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Potential business failure is recognized much earlier

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Research (1)

Would you entrust your child with the following group of doctors? 7149 patients with complaints were examined by a group of doctors. Of these patients, 1571 (22%) received a prognosis predicting they would die within one year. Virtually 99% of the predictions were inaccurate: a year later only 69 patients had actually died, and of those patients only 71% had not been predicted to die.

 

 

 

 

 

The research results shown above have been presented by Prof. Breesch (VUB University, Brussels) and Dr. Hardies (University of Antwerp) during the EAA Annual Congress 2014 in Tallinn. Their research, however, did not regard death-prediction of sick patients, but focused on failure-prediction of auditors regarding financially distressed companies.

When large companies fail (every year 1-2% fail), there is normally a period of uncertainty before the actual bankruptcy regarding threats and risks, including fraud risk. Auditors are expected to keep a meticulous eye on their clients to ensure that the client addresses the situation accurately. 

The social significance associated with early warnings of business failure is immense, especially when relating to listed entities and companies with high employment rates. Indeed, business failure implies massive employment termination and capital loss. A distressed company, if offered no early warning for business failure, lacks the knowledge and motivation to commence restructuration of the company. On the other hand, a company which was given an overly-cautious prediction of failure will face increased costs of capital, which in turn negatively effects employment and economic growth.

The accuracy profile of auditors’ failure predictions (see Table above) is somewhat comparable to that of credit rating agencies. By default, credit raters do not warn (classify as CCC/CC/C-grade) 63% of the cases. And of those classified as CCC/CC/C-grade, 74% are a false warning. Unfortunately, the accuracy profiles of auditors and credit rating agencies have yet to be improved in the past decades. There is a need for change.

(1) Breesch D. en Hardies K. “Auditor’s Going-Concern Reporting Accuracy”. Working paper of the Department Business (Vrije Universiteit Brussel), submitted to the 37th EAA-conference, May 2014