There are six main categories of corporate failure causes: poor strategic decisions, overexpansion, dominance of CEOs, greed, pride and power, failure of internal controls, and ineffective board of directors (Hamilton and Micklethwait, 2006).
Business collapse can happen in cases where companies do not fully comprehend the relevant business drivers when they decide to expand to new lines of products and services, or meet the demands of additional geographic markets. These lead to poor strategic decisions because they fail to recognize the importance of risk management in their respective industries. They should be able to determine the overall impact of economics, politics, social environment, etc. with their decision (Dubrovski, 2007).
Corporate failure can also occur with overexpansion when firms do not perform well in their existing businesses and as such, they decide to expand by acquiring smaller companies (Mbat and Eyo, 2013). While these decisions do not always have unfavorable outcome, it is often that there will be lack of management capacity and cultural differences. One particular example of this is the merger of AOL and Time Warner where the expected benefits were insufficient to cover their integration costs. The company’s goal of short-term growth results to this type of strategy. Through acquisition, businesses can mislead shareholders by manipulating long-term forecasts and short-term growth through purchase accounting adjustments.
When companies experience a period of successful business operations and management, executive are more likely to be more submissive to the judgment of their CEOs decisions and disregard drastic changes even through specific performance indicators would suggest otherwise. Thus, past achievements result to a loss of constructive criticisms with regard to the company’s current financial performance. The shareholders and board of directors lose focus and become irrelevant overtime because of the CEO’s concept of infallibility. Gradually, the misguided forecasts for growth and poor performance in reality lead to the company’s downfall.
Greed, pride, and desire for power also drive people to be particularly ambitious. Since business acquisition is one of the fastest ways to grow companies, capital investments provide incentives for executives and employees. Studies have shown that there is a positive correlation between market capitalization, and executive status and pay. Bonuses, share options, and remuneration benefits are often linked to short-term earnings. Thus, business failures eventually occur in satisfaction of the individual interests.
Weak internal control is a significant risk factor for companies. Since the audit function is regarded as an expensive overhead, many firms are understaffed in this department and its operations emphasize the discovery of potential cost savings rather than safeguarding company assets. Vague organizational structures also make it more difficult in terms of reporting, decision-making, authority, and delegation. These can lead to many unfavorable financial consequences such as poor cash control. In addition, professional accounting qualification is a major concern in the management of big companies.
With extended period of company success, the board of directors can eventually fail to question and evaluate the competence of management. The lack of independence among the directors can lead to poor judgment of strategic proposals and actions of senior management. There is also a problem with excessive executive compensation and conflict of interest when the chairman of the board and the CEO is the same person. These have resulted to one of the world’s most controversial corporate failure – Enron. The members of an audit committee have to be competent consistently provide stakeholders faithful representation of the company’s financial standing.
There are a number of ways that companies can prevent the occurrence of corporate collapse. First, they can emphasize the responsibilities of the board and constantly monitor their performance. A number of business failures were caused by neglected board duties, lack of knowledge and inexperience in the specific industry (Watson and Vasudev, 2012). Independence should be a state of mind for the board members and confrontation should be taken as a necessary step in achieving a consistent, good performance. Positions with conflicts of interests should never be assigned to the same person to ensure that the concept of check and balance is always in place. Regular meetings of board members can also be beneficial.
Second, shareholder involvement should be viewed as a necessity. It takes a very long time to completely change the board of directors because of the staggered election. Thus, all directors should stand for election at the same time and shareholders must have an easier way to nominate them. Institutional investors must give particular importance on board composition and executive compensation in companies where they exercise influential voting rights and promote corporate governance.
Third, executive compensation should be realigned with long-term performance to encourage the achievement of the company’s vision. They should avoid the granting of share options. Thus, the use of restrictive shares provides a more reasonable incentive scheme. They should also terminate guaranteed bonuses and charitable donations funded by the company should rightfully be credited to the company and not the individual directors.
Fourth, there should be increased involvement of an audit committee. Control problems and issues regarding the financial statements are responsibilities of internal and external auditors. A strong audit committee is one that can restore shareholder confidence by providing constant recommendations and putting pressure on management for their implementation. They are especially important when detecting problems before they become critical.
Fifth, financial organization should have operational reforms. For instance, investment banks must have strict barriers on banking services and research. Banks should be prohibited accelerating earnings when the gains are doubtful or still contingent upon some unlikely condition. Any responsible behavior by financial institutions should constantly be upheld to discourage greed in a company that prioritizes short-term earnings.
Sixth, accounting firms should provide the faithful representation of financial information to guarantee confidence among the stakeholders. They should not deceive investors, creditors and shareholders with unrealistic business profits or misrepresent financial expenditures (Dean et. al., 2003). For instance, the failure of Arthur Andersen, one of the biggest accounting firms in the world at that time, also caused the subsequent collapse of Enron that resulted to the implementation of the Sarbanes-Oxley act.
Seventh, companies should employ a competent workforce. People who have the competence are those that finished a degree in the required field and those that have the practical experience necessary to manage the company. Without them, companies are bound to fail because the people that compose the institution conduct operations and make decisions based on their inferior judgment.
Eight, companies should uphold ethics at all times. No matter how companies implement strict rules when conducting businesses, corporate failures can still occur because personal interests drive people to commit fraud. As such, organizations should make it a point to reward people based on long-term and overall performance so its employees will work on that shared goal and disregard individual benefits and commit unethical considerations.
There have been large financial disasters that occurred in the last 10 years. This has caused big companies to shut down and the government to implement new laws to prevent them such as the Sarbanes-Oxley Act. Some of these companies include Enron, Arthur Andersen, WorldCom, Tyco, and Marconi (Jones, 2011). Enron collapsed because its CEO committed securities fraud. Worldcom also went bankrupt because it apparently had too much debt in place. Tyco was also eventually split because it failed in corporate governance. Marconi also collapsed because of excessive spending on mergers and acquisitions.
Clark, F., Dean, G., and Oliver, K. (2003). Corporate Collapse: Accounting, Regulatory, and Ethical Failure. New York: Cambridge University Press.
Dubrovski, D. (2007). Management Mistakes as Causes of Corporate Crises: Countries in Transition. Managing Global Transitions, Volume 5, No. 4.
Hamilton, S., and Micklethwait, A. (2006). Greed and Corporate Failure: The Lessons from Recent Disasters. New York: Palgrave Macmillan.
Jones, M. (2011). Creative Accounting, Fraud and International Accounting Scandals. West Sussex, UK: John Wiley & Sons, Ltd.
Mbat, D., and Eyo, E. (2013). Corporate Failure: Causes and Remedies. Business Management and Research, Volume 2, No.4.
Watson, S., and Vasudev, P. (2012). Corporate Governance After the Financial Crisis. Gloucestershire, UK: Edward Elgar Publishing Ltd.