Academic journal article Academy of Accounting and Financial Studies Journal

The Impact of the Response Measure Used for Financial Distress on Results concerning the Predictive Usefulness of Accounting Information

Academic journal article Academy of Accounting and Financial Studies Journal

The Impact of the Response Measure Used for Financial Distress on Results concerning the Predictive Usefulness of Accounting Information

Article excerpt

ABSTRACT

Researchers testing the usefulness of accounting information in predicting financial distress have used many different responses as proxies for financial distress. They often compare results across these different studies, attempting to make conclusions concerning the usefulness of particular accounting information. However, comparisons are valid only if the various response variables used by the various studies have construct validity; the different response variables all measure the same intended construct, economic financial distress.

The primary purpose of this paper is to determine the validity of various response variables of financial distress by observing the stability of results across three different response variables. Similar results across the different response variables would suggest that researchers could validly compare results of the various financial distress studies. However, results that vary depending on the response variable used would indicate that different response variables may actually measure different constructs, and that the results reported in previous studies may be dependent on the response variable used.

The findings of this study suggest that results very dependent on the response variable used for financial distress. Thus, one cannot validly compare the results of prior financial distress studies that used different measures of financial distress. The results of this study suggest that the various response variables are not equal measure of financial distress. Results seem to suggest that a dichotomous bankruptcy measure may be the poorest measure of economic financial distress.

INTRODUCTION

Since the 1960s, accounting researchers have used an ability to predict financial distress criterion to evaluate the usefulness of competing accounting methods. A major area of accounting information predictive usefulness research in the last three decades has concerned the predictive ability of accrual and cash flow information. The profession stressed the incremental usefulness of cash flow information by requiring that companies present a Statement of Cash Flows in 1987. In Opinion No. 95, the Financial Accounting Standards Board (FASB) expressed the board's belief that cash flow information, when taken together with accrual information, should help users predict future cash flows and future firm insolvency. The board required that companies report three net cash flows by activities: cash flow from operating activities, cash flow from investing activities, and cash flows from financing activities.

Prior researchers have used various response variables as proxies for financial distress. The earliest researchers used a dichotomous nonfailed versus failed response variable, while subsequent researchers have primarily used a dichotomous nonbankrupt versus bankrupt response variable for financial distress. A few studies have used multi-state response variables for financial distress.

Researchers often compare results across these different studies, attempting to make conclusions concerning the usefulness of particular accounting information. However, comparing the results of prior financial distress studies is questionable considering researchers used different response variables (dependent variables) for financial distress. Comparisons between studies are valid only if the various response variables have construct validity; the different response variables must all measure the same intended construct, economic financial distress.

This study compares the predictive ability of cash flow and accrual information using different response variables for financial distress. The primary purpose of this paper is to determine the validity of various response variables of financial distress by observing the stability of results across three different response variables. Similar results across the different response variables would suggest that researchers can validly compare results of the various financial distress studies. …

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