The Enclosure of Governance and Social Information into the Accounting Based Models to Predict Corporate Default – Evidence from Pakistan Stock Exchange

Abstract

Financial distress within the corporations may lead to corporate default, and subsequent bankruptcy. Unexpected corporate defaults erode the stakeholders’ trust in the financial markets. Therefore, an accurate, and timely prediction of the corporate default is important. The Accounting Based Models, including the Altman Z-Score, and Ohlson O-Score, are widely used to identify financially distressed firm. The wide use of the Accounting Based Models is attributable to the elements of authenticity, prudence, and conservatism present within the accounting information. Though reliable, these models lack foresight, yielding type-I and type-II corporate default prediction errors. Addition of foresight to these models may reduce the quantum of errors, hence improving their existing ability to predict corporate defaults. This study has identified the Corporate Governance, and the Corporate Social Responsibility, as the suitable elements for their enclosure into the Accounting Based Models. This enclosure improves upon the existing corporate default prediction ability of the Accounting Based Models. The non-financial firms, listed at the Pakistan Stock Exchange, during the study period 2010-2016, have been taken as the sample for this study. Default indices have been formed, i.e., Z-Score Default Index, compared with Z-Score Composite Default Index, and O-Score Default Index compared with O-Score Composite Default Index. The Composite Default Indices yield a significantly lesser number of type-I and type-II errors, hence being more accurate in predicting the corporate default.