Rev Quant Finan Acc (2007) 28:5578

DOI 10.1007/s11156-006-0003-x
A re-evaluation of auditors opinions versus statistical
models in bankruptcy prediction
Lili Sun
Published online: 15 November 2006
C
Springer Science + Business Media, LLC 2006
Abstract Existent empirical evidence on the relative performance of auditors going
concern opinions versus statistical models in predicting bankruptcy is mixed. This
study attempts to add new reliable evidence on this important issue by conducting
the comparison based upon an improved statistical model. The improved statistical
model incorporates some new developments advocated by recent bankruptcy predic-
tion research (e.g., Shumway, 2001). First, the following non-traditional variables are
added: a composite measure of nancial distress, industry failure rate, abnormal stock
returns, and market capitalization. Secondly, a hazard model is employed.
The prediction ability of the hazard model with incorporation of non-nancial-
ratio variables is superior to that of auditors going concern opinions in the holdout
sample. This suggests that a well-developed statistical model could serve as a decision
aid for auditors to better make going-concern judgments. Further analyses reveal
some evidence that industry failure rate does not have a signicant impact upon
auditors going concern judgments as it should be; auditors could improve their going
concern judgments by considering industry-level information in addition to rm-
specic information. Finally, we nd that auditors opinions do have incremental
contribution beyond stock-market information and industry failure rate in predicting
bankruptcy.
Keywords Bankruptcy prediction
.
Going concern opinions
.
Financial distress
JEL Classications M41
.
G33
L. Sun (

)
Department of Accounting and Information Systems, Rutgers, the State University of New Jersey,
Ackerson Hall, Room 317, 180 University Ave, Newark, NJ 07102-1897, USA
e-mail: sunlili@rbsmail.rutgers.edu
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56 L. Sun
1 Introduction
In todays dynamic economic environment, the number and the magnitude of
bankruptcy lings are increasing signicantly.
1
Given the challenging nature of
bankruptcy prediction task, even auditors, who have a good knowledge of rms sit-
uations, often fail to make an accurate judgment on rms going-concern conditions.
It is valuable to explore the relative performance of statistical models and auditors
going-concern opinions in predicting bankruptcy. The result of the comparison sug-
gests whether auditors should use statistical models as decision aids when making
going-concern judgments. Research has been done to compare the performance of
auditors going-concern opinions with statistical models in predicting bankruptcy.
The comparison results are mixed. Some studies (e.g. Altman and McGough, 1974;
Altman, 1982) show that statistical models outperform auditors opinions, while oth-
ers (e.g. Hopwood et al., 1994) nd that statistical models and auditors opinions are
indifferent in their prediction ability.
Literature review shows that statistical models used for the comparison with au-
ditors opinions do not keep pace with the development of bankruptcy prediction
modeling research. It is interesting to build a statistical model with incorporation of
some improvements suggested by recent bankruptcy prediction work and reevaluate
the relative performance between such an improved statistical model and auditors
going concern opinion. This study serves this purpose. Specically, this study in-
corporates two aspects of improvement suggested by recent bankruptcy prediction
work. First, the following predictors are employed: a composite score of nancial
distress, stock-market variables, and industry failure rate. Secondly, a hazard model
(Shumway, 2001) is employed.
Our analysis shows that the hazard model with incorporation of both nancial and
non-nancial variables outperforms auditors going concern judgment in the holdout
sample. Further analysis shows that stock market variables are effective in explaining
auditors going concern opinions, but industry failure rate is not. Our results have
the following contributions and practical implications. First, our study contributes to
the stream of research that compares the relative performance of auditors opinions
and statistical models in predicting bankruptcy. Using a recent period of sample, we
nd that a hazard model that employs both nancial and non-nancial variables out-
performs auditors opinion in predicting bankruptcy. Thus, our ndings imply that
a well-developed statistical model can serve as a useful decision-aid for auditors to
make judgment in clients going concern status. Secondly, the accuracy of auditors
going concern judgment could be improved by focusing on not only rm-level in-
formation including traditional nancial-accounting information and stock market
information, but also industry-level factors, such as industry failure rate. Finally, this
study contributes to the stream of research that examines the incremental contribution
of auditors going concern opinions in predicting bankruptcy. Specically, we nd that
auditors opinions do have incremental contribution beyond stock-market information
and industry failure rate in predicting bankruptcy.
1
12 of the 20 largest bankruptcy lings in U.S. history took place in 2001 and 2002. In total, these
12 companies, including Worldcom, Enron, UAL Corp, Kmart Corp, brought $381 billion of assets into
bankruptcy (Venuti, 2004).
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A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 57
The remainder of this study is organized as follows. Section 2 provides literature
review. In Section 3, we discuss research questions and specify the research hypothesis.
Section 4 describes the research methodology. Section 5 discusses empirical results,
while the last section concludes the paper.
2 Prior literature
Research has been done to explore the relative performance of auditors going con-
cern opinions and statistical models in predicting bankruptcy. Empirical ndings on
this topic are divergent. One stream of research (e.g., Altman and McGough, 1974;
Altman, 1982; Levitan and Knoblett, 1985; Koh and Killough, 1990) suggests that sta-
tistical models outperform auditors going-concern opinions in predicting bankruptcy
and therefore can be useful aids in the formulation of auditors going concern opinion
decisions. On the contrary, the more recent work by Hopwood et al. (1994) suggests
that auditors opinions and statistical models have equivalent performance after mak-
ing the comparison considerably more reective of the auditors real-world decision
environment.
Now we discuss, respectively, the role of auditors going-concern opinions and
statistical models in bankruptcy prediction. SAS 59 (AU341) requires the auditor
to evaluate whether there is a substantial doubt about a clients ability to continue
as a going concern for at least one year beyond the balance sheet date. Therefore,
The nature of auditors qualied opinions gives rise to the belief that they can signal
entity failure. (Hopwood et al., 1989, p. 28) Research has been done to explore
the usefulness of auditors going concern opinions in predicting bankruptcy (e.g.
Hopwood et al., 1989, Foster et al., 1998) and to explore why auditors sometimes
fail to issue going concern opinions to subsequently bankrupt clients (e.g. McKeown
et al., 1991).
The literature on developing statistical models for bankruptcy prediction is exten-
sive and continues to grow. Starting from Winakor and Smith (1935), researchers
have developed various statistical models using different techniques and predictors.
Among earlier models, some well-known ones include Altmans Z-score (Altman
1968), ZETA model (Altman et al., 1977), Ohlson (1980) Logit model, Zmijewski
(1984) Probit model, etc.
Later on, more advanced estimation methods are introduced to bankruptcy pre-
diction. Articial Neural Network (ANN) model (e.g., Altman et al., 1994, Tam and
Kiang, 1992) and Bayesian Network models (e.g., Sarkar and Sriram, 2001; Sun
and Shenoy, 2005) are introduced to the eld. Data envelopment analysis (DEA) is
also suggested (Cielen et al., 2004). Jones and Hensher (2004) argue that mixed logit
model outperforms standard binary logit model in predicting nancial distress. Hazard
model are advocated (Shumway, 2001) and employed by later research (e.g. Beaver
and McNichols, 2005).
Performance of statistical models can be improved not only through implementing
new prediction tools but also through identifying novel predictors. Earlier studies
(e.g., Winakor and Smith, 1935; Altman, 1968) focus on traditional nancial ratios.
Later on, the usefulness of cash ows in predicting bankruptcy has been explored (e.g.,
Gentry et al., 1985; Aziz and Lawson, 1989; Emery and Cogger, 1982). Bond ratings,
which are based on both public information and private information conveyed to the
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58 L. Sun
rating agencies by rms, are employed in predicting bankruptcy (e.g. Barth et al.,
1998; Billings, 1999). Shumway (2001) shows that market-based variables, such as,
abnormal stock returns, and market capitalization, have incremental prediction power
beyond traditional nancial ratios. Bharath and Shumway (2004) and Hillegeist et al.
(2004) suggest the use of Merton option-pricing model that incorporate rms asset
volatilities.
3 Research questions and research hypothesis
The purpose of this study is to re-examine the relative performance of auditors
opinions and statistical models in predicting bankruptcy, by developing an improved
statistical model that incorporates some new features advocated by recent bankruptcy
prediction studies. Specically, the improvement is related to two aspects: adding new
predictors and employing a new statistical tool. Next we turn to detailed discussion
on each aspect.
3.1 Bankruptcy predictors
Statistical models used by prior research for the comparison between auditors opin-
ions and statistical models mainly employ traditional nancial ratios as bankruptcy
predictors. In this study, we introduce the following additional variables: a composite
measure of nancial distress, stock-market variables, and industry failure rate.
3.2 A composite measure of nancial distress
The most typical reason for bankruptcy ling is nancial distress. The more nancially
distressed a company is the more likely it will go bankruptcy. Different fromindividual
nancial ratio which only captures rms nancial healthiness distress in one or
certain aspects, a composite measure evaluates rms nancial condition from a
multifaceted perspective and therefore is a more informative and reliable measure.
Several such composite measures exist as discussed below. Hopwood et al. (1994)
introduce a stress indicator which originates from an interview and questionnaire
process conducted by Mutchler (1984), using sixteen partners, two from each of the
Big Eight accounting rms. This stress criterion denes a company into the stressed
category if the company exhibits at least one of the following nancial distress signals:
negative working capital, a loss from operations, a retained earnings decit, and a
bottom line loss. Secondly, Altman (1968) Z-score is a ve-ratio-based score, which
is often used by accounting and nance researchers to measure rms nancial distress.
Thirdly, a three-ratio-based score derived from Zmijewskis (1984) probit model is
also often used (e.g., Carcello and Neal, 2000; Anandarajan et al., 2001). Finally,
some researchers (e.g. Clark and Ofek, 1994) suggest the use of abnormal stock
returns as a composite measure of nancial distress, conditioning on the belief that
stock prices in an efcient market are able to reect rms overall healthiness. No
theory or empirical evidence currently exists to favor one measure over the others. In
this study, we empirically test the effectiveness of the above measures and choose the
better one(s).
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A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 59
3.3 Stock-market variables and industry level factors
Shumway (2001) nds that market variables have signicant contribution to
bankruptcy prediction. Not only rm-level factors but also industry-level factors can
inuence a rms survival (Everett and Watson, 1998). Hensler et al. (1997) nd an
industry effect on the survival time of initial public offerings, with IPOs in certain
industries (such as the computer and data, wholesale, restaurant, and airline industries)
having a shorter survival time and rms in other industries (such as the optical or phar-
maceutical industries) enjoying a longer survival time. Honjo (2000) nds that a higher
entry rate and higher geographical concentration in an industry lead to a higher hazard
rate for rms. In this study, we employ two market variables (abnormal stock returns
and market capitalization) and one industry-level variable (industry failure rate).
3.4 A hazard model
Recent work by Hopwood et al. (1994) that examines the relative performance of au-
ditors opinions and statistical models employs a static binary logit model. Shumway
(2001) elaborates the econometric advantages of a hazard model over a static binary
logit model. First, hazard models control for each rms period at risk, while static
models do not. Secondly, hazard models exploit each rms time-series data by includ-
ing annual observations as time-varying covariates. Thirdly, hazard models produce
more efcient out-of-sample forecasts by utilizing much more data. The hazard model
can be thought of as a binary logit model that includes each rm year as a separate
observation. Shumway (2001) further empirically demonstrates that a simple hazard
model outperforms static models in out-of-sample forecasts. Therefore, this study
employs a hazard model.
3.5 Research hypothesis
To summarize, this study builds a hazard model with the incorporation of a composite
stress measure, two market variables, and one industry-level factor in addition to
traditional nancial ratios. It is unknown which will perform better in predicting
bankruptcy, the auditors opinions or the hazard model. Therefore the main hypothesis
is formed in a null form:
Hypothesis (Null). The hazard model estimated by this study and the auditors
opinions do not differ in ability to predict bankruptcy.
4 Research method
4.1 Sample and data
The data employed in estimating and testing models span the period from 1991 to
2002. This period is chosen to obtain a sizable sample while providing evidence
for a recent period of bankruptcy activity. Firms in this studys sample are public
rms traded on major stock exchanges, including NASDAQ, the New York, and
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60 L. Sun
American Stock exchanges. The following steps are used to identify bankrupt
2
rms.
First, bankrupt rms are identied through Compustat and Lexis-Nexis Bankruptcy
Report databases. Next, bankruptcy ling dates are determined using the Lexis-Nexis
Bankruptcy Report library, Lexis-Nexis News, and rms Form 8-K reports. Firms
without available bankruptcy ling dates are eliminated. For each bankrupt rm, the
most recent annual report led prior to its bankruptcy ling date is identied. The lag
between the scal year-end of the most recently led annual report and bankruptcy
ling date must be less than 2 years.
3
Financial-accounting information for bankruptcy
sample is for the scal year-end corresponding to the most recently led annual report
prior to bankruptcy. Firms in nancial or utility industries are excluded. The nal
bankruptcy sample consists of 587 rms, which are randomly assigned to the training
(344 rms) or the test sample (243 rms). Since the model is trained as a hazard model,
for bankrupt rms, rm-years prior to their bankruptcy years are also included into the
training sample as nonbankruptcy rm-years. 344 training bankrupt rms contribute
1,313 nonbankruptcy rm-years. 3,183
4
active rms are randomly selected to form
the non-bankruptcy training sample. These active rms contribute 20,918 rm-years
which have complete data required by this study. 1,165 active rms are randomly
selected to form the non-bankruptcy test sample. To summarize, the nal training
sample consists of 344 bankruptcy rm-years and 22,231 nonbankruptcy rm-years
(the sum of 1,313 nonbankruptcy rm-years of bankrupt rms prior to bankruptcy
and 20,198 rm-years of nonbankrupt rms). The nal test sample is composed of
243 bankrupt rms and 1,165 unique
5
active rms.
We obtain nancial-accounting information from Compustat and stock informa-
tion from CRSP. Auditors going concern opinions are obtained by manually read-
ing auditors reports in annual reports led in Form 10-K/10-KSB/10-K405/20-F.
Table 1 describes the sample selection process.
4.2 Hazard model
A general form of the hazard model (Beaver and McNichols, 2005) used here is as
follows:
ln[h
j
(t )/(1 h
j
(t ))] = (t ) + BX
j
(t ). (1)
In Eq. (1), h
j
(t ) is the hazard, or the risk of bankruptcy, at time t for rm j ;
h
j
(t )/(1 h
j
(t )) is the hazard ratio, or the likelihood odds; (t ) is the baseline
hazard, which is assumed to be a constant; B is a vector of coefcients; and X
j
(t ) is
2
The bankrupt sample in this study consists of rms that le bankruptcy petitions under both Chapter 11
and Chapter 7.
3
Similar to Begley et al. (1996), we use this requirement to ensure the data used for prediction are
reasonably current.
4
This was an ex ante-determined stopping point and has no bearing on the randomness of the sample (see
Hopwood et al., 1994).
5
The study requires auditors going concern opinions for the holdout sample. The reason for us to use
unique rms instead of all rm-years for these rms in the holdout sample is to reduce the labor-intensive
work in manually gathering going-concern opinions. Asample year is randomly assigned to a non-bankrupt
rm in the test sample.
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A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 61
Table 1 Sample selection
Bankruptcy Sample No. of rm-years No. of rms
Step 1: Bankrupt rms identied from Lexis-Nexis Bankruptcy Report
Database
974
Minus: bankrupt rms not included in Compustat 134
Subtotal 840
Step 2: Bankrupt rms identied from Compustat 413
Minus: bankrupt rms that do not havebankruptcy ling dates identied 124
Minus: bankruptcy ling dates are not in the period of 19912002 19
Subtotal 270
Step 3: Total number of bankrupt rms from both sources with
bankruptcy ling dates between 19912002
1110
Minus: bankrupt rms that do not have such a 10-K led prior to
bankruptcy that the lag between the scal year end of the 10-K and
the bankruptcy ling date is within two years
220
Subtotal 890
Step 4: Minus: bankrupt rms that do not have complete information 278
Minus: bankrupt rms in nancial (SIC 60006999) or utility (SIC
49004999) industries
25
The entire nal bankruptcy sample 587
The nal bankruptcy training sample [No. of rm-years] [1,657] 344
The nal bankruptcy test sample 243
Nonbankruptcy sample
Nonbankrupt rms with complete information randomly selected in the
periods of 19912002
4,348
The nal nonbankruptcy training sample [No. of rm-years] [20,918] 3,183
The nal nonbankruptcy test sample 1,165
a matrix of observations on bankruptcy predictors, whose values vary with time. The
hazard model is estimated as a multiperiod logit model, as suggested by Shumway
(2001), using maximum likelihood method.
The dependent variable in the prediction models is each rm-years bankruptcy
status (0, 1) in a given sample year. In a hazard analysis, for a bankrupt rm, the
dependent variable equals 1 for the year in which it les bankruptcy, and the dependent
variable equals 0 for all sample years prior to the bankruptcy-ling year. The non-
bankrupt rms are coded 0 every year they are in the sample.
Shumway (2001) emphasize that the test statistics produced by a logit program are
incorrect for the hazard model because they assume that the number of independent
observations used to estimate the model is the number of rm years in the data.
Dividing these test statistics by the average number of rm-years per rm makes the
logit programs statistics correct for the hazard model.
2
test statistics reported in
this study have been adjusted accordingly.
To avoid oversampling bias (which occurs when the sample proportion of bankrupt-
cies is higher than the population proportion), the hazard models intercept, (t ), is
adjusted for the difference between the proportion of bankrupt rms in the study
sample and that in the real world. Similar to Hopwood et al. (1994), the following
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62 L. Sun
adjusted model, suggested by Anderson (1972), is employed:
Pr =
1
1 +e
( ++BX)
(2)
where: = Ln[prop(NB) prop

(B)] Ln[prop

(NB) prop(B)]
where: prop(NB) = sample proportion of nonbankrupt rms (NB).
prop(B) = sample proportion of bankrupt rms (B).
prop

(NB) = estimated population proportion of nonbankrupt rms.

prop

(B) = estimated population proportion of bankrupt rms

In order for the models to predict whether or not a rmwill le bankruptcy, a cutoff
probability is needed. Following Hopwood et al. (1994), we use the formula below to
calculate the cutoff:
Cutoff =
1
1 +misclassication cos t ratio
=
1
1 +
C(NB|B)
C(B|NB)
(3)
where C(NB|B) represents the cost for misclassifying a bankrupt rmas nonbankrupt,
andC(B|NB) represents the cost for misclassifying a nonbankrupt rm as bankrupt.
The prediction power of the estimated hazard model in the holdout sample is
measured using Estimated Misclassication Cost (EMC), calculated as follows:
EMC = C(NB|B) prop

(B) P(NB|B) +C(B|NB) prop

(NB)
P(B|NB) (4)
where P(NB|B) represents the probability that a prediction model misclassies a
bankrupt rm as nonbankrupt, calculated as the number of bankrupt rms misclas-
sied as nonbankrupt divided by the total number of bankrupt rms in the holdout
sample; P(B |NB) represents the probability that a prediction model misclassies a
nonbankrupt rm as bankrupt, calculated as the number of nonbankrupt rms mis-
classied as bankrupt divided by the total number of nonbankrupt rms in the holdout
sample; C(NB|B) , C(B |NB) , prop

(NB), and prop

(B)are dened same as above.

The advantage of EMC is that it takes into consideration the population proportion of
bankrupt rms and the relative costs of Type I error and Type II error. The analysis of
EMCs are conducted under various misclassication cost ratios ranging from 1:1 to
100:1 (C(NB|B) : C(B |NB) ).
4.3 Variables
As of our knowledge, Hopwood et al. (1994) is a more recent study that examines
the relative performance of auditors going concern opinions and statistical models.
Therefore, for the traditional nancial ratios, we take the seven nancial ratios from
Hopwood et al. (1994). As discussed earlier, four alternative composite measures
of nancial distress are studied. They are: Criterion 1: the Auditor View Criterion;
Criterion 2. The Altman Z-score, Criterion 3. Zmijewskis Probability, and Criterion 4.
Stock Return. Two stock-market variables are market capitalization and abnormal
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A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 63
Table 2 Denitions of nancial ratios, stock-market variables, and industry-level variables
Name Denition
NITA Net Income/Total Assets
CASALES Current Assets/Sales
CACL Current Assets/Current Liabilities
CATA Current Assets/Total Assets
CASHTA Cash/Total Assets
LTDTA Long Term Debt/Total Assets
LSALES Natural Logarithm of Sales
IFR Industry failure rate, calculated as the average annual industry bankruptcy rate in the past
two years, where annual industry bankruptcy rate =(the number of bankruptcies in a
two-digit SIC industry in a year/the total number of Compustat rms in the same
industry in the same year) 100%
CAR Cumulative abnormal return, calculated as a rms annual stock return minus the
value-weighted CRSP NYSE/AMEX/NASDAQ index annual return in the past year
LNMCP Natural log of each rms most recent available market capitalization in the last month of
the past year relative to the total market value in the same day.
stock returns. The industry-level factor is industry failure rate, calculated as the average
annual industry bankruptcy rate in the past two years by two-digit SIC code. To avoid
outliers, all variables are winsorized at rst percentile and ninety-ninth percentile.
Table 2 provides detailed denitions for nancial ratios, stock-market variables, and
industry-level factor; while Table 3 denes alternative composite measures of distress.
5 Empirical results
5.1 Descriptive statistics
Table 4 describes the sample distribution under each stress measure using the test
sample. The percentage of bankrupt rms dened as stressed under Criterion 1
(Auditor View), Criterion 2 (Altman Z-score), Criterion 3 (Zmijewski Probability),
and Criterion 4 (Stock Return) is, respectively, 97%, 90%, 81%, and 91%. The per-
centage of nonbankrupt rms dened as stressed under Criterion 14 is, respectively,
59%, 41%, 25%, and 46%. Since there are more rms (both bankruptcy and non-
bankruptcy) being dened as stressed under Criterion 1 (Auditor View), Criterion
1 (Auditor View) represents a relatively lower level of stress criterion. Criterion 3
(Zmijewski Probability) is a stricter level of stress criterion since fewer rms (both
bankruptcy and nonbankrutcy) are dened as stressed under this criterion. Criterion 2
and 4 are in between.
Table 5 provides the mean values of the independent variables in the test sam-
ple by the stress status
6
(stressed vs. nonstressed) and bankruptcy status (bankruptcy
vs. nonbankruptcy). T-tests are used to evaluate differences in mean values between
6
Stress status here is dened under Criterion 4 Stock Returns. If we partition the sample based upon the
other 3 alternative composite stress measures, we observe similar patterns in mean values of variables
across groups.
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64 L. Sun
Table 3 Denitions of alternative composite measures of distress
Criterion Denition
Criterion 1.
Auditor view
A company is classied into the stressed category if it exhibits at least one of the
following nancial distress signals:
(1) negative working capital in the most recent year,
(2) a loss from operations in any of the last three years,
(3) a retained earnings decit in Y-3 (where Y-1 is the last nancial statement date
preceding a bankruptcy prediction date),
(4) a bottom line loss in any of the last three years.
Criterion 2.
Altman Z-score
A company is classied into the stressed category if Altman Z-score derived from the
most recent nancial statement is smaller than 3. Z-score is dened by Altman
(1968) as:
Altman Z-score = 0.012

(Working Captial/Total Assets) +0.014

(Retained
Earnings/Total Assets) +0.033(Earnings Before Interest and Tax/Total Assets)
+0.006

(Market Value Equity/Book Value of Total Debt) +0.999

(Sales/Total
Assets)
Criterion 3.
Zmijewski
probability
A company is classied into the stressed category if Zmijewski Probability derived
from the most recent nancial statement prior to a prediction date is larger than 28%.
Zmijewskis probability =

2
e

z
2
2
dZ, where y is calculated based upon the
following formula from Zmijewski (1984)
y =4.3364.513

(Net Income/Total Assets) +5.679

(Total Liabilities/Total
Assets) +0.004

(Current Assets/Current Liabilities)

Criterion 4.
Stock return
A company is classied into the stressed category if its annual accumulated abnormal
stock return in last year is smaller than 15%. A rms annual abnormal returns is
calculated by accumulating daily abnormal returns using the following formula:
Annual abnormal return =
n
i =1
(1 +dail y abnormal return
i
) 1
where: n =number of trading days.
Daily abnormal return = a rms daily return the CRSP daily value-weighted
NYSE/AMEX/NASDAQ market return index
Table 4 Sample distribution by stress criteria (test sample)
No. of rms
Bankruptcy Nonbankruptcy
Stress criterion Stress Nonstress Stress Nonstress
1. Auditor view 236 7 693 472
2. Altman Z-score 218 25 483 682
3. Zmijewski
Probability
197 46 291 874
4. Stock return 222 21 538 627
groups. Some interesting results related to the natural log of sales variable (LSALES)
should be noted here. In the nonstressed category, the natural log of sales variable
(LSALES) for the bankruptcy group is insignicantly lower than that for the non-
bankruptcy group. However, surprisingly, in the stressed group, the bankruptcy group
has a signicantly higher mean value of the natural log of sales variable (LSALES)
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A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 65
Table 5 Mean variable values (test sample only)
Nonstressed
a
Stressed
T-test of T-test of
Nonbankrupt Bankrupt means Nonbankrupt Bankrupt means
Variable (n = 627) (n = 21) difference (n = 538) (n = 222) difference
NITA 0.007 0.213 5.319

0.121 0.385 8.201

CASALES 0.896 0.541 0.707 1.111 0.881 1.184

CACL 2.903 1.498 2.356

3.003 1.403 7.546

CATA 0.530 0.502 0.542 0.543 0.466 3.933

CASHTA 0.166 0.084 1.897 0.190 0.102 5.281

LTDTA 0.165 0.208 1.055 0.153 0.260 6.295

LSALES 5.157 4.979 0.375 4.277 4.769 3.000

IFR 1.010 1.980 3.848

0.800 1.400 7.127

CAR 0.442 0.244 1.307 0.440 0.682 14.767

LNMCP 10.467 12.389 4.268

11.854 13.167 8.930

a
The stress criterion used here is Criterion 4. Stock Return.

Signicant at p <0.05.

Signicant at p <0.01.

Signicant at p <0.001.
than the nonbankruptcy group. A possible explanation for the higher sales in the
stressed bankruptcy group is that managers sometimes might attempt to boost sales in
order to hit specic sales targets or meet analyst expectations, even at the expense of
protability.
7
Another possible explanation is that it may be more difcult for large
rms to recover from stress since the recovering requires more resources. Or the large
size of a stressed rm may also indicate that managers in such a rm unwisely expand
the rms size, which leads to non-value-generating assets or non-prot-generating
sales. This, in turn, increases its probability of bankruptcy. Further research is desired
to explore why compared to the stressed nonbankruptcy group, the stressed bankruptcy
group has a higher mean value in the natural log of sales.
5.2 The effectiveness of four alternative composite stress measures
To compare the effectiveness of four composite stress measures, we evaluate tting-
levels of models with different measures. The models are estimated using the training
sample. The model that consists of only seven nancial ratios used by Hopwood et al.
(1994) is called Model 0 for the following discussion. We add STRESSas an individual
variable to Model 0 to form Models 1.1, 2.1, 3.1, and 4.1, respectively under Criterion
1 (Auditor View), Criterion 2 (Altman Z-score), Criterion 3 (Zmijewski Probability),
7
At one international heavy-equipment manufacturer, managers were so set on hitting their quarterly
revenue target that they shipped unnished products from their plant in England all the way to a warehouse
in the Netherlands, near the customer, for nal assembly. By shipping the incomplete products, they were
able to realize the sales before the end of the quarter and thus fulll their budget goal and make their
bonuses. But the high cost of assembling the goods at a distant location-it required not only the rental of
the warehouse but also additional labor-ended up reducing the companys overall prot (Jensen, 2001,
p. 96).
Springer
66 L. Sun
and Criterion 4 (Stock Return). The variable, STRESS, is set to one if a rm is
dened as stressed under a stress criterion, otherwise zero.
The relative t between Model 0 and Models 1.11.4 are tested using a logit-
based version of the Vuong (1989) test for nested models. The relative t among
non-nested models 1.11.4, are evaluated using Akaike Information Criterion (AIC,
Akaike, 1974). Panel A of Table 6 reports the estimations of models. Panel B of
Table 6 presents the comparison of model t.
2
test statistics reported in Table 6 are
after-adjustment
8
suggested by Shumway (2001).
Panel A shows that the overall ts for all models are signicant at a p <0.001 level
based upon one-tailed likelihood ratio test. Results from Panel B of Table 6 suggest
that, compared to Model 0, Models 1.1, 2.1, 3.1, and 4.1 have incremental
2
(twice the
likelihood ratio, 2LR) statistics signicant at a p <0.001 level (1 degree of freedom),
based upon one-tailed tests. This indicates that a composite stress measure does
have incremental contribution in predicting bankruptcy beyond individual nancial
ratios. Model ts for non-nested models 1.11.4 are compared based upon Akaike
Information Criterion (AIC, Akaike, 1974 ). AICs are not based upon signicance
testing. The established rule of thumb is that Model A is considered as denitely
better than Model B if Model As AIC is lower than Model Bs by more than 10
(Burnham and Anderson, 1998). According to the results in Panel B of Table 6,
among the four models, Model 4.1 and Model 3.1 are the best and their effectiveness
is equivalent. Next is Model 1.1, and the worst is Model 2.1. This implies that there
are differences in the effectiveness of four alternative composite stress measures, with
the Zmijewski (1984) Probability and Abnormal Stock Returns as the best, Auditor
view (Hopwood et al., 1994) next,
9
and Altman Z-score (1964) the worst.
5.3 Analysis of the usefulness of non-nancial-accounting factors
We examine the effects of industry failure rate (IFR) and market variables (abnormal
stock return (CAR) and market capitalization (LNMCP)) by comparing the tting
levels of Model 0 with models having these non-nancial-accounting variables. It
should be claried that effectiveness of these variables, especially market variables, has
been documented in previous literature (e.g. Shumway, 2001). Analyses done here are
more conforming rather than discovering. Nevertheless, as of our knowledge, industry
failure rate is a relatively novel predictor variable. Again, models are estimated using
the training sample. The denitions of IFR, CAR and LNMCP have been provided
in Table 2. Table 7 provides detailed information of the average annual industry
failure rate by two-digit SIC during the study period of 19912002. The average
annual industry failure rate is 1.35%. Note that some high industry failure rates are
driven by the small number of rms existing in the industry. For instance, the average
8
Adjusted
2
equals the original
2
reported by the Logit program divided by 6.4, which is the average
number of rms-years per rm in the training sample. 6.4 rm-years per rm = 22,575 rm-years/3,527
rms.
9
One potential reason to explain the deteriorating performance of the Auditor View Criterion is that
working capital behavior changed around 1990 to the extent that negative working capital is not a good
stress signal. During that period, a number of rms had credit lines available which allowed them to run
working capital essentially at zero. Sometimes working capital slipped slightly negative for very healthy
rms.
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 67
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Springer
68 L. Sun
Table 6 (Continued)
Model 0 Model 1.1 Model 2.1 Model 3.1 Model 4.1
Panel B: Comparison of model t
#
Model 0
Model 1.1 16.624

(1 df)
29.576 31.209 29.983
Model 2.1 12.003

(1 df)
60.785 59.559
Model 3.1 21.500

(1 df)
1.226
Model 4.1 21.309

(1 df)

Signicant at p <0.05.

Signicant at p <0.01

Signicant at p <0.001.
#
The lower diagonal refers to 2LR statistics for the comparisons of nested models, while the upper diagonal
refers to Akaike Information Criterion (AIC) statistics for the comparisons of non-nested models
AICs are not based upon signicance testing. Instead, there are established rules of thumb. The model
with a lower AIC is better. The established rules of thumb are that two models with AICs apart more than
10 are denitely different (Burnham and Anderson, 1998).
2LRstatistics conformto the Chi-square distribution, with the degrees of freedom(p q), given information
matrix equivalence (Corollary 7.3, Vuong, 1989).
Both AIC statistics and 2LR statistics are calculated as: statistics for models in the rst column minus
statistics for models in the rst row. For instance, the 2LR statistics for the comparison of Model 1.1 and
Model 0 is calculated as: 76.453 (Model 1.1) 59.829 (Model 0) = 16.624.
annual industry failure rate for Legal services is 7.14%; on average, annually there
is only a total of 3 rms in the industry. Industries with relatively high industry failure
rates and a sizable number of rms in total ( >40) include Home furniture and
equipment store (annual average industry failure rate =3.76%), Transportation by
air (3.38%), General merchandise stores(3.28%), Textile mill products (3.26%),
Apparel and other nished products(2.91%), Apparel and accessory stores (2.57%),
Miscellaneous retail (2.32%), and Motion pictures (2.09%).
We test both the individual effect of industry factor and market factor and their
combined incremental contribution together. Table 8 shows that, based upon Vuongs
test for nested models, Model with IFR leads to an incremental
2
of 13.869
10
(one
degree of freedom) beyond Model 0, signicant at p <0.001; Model with two market
variables (CAR and LNMCP) have an incremental
2
of 42.790 (two degrees of free-
dom) beyond Model 0, signicant at p <0.001. Model with IFR, CAR and LNMCP
together have an incremental
2
of 51.437 (three degrees of freedom), signicant at
p <0.001.
Next, we add the composite stress measure dened by Zmijewski Probability
(1984), two market-variables, and the industry failure rate into the Model 0 to build a
new hazard model. Analysis results reported earlier suggest that Zmijewski Probabil-
10
Results reported in the paper are based upon IFR dened by two-digit SIC. We also conduct the analysis
using IFR based upon the industry denition from Barth et al. (1998), which denes industries roughly by
one-digit SIC. Similar results are found.
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 69
Table 7 Average annual percentage of bankruptcies by two-digit SIC during the entire study period
(y9102)
a
Total number of rms Average annual
in an industry percentage of
Two-digit SIC Description of industry annually on average bankruptcies
81 Legal services 3 7.14
52 Building materials & garden supplies 19 4.88
12 Coal mining 8 4.39
41 Transit and passenger transportation 5 3.81
57 Home furniture and equipment store 43 3.76
45 Transportation by air 46 3.38
53 General merchandise stores 50 3.28
22 Textile mill products 49 3.26
23 Apparel and other nished products 70 2.91
56 Apparel and accessory stores 55 2.57
7 Agricultural services 4 2.38
59 Miscellaneous retail 134 2.32
76 Misc repair services 7 2.21
78 Motion pictures 70 2.09
55 Automotive dealers & services 23 1.96
54 Food stores 45 1.93
61 Nondepository credit institutions 94 1.92
75 Auto repair, services, parking 15 1.74
58 Eating and drinking places 116 1.74
80 Health services 141 1.69
15 General building contractors 53 1.61
17 Special trade contractors 27 1.59
39 Misc manufacturing industries 85 1.57
42 Motor freight transportation,
warehouse
47 1.55
48 Communications 255 1.48
25 Furniture and xtures 41 1.39
82 Educational services 22 1.32
16 Heavy construction-not building
construction
25 1.29
79 Amusement and recreation services 80 1.28
33 Primary metal industries 105 1.27
50 Durable goods-wholesale 200 1.16
37 Transportation equipment 140 1.13
99 Nonclassiable establishment 94 1.13
30 Rubber & misc. plastic products 91 1.12
14 Nonmetallic minerals, except fuels 20 1.11
51 Nondurable goods-wholesale 112 1.05
35 Industrial machinery equipment 472 1.02
64 Insurance agents,brokers and service 40 0.94
32 Stone,clay,glass,concrete products 50 0.93
20 Food and kindred products 158 0.85
27 Printing,and publishing 99 0.79
34 Fabricated metal products 111 0.78
(Continued in next page)
Springer
70 L. Sun
Table 7 (Continued)
Total number of rms Average annual
in an industry percentage of
Two-digit SIC Description of industry annually on average bankruptcies
47 Transportation Services 21 0.74
49 Electric, gas & sanitary services 278 0.74
1 Agricultural production-crops 20 0.74
73 Business services 809 0.72
87 Engineering & management services 140 0.70
83 Social services 16 0.70
29 Petroleum & coal products 41 0.68
36 Electronic & other electric equipment 517 0.68
13 Oil and gas extraction 272 0.68
70 Hotels, other lodging places 38 0.66
72 Personal services 19 0.66
65 Real estate 90 0.66
31 Leather and leather products 21 0.65
24 Lumber and wood products, except
furniture
38 0.54
62 Security and commodity brokers 88 0.53
10 Metal mining 115 0.48
44 Water transportation 26 0.45
38 Instruments & related products 447 0.44
26 Paper and allied products 75 0.39
28 Chemicals and allied products 499 0.30
63 Insurance carriers 214 0.27
67 Holding & other investment ofces 725 0.11
60 Depository institutions 827 0.08
2 Agricultural production-livestock 4 0.00
8 Forestry 3 0.00
9 Fishing, hunting, and trapping 2 0.00
21 Tobacco products 8 0.00
40 Railroad transportation 19 0.00
46 Pipe lines, except natural gas 4 0.00
86 Membership organizations 1 0.00
89 Services, NEC 1 0.00
Average 1.35
a
Financial or utility industries are also presented in this table for readers reference. However, they are
excluded from this studys other analyses.
ity and Abnormal Stock Return are equivalently good in measuring stress. The reason
for us to use the former is because the Abnormal Stock Return stress measure overlaps
with the market variable CAR. The most-right column of Table 8 provides the estima-
tion of the hazard model with added variables. This hazard model consists of seven
nancial ratios from Hopwood et al. (1994), three non-nancial-accounting variables
(IFR, CAR, and LNMCP), and a stress dummy (STRESS) dened under Zmijewski
Probability Criterion. Compared to Model 0, the modied statistical model has an
incremental
2
of 62.620 with four degrees of freedom, signicant at p <0.001 level.
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 71
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Springer
72 L. Sun
Table 9 The comparison of prediction ability in test sample between the estimated hazard model and
auditors going concern opinions
The estimated hazard model Auditors opinions
Difference in
estimated
misclassication
costs (EMCs)
Cost
ratio (B
to NB)
% correct % correct
(the hazard model
auditors opinions)
NB B EMC NB B EMC
1 to 1 100.0 0.0 0.0105 96.6 44.0 0.0398 0.0294

10 to 1 98.4 21.4 0.0983 96.6 44.0 0.0925 0.0058

20 to 1 96.9 45.7 0.1442 96.6 44.0 0.1510 0.0068
30 to 1 94.4 60.9 0.1778 96.6 44.0 0.2095 0.0317

40 to 1 91.9 71.6 0.1986 96.6 44.0 0.2680 0.0694

50 to 1 90.5 74.5 0.2277 96.6 44.0 0.3265 0.0989

60 to 1 88.9 78.6 0.2438 96.6 44.0 0.3851 0.1412

70 to 1 87.3 80.7 0.2673 96.6 44.0 0.4436 0.1763

80 to 1 85.8 81.9 0.2924 96.6 44.0 0.5021 0.2096

90 to 1 84.0 83.1 0.3167 96.6 44.0 0.5606 0.2438

100 to 1 82.7 84.0 0.3385 96.6 44.0 0.6191 0.2806

Signicant at p-value <0.05.

Signicant at p-value <0.01.

Signicant at p-value <0.001

5.4 Hypothesis testing
Next we compare the performance of the newly-built hazard model with that of
auditors going concern opinions in the holdout sample. The holdout sample consists
of 1,165 unique nonbankrupt rms and 243 bankrupt rms. Table 9 presents the
comparison results.
As discussed earlier, statistical models are adjusted for oversampling bias. The
adjustment, , is 0.38156.
11
Estimated Misclassication Cost (EMC)
12
is used to
measure models prediction abilities. There are no theoretical distributions existing
for describing EMC. Bootstrapping is used to estimate the empirical distributions of
EMCand to determine the critical values for hypotheses testing (Hopwood et al., 1994;
11
The sample proportions of bankrupt rms and nonbankrupt rms during the training period are re-
spectively 0.015238 (344/22,575), and 0.984762 (22,231/22,575). The study-period population propor-
tion of bankrupt rms and nonbankrupt rms are respectively 0.010455 and 0.989545. The population
proportions are the average of annual proportions over the study period. The population number of
bankruptcies is assumed to be equal to the number of bankruptcies in this studys sample; the popu-
lation number of nonbankruptcies is assumed to be equal to the number of active rms in Compustat
database. Therefore, as dened in Eq. (2), the adjustment for the modied statistical model is calculated
as: =ln(0.984762 0.010455) ln(0.989545 0.015238) = 0.38156.
12
The estimated population proportion of nonbankrupt rms, prop

(NB), and the estimated population

proportion of bankrupt rms, prop

(B), are employed in the calculation of EMC. Since EMC is an ex post

measure, prop

(NB) and prop

(B) are the actual population proportions during the study period. In this
study, prop

(NB) = 0.989545, prop

(B) = 0.010455. Again, these population proportions are the average

of annual proportions over the study period.
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 73
Foster et al., 1998). Specically, to construct the statistical tests for the difference of
EMC between the modied statistical model and auditors going concern opinions,
the following bootstrapping procedure is performed.
1. Select 22,231 nonbankrupt rm-years randomly with replacement from the 22,231
nonbankrupt rm-years in the training sample. Use these with all (344) bankrupt
rm-years in the training sample to form a training resample. (There is no need to
randomly select bankrupt rms since they are deterministic.) Repeat this process
500 times to form 500 training resamples.
2. Select 1,165 nonbankrupt rms randomly with replacement from the 1,165 non-
bankrupt rms in the holdout sample. Use these with all (243) bankrupt rms in
the holdout sample to form a holdout resample. Repeat this process 500 times to
form 500 holdout resamples.
3. One training resample is randomly paired with one holdout resample. For each
pair of training and holdout resamples, estimate a set of parameters for the hazard
model, using the training resample. Generate predictions for each holdout rm,
using the estimated hazard model with the set of parameters estimated from the
training sample, and using the auditors opinion decision. To operationalize the
null hypothesis (which is, compared models have equivalent prediction power), the
predictions made by the hazard model and auditors opinions are then randomly
assigned to each compared model.
4. EMC is computed for each of the 500 holdout resamples using the randomly
assigned predictions for each model. Then for the two compared models, 500 pairs
of EMCs are formed and 500 differences in EMC are calculated.
5. Count the percentage of differences in EMC that have a higher value than the
observed difference in EMC for the two compared models. This percentage gives
the alpha level to reject the null hypothesis that the two models compared have the
same EMC.
In Table 9, regardless of cost ratio levels, auditors going-concern opinions accu-
rately predict 96.6% of nonbankruptcies and 44% of bankruptcies.
13
As the cost ratio
levels vary from 1:1 (the cost of misclassifying a bankrupt rm as a nonbankrupt one
versus the cost of misclassifying a nonbankrupt rm as a bankrupt one) to 100:1,
the estimated hazard models accuracy in predicting nonbankrupt rms vary from
100% to 82.7%; its accuracy in predicting bankrupt rms vary from 0.0 to 84%. The
differences in EMCs between the hazard model and auditors opinions suggest the
following. The hazard model signicantly outperforms the auditors going concern
opinions in the holdout sample at all cost ratios levels except for two levels: 10:1,
and 20:1. At the cost ratio levels of 10:1 and 20:1, there is no statistical difference
between the hazard model and the auditors opinions. Therefore, the null hypothesis
is rejected. The hazard model with incorporation of the Zmijewski Probability stress
measure, and three non-nancial-accounting variables (i.e., abnormal stock returns,
market capitalization, and industry failure rate) in addition to traditional nancial
ratios, has signicantly better performance than auditors going concern opinions in
13
Unlike that of statistical models, the performance of auditors opinions is irrelevant to the value of the
cutoff calculated based upon the cost ratio (see Eq. (3)).
Springer
74 L. Sun
predicting bankruptcy. This conrms Hopwood et al. (1994, p. 426) that It could be
that there is a model that would prove to be clearly superior to auditors opinions.
5.5 Additional analyses on auditors going concern opinions
Some studies (Hopwood et al., 1989; Foster et al., 1998) have been done to exam-
ine the incremental contribution of auditors going concern opinions in predicting
bankruptcy. It is found that auditors going concern opinions have incremental contri-
bution in predicting bankruptcy beyond traditional nancial ratios, but not beyond loan
default/accommodation and covenant violation variables. Here we examine whether
auditors opinions have incremental contribution beyond the composite stress mea-
sure, the market-variables, and the industry failure rate. Table 10 presents the result
using the test sample. Since we only gather going-concern opinions for the test sample,
additional analyses reported in this section are based upon the test sample only. Mean-
while, the method used is the binary logit model since the number of observations
equals the number of rms in the test sample. Table 10 presents the result. In the left
column is the logit model without auditors going concern opinions variable (GC = 1
Table 10 Incremental prediction ability of auditors going concern opinions
Model without Going-concern opinion Model with Going-concern opinion
Variable Co-efcient Wald Chi-square Co-efcient Wald Chi-square
Intercept 10.995 89.275

11.330 88.439

NITA 0.675 5.812

0.361 1.545
CASALES 0.166 8.320

0.138 5.164

CACL 0.204 3.951

0.113 1.457
CATA 0.126 0.061 0.403 0.567
CASHTA 0.935 1.142 0.862 0.925
LTDTA 0.507 0.983 1.014 3.437
LSALES 0.411 29.912

0.461 34.330

STRESS
(Zmijewski
Probability)
1.116 18.533

0.818 9.054

IFR 0.291 12.160

0.270 9.746

CAR 2.535 59.329

2.407 51.061

LNMCP 0.472 41.436

0.445 34.940

GC 1.829 36.948

Vuongs test for

nested models
(Incremental
Chi-square
=Model with GC
Model without
GC)
41.155

(1d f )
Dependent variable = 1 if a rm is bankrupt in a given year, 0 otherwise.

Signicant at p-value <0.05.

Signicant at p-value <0.01.

Signicant at p-value <0.001.

GC = 1 if a rm receives going concern opinion, 0 otherwise. All other variables are dened in (Table 2)
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 75
Table 11 Explaining auditors going concern opinions
Variable Co-efcient Wald Chi-square
Intercept 7.522 30.460

NITA 0.916 9.648

CASALES 0.189 5.974

CACL 0.629 12.980

CATA 0.616 0.924

CASHTA 0.204 0.034
LTDTA 1.421 6.087

LSALES 0.080 0.940

STRESS (Zmijewski probability) 2.332 33.835

IFR 0.164 2.702

CAR 0.903 9.852

LNMCP 0.386 18.184

Dependent variable: auditors going concern opinions (GC). GC = 1 if a rm receives going concern
opinion, 0 otherwise.

Signicant at p-value <0.05.

Signicant at p-value <0.01.

Signicant at p-value <0.001

if a rm received going-concern opinion, 0 otherwise); in the right column is the logit
model result with going-concern opinions variable. GC variable is statistically sig-
nicant at p <0.001 level. And the model with GC has an incremental
2
of 41.155,
signicant at p <0.001 level. This indicates that auditors going concern opinions
do have incremental contribution in predicting bankruptcy beyond a composite stress
measure, market variables, and industry failure rate.
The nal additional analysis we perform is to examine whether auditors consider
non-nancial-accounting information (market variables and industry-level factors)
when making going-concern judgments. In order to test this issue, we regress auditors
going concern opinions against these variables. Again, we use only the test sample
and employ a binary logit analysis. Table 11 presents the result. We nd that market
variables are signicant explanatory variables but industry failure rate is not. This
could imply that auditors are not able to pay enough attention to industry-level factor
when making going-concern judgments. Auditors going-concern judgments could
be improved by taking into account the industry-level information such as industry
failure rate.
6 Conclusions
To compare the relative performance of auditors going concern opinions and sta-
tistical models in predicting bankruptcy, this paper develops a hazard model with
incorporation of a composite stress measure derived from Zmijewski (1984) probit
model, two market variables (abnormal stock returns and market capitalization), and
one industry-level factor (industry failure rate) in addition to traditional nancial ratios.
Our work is motivated by the fact that statistical models used for comparing the predic-
Springer
76 L. Sun
tion ability of auditors going concern opinions with that of statistical models have not
incorporated some new features suggested by recent bankruptcy prediction research.
Our results show that the hazard model estimated in this study statistically out-
performs the auditors going concern opinions in the holdout sample. This suggests
that a well-developed statistical model as suggested by recent bankruptcy work (e.g.,
Shumway, 2001) could serve as a useful decision-aid for auditors going concern
judgments.
Further analysis shows that auditors going concern opinions have incremental
prediction ability beyond traditional nancial ratios, a composite measure of nan-
cial distress, and non-nancial-accounting information (market variables and industry
failure rate). We also nd that market variables have signicant power in explaining
auditors going concern opinions, but industry failure rate does not have such a sig-
nicant explanatory power. Auditors going concern judgments could be improved by
considering not only rm-level factors (nancial and non-nancial) but also industry-
level factors (such as, industry failure rate).
The study has its limitations. Similar to other empirical studies in bankruptcy
prediction, this studys results are based upon the particular data set employed. It
should also be admitted that the signicance of predictor variables may become
unstable across time periods (Begley et al., 1996).
More importantly, the statistical model built in this study incorporates only some
new features suggested by recent bankruptcy studies. Among other development,
Merton option-pricing model is of particular interest. Merton model is based upon
the original work of Merton (1974), in which the equity of the rm is a call op-
tion on the underlying value of the rm with a strike price equal to the face value
of the rms debt. The probability of default depends upon the rms underlying
value, the rms volatility and the face value of the rms debt. Different versions
of default measures based upon Merton model have been derived and tested by both
practitioners and academicians. For instance, researchers in KMV Corporation, sub-
sequently acquired by Moodys, develop the KMV-Merton model, which is available
to its subscribers. Hillegeist et al. (2004) estimate the BlackScholesMerton Proba-
bility of Bankruptcy (Black and Scholes, 1973; Hillegeist et al., 2004) which is found
to outperform both Ohlson (1980) Model and Altman Z-score (1968). Bharath and
Shumway (2004) propose a naive alternative to the KMV-Merton model and further
prove that the former outperformed the latter. The beauty of the nave alternative is
that while capturing both the functional form and the same basic inputs of the KMV-
Merton Model, it does not require solving the simultaneous nonlinear equations as
the KMV-Merton Model does. It would be interesting future research to examine how
to better apply the Merton option-pricing model into bankruptcy prediction and how
to better utilize the Merton model in facilitating auditors going concern decision
makings.
Acknowledgments This paper is part of my dissertation. I am indebted to my dissertation co-chairs
Michael Ettredge and Rajendra P. Srivastava for their guidance and valuable suggestions. I am also grate-
ful to suggestions provided by Cheng-few Lee (the editor), an anonymous reviewer, James McKeown,
Xiangdong Yang and participants at the University of Kansas AIS workshop. I thank the Whitcomb
Center for Research in Financial Services for providing research support through use of the WRDS
system.
Springer
A re-evaluation of auditors opinions versus statistical models in bankruptcy prediction 77
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