Financial statements are still valuable tools for predicting bankruptcy.(SELECTED TOPIC)

Despite growing public skepticism over how useful financial statements are in providing information to investors, researchers at Stanford's Graduate School of Business have found that the value of financial ratios for predicting bankruptcy has not declined significantly over time.

Professors Maureen McNichols and William Beaver and graduate student Jung-Wu Rhie have reexamined the usefulness for predicting bankruptcy of financial ratios such as return on assets (net income divided by total assets), cash flow to total liabilities (earnings before interest, depreciation, and taxes divided by both short- and long-term debt), and leverage (total liabilities to total assets). The study explored how three forces have influenced this predictive value over the past 40 years.

The first force is that standard-setting bodies such as the Financial Accounting Standards Board and the Securities and Exchange Commission have been trying to increase the usefulness of the information found in financial statements and to enhance the ability of such statements to convey the fair value of assets and liabilities.

"One prediction is that if standard-setters are successful at incorporating additional information about fair values into financial statements, then we might expect their predictive ability for bankruptcy to increase," said McNichols, the Marriner S. Eccles Professor of Public and Private Management at the Business School.

On the other hand, two forces could work against an increase in the usefulness of financial statements. First, the range of activities that today's companies engage in might be less well captured by traditional accounting methods.

"If we took back to the 1960s, intangible assets--as represented by investments in brands, research and development, and technology--were much less pervasive than they are today," said McNichols. "These kinds of transactions are not well captured by our current accounting model." So even if standard-setting bodies were successful in improving standards and increasing the informativeness of financial statements, the shift in economic activities of businesses might offset that.

Second, financial statements may be more "managed" today than in the past. "Certainly, there is much greater documentation of earnings management today than we've seen historically," said McNichols.