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with a Temporal and an Atemporal Bankruptcy Risk Model: Analysing U.S

Trade and Service Industry Failures 1974 - 1988

Patti Cybinski, Carolyn Windsor

Article information:

To cite this document:

Patti Cybinski, Carolyn Windsor, (2005),"The Efficacy of Auditors' Going-Concern Opinions Compared with a Temporal and an

Atemporal Bankruptcy Risk Model: Analysing U.S Trade and Service Industry Failures 1974 - 1988", Pacific Accounting Review, Vol.

17 Iss: 1 pp. 3 - 36

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Pacic Accounting Review Vol. 17, No. 1, June 2005 3

The Efcacy of Auditors Going-Concern Opinions

Compared with a Temporal and an Atemporal

Bankruptcy Risk Model: Analysing U.S Trade and

Service Industry Failures 1974 1988

PATTI CYBINSKI*

CAROLYN WINDSOR*

Conicting results have emerged from several past studies as to whether

bankruptcy prediction models are able to forecast corporate failure more

accurately than auditors going-concern opinions. Nevertheless, the last

decade has seen improved modelling of the path-to-failure of nancially

distressed rms over earlier static models of bankruptcy. In the light of the

current crisis facing the auditing profession, this study evaluates the efcacy

of auditors going-concern opinions in comparison to two bankruptcy

prediction models. Bankrupt rms in the U.S. service and trade industry

sectors were used to compare model predictions against the auditors

going-concern opinion for two years prior to rm failure. The two models

are the well-known Altman (1968) Multiple Discriminant Analysis (MDA)

model that includes only nancial ratio variables in its formulation and

the newer, temporal logit model of Cybinski (2000, 2003) that includes

explicit factors of the business cycles in addition to variables internal to

the rm. The results show overall better bankruptcy classication rates for

the temporal model than for the Altman model or audit opinion.

* Patti Cybinski and Carolyn Windsor are Senior Lecturers at the Department of

Accounting, Finance and Economics, The Griffith Business School, Griffith

University, Nathan Campus, Brisbane.

The authors would like to acknowledge the helpful suggestions of Dr. John Forster

as well as the useful feedback of the many members of the School of Accounting,

Banking and Finance and the School of Economics who attended the ABF Seminar

Series presentation of this work.

4 Pacic Accounting Review

(1) INTRODUCTION

An auditor must issue an alert by way of an audit opinion to investors and the public

when a rms ability to operate as a going-concern is impaired. A number of studies

have shown that in only half the cases where companies ultimately went bankrupt was

a going concern opinion ever issued before their ling for bankruptcy (Altman and

McGough 1974; Altman 1982; Menon and Schwartz 1986; Chen and Church 1992;

Johnson and Khurana 1993). Although auditor evaluations are not intended to be

predictors of bankruptcy, users of nancial statements still treat the evaluation as an

early warning of impending failure, and hence treat an unmodied audit opinion as a

clean bill of health. Not surprisingly then, the issuance of unmodied opinions to

rms that subsequently le for bankruptcy can be viewed as failures of the nancial

reporting process (Casterella et al. 2000, p. 510).

The magnitude of recent corporate collapses and the economic losses suffered by the

community has again raised the issue of public condence in the auditing professions

ability to warn investors and the public about a rms future viability (Pearlstein and

Behr 2001; Day and Crenshaw 2002). As a result, some governments have introduced

new regulations affecting the audit professions self regulated monopoly franchise.

For example, the U.S. Congress responded to the wave of corporate scandals with

the landmark Sarbanes-Oxley Act of 2002. The broad corporate governance reforms

and antifraud provisions of the act have been felt in boardrooms across the nation

(Labaton 2003). Further, the Act has also affected auditors who are now much more

risk averse when assessing client risk, with the top audit rms dropping their risky

corporate clients in droves (Browning 2005). An implication of the Act is that auditors

are now forced to scrutinize the nature and extent of client risk to ensure the veracity

of the auditors opinion.

Since, for many users, the early warning function is one of the most useful and

important deliverables provided by auditors (Casterella et al. 2002, p. 508), the purpose

of this study is to reconsider the issue of whether auditors going-concern opinions,

based on professional judgements, are less precise and less reliable compared with

statistically produced bankruptcy models in their predictions.

The literature examining why auditors allegedly miss soon-to-be-bankrupt lers is

extensive and some insights have been gained from the research. For example, in many

cases, soon-to-be-bankrupt companies do not present as nancially distressed in that

they do not have the distress characteristics that are expected from such companies (see

McKeown et al. 1991). The results of Mutchler et al. (1997) are also consistent with

Pacic Accounting Review Vol. 17, No. 1, June 2005 5

the view that the auditor is often not presented with enough cues to trigger an adverse

going-concern opinion. In addition, businesses operate in an increasingly complex

and changing macro-economic environment that challenges auditor judgment. But

these same difculties and challenges also face the statistical modeler who can only

rely on the available data when formulating a bankruptcy prediction model. Hence, a

comparison of the two is not unreasonable given they are using similar information.

A problem facing auditors is that the current compliance-oriented standards that

guide audit judgments have been less responsive to the complexity of business and

stakeholders demands for a more reliable analysis of a clients performance. The

current auditing standards maintain simplistic procedures, reductionist static measures

and a rule of thumb approach (for example, adverse key nancial ratios, possible

nancial difculties, internal work stoppages, legal proceedings and so on, as outlined

in AU Section 341.06 (Georgiades 2001)). Moreover, the standards provide little

guidance for a more sophisticated analysis of the clients audit risk including the

entitys macro-economic context that affects the clients future viability. In fact, the

auditing standards require evaluating mainly historical cost accounting for judgments

about going concern decisions that may be unrepresentative of the current nancial

position.

This study compares the bankruptcy predictions of two very different bankruptcy

models against the auditors going-concern opinion for a group of bankrupt rms

in the U.S. service industry and trade industry sectors. We conduct the comparison

for each of the two years prior to failure. First, predictions are made using the well-

known Altman (1968) Multiple Discriminant Analysis (MDA) model that includes

only nancial ratio variables in its formulation. Second, predictions are also made

using a more recent temporal logit model of Cybinski (2000, 2003), which includes

explicit factors of the business cycles in addition to the variables internal to the rm,

thus making it more representative of the complex business environment.

(2) BANKRUPTCY MODEL FORECASTS VS. AUDITORS OPINIONS

More than two decades ago, the Cohen Commission (AICPA 1978) voiced concern

about evidence that bankruptcy prediction models forecast company failures more

accurately than auditors going-concern opinions. Furthermore the international

auditing standards require the auditor to be alert to the possibility that the going-

concern assumption may be subject to question (International Federation of

Accountants 1989). While auditors often look to nancial distress models as decision

aids

1

, the auditors accuracy in predicting imminent client insolvency does not appear

1

See Kida (1984), Mahzin (1988), Dugan and Zavgren (1989), Koh and Killough (1990), Koh and Oliga

(1990), and Graham et al. (1991) for evidence that auditors use nancial distress models.

6 Pacic Accounting Review

to approach the levels achieved by the premier bankruptcy prediction models

(Louwers 1998, p. 144).

Bankruptcy model research began with Beavers (1966) univariate model while later

research turned to multivariate models. Among the most common methods are those

of Altman (1968), Deakin (1972), and Ohlson (1980), and in their literature reviews,

Zavgren (1983) and Jones (1987) proposed various bankruptcy prediction models that

may be useful to auditors. The Altman and McGough (1974) study provided the link

between bankruptcy prediction models and auditors independent judgements. They

compared Altmans (1968) Z-score bankruptcy prediction model with the accuracy

of auditors going-concern decisions one-year prior to the event for a sample of 34

corporate bankruptcies between 1970 and 1973. The model predicted bankruptcy

for 82 percent of the cases while auditors issued going concern opinions for less than

half of these failed companies.

Several other studies also concluded that bankruptcy prediction models forecast

corporate failure more accurately than auditors opinions (see Altman 1982; Levitan

and Knoblett 1985; Koh and Killough 1990). These suggest that auditors can use

a bankruptcy prediction model to improve their decision accuracy. However, this

implication casts doubt upon auditors rationality. Further, it suggests that auditors

fail to adequately incorporate readily available information such as ratio-based models

into their judgments.

Unlike earlier studies that matched bankrupt rms and non-bankrupt rms equally

in the estimation samples for bankruptcy modelling, Hopwood et al. (1994) used

a bootstrap procedure and sample partitioning to reect the true proportion of

bankrupt companies experienced by auditors. Their results indicate that auditors

were confronted with different decision problems with stressed companies than with

non-stressed companies. Notably, they document and analyze two primary failure

processes: a relatively rapid and unexpected failure where nancial distress is not

evident in the accounting numbers, and a second process of relatively long duration

in which nancial distress is evident. They argued that accounting-based statistical

models could only explain the second type of corporate failure. Hence their ndings

do not support the previous research that auditors opinions are inferior predictors

of bankruptcy relative to statistical prediction models in general. They do contend,

however, that bankruptcy not preceded by nancial distress is more likely to be driven

by management fraud.

In the context of nancial distress prediction, Gadenne and Iselin (1996, p. 45) found

that when interested user groups of accounting information, including auditors, were

presented with relevant and manageable levels of information, their decision accuracy

Pacic Accounting Review Vol. 17, No. 1, June 2005 7

was not signicantly different from that of the statistical models. However, when the

level of information was increased, the statistical model outperformed the user groups.

Their ndings suggest that higher data load may adversely affect human decision

accuracy, further supporting the use of well-formulated models as a decision-support

tool for the auditor.

Conicting results can occur between studies that compare the accuracy of decisions

arising from statistical models and from auditors deliberations for other reasons than

those given above. For instance, research has shown that the time interval between

the particular model formulation and its application is important. Where bankruptcy

models are estimated using recent data, say one-year prior to bankruptcy, Houghton

(1984) and Simnett and Trotman (1989) found higher classication accuracy than

when the data were older.

Also, when model formulations employ an inferior or inappropriate statistical

technique

2

, they would fare badly in any comparison of prediction accuracy with

auditor opinions, as would models that are incomplete, in that they are missing

important predictors of nancial distress. For instance, the inclusion of cash-ow

variables in model formulations has been hotly debated as an important discriminator

of distressed and non-distressed rms (see Largay and Stickney 1980; Ketz and

Kochanek 1982; Mensah 1984; Gentry et al. 1985; Casey and Bartczak 1984,1985;

Aziz et al.1988; and Gilbert et al.1990; among others).

(3) IMPROVED MODELLING AND THE TEMPORAL MODEL PROCESS

Much has been written about why the traditional bankruptcy prediction models of the

60s, 70s and 80s have not been entirely satisfactory (see Chen and Shimerda 1981;

Zmijewski 1984; and Gilbert et al.1990; among others). As noted by Dimitras et

al. (1996, p.487), a unifying theory of business failure has not been developed....

Bankruptcy research has been concerned with prediction before proper explanations

for the bankruptcy phenomenon have been developed and tested, yet software can be

purchased that claims to predict nancial distress of individual enterprises with near

perfect accuracy

3

. Nevertheless, their validity and applicability are limited, most being

based on study designs that have estimation samples that consist of bankrupt versus

solvent (usually strong) rms, as the basis for discrimination. Gilbert et al (1990)

tested traditional bankruptcy models based only on rms nancial characteristics and

2

See next section for more on improved modelling techiques.

3

Examples of commercially marketed Risk Management/Investment tools are Merv Lincolns

STOCKdoctor by Lincoln Indicators (The Weeknd Australian, May 9/10, 1998) and Richard Tafers

PAS-score by Syspas (Financial Review, October 8, 1993).

8 Pacic Accounting Review

demonstrated that if the objective is to identify likely bankruptcies from a pool of

problem companies, these bankruptcy models perform poorly (p.169). They reiterate

Tafers (1984) contention that bankruptcy model scores should be interpreted as

descriptions of nancial distress rather than as predictions of bankruptcy per se.

Research into nding superior bankruptcy model formulations in the 1980s led to

replacing the popular multivariate discriminant analysis (MDA) formulation (Altman

1968) with logistic analysis (Ohlson 1980), which until recently has been the most used

statistical method for failure prediction purposes. The reason was that the assumption

of normality of the nancial ratio distributions in the MDA procedure was problematic,

whereas the maximum likelihood procedure, on which the logistic/probit model is

based, does not require that assumption. It also has the added advantage of allowing

qualitative variables (i.e., those with categories rather than continuous data) into its

formulation. Also the interpretation of individual coefcients is appropriate in the

logit model, which therefore lends itself to broader research applications. This is not

the case for the MDA model

4

.

A major criticism of bankruptcy formulations, in the absence of a generally accepted

theoretical basis, is that model construction has necessarily involved selecting nancial

variables on an empirical basis, according to their ability to increase prediction

accuracy. The process is usually by stepwise selection procedures that can lead to

biased estimates that are then difcult to interpret, and since the choice of variables

is based solely on statistical grounds, it ignores other characteristics of the variables.

On the other hand, because of the typically large number of independent variables

considered in these models without any compelling theory to guide the choice, the

multicollinearity that is inevitably present with accounting data dictates the necessity

of such data reduction methods in order to reduce the non-independence and increase

our ability to make inferences from the model as a whole.

Moreover, most of these models are atemporal and ignore the impact of the external

macro-economy, excluding macroeconomic indicators such as GDP, interest rates and

unemployment rates in their formulations. In other words, most model formulations

in the literature are treated as stationary when they are not. Without these variables

included, predictions have been successful only insofar as the conditions of the

predictive environment mimicked the economic conditions for the sample of rms

used to derive the formula.

4

Press and Wilson (1979) give the reasons why the logistic regression model with maximum likelihood

estimators is preferred for both classication and for relating qualitative variables to other variables under

non-normality and Martin (1977) gives a comprehensive explanation of maximum likelihood estimation

techniques in the context of bank failure predictions.

Pacic Accounting Review Vol. 17, No. 1, June 2005 9

Since the totality of a rms business environment impacts enormously upon its

success and future viability, models can logically only be expected to be useful to

auditors if they include the relevant macroeconomic measures. The rms product

market, its creditors, its suppliers and its business partners are all affected by the

macro-economy.

It has long been established that the rate of corporate failures rises sharply during

economic recessions (Lev 1974, pp.134-139). Rose et al. (1982) suggest a complex

relationship between overall business failure rates and business cycle indicators.

While this means any temporal modelling of rm failure risk calls for the inclusion

of macro-economic variables, this remains a relatively unexplored dimension of

nancial distress modelling. While the bankruptcies and closures engendered by the

economic downturn of the seventies led to a surge in studies concerned with business

failure, few of them took explicit account of business cycles.

Zavgren (1983) noted that in boom periods when failures are relatively rare, the

empirical link between certain otherwise important indicators and the actual occurrence

of failure would be weak. So most failure studies that have included macroeconomic

conditions measure the asymmetric impacts of the expansion and contraction stages

of the cycle upon failure rates (Lev 1974; Mensah 1984; Kane et al. 1996). This

helps explain the lack of consistency among studies relying solely on rm-specic

information as explanatory variables of failure risk. This lack of consistency arises

in relation to (a) the empirically estimated values of the similarly dened coefcients

reported in different studies, and (b) differences in the relative contributions of various

nancial ratios to failure between studies. Such inconsistencies necessarily cast doubt

on the empirical methodological framework of nancial distress modelling and suggest

only limited use of models as a support for auditors decisions.

Users of bankruptcy models often judge and choose models on the basis of their

reported Type I (misclassifying a bankrupt rm) and Type II (misclassifying a

nonbankrupt rm) errors. Unfortunately, these errors may reect only the difculty

of the discrimination task on the estimation sample upon which the model was

formulated rather than the true errors. If the sample was already well-separated on

the distress continuum (see Cybinski 2000, p.12-13), in that it consisted of bankrupt

versus solvent (usually strong) rms, then the misclassication errors reported would

be misleadingly good. More information value would be provided by a model that

distinguishes distressed rms ling bankruptcy from others, also at risk, but avoiding

it (Gilbert et al 1990).

The temporal model by Cybinski (2000, 2003) was developed from one of the few studies

that have analysed bankruptcy as a failure process rather than as an event (among them

10 Pacic Accounting Review

Partington et al. 1991; Theodossiou 1993; Hill et al. 1996; Richardson et al. 1998).

The rm is modelled over several periods of time as it moves towards failure, given

that rms do not instantly fail, but generally experience deterioration towards failure

over a period of time. In modelling the distress-to-failure process, each rm acts as its

own control; its nonfailing years data are compared to its own nal years data before

failure. This is distinct from the usual comparison between different rms featuring a

strictly dichotomous failed/non-failed distinction. Rather, the model is based on a more

difcult (but realistic) study design akin to a pool of problem companies, with some

just surviving while others fail. It presents not only a greater modelling challenge but

a stronger case for information value if such a model can discriminate between at risk

rms that survive and at risk rms that fail (see Wood and Piesse 1987).

Additionally, the sample on which the temporal model by Cybinski (2000, 2003) is

estimated encompasses rms that fail at different years in calendar time and over a

long enough time period to cover at least a full business cycle. This temporal aspect

of the business environment was explicitly included in the temporal model with

orthogonal factor scores representing the prevailing macroeconomic conditions. See

Cybinski and Forster (2002) for more detail on these factor scores and the economic

series upon which they are loaded.

Thus, future progress in the eld of bankruptcy modelling not only depends on the

current preoccupation with the identication of relevant nancial variables, but, at the

very least, also upon incorporating measures of economic adversity, and appropriate

time lag effects. Such developments coupled with an extension of the data base both

cross-sectionally and over time will hopefully give more reliable models with smaller

standard errors for the parameter estimates.

Details of both the Altman (1968) model and the temporal model by Cybinski (2000,

2003) can be found in Appendix A.

(4) SAMPLE

In this study we compare the risk estimates from a recent logit model (Cybinski

2000, 2003) as well as scores from a multiple discriminant analysis (MDA) model

(Altman 1968) with the auditors going concern opinions for a group of bankrupt rms.

This group consisted of all 54 service industry rms and all 56 trade industry rms

recorded in the 1991 Standard and Poors Compustat Research

5

Files as bankrupt or

5

The Research Companies dataset includes companies for which data is no longer included in the Compustat

Industrial Files due to a merger, acquisition, bankruptcy, liquidation, etc. [No Chapter 11 lings are included].

There were approximately 6100 Research companies in 1991.

Pacic Accounting Review Vol. 17, No. 1, June 2005 11

liquidated

6

during the 20 year period back to 1971

7

. Hence, the rms in our sample came

under SAS No. 34. This standard required only that the auditor be aware of evidence that

might indicate that the going-concern assumption was violated and a qualied opinion

was issued. The American Institute of Certied Public Accountants (AICPA) amended

the way going-concern opinions are reported in SAS No. 59 in 1989. Under SAS No.

59 a going-concern opinion is expressed as a modication of the standard audit report

rather than a qualication to the audit report, as was the case under SAS No. 34

8

. The

failed rms were selected from industry groups that were broad enough to yield data

for a sufciently large sample (originally 60) from each industry.

Both Altmans MDA score and the auditors opinion for the set of bankrupt service industry

rms were taken from the COMPUSTAT Research les. The temporal model risk estimates

were calculated after the model coefcients were estimated from the same dataset. In this

respect, one expects the Type I error (misclassied bankrupt rm) to be smaller for the

temporal model than for the Altman model (out-of-sample classication) for this dataset.

Therefore an extra set of rms was taken from the same Compustat Research database

that was out-of-sample for both the temporal model and the Altman model, which was

originally formulated on a set of manufacturing rms. The extra set consisted of all 56

Trade Industry rms recorded there as bankrupted or liquidated in the period from 1971

to 1991 and with enough data available for at least one of the three decisions compared.

Tables 1a - 1d show, respectively, the frequency distributions of the auditors opinion

in the last and second last reporting periods prior to bankruptcy/liquidation for both

the industry datasets. For easier comparison between statistical model predictions and

the auditors decision, the audit opinions were re-coded from the ve level Compustat

scale into two levels as unqualied vs. not unqualied as follows: -

6

Only these two Reasons for Deletion codes were used here. Other reasons not included were: Aquisition

or merger, Reverse acquisition (1983 forward), No longer ts original format, Leveraged buyout (1982

forward), Now a private company, Other reason (e.g. no longer les with SEC).

7

This happened to include rms bankrupted or liquidated only in the period 1974-1988. It is expected that

the most recent failures may not yet have been recorded onto the Research File by October November

1991 when data was collected.

8

Bryan, Tiras and Wheatley (2001) provide evidence that going concern opinions as modications under

SAS No. 59 may be a less effective warning of distress to external users than was a going concern opinion

issued as a qualication under SAS 34.

*Auditors Opinion Code (AUOP Compustat code)

0=unaudited =>NA - not compared

1=unqualied => code 0

2=qualied => code 1

3=no opinion => code 1

4=unqualied with additional explanatory language added => code 0

5=adverse opinion => code 1

12 Pacic Accounting Review

Tables 1a-1d

Frequency Distributions of Auditors Opinion in the Last and Second Last

Reporting Periods Prior to Bankruptcy/Liquidation for the Service Industry

and Trade Industry datasets.

Note: Taken from the Compustat variable AUOP. The nal two categories of auditor

opinion were collected from 1988 forward. Hence only 7 of the 50 audited rms

from the Service Industry set and 4 of the 31 audited rms from the Trade Industry

set had the possibility of being coded into these two categories in their last nancial

reports, but none were.

Table 1a

Last Reporting Period (Service Industry)

Unaudited or not available 4

Unqualied 26

Qualied* 22

No opinion ** 2

unqualied with additional

explanatory language added***

0

Adverse opinion**** 0

Table 1b

Second Last Reporting Period (Service Industry)

Unaudited or not available 11

Unqualied 30

Qualied* 12

No opinion ** 1

Unqualied with additional

explanatory language added***

0

Adverse opinion**** 0

Table 1c

Last Reporting Period (Trade Industry)

Unaudited or not available 32

Unqualied 25

Qualied* 6

No opinion ** 0

Unqualied with additional

explanatory language added***

0

Adverse opinion**** 0

Pacic Accounting Review Vol. 17, No. 1, June 2005 13

For comparison between model predictions and the auditors decision, the values from

the two statistical models were also re-coded as a dichotomy as follows: -

Altmans Discriminant Analysis Model

(1968) Zscore:

Cybinskis Temporal Logit Model

(1998) Risk of Bankruptcy:

An MDA score >1.8 denotes a nonbankrupt

prediction => code 0

Probability less than 0.5 => code 0

An MDA score <1.8

9

denotes a bankrupt

prediction => code 1

Probability greater than 0.5 =>

code 1

(5) ANALYSIS

The rows of Tables 2a-2d show the binary decisions for each rm by the three entities

to be compared within the two sample industries and the two nal reporting periods

before failure. The extent of agreement between the temporal model, Altmans model

and the auditors opinion can thus be ascertained visually and from the sum total of

correct predictions for each decision entity.

Hypothesis tests can be applied to the column totals in Tables 2a-2d to compare

the three decision entities: Altman model, temporal model, auditor. Because the

Table 1d

Second Last Reporting Period (Trade Industry)

Unaudited or not available 22

Unqualied 26

Qualied* 8

No opinion ** 1

Unqualied with additional explanatory

language added***

0

Adverse opinion**** 0

* Financial statements reect the effects of some limitation on the scope of the

examination or some unsatisfactory presentation of nancial information, but are

otherwise presented fairly. SPC assigns this code when a company is in the process

of liquidating (even if opinion is not actually qualied).

** Auditor refuses to express an opinion regarding the companys ability to sustain

operations as a going concern.

*** Auditor has expressed an unqualied opinion regarding the nancial statement

but has added explanatory language to the auditors standard report.

**** Auditor has expressed an adverse opinion regarding the nancial statements of

the company.

9

Note that Altman also identied a grey area of undecideds with Zscores between 1.8 and 2.99.

14 Pacic Accounting Review

data is incomplete with many missing entries, we rst treat these as independent

decisions and use the simplest possible statistical test for detection of a difference

between proportions for more than two entities - the chi-squared test of a multinomial

experiment. The null hypothesis is that there is no difference in the proportions of

correct decisions between the three decision entities.

H

0

: p

1

= p

2

= p

3

against the alternative that not all three proportions are equal:

H

1

: not all p

j

are equal (where j=1,2,3)

We compute the test statistic for an r x c contingency table (r rows, c columns):

where f

0

= observed frequency in a particular cell of a 2x3 contingency

table

fe = expected frequency in a particular cell of a 2x3 contingency table

with (r-1)(c-1) degrees of freedom.

If the null hypothesis: p

1

= p

2

= p

3

is rejected above, further Z-tests for differences in

two proportions can then be employed to isolate which particular pair/s of decision

entities are different in their proportion of correct decisions and in what direction

that difference lies.

with p

i

and p

i

, respectively, the sample and hypothesized values of the relevant

proportions and

where X

1

= number of correct decisions by entity 1

X

2

= number of correct decisions by entity 2

=

cells all e

e o

f

f f

c r

2

2

) (

) 1 )( 1 (

)

1 1

)( 1 (

) ( ) (

2 1

2 1 2 1

n n

p p

p p p p

Z

+

=

v v

2 1

2 1

n n

X X

p

+

+

=

Pacic Accounting Review Vol. 17, No. 1, June 2005 15

Table 2a

Extent of Agreement between the Temporal Model, Altmans Model and Auditors

Opinion in the Last Reporting Period Prior to Bankruptcy/Liquidation (Service

Industry)

Code 1 denotes either a bankrupt prediction or an audit not unqualied (see codes

below)

Firm

Number

Temporal Altman Auditor Firm

Number

Temporal Altman Auditor

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

1 0 28 1 1 0

2 1 1 1 29 1 0

3 1 0 0 30 1 1 0

4 1 0 1 31 1 1

5 0 1 32 1 1 1

6 1 1 1 31 1 0 0

7 1 0 0 34 0 0 0

8 1 1 1 35 0 0 0

9 1 1 1 36 1 1 0

10 0 0 0 37 1 0 0

11 1 0 38 1 1 0

12 1 1 0 39 1 0 1

13 1 0 40 1 1

14 0 1 1 41 0 0 0

15 1 1 42 1 0

16 1 1 43 0 1 1

17 1 1 1 44 1 1 0

18 0 1 1 45 1 0

19 1 1 1 46 1 0

20 1 1 1 47 1 1

21 1 1 1 48 0 1 1

22 1 1 1 49 0 1 0

23 1 1 0 50 0 1 1

24 1 0 0 51 0 0 0

25 1 1 0 52 0 1 1

26 1 0 0 53 1 1

27 0 1 54 0 0 0

Number of Bankrupt Predictions/Opinions 38 28 24

Total Number of Predictions/Opinions Reported 53 43 50

*Auditors Opinion Code (AUOP Compustat code)

0=unadited => blank 3=no opinion => code 1

1=unqualied => code 0 4=unqualied with additional explanatory

language added => code 1

2=qualied => code 1 5=adverse opinion = code 1

Altmans Multiple Discrimination Analysis

Model (1968) Zscore:

Cybinskis Temporal Model (1998) Risk of

Bankruptcy:

A Zscore (>1.8) is classied as not bankrupt

=> code 0

Probability less than 0.5 => code 0

A Zscore (<1.8) is classied as bankrupt =>

code 1

Probability greater than 0.5 => code 1

16 Pacic Accounting Review

Table 2b

Extent of Agreement between the Temporal Model, Altmans Model and Auditors

Opinion in the Last Reporting Period Prior to Bankruptcy/Liquidation (Trade

Industry)

Code 1 denotes either a bankrupt prediction or an audit not unqualied (see codes

below)

Firm

Number

Temporal Altman Auditor Firm

Number

Temporal Altman Auditor

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

1 1 29 0 1 0

2 1 30 1

3 1 31 0 1 0

4 0 32 1 1

5 1 33 1 1

6 0 0 34 0 0

7 1 35 0 0

8 1 36 1 0 0

9 1 37 1 0

10 1 38 1 0 0

11 1 39 1 1 0

12 1 0 0 40 0 0

13 1 0 0 41 0

14 0 0 42 0 0

15 0 0 43 1 0

16 1 1 44 1 1

17 0 0 45 1 1 1

18 0 0 0 46 0

19 0 0 47 0 0

20 1 48 1 0

21 0 49 1 1 1

22 1 50 1 1

23 0 51 0 1 0

24 0 52 1 0 0

25 1 53 1 1 0

26 1 1 0 54 0 1

27 1 0 55 0 1

28 1 0 0

Number of Bankrupt Predictions/Opinions 29 6 7

Total Number of Predictions/Opinions Reported 43 28 31

*Auditors Opinion Code (AUOP Compustat code)

0=unadited => blank 3=no opinion => code 1

1=unqualied => code 0 4=unqualied with additional explanatory

language added => code 1

2=qualied => code 1 5=adverse opinion = code 1

Altmans Multiple Discrimination Analysis

Model (1968) Zscore:

Cybinskis Temporal Model (1998) Risk of

Bankruptcy:

A Zscore (>1.8) is classied as not bankrupt

=> code 0

Probability less than 0.5 => code 0

A Zscore (<1.8) is classied as bankrupt =>

code 1

Probability greater than 0.5 => code 1

Pacic Accounting Review Vol. 17, No. 1, June 2005 17

Table 2c

Extent of Agreement between the Temporal Model, Altmans Model and Auditors

Opinion in the Second Last Reporting Period Prior to Bankruptcy/Liquidation

(Service Industry)

Code 1 denotes either a bankrupt prediction or an audit not unqualied (see codes

below)

Firm

Number

Temporal Altman Auditor Firm

Number

Temporal Altman Auditor

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

1 1 0 28 0 0 0

2 0 1 1 29 0

3 0 0 0 30 1 0 0

4 0 31 0

5 0 1 32 0

6 1 0 1 33 1 1 0

7 0 0 0 34 0 0 0

8 1 35 0 0 0

9 0 36 1 1 0

10 1 0 0 37 1 1 0

11 1 0 0 38 1 1 0

12 1 39 0 0 0

13 0 0 40 0 1 0

14 0 1 1 41 0

15 1 1 42 1 0 1

16 0 1 1 43 0 1 1

17 1 1 44 1 1 1

18 1 1 1 45 0 0

19 0 0 0 46 1 0 0

20 0 0 0 47 0

21 0 0 1 48 0

22 1 1 1 49 0 0 0

23 0 1 0 50 1 1 0

24 1 0 0 51 0 0 0

25 0 0 0 52 1 0 0

26 1 0 0 53 1 1 0

27 0 1 1 54 0

Number of Bankrupt Predictions/Opinions 23 17 13

Total Number of Predictions/Opinions Reported 54 38 43

*Auditors Opinion Code (AUOP Compustat code)

0=unadited => blank 3=no opinion => code 1

1=unqualied => code 0 4=unqualied with additional explanatory

language added => code 1

2=qualied => code 1 5=adverse opinion = code 1

Altmans Multiple Discrimination Analysis

Model (1968) Zscore:

Cybinskis Temporal Model (1998) Risk of

Bankruptcy:

A Zscore (>1.8) is classied as not bankrupt

=> code 0

Probability less than 0.5 => code 0

A Zscore (<1.8) is classied as bankrupt =>

code 1

Probability greater than 0.5 => code 1

18 Pacic Accounting Review

Table 2d

Extent of Agreement between the Temporal Model, Altmans Model and Auditors

Opinion in the Second Last Reporting Period Prior to Bankruptcy/ Liquidation

(Trade Industry)

Code 1 denotes either a bankrupt prediction or an audit not unqualied (see codes

below)

Firm

Number

Temporal Altman Auditor Firm

Number

Temporal Altman Auditor

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

Prob>0.5 Zscore<1.8

not

unqualied

opinion*

1 0 30 0 1

2 1 31 1 1 0

3 0 32 0

4 0 33 0 0 0

5 0 1 34 1 1 1

6 1 0 0 35 0 1

7 0 36 0

8 0 37 0 0 0

9 0 0 38 0 0

10 0 39 1 0 0

11 1 40 1

12 1 0 0 41 1 0 0

13 0 0 0 42 0 0

14 0 1 43 0 0

15 0 1 44 0

16 0 1 45 0 0 0

17 0 0 46 1

18 0 0 0 47 0 1 1

19 0 0 48 0

20 0 1 0 49 0

21 0 0 50 1 0 0

22 1 51 1 1 1

23 1 1 0 52 1

24 0 53 0 0 0

25 1 54 0 0 0

26 1 0 0 55 0 0 0

27 0 1 0 56 1

28 0 0 57 1 0 1

29 1

Number of Bankrupt Predictions/Opinions 20 8 9

Total Number of Predictions/Opinions Reported 46 33 36

*Auditors Opinion Code (AUOP Compustat code)

0=unadited => blank 3=no opinion => code 1

1=unqualied => code 0 4=unqualied with additional explanatory

language added => code 1

2=qualied => code 1 5=adverse opinion = code 1

Altmans Multiple Discrimination Analysis

Model (1968) Zscore:

Cybinskis Temporal Model (1998) Risk of

Bankruptcy:

A Zscore (>1.8) is classied as not bankrupt

=> code 0

Probability less than 0.5 => code 0

A Zscore (<1.8) is classied as bankrupt =>

code 1

Probability greater than 0.5 => code 1

Pacic Accounting Review Vol. 17, No. 1, June 2005 19

Next, pairwise comparisons of the three decision entities can be made as shown in

Tables 3a-3d by cross-tabulating the binary decision outcome and applying the chi-

square test for independence (or non-agreement) for each pair of decision-makers

10

.

Note the data is reduced here to just those rms for which complete data exists for

both decisions.

As a test of independence now, the null and alternative hypotheses are:

H

0

: The two categorical variables (binary decision sets for each entity)

are independent (ie. there is no relationship between them).

11

against the alternative:

H

1

: The two categorical variables are dependent (ie. they are related in

that they predominately agree or predominately disagree).

12

Note that the rule of ve applies for both a chi-squared test of a multinomial experiment

in Tables 2a-2d, as well as for a chi-squared test of independence (contingency

table) in Tables 3a-3d. The expected values should be at least ve to ensure that the

(continuous) chi-squared distribution provides an adequate approximation of the

(discrete) sampling distribution. Note that if an observed value is less than ve it is

possible that the expected value may be ve or greater and the rule is still satised.

Where possible, cells can be combined in order to satisfy this rule.

13

The rule of ve

is satised here for all of the cells in Tables 3a-3b (i.e. for the Service Industry data)

but not for all cells of the Trade Industry tables in Tables 3c-3d where Fishers Exact

Test may be applied using the hypergeometric distribution, or a Mantel-Haenszel

Chi-Squared Test is applied (see Conover 3

rd

ed. 1999, pp.188-193).

10

Note that the two extreme cases that would result in rejection of the null hypothesis of independance is

actually that either all of the decisions agree (+ve agreement) or all disagree (ve agreement).

11

This implies that their joint probability is equal to the product of their marginal probabilities of occurrence

and conditional probabilities do not enter the formula. If the null hypothesis cannot be rejected, this means

that the data shows no evidence of any relationship (either +ve or ve agreement) between the decision

entities.

12

Hence it is a two-tailed test of independence. If signicant, one gauges whether the direction of agreement

is positive or negative by the ratio of agreements: disagreements in the table.

13

Note that the rule of ve is somewhat conservative. A discussion of alternatives to the rule of ve can

be found in Conover (1971, p.152) and in Siegel (1956, p.178).

20 Pacic Accounting Review

Table 3a

Chi-Squared Tests for Independence of Two Categories/Variables in the Last

Reporting Period before Bankruptcy/Liquidation (Service Industry).

In each case H

0

: The two categories are independent (ie. not generally related) vs.

H

1

: the two categories are not independent

(ie. they are related - the predictions/opinions either predominantly agree

or predominantly disagree).

Contingency Tables

Data taken from nancial reports tendered in the last reporting period prior to

bankruptcy/liquidation

Temporal model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Temporal Not bankrupt 7 8 15

Model Bankrupt 18 16 34

Predictions Total 25 24 49

Test Statistic Chi-Squared = 0.16

P-Value = 0.69

Ratio of Agreements: Disagreements 23:26

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Temporal model predictions vs Altman model predictions

Altman Model Predictions

Not bankrupt Bankrupt

Total

Temporal Not Bankrupt 6 7 13

Model Bankrupt 9 21 30

Predictions Total 15 28 43

Test Statistic Chi-Squared = 1.04.

P-Value = 0.31

Ratio of Agreements: Disagreements 27:16

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Altman model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Altman Model Not bankrupt 12 2* 14

Predictions Bankrupt 9 16 25

Total 21 18 39

Test Statistic Chi-Squared = 8.9

P-Value = 0.003

Ratio of Agreements: Disagreements 28:11

Conclusion: Not Independent/Predominant Agreement the outcomes of the two

decision entities are related.

*

Note: the expected value of this cell is 6.5 > 5 so Chi-Squared is valid under the Rule of Five.

Pacic Accounting Review Vol. 17, No. 1, June 2005 21

Table 3b

Chi-Squared Tests for Independence of Two Categories/Variables in the Second

Last Reporting Period before Bankruptcy/Liquidation (Service Industry).

In each case H

0

: The two categories are independent (ie. not generally related) vs.

H

1

: the two categories are not independent

(ie. they are related - the predictions/opinions either predominantly agree

or predominantly disagree).

Temporal model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Temporal Not bankrupt 16 7 23

Model Bankrupt 14 6 20

Predictions Total 30 13 43

Test Statistic Chi-Squared = 0.001

P-Value = 0.98

Ratio of Agreements: Disagreements 22:21

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Temporal model predictions vs Altman model predictions

Altman Model Predictions

Not bankrupt Bankrupt

Total

Temporal Not Bankrupt 12 7 19

Model Bankrupt 9 10 19

Predictions Total 21 17 38

Test Statistic Chi-Squared = 0.96

P-Value = 0.33

Ratio of Agreements: Disagreements 22:16

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Altman model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Altman Model Not bankrupt 18 3* 21

Predictions Bankrupt 8 8 16

Total 26 11 37

Test Statistic Chi-Squared = 5.54

P-Value = 0.02

Ratio of Agreements: Disagreements 26:11

Conclusion: Not Independent/Predominant Agreement the outcomes of the two

decision entities are related.

*

Note: the expected value of this cell is 6.5 > 5 so Chi-Squared is valid under the Rule of Five.

22 Pacic Accounting Review

Table 3c

Chi-Squared Tests for Independence of Two Categories/Variables in the Last

Reporting Period before Bankruptcy/Liquidation (Trade Industry).

In each case H

0

: The two categories are independent (ie. not generally related) vs.

H

1

: the two categories are not independent

(ie. they are related - the predictions/opinions either predominantly agree

or predominantly disagree).

Temporal model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Temporal Not bankrupt 4* 0* 4

Model Bankrupt 12 3* 15

Predictions Total 16 3 19

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 0.9

P-Value 0.98 P-Value = 0.34

Ratio of Agreements: Disagreements 7:12

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Temporal model predictions vs Altman model predictions

Altman Model Predictions

Not bankrupt Bankrupt

Total

Temporal Not Bankrupt 3* 1* 4

Model Bankrupt 10 3* 13

Predictions Total 13 4 17

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 0.006

P-Value 1.0 P-Value = 0.94

Ratio of Agreements: Disagreements 6:11

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Altman model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Altman Model Not bankrupt 21 1* 22

Predictions Bankrupt 2* 4 6

Total 23 5 28

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 11.96

P-Value 0.003 P-Value = 0.0005

Ratio of Agreements: Disagreements 25:3

Conclusion: Not Independent/Predominant Agreement the outcomes of the two

decision entities are related.

*

Note: the expected values of the asterisked cells are <5 so a Chi-Squared Test of Independence is not

valid. Both a Fishers Exact Test and a Mantel-Haenszel Chi-Sqaured Test are valid.

Pacic Accounting Review Vol. 17, No. 1, June 2005 23

Table 3d

Chi-Squared Tests for Independence of Two Categories/Variables in the Second

Last Reporting Period before Bankruptcy/Liquidation (Trade Industry).

In each case H

0

: The two categories are independent (ie. not generally related) vs.

H

1

: the two categories are not independent

(ie. they are related - the predictions/opinions either predominantly agree

or predominantly disagree).

Temporal model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Temporal Not bankrupt 11 3* 14

Model Bankrupt 8 3* 11

Predictions Total 19 6 25

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 0.11

P-Value 1.0 P-Value = 0.74

Ratio of Agreements: Disagreements 14:11

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Temporal model predictions vs Altman model predictions

Altman Model Predictions

Not bankrupt Bankrupt

Total

Temporal Not Bankrupt 8 3* 11

Model Bankrupt 7 4* 11

Predictions Total 11 7 22

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 0.2

P-Value 1.0 P-Value = 0.65

Ratio of Agreements: Disagreements 12:10

Conclusion: Independent. Neither the number of agreements or disagreements are

signicantly large enough to reject the hypothesis that the outcomes of the two decision

entities are unrelated.

Altman model predictions vs Auditors opinion

Auditor Opinion

Unqualied Not Unqualied

Total

Altman Model Not bankrupt 21 4 25

Predictions Bankrupt 5 3* 8

Total 26 7 33

Test Statistic Fishers Mantel-Haentszel Chi-

Exact Test Squared = 1.63

P-Value 0.32 P-Value = 0.20

Ratio of Agreements: Disagreements 24:9

Conclusion: Not Independent/Predominant Agreement the outcomes of the two

decision entities are related.

*

Note: the expected values of the asterisked cells are <5 so a Chi-Squared Test of Independence is not

valid. Both a Fishers Exact Test and a Mantel-Haenszel Chi-Sqaured Test are valid.

24 Pacic Accounting Review

(6) RESULTS

For both industry datasets in the last reporting period before bankruptcy/liquidation,

the binary decision outcomes are summarized in Table 4a below.

Table 4a

Summary of binary decision outcomes in the last reporting period before

bankruptcy/liquidation

SERVICE INDUSTRY DATASET

Temporal

Model

Altman

Model

Auditor's

Opinion

Number of Bankrupt Predictions/Not Unqualied Opinions 38 72% 28 65% 24 48%

Number of Nonbankrupt Predictions/Unqualied Opinions 15 15 26

Total Number of Predictions/Opinions Reported 53 43 50

TRADE INDUSTRY DATASET

Temporal

Model

Altman

Model

Auditor's

Opinion

Number of Bankrupt Predictions/Not Unqualied Opinions 29 67% 6 21% 7 23%

Number of Nonbankrupt Predictions/Unqualied Opinions 14 22 24

Total Number of Predictions/Opinions Reported 43 28 31

For both industry datasets in the second-last reporting period before bankruptcy/

liquidation, the binary decision outcomes are summarized in Table 4b below.

Table 4b

Summary of binary decision outcomes in the second last reporting period before

bankruptcy/liquidation

SERVICE INDUSTRY DATASET

Temporal

Model

Altman

Model

Auditor's

Opinion

Number of Bankrupt Predictions/Not Unqualied Opinions 23 43% 17 45% 13 30%

Number of Nonbankrupt Predictions/Unqualied Opinions 31 21 30

Total Number of Predictions/Opinions Reported 54 38 43

TRADE INDUSTRY DATASET

Temporal

Model

Altman

Model

Auditor's

Opinion

Number of Bankrupt Predictions/Not Unqualied Opinions 20 43% 8 24% 9 25%

Number of Nonbankrupt Predictions/Unqualied Opinions 26 25 27

Total Number of Predictions/Opinions Reported 46 33 36

Tables 2a and 2b show the extent of agreement between the temporal model, Altmans

model and the auditors opinion for individual rms in the last reporting period prior

to bankruptcy/liquidation for the service industry and the trade industry datasets

respectively. Table 4a shows that the temporal model identied 72% of the service

industry bankrupt rms as distressed

14

at this time compared with 65% for the Altman

model, whilst only 48% of the audited bankrupt rms were denied an unqualied

going concern opinion by the auditor.

14

The denition of distressed here is having a bankruptcy risk estimate greater than 0.5.

Pacic Accounting Review Vol. 17, No. 1, June 2005 25

With regards to the last comparison, it is worth pointing out that the auditor is given

an advantageous position (as explained next) and nevertheless, still showed the lowest

percentage of correct decisions. Firstly, if a company is in the process of liquidation at the

time of submitting their nancial reports, Standard and Poors assigns a qualied code

regardless, even if the opinion is not actually qualied. The authors are not able to know

to what extent this occurred for the companies in the datasets used here. Secondly, if the

auditor refuses to express an opinion regarding the companys ability to sustain operations

as a going concern, it is also regarded as not unqualied (i.e. code 1 in this study) as the

authors have regarded non-commital as a denial, to some extent, of an unqualied report.

So, in both instances, since we are dealing with just bankrupt rms, the auditor would have

been coded with a correct decision without actually having made a decision.

Notwithstanding the above, the null hypothesis of equal proportions of correct

decisions by the three decision entities is rejected at the .04 level of signicance [

2

2

=

6.42, p=0.040]. The follow-up Z-tests, for paired differences in the overall proportion

of correct decisions made, show that outcomes from the temporal model and Altmans

model are not statistically signicantly different from each other [Z=0.69, p=0.49] and

that both give signicantly higher correct classications than the auditors [p=0.007,

p= 0.049 respectively].

Tables 2c and 2d show the gures for the second last reporting period before failure

for the service industry and trade industry datasets respectively. The accuracy of the

decision is not as straightforward here as in the nal year before failure since the

rms all survived another reporting period. Note that the temporal model is based on

discriminations between rms in their previous surviving years against their nal year

before bankruptcy so a not bankrupt decision is a correct classication at this time

within that model structure. A bankrupt decision therefore signals that the rm is

already in trouble despite its continued survival. Altman (1968), on the other hand,

used his model to ascertain whether a rm would fail for up to 5 periods into the future

(though he noted it was accurate for up to only two periods, p. 604).

Table 4b shows that, for the service industry dataset, Altmans model signalled

bankruptcy for 45% of the bankrupt rms two reporting periods prior to bankruptcy,

whereas the temporal model gure was 43%, and only 30% of the audited rms

were denied an unqualied going concern opinion. Whether such comparisons

are meaningful or not, there was not enough evidence in the data to reject the null

hypothesis of equal proportions of bankrupt/not unqualied decisions made by the

three decision entities [

2

2

=2.2, p=0.33].

Table 4a shows that for the out-of-sample predictions using the trade industry dataset,

in the nal reporting period before failure, the temporal model still identied 67%

26 Pacic Accounting Review

of these bankrupt rms as failing even though the model was formulated specically

for the service industry. This compared with only 21% for the Altman model also

formulated on a different sample of manufacturing rms, while just 23% of the audited

bankrupt rms were denied an unqualied going-concern opinion by the auditor.

There is a statistically signicant difference in prediction accuracy here, with the

null hypothesis of equal proportions of correct decisions by the three decision entities

rejected [

2

2

= 21.2, p<0.0001], and the temporal model outperforming the other two

decision entities [both p<0.0001].

For the trade industry dataset at two reporting periods prior to bankruptcy, the temporal

model signalled bankruptcy for 43% of the bankrupt rms, whereas Altmans model

gure was 24%, and 25% of the audited rms were denied an unqualied going-

concern opinion at this time. The null hypothesis of equal proportions of bankrupt/not

unqualied decisions made by the three decision entities can be rejected at the 10%

level of signicance but not the 5% level [

2

2

=5, p= 0.08], but the statistically more

powerful pairwise Z-test comparisons show that the decisions of the auditor and the

Altman model are not statistically signicantly different from each other [Z=0.07,

p= 0.94] whereas the temporal model again signals more bankruptcies than the other

two entities [both p=0.04].

Tables 3a-3d give pairwise cross-tabulations of the binary decisions of the three

decision-entities and the respective tests for independence (no relationship) for each

pair. For the trade industry dataset, there were too many missing values and too few

bankrupt decisions arising from both Altmans model and the auditors to give valid

chi-squared tests of independence with the temporal model for paired contingency

tables in both nal reporting periods. Consequently other nonparametric tests have

been employed here

15

as detailed in the Analysis section above.

For pairwise comparisons between the temporal model and the other two decision

entities, for both the nal reporting periods before failure and for both the service

industry and the trade industry datasets, there is not enough evidence to reject the

null hypothesis that the decision outcomes are unrelated. In other words, they dont

consistently agree or disagree [all p>0.33]. In contrast, for the comparisons between

the auditors decisions and Altmans atemporal model, there is predominant agreement

[p<.02]. The only exception occurs in the second last reporting period for the trade

industry dataset where the total number of agreements for the sample size of 33 is

not signicantly large enough to reject the hypothesis that the decision outcomes of

15

The actual distribution of the test statistic is discrete and can be approximated by a continuous chi-

squared distribution when the sample size is large. However, the approximation is poor if the expected cell

frequencies are small (the rule of ve convention is that no more than 20% of cell frequencies less than

ve). Fishers Exact Test or a Mantel-Haenszel Test is appropriate in these cases.

Pacic Accounting Review Vol. 17, No. 1, June 2005 27

the auditors and from Altmans model are unrelated [p=0.32]. Nevertheless, for this

comparison, the ratio of agreements:disagreements is 24:9 and agreement does occur

predominantly on nonbankrupt/unqualied decisions (21 of the 24 agreements).

(7) DISCUSSION

The macroeconomic environment of rms has largely been excluded from empirical

analyses of business failure. This may explain the inconsistencies in the prediction

accuracy of the various bankruptcy models when they are applied to more recent

data, as well as auditors reluctance to rely more on them in a going-concern decision.

Based on the ndings of this study, we suggest here that the auditors could indeed

have beneted from the information supplied by the bankruptcy models. In the nal

reporting period for the service industry dataset, this study has shown that with respect

to the total percentage of accurate decisions, both bankruptcy models outperform the

auditor. Moreover, on comparing both models against the auditors opinions we nd

that in the nal reporting period before bankruptcy, the temporal model gave superior

prediction accuracy on both datasets (i.e. including the holdout dataset).

In the second last reporting period before bankruptcy, we nd that the margin of

difference in prediction accuracy between the bankruptcy models and the auditors

opinions is reduced and it is signicantly different only for the trade industry dataset

and only between the temporal model and the auditors (43% to 25% resp.) .

It is not surprising, then, to nd that there is no overall agreement between the temporal

model and both the other decision models on individual rm decisions in both reporting

periods before failure. They clearly signal different rms as failing.

For the service industry dataset, the Type I (false negative) error rate for the temporal

model was 28% in the nal reporting period before failure. In other words the model

classied slightly more than a quarter of the bankrupt rms as not distressed or

able to survive another reporting period. This compares with 35% of the bankrupt

rms predicted as not bankrupt by the Altman model and slightly more than half

given an unqualied going-concern opinion by the auditors. The differences in Type

I errors were even more startling for the trade industry dataset that was out-of-sample

for both the Altman model and the temporal model formulations; one third for the

temporal model compared to 79% for the Altman model and 77% for the auditors.

The temporal model correctly classied more of the (bankrupt) rms as risking failure

in the next year for both its estimation sample (as expected) and for another holdout

sample of rms, and the difference was statistically signicant in all but one case.

28 Pacic Accounting Review

This study also found that the Altman model and the auditors agree more often on

individual rms. There is consistently strong agreement across three of the four

comparison tables between the auditors and the Altman model [p<.003, p<.003,

p<.02 respectively]. Both decision entities predominantly make nonbankrupt/

unqualied decisions and they both agree on 70-89% of all their decisions. These

results could indicate that they both have a bankrupt/not unqualied outcome for

only the most distressed rms, i.e., those with a very high risk of bankruptcy in the

temporal model.

Clearly, the higher bankruptcy classication rates for the temporal model would

suggest that, for a sample of distressed or problem companies at least, a more complex

failed-rm model including macroeconomic factors in its formulation can perform

far better than an atemporal model or the auditors decision process, especially in

providing support in the form of a risk assessment.

(8) CONCLUSION

Professional audit standards require auditors to understand the client entity and

its economic environment by using various operating indicators such as nancial

indicators and management attributes and/or deciencies. There is no professional

requirement for any more sophisticated analysis of the entitys business environment

using statistical modelling. The problem with using operating indicators is that they

provide only a simplistic and static measure of the entitys business environment when

auditors are supposed to give a going-concern opinion that in reality predicts the

entitys viability or otherwise (for 12 months). It is argued that a bankruptcy model

that includes a temporal approach can provide a sophisticated tool to assist forming

a going-concern opinion and complement the auditors professional judgement.

This study has shown that newer models like the temporal model presented by Cybinski

(2000, 2003) can improve decision accuracy over the static or atemporal models of

the past, when used as an adjunct to the auditors tools in the going-concern decision.

One reason is simply because they are more sensitive to changing macroeconomic

conditions and how they impact on distressed rms. Hence temporal models are

more useful for out-of-sample predictions of distress (or bankruptcy risk), although

we need always to be mindful of limitations due to external validity concerns when

using models for the assessment of a particular rms insolvency risk (other than in the

industry in which the model was estimated and, in the case of the Cybinski temporal

model, for other than failed rms). Nevertheless these limitations do not preclude the

application of these models in a practical way when researchers/auditors use them for

explanatory purposes rather than for forecasting - as a decision support.

Pacic Accounting Review Vol. 17, No. 1, June 2005 29

Although exploratory in nature, the formulation of a temporal model for failure risk is

informative concerning the possible comparative effects of the internal ratios and the

external economy on failure risk and the means of examining these effects together.

The fact that reasonable results were obtained when a particular temporal model for

the service industry was applied to the trade industry group is an encouraging result

for testing external validity of such models in future research.

Improved bankruptcy modelling will also, no doubt, engender greater public

condence in auditor objectivity with the professional use of quantitative decision

support. Current audit procedures require the auditor to trust client management

for information in an intensive interactive relationship, which has led to standards

that focus on prescriptive behavioural parameters for that relationship (Windsor and

Ashkanasy 1995). Rather than introducing more of the same in the imminent revision

of auditing standards, the inclusion of sophisticated and objective approaches to audit

procedures such as statistical modelling should be seriously considered. This would

allow for a more impartial analysis of the client rm in a more holistic environment

and provide an opportunity for auditors to increase their professional decision-making

expertise.

30 Pacic Accounting Review

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34 Pacic Accounting Review

APPENDIX A

THE ALTMAN MODEL(1968)

Concept Calculation in Standard and Poors COMPUSTAT database.

ZSCORE=1.2

*

(WCAP/AT)+1.4

*

(RE/AT)+3.3

*

(EBIT/AT)

+0.6

*

(@VALUE(PRCCF

*

CSHO,CEQ)+PSTK)/(AT-CEQ-PSTK)+.999

*

(SALE/AT)

This concept is a bankruptcy prediction model developed by Edward Altman at New York University in

1968.

Altmans (1968) Multiple Discriminant Analysis model was written:

Z = .012X

1

+ .014X

2

+ .033X

3

+ .006X

4

+ .999X

5

where

X

1

= Working capital/total Assets

X

2

= Retained earnings/total assets

X

3

= EBIT/total assets

X

4

= Market value equity/book value of total debt

X

5

= Sales/total assets

Note that in this formulation X

1

to X

4

must be calculated as absolute % values hence the the coefcients

of these ratios are one hundredth those of the COMPUSTAT formulation.

The sample on which the model is based was composed of 66 manufacturing corporations with 33 rms

in each of two groups; a bankrupt group and a non-bankrupt group.

THE MODEL BY CYBINSKI (2000, 2003)

The path to failure was analyzed using a stepwise logit model of probability of failure in the next

reporting period using the dependent variable 1 for bankrupt in the nal year before failure and 0

for surviving in all previous years. The stepwise regression was based on the nal four consecutive

years of nancial statements available in Standard and Poors COMPUSTAT database for sixty bankrupt

service industry rms.

The parameter estimates for the nal logit model of rm failure risk (using goodness of t criterion) are

listed below.

*

Extract from SAS output.

Pacic Accounting Review Vol. 17, No. 1, June 2005 35

The Estimated (Logit) Model: Analysis of Maximum Likelihood Estimates

#

Parameter Standard Wald Pr >

Variable Estimate Error Chi-Square Chi-Square

INTERCEPT 1.4658 0.3972 13.6212 0.0002

PC3 0.9115 0.1818 25.1319 0.0001

PC4 0.4133 0.1404 8.6650 0.0032

PC5 -0.7695 0.2497 9.4930 0.0021

PC2_1 0.4736 0.1327 12.7349 0.0004

PC5_1 -0.8011 0.1790 20.0306 0.0001

INT1 -0.0206 0.00441 21.8895 0.0001

INT2 -0.0166 0.00383 18.8065 0.0001

INT3 -0.0821 0.0533 2.3675 0.1239

INT4 - 0.6916 0.2952 5.4874 0.0192

INT5_1 - 2.2866 0.6560 12.1513 0.0005

INT5_4 1.6171 0.5183 9.7339 0.0018

Model Chi-Square of 120.776 with 11 DF (p=0.0001), Residual Chi-Square = 8.8668 with 4 DF

(p=0.0645).

Note: the residual chi-square value is nearly signicant at 0.05 level - i.e. lack-of-t is not signicant.

The overall signicance of the above model was p=0.0001 with an overall classication accuracy for

predicting a nal or surviving year for the 60 service industry rms of 72% in the estimation sample, a

type I error rate (probability of misclassifying a nal year before bankruptcy) of 29%, and a Type II error

rate (probability of misclassifying a surviving year as a nal one) of 28%.

#This is a minimum adequate model and was estimated from an original set of variables comprising the

current and lagged values of: -

(a) Twenty-three nancial ratios considered relevant to bankruptcy in the current literature, and

(b) Five principal components representing the macro-environment of the U.S. matched by year.

THE INTERNAL VARIABLES IN THE FINAL MODEL: THE FINANCIAL RATIOS.

The following are the ratio labels in the model above (bracketed by type) with their denitions and

explanation notes (and the formula using COMPUSTAT names).

INT1 (liquidity) working capital/total assets (%) where working capital = (current assets-current liabilities).

[(ACT-LCT)/AT x100]

INT2 (leverage) total liabilities/total assets (%) or the debt ratio [LT/AT x 100]

This ratio is interpreted as a measure of the rms capital structure -the higher the debt ratio, the greater

the chance of predicting failure.

INT3 (cash-ow) cash ow from operations

**

/total current liabilities [(FOPT+WCAPCH)/LCT]

INT4 (leverage) a binary dummy variable taken from interest coverage after tax = (net income before

extraordinary items + interest expense)/interest expense [(IB+XINT)/XINT

*

] or COMPUSTAT ratio, IC.

INT5_1 AND INT5_4 (turnover) are respectively, the lowest and highest dummy variable categories of sales/

net plant (property plant and equipment total on balance sheet minus depreciation) [SALE/PPENT

*

]

**

Cash Flow is dened here as Total Funds from Operations plus Working Capital Changes - taken from,

the Statement of Changes/Statement of Cash Flows.

*

The denominator of the ratio is often equal to zero so there was a need to categorize this ratio..

36 Pacic Accounting Review

THE EXTERNAL VARIABLES IN THE FINAL MODEL: THE MACROECONOMIC

VARIABLES.

Refer to Cybinski (2000, 2003) for more detail on these factors and the economic series upon which they

are loaded.

PC2_1 Cost of Capital and Borrowing Factor (lagged one year)

PC3 Labour Market Tightness Factor

PC4 Construction Activities Factor

PC5 Expenditures Factor

PC5_1 Expenditures Factor (lagged one year)

Three lag periods were initially used in the stepwise regression analysis. Loss of degrees of freedom,

and non-orthogonality between lagged variables resulted in only one lag period showing any statistical

signicance (p<0.05), and then for only two of the ve macro-economic variables, shown above.

Note: Both models rated Working capital/total assets as the best indicator of ultimate discontinuance.

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