Finance company failure in New Zealand was predictable

Otago study finds Finance company failure in New Zealand was predictable

Thursday 23 October 2014

Annual reports and other public disclosures contained enough information to predict more than 80% of New Zealand finance company failures that occurred during the recent financial crisis, a study led by the University of Otago shows.

Losses of over $3 billion have been estimated by a New Zealand parliamentary inquiry into the finance company failures. Despite ongoing attention in New Zealand, including criminal and civil lawsuits, few people have considered whether the failures were predictable.

University of Otago Professor in accounting, David Lont, Dr Tom Scott from the University of Auckland, and Otago honours student Ella Douglas found that annual reports and other public information successfully predicted whether a finance company would fail in the following year for 88.7% of companies.

The study looked at 31 finance companies (non-bank deposit takers) that failed in New Zealand over the 2006–2009 period, and an equal number that did not fail.

"Our result suggests that failures were predictable and so the financial information was more useful than some believed. This is important, as our research suggests that warning signals were available prior to the failure of these companies, thus contradicting the overall media impression in the wake of finance company collapses, which often focused on CEO fraud and that financial reporting was unreliable,” says Professor Lont.

“However the adequacy of communication to investors does need further investigation because many investors were clearly unaware of the increasing risks that the financial accounts were indicating”, said Professor Lont.

The researchers found that failed finance companies had lower capital adequacy, inferior asset quality, more loans falling due, and a longer audit lag - a possible indicator of audit / client disputes.

Trustee monitoring was also a risk factor and the authors have suggested further research to better understand why that was the case.

“As many of these differences have been either totally or in part ameliorated by regulatory reform that happened in New Zealand as a result of these losses, this research does suggest that the regulatory reforms may have been broadly appropriate” added Dr Tom Scott.

“We hope our model is an useful example to help auditors, trustees, regulators and investors better use financial reports to identify at-risk finance companies”, concluded Professor Lont.
Regulatory reforms have included the creation of a new Financial Markets Authority that monitors auditors and trustees regulations among its other functions, and the Reserve Bank now requires risk management policies, credit ratings and set capital and governance requirements.

Dr David Lont is a professor of accounting at the University of Otago’s School of Business. Ella Douglas was an Otago honours student and Dr Tom Scott is from the Graduate School of Management at the University of Auckland. The full paper will be published in the Journal of Contemporary Accounting and Economics December edition.

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