Diagnosing companies in financial difficulty based on the auditor’s report

Abstract

The approach used in this paper expands on existing research that focuses on devising prediction models for companies experiencing financial difficulties and which in turn serves as a criteria-based diagnosis tool for distinguishing healthy companies from those facing seriously financial difficulties. It draws on auditors’ reports on company financial statements that emphasize a company’s ability to continue as a going concern as the main criterion used to distinguish companies experiencing financial difficulties from companies that are not. Two closely-related hypotheses were tested in this paper. First, the authors tested the hypothesis that an auditor’s report accompanied by an explanatory paragraph pointing out issues associated with the going concern assumption is the proper criterion for differentiating companies experiencing financial difficulties from those that are not. Second, the central assumption that is tested relates to a combination of financial ratios whereby authors presume that an appropriate combination of financial ratios is a good analytical tool for distinguishing companies experiencing serious financial difficulties from those that are not. Research results conducted among 191 companies listed on the Zagreb Stock Exchange confirm both hypotheses. The LRA model – a diagnosis tool for identifying companies with financialproblems, was also derived using logistic regression analysis. The statistical adequacy and quality of the model was tested using measures like Nagelkerke R2, type 1 and type2 errors that appear when calculating the classification ability of the model. All measures indicated that model was statistically sufficient and validated its use as a diagnosis tool in recognizing the companies facing financial difficulties.