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«FINANCIAL DIFFICULTIES AND PERFORMANCE AMONG FRAUDULENT FIRMS EVIDENCE FROM MALAYSIA Noor Azira Sawala, Nor Balkish Zakariab and NorhidayahAbdullahb ...»

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I J A B E R, Vol. 13, No. 1, (2015): 161-175

FINANCIAL DIFFICULTIES AND PERFORMANCE

AMONG FRAUDULENT FIRMS EVIDENCE FROM

MALAYSIA

Noor Azira Sawala, Nor Balkish Zakariab and NorhidayahAbdullahb

Abstract: This study aims to examine the effect of financial difficulties faced by the fraudulent

firms. The population for this study is 175 fraudulent firms which identified as PN17 based on media released by Bursa Malaysia from 2001 to 2012. The results of this studyshow that default risk and financial distress has significant negative effect on Tobin Q. The result of this study could pave way to any agency that monitors the misconducts among listed firms as financial difficulties may give early signal of any fraud possibility in the future.

Keywords: performance, default risk, financial distress

1. INTRODUCTION Financial frauds typically involve complex methods for misusing funds, overstating revenues and misappropriation of assets. In Malaysia, a mini Enron scandal has been alerting those corporate governance players such as directors, managers, accountants, Bursa Malaysia and other agencies. The revealed financial scandal of Transmile Group Berhad, probably become the highlight for being the highest- profile scandal among Malaysian firms that involved in financial irregularities 1.

When the financial statement can no longer portray a true picture of financial position of business, the element of financial irregularities already exist and can be connected with fraud.

On the other hand, prior studies highlight that the financial distressed firms were likely to involve in the fraudulent activities (Liou 2008; Rosner, 2003; Spathis, 2002). Fraudulent firms commit several violations such as breaching listing requirement, asset misappropriation and litigation. There could be several possible factors that contributed to the existence of fraudulent firms and these factors could be financial or non-financial. As for financial factors, the fraudulent firms may suffered financial difficulties like financial distress or high default risk. Besides Politeknik Merlimau, Melaka, Malaysia.

a Accounting Research Institute, Universiti Teknologi MARA, and Universiti Teknologi MARA Johor, b Malaysia.

162 Noor Azira Sawal, Nor Balkish Zakaria and Norhidayah Abdullah � that, fraudulent firmsalso suffered non-financial problems such as poor corporate governance, weak internal control or less ethical business conduct (Law, 2011).

PN 17 classification highlights the business misconducts by Malaysian listed firm such as firms with capital inadequacy, suffers an adverse or disclaimer opinion on the latest audited financial statements, the auditors have expressed an emphasis of matter of the ability of the firm to continue as a going concern, business has ceased its operation and etc.Nevertheless, there were scarce findings that relate the financial difficulties of PN 17 firms to its worthiness. Common prior studies served evidences on the earnings quality of PN 17, initial public offering, value relevance and other ethical behaviour.

Thus, this study aims to investigate the effect of financial difficulties on firm’s worthiness among these PN 17 firms. The fraudulent firms were identified based on Bursa Malaysia media released and categorised as PN17with the exclusion of any firms charged with financial litigations or under financial distressed position since the financial difficultyaspects that will be examined in this study are based on default risk and financial distress. This study hence expects to see the extent of financial difficulties that may affect the firms’ performance among identified fraudulent firms in Malaysia from 2001 to 2012.

The remainder of this paper will be followed by a prior studies review section with developed hypotheses. This is then followed by methodology section that explain the research methods that have been carried out in this study and this next section is the finding and discussion section. Finally a summary section conclude the whole study.

2. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

According to Elliot and Willingham (1980) the management fraud can be described as deliberate actions by management through misleading financial statements that impairs investors and creditors. According to Crawford and Weirich (2011) fraud can be categorized into two categories namely; financial reporting fraud and asset misappropriation. Financial reporting fraud is known as management fraud arises from misstatements with intention, amounts omitted and financial statements disclosures while assetmisappropriation involves the theft of an entity’s assets.Fraudulent firms are those firms involved in various types of fraudulent activities such as financial reporting fraud, misappropriation of assets and could also be the one that involved with litigation, fraud guilty and alleged misconduct (Crawford & Weirich, 2011). According to Martin and Cullen (2006) firms that are involved in corporate misconduct adopts a ‘bad barrels’ or perspectives of how organizational behavior and cultures adapt with unethical behavior. Firms should compete and cooperate with other firms that could influence their behavior and norms.

Financial Difficulties and Performance among Fraudulent Firms... 163 � In Malaysia, Securities Commission (SC) is a statutory body with enforcement and investigation powers to protect the investors. Any listed firms that committed with any fraudulent activities will be penalized by Securities Commission.





Mohamed Sadique, Roudaki, Clark and Alias (2010) examine the fraud cases as reported by the Malaysian Securities Commission in 2007 and found that accounting and auditing offences were higher than the other offences compared to the previous years2. In this study, the fraud firms will be known as fraudulent firms as these firms commit both fraudulent financial reporting and other alleged misconduct like misappropriation of assets, involved with litigation and fraud guilty. Generally, the financial needs and problems could affect the sustainability of the firm. Successful firm will understand, anticipate, and mostly avoid financial problems or financial difficulties because it may severely result in insolvency. Ofek (1993) finds that financial difficulties may result in default debts payments, modified terms and structure of debt in financing the operation of business and the worst part, bankruptcy filings or financial distress.Thus, the effects of financial difficulties are severe and will impair the performance of firms.

2.1. Default Risk A common proxy for financial difficulties is default risk. According to Vassalou and Xing (2004) a firm is said as default when it fails to service its debt obligation.

Therefore, the default risk is the risk that firms unable to make the required payment on their debt obligation. Another key factor in determining default risk is a firm’s leverage.Chow and Rice (1982) suggest that leverage increases when the potential for wealth transfer from debt holders to managers increases. However, Pearson (1995) poses an open question whether high debt could be associated with fraudulent financial statements since high structure of debt may increase the likelihood of fraudulent financial statements.Higher debt may expose the borrower a higher default risk. Creditors may also fear of the same risk and debt covenants are one of their protections to ensure the debt repayment obligation meets its schedule. However, management may manipulate financial statements, given the need to meet certain debt covenants (Spathis, 2002). DeFond and Park (1997) highlighted in their studies that the higher leveraged company lead to greater the risk on defaulting the debt agreements. The finding is consistent with the study by Zeitun, Tian and Keen (2007) which highlight that firm with higher leverage would have higher probability of default3. Therefore, high leverage may lead to high default risk.

Meanwhile, the default risk is connected with financial leverage. Higher financial leverage will decrease firm value due to increasing bankruptcy risk.

Pioneering in the Theory of Agency Cost, Jensen and Meckling (1976) also demonstrate that by constraining or encouraging managers to act more in the interest of shareholders, the amount of leverage in a ûrm’s capital structure affects 164 Noor Azira Sawal, Nor Balkish Zakaria and Norhidayah Abdullah � the agency conflicts between managers and shareholders. Higher financial leverage will decrease firm value by increasing bankruptcy risk. Therefore, to enhance the market value of the firm, every firm has to have a sound optimal capital structure.

Chiang, Chang and Hui (2002) have used sample of construction firms in Hong Kong and investigate the relationship between capital structure and firm’s performance. Their finding shows that high gearing negatively related with firm performance. The study shows that high gearing negatively related with firm performance among construction firms. Previous studies such as Foong and Razak (2012) and Whiting and Gilkison (2000) also have highlight that financial leverage has negative effect on the firm’s performance.However, the findings of the study towards firms in Pakistan conducted by Rasool,Asif, Kayani and Zafar (2011) contradicted the above studies4. This studystates that larger firms have higher target debt levels and stable cash flows. These stable cash flows lead to lessen down the bankruptcy chances as well as the costs of default risk.This is supported by the findings of Gill and Obradovich (2012) who examine the relationship between financial leverage and firm’s performance among American firms. Their finding shows that financial leverage has positive impact the firm’s performance5.

2.2. Financial Distress Another common proxy for financial difficulties is financial distress. Rosner (2003) agrees financial distressed firms also tend to engage in fraudulent financial reporting to disguise their financial condition6. According to Kahl (2002), financial distress is an imperfect indicator of economy sustainability due to creditors are in control and may liquidate the firm against the will of management after a firm’s default. There are many techniques and models to predict financial distress. One of the techniquesis known as Analytical Procedure (AP). Thornhill (1995) posit APs to be a useful tool for identifying fraud. AP was referred to a variety of techniques the auditors use to assess the risk of material misstatements in financial records. Besides, analysis of trends, ratios, and reasonableness tests derived from an entity’s financial and operating data were also involve in AP procedures (Kaminski, Wetzel & Guan, 2004). Meanwhile, Hill, Perry and Andes (1988) use event history analysis from 1977 to 1987. Their study compares the magnitude of coefficient across the dependent variables (stable and financial distress). They find that when leverage increases, the likelihood of financial distress or bankruptcy also increases.According to Altman (1968) the model consists of five ratios selected to be the Z score model variables and highlights that Z-score below 1.10 indicates a distress condition7.

The performance of the fraudulent firm is essential and important to be known since if a firm suffers financial difficulties,firms might embrace loss of reputation and the worst part losing the shareholders and potential investors’ confidence.

The fraud revelation may negatively affect the performance of the fraudulent firms Financial Difficulties and Performance among Fraudulent Firms... 165 � (Tan, 1999). Consequently, the share price of the firm may experience a contraction and become volatile particularly in the short run. Prior literature, Tan (1999) uses a sample of 277 firms from eight East Asian countries during the Asian Financial Crisis from 1997 to 1998 to study the relationship between financial distress and firm’s performance. The result shows that financial distress is negatively related to firm’s performance8. The study by Smith and Graves (2005) which takes 183 distressed companies (exhibited negative Z score) from London Stock Exchange for the period of 1980 to 1990 shows that there is negative relationship between financial distress and firm’s performance. Chan, Munusamy, Chelliah and Mandari (2011) study the performance of Malaysian companies after suffering from a financial distress condition and the finding reveals that the distress condition companies for second time affect firm’s performance negatively 9.Abidali and Harris (1995) take 11 failed and 20 non-failed companies and used a modiûed Z-score to predict the failure. Their results indicate that all the failed companies have exhibited negative Z-scores for several years before failure. The more years the company is classed as at risk, the lower the Z-score for the company and the more likely the company will fail. Thus, they conclude that the Z-score can be used to rank the solvency of the company.

Thus, this study aims to examinethe effect of financial difficulties on firm performance among the fraudulent firms. The research questions are: 1) Does the default risk affect the firm performance among the fraudulent firms? And 2) Does the financial distress position affect the performance among the fraudulent firms?

Default risk and financial distress position are the proxies of financial difficulties.

Using these proxies, it is hypothesized that the default risk and financial distress position will give negative relationship with firm performance. Thus, the following

hypotheses are predicted:

H1: There is significant negative effect between the default risk and firm performance among fraudulent firms.

H2: There is significant negative effect between the financial distress position and firm performance among fraudulent firms.

3. METHODOLOGY



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