Review of Accounting Studies, 10, 93–122, 2005

Ó 2005 Springer Science+Business Media, Inc. Manufactured in The Netherlands.

Have Financial Statements Become Less Informative?

Evidence from the Ability of Financial Ratios to
Predict Bankruptcy
WILLIAM H. BEAVER fbeaver@stanford.edu
Graduate School of Business, Stanford University, Stanford, CA 94305

MAUREEN F. MC NICHOLS* fmcnich@stanford.edu

Graduate School of Business, Stanford University, Stanford, CA 94305

JUNG-WU RHIE
Graduate School of Business, Stanford University, Stanford, CA 94305

Abstract. Using a hazard model, we examine secular changes in the ability of financial statement data to
predict bankruptcy from 1962 to 2002. We identify three trends in financial reporting that could influence
predictive ability with respect to bankruptcy: FASB standards, the perceived increase in discretionary
financial reporting behavior, and the increase in unrecognized assets and obligations. A parsimonious
three-variable model provides significant explanatory power throughout the time period, with only a slight
deterioration in predictive power from the first to the second time period. The striking feature of the results
is the robustness of the predictive models over a forty-year period.

Keywords: bankruptcy, accounting information, financial ratios

JEL Classification: M41, G14, G33, C41

A significant body of research in accounting examines the relation between financial

statement information and security returns. Recent research has focused on ques-
tions of secular changes in the ability of the income statement to explain security
returns (e.g., Collins et al., 1997; Francis and Schipper, 1999, among others).1 The
results are mixed and are subject to diverse interpretations. In a comprehensive
review of the literature, Dechow and Schrand (2004) conclude there has been a
secular decline in the informativeness of earnings for security prices. Brown et al.,
(1999) on the other hand find no such decline. Landsman and Maydew (2002) find
that trading volume and incremental variance at the time of earnings announcements
have, if anything, increased over time, not diminished.
A second body of research in accounting has sought to examine the ability of
financial statement information to predict bankruptcy. The use of financial ratios to
predict bankruptcy has a long history (Beaver, 1966). It is well established that
financial ratios do have predictive power up to at least five years prior to bankruptcy.
In this paper, we extend this literature and the literature on the secular change in the
explanatory power of financial statements by examining changes in the predictive
ability of financial ratios with respect to bankruptcy.

*Corresponding author
94 BEAVER ET AL.

Several forces over the last 40 years potentially affect the ability of financial ratios
to predict bankruptcy. Here we identify three major trends: (1) The establishment of
the FASB and the development of accounting standards, many of which have a fair
value orientation. (2) An increase in the relative importance of intangible assets and
financial derivatives, especially during the 1990s. (3) A perceived increase in the
degree of discretion entering financial statements.
The intent of the FASB and the SEC is to set standards that make financial
statements more useful and relevant to investors and other user groups. To the
extent that standard-setting has been successful in its goals, we would expect the
quality of financial statement data to be enhanced, and the predictive ability with
respect to bankruptcy to increase. The second force, other things being equal, acts to
impair the quality of accounting. Many intangible assets and financial derivatives are
not captured by extant financial ratios and constitute potentially important omitted
variables. The third force, the increase in discretion, in principle, could operate to
enhance or impair financial statement data to the extent it is used to signal man-
agement’s private information or used to obscure important aspects of a firm’s
financial performance, although prior research largely finds opportunistic behavior.
It is difficult to predict which of these diverse effects will dominate.
In order to provide evidence on this issue, we examine a sample of bankrupt and
non-bankrupt firms for the years 1962–2002. In addition to verifying the findings of
prior research regarding predictive power, we divide the sample into two major
sub-periods: 1962–1993 and 1994–2002.
The first sub-period experienced many major developments with respect to
accounting standards. Prior to 1973, the Accounting Principles Board set accounting
standards. In 1973, the FASB was formed and issued its first standard. Since then, the
FASB has issued 150 standards, most of which added to the required accounting
methods or restricted available methods. A major trend was the development of a
series of standards many characterize as ‘‘fair value’’ oriented. (Barth and Landsman,
1995) Statement No. 87 with respect to pensions (1985), No. 106 with respect to other
post retirement benefits (1990), No. 107 with respect to disclosure of the fair value of
financial instruments (1991), No. 115 with respect to accounting for investments in
debt and equity securities (1993) are major examples. Of course, the effects of the
standards are not reflected immediately in the financial statements, since many of the
standards contain a time span over which the standard may be adopted.
The relative importance of intangible assets has increased over time as a result of
technology-based assets generated through research and development expenditures.
A crude approximation of the relative importance of intangible assets is reflected in
market-to-book ratios. From 1992 to 1999, the average market-to-book ratio for our
sample firms was at a forty-year high, ranging between 2 and 2.5, although there has
been a marked decline since.
The financial derivatives market experienced an explosion in the 1990s, although it
is unclear how this affected measures such as financial ratios, since the fair value of
off-balance sheet derivative items could be either positive or negative. Many of the
financial derivatives were used as a substitute for leverage. To that extent, traditional
calculations of leverage variables are understated. On the other hand, derivatives
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 95

may constitute a correlated omitted variable to the extent that firms that are highly
levered with on-balance sheet financing are more likely to use off-balance sheet
financing as well. In any event, financial derivatives constitute an omitted variable
that potentially increases measurement error in the financial ratios.
With respect to discretion over reported financial statement amounts, claims are
made that discretion has substantially increased over time. For example, the GAO
study (2002) stated that the number of earnings restatements grew substantially over
the 1997–2002 period, and even in 1997 was high by historical standards. Of course,
an earnings restatement made in a given year applies to prior years’ financial state-
ments. Lu (unpublished working paper) examines a sample of firms from 1988 to 2000
and reports a substantially higher litigation level in the 1994–2000 period than the
1988–1993 period. Certainly, recent high profile cases, such as Enron and WorldCom,
have led to the perception that manipulation of the financial statements is on the rise.
We are careful to state that the perception is that discretion has increased, because it is
difficult to determine whether there is in fact an increase or merely that instances of
discretion are being better documented over time. In a similar vein, the number of
academic articles devoted to discretion and earnings management has substantially
grown over time, although it is not clear whether this is because the underlying
phenomenon is more prevalent or whether there is an increase in awareness in the
academic literature of the role of discretion in financial reporting.
While it is difficult to select a single ‘‘watershed’’ year that clearly divides the
sample time series, our analysis examines two time periods, pre-1994 and post-1994.
We believe these represent different regimes with respect to the secular features
discussed above. However, as a robustness check, we also conduct a time series
analysis that is not dependent upon decomposing the overall time period into
sub-periods and results are essentially unaltered.
The layout of the paper is as follows. Section 1 discusses prior research and its
implications for the modeling of bankruptcy. Section 2 describes our data and
presents descriptive statistics. Section 3 presents the empirical results concerning the
predictive ability of financial ratios through time. Section 4 presents the empirical
results of the predictive ability of market-related variables through time. Section 5
presents the results of models including financial statement and market-related
variables, and Section 6 concludes.

1. Modeling the Probability of Bankruptcy

Models of bankruptcy focus on three areas: profitability, cash flow generation, and
leverage. Beaver (1966) uses a univariate analysis, while multivariate analyses have
included multiple regression (Beaver, unpublished doctoral thesis), discriminant
analysis (Altman, 1968), logistic regression (Ohlson, 1980), and hazard analysis
(Shumway, 2001; Suh, 2003; Hillegeist et al., 2004; Chava and Jarrow, forth com-
ing). The results have been robust with respect to the predictive power of financial
statement data. The precise combination of ratios used seems to be of minor
importance with respect to overall predictive power, because the explanatory
96 BEAVER ET AL.

variables are correlated. Shumway, among others, reports improved predictive

power via the use of hazard analysis.
Hazard models have been applied to a variety of accounting issues. Beatty et al.
(2002) use a hazard model to predict the duration of consecutive earnings increases
for public and private banks. Roundtree (unpublished working paper) predicts the
duration of the time between the announcement of SAB 101 and the first disclosure
by firms of its impact. Lin et al. (unpublished working paper) use hazard models to
predict the duration of the time between an equity offering and the first downgrade
by analysts. The statistical method also enjoys widespread use in the biological and
social sciences.
As in Shumway’s study, the statistical estimation method adopted here is that of
hazard analysis, also known as survival analysis and duration analysis. The hazard
rate is the probability of ‘‘bankruptcy’’ as of time t, conditional upon having sur-
vived until time t. However, the ex post event is either zero or one in any finite period
of time. Many hazard models are applied in a context where the passage of time
naturally affects the hazard rate. A typical example would be the study of living
organisms with a finite life. The basic hazard rate is a function of time since birth and
is coupled with the notion that the cumulative probability of death prior and up to
time t is an increasing function of time, starting at zero and approaching one over a
finite time period.
Various estimation methods allow the hazard rate to come from a family of
distributions that are a function of time (Allison, 1999). In addition to an estimation
of the basic hazard rate, hazard models permit the examination of a variety of
covariates to affect the hazard rate (e.g., the effect of DDT exposure on mosquitoes).
In many applications, the covariates are constant over time. However, a sub-class of
models permits the covariates to vary over time. This class of hazard models is of
interest here because the financial condition of the firm as manifest in the financial
ratios varies over time. The time-varying covariates can be somewhat tedious to
incorporate into many of the traditional hazard models.
However, it has been shown that the familiar logistic model can be used to esti-
mate the effect of time-varying covariates on the hazard rate. In our context, the
‘‘dependent variable’’ is either one if the firm is bankrupt in year t or zero if it is not.
In a sample of non-bankrupt and bankrupt firms, the non-bankrupt firms are coded
zero every year they are in the sample, while the bankrupt firms are coded zero in
every sample year except the year in which they fail.
As in Shumway, the contrast with prior usage of logistic estimation in bankruptcy
studies is that we include the bankrupt and non-bankrupt firm data for years prior to
the final year before bankruptcy. Shumway argues that the inclusion of these
additional observations can increase the efficiency and reduce the bias of the
estimated coefficients. Specifically, in contrast to a static model with only a single
firm-year observation for a non-failed firm, the multiperiod logit approach considers
the hazard of bankruptcy in multiple years for firms that do not go bankrupt.
We examine whether the predictive ability of financial ratios for bankruptcy has
declined from the first to the second sample period. A general form of the hazard
model used here is:
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 97

ln½hj ðtÞ=ð1
hj ðtÞÞ ¼ aðtÞ þ BXj ðtÞ: ð1Þ

In this model, hj(t) represents the hazard, or instantaneous risk of bankruptcy, at

time t for company j, conditional on survival to t; a(t) is the baseline hazard; B is a
vector of coefficients; and Xj(t) is a matrix of observations on financial ratios, which
vary with time. Here the hazard ratio is defined as the likelihood odds ratio in favor
of bankruptcy and the baseline hazard rate is assumed to be a constant. The model is
estimated as a discrete time logit model using maximum likelihood methods, and
provides consistent estimates of the coefficients B.
The primary question we address is whether the ability of financial ratios to
predict bankruptcy has changed over time. We test this by comparing the accuracy
with which the estimated probability of bankruptcy conditional on financial ratios
can be used to classify firms that declare bankruptcy in the first and second sample
periods.

2. Data and Descriptive Statistics

The sample consists of NYSE and AMEX-listed Compustat firms. Bankrupt firms
were identified through a variety of sources including the 2003 Compustat Annual
Industrials file, the 2003 CRSP Monthly Stock file, the website Bankruptcy.com, the
Capital Changes Reporter, and a list of firms generously supplied by Shumway. The
bankrupt year is defined as the calendar year that a firm files for bankruptcy.
Following Shumway (2001), all NYSE- and AMEX-listed firms that did not file
for bankruptcy and are not in financial or utility industries are included in the sample
as non-bankrupt firms. The independent variables are lagged to ensure that the data
are observable prior to the declaration of bankruptcy. Since all sample firms file
annual financial statements with the SEC (i.e., 10-Ks), it is assumed that financial
statements are available by the end of the third month after the firm’s fiscal year-end.
Of course, quarterly statements have also been filed several months prior to this time.
However, for a firm that declares bankruptcy within three months of its fiscal year-
end, it is assumed that the most recent year’s financial statements are not available
and the prior fiscal year is defined as the year before bankruptcy. Because of the
availability of quarterly financial statements, this rule is a ‘‘conservative’’ one that
will tend to understate the predictive power of financial statement data. The process
resulted in the identification of 585 bankrupt firms, of which 544 were used in the
analysis. Table 1 describes the attrition process from 585 to 544, where 41 firms were
excluded because they were either utilities or financial institutions. This provided
8,130 firm-year observations for the bankrupt firms. As reported in Table 1, similar
exclusions resulted in a sample of 4,237 non-bankrupt firms with 74,823 observa-
tions.
The sample sizes of the bankrupt and non-bankrupt firms for each sample year
from 1962 to 2002 are reported in Table 2. Note that the frequency of bankrupt
firms reflects the number of bankruptcies (that is, the number of bankrupt firms),
while the frequency of non-bankrupt firms reflects the number of firm-years provided
98 BEAVER ET AL.

Table 1. Characteristics of sample, bankrupt and non-bankrupt firms (1962)2002) and reasons for the
attrition rate in the sample.

Number of Firms

Bankrupt Non-Bankrupt Total

NYSE- and AMEX-listed compustat firms 585 6,385 6,971

Less: firms in financial or utility industries 41 2,148 2,189
Final sample (number of firms) 544 4,237 4,781
Final sample (number of firm-years) 8,130 74,823 82,953

by the non-bankrupt firms. In particular, a bankrupt firm appears in the number

count only once (the year bankruptcy is declared). Hence, the ratio of bankrupt to
non-bankrupt firms in a given year is an approximation of the overall relative fre-
quency of bankruptcy. Overall, the ratio is less than 1% (544/82,953). Table 2 also
indicates how the bankrupt firms are distributed across the years. Poorer economic
conditions are reflected in the clustering of observations in 1990–1992 and 1999–
2002.

2.1. Descriptive Statistics

First, we begin with some descriptive statistics. Table 3 reports the mean (median)
values for each of the explanatory variables. The three explanatory variables are
ROA, ETL, and LTA. ROA is return on total assets, which is earnings before interest
divided by beginning of year total assets. ETL is EBITDA to total liabilities, which is
net income before interest, taxes, depreciation, depletion and amortization divided
by beginning total liabilities (both short term and long term). In prior studies (e.g.,
Beaver, 1966), ETL is called the ‘‘cash flow’’ to total liabilities ratio. LTA is a
measure of leverage, which is total liabilities divided by total assets. In unreported
results, we tested the models of Ohlson, Zmijewski, and Shumway. We found the
models produced very similar results and that a linear combination of the three
variables reported here captured essentially all of the explanatory power of the
financial statement variables used in the three models. This result is not surprising
since the financial ratios are highly correlated. Because model comparison is not the
purpose of this study, we have chosen the parsimonious route of examining the
predictive performance over time of the parsimonious three variable model.
The three variables capture three key elements of the financial strength of a firm.
ROA is a measure of the profitability of the assets. Profitability is expected to be a
critical element, since prior research has shown that capital markets are concerned
about the ability of the firm to repay its debts and profitability is a key indicator of
ability to pay. The second element is the ability of cash flow from operations pre-
interest and pre-taxes to service the principal and interest payments. EBITDA has
been widely used as an available proxy for pre-interest, pre-tax cash flow from
operations. Total liabilities are a proxy for the amount of principal and interest to be
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 99

Table 2. Distribution by calendar year of bankrupt and non-bankrupt firms (1962)2002).

Bankrupt Firms Non-Bankrupt Firms

Year Frequency Percent Frequency Percent

1962 0 0.00 1,241 1.66

1963 1 0.18 1,342 1.79
1964 3 0.55 1,422 1.90
1965 2 0.37 1,500 2.00
1966 1 0.18 1,588 2.12
1967 0 0.18 1,670 2.23
1968 0 0.18 1,784 2.38
1969 1 0.18 1,850 2.47
1970 7 1.29 1,868 2.50
1971 8 1.47 1,918 2.56
1972 8 1.47 1,959 2.62
1973 13 2.39 1,975 2.64
1974 16 2.94 2,013 2.69
1975 13 2.39 1,989 2.66
1976 19 3.49 1,953 2.61
1977 8 1.47 1,889 2.52
1978 12 2.21 1,820 2.43
1979 12 2.21 1,760 2.35
1980 9 1.65 1,735 2.32
1981 13 2.39 1,683 2.25
1982 6 1.10 1,687 2.25
1983 13 2.39 1,707 2.28
1984 14 2.57 1,666 2.23
1985 16 2.94 1,703 2.28
1986 19 3.49 1,729 2.31
1987 11 2.02 1,752 2.34
1988 14 2.57 1,719 2.30
1989 6 1.10 1,721 2.30
1990 20 3.68 1,754 2.34
1991 33 6.07 1,816 2.43
1992 20 3.68 1,904 2.54
1993 14 2.57 1,997 2.67
1994 10 1.84 2,067 2.76
1995 14 2.57 2,204 2.95
1996 14 2.57 2,264 3.03
1997 11 2.02 2,207 2.95
1998 18 3.31 2,182 2.92
1999 26 4.78 2,119 2.83
2000 39 7.17 2,014 2.69
2001 42 7.72 1,916 2.56
2002 38 6.99 1,736 2.32
Total 544 100.00 74,823 100.00

paid. Beaver (1966) found this ratio to be the best single ratio for bankruptcy pre-
diction purposes. The third element, LTA, is a measure of the debt to be repaid
relative to the total assets of the firm available as a source for repaying the debt.
100 BEAVER ET AL.

Table 3 provides a description of the mean (median) value of the individual ratios
for the bankrupt and non-bankrupt firms in each of the 4 years prior to bankruptcy.
Here, the year before bankruptcy represents the financial statements reported in the
year prior to the year of bankruptcy.2 Since the non-bankrupt firms have no year of
bankruptcy, their mean (median) is pooled across all years. The behavior of the
financial ratios of the bankrupt firms shows that there is a mean (median) difference in
the ratios for as much as four years prior to bankruptcy and that the deterioration in
the ratios is progressive as the year of bankruptcy approaches. These results are

Table 3. Descriptive statistics for bankrupt and non-bankrupt firms by year before failure.

Variable N Mean Median Std Dev Minimum Maximum

Panel A: year before bankruptcy

ROAb 524 )0.18 )0.12 0.28 )2.36 0.49
LTA 528 0.98 0.85 0.49 0.07 3.27
ETL 526 )0.05 0.01 0.43 )5.32 2.43
Panel B: two years before bankruptcy
ROA 529 )0.10 )0.04 0.29 )2.36 0.49
LTA 532 0.82 0.76 0.39 0.07 3.27
ETL 530 )0.01 0.07 0.50 )5.43 1.97
Panel C: three years before bankruptcy
ROA 507 )0.04 0.01 0.24 )2.36 0.49
LTA 519 0.74 0.70 0.35 0.03 3.27
ETL 515 0.05 0.10 0.51 )5.43 2.26
Panel D: four years before bankruptcy
ROA 482 )0.03 0.01 0.25 )2.36 0.49
LTA 500 0.71 0.67 0.33 0.03 3.27
ETL 497 0.09 0.13 0.57 )5.43 2.43
Panel E: descriptive statistics
for the full sample
ROA 73106 0.05 0.06 0.49
LTA 75676 0.52 0.51 3.27
ETL 75384 0.35 0.28 2.43
ROA LTA ETL

Correlationa
ROA 1 )0.2586 0.5978
LTA )0.3907 1 )0.3150
ETL 0.7554 )0.6334 1
a
The lower diagonal refers to Pearson product moment correlations, while the upper diagonal refers to
Spearman rank correlations.
b
ROA, Net income divided by total assets; LTA, Total liabilities divided by total assets; ETL, EBITDA
divided by total liabilities; EBITDA, Earnings before interest, taxes, depreciation, and amortization.
This Table presents descriptive statistics on the three financial ratios that are explanatory variables in the
hazard model of bankruptcy. Panels A–D present the ratios for the first through fourth years prior to the
bankruptcy year, which is determined as the latest fiscal year that has ended at least three months before
the bankruptcy filing. Panel E presents descriptive statistics and correlations for the full sample.
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 101

similar in spirit to those reported by Beaver (1966) and subsequent research. This
manner of presentation of the data, of course, exploits the ex post knowledge of which
firms failed and does not show the degree of overlap of the two distributions. How-
ever, they can provide some preliminary visual indication of the behavior of the ratios.
Following Shumway, we mitigate the effects of outliers on the estimates of the
hazard model parameters by ‘‘winsorizing’’ all observations at the 1% and 99%
level, respectively. As a result, the minimum and maximum values of each of the
three years before bankruptcy and for the non-bankrupt firm distribution are
identical, as reported in Table 3.
In order to simplify the presentation of the non-bankrupt firms, a single pooled
distribution of non-bankrupt firms is reported. However, in unreported results, we
conducted a similar analysis where we matched each bankrupt firm with a non-
bankrupt mate from the same industry and for the same calendar years. The
resulting distribution of non-bankrupt firms (i.e. pooled relative to year before
bankruptcy) was constant across event time and hence is well approximated by a
single pooled sample here. This is not surprising, since the ex ante probability of
bankruptcy for the entire sample of ex post non-bankrupt firms is likely to be low.
The mean ROA for the non-bankrupt firms is 0.05, while the mean for the bankrupt
firms is )0.03, )0.04, )0.10, and )0.18, declining over the four years prior to bank-
ruptcy. For ETL, the non-bankrupt mean is 0.35, while the means for the fourth
through the last year prior to bankruptcy are 0.09, 0.05, )0.01, and )0.05. For LTA,
the non-bankrupt mean is 0.52, while the bankrupt firms’ means are 0.71, 0.74, 0.82,
and 0.98 for the four years prior to bankruptcy. When compared with the means of the
non-bankrupt firms, the poor profitability, poor cash flow, and higher leverage
positions are evident as early as four years prior to bankruptcy. Moreover, the mean
ratios of the bankrupt firms deteriorate as the year of bankruptcy approaches.
Figures 1–4 show similar information in a different format. Each figure reports the
cumulative distribution function (cdf) for the bankrupt and non-bankrupt firms for
each of the four years prior to bankruptcy for each of the three financial ratios.
Figure 4 shows the cdf for the combined ratio model. An advantage of the cdf’s is
that they report the entire distribution. As the figures indicate, the cdf for the
bankrupt firms is distinct from that of the non-bankrupt firms for at least four years
prior to bankruptcy and as the year of bankruptcy approaches, the cdf of the
bankrupt firms moves farther away from that of the non-bankrupt firms.

3. Secular Change in the Predictive Ability of Financial Ratios

Table 4 reports the estimated coefficients (Panel A) and predictive results for logistic
estimation for the entire period (1962–2002). All three ratios are significant and have
the predicted sign. The probability of bankruptcy within the next year is an
increasing function of leverage and a decreasing function of profitability and cash
flow. With respect to predictive results, the predicted scores of the entire sample are
ranked and divided into deciles. The data are divided into deciles based on the
combined distribution of bankrupt and nonbankrupt firm-years. The frequency and
102 BEAVER ET AL.

Figure 1. Cumulative distribution function of ROA for the entire sample period (1962–2002). The distri-
bution of ROA at the year of bankruptcy, marked as the black square, is the distribution of ROA from the
latest fiscal year that ended at least 3 months before the bankruptcy filing. The dark gray triangle, medium
gray diamond, and light gray circle represent the distributions of ROA in one, two, and three years before
bankruptcy, respectively. The distribution of ROA of non-bankrupt firms is presented as a solid line.

Figure 2. Cumulative distribution function of ETL (EBITDA divided by total liabilities) for the entire
sample period (1962–2002). The distribution of ETL at the year of bankruptcy, marked as the black
square, is the distribution of ETL from the latest fiscal year that has ended at least 3 months before the
bankruptcy filing. The dark gray triangle, medium gray diamond, and light gray circle represent the
distributions of ETL in one, two, and three years before bankruptcy, respectively. The distribution of ETL
of non-bankrupt firms is presented as a solid line.
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 103

Figure 3. Cumulative distribution function of LTA (total liabilities divided by total assets) for the entire
sample period (1962–2002). The distribution of LTA at the year of bankruptcy, marked as black square, is
the distribution of LTA from the latest fiscal year that has ended atleast 3 months before the bankruptcy
filing. The dark gray triangle, medium gray diamond, and light gray circle represent the distributions of
LTA in one, two, and three years before bankruptcy, respectively. The distribution of LTA of non-
bankrupt firms is presented as a solid line.

Figure 4. Cumulative distribution function of the hazard rate for the entire sample period (1962–2002).
The hazard rates are calculated from the estimates of the coefficients in Table 4. The distribution of the
hazard rate at the year of bankruptcy, marked as the black square, is the distribution of the hazard rate
based on the latest fiscal year that ended atleast 3 months before the bankruptcy filing. The dark gray
triangle, medium gray diamond, and light gray circle represent the distributions of the hazard rate in one,
two, and three years before bankruptcy, respectively. The distribution of the hazard rate of non-bankrupt
firms is presented as a solid line.
104 BEAVER ET AL.

Table 4. Hazard model estimation and prediction for the full sample period (1962–2002).
Panel A: hazard model estimation results.

Coefficients v2 p value

Intercept )6.4446 5,307.53 <0.0001

ROA )1.1919 55.04 <0.0001
LTA 2.3074 538.07 <0.0001
ETL )0.3464 20.84 <0.0001
Panel B: in-sample prediction test.

Bankrupt Firms Earlier Bankrupt Firm Years Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%) N Cumulative (%)

0 314 68.71 1,445 24.12 5,205 8.21

1 64 2.71 1,014 41.05 5,909 17.53
2 32 89.72 688 52.54 6,268 27.42
3 16 93.22 528 61.35 6,447 37.59
4 15 96.50 511 69.88 6,455 47.77
5 7 98.03 433 77.11 6,555 58.11
6 4 98.91 402 83.82 6,588 68.50
7 2 99.34 358 89.80 6,625 78.95
8 2 99.78 348 95.61 6,640 89.42
9 1 100 263 100 6,706 100
Total 457 5,990 63,398

Panel A presents the estimation results for the accounting-based hazard model for the full sample of
bankrupt and non-bankrupt firm-years. Panel B shows the distribution of firms across deciles of the
predicted probability of bankruptcy, ranked from highest probability (decile 0) to lowest probability
(decile 9). Column 3 shows that 68.71% of bankrupt firms in our sample were estimated to have a
probability of bankruptcy in the top decile for all firm-years, whereas less than 1% were estimated to have
a probability of bankruptcy in the lowest decile. Column 5 (7) shows the comparable percentage for
bankrupt firms in earlier firm-years (non-bankrupt firms).

percentage of firms in each decile is reported separately for the bankrupt and non-
bankrupt firm-years. If financial ratios had no predictive power, the expected frac-
tion of firms in each decile for each group (bankrupt and non-bankrupt) would be
10%. In order to facilitate comparison across tables, the same firm-year observations
are used throughout, which requires availability of all of the accounting and market
value based variables. This reduces the sample to 457 bankrupt firm-years and
63,398 non-bankrupt firm-years. Unreported results indicate that the inferences are
essentially the same if the maximum number of observations is used for each
respective model.
In Panel B, the first three columns report the bankruptcy index for bankrupt firms
in the year prior to bankruptcy by decile. Each decile is computed from the sample of
both bankrupt and non-bankrupt firm-years, and is ranked in descending order, so
decile 0 has the highest predicted probability of bankruptcy (or alternatively, the
lowest probability of survival). In decile 0, 68.71% of the bankrupt firms appear. The
number of bankrupt firms declines in each subsequent decile and bankrupt firms are
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 105

virtually non-existent in the three highest deciles. In the two (three) lowest deciles,
82.71 (89.72) percent of the bankrupt firms appear, as compared with an expected 20
(30) percent under the null hypothesis of no predictive power.
The remaining firm-years are separated for descriptive purposes into two groups,
the number of firm-years of bankrupt firms (years prior to the year before bank-
ruptcy) and the firm-years of non-bankrupt firms. Columns 4 and 5 of Panel B
indicates that years prior to the year of bankruptcy tend to be higher in the lower
deciles than would be expected by chance. The number of firms in each decile
declines monotonically. This is consistent with the results in Figures 1–4 and Table 3
which show that the deterioration in financial performance is evident at least four
years prior to failure. For sake of parsimony, these additional columns will not be
reported in the subsequent tables but the same general behavior is exhibited in the
subsequent analyses as well. By contrast, the last two columns in Panel B show that
the non-bankrupt firms have fewer firms in the lowest two deciles and the percentage
monotonically increases for the higher deciles.
The combined percentage of non-bankrupt firm-years in the lowest decile is 9.6%.
The estimated likelihood odds ratio for the lowest decile is 7.16 times (68.71/9.6%),
which implies that a firm whose financial ratio index is in the lowest decile is 7.16
times more likely to fail within the next year than the population. Obviously, if we
were to use a finer partition than deciles, the likelihood odds ratios would be even
higher for the lowest partitions.
Table 5 reports the estimation and prediction results for each of our two sub-
periods: 1962–1993 and 1994–2002. Panels A and C report the estimation results for
each of the two sub-periods. In both cases, all three variables are significant and the
signs are as predicted. The coefficient on the leverage variable appears to be similar
across the sub-periods, while there are decreases in both the ROA and the ETL
coefficient.
Table 5, Panels B and D report the prediction results for each sub-period. For the
first sub-period, the cumulative percentage of bankrupt firms in the lowest two
(three) deciles are 84.85 (92.05) percent, respectively, while for the second sub-period,
the percentages are 80.31 (86.01), which represents a slight deterioration from sub-
period 1 to sub-period 2. In other words, there is a reduction of about 5%. These
in-sample ‘‘prediction’’ results are based on predicting the data back on themselves.
Out-of-sample prediction provides a more challenging test of predictive ability and
guards against over-fitting of the data. One form of out-of-sample prediction test is
to use the coefficients from period 1 to predict bankruptcy in period 2. Panel E
reports the results of one out-of-sample test, where the coefficients from sub-period 1
were used to predict bankruptcy in sub-period 2. The percentage of bankrupt firms
in the lowest two (three) deciles is 80.31 and 86.53, respectively, which is identical to
the percentages observed using sub-period 2 coefficients. The sub-period 1 weighting
scheme is as effective in correctly classifying the bankrupt firms as those derived from
fitting the sub-period 2 coefficients to the sub-period 2 data. This finding reflects the
similarity of the coefficients and the degree of collinearity among explanatory vari-
ables. It suggests that the index of bankruptcy based on financial ratios is robust over
time.
106 BEAVER ET AL.

Table 5. Hazard model estimation and prediction for 1962–1993 (Period 1) and 1994–2002 (Period 2).
Panel A: hazard model estimation results (Period 1)

Coefficients v2 p value

Intercept )6.8542 3156.08 <0.0001

ROA )1.5405 37.11 <0.0001
LTA 2.6429 364.86 <0.0001
ETL )0.3492 7.68 0.0056
Panel B: in-sample prediction test (Period 1)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 197 74.62 3,779 8.11

1 27 84.85 4,339 17.43
2 19 92.05 4,604 27.32
3 7 94.70 4,727 37.47
4 7 97.35 4,767 47.70
5 3 98.48 4,830 58.07
6 3 99.62 4,851 68.49
7 0 99.62 4,860 78.93
8 0 99.62 4,882 89.41
9 1 100.00 4,933 100.00
Total 264 46,572

Panel C: hazard model estimation results (Period 2)

Coefficients v2 p value

Intercept )5.754 1880.35 <0.0001

ROA )0.985 23.01 <0.0001
LTA 1.802 154.00 <0.0001
ETL )0.218 4.61 0.0316
Panel D: in-sample prediction test (Period 2)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 117 60.62 1,419 8.43

1 38 80.31 1,580 17.82
2 11 86.01 1,683 27.83
3 8 90.16 1,705 37.96
4 8 94.30 1,688 47.99
5 6 97.41 1,719 58.21
6 1 97.93 1,747 68.59
7 2 98.96 1,751 79.00
8 2 100.00 1,764 89.48
9 0 100.00 1,770 100.00
Total 193 16,826
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 107

Table 5. Continued.
Panel E: out-of-sample prediction test (Period 1 coefficients used to predict Period 2)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 118 61.14 1,422 8.45

1 37 80.31 1,577 17.82
2 12 86.53 1,676 27.78
3 7 90.16 1,710 37.95
4 9 94.82 1,688 47.98
5 5 97.41 1,720 58.20
6 1 97.93 1,746 68.58
7 2 98.96 1,754 79.00
8 2 100.00 1,763 89.48
9 0 100.00 1,770 100.00
Total 193 16,826

Table 5 presents the estimation results for our two sub-periods, 1962)1993 and 1994)2002. Panel A
presents the hazard model estimation results for the first period and Panel C presents the estimation results
for the second period. Panels B and D show the in-sample predictive ability of the models for periods 1 and
2, respectively. Panel E shows the out-of-sample predictive accuracy obtained using period 1 coefficients to
predict bankruptcies for the period 2 sample.

Of course, some deterioration in predictive power could have occurred to the

extent that the in-sample estimates ‘‘over-fit’’ the data or the relative weighting
changes over time. We also conducted another out-of-sample test that does not
require the coefficients to be constant over time. We call this test a contemporaneous
out-of-sample test. To conduct such a test, within each sub-period the firms are
randomly divided into two sub-samples (sub-samples 1A, 1B, 2A and 2B, respec-
tively).
Panels A, C, E, and G of Table 6 report the estimated coefficients for each of the
four groups, as well as the out-of-sample results. Again the coefficients for each of
the variables are always significant, the coefficients are always of the predicted sign,
and the magnitudes of the coefficients are remarkably similar across sub-samples for
a given time period.
Panels B, D, F, and H of Table 6 report the out-of-sample prediction results. Here,
sub-sample 1A (2A) coefficients are used to predict sub-sample 1B (2B) and vice
versa. This leads to four out-of-sample predictions, and the cumulative percentages
in the three lowest deciles are 91.53 and 93.84 for time period 1 and 84.62 and 87.64
percent for sub-period 2. There is a slight deterioration in the combined predictive
power from sub-period 1 to sub-period 2, from an average of 92% to 86%. Using a
v2 test for the difference between two samples, the value is 5.68, which is not sig-
nificant at the conventional 5% significance level.3
Although not reported in Table 6, the in-sample prediction percentages for the
four groups are about the same as the out-of-sample prediction percentages. Hence,
the out-of-sample deterioration between periods 1 and 2 is not due to a change in the
108 BEAVER ET AL.

Table 6. Hazard model estimation and prediction: Two time periods and two samples within each time
period.
Panel A: hazard model estimation results (Period 1, Sub-sample A)

Coefficients v2 p value

Intercept )7.0885 1575.66 <0.0001

ROA )1.4471 14.10 0.0002
LTA 3.1425 224.35 <0.0001
ETL )0.3371 3.14 0.0761
Panel B: out-of-sample prediction test (Period 1, Sub-sample B)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 86 72.88 1,848 8.14

1 15 85.59 2,129 17.52
2 7 91.53 2,250 27.42
3 4 94.92 2,309 37.59
4 3 97.46 2,326 47.84
5 1 98.31 2,373 58.29
6 1 99.15 2,338 68.59
7 1 100.00 2,371 79.03
8 0 100.00 2,376 89.49
9 0 100.00 2,386 100.00
Total 118 22,706

Panel C: hazard model estimation results (Period 1, Sub-sample B)

Coefficient v2 p value

Intercept )6.7303 1647.94 <0.0001

ROA )1.5647 21.59 <0.0001
LTA 2.3006 178.27 <0.0001
ETL )0.4180 6.13 0.0133
Panel D: Out-of-Sample Prediction Test (Period 1, Sub-sample A)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 108 73.97 1,900 7.96

1 15 84.25 2,219 17.26
2 14 93.84 2,370 27.19
3 3 95.89 2,421 37.33
4 4 98.63 2,435 47.54
5 0 98.63 2,473 57.90
6 1 99.32 2,518 68.45
7 0 99.32 2,498 78.92
8 0 99.32 2,498 89.38
9 1 100.00 2,534 100.00
Total 146 23,866
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 109

Table 6. Continued.
Panel E: hazard model estimation results (Period 2, Sub-sample A)

Coefficients v2 p value

Intercept )6.001 801.41 <0.0001

ROA )0.9583 8.77 0.0031
LTA 2.041 69.44 <0.0001
ETL )0.1550 0.81 0.3678
Panel F: out-of-sample prediction test (Period 2, Sub-sample B)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 58 55.77 714 8.41

1 22 76.92 793 17.75
2 8 84.62 843 27.68
3 5 89.42 862 37.83
4 4 93.27 856 47.91
5 5 98.08 864 58.09
6 0 98.08 891 68.58
7 1 99.04 878 78.92
8 1 100.00 895 89.46
9 0 100.00 895 100.00
Total 104 8,491

Panel G: hazard model estimation results (Period 2, Sub-sample B)

Coefficients v2 p value

Intercept )5.5743 1031.6915 <0.0001

ROA )0.9633 12.1669 0.0005
LTA 1.6508 80.8763 <0.0001
ETL )0.2783 4.6981 0.0302
Panel H: out-of-sample prediction test (Period 2, Sub-sample A)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 57 64.04 703 8.43

1 15 80.90 783 17.83
2 6 87.64 845 27.97
3 2 89.89 838 38.02
4 4 94.38 841 48.11
5 2 96.63 849 58.30
6 0 96.63 865 68.67
7 2 98.88 868 79.09
8 1 100.00 872 89.55
9 0 100.00 871 100.00
Total 89 8,335

Table 6 presents the estimation results within each period for two subsamples. Panel A (C) presents the
estimation results for period 1 (1962–1993) subsample A (B), and Panels B (D) present the out-of-sample
prediction results using the coefficients estimated on subsample A to predict bankruptcy for subsample B.
Panels E–H present this analysis for the 1994–2002 period.
110 BEAVER ET AL.

coefficients over time nor due to differences in the coefficients across random sub-
samples within a given sub-period.
These tests do not support a dramatic change in the predictive power of financial
ratios with respect to bankruptcy. The time-series in-sample test shows a decline
from 91% accuracy to 86% accuracy with respect to the bottom three deciles.
Similarly, the contemporaneous out-of-sample tests show a decline from 92% to
86% when conducted out-of-sample.

4. Secular Change in the Predictive Ability of Market-Based Variables

Prior research has also examined the ability of variables based on market values to
predict bankruptcy (Shumway, 2001; Hillegeist et al., 2004; Chava and Jarrow,
forthcoming). The inclusion of market-based variables is appealing for several rea-
sons. First, prior research indicates that market prices reflect a rich and compre-
hensive mix of information, which includes financial statement data as a subset.
Assuming the market-based measures can be successfully defined to extract the
probability of bankruptcy from the observed series of security prices, the resulting
model can potentially provide superior estimates of the probability of bankruptcy.
The difference in the predictive power of models based on financial statement vari-
ables and more comprehensive models can be used to assess the importance of
information that is not contained in financial statements. As discussed shortly, this
feature is of particular interest to our study.
Second, the market-based variables can be measured with a finer partition of time.
While financial statements are available at best on a quarterly basis and prior
research largely uses annual data (including our study), market-based variables can
exploit the availability of prices daily. Third, the market value based variables can
provide direct measures of volatility, as we discuss shortly.
Of course, it is a non-trivial exercise to extract the probability of bankruptcy from
an observed series of market prices. The market price of a security reflects the
expected present value of future cash flows. Embedded in the market price is an
assessment of the probability of bankruptcy, but it is not a direct measure of that
probability. As the probability of bankruptcy increases, the non-linear nature of the
payoff function for common stock becomes increasingly more important because of
risky debt and limited liability. Another deterrent to extracting information about
bankruptcy risk from equity prices is that they may not fully reflect publicly available
information and in this sense are not informationally efficient.
The market-based variables typically used in prior research are: logarithm of
market capitalization, LSIZE, lagged cumulative security residual return, LERET,
and lagged standard deviation of security residual returns, LSIGMA. Market capi-
talization is computed as of the end of the third month after the end of the fiscal year
and is divided by the market capitalization of the market index of NYSE, AMEX,
and NASDAQ firms. Security return and standard deviation are defined over a
twelve-month period ending with the third month after the end of the fiscal year.
This rule provides assurance that the fourth quarter financial statement data have
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 111

been filed. Obviously, this rule also permits market-based variables to reflect any
other information announced after the fiscal year end, including information about
the first fiscal quarter performance.4
The logarithm of market capitalization is a measure of firm size. The notion is that
the market value of common equity represents the equity cushion available to debt-
holders before their principal and interest become jeopardized. This variable reflects
the amount by which the value of assets can decline before they are insufficient to
cover the present value of the debt payments.
As discussed earlier, the option-like feature of common stock and risky debt may
impair the informativeness of this variable. Moreover, the market capitalization
variable is not ‘‘scaled’’ in that it is not compared with the magnitude of debt
outstanding. Of course, market capitalization may also proxy for the volatility of
returns to the extent that the firm’s asset returns are less than perfectly correlated
with each other. This diversification effect would imply ceteris paribus that large
firms have a smaller probability of bankruptcy. In any event, prior research indicates
that the probability of bankruptcy is a decreasing function of market capitalization.
The second market-based variable is prior year security returns, LERET. The basic
notion here is that large declines in equity value imply a greater probability of
bankruptcy because the equity cushion is declining. Again this market-based measure
omits information on the amount of debt outstanding. However the prediction would
be that the probability of bankruptcy is decreasing in lagged security returns.
The third market-based variable is the standard deviation of security returns,
LSIGMA, computed as standard deviation of residual return from a linear regres-
sion of the security’s monthly return regressed on the return on the market portfolio.
The regression is computed using monthly returns from the twelve-month period
ending with the third month after the end of the fiscal year. This time period provides
reasonable assurance that the fourth quarter financial statements are available. This
volatility measure potentially offers additional information regarding bankruptcy
risk that is not contained in traditional financial statement analysis. Conceptually,
we would expect that the probability of bankruptcy is not only a function of the
current expected value of the key variables but also a function of the variability of
those key drivers. For example, simple bankruptcy models that predict ‘‘stock-outs’’
of a liquid asset include a measure of the variability of the cash flows as well as their
expected values. Similarly, the variability of future asset returns is a key variable in
the option based Black-Scholes-Merton default model.5 Traditional financial ratios
do not provide estimates of variability, perhaps because of the relative infrequency
with which financial statement data are reported. The notion is that the greater the
volatility, ceteris paribus, the higher the probability of bankruptcy. Again, as with
the other market-based variables, there is no explicit consideration of debt. For
example, an all equity firm has volatility in its security returns because of its asset
risk and yet has a zero probability of bankruptcy.
In examining the market-based models, we adopt a somewhat different perspective
than that of prior research, which compares the two models as mutually exclusive
alternatives or asks how much predictive power is added to the market-based model
by also including accounting variables. Our perspective is that the market-based
112 BEAVER ET AL.

variables differ from the accounting-based measure in at least one more important
way. The market-based measures are endogenous variables and a function, among
other things, of the financial statement variables themselves. In this sense, they are
not a substitute for the accounting-based information, but rather a proxy for the
predictive power attainable by capturing the total mix of information, including both
financial statement and non-financial statement information. From our perspective,
a central question is how much is added to predictive power by including nonfi-
nancial statement information. We provide evidence on this issue by examining the
predictive power of a combined model of accounting and market value variables vis-
à-vis a model of accounting variables.
Earlier we discussed several forces that could operate to impair or improve the
predictive ability of financial statement data with respect to the prediction of
bankruptcy. Those same forces affect the relative importance of non-financial
statement data. This emphasizes the competing nature of financial and non-financial
statement data to capture the economically relevant characteristics of bankruptcy
risk. In particular, to the extent that FASB standards improve the quality of
reported financial statement data, this provides less opportunity for non-financial
statement data to provide incremental explanatory power. Also to the extent that
increased discretion impairs the quality of financial statement data, it provides an
opportunity for non-financial statement data to to aid in adjusting for discretion in
financial reporting. Similarly, to the extent that the increased importance of intan-
gible assets impairs the predictive power of financial statement data, this provides a
greater opportunity for non-financial statement data to step in and provide infor-
mation about such assets (Lev and Sougiannis, 1996; Deng et al., 1999; Joos, 2002).
Needless to say, these two sources of information may not act in a strictly com-
petitive manner. Moreover, the importance of non-financial-statement data may be
affected by forces that do not affect the predictive power of financial statement data.
Hence, overall predictive power may be subject to secular change independent of the
allocation between the two sources of information.
While the ultimate interest is in performance of the combined model, we briefly
present some evidence on the predictive power of the market-based model. Table 7
reports the estimates of the coefficients and the in-sample predictive results for the
market-based model for the overall period and for each of the two sub-periods. All
three market-based variables are significant and have the predicted sign. The per-
centage of bankrupt firms predicted in the bottom two (three deciles) are 87.09
(93.44), 89.39 (92.42), and 85.49 (93.26) percent, respectively, for the total period and
for each of the two sub-periods. When the coefficients from sub-period 1 are applied
to sub-period 2, the percentage of bankrupt firms in the bottom two (three) deciles
are 83.42 and 92.23 percent, respectively.
The predictive power of the model is approximately the same over time. Although
not reported here, the contemporaneous out-of-sample tests also show similar
behavior over time. These percentages are higher than those observed for the
accounting model. However, from this comparison one cannot infer whether
the market-based model dominates the accounting-based model nor can one infer
the incremental predictive power provided by non-financial statement data. We
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 113

Table 7. Market-based hazard model: Estimation and prediction for two time periods.
Panel A: market-based hazard model estimation results

Coefficients v2 p value

Intercept )11.9351 989.52 <0.0001

LERET )1.8362 378.75 <0.0001
LSIGMA 9.5243 313.23 <0.0001
LRSIZE )0.4731 189.20 <0.0001
Panel B: in-sample prediction test for the full sample period

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 333 72.87 5,226 8.24

1 65 87.09 5,864 17.49
2 29 93.44 6,151 27.19
3 13 96.28 6,302 37.14
4 5 97.37 6,451 47.31
5 5 98.47 6,577 57.68
6 2 98.91 6,617 68.12
7 4 99.78 6,675 78.65
8 0 99.78 6,742 89.29
9 1 100.00 6,793 100.00
Total 457 63,398

Panel C: market-based model estimation results for period 1, 1962—1993

Coefficients v2 p value

Intercept )13.7452 608.89 <0.0001

LERET )1.7569 181.79 <0.0001
LSIGMA 9.651 162.75 <0.0001
LRSIZE )0.6334 156.47 <0.0001

Panel D: In-sample prediction test for period 1

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 197 74.62 3,771 8.10

1 39 89.39 4,284 17.30
2 8 92.42 4,451 26.85
3 10 96.21 4,608 36.75
4 6 98.48 4,748 46.94
5 1 98.86 4,846 57.35
6 2 99.62 4,878 67.82
7 1 100.00 4,947 78.44
8 0 100.00 4,997 89.17
9 0 100.00 5,042 100.00
Total 264 46,572
114 BEAVER ET AL.

Table 7. Continued.
Panel E: Estimation Results for Period 2, 1994)2002

Coefficients v2 p value

Intercept )10.3263 336.2529 <0.0001

LERET )1.9688 190.8154 <0.0001
LSIGMA 9.5169 147.8365 <0.0001
LRSIZE )0.3294 44.3111 <0.0001
Panel F: In-Sample Prediction Test for Period 2

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 146 75.65 1,428 8.49

1 19 85.49 1,606 18.03
2 15 93.26 1,661 27.90
3 5 95.85 1,689 37.94
4 1 96.37 1,715 48.13
5 3 97.93 1,733 58.43
6 1 98.45 1,742 68.79
7 1 98.96 1,742 79.14
8 2 100.00 1,749 89.53
9 0 100.00 1,761 100.00
Total 193 16,826

Panel G: out-of-sample prediction (time Period 1 coefficients used to predict in Period 2)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 138 71.50 1,452 8.63

1 23 83.42 1,600 18.14
2 17 92.23 1,665 28.03
3 6 95.34 1,696 38.11
4 1 95.85 1,689 48.15
5 3 97.41 1,732 58.45
6 2 98.45 1,730 68.73
7 2 99.48 1,740 79.07
8 0 99.48 1,758 89.52
9 1 100.00 1,764 100.00
Total 193 16,826

LERET, Cumulative residual return defined as the difference between the cumulative monthly return for
the firm less the cumulative monthly return on a market index of NYSE, AMEX, and NASDAQ firms;
LSIGMA, The standard deviation of the residual return from a regression of twelve monthly returns of the
firm on monthly returns of the market index; LRSIZE, Logarithm of the ratio of the market capitalization
of the firm divided by the market capitalization of the market index.
LERET and LSIGMA are computed for a 12 month period ending with the third month after the fiscal
year end by the firm. LRSIZE is computed as of the end of the third month after the fiscal yearend.
Table 7 presents the estimation results for the market-based prediction model for the full sample period in
Panel A, and the in-sample prediction tests in Panel B. Panel C (E) separately shows the estimation results
for the 1962–1993 period ((1994–2002) and Panels D (F) show the in-sample prediction results. Panel G
shows the out-of-sample prediction results using period 1 coefficients from Panel C to predict bankruptcy
in period 2, 1994–2002.
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 115

address both questions in a model that combines both accounting and market-based
variables.

5. Secular Change in the Combined Predictive Ability of Financial Ratios and

Market-Based Variables

Table 8 reports the estimated coefficients and prediction results for a combined
model of both financial statement and market-based variables. The market-based
variables remain significant even in the presence of the financial statement variables.
However, ROA and ETL are no longer significant. This is consistent with the notion
that the market-based variables contain the financial statement variables as a subset.
Note however, consistent with our earlier arguments, leverage remains significant,
since the market-based variables do not distinguish between volatility induced by
business risk and that induced by financial risk.
The cumulative percentage of bankrupt firms in the bottom two (three) deciles for
the total period and the two sub-periods are 90.59 (95.19), 92.05 (96.21), and 90.16
(94.30) percent, respectively. Using period 1 coefficients to predict period 2 bank-
ruptcy probability, the percentage of bankrupt firms in the bottom two (three)
deciles are 88.08 (94.30) percent. Based on the in-sample tests, the accuracy with
respect to the bottom three deciles shows little decline (96–94%). In the time-series
out-of-sample test, the accuracy for period 2 is 94.30%, which is the same as that
obtained for period 2 in the in-sample test.
Table 9 presents the estimation results for the contemporaneous out-of-sample
tests. The findings indicate that the prediction accuracy for the bottom three deciles
is essentially the same, 98.31% and 93.83% for period 1 with 94.23% and 94.38%
for period 2. This reflects a decline over time from 96% to 94% that is smaller
than that observed for the financial ratio model. The v2 value for a test of a
difference in the two distributions is 0.87, which is not significant at the 0.05
significance level.
The estimation results for the accounting model reported in Tables 4 and 5 can be
compared with those of the combined model in Table 8. The findings indicate that
the addition of market-related variables in the combined model increases the
cumulative percentage of bankrupt firms in the bottom three deciles by 5%, 4%, and
8% for the total period and the two sub-periods, respectively. For the use of period 1
coefficients to predict bankruptcy in period 2, the increase is from 86.53% to
94.30%, or 7.77%.
For the contemporaneous out-of-sample tests, the cumulative percentage in the
bottom three deciles for the combined model is 98.31% and 93.84% for period 1
with 94.23% and 94.38% for period 2, in contrast to 91.53% and 93.84% for period
1 and 84.62% and 87.64% for the accounting model. The incremental predictive
power is 4% in period 1 and 8% for period 2. As indicated earlier, the difference is
viewed as evidence of the incremental explanatory power of nonfinancial ratio data.
Using a v2 test for differences in the two distributions, the difference for period 1 is
116 BEAVER ET AL.

Table 8. Combined hazard model: Estimation and prediction.

Panel A: Combined Hazard Model Estimation Results (Total Period)

Coefficients v2 p value

Intercept )12.3382 972.95 <0.0001

ROA )0.1963 0.96 0.3251
LTA 1.5476 200.96 <0.001
ETL 0.0514 0.35 0.5507
LERET )1.6849 307.13 <0.0001
LSIGMA 7.9908 190.01 <0.0001
LRSIZE )0.4405 154.52 <0.0001

Panel B: In-Sample Prediction Test (Total Period)

Bankrupt Firms

Rank N Cumulative (%)

0 368 80.53
1 46 90.59
2 21 95.19
3 9 97.16
4 3 97.81
5 5 98.91
6 2 99.34
7 1 99.56
8 2 100.00
9 0 100.00
Total 457

Panel C: combined hazard model estimation results (Period 1)

Coefficients v2 p value

Intercept )13.8428 578.2969 <0.0001

ROA )0.6873 5.6142 0.0178
LTA 1.5815 121.2943 <0.0001
ETL )0.0223 0.0305 0.8613
LERET )1.4144 112.4187 <0.0001
LSIGMA 6.7326 66.9509 <0.0001
LRSIZE )0.5914 130.5407 <0.0001
Panel D: In-Sample Prediction Test (Period 1)

Bankrupt Firms

Rank N Cumulative (%)

0 214 81.06
1 29 92.05
2 11 96.21
3 5 98.11
4 2 98.86
5 2 99.62
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 117

Table 8. Continued.

Bankrupt Firms

Rank N Cumulative (%)

6 1 100
7 0 100
8 0 100
9 0 100
Total 264

Panel E: combined hazard model estimation results (Period 2)

Coefficients v2 p value

Intercept )10.9064 352.70 <0.0001

ROA 0.0163 0.00 0.9531
LTA 1.4867 72.54 <0.0001
ETL 0.1429 1.39 0.2383
LERET )1.9384 178.58 <0.0001
LSIGMA 9.1394 115.94 <0.0001
LRSIZE )0.2976 34.32 <0.0001
Panel F: in-sample prediction test (Period 2)

Bankrupt Firms

Rank N Cumulative (%)

0 153 79.27
1 21 90.16
2 8 94.30
3 2 95.34
4 3 96.89
5 3 98.45
6 1 98.96
7 0 98.96
8 2 100.00
9 0 100.00
Total 193

Panel G: out-of-sample prediction (time period 1 coefficient used to predict period 2)

Bankrupt Firms

Rank N Cumulative (%)

0 149 77.2
1 21 88.08
2 12 94.30
3 3 95.85
4 2 96.89
5 2 97.93
6 2 98.96
118 BEAVER ET AL.

Table 8. Continued.

Bankrupt Firms

Rank N Cumulative (%)

7 0 98.96
8 1 99.48
9 1 100.00
Total 193

Table 8 presents the estimation results for the combined market and accounting prediction model for the
full sample in Panel A, and the in-sample prediction tests in Panel B. Panel C (E) separately shows the
estimation results for the 1962–1993 period (1994–2002) and Panels D (F) show the corresponding in-
sample prediction results. Panel G shows the out-of-sample prediction results using period 1 coefficients
from Panel C to predict bankruptcy in period 2, 1994–2002.

not significant (a v2 value of 0.108), while the difference in period 2 is significant (a v2

value of 7.47).
Not surprisingly, the market-based variables absorb a great deal of the predictive
power of financial statement variables and provide additional explanatory power not
reflected in the financial ratios. The incremental explanatory power of market-based
variables increases slightly in the second sub-period while the predictive power of the
financial statement variables declines slightly. The overall predictive power of the
combined model remains essentially unchanged when accuracy is measured with
respect to the bottom three deciles. The evidence is consistent with the market-
related variables compensating for the slight reduction in predictive power of the
financial ratios.

6. Concluding Remarks

Our study of secular change in the predictive ability of financial ratios for bank-
ruptcy documents two striking findings: (1) The robustness of the predictive models
is strong over time, showing only slight changes. (2) The slight decline in the pre-
dictive ability of the financial ratios is offset by improvement in the incremental
predictive ability of market-related variables. When the financial ratios and market-
related variables are combined, the decline in predictive ability appears to be very
small. The finding is consistent with non-financial-statement information compen-
sating for a slight loss in predictive power of the financial ratios. In terms of the three
financial reporting trends discussed at the outset, this finding is also consistent with
deterioration in the predictive ability of financial ratios for bankruptcy due to in-
creased discretion or the increase in intangible assets not being offset by improve-
ments due to additional FASB standards.
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 119

Table 9. Combined hazard model estimation and prediction two time periods and two samples within
each time period.

Panel A: hazard model estimation results (Period 1, Sub-sample A)

Coefficients v2 p value

Intercept )13.241 322.28 <0.0001

ROA )0.612 2.09 0.1474
LTA 1.668 55.31 <0.0001
ETL 0.030 0.03 0.8601
LERET )1.416 57.78 <0.0001
LSIGMA 7.294 41.08 <0.0001
LRSIZE )0.539 65.00 <0.0001

Panel B: out-of-sample prediction test (Period 1, Sub-sample B)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 101 85.59 1,754 7.72

1 10 94.07 2,047 16.74
2 5 98.31 2,176 26.32
3 1 99.15 2,264 36.29
4 1 100.00 2,310 46.47
5 0 100.00 2,387 56.98
6 0 100.00 2,402 67.56
7 0 100.00 2,439 78.30
8 0 100.00 2,461 89.14
9 0 100.00 2,466 100
Total 118 22,706

Panel C: hazard model estimation results (Period 1, Sub-sample B)

Coefficients v2 p value

Intercept )14.810 257.86 <0.0001

ROA )0.694 2.93 0.0867
LTA 1.561 65.12 <0.0001
ETL )0.151 0.58 0.4454
LERET )1.379 49.84 <0.0001
LSIGMA 6.027 25.32 <0.0001
LRSIZE )0.671 67.68 <0.0001

Panel D: out-of-sample prediction test (Period 1, Sub-sample A)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 115 78.77 1,878 7.87

1 16 89.73 2,208 17.12
2 6 93.84 2,328 26.88
3 4 96.58 2,377 36.83
120 BEAVER ET AL.

Table 9. Continued.

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

4 2 97.95 2,409 46.93

5 2 99.32 2,472 57.29
6 1 100 2,516 67.83
7 0 100 2,540 78.47
8 0 100 2,571 89.24
9 0 100 2,567 100
Total 146 23,866

Panel E: hazard model estimation results (Period 2, Sub-sample A)

Coefficients v2 p value

Intercept )10.53 157.0328 <0.0001

ROA 0.01 0.0024 0.961
LTA 1.50 27.445 <0.0001
ETL 0.34 2.3866 0.1224
LERET )2.26 100.1291 <0.0001
LSIGMA 10.21 66.0052 <0.0001
LRSIZE )0.22 8.6747 0.0032
Panel F: out-of-sample prediction test (Period 2, Sub-sample B)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 76 73.08 697 8.21

1 17 89.42 815 17.81
2 5 94.23 839 27.69
3 1 95.19 855 37.76
4 2 97.12 873 48.04
5 1 98.08 880 58.40
6 0 98.08 881 68.78
7 2 100 881 79.15
8 0 100 888 89.61
9 0 100 882 100
Total 104 8,491

Panel G: Hazard Model Estimation Results (Period 2, Subsample B)

Coefficients v2 p value

Intercept )11.20 194.5839 <0.0001

ROA )0.07 0.0411 0.8393
LTA 1.45 44.4446 <0.0001
ETL 0.08 0.3104 0.5774
LERET )1.71 79.9867 <0.0001
LSIGMA 8.41 51.9855 <0.0001
LRSIZE )0.35 26.1878 <0.0001
HAVE FINANCIAL STATEMENTS BECOME LESS INFORMATIVE? 121

Table 9. Continued.

Panel H: out-of-sample prediction test (Period 2, Sub-sample A)

Bankrupt Firms Non-bankrupt Firms

Rank N Cumulative (%) N Cumulative (%)

0 74 83.15 694 8.33

1 6 89.89 792 17.83
2 4 94.38 822 27.69
3 2 96.63 847 37.85
4 1 97.75 836 47.88
5 1 98.88 856 58.15
6 0 98.88 873 68.63
7 0 98.88 870 79.06
8 1 100.00 870 89.50
9 0 100.00 875 100.00
Total 89 8,335

Table 9 presents the combined hazard model estimation results within each period for two sub-samples.
Panel A (C) presents the estimation results for period 1 (1962–1993) sub-sample A (B), and Panels B (D)
present the out-of-sample prediction results using the coefficients estimated on sub-sample A to predict
bankruptcy for sub-sample B. Panels E–H present this analysis for the 1994–2002 period.

Acknowledgments

The authors thank Tyler Shumway for providing us with his sample of bankrupt
firms, and thank Jim Ohlson (the editor), an anonymous referee, and the 2005
Stanford Accounting Summer Camp participants for many helpful comments. The
authors gratefully acknowledge the financial support of the Stanford Graduate
School of Business.

Notes

1. While the main title is in the spirit of Francis and Schipper (1999), the study is directed explicitly toward
the predictive ability of financial ratios. No claim is made about the changing predictive power of other
information in financial statements, such as footnotes.
2. Because failure can occur at any time during the year, the year prior to bankruptcy represents a varying
number of days between the end of the fiscal year of the financial statements and the declaration of
bankruptcy.
3. In conducting this test, each distribution is divided into two groups, the lowest three deciles and the
upper seven deciles. This results in a two-by-two panel. The degrees of freedom for the v2 test are 2. To
mitigate the potential arbitrary nature of dividing the time period into two sub-periods, we conducted
an alternative test that requires no partitioning. The percentage of bankrupt firms whose predicted
value in the year before bankruptcy falls in the bottom three deciles is computed for each calendar year.
The yearly percentage was then regressed on time. The results are consistent with those reported here.
In particular, there is a decline over time in the predictive power of the accounting model but it is not
122 BEAVER ET AL.

significant at the conventional 0.05 significance level. We are indebted to George Foster for suggesting
this test.
4. Following Shumway, cumulative residual return is the sum of monthly residual returns computed as the
difference between the actual monthly return minus the return on the market portfolio.
5. The Black–Scholes–Merton default model, as well as other option based default models is set forth in
Duffie and Singleton (2003), which contains an excellent review of the empirical default literature.
6. In other words, a firm could have high operating risk but without leverage would not face bankruptcy
risk.

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