Have Changes in Financial Reporting Attributes Impaired Informativeness? Evidence from the Ability of Financial Ratios to Predict Bankruptcy

Abstract

This study explores the effect of cross- sectional and time-series differences in financial reporting attributes on the predictive ability of financial ratios for bankruptcy. We identify proxies for discretion over financial reporting, the importance of intangible assets, and the effects of changing accounting standards over time. Our proxies include earnings restatements, discretionary accruals, research and development intensity, book-to-market ratios and incurrence of losses. We test the ability of financial ratios to predict bankruptcy for a sample of bankrupt and non-bankrupt firms listed on NYSE/AMEX or NASDAQ during the 1962-2002 period. Each of our proxies is associated with less informative financial ratios as reflected in predictive ability for bankruptcy. We compare the findings for the accounting model to those of a model based on market-related variables, and find that the market-related variables do not compensate for the lessened predictive ability of financial ratios. In our time-series analysis, descriptive statistics confirm that each of our proxies exhibits a trend consistent with decreasing informativeness over time. Our time-series tests reveal a decline in the predictive ability of financial ratios for bankruptcy, and document that this decline is associated with our financial reporting variables.