Accounting Research Center, Booth School of Business, University of Chicago

Accounting Ratios and the Prediction of Failure: Some Behavioral Evidence

Author(s): Robert Libby
Reviewed work(s):
Source: Journal of Accounting Research, Vol. 13, No. 1 (Spring, 1975), pp. 150-161
Published by: Wiley-Blackwell on behalf of Accounting Research Center, Booth School of Business,
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Research Reports
AccountingRatios and the Predictionof
Failure: Some BehavioralEvidence

ROBERT LIBBY*

Researchershave investigatedthe predictiveabilityand behavioralim-

pact of accountinginformationseparately.For example, Beaver (1968)
and Deakin (1972) examinedthe predictiveabilityof accountinginforma-
tion in the predictionof businessfailure,whereasBruns (1966) and Hof-
stedt(1972) investigatedthebehavioralimpactofaccountingvariationson
decision making.Given that the predictivepower of the measurements
(the accuracyofthe signals)and the abilityofthe decisionmaker(DM) to
use the information(the accuracy of the DM's responseto the signals)
jointlydeterminethe qualityof decisions,it would seembeneficialto use a
methodologythat examinesboth factorsjointly.' Failure to considerthe
accuracyof responsescould resultin judgingas relevantinformation that
cannotbe utilizedeffectively by the DM because of his limitationsas an
information processor.
In thispaper I reporttheresultsofa fieldstudydesignedto jointlyevalu-
ate the predictivepowerofratioinformation and the abilityofloan officers
to evaluate that informationin the business failurepredictioncontext.
Previousstudiesby Beaver (1966, 1968), Altman(1968a, 1968b). Edmister
* AssistantProfessorof Accounting,The PennsylvaniaState University.The
authorexpresseshis gratitudeto A. Rashad Abdel-Khalik,MartinBariff,and James
P. Mandel fortheirhelpfulcomments.
1 The CommitteeonTheoryConstruction (1971)followeda similar
andVerification
orientationwhentheyconcludedthat thereare two broad areas of significanceto
accountingresearchers:(a) the predictivepowerof accountingmeasuresand (b) the
effectsof the measureson decision-maker behavior.
150

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 PREDICTING FAILURE 151

(1970, 1972), and Deakin (1972) utilizedboth univariateand multivariate

statisticaltechniquesto assess the predictiveability of a large group of
ratios.All of the above studiesempiricallysupportthe contentionof pro-
ponentsand practitioners of ratio analysis (e.g. Foulke, 1968) that certain
ratiosare highlyrelatedto businessfailure.Feltham and Demski (1970, p.
637) suggestthat once the signal'sabilityto reflecta priorirelevantevents
has been established,the next logical extensionis to move fromanalysis
of the signal to analysis of action induced by signals. In anotherstudy
Abdel-Khalik(1972, 1973) has takenthenextstep-to see whetheranalysts
can successfullyuse the ratios.In his studyof loan officers' decisions,Ab-
del-Khalik(1973, p. 45) concludedthat his resultscast doubtupon the use-
fulnessof financialratios as predictorsof failurein an ex ante prediction
situation. These resultsare inconsistentwith those of the studies cited
previously.Given the contradictory nature of the resultsand the limited
numberof firmsevaluatedby the subjectsin the Abdel-Khalikstudy,fur-
therexaminationof the issue is in order.
This reportdescribesa studydesignedto determinewhetheraccounting
ratiosprovideusefulinformation to loan officers in the predictionof busi-
ness failure.In the experiment, loan officers predictedbusinessfailurefrom
a small set of accountingratios. The usefulnessof the information to the
participantswas measuredin termsof the accuracy of the loan officers'
predictions.This measurewill be called predictionachievement. Evidence
concerningthe relationshipbetweenexpectedand actual performance and
individualvs. compositeperformance is also presented.
The analysisalso measuresthe consistencyofinterpretation ofthe ratios
(1) withinloan officersovertimeand (2) betweenloan officers. significant
A
part of human decisionerrorhas been attributedto inconsistencies in de-
cisionsfromday to day or situationto situation(see e.g., Bowman, 1963).
This typeofwithin-subject across-timeagreementis commonlycalled test-
retestreliability.Test-retestreliabilityis relatedto accuracyin thatit sets
a theoreticalmaximumforaccuracy.2In this study,agreementover time
was measuredover immediateand one-weekintervals.
in cognitivejudgmentshave long been recognized
Individual differences
in psychology(see e.g., Wiggins,1973). Substantial disagreementamong
usersin the interpretation of accountingdata would presenta paradoxical
situationforaccountantssince information whichis optimalforone deci-
sion makermightbe nonoptimalforanother.In such a case, accountants
would be forcedto decide whichuser's utilityshould be maximized.The
level of agreementbetweenthe loan officers'predictionsbased upon the
ratioswas measuredto provideevidenceconcerningthisissue ofindividual
differences.
2 reliabilitysetsthetheoreticalmaximumaccuracyat:
In a binarytask,test-retest
N(1 + R)/2
where:N numberofpredictionsmade,and R = test-retest
= reliabilitymeasuredas
the fractionofmatchingpredictionsbetweenthe two repetitionsover time.

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152 JOURNAL OF ACCOUNTING RESEARCH, SPRING, 1975

Method
USEFULNESS

Withinthe presentframework, information is judged to be usefulif it

allows users to make correctpredictions.Given no information,DMs
shouldbe expectedto performat a level equal to randomaccuracy.Opera-
tionally,a set of usefulaccountinginformation should allow DMs to per-
formabove this level. The usefulnessof the set of ratio data selectedfor
thisstudywas examinedby testingthe followingnull hypothesis:
H1: Subject's predictionaccuracydoes not deviate fromthat expected
fromrandompredictions.
This hypothesiswas testedforeach subjectindividually.
In recognitionof a prioridifferenceswithinuser groups,two subgroups
(describedlaterin this section)were chosenand the followingrelatednull
hypothesiswas tested.
H2: User subgroupmembership has no effectupon predictionachieve-
ment.
The inclusionofsubjectsfrommorethan one subgroupshouldincreasethe
generalityof the resultsof the study.Also, correlationalstatisticsare pre-
sentedas tentativeexplanationsof individualdifferences in accuracy.

CONSISTENCY

Inconsistencyin decisionsover time (lack of test-retestreliability)is

theoreticallydue to changesin the way in whichuserscombineinformation
in theirdecisionmodelsand to randomerror.If significant changesin in-
formation utilizationtake place, thereshouldbe greateragreementbetween
decisionsmade over consecutiveperiodsthan thoseseparated by a longer
periodof time.The followinghypothesiswas testedto determinewhether
this type of consistencyvaried as the time interval between decisions
changed.
H3: Test-retestreliabilityis equal when measured over consecutive
periodsand whenmeasuredoverperiodsseparatedby one week.
Uniformityof interpretationof the ratios between subjects (interrater
reliability)was measuredas the numberof agreementson the fail-notfail
scale.

DESIGN

A three-group experimentwas designedto test the above mentionedhy-

potheses.As a methodof testingforuser subgroupdifferences (H2), com-
participantsweredrawnfromtwo bank subpopulations
mercialloan officer
seven small banks in Urbana-Champaign,Illinois (C-U) and fivelarge
banks in Philadelphia,Pennsylvania.3Each small bank providedfrom1 to
I Total assetsoftheC-U banksrangedfromapproximately $3millionto $56million
and averaged$41million.Total assetsoftheparticipating Philadelphiabanksranged
from$.6 billionto $4 billionand averagedat $2.2billion.(Bank assetsizes as of1972.)

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 PREDICTING FAILURE 153

4 participantstotaling16 smallbank loan officers. The largebanksprovided

Both groupsof
from2 to 8 subjectseach to total 27 largebank loan officers.
participantsspanneda broad rangeof age, experience,and rank,but they
differed in estimatedaverageclienttotal assets. The C-U bankersexpressed
the opinionthat theywouldbe outperformed by the Philadelphiabankers.
They attributedthis feelingto the larger client size of the Philadelphia
banks and the difference in experiencecaused by the heavier emphasis
placed upon financialanalysisin the evaluation of largerclientswith au-
dited financialstatements.A subject descriptionsummaryis exhibitedin
table 1.
The large bank loan officers were split into two groupsto examinethe
hypothesisof consistencyover time (H3). The two groupsdiffered in the
timeintervalbetweenevaluationsof a set of repeatfirms.Half of the par-
ticipantsevaluated all 70 firmsin one sittingover one week. These 70
firmsincludedthe 60 firmsample describedbelow placed in randomorder
with10 repeatfirmsplaced as everyfourthfirmfollowing the first30 cases.
The remainingparticipantsevaluated the first30 cases in one sittingover
one week and the remaining40 cases includingthe 10 repeat firmsin a
secondsittingoverthe followingweek. This techniqueallows measurement
of test-retestreliabilityover the two interveningtime intervalswhile ef-
fectivelyhidingthe identityofthe repeatfirms.All of the small bank par-
ticipantsevaluatedthe 70 cases in one sittingbecause ofsmall samplesize.
DATA SET AND FIRM SAMPLE

The 60 firmsample evaluated by the participantsconsistedof 30 failed

and 30 nonfailedfirmsdrawnat randomfromthe Deakin (1972) derivation
sample.4The 14 ratios5studiedby Beaver (1968) and Deakin (1972) were
thencomputedforone of the threeyearspriorto failurechosenat random
to resultin an equal numberof firms(10 failuresand 10 nonfailures)for
each of the threeyearsbeforefailure.To reducethe numberof ratios,re-
moveredundancy,and identifythe salientfinancialdimensionsrepresented
by theratios,principalcomponentsanalysisfollowedby a varimaxrotation
was applied to this data. This analysisidentifiedfiveindependentsources
ofvariationwithinthe 14-ratioset. These werelabeled (1) profitability,
(2)
activity,(3) liquidity,(4) asset balance, and (5) cash position.Through
The authorwishesto thankEdwardB. Deakin forgenerously providingthedata
fromhis studyforuse in this research.The Deakin (1972) sample consistedof 32
failedfirms experiencingfailurebetween1964and 1970.Failurewas definedto include
thosefirmswhichexperiencedbankruptcy, insolvency,or wereotherwiseliquidated
forbenefitof creditors.The 32 nonfailedfirmsweredrawnat randomfromMoody's
IndustrialManuals from1962to 1966.Sixtyof the 64 cases werechosento provide
a roundnumberof cases forthe subjects.
I The 14 ratiosincluded: (1) cash flow/total debt, (2) net income/total assets, (3)
total debt/totalassets, (4) currentassets/totalassets, (5) quick assets/totalassets,
(6) workingcapital/totalassets, (7) cash/totalassets, (8) currentassets/current lia-
bilities,(9) quick assets/currentliabilities,(10) cash/current liabilities,(11) current
assets/sales,(12) quick assets/sales,(13) workingcapital/sales,(14) cash/sales.

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 154 ROBERT LIBBY

TABLE 1
SubjectDescriptions
Mean Minimum Maximum
1. Age 39 23 60
2. Years of experience 9 0 32
3. Estimated N of applicationsprocessed * 51 >250
annually
4. Highestgradein school completed 16.2 12 17
5. Averageclienttotal assets (in000's) C-U $127 -
bankers -$25 $700,000
6. Average client total assets (in 000's) $146,198 -
Phila. bankers
* Computationof the mean responseto the questionwas inappropriatesince it
requiredchoice of one of six responsesrangingfrom"0 to 50" to "more than 250"
applicationsper year.

analysisoftherotatedfactormatrix,netincome/total assets,currentassets/
sales, currentassets/currentliabilities,currentassets/totalassets, and
cash/totalassets were chosen respectivelyto representthe fivefinancial
dimensions.'
The predictiveabilityofthe 14-ratioset and ofthereducedset werethen
compared.The original14 ratioswereable to predictcorrectly
54 of60 cases
based upon the derivationsample and 41 of 60 predictionsbased upon
double cross-validation.7
The reducedset predicted51 and 43 correctof 60
based upon the derivationsampleand double cross-validation
respectively.
This slightreductionin predictiveabilitywas deemedsatisfactoryforthis
experiment.
TASK AND INSTRUCTIONS

The 70 cases (includingthe 10 repeat cases) wereprintedtwo to a page

and bound in two types of booklets. All 70 cases were included in one
booklet forthe participantsevaluatingthe cases in one sitting.The first
30 cases and the second40 (containingthe 10 repeatfirms)wereseparately
bound forthe bankersevaluatingthe firmsin two separatesittings.Each
bookletcontainedinstructions whichemphasizedthe followingpoints:
(1) The cases wereto be completedand returnedin one week.
(2) Independentworkwas required.
(3) One half of the firmsexperiencedfailurewithinthreeyears of the
statementdate.
6 A similarapproachwas takenby Pinchesand Mingo (1973)and Stevens (1973).
For a morecompletedescriptionof the data reductionsee Libby (1974).Note that
Beaver's (1968)best ratio (1) was omittedfromthe finalfive.Whenchoosingamong
highlycorrelatedvariables,thisnormallyhas littleor no effecton predictiveability.
' Classifications
weremade usingthe x2classification methodwhichassumesthat
the two distributionsof values on the discriminantaxis are normaland employs
Bayes Theoremto determineposteriorprobabilitiesof groupmembership. See Tat-
suoka (1971)fora completetreatmentof thismethod.

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 PREDICTING FAILURE 155

(4) The evaluationswould be scoredbased upon one pointfora correct

predictionand minusone pointforan incorrectprediction.
Instruction(3) was includedto set uniformly the priorprobabilitiesof
the participants. Since prior probabilitieswere seen as a componentof
experience, this instructioncontrolled for lendingexperiences
differential
in termsofthepercentageoffailingand nonfailing loan applicantsevaluated
each day by the participants.Instruction(4) attemptedto providesubjects
with a uniformrewardstructureor payoffmatrix.Also, the definitionof
failurewas givenand thefirmsweredescribedas largeindustrialfirmswhose
financialstatementshad been subjectedto an independentaudit.
-A debriefing questionnairefollowedthe cases in the one-sittingbooklet
and in the secondbookletreceivedby the participantsevaluatingthe cases
in two sittings.The questionnairecontainedquestionsconcerningexperi-
ence, clarityof instructions,methodof task completion,confidence,and
attitudetowardthe experiment.
Each case requiredthesubjectto classifythefirmas a failureornonfailure
withinthreeyearsofthe statementdate and rate his confidencein his pre-
dictionon a threepointscale. All ofthe participantscompletedthe assigned
task in the allottedtime except two small bank participants.These sub-
jects returnedtheirbookletsthe followingweek.

Results

USEFULNESS

As previouslymentioned,predictionaccuracyor achievementwas meas-

uredby the correspondence betweenthe environmental eventand the sub-
ject prediction,i.e., the numberof correctpredictions.The secondreplica-
tion of the 10 repeat firmswas not employedin measuringprediction
achievementor agreementbetweenbankers.
Individualaccuracy.That predictionachievementwas superiorto random
performanceindicates the presenceof correctutilizationof information.
HypothesisH1 testedforthe presenceofthisnonrandomperformance.
The expectedaccuracygivenrandomassignmentofresponsesin a binary
task is 50%l. The binomialtest (Siegel, 1956, pp. 36-42) determinesthe
probabilityof observingthe actual proportionor a largerproportionof
correctpredictionsgivenrandomassignment.This testwas applied to each
individual'sperformance. If the probabilityof actual or superiorperform-
ance being the result of random predictionswas less than .05, the per-
formancewas judged to be nonrandom.
The probabilityofrandomlypredicting37 or moreofthe cases correctly
was determinedto be slightlyless than .05. Accuracyat thislevel or higher
was judged to be nonrandomleadingto the rejectionofHi forthat subject.
All but three of the subjects were able to accuratelypredictfailureat a
higherrate than chance (numberof correctpredictions>37). Accuracy

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156 ROBERT LIBBY

49-51 * * * * * * * * * 9
46-48 * * * * * * * * 8
43-45 * * * * * * * * * * * * * * 14
40-42 * * * * * * * * 8
37-39 * 1
34-36 * * 2
31-33
28-30
25-27 * 1
Mean 44.4
Std. deviation4.5
Maximum 50.0
Minimum 27.0
FIG. Scores(Number
Achievement
1. Prediction outof60Responses)
Correct

rangedfrom27 to 50 correctout of 60 predictionsand averaged at 44.4

out of 60. A histogramof theseachievementscoresis exhibitedin figure1.
Althoughnormallyavailable supplementalinformation suchas trendand
industrydata were unavailable to the subjects and the firmsample was
drawnfroma populationof firmsdissimilarto the customerpopulationof
the participants,predictionachievementaveraged at 74%. This result
suggeststhat the traditionalconfidencein ratio analysisforcreditrating
seemsjustified.
Groupdifferences. To investigateH2,the differencesin mean accuracybe-
tweengroupswereanalyzedusingthe F test of the one-wayANOVA. The
differences werenot foundto be significantat the .05 level and H2 was not
rejected. This should be consideredin view of the C-U bankers' strong
feelingsthat the Philadelphiabankerswouldperform in a superiormanner.
Individualdifferences.8In an attemptto explainindividualdifferences in
predictionaccuracy,the responsesto the debriefing questionswere corre-
lated withaccuracy.9All but one of the debriefing questionswerenot sig-
nificantlyrelatedto predictionaccuracy. The respondentswho indicated
the placementof a greateremphasisupon Net Income/TotalAssets were
more accurate (r = .385, N = 43). Analysisof the scaled vector of the
linear discriminantfunctionrelatingthe ratios to actual failuresuggests
that such a relationshipshould existas this variable is optimallyweighed
at 28.3 %. None of the othervariablesrelatedto methodof task comple-
tion,age-experiencevariables,task interestvariables,or expectedaccuracy
8 Since somesubjectsdid notrespondto somequestions,missingdata correlations
werecomputedusingthe SOUPAC (1972)system.
testingofmanyunivariatecorrelationspresentsan interpreta-
The significance
tionproblem.As in thiscase, whenmanyvariablesare correlatedwithanothervaria-
tests (t test of significant
ble, the significance correlations,see Hays (1963,p. 259)
are not independent.Also, even if these testswereindependent,one wouldexpect
a% of the significanceteststo be positivedue to chancealone (Hays, 1963,pp. 576,
577). Thus,a overstatesthelevel ofconservatism ofthetests.Because oftheseprob-
lems,onlycorrelationsfoundto be significant at the .01 level (r > .38,N = 43) are
presented.Even theseresultsmustbe judgedto be highlytentative.

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 PREDICTING FAILURE 157

10/10 * * * * * * * * * * * * * 13
9/10 * * * * * * * * * * * * * * * * 16
8/10 * * * * * * * * * * * * 12
7/10 * 1
6/10 * 1
Mean 8.9
Std. deviation .9
Maximum 10.0
Minimum 6.0
FIG. 2. Test-RetestReliabilityof Failure Predictions

correlatedwith predictionaccuracy.'0This resultis in

were significantly
conflictwith commonlyheld suppositionsconcerningbusiness decision
making.But a reviewof studiesin otherfields(see e.g., Goldberg,1968)
indicatesthat such a findingis common.

CONSISTENCY

Agreement overtime.Test-retestreliabilitywas measuredas the number

of agreementsof each subject betweenhis earlierand later predictionsof
therepeatfirms.H3 was testedby comparingthe meantest-retest reliability
of the one-sittingand two-sittingPhiladelphia bankers. A difference be-
tweenthese groupswould indicatethat subject decisionrulesbecome less
stable as the time span betweendecisionsis increased.The F test of dif-
ferencesbetweenall threegroupmeansindicatedno significant differences
reliability.This led to the failureto rejectH3 and the conclu-
in test-retest
sion that no differencesexistedin shorttermtest-retest reliabilitybetween
user subgroups.Test-retestreliabilityrangedfrom6 out of 10 to 10 out of
10 and averaged at 8.9. Thirteenof the 43 subjects exhibitedperfectreli-
ability.The binomialprobabilitythat 8 or moreor 10 agreementscan occur
by chancealone is .05 (binomialtest). All participantsbut twoPhiladelphia
one-sittingbankers performedin a mannersuperiorto this level. Test-
retestreliabilitywas not significantly correlated(p < .01) withany of the
debriefingquestionsnor with accuracy." A graph of the test-retestreli-
abilityscoresis presentedin figure2.
On the average, subject predictionswere highlyreliable over both an
immediateand one-weekperiod.This resultimpliesthat interpretations of
accountingdata do not vary greatlyacross time.
Agreement betweensubjects.Substantialagreementbetweenparticipants
in theirpredictionswould suggesta relativelyuniforminterpretationof
10The debriefingquestionsweredesignedto measureage, yearsexperience,yearly
loan activity,clientsize, area of specialization,education,time to completetask,
estimatedperformance, estimatedweightingof ratios,what additionalinformation
wouldbe helpfuland the effectof such information on estimatedperformance, and
task interest.
11The lack ofcorrelationbetweentest-retest reliabilityand accuracymay be due
to the small variabilityacross subjects in test-retestreliability(standarddevia-
tion = .9).

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158 ROBERT LIBBY

the accountingdata acrossbankers.As measuredby the numberof agree-

mentson the fail-notfail scale, interraterreliabilityrangedfrom31 to 57
agreementsout of60 predictionsand averagedat 48 of60. Consideringthe
factthat,on the average,the participantsgave the same responses90 % of
the time,an average betweenbankeragreementof 80 % is extremelyhigh
Thissuggeststhatindividualdifferences in interpretationsofthe ratioswere
not verylarge.

RELATED ISSUES

Confidence and performance. The subject'sdegreeofconfidence was meas-

uredin two ways: (1) by the mean responseon the confidence scale and (2)
by the subject's estimateof his predictionaccuracy.The confidencescale
was scoredas one, three,or fivefromleast to mostconfident. The average
mean responseon the confidencescale was 2.73. The rangewas 1 to 3.77.
Estimatedaccuracyrangedfrom10 to 65 out of 70 and averaged51.3. No
significantgroup differences were foundin eitherof these variables. The
two confidencemeasureswere significantly correlated(r = .65, p ? .01),
but correlationsof both of the measureswithaccuracyand test-retestre-
reliabilitywere foundnotto be significant(p < .01). In otherwords,ac-
tual and expectedperformance werenot related.
The lack of significantcorrelationbetweenactual performance and both
confidence in decisionand expectedaccuracycasts doubt upon the validity
of judging accountingalternativesbased upon the users' opinionsas to
whichinformationset would maximizeperformance.This question is of
extremeimportancegiventhe fact that various accountingpolicy-making
organizationshave accepted this opinionresearchapproach. Furtherex-
perimentationcomparingexpectedand actual performance given alterna-
tive data sets should be completedbeforeany weightis placed upon the
opinionresearchapproach.
Compositejudge. A compositeor consensusjudge was formedby com-
puting the average responseon the dichotomous(fail-notfail) scale for
each firmacross subjects. Scoringthe two predictionsplus one or minus
one, average responsesof less than and greaterthan zero were counted
as fail or nonfailpredictionsrespectively.This techniqueis similarto an
equal weightedmajorityvoting system. The consensusjudge correctly
classified49 out of 60 cases.
While the individualdecisionmakers'predictionachievementaveraged
at 74.4%, the compositejudge performedat a level of 81.7 %, just one
predictionless accurate than the best individual judge. The composite
judge is analogous to a noninteractive, closed ballot, majorityrule voting
system.This resultimpliesthat implementationof such a systemcould
cause improvementin achievementand suggeststhe need forfurtherre-
searchto test the efficacyof differenttypesof committeedecisionmaking
in bank lending.

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 PREDICTING FAILURE 159

DEBRIEFING

Methodof task accomplishment. The average estimate of time taken to

completethe task was 82 minutes.The range was 20 to 300 minutes.On
the average, the subjects estimatedthat they weightedcurrentassets/
currentliabilitiesand net income/totalassets moststrongly.The subjects'
rankingof the currentratio as mostimportantagreeswiththe traditional
view voicedin mosttreatmentsoffinancialanalysis.All ofthe participants
exceptthreesmallbankofficers indicatedthat theyreviewedtheirresponses
upon completion.
Attitudestowardtheexperiment. The postexperimental debriefingques-
tionnaireincludedquestionsdesignedto deal with three otherareas: (1)
clarityofinstructions; in
(2) interest the study;and (3) withthe
satisfaction
limitedinformation of
set. All but two the Philadelphia bankers and all of
the C-U bankersindicatedthat all of the instructions wereclear. The oral
debriefingsconfirmed thatthesubjectsunderstoodthe instructions. Thirty-
threeofthe subjectsresponded that they found the task interestingor very
interesting while ten indicated that the task was dull or verydull. All but
threeof thesubjects indicated that they would like to receivea summary
of the resultsof the study.The oral debriefings indicateda similardegree
of interest.The subjectsindicatedsome dissatisfaction withthe complete-
ness of the data set presented.But theystated that the additionof other
accountingand nonaccountinginformation they would have founduseful
in the task would onlyhave increasedtheirachievementby 11.4 out of 70
on the average.

Limitations
The major limitationsof the study relate to the generalizability of the
resultsofthe studywithrespectto (1) actors,(2) otherexperimental situa-
tions,(3) the real worldsituationsrelatedto the experimental task and (4)
otherdefinitionsof failure.Participantsin the study were not randomly
selected.The two groupswere specificallychosenbased upon a prioridif-
ferencesin lendingexperienceconstrainedby subjectavailability.Although
valid statisticalinferencecan only be made to otherresponsesmade by
the same subjects,the similarityin resultsbetweenthe two a prioridiffer-
ent subgroupssuggestsa higherdegreeof generalizability.
The specificinstructions,data presentations,and dependentmeasures
used in the experimental situationmay affectthe resultsofthe study.Such
seeminglyminorchangesas usinga six-pointscale in place of a two-point
scale or seven in place of fiveratiosmay have significanteffects.This type
of externalvaliditycan onlybe determinedthroughadditionalexperimen-
tation.
In the actual lendingdecision,loan officershave an abundanceof multi-
period quantitativeand qualitative informationavailable to them. The
presentexperiment attemptedto testtheusefulnessofonlya smallsegment

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160 ROBERT LIBBY

ofthe available quantitativeinformation in single-period

form.The specific
information set used in the studywas chosenbecause ofthe theoreticaland
empiricalsupportconcerningthe relationshipbetweensingleperiodfinan-
cial ratiosand businessfailure.Hence, the effectof additionalinformation
on accuracy and reliabilitycannot be estimatedbased upon the present
study.Anyone studycan onlyestablisha limitedrangeofexternalvalidity.
The operationaldefinition of failureemployedin thisstudy'2was a very
extremeform.Otherless extremeformsoffailuresuch as the need forloan
renegotiation due to missedinterestor principalpaymentsare also costly
to bankers.Generalizationsconcerning the accuracyofpredictionsofother
typesof failurecannotbe made fromthis study.

Summaryand Conclusions
The major thesisof this studywas that the usefulnessof accountingin-
formationis a functionof the predictiveabilityof the informationand the
abilityof usersto interpretthe data. The predictionachievementcriterion
was developed based upon this thesis.The experimentconductedin this
study directlymeasuredthe predictionachievementof a selected set of
accountingratios and loan officers in the predictionof failure.Also, the
test-retestand interraterreliabilityof the loan officers'predictionswas
measured.
A small empiricallyderived set of accountingratios allowed bankers
rangingwidelyin backgroundto make highlyaccurateand reliablepredic-
tions of business failure.The resultssuggestthat futureresearchwhich
wouldtestthegeneralityoftheresultsoverdecisionmakers,environmental
events,and information sets may be profitable.The presentsituationwas
chosenbecause it was simple,well defined,and the subject of previousre-
search.Testingthe same hypothesesin othersituationswill be morecom-
plex.
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