The Efficacy

Pacific Accounting Review
Emerald Article: 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
Patti Cybinski, Carolyn Windsor
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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
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.
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
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).
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.
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
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.
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
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)
Unqualied 30
Qualied* 12
No opinion ** 1
Unqualied with additional
0
Table 1c
Last Reporting Period (Trade Industry)
Unqualied 25
Qualied* 6
No opinion ** 0
Unqualied with additional
0
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)
Unqualied 26
Qualied* 8
No opinion ** 1
Unqualied with additional explanatory
language added***
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.
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
+
+
=
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
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
A Zscore (<1.8) is classied as bankrupt =>
code 1
Probability greater than 0.5 => code 1
Table 2b
Opinion in the Last Reporting Period Prior to Bankruptcy/Liquidation (Trade
Industry)
below)
Firm
Number
Number
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
Bankruptcy:
=> code 0
code 1
Table 2c
Opinion in the Second Last Reporting Period Prior to Bankruptcy/Liquidation
(Service Industry)
below)
Firm
Number
Number
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
Bankruptcy:
=> code 0
code 1
Table 2d
Opinion in the Second Last Reporting Period Prior to Bankruptcy/ Liquidation
(Trade Industry)
below)
Firm
Number
Number
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
Bankruptcy:
=> code 0
code 1
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).
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
Test Statistic Chi-Squared = 1.04.
P-Value = 0.31
Altman model predictions vs Auditors opinion
Auditor Opinion
Total
Altman Model Not bankrupt 12 2* 14
Predictions Bankrupt 9 16 25
Total 21 18 39
P-Value = 0.003
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.
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
H
1
Auditor Opinion
Total
Temporal Not bankrupt 16 7 23
P-Value = 0.98
Total
Temporal Not Bankrupt 12 7 19
P-Value = 0.33
Auditor Opinion
Total
Predictions Bankrupt 8 8 16
Total 26 11 37
P-Value = 0.02
*
Note: the expected value of this cell is 6.5 > 5 so Chi-Squared is valid under the Rule of Five.
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
H
1
Auditor Opinion
Total
Temporal Not bankrupt 4* 0* 4
Model Bankrupt 12 3* 15
Test Statistic Fishers Mantel-Haentszel Chi-
Exact Test Squared = 0.9
P-Value 0.98 P-Value = 0.34
Total
Temporal Not Bankrupt 3* 1* 4
Auditor Opinion
Total
Predictions Bankrupt 2* 4 6
Total 23 5 28
*
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.
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
H
1
Auditor Opinion
Total
Temporal Not bankrupt 11 3* 14
Total
Temporal Not Bankrupt 8 3* 11
Auditor Opinion
Total
Altman Model Not bankrupt 21 4 25
Predictions Bankrupt 5 3* 8
Total 26 7 33
*
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.
(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
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
TRADE INDUSTRY DATASET
Temporal
Model
Altman
Model
Auditor's
Opinion
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
SERVICE INDUSTRY DATASET
Temporal
Model
Altman
Model
Auditor's
Opinion
TRADE INDUSTRY DATASET
Temporal
Model
Altman
Model
Auditor's
Opinion
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.
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%
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.
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.
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.
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.

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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.
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..
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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