique products. For these reasons, a high degree of specificity or uniqueness engenders high distress costs. Expenditures on research and development over sales (RD) and advertising over sales (ADV) are indicators of uniqueness. RD expenditures measure uniqueness because firms that sell products with close substitutes have low RD intensity since their innovations can be easily duplicated. Similarly firms marketing relatively unique products advertise intensely. Liquidation costs are also likely to be high for firms which make products requiring specialized servicing and spare parts. As a proxy for asset specificity, a dummy variable SPC is constructed, where SPC equals one for firms with SIC codes between 3400 and 4000 (firms producing machines and equipment) and zero otherwise. The variables RD and ADV will proxy for indirect costs of financial distress also through another channel. Myers [24] has argued that risky debt and financial distress can lead to underinvestment in growth options. RD expenditures and advertising expenditures create a stock of future investment options that can expire unutilized if the firm runs into financial distress. These costs can be minimized if the firm reduces its insolvency risk by maintaining high liquidity. Measures of corporate liquidity should be higher for firms with high RD and advertising. Another measure of the liquidity costs of asset restructuring is the collateral value of the assets (see Shleifer and Vishny [28]). Titman and Wessels [31] suggest two proxies for the collateral value. The ratio of inventory plus gross plant an d equipment to total assets (IGP/TA) is positively related to collateral value. The ratio of intangible assets to total assets (INT/TA) is negatively related to collateral value. The liquidity costs of asset restructuring are negatively related to collateral value. A firm with assets of high collateral value need only maintain low levels of liquidity. In other words, the liquidity measures will be decreasing in IGPlrA and increasing in INT/TA. Another proxy for the expected costs of financial distress will be the variable BR, which is a dummy variable for the actual incidence of bankruptcy (Chapter 11 filing by the firm) during a ten-year period after the liquidity decision is taken. (If the firm had a bankruptcy filing during this period, BR = 1, otherwise BR = O.) This variable is meant to proxy for factors not included above, which the management may have considered when the liquidity decision was taken, as potentially affecting the probability of bankruptcy. Corporate liquidi ty will be increasing in the probability of bankruptcy.(4) Given the above proxies for costs of financial distress, hypotheses H1 and H2, as developed in Section I.B., can now be tested. II. METHODOLOGY AND DATA A. METHODALOGY In the first part, the relationship between corporate liquidity and expected costs of financial distress is examined. Here, a linear relationship between measures of liquidity and proxies for expected costs of financial distress will be used. Different specifications of a linear model of the following form will be tested: Equation (1) LIQR = a sub 0 +a sub 1 +a sub 2 RD+a sub 3 ADV+a sub 4 BR+a sub 5 SPC +a sub 6 DEBT+a sub 7 CASHCY+a sub 8 GROWTH +a sub 9 LSALES+a sub 10 OI/S+a sub 11 OI/TA +a sub 12 IGT/TA+a sub 13 INT/TA+a sub 14 VOI+e sub 1 where LIQR = the liquidity ratio, measured as the average ratio of cash and marketable securities to total assets in 1979-1981; Q = the average Tobins q ratio in the peniod 1979-1981, which is calculated as the market value of the firm (sum of the market value of the preferred stock, the market value of the common stock, the market value of long-term debt adjusted for its age structure, less the short-term assets) divided by the replacement costs of the firms plant and inventories. The associated numbers are obtained from the Griliches RD Master File (Cummins et al [10]); RD = the average ratio of RD expenditures to capital expenditures in 1979-1981; ADV = the average ratio of advertising expenditures to capital expenditures in 1979-1981; BR = 1 if the firm has filed for Chapter 11 during 1981-1991, and equals 0 otherwise; SPC = 1 if the firm has an SIC code between 3400 4000 (firm produces machinery and equipment); equals 0 otherwise; DEBT = the average debt ratio (calculated as the sum of short-term nonspontaneous debt and long-term debt) divided by the sum of short-term nonspontaneous debt, long-term debt, preferred stock and market value of equity) in the period 1979-1981; LTDEBT = the average debt ratio (calculated as long-term debt over total assets) in the period1979-1981; CASHCY = the average cash cycle (calculated as the difference of average inventory age plus average collection period minus average payment period) in 1979-1981; GROWTH = the average compound growth rate of sales between 1974 and 1979; LSALES = the natural logarithm of average annual sales in 1979-1981; VOI = the volatility of operating income, estimated as the standard deviation of the first-level differences of EBIT in the years 1975-1978 divided by average total assets in the same period (see Bradley et al [71); OI/S = the average ratio of operating income over sales in 1979-1981; OI/TA = the average ratio of operating income over total assets in 1979-1981; IGP/TA = the average ratio of inventory plus gross plant and equipment to total assets in 1979-1981; INT/TA = the average ratio of intangible assets to total assets in 1979- 1981; and e sub 1 = the error term. The main explanatory variables on which this study focuses are the proxies for the expected costs of financial distress. In Section I.C., it was argued that Tobins q ratio (Q) represents a measure of the indirect costs of financial distress. WeR will be increasing in e. The dummy variable BR proxies for the probability of bankruptcy. An underlying assumption is that the ex post incidence of Chapter 11 filings during 1979-1989 would equal the ex ante estimation made by the management in 1979 (based on some bankruptcy prediction models, see, e.g., Altman [11). LIQR will be increasing in BR. The other proxies for costs of financial distress are those that are related to costs of liquidation of assets. As argued in Section LC., the costs of liquidation are higher for firms that produce unique or specialized products and lower for firms with assets of high collateral value. The costs of liquidation, and hence LIeR, are increasing in RD, ADV, SPC and INT/TA and decreasing in IGP/TA, as argued earlier in Section I.C. The variables LSALES, CASNCY, DEBT, OI/S, OI/TA and VOI are control variables to account for the level of liquidity justified by transaction and precautionary motives. The variable LSALES proxies for the transaction needs of the firm. The cash cycle of the firm (CASHCY) measures the time it takes to recoup cash outlays, and hence it affects cash balances. A larger cash cycle (say, for example, due to a large average collection period) implies a larger amount of receivables, which are near-cash assets which will be converted into liquid assets periodically. Therefore a large cash cycle is a net source of liquidity which is not already accounted for in LIQR. Corporate liquidity should be decreasing in the length of the cash cycle (CASHCY). Similarly, operating incomes or cash flows provide a ready source ofliquidity. Firms with ready access to debt markets and other sources of borrowing can also use debt as a su bstitute for liquidity maintenance. Therefore, firms with good operating incomes (OIlS or OI/TA) or ready sources of financing (proxied by measures of debt) can afford to keep lower levels of liquidity. Hence liquidity ratios (LIQR) would be lower for firms with higher operating incomes or debt. The growth of sales (as proxied by GROWTH) may also provide a source of liquidity. If sales growth and corresponding cash flows build up the liquid reserves of the firm faster than its use, then liquidity maintained would be decreasing in GROWTH. The variable VOI, volatility of operating income will capture the maintenance of liquidity for precautionary reasons (i.e., to avert shortfalls of cash). Hence liquidity ratio (LIQR) would be increasing in VOI. Costs of financial distress may not be the only reason for the relationship between corporate liquidity and variables such as RD and advertising expenditure. RD and advertising expenditure may contribute to building up of assets and resour ces characterized by asymmetric information between corporate insiders and outside investors in the market. In this setting, Myers and Majluf [26] have argued that firms can optimally maintain financial slack (i.e., excess liquidity) which can be used to finance projects, avoiding the adverse-selection costs of interacting with a less informed market. This would give rise to an increasing relationship between corporate liquidity and ADV and/or RD. In summary, the predicted signs of the coefficients in the regression model in Equation (1) are positive for a sub 1 , a sub 2 , a sub 3 , a sub 4 a sub 5 a sub 13 and a sub 14 , and negative for a sub 6 , a sub 7 , a sub 8 a sub 10 , a sub 11 and a sub 12 . The coefficient of LSALES is indeterminate. In the second part, the relationship between measures of debt and expected costs of financial distress is examined. In addition to the debt measure (DEB73 defined following Equation (1), I will introduce another debt measure called long -term debt (LTDEB defined as follows: LTDEBT is the average debt ratio (calculated as long-term debt over total assets) in the period 1979-1981. A linear relationship between the debt measure (DEBT or LTDEBT) and proxies for the costs of financial distress will be used. Different specifications of a model of the following form for both of the debt measures will be estimated: Equation (2) DEBT or LTDEBT} = b sub 0 +b sub 1 Q+b sub 2 RD+b sub 3 SPC+ b sub 4 JGP/TA+b sub 5 OI/S+b sub 6 OI/T+b sub 7 GROWTH+ b sub 8 LSALES+b sub 9 VOI+b sub 10 BR+e sub 2 where the variables are as defined following Equation (1), and e sub 2 is the error term. As argued before, Tobins q is a proxy for indirecl bankruptcy costs and costs of illiquidity which would have a negative impact on the use of debt. Similarly, RD and SPC are associated with higher costs of financial distress. Hence, both measures of debt should be decreasing in Q, RD and SPC. IGP/TA denotes the collateral value of the as sets and it is associated with lower costs of illiquidity in an asset sale or premature liquidation. Hence, assets with high collateral value have a large debt capacity. Debt measures will be positively related to IGP/TA. Firms with large cash inflows need less extemal financing and less debt financing.(5) In other words, firms with large operating incomes should have less borrowing. Debt should be decreasing in OI/S and OI/TA. Finally, a higher incidence of bankruptcy will be associated with larger levels of debt. In summary, the expected sign for coefficients b sub 1 , b sub 2 , b sub 3 and b sub 10 is positive; it is negative for b sub 4 , b sub 5 , b sub 6 , and b sub 7 . Coefficients b sub 8 and b sub 9 of control variables LSALES and VOI may be positive or negative. B. THE DATA The original sample contains 223 firms from the Fortune 500 companies in 1980 for which we were able to find the q ratio in the Griliches RD Master File for 1979-1981 (Cummins et al [10]) . Data to calculate the remaining variables LSALES, CASHCY, VOI, GROWTH, LTDEBT, DEBT, RD and ADV were retrieved from the COMPUSTAT tapes.(6) Exhibit 1 contains some descriptive statistics (mean, median, standard deviation, minimum and maximum value) of the variables. (Exhibit 1 omitted) For the firms in our sample, the liquidity ratio, LIeRAT, ranges from a minimum value of 0.01 to a maximum of 0.29, with a mean of 0.06 and median of 0.05. Of the firms, 43% had liquidity ratios in excess of 0.05, whereas 19% had liquidity ratios of 0.10. Thus, for a typical irm, liquidity requires a nontrivial commitment of capital. The q ratio ranges from 0.20 to 4.98 with a mean of 0.95 and a median of 0.69. The debt ratio ranged from 0 to 0.8 with a mean of 0.30 and a median of 0.29. Similarly, the long-term debt ratio ranged from 0 to 0.43 with a mean of 0.18 and a median of O.17. Therefore, the sample is representative of large firms which are not currently in financial trouble. III. RES ULTS Exhibit 2 presents regression results from five different specifications of the basic model in Equation (1). (Exhibit 2 omitted) In all specications, the coefficient of the variable e, the primary proxy for financial distress (Tobins q), is positive and significant at the 0.01 level. Other proxies for high liquidation costs, such as research and development (RD) and advertising expenditure (ADV), were also positive and significant at the 0.01 level in regressions (1), (2), (3) and (5) where they were included. The coefficient of BR, the dummy variable for the incidence of bankruptcy, is also positive and significant in specifications (3) and (5). Together, these results provide strong evidence in support of hypothesis H1 that corporate liquidity is increasing in proxies of financial distress costs. The coefficients of the control variables also had the predicted signs, many of them statistically significant. As predicted, variables which stand for ready sources of liquidi ty, such as CASHCY, DEBT, GROWTH, IGP/TA, OI/S and OI/TA, have a negative relationship to corporate liquidity. In all specifications, i.e., (2), (3), (4) and (5), where DEBT is included, its coefficient is negative and significant at the 0.01 level. Similarly, the coefficient of GROWTH is negative and significant at the 0.01 level in specifications (2) through (4), and at the 0.05 level in specification (1). Coeficients of the proxy for collateral value, IGP/TA, and the proxies for intermediate cash flows (OI/S and OI/TA) are also negative and significant at the 0.05 level in all regressions that include them. Overall, colporate liquidity is decreasing in proxies for altemate sources of liquidity (as predicted). This negative relationship is strong, as suggested by the statistical significance of the coefficients of CASHCY and DEBT. The coefficients of SPC, NTlTA and LSALES are not statistically significant. As predicted, a higher eamings volatility implies a higher corporate liq uidity need (the coefficient of VOI is positive and significant at the 0.10 level). In summary, corporate liquidity maintained is increasing in proxies of financial distress costs; it is decreasing in the collateral value of the assets, and other sources of liquidity available, such as intermediate cash flows, projected growth in cash flows, sources of borrowing and the length of the cash cycle. In Exhibit 3, I present regression results on different specifications of the model in Equation (2), using two measures of debt, DEBT and LTDEBT, as dependent variables. (Exhibit 3 omitted) In all three specifications with DEBT as the dependent variable, the coefficient of Tobins q, the main proxy for financial distress costs, is negative (as predicted) and significant at the 0.01 level. Asset specificity (as proxied by the dummy variable SPC) is negative (as predicted) and significant in specifications (1) and (2). Proxies for intermediate cash flows (OI/S and OI/TA) have coefficients which are negative (as predicted) and significant at the 0.01 level in specifications (1), (2) and (3). In summary, corporate debt levels are decreasing in proxies of financial distress costs (e and SPC) and proxies of intermediate cash flows (OI/S and OI/TA). All three regressions have adjusted R sup 2 values around 50%. In the two specifications of Equation (2) presented in the last two columns of Exhibit 3, LTDEBT is the dependent variable. As predicted, the coefficients for proxies of financial distress costs (Q and SPC) are negative in both specifications. The coefficients of Q are statistically significant at 0.01 levels in specifications (1) and (2), and those of SPC are significant at the 0.05 level in specification (2). Overall, this negative relationship with financial distress proxies seems to be the strongest. As predicted, firms with larger long-term debt have a higher probability of bankuptcy (coefficient of BR is positive and significant at the 0.05 level). The co efficients of OI/S, OI/TA and IGP/TA are not significant. Overall, long-term debt is decreasing in proxies of financial distress costs. In summary, the evidence in Exhibit 3 is consistent with hypothesis H2 that debt levels are decreasing in proxies of financial distress costs. We have used a new measure of destruction of going-concem value (i.e., Tobins q) and found such a relation to be strong with either measure of leverage, DEBT or LTDEBT, as the dependent variable.(7) IV. CONCLUSION Based on a simple model of financial distress, I postulate a positive relationship between the optimal liquidity maintained by a corporation and the costs of illiquidity of its assets. These costs include costs of distressed asset sales and loss of going-concern value in liquidations. Some new proxies are proposed for the costs of illiquidity and the indirect costs of financial distress. These include Tobins q, RD and advertising expenditures, an index of asset specificity and an index of t he probability of bankruptcy. The liquidity ratio is documented to be positively related to these proxies of financial distress costs. It is negatively related to proxies for altemate sources of anticipated liquidity such as intermediate cash flows, debt financing, length of cash cycle and the collateral value of assets. Total debt is also negatively related to Tobins q and asset specificity as well as measures of intermediate cash flows. Long-term debt is also negatively related to Tobins q and asset specificity. Overall, the evidence is strongly consistent with the hypothesized relationships between corporate liquidity and financial distress costs, and corporate leverage and financial distress costs. FOOTNOTES (1) Recent cross-sectional studies include Feni and Jones [11], Flaath and Knoeber [12], Marsh [23], Titman [29], Castanias [9], Bradley, Jarrell, and Kim [7], Auerbach [5], Long and Malitz [22], and Titman and Wessels [31]. Some of these papers (e.g., Titman [29], Bradley, Jarrell, and Kim [7], Auerbach [5], Long and Malitz [22], and Titman and Wessels [31]), examine uariables that are similar to some of those examined here. The studies find a negative relation between both research and development and advertising and leverage, but have mixed findings relating to the different measures of nondebt tax shields and leverage and volatility and leverage. (2) Haugen and Senbet [15] argue that capital market mechanisms could accomplish restructuring of the problematic hard contracts and replacing them with a softer mix. They argue that the transactions cost of these private mechanisms are small and should form an upper bound on the costs of coping with financial distress. (3) Brown, James, and Mooradian [8], Asquith, Gertner, and Scharfstein [4], Lang, Poulsen, and Stulz [20], and Ofek [27] present evidence of asset restructuring by firms in distress. All the above papers document that asset sales are frequently used by financially distressed firms in their sample, either during private debt restructuring or the formal Chapter 11 reorganization. (4) In analyzing the costs of bankruptcy, it has become common to distinguish between direct and indirect costs. Direct costs are out-of-pocket transactions costs (such as charges for legal and investment banking services). Indirect costs include all other costs related to the firms bankruptcy. For example, managers may forego profitable investment opportunities because they are distracted by dealings with creditors of the bankruptcy court. Warner [32], Ang et al [3], Altman [2], and Weiss [33] have estimated the costs of Chapter 11 reorganizations empirically. 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John, Private Corporate Funding, The New Palgrave Dictionary of Money and Finance, McMillian Press Reference Books, October 1992. 18. K. John and G.K. Vasudevan, Bankruptcy and Reorganization: A Theory of the Choice Between Workouts and Chapter 11. Unpublished Manuscript, New York University, December 1992. 19. J. Kallberg and K. Parkin son, Corporate Liquidity Management and Measurement, Homewood, IL, Irwin, 1992. 20. L. Lang, A. Poulsen, and R.M. Stulz, Asset Sales, Leverage, and the Agency Costs of Managerial Discretion, Unpublished Manuscript, Ohio State University, February 1992. 21. E. Lindenberg and S. Ross, Tobins Q Ratio and Industrial Organization, Journal of Business (January 1981), pp. 1-32. 22. M.S. Long and E.B. Malitz, Investment Pattems and Financial Leverage, in Corporate Capital Structures in the United States, B. Friedman (ed.), Chicago, University of Chicago Press, 1985. 23. P. Marsh, The Choice Between Equity and Debt: An Empirical Study, Journal of Finance (March 1982), pp. 121-144. 24. S.C. Myers, Determinants of Corporate Borrowing, Journal of Financial Economics (November 1977), pp. 147-176. 25. S.C. Myers, The Capital Structure Puzzle. Journal of Finance (July 1984), pp. 575-592. 26. S.C. Myers and N. Majluf, Corporate Financing and Investment Decisions When Firms Have Information Investors Do Not Have. Journal of Financial Economics (June 1984), pp. 187-221 . 27. E. Ofek, Capital Structure and Firm Response to Poor Performance: An Empirical Analysis. Journa[ of Financial Economics (August 1993).pp. 3-30. 28. A. Shleifer and R. Vishny, Liquidation Values and Debt Capacity: A Market Equilibrium Approach, Journal of Finance (September 1992), pp. 1343-1366. 29. S. Titman, Determinants of Capital Structure: An Empirical Analysis, Working Paper, University of California at Los Angeles, 1982. 30. S. Titman, The Effect of Capital Structure on a Firms Liquidation Decision, Journal of Financial Economics (March 1984), pp. 137-151. 31. S. Titman and R. Wessels, The Determinants of Capital Structure Choice, Journal of Finance (March 1988), pp. 1-19. 32. J. Warner, Bankruptcy Costs: Some Evidence, Journal of Finance (May 1977), pp. 337-347. 33. L. Weiss, Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims, Journal of Financial Economics (October 1990), pp. 285-314. 34. M. White,Bankruptcy, Liquidation and Reorganization, in Handbook of Modern Finance, D.E. Logue (ed.), Warren, Gorham, Lamont, 1990. Teresa A. John is an Assistant Professor of Accounting at the Stern School of Business, New York University, New York, New York. I thank Elizabeth Bagnani and Edith Hotchkiss for providing some of the data used in this study for many helpful comments. Don’t waste time! 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Trade And Manufacturing In America Essay - 1249 Words

Trade and Manufacturing in United States and Effects on the Economy The action of buying and selling goods and services in America during the colonial and early republic era helped establish the United States’ economy and found the nation as a world power. Before the founding of European colonies into Northern, America trade was plentiful in the Americas. The Spanish had discovered the New World and during their exploration had brought over and traded with Native Americans. The New and Old Worlds exchanged crops, and the most relevant of them include potatoes, maize, and sugarcane. These three crops were immensely beneficial to the Old World, and this created a connection between the two worlds. The relationship was advantageous to both†¦show more content†¦The cycle began in Britain and other European countries. They would trade beads, copper, guns, ammunition, and cloth in Africa for slaves to work on sugar plantations and hemp plantations. The slaves â€Å"were transported in below-human conditions†(Boston Tea Party Historical Society). Many died along the way of their voyage, but those that did survive arrived in America and were put to work. British goods were â€Å"traded for slaves on the African coast, who were shipped to America and traded for the raw materials†(Erin). This system was beneficial to Britain as the raw materials gained from the Colonies supported their cause of Mercantilism, while they did not discover gold or silver as hoped, the commerce from raw materials supported Britain’s booming population. This cycle of trade would take around a year to complete(Boston Tea Party Historical Society). Many New Englanders were making a huge profit off this business, and Britain realized and put the Navigation and Trade Acts into place which put a hefty tax on Colonial imports and forced them to only trade with Britain. These acts led some Colonists to smuggle their goods and make a profit under Britain’s nose. 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Auditing - Assurance Services and Ethics Process

Question: Discuss about the Auditing, Assurance Services and Ethics Process. Answer: Introduction This report seeks to shed light on the subject of auditor liabilities that tend to arise on account of the losses borne by the users. While there are a host of users of financial report, however, shareholders and creditors are the two significant stakeholders whose interest is highly impacted by any misreporting. Considering the role of auditors in the bankruptcy of businesses as has been witnessed in the GFC (Global Financial Crisis), the concept of auditor liability for the losses of the user groups has gained currency. In this context, the liquidation of investment bank Lehman Brothers was indeed a watershed event. The given report carries an in-depth analysis of the auditor liability concept in the wake of GFC like events. Additionally, it also offers a host of recommendations to auditors on how to ensure that their respective liability remains minimal in case of a future GFC. Impact of GFC There is no denying the fact that the adverse impact of GFC has been felt by all sectors of economy but unarguably the sector that has borne majority of the brunt are the organisations involved in financial services and products in the developed nations (Shefrin and Shaw, 2016). As a result, the so called invincible firms also succumbed to the mounting liability burden and had to file for bankruptcy. Arguably, the biggest name in this regard was that of Lehman Brothers. In relation to Lehman Brothers, while there are a plethora of factors coupled from untamed greed to financial statement misrepresentation that could be held responsible, but the role of auditors is undeniably one of the contributory factors. This is primarily because the bankruptcy did not just happen in a particular quarter but was the result of malicious practices being practiced over a longer period. Prominent amongst these was the usage of 105 Repo which the auditor of the company EY failed to capture in their rep ort which clearly indicates towards negligence or fraud (Leung, Coram Cooper, 2012). HBOS is another financial organisation based in the UK which became bankrupt as a result of the GFC. However, GFC merely exposed the reckless lending practices which the company adhered to and were the real cause of failure. The company did not provide due consideration to the underlying creditworthiness of the prospective lender but rather extended loan facility on the back of rising asset prices which could serve as an effective collateral. This effectively led to the diminishing financial position which the auditors failed to capture before the actual damage was done (Caanz, 2016). Legal Concept of Auditors liabilities The role of the external auditor with regards to organisational progress and sustainability cannot be undermined as these adequately capture the various risks and verify the contents of the financial statements. This role assumes a greater responsibility in the modern financial markets where there are complex products whose implications are difficult to understand by the stakeholders and there is an increasing reliance on services offered by auditors. Considering the importance of their role, it is apparent that the auditors have a duty towards both their users and client and must uphold professional standards at all time (Gay and Simnett, 2012). The performance of the audit function with prudence and adequate care would ensure that the interest of both client and users is safeguarded which the auditors must seek to aim (Arens et. al., 2013). In case of any negligence or intention wrongdoing observed by the auditor, common law prescribes liability for the auditors on account of non-compliance of their respective fiduciary duties along with professional standards. The key auditor liabilities are highlighted below. Negligence liabilities Apparent from the name itself, this seeks to capture the auditor liabilities that tend to arise primarily on account of negligence on part of auditor leading to losses for the users (Caanz, 2016). The auditors have a duty to care directly towards the users as well as their clients and hence must conduct their work with skill and adequate due diligence. Failure to do may lead to breach of this duty which may cause significant losses to clients and users alike. In wake of this, the negligent auditors may have to pay damages for the losses caused due to their negligent conduct (Arens et. al., 2013). Civil and Criminal offence liabilities Auditors would be subject to criminal liabilities only when they conduct fraud i.e. indulges in intentional wrongdoing. This usually transacts through the formation of a quid pro relationship between the external auditor and management which has severe adverse implications for the interest of the users specially shareholders (Gibson and Fraser, 2014). In such cases, the stakeholders who suffer loss could initiate legal proceeding against the defaulting auditor. Also, in certain cases the client may press charges against the concerned auditors if they fail to deliver the expected professional standards (Lindgren, 2011). Proportionate liabilities It is noteworthy that liability of auditor tends to be proportional to the resultant losses that is caused to the host of user groups and the client which may arise either due to intentional misconduct (fraud) or misconduct by mistake (negligence). Currently in the Australian context, there is capping of the auditor liability to 10x the audit free obtained from the given client. However, this amount is significantly lower in comparison to the quantum losses suffered by the user groups and hence in accordance with proportionate liabilities concept, there is a strong case either to increase the cap or to remove it all together (Cheung Kandiah, 2016). Auditor liability and GFC A key observation which was made during the bankruptcy of various financial institutions during GFC was the fact that these organisations collapsed despite having an unqualified audit report within the past year. This clearly raises questions on the intent and underlying relevant of the auditing profession as the professionals are supposed to act as alarm bells and indicate the users about the potential risks (Humphrey, Loft Woods, 2009). The unqualified remark by the external auditor on the audit report is indicative of the fact that the underlying firm has adhered to the relevant accounting norms and has managed to faithfully represent the financial performance (ASIC, 2016). The importance of this opinion is apparent from the fact that an auditor on account of incorrect opinion offered on purpose, could have to face criminal proceedings (Arens et. al., 2013). The statements outlined above can be validated on account of the host of cases that the auditor of Lehman Brothers i.e. E Y had to face from the investors in the aftermath of the bankruptcy of the company. In this context, it is noteworthy that the company deployed plenty of dubious accounting practices which led to misrepresentation of liabilities in a systematic manner but the auditors failed to highlight this. A critical example in this regard is Repo 105 usage which has tremendous adverse implications for the accurate financial performance representation but the issue was not raised in the audit report. EY eventually closed the lawsuit by agreeing to a settlement amount to the tune of $ 10 million in 2015 (Freifeld, 2016). It is noteworthy that this is not an isolated case of lawsuit being initiated against auditor in case of bankruptcy of the client. With regards to the auditing of a Chinese firm Sino-Forest, Ernst and Young (EY) was at the receiving end as substandard audit cla ims were filed by the aggrieved investors when the firm became bankrupt. The audit report produced by EY did not indicate any concern with regards to the falling financial performance and hence auditor failed in the duty. As a result, EY has to pay a sum of $ 118 million for settlement of the claim. A similar lawsuit was settled in Australia by PWC (PricewaterhouseCoopers) in 2013 when it made a payment of AUD 67 million to placate the duped investors of Centro Retail (Aubin, 2013). It is significant to note that the various firms which became bankrupt during the GFC had a common issue in terms of financial statements representation. As a result, their financial statements in the audited reports did not accurately and fairly reflect the outstanding liabilities in the form of various non-balance sheet items and complex derivative contracts. Besides, there was stretching of asset valuation through creative accounting so as to present a healthy financial position in order to support the artificially high stock price. Moreover, these institutions were also characterised with weak internal controls which failed to provide any credible resistance to wrong and fraudulent business practices (Soh and Bennie, 2011). It is evident from the above discussion that the auditor through audit procedures must avoid any material misrepresentation of financial performance and simultaneously ensure relevance of services for the users. To ensure correction of the any lapses, correcti ve measures need to be adopted by the external auditor failing which a qualifying remark should be given in the audit report. It is requisite that the auditor must carry out the job entrusted with utmost skill and care as the external auditor tends to act as the last line of defence. Additionally, auditors also have to provide evidence to highlight that the external auditors does not share any quid pro quo understanding with the clients management. This is critical when the auditors may be accused of intentional misrepresentation or fraud (Gay Simnett, 2012). This is apparent from the various arguments presented in the proceedings pertaining to the Pacific Acceptance Corporation v. Forsyth (1970) 92 WN (NSW) 29 at 65 case. It was debated that the prime determinant of the auditor liability would be auditors conduct based on which it would be detected whether fraud or negligence is present or not (Serperlaw, 2016). In order to prevent auditor liability, it is essential that the auditor must carry out the audit job with utmost professionalism and skill so as to produce relevant audit reports. With regards to asset valuation, one key concern is whether the auditor should provide estimated value of the asset on the basis of certain assumptions and besides, ascertain if the companys valuation of the same asset lies in that range or not. In this process, if the auditor comes across some discrepancies, then these must be reflected in the auditor report. In performance of these complex tasks, it is essential that along with the underlying professional skills, the auditor also needs to capitalise on the rich experience (Caanz, 2016). However, considering the increasingly volatile financial markets and ever complex products, it becomes challenging for the auditors also to provide an accurate and object valuation. Hence, in such cases, the audit limitations should also be provided due reference to (Leung, Coram Cooper, 2012). A critical business assumption pertains to the going concern which prescribes that the business is likely to continue in the long run and has no concerns in the short run which could potentially lead to its closure. In instances, where the client faced cash crunch, liquidity concerns may be present and this needs to be extended in the annual report of the company by the directors (Taylor, Tower and Neilson, 2010). With regards to the director assessment of business and the underlying review also, the auditor needs to opine as part of the audit report as the guidance provided by the management enables the investors to make investment decisions. The above information tendered by the auditor enables providing relevant information to the stakeholders in a timely basis thus enhancing decision making and preventing future losses (Xu et al., 2013). In case the directors fail to produce this assessment or produce a misrepresented version, then the auditor would need to tender a qualified opi nion. If there is failure on auditors part with regards to fair representation of significant uncertainty in the audit report, then this would amount to negligence on part of the auditor. With regards to GFC, the critical issue is to determine whether some information regarding the going concern risk was indeed present and whether the same was appropriately captures in the audit report or not. This would go a long way in determining the underlying auditor liability during liquidation of firms at difficult times such as GFC (Arens et. al., 2013). Also, a key role in determination of auditor liability is played by the internal controls which are in place so as to minimise the incidence of financial misrepresentation. Since the auditor also needs support of the internal controls, hence it is essential that these should be functional which would minimise the risk of lapses in the audit process. The internal controls have come to light in a big way in the aftermath of the GFC as most companies observing bankruptcy had very weak or non-existent internal controls which also led to the increasing liabilities burden that effectively led to the demise of the business (Taylor, Tower and Neilson, 2010). Further, it is expected that in the future, the importance of the internal controls would grow and would also impact the overall auditor liability (Azim, 2012). Recommendations It is apparently evident from the discussion carried out above that role of auditor cannot be undermined in ensuring fair and accurate financial performance representation. Their role has shot to limelight during the recent bankruptcies observed in the GFC. While, the external auditor has duty to care towards the client towards the client and users, but in wake of increasing complexity and subjectivity in the assessment, it is imperative that the able support of functional internal controls and related procedures needs to be extended. Further, the corporate governance framework exhibited in various companies also needs to be strengthened through benchmarking. This is likely to act as a defence to the abuse of the powers by the higher management especially the executive directors (Caanz, 2016). The companies also need to take appropriate measures so as to keep the business risk under control and the directors should adhere to their duties as highlighted in the Corporations Act 2001. However, the auditors also need to mend ways and take proactive measures in line with professional conduct so as to ascertain that independence should not be compromised in any manner (Arens et. al., 2013). Also, in view of increasing complexity, it is essential that the auditors must undergo constant professional training for skill upgradation so as to ascertain that they could perform the audit accurately and reduce the overall subjectivity. This would ensure that an accurate estimation of the various assets and underlying liabilities may be made in time and associated risks captured in the audit report. This would enable the auditors to minimise their liability in case of any future bankruptcy (Gay Simnett, 2012). References Arens, A., Best, P., Shailer, G. and Fiedler, I. 2013. Auditing, Assurance Services and Ethics in Australia, 2nd ed., Sydney: Pearson Australia ASIC 2016, Financial Reports. [Online] Available at: https://asic.gov.au/regulatory-resources/financial-reporting-and-audit/preparers-of-financial-reports/financial-reports/ (Accessed 25 January 2017) Aubin, D. 2013, Analysis: Knives out for auditors as class actions go global, Reuters Website, [Online] Available from https://www.reuters.com/article/us-usa-accounting-lawsuits-idUSBRE92K0QB20130321 (Accessed 25 January 2017) Azim, M. 2012, Corporate Governance Mechanisms And Their Impact On Company Performance: A Structural Equation Model Analysis, Australian Journal Of Management, [Online] Available from https://aum.sagepub.com/content/early/2012/07/30/0312896212451032.abstract (Accessed 25 January 2017) Caanz, S. 2016, Auditing And Assurance Handbook 2016 Australia, 3rd ed., Sydney: John Wiley Sons Chung, J, Farrar, J , Puri, P and Thorne, L 2010, Auditor Liability To Third Parties After Sarbanes-Oxley: An International Comparison Of Regulatory And Legal Reforms, Journal of International Accounting, Auditing and Taxation, 19(1), pp. 6678 Cheung, J. and Kandiah, S. 2016, Audit Negligence: Who Is To Blame When It All Goes Wrong, Kordamentha Website, [Online] Available from https://www.kordamentha.com/docs/for-publications/issue2011-04-auditnegligence.pdf?Status=Master (Accessed 25 January 2017) Gay, G. and Simnett, R. 2012, Auditing and Assurance Services in Australia, 5th ed., Sydney: McGraw-Hill Education Freifeld, K. 2016, Ernst and Young Settles With N.Y. For $ 10 Million Over Lehman Auditing. Reuters Website, [Online] Available from https://www.reuters.com/article/us-ernst-lehman-bros-idUSKBN0N61SM20150415 (Accessed 25 January 2017) Gibson, A. and Fraser, D. 2014. Business Law, 8th ed., Sydney: Pearson Publications Humphrey, C., Loft, A. and Woods, M. 2009, The global audit profession and the international financial architecture: Understanding regulatory relationships at a time of financial crisis, Accounting, organizations and society, 34(1), pp.810-825. Leung, P., Coram, P. and Cooper, B.J. 2012, Modern Auditing and Assurance Services. 4th ed., New York: John Wiley and Sons Lindgren, K.E. 2011, Vermeesch and Lindgren's Business Law of Australia, 12th ed., Sydney: LexisNexis Publications Serperlaw (2016) Liability Of Auditors In The Common Law System: Australian Position. [Online] Available from https://www.serperlaw.com/about-us/publications-and-articles/liability-of-auditors (Accessed on 25 January 2017) Shefrin, H. and Shaw, L. 2016, The Global Financial Crisis and its Aftermath: Hidden Factors in the Meltdown. 4th ed., London: Oxford University Press Soh, D. and Bennie, N. 2011, The Internal Audit Function: Perceptions Of Internal Audit Roles, Effectiveness And Evaluation,Managerial Auditing Journal, 26(7), pp. 605 622 Taylor, G., Tower, G. and Neilson, J. (2010), Corporate Communication Of Financial Risk,Accounting Finance,50(2), pp.417-446 Xu, Y., Carson, E., Fargher, N. and Jiang, I. 2013, Responses By Australian Auditors To The Global Financial Crisis, Accounting And Finance, 53(1), pp. 301338