Identification of the Financially Distressed Firms through Enclosure of Corporate Governance Information into the Altman Z-Score

Abstract

Timely and accurate identification of the financially distressed firms helps safeguarding the interests of the stakeholders, and brings stability to the financial markets. Accounting based models are widely used to identify financially distressed firms, which may default and face subsequent bankruptcy. These models use accounting information from the published financial statements of the firms. Based on the accounting conventions of prudence and conservatism, this information is considered reliable and authentic. Despite reliability and authenticity, the accounting-based models yield type-I and type-II corporate default prediction errors. To reduce the quantum of these errors, this study has enclosed the corporate governance (a foresighted market information) into the Altman Z-Score (a hind-sighted accounting-based information). 161 non-financial firms listed at Pakistan Stock Exchange during the period of 2010-2016, have been taken as the study sample. Additive index methodology has been used to create two distinct indices, i.e., the Z-Score Default Index, and the Composite Default Index. Z-Score Default Index comprises of Z-Score, while the Composite Default Index comprises of the Z-Score and the Corporate Governance information in form of Corporate Governance Index. The results reveal that the Composite Default Index yields significantly lesser number of type-I and type-II corporate default prediction errors in comparison with the Z-Score Default Index. This study concludes that the enclosure of Corporate Governance into the Altman Z-Score improves the Z-Score’s ability to identify the financially distressed firms. While concluding this study acknowledges the limitation in terms of the selecting the accounting-based model, and the market information. The study recommends considering different accounting-based models, market information, and the financial market for the future studies.Corporate Governance