Journal of Information Technology (1995) 10,26-36

Predicting bankruptcy via induction

THOMAS E. McKEE
Department ofAccountancy, East TennesseeState University, PO Box 70710, Johnson City, TN 37614, USA
Research has consistently shown that auditors disclose going-concern problems for less than 50% of all business
failures. As evidenced by widespread litigation, investors and creditors believe that this performance needs to be
improved. This paper reportson research which analysed financial data for 60 publiccompanies viaan inductive
inferencing algorithm. The end result was a simple and theoretically consistent model that was 97% accurate in
predicting bankruptcy. Auditors, investors and creditors mayfind the model useful inimproving their bankruptcy
prediction capability.
Introduction
A basic assumption underlying corporate financial
reporting is that the entity will continue in existence for a
reasonable time (i.e. is a going-concern). Auditors in the
United States are required to modify their reports if the
time period for existence is expected to be less than a year.
There have been a significant number of cases where
businesses failed shortly after receiving unqualified audit
reports. For example, Lincoln Savings and Loan and
United American Bank are two highly publicized cases
where entities that received unqualified audit reports were
taken over by the US Government as failing institutions
shortly after receiving their unqualified audit reports.
Widely publicized business failures such as the previous
two have given the public the perception, rightly or
wrongly, that audit failures were also involved. Auditors,
investors and creditors could benefit from an improve-
ment in bankruptcy predictive ability.
Prediction of going-concern status can be a difficult
problem for auditors. Research by Kida (1980) indicated
that audit partners presented with a variety of going-
concern data made accurate going-concern judgements
only approximately 83% of the time.
Even when auditors can predict potential bankruptcy
problems they are frequently reluctant to disclose that
information due to the possible consequences of a going-
concern report. Therefore, auditor predictive ability is
significantly higher than auditor disclosure rates for
going-concern problems. Research examining the
frequency of auditor disclosures in the period prior to
actual bankruptcy revealed that auditor disclosure rates
have varied from a lowof 15% (Deakin, 1977) to a high of
84% (Levitan and Knoblett, 1985) with a mode around
45% as evidenced by three other studies indicating
disclosure rates of 43% (Menon and Schwartz, 1986),
44% (Altman and McGough, 1974) and 48% (Altman,
1982).
Auditors do a poor job of choosing which companies
with going-concern problems should receive modified
audit reports. Research which examined the actual status
of companies for the year after they received a going-
concern disclosure by their auditors revealed that, in one
case, only approximately 25% (Altman, 1982) and, in
another case, approximately 38% (Little and McAlum,
1991) of the companies actually went bankrupt in the year
after they received a going-concern disclosure from their
auditors.
There has been a significant amount of research
oriented towards developing highly accurate models
capable of predicting going-concern status. Asare (1990,
p. 50) notes, 'Most of the studies indicate model
superiority over auditors in assessing a client's going-
concern status'. These models, especially when coupled
with the related statistical assumptions, are fairly
complex. Auditors appear to be reluctant to rely heavily
on complex models that they poorly understand. Complex
models which are highly accurate but seldom used will not
improve auditors' predictive ability.
The objective of this research was to develop a highly
accurate, theoretically consistent, but simple, model for
bankruptcy prediction. The research employed an
inductive inferencing algorithm developed for machine
learning to extract knowledge structures from real world
cases. Existing theory was then used to evaluate pruning
choices among the various knowledge structures
developed.
Prior approaches to predicting going-concern
status
Auditors have typically sought decision aids for making
going-concern predictions. Considerable research has
been devoted to developing empirically derived assistance
or models to predict going-concern problems. This
Predictingbankruptcy 27
Example application of ID3
Table 1 An example set of company ratios and bankruptcy
outcomes
accuracy of ID3 against discriminant analysis for the
problems of predicting loan defaults and predicting
bankruptcy. The loan default sample included 46 US
companies while the bankruptcy prediction sample
included 23 Australian land development firms. They
found that ID3 outperformed discriminant models in all
cases tested.
where i = 1, ... ,n is the index of possible classifications
(in this case n = 2, where i = 1, bankrupt; i =2 not
bankrupt), e is the classification group and p(el) is the
probability of occurrence for class i (Messier and Hansen,
1988, p. 1408).
The probabilities for this fomula are estimated from the
overall sample. In this example, three ofthe sixcases are in
each of the two classification groups, so p =0.5 (each
(1)
Non-bankrupt
Bankrupt
Non-bankrupt
Bankrupt
Non-bankrupt
Bankrupt
Bankruptcy
outcome
0.03
0.04
0.10
-0.05
0.01
0.02
Netincomel
total assets ratio
n
B(G) = - peeD log, peeD
i=!
Current
ratio
2.2
1.1
1.2
1.4
1.6
1.3
Company
number
1
2
3
4
5
6
This section presents an example of how ID3 works. The
example should aid in understanding the application of
the ID3 algorithmin this study. In the example, the values
for two ratios are analysed to develop a bankruptcy
prediction rule.
Table 1 lists the values of two attributes, the current
ratio and net income/total assets ratio, for six hypothetical
companies. The example employs only ratios as attributes
(variables), although non-financial attributes could be
used as well.
To determine an initial splitting point for classifyingthe
cases, ID3 proceeds by analysing each attribute (ratio) in
the example set to determine if it will form an optimal
classification rule. The purpose of a classification rule is
to split the sample into two classification groups in a
manner that minimizes the misclassifications. The
measure for misclassification is the entropy (measure of
disorder) designated B(G) which is calculated for a sample
according to the following formula:
Inductive inference is the process of taking a series of
examples or observations and generating an explanation
for the behaviour observed. Dietterich and Michalski
(1983, p. 43) note, 'The process of inductive learning can
be viewed as a search for plausible general descriptions
(inductive assertions) that explain the given input data and
are useful for predicting new data' .
This study uses a data-driven method attributable to
Quinlan (1979, 1982) which he called interactive
dichotomizer 3 (ID3). The object of this method is to
identify rules which will permit the correct classification
of sample data into two or more categories. ID3 uses the
information-theoretic measure of entropy to assess the
information value of each variable. It develops a splitting
point for each variable that is used to classify the sample
data.
Tam and Kiang (1992, p. 943) note that ID3 employs a
symbolic approach that, '. . . sheds some light on the
importance of individual variables'. Thus, it can assist in
evaluating the significance of the individual variables.
This is not true for many other bankruptcy prediction
techniques. For example, linear discriminant functions,
neural nets and K nearest neighbour classifiers have been
criticized for their failure to assist in identifying variable
significance. Another widely used technique, logit
analysis, does have rigorous statisticial tests on the
significance of individual variable coefficients but it does
not do well with dimension reduction. On the other hand,
' ... the ID3 method has a built-in mechanism to reduce
the dimensions of the variable space' (Tam and Kiang,
1992, p. 943). Therefore, with respect to ability to analyse
the significance of individual variables and the ability to
reduce dimensions, ID3 offers comparative advantages
over the classification techniques, linear discriminant
functions, neural nets, K nearest neighbour classifiers and
logit analysis.
Messier and Hansen (1988) compared the classification
Inductive inferencing algorithms
assistance may be classified into seven categories based on
the underlying techniques employed. Assistance has
taken the form of (1) check-lists of factors to consider,
(2) univariate ratio models (Beaver, 1966), (3) multiple
discriminant analysis (Altman, 1968), (4) multivariate
conditional probability models (Ohlson, 1980), (5) expert
systems (Messier and Hansen, 1988), (6) inductive
inferencing techniques derived from machine learning
research (Marais et al., 1984; Frydman et al., 1985) and,
most recently, (7) neural networks (Bell et al., 1990;
Hansen and Messier, 1991). Each type of assistance has
advantages over unaided decisions, although all have
potentially significant weaknesses which have been
documented in the literature.
28 McKee
attribute (ratio) has an equal prior probability of
appearing in a classification group). Accordingly, to
calculate the initial entropy of our example set before
selecting a classification rule, we would calculate
Table 4 Table 3 displayed as a 2 x 2 probability table
Frequency of classifications
E(G) = - [[(0.5) Iog, (0.5)] + [(0.5) log; (0.5)]]
E(G) = - [[(0.5) (-1)] + [(0.5) (-1)]]
E(G) = 1
(2)
(3)
(4)
Splitting point
<1.6

Bankrupt
0.5
o
Non-bankrupt
0.1667
0.3333
n
E(G IA) = - P(Ci Iaj) IOg2P(Ci Iaj) (5)
i=!
where n is the number of subsets of c..
Dsing the formula for calculating subtable entropy, the
entropy for the subset represented by the values <1.6 is
calculated as follows:
would only misclassify one company. It would classify
company 3 in the bankrupt group even though it was a
non-bankrupt company.
The classification of the six examples using a current
ratio of as a splitting point is displayed in a 2 x 2
frequency table (Table 3). These frequencies may be
displayed as probabilities (Table 4).
When a data set is split around a splitting point, the data
on each side of the splitting point forms a subtable. The
entropy of each subtable E(G Iaj) is given by
(6)
(
0.167 1 0.167)]
+ 0.167 +0.5 Og2 0.167 +0.5
This means that the initial entropy for the data set in the
example is 1.
In this example, the current ratio is designated as
attribute A with values ai' a2' ... , a6 and the net income/
total assets ratio as attribute B with values b
i
, b
2
, , b.,
Our example set can be split on one of these two attributes
by determining which variable will provide the best
classification. Since entropy is used to measure classi-
fication success, the goal is to split on the variable that will
minimize the entropy. To determine which variable offers
the best split, ID3 actually computes the change in
entropy occurring from each possible splitting point. This
can involve a lot of calculations when there are many
attributes with numerous values. Rather than making all
these computations for our example data set, a visual
selection of the best splitting point will be made and the
computations to calculate the entropy improvement will
be illustrated for that point.
To facilitate the visual selection of the best splitting
point the example set is sorted into ascending order based
upon the current ratio as indicated in Table 2. A visual
inspection of Table 2 indicates that the best splitting
rule for the current ratio is to classify all companies with a
current ratio of 1.6 or higher as non-bankrupt. This rule
Table 2 Example set sorted on current ratio in ascending order
Company Current Net income/ Bankruptcy
number ratio total assets ratio outcome
2 l.l 0.04 Bankrupt
3 1.2 0.10 Non-bankrupt
6 1.3 0.02 Bankrupt
4 1.4 -0.05 Bankrupt
5 1.6 0.01 Non-bankrupt
I 2.2 0.03 Non-bankrupt
E(G I< 1.6) = - [(0.7510g
2
0.75) + (0.2510g
2
0.25)] (7)
E(G I < 1.6) = - [(0.75 (- 0.415)) + (0.25 (- 2))] (8)
E(G 1<1.6) = 0.811 (9)
In a similar manner, the entropy for the subset
represented by the values can be calculated as 0
(there is no disorder since there is no misclassification).
The entropy for the entire table after the split around the
current ratio of 1.6 is then calculated according to the
following formula:
Table 3 Example set classified using 1.6 as splitting point
M
E(G IA) = p(aj) E(A Iaj)
j=!
(10)
Splitting point Number of classifications
where M is the number of subsets. For the previous
example, this becomes
<1.6

Bankrupt
3
o
Non-bankrupt
I
2
E(GIA) = +
E(G IA) = 0.541
(11)
(12)
Predicting bankruptcy
Since the initial entropy was I before any splitting took
place, splitting at this point yields an improvement of
0.459 [I - 0.541 = 0.459]. Entropy improvement occurs
because the disorder in the data is reduced.
In the absence of a visual selection of the best splitting
point, it is normally only possible to determine if a single
point is the optimum splitting point by calculating the
entropy improvement for all other possible splitting
points. Table 5 displays the values that would be obtained
by calculating the entropy improvement for each possible
splitting point for the current ratio. It confirms the
conclusion that the visually selected splitting point is the
best.
Once the best splitting point for the current ratio is
calculated, the next step is to compare that with the best
splitting point for the net incomeltotal assets ratio to see
which ratio should be used for the initial split. Table 6
shows the entropy improvements achieved for all possible
splitting points of the net income/total assets ratio. Table 6
reveals that the maximum entropy improvement possible
by splitting on the net incomeltotal assets ratio is 0.191,
which is considerably less than the 0.459 improvement
possible from splitting on the current ratio. Accordingly,
the sample of six cases would first be split into two groups
based on the current ratio splitting point of <1.6. As
Table 5 Entropy improvement for various current ratio split-
ting points
29
shown by Table 2, the group ~ 6 contains two cases
which are perfectly classified, so no further splits would be
considered on this group. The group <1.6 contains four
cases and needs further classification since it contains both
bankrupt and non-bankrupt cases.
At this point, ID3 would consider the four remaining
cases in the group <1.6 as a new classification problem
and proceed to use all the previously illustrated formulae
to determine a splitting point for these cases. This analysis
is not shown but would yield a splitting point of ~ O I for
the net income/total assets ratio for a non-bankruptcy
classification.
The final decision tree obtained by ID3 splitting the
example cases is displayed in Figure I. As you can see in
Figure I, ID3 developed a two-stage rule that classified all
six cases perfectly. The rule is:
If the current ratio is greater than or equal to 1.6 and
if the net income/total assets ratio is greater than
or equal to 0.1, then the company will not go
bankrupt, else the company will go bankrupt.
3B
3NB
Table 6 Entropy improvement for various net incomeltotal
assets ratio splitting points
Splitting Initial Post-split Improvement
point entropy entropy
<1.1 1 1 0
<1.2 1 0.809 0.191
<1.3 1 1 0
<1.4 1 0.918 0.082
<1.6 1 0.541 0.459
<2.2 1 0.809 0.191
>2.2 1 1 0
Splitting
point
<-0.05
<0.01
<0.02
<0.03
<0.04
<0.10
>0.10
Initial
entropy
1
1
1
1
1
1
1
Post-split
entropy
1
0.809
1
0.918
1
0.809
1
Improvement
o
0.191
o
0.082
o
0.191
o
2NB
3B
Figure 1 Decision tree for example cases. Cases to be classified,
rectangle; non-terminal nodes (non-terminal subsets), circles;
terminal nodes (terminal subsets), squares; bankrupt firms,
B; non-bankrupt firms, NB
30
The current research
This research used the ID3 inductive inferencing
algorithm to extract knowledge structures from data on 60
actual companies. Once the knowledge structures were
extracted, a previously published theory with related
model was used to select the data utilized and to evaluate
pruning choices among the various knowledge structures.
Guiding theoretical model
McKee (1986) proposed a temporal continuity theory to
replace the classical going-concern concept. This theory
suggested variables that might be appropriate for pre-
dicting going-concern status. It also provided a basis for
evaluating the knowledge structures developed.
The temporal continuity theory posits that a firm has a
planning or operating horizon related to resource commit-
ments made by the firm. A firm processing continuity
must have '. . . expectations of both sufficient current
resources to fulfil its commitments and sufficient market
returns or benefits flowing to it' (McKee, 1986, p. 27).
'Current resources' refers to either the actual liquid assets
available or that may be made available (i.e. a line of
credit) to an entity. It may be estimated using a variety of
current liquidity surrogates. For example, the current
ratio is a common current liquidity surrogate. 'Sufficient
market returns' refers to the prospect of future cash flows
to the entity. These cash flows may be generated from
earning capacity or borrowing capacity based on future
earning potential. Surrogates for estimating future cash
flows are projected earnings or projected cash flows.
Ratios selected
This research utilized the following eight ratios: (1) net
income/total assets (NIITA), (2) current assets/total assets
(CA/TA), (3) current assets/current liabilities (CAlCL),
(4) cash/total assets (CASH/TA), (5) current assets/sales
(CA/SALES), (6) long-term debt/total assets (LTD/TA),
(7) inventory/cost of goods sold (INV/COGS) and
(8) accounts receivable/sales (AR/SALES).
The first six ratios provide comparability with prior
research and were obtained from the Hopwood et al,
(1989) study. They derived those ratios from the Beaver
(1966), Deakin (1977) and Libby (1975) studies. Many
of those ratios were also used by a variety of other
researchers exploring the bankruptcy prediction problem.
The last two ratios were obtained from McKee (1989).
They are turnover ratios that prior research has suggested
are significant in analysing the current financial liquidity
of a company. The eight ratios were viewed as possible
surrogates for the theoretical constructs 'current
resources' and 'sufficient market returns' .
McKee
Data and definitions
Sixty companies were selected from Compact Disclosure
which reports financial data for all public companies filing
with the US Securities and Exchange Commission
(Disclosure Incorporated, 1990). The fiscal years utilized
spanned the 4 year period 1986-1989. One-half of these
companies were defined as going-concerns and one-half
were defined as non-going-concerns.
Going-concerns were defined in this study as companies
having a positive cash flow from operations for the most
recent 5 year period. Non-going-concerns were defined as
companies that have either filed for bankruptcy or had a
significant subsidiary file for bankruptcy.
A minimum existence period of 5 years was adopted for
companies utilized in this study to eliminate start-up
companies from consideration in this research.
In order to provide evidence on the issue of whether
a general or industry-specific model provides the best
predictions, 20 of the 60 companies selected were chosen
solely from the electronics industry (standard industrial
classification 367). That industry was chosen due to the
high number of failed companies during the time period
the data was selected from. The remaining 40 companies
were randomly selected from the database and included
a variety of industries.
Table 7 contains a listing of 60 companies from a variety
of industries along with related data about fiscal periods,
company size and standard industrial classification
number.
As revealed in Table 7 the asset sizes of companies
employed in this study varied from approximately
$300000 to $33000000000. The possible effects of asset
size were mitigated through the use of scaled ratios. Ratios
were converted to percentile rankings based on the sample
group.
Results
The data were analysed using EXPERT-EASE, an
inductive inferencing software system employing ID3
(Human Edge Software Corporation, 1983).
The data for 60 companies was used to form three
different knowledge base sources.
(1) Twenty company single industry sample.
(2) Forty company multiple industry sample.
(3) Sixty company multiple industry sample.
Each knowledge base had an equal number of bankrupt
and non-bankrupt companies. Each knowledge base
source was analysed using both unsealed ratios and ratios
scaled between 0 and 100, based on sample percentiles,
thus forming a total of six knowledge base sources.
The remaining cases (either 20 or 40) formed a
validation sample for the first two knowledge base sources
Table 7 Sample companies
Company name Bankruptcy Financial Total assets SIC
date statement date ($1000) number
Bankruptcy companies
ACAJoe Inc. 05.27.88 01.31.87 20991 5136
ANAC Holding Corp. 07.28.88 05.30.87 2095838 5912
BasixCorp. 02.29.88 12.31.87 172605 6159
Bercor Inc, 06.23.88 04.03.87 72360 5064
Berkey Inc. 07.20.88 12.31.87 80869 5043
Cardis Corp. 05.25.88 04.30.87 188565 5013
Care Enterprises 03.28.88 12.31.87 215465 8051
Detroit Texas Gas 11.02.87 02.28.85 30723 1311
First Republic Bank 07.30.88 12.31.87 33210686 6028
Gibraltar Financial 02.08.90 12.31.88 15Oil 110 6122
Hauserman Inc. 10.05.89 06.30.88 79496 2541
Hydrogen Energy 09.30.89 12.31.88 2285 7392
InterdyneCo. 11.22.88 10.31.86 4555 3573
International Texas 05.19.89 04.30.88 1174 3842
Jumping Jack Shoes 02.06.90 04.30.89 24377 3149
KayproCorp. 07.10.87 01.30.86 26672 3573
Kenai Corp. 07.10.87 01.31.86 47048 3533
L.F. Rothschild 06.30.89 06.30.88 2778222 6200
Lankmark American 01.30.90 12.31.88 46417 NA
Lapointe Industries 02.10.89 06.30.88 6361 3662
ADI Electronics 10.30.86 07.31.85 13700 367
Dense Pac 02.10.87 02.28.86 4503 367
Domain Technology 06.26.89 06.30.88 60069 367
Final Test 03.10.89 12.31.87 2186 367
KossCorp. 12.21.84 06.30.83 25641 367
Labarge 12.31.86 06.30.85 86705 367
Semicon 10.06.87 06.30.86 35644 367
Solitron Devices 05.11.89 02.28.88 58529 367
Spectrascan 07.21.89 10.31.88 303 367
Technodyne 08.01.89 07.30.88 45557 367
Non-bankruptcy companies
A.A. Importing Co. 02.02.88 16042 5719
A.T.CrossCo. 12.31.89 196315 3951
Abatix Environmental Corp. 12.31.89 3076 5080
Academy Computing Corp. 12.31.89 1273 7374
Acuson Corp. 12.31.89 183879 3811
ADC Telecommunications 10.31.89 143831 3661
Advance Ross Corp. 12.31.89 16387 3564
AEP Industries Inc. 10.31.89 65573 3079
Beeba S. Creations Inc. 08.31.89 51883 5137
BEl Electronics Inc. 09.30.89 53907 3483
Berry PetroleumCo. Calif. 12.31.89 115597 13ll
Bio Logic Systems Corp. 02.28.89 10334 7372
Central Sprinker Corp. 10.31.89 55989 3569
Devon Group Inc. 03.31.89 134603 2791
E. Systems Inc. 12.31.89 852145 3674
Fastenal Co. 12.31.89 21534 5070
Frank E. Best Inc. 12.31.88 46488 3429
General Ceramics Inc. 06.30.88 27 451 3264
IIS Intelligent Information 12.31.88 34025 3573
Kelly Services 12.31.89 394283 7362
Advance Circuits 08.29.87 40221 367
Bel Fuse 12.31.86 24390 367
DELElectronics 08.01.87 3997 367
EspeyMfg 06.30.87 20414 367
Int'l Power Machines 12.31.86 13491 367
Kevlin Microwave 05.31.87 7298 367
Methode Electronics 04.30.87 62973 367
Supertex 03.31.87 11418 367
Technitrol 12.31.86 25788 367
ZitelCorp. 09.30.86 13141 367
Note: this study classified companies in the bankruptcy group if either the company or a significant subsidiary filed for bankruptcy. Thus, some
of the companies listed in the bankruptcy column may not have filed for bankruptcy but rather had a significant subsidiary to do so.
32
listed. Since all cases were used to form the knowledge
bases in the 60 company samples there was no validation
sample available for this knowledge base source.
An additional knowledge base was formed from ratio
values rounded to the nearest multiple of 10(i.e. a value of
26.8 on a 0-100 scale would be rounded to 30). This
reduced the complexity of the classification problem by
only providing 11possible values to consider for each ratio
rather than 101. This reduced the number of splitting
points. It was theorized that the reduced complexity
might improve the development of a knowledge structure.
The classification accuracy for the seven previously
described knowledge base sources is presented in Table 8.
As illustrated in Table 8, the inductive inferencing
algorithm was able to achieve 100%accuracy on all seven
knowledge base sources. This accuracy level on the
knowledge bases is not surprising since the algorithm will
continue splitting the sample data, if possible, until no
misclassifications exist. In fact, one valid criticism of this
technique is that it is prone to extreme overfitting. This
weakness is mitigated in this study since the cognitive
structures were 'pruned' to a less complex form using
existing theory.
McKee
Developing a single cognitive system
The next step in this research was to try to identify which
cognitive structure offered the best general predictive
ability. The objectives were to determine to what extent
the cognitive structures may have overfitted the data and
to what extent the knowledge structures overlap.
The data in Table 8 generally indicate that the cognitive
systems developed from the scaled ratios were more
accurate than the ones developed from the unsealed ratios,
even though the same ratios were used to develop both
groups of structures. The process of scaling the ratios
apparently adds to their information value. Accordingly,
due to their lower accuracy levels, the three knowledge
structures developed from the unsealed ratios were
eliminated from further consideration.
Pruning the cognitive structures
Since ID3 performs a stepwise splitting that attempts to
optimize at each individual split, rather than on an overall
basis, it may oversplit (overfit) the data. Oversplitting
occurs when a terminal node has one or a few cases that
have been split into that node on an arbitrary rather than a
Table 8 Classification accuracy for different knowledge bases developed
Knowledge base source Ratios in
order utilized
Development
sample accuracy
(%)
Validation
sample accuracy
(%)
Unsealed ratios
Twenty company single CASH/TA
industry sample CA/CL
CA/TA
Forty company multiple
industry sample CA/CL
Sixty company multiple CA/CL
industry sample NIITA
CASH/TA
Scaled ratios
Twenty company single CA/CL
industry sample CA/TA
NIITA
Forty company multiple
industry sample CA/CL
Sixty company multiple CA/CL
industry sample NIITA
Twenty company single CA/CL
industry sample with NIITA
ratios rounded to ARISALES
nearest tenth CA/TA
100
100
100
100
100
100
100
80
75
None
90
85
None
97.5
Note: data from 60 companies were utilized in this study. When the knowledge base was developed from a sample of
these companies, the remaining companies comprised the validation sample.
Predicting bankruptcy
logical basis. Breimanet al. (1984, p. 60) note, 'Too large a
tree will have a higher true misclassification rate than the
right size tree. On the other hand, too small a tree will not
use some of the classification information available ...'.
Research has indicated that the best approach is to let trees
grow to the maximum size based on the splitting rule and
then 'prune' them back to an appropriate size. Pruning
is frequently accomplished by a backward dynamic
programming algorithm. However, due to the small
number of trees in the current research, the following two
theory-based, simple, pruning rules were utilized.
(I) Pruning rule 1: eliminate a node if the direction of
the split is inconsistent with theory.
(2) Pruning rule 2: eliminate a node if the ratio used to
determine the split has been previously used in the
tree.
The logic behind the first pruning rule is simply that all
splits should be theoretically logical. For example, if the
splitting rule classified a company as a going-concern
based on a lower current ratio, such a split would not
be acceptable. The logic behind the second rule is that
since the splitting rule can only split in a linear fashion
(i.e. all splits are perpendicular to the coordinate axes), the
classification power of a ratio is primarily used on the first
split. Accordingly, a second split with the same ratio
would be expected to have minimal classification power
and would probably result in overfitting.
Figure 2 displays the decision tree that had the highest
validation sample accuracy level. Application of the two
pruning rules to this tree produced a nine-node decision
tree, thus reducing the complexity of the decision tree.
Pruning on the other knowledge structures alsoresulted in
less complex decision trees.
Extracting the final knowledge structure
The next step in the research was to see if the ratios
included and their order of inclusion in the four pruned-
knowledge structures could provide guidance on how to
form an 'optimal' knowledge structure.
A review of the four pruned-knowledge structures
developed from the scaled ratios indicates that the first
ratio selected in every structure was the current ratio. This
means that this research strongly indicates that a current
liquidity measure, the current ratio, is the best single
predictor of bankruptcy. This conclusion is consistent
with the results of the Messier and Hansen (1988) study
which found the current ratio to be the most significant
predictor based on two different samples of data.
If we assume that the current ratio can adequately
measure current liquidity then we can exclude all other
current liquidity measures from consideration. When all
current liquidity measures are excluded from consider-
ation, an analysis of the four knowledge structures
33
Figure 2 Fifteen-node cognitive structure developed from 20
company single industry sample of scaled ratios rounded to the
nearest tenth. Non-terminal nodes (non-terminal subsets),
circles; terminal nodes (terminal subsets), squares; going-
concerns, GC; non-going concerns, NGC
indicates that only other ratio to be selected was the
NIITA ratio, a profitability measure. It was selected
second in two of the four knowledge structures and
selected third in one of the four knowledge structures.
This indicates that, after excluding current liquidity
measures, the NIITA ratio is the second best predictor of
bankruptcy. This is partially consistent with the Messier
and Hansen (1988) study since they found a profitability
measure to be the second most significant ratio in one of
their two data sets and the third most significant ratio in
the other one of their two data sets.
The previous review and related assumptions indicate
that an optimal knowledge structure would have the
current ratio, a current liquidity surrogate, as the first
ratio and the net income/total assets ratio, a profitability
surrogate, as the second ratio. The next step was to review
the pruned-knowledge structures to see ifany actual splits
were consistent with the optimal knowledge structure.
The knowledge structure pruned from the nine-node
knowledge structure developed from all 60 companies was
34
the only one that incorporated the current ratio and the net
income/total assets ratio for the first two splits in a manner
consistent with the previous analysis. Accordingly, two
splitting points from that structure were used in the
optimal knowledge structure. Since the current ratio was
used only once in the pruned knowledge structure that
splitting point was used in the optimal knowledge
structure. The NIITA ratio was used twice in the pruned
knowledge structure, so a decision had to be made as to
which splitting should be used. On a judgemental basis,
the most restrictive splitting point for the NIITA ratio in
the original structure was adopted as the splitting point for
this ratio in the optimal knowledge structure.
Figure 3 contains the final optimal knowledge structure
developed. It was 97%accurate (two going-concerns were
misclassified) when tested on all 60 cases.
Integration with a theoretical model
The final optimal knowledge structure developed in this
research is consistent with the temporal continuity theory
model. The two ratios identified through the current
research, the current ratio and the net income/total assets
ratio are surrogates for the 'current resources' and
'positive long-run resource flows' in the temporal
continuity theory. Also, the final optimal knowledge
structure includes them in an order that is consistent with
the temporal continuity theory. Thus, this research
indicates that the final optimal cognitive system is an
GC
NGC
Figure 3 Five-node cognitive structure developed frompruned
cognitive structures (96.7% accurate on 60 company sample).
Non-terminal nodes (non-terminal subsets), circles; terminal
nodes (terminal subsets), squares; going-concerns, GC; non-
going concerns, NGC
McKee
empirically successful implementation of the temporal
continuity model in the form:
If the scaled current ratio is 24 and if the scaled net
income/total assets ratio is 81, then the firm will
not go bankrupt, else the firm will go bankrupt.
In summary, the final knowledge structure developed
was 97% accurate in classifying all 60 companies and was
consistent with the previously posited continuity theory.
Limitations
Since ID3 determines prior probabilities from the original
sample proportions and all samples had an equal number
of bankrupt and non-bankrupt firms, the prior prob-
abilities used in this research were equal. This could be
considered a limitation since several earlier bankruptcy
prediction studies using other techniques have been
criticized for assuming equal prior probabilities.
However, this assumption was deemed appropriate for
this study since prior probabilities can vary substantially
depending on the population from which they are
selected.
Another limitation concerns misclassification costs.
Although it is recognized that the cost of misclassifying a
bankrupt firm as non-bankrupt may differ from the cost of
misclassifying a non-bankrupt firm as bankrupt, these
misclassification costs were assumed to be equal in this
study. As noted by Marais et al. (1984) in a research study
using a similar technique, 'Proper specification ofthe loss
function may be a research project in itself .. .' (p. 95).
The final limitation is that the pruning rules adopted
and the process of determining the optimal model,
although supported by theory, were somewhat subjective.
Discussion and conclusions
Business failure in the form of bankruptcy imposes
significant costs on stakeholders such as investors and
creditors. These stakeholders have indicated that they
believe that auditors are in a unique position to signal
them about possible bankruptcy problems so they can
minimize such costs. The frequency and amount of settle-
ments in court cases filed against auditors associated with
business failures that were not signalled to stakeholders
indicates that auditors pay a price for not meeting
stakeholder expectations.
Auditors have used a variety of decision aids including
complex statistical models to assist them in making going-
concern judgments. Research indicates that experienced
auditors can only correctly forecast bankruptcy approxi-
mately 83%of the time. It alsoindicates that auditors only
disclose possible bankruptcy for approximately 45%of the
Predictingbankruptcy
companies that actually go bankrupt within 1 year after
receiving the auditors' report. Furthermore, very recent
research indicates that 62% of the companies receiving a
going-concern modification in their auditors' report did
not go bankrupt in the year after receiving that report.
Clearly, auditors have a difficult time forecasting and
disclosing bankruptcy.
This research has focused on developing a decision
model to assist auditors, investors and creditors in
forecasting bankruptcy. It employed a data-driven
approach, an inductive inferencing algorithm developed
for machine learning, with a model-driven approach and
use of an existing bankruptcy theory model. It is hoped
that this approach has resulted in a more robust model.
The final model developed used only two publicly avail-
able ratios and was 97% accurate in classifying the
bankruptcy status of 60 public companies. The model
employed scaled versions of the current ratio and the net
income to total assets ratio in a simple decision rule. To be
widely accepted by auditors, the model, of course, would
need to be further tested on a much larger sample of
companies. Nevertheless, it suggests that perhaps a
simple, theoretically consistent model may exceed current
auditor predictive capabilities.
The simplicity of the final model and the fact that it uses
ratios which are readily available for public companies
suggests that many stakeholders could themselves make
fairly accurate assessments of bankruptcy possibilities for
the types of companies included in this study. This raises
the question of whether auditors can or should influence
such objective assessments by incorporating their
opinions about management's plans and capabilities to
deal with the factors that would lead a company into
bankruptcy. Perhaps auditor training and the available
professional guidance does not provide an adequate basis
for expressing such an opinion.
The two-ratio model developed in this study should be
useful to auditor, investor, creditors and other stake-
holders in making highly accurate bankruptcy
predictions.
Acknowledgement
The author would like to acknowledge support provided
by Massey University, New Zealand while conducting
part ofthis research.
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Biographical notes
Thomas E. McKee is currently Chairman and Professor of
Accountancy at East Tennessee State University. He also
holds a Professor II appointment at the Norwegian School
of Economics and Business Administration. He has been
a Visiting Professor at Massey University, New Zealand,
the Norwegian School of Economics and Business
Administration and the University of Tennessee. He has
also been a member of the faculties at the University of
McKee
Maryland and Georgia State University. Prior to that he
was a senior accountant with Price Waterhouse.
Professor McKee has authored or co-authored several
books including an auditing textbook titled Auditing
(currently the 5th edition) and an auditing professional
reference book titled Analytical Auditing (1989). He has
written numerous articles which have appeared in
publications such as the Journal of Accountancy, Internal
Auditor, The CPA Journal, The Practical Accountant,
Accounting Education, Advances In Accounting and
Intelligent Systems in Accounting, Finance, and
Management.
Professor McKee annually makes numerous speeches
and technical presentations on different contemporary
accounting and auditing topics for a variety of audiences.
He consistently receives exceptional ratings for these
presentations and was previously selected as Outstanding
Discussion Leader of The Year by the Tennessee Society
ofCPAs.
Professor McKee has also provided consulting services
to both businesses and CPA firms. He has recently been
involved as an expert witness in a variety of litigation
cases.
Professor McKee's teaching and research interests
primarily relate to auditing. He is currently researching
the development of knowledge bases via neural networks,
inductive inferencing algorithms or fuzzy logic that can
assist in auditing or business decisions.
Address for correspondence: Department of
Accountancy, East Tennessee State University, PO Box
70710, Johnson City, TN 37614, USA.
Reproducedwith permission of thecopyright owner. Further reproductionprohibited without permission.