Predicting Corporate Failure Using a Neural Network Approach

International Journal of Intelligent Systems in Accounting, Finance and Management Vol. 4, June, 1995, pp. 95-111

Posted: 22 Nov 2014

See all articles by J. Efrim Boritz

J. Efrim Boritz

University of Waterloo - School of Accounting and Finance

Duane B. Kennedy

University of Waterloo - School of Accounting and Finance

A Albuquerque

Independent

Date Written: 1994

Abstract

This paper investigates the performance of Artificial Neural Networks for the classification and subsequent prediction of business entities into failed and nonfailed classes. Two techniques, back-propagation and Optimal Estimation Theory (OET), are used to train the neural networks to predict bankruptcy filings. The data are drawn from Compustat data tapes representing a cross-section of industries. The results obtained with the neural networks are compared with other well-known bankruptcy prediction techniques such as discriminant analysis, probit and logit, as well as against benchmarks provided by directly applying the bankruptcy prediction models developed by Altman (1968) and Ohlson (1980) to our data set. We control the degree of 'disproportionate sampling' by creating 'training' and 'testing' populations with proportions of bankrupt firms ranging from 1% to 50%. For each population, we apply each technique 50 times to determine stable accuracy rates in terms of Type I, Type II and Total Error. We show that the performance of various classification techniques, in terms of their classification errors, depends on the proportions of bankrupt firms in the training and testing data sets, the variables used in the models, and assumptions about the relative costs of Type I and Type II errors. The neural network solutions do not achieve the 'magical' results that literature in this field often promises, although there are notable 'pockets' of superior performance by the neural networks, depending on particular combinations of proportions of bankrupt firms in training and testing data sets and assumptions about the relative costs of Type I and Type II errors. However, since we tested only one architecture for the neural network, it will be necessary to investigate potential improvements in neural network performance through systematic changes in neural network architecture.

Keywords: Optimal Estimation Theory, back-propagation, neural networks, predict bankruptcy filing

Suggested Citation

Boritz, Efrim and Kennedy, Duane B. and Albuquerque, Augusto, Predicting Corporate Failure Using a Neural Network Approach (1994). International Journal of Intelligent Systems in Accounting, Finance and Management Vol. 4, June, 1995, pp. 95-111 , Available at SSRN: https://ssrn.com/abstract=2528736

Efrim Boritz (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada
519-888-4567 (Phone)
519-888-7562 (Fax)

Duane B. Kennedy

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1
Canada
519-888-4752 (Phone)

Augusto Albuquerque

Independent ( email )

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