Empirical data analysis in

accounting and finance

Some examples on quantitative empirical
research problems in accounting and finance

 Pattern recognition
 Financial classification models
 Financial distress prediction
 Web Questionnaires
 ANOVA, MANOVA and MRA modelling
 Causality models
 Association between accounting data and financial market
reactions
 Causality patterns on international financial markets
 Time series modelling and prediction
 Optimization models, e.g.
 Portfolio optimization
 product mix optimization
A typical process for empirical data
analysis
 Define the test problem
 Collect data
 Data bases for financial data, e.g. market data,
financial statements, interest rates, exchange rates
 Surveys for opinion data
 Select the analysis method
 Control for the suitability of the data to the
selected method
 Different methods have different assumptions on
the properties of the data, e.g. approximate
normality
A typical process for empirical data analysis ...

 If necessary, improve the quality of the

data
 Different transformations
 Taking logarithms of the data
 Differencing (for time series data)

 Removing the outliers

 Perform the data analysis by a suitable
statistical program, e.g. SPSS, SAS
 Interpret the results critically
The quality of the data
 Practically all statistical methods assume the
data to follow some predefined distribution
(probability density function or pdf), e.g.
 Standard normal distribution
 Normal distribution
 Most empirical data sets fail to satisfy the
basic assumption on normal distribution
 Typical problems are
 Skewness of the data
 Leptokurtosis (thick tails)
 Outliers
The standard normal (Gaussian)
distribution ( = 0, = 1)

0.45

0.4

0.35

0.3

0.25

0.2

0.15

0.1

0.05

0
-3

3
-2.7
-2.4
-2.1
-1.8
-1.5
-1.2
-0.9
-0.6
-0.3

0.3
0.6
0.9
1.2
1.5
1.8
2.1
2.4
2.7
Skewness
 A measure of the asymmetry of the probability
distribution
 Skewness = 0 for a symmetric distribution
 Negative skewness (left skewed pdf): The left tail is
longer; the mass of the distribution is concentrated on
the right of the figure
 Positive skewness (right-skewed pdf): The right tail
is longer; the mass of the distribution is concentrated
on the left of the figure
Kurtosis
 A measure of the peakedness of the probability
distribution
 Many financial data series (for example, stock returns)
have leptokurtic distributions
 A leptokurtic distribution has a more acute peak
around the mean and fatter tails
Histogram of the Canadian stock market returns and a
normal distribution with the observed mean and
standard deviation

180
160
140 Leptokurtic
120
100
80
60
40
20
0
-3 -2 -1 0 1 2 3

Observed Frequency Normal Distribution

Testing for the normality of a data set

 There are several tests for measuring

the normality of a data set, for example
 Kolmogorov-Smirnov test (Massey, 1951)
 Pearson’s chi-square test (Pearson, 1900)

 Jarque-Bera test (Jarque & Bera, 1980)

 Shapiro-Wilk test (Shapiro & Wilk, 1965)

SPSS-output for the K-S test with the
Canadian data

One-Sample Kolmogorov-Smirnov Test

Can
N 752
Normal Parametersa,,b Mean ,0340
Std. Deviation ,57275
Most Extreme Differences Absolute ,077
Positive ,047
Negative -,077
Kolmogorov-Smirnov Z 2,103
Asymp. Sig. (2-tailed) ,000
a. Test distribution is Normal.
b. Calculated from data. Data not normal
(α < 0.01)
The classification problem
 In a traditional classification problem the main
purpose is to assign one of k labels (or
classes) to each of n objects, in a way that is
consistent with some observed data, i.e. to
determine the class of an observation
based on a set of variables known as
predictors or input variables
 Typical classification problems in finance are
for example
 Financial failure/bankruptcy prediction
 Credit risk rating
Classification models

 Discriminant analysis
 Logistic regression
 Recursive partitioning algorithm (RPA)
 Mathematical programming
 Linear programming models
 Quadratic programming models
 Neural network classifiers
Discriminant analysis

 Discriminant analysis is the most

common technique for classifying a set
of observations into predefined classes
 The model is built based on a set of
observations for which the classes are
known
 This set of observations is sometimes
referred to as the training set or
estimation sample
Discriminant analysis...

 Based on the training set, the technique

constructs a set of linear functions of the
predictors, known as discriminant functions,
such that

L= 1x 1 + 2x 2 +…+ nx n + c,

where the 's are discriminant coefficients,

the x's are the input variables or predictors and
c is a constant.
Discriminant functions
 The discriminant functions are optimized to provide a
classification rule that minimizes the probability of
misclassification
 In order to achieve optimal performance, some
statistical assumptions about the data must be met
 Each group must be a sample from a multivariate
normal population
 The population covariance matrices must all be equal
 In practice the discriminant has been shown to
perform fairly well even though the assumptions on
data are violated
Distributions of the discriminant
scores for two classes

Score

Class 1 Class 2

A discriminant function
is optimized to minimize
the common area for the
distributions
Case: Bankruptcy prediction in the
Spanish banking sector
 Reference: Olmeda, Ignacio and Fernández, Eugenio:
"Hybrid classifiers for financial multicriteria decision
making: The case of bankruptcy prediction",
Computational Economics 10, 1997, 317-335.
 Sample: 66 Spanish banks
 37 survivors
 29 failed
 Sample was divided in two sub-samples
 Estimation sample, 34 banks, for estimating the model
parameters
 Holdout sample, 32 banks, for validating the results
Case: Bankruptcy prediction in the
Spanish banking sector
Input variables
 Current assets/Total assets
 (Current assets-Cash)/Total assets
 Current assets/Loans
 Reserves/Loans
 Net income/Total assets
 Net income/Total equity capital
 Net income/Loans
 Cost of sales/Sales
 Cash flow/Loans
Empirical results

 Analyzing the total set of 66 observations

 Group statistics – comparing the group means
 Testing for the equality of group means
 Correlation matrix
 Classification with different methods
 Estimating classification models using the
estimation sample of 34 observations
 Checking the validity of the models by classifying
the holdout sample of 32 observations
Group statistics
Class 0 N=37 Class 1 N=29 Total N=66
Mean St.dev Mean St.dev Mean St.dev
CA/TA ,410 ,114 ,370 ,108 ,393 ,112
(CA-Cash)/TA ,268 ,089 ,264 ,092 ,266 ,089
CA/Loans ,423 ,144 ,390 ,117 ,409 ,133
Reserves/Loans ,038 ,054 ,016 ,012 ,028 ,043
NI/TA ,008 ,005 -,003 ,019 ,003 ,014
NI/TEC ,167 ,082 -,032 ,419 ,079 ,299
NI/Loans ,008 ,005 -,003 ,020 ,003 ,015
CofS/Sales ,828 ,062 ,957 ,188 ,885 ,147
CF/Loans ,018 ,029 ,004 ,012 ,012 ,024
 Tests of equality of group means

Significant if close to zero Wilks’

F df1 df2 Sig.
Lambda
CA/TA ,969 2,072 1 64 ,155
(CA-Cash)/TA 1,000 ,027 1 64 ,871
CA/Loans ,985 ,981 1 64 ,326
No
Reserves/Loans ,932 4,667 1 64 ,034 significant
NI/TA ,864 10,041 1 64 ,002 difference
in group
NI/TEC ,889 8,011 1 64 ,006 means
NI/Loans ,863 10,149 1 64 ,002
CofS/Sales ,805 15,463 1 64 ,000
CF/Loans ,918 5,713 1 64 ,020
Fisher’s discriminant function
coefficients
Survived Failed

Constant -758.242 -758.800

CA/TA 48.588 34.572
CA_Cash/TA 9.800 23.506
CA/Loans -18.031 -16.947
Res/Loans 351.432 342.204
NI/TA -246 563.200 -236 546.700
NI/TEC 774.368 740.035
NI/Loans 23 681.300 21 4974.000
CofS/Sales 1 499.659 1 505.547
CF/Loans 14 625.844 14 245.368
Example on classifying an observation
by discriminant functions

Obs. 1 Survived Score Failed Score

Constant -758.24 -758.24 -758.800 -758.80
CA/TA 0.4611 48.59 22.40 34.572 15.94
CA_Cash/TA 0.3837 9.80 3.76 23.506 9.02
CA/Loans 0.4894 -18.03 -8.82 -16.947 -8.29
Res/Loans 0.0077 351.43 2.71 342.204 2.63
NI/TA 0.0057 -246563.2 -1405.41 -236546.7 -1348.32
NI/TEC 0.0996 774.37 77.13 740.035 73.71
NI/Loans 0.0061 23681.3 1364.46 214974.0 1311.34
CofS/Sales 0.8799 1499.66 1319.55 1505.547 1324.73
CF/Loans 0.0092 14625.84 134.56 14245.368 131.06
Total Score 752.08 753.02
Larger score
Classification: Failed
Confusion matrix – Classification results for
the holdout sample

Predicted class
Survived Failed
True Survived 15 3
class
83.33 % 16.67 %
Failed 4 10
28.57 % 71.43 %
Summary of classifications
(Estimation sample)

Correct Errors Total Percents

Method
class SW NE number Correct SW NE
RPA 30 1 3 34 88.24 % 2.94 % 8.82 %
MDA 30 0 4 34 88.24 % 0.00 % 11.76 %
MDA-Q 31 0 3 34 91.18 % 0.00 % 8.82 %
MDA-W 31 0 3 34 91.18 % 0.00 % 8.82 %
LogR 33 0 1 34 97.06 % 0.00 % 2.94 %
LP 28 1 5 34 82.35 % 2.94 % 14.71 %
LP-Q 34 0 0 34 100.00 % 0.00 % 0.00 %
LPG 33 0 1 34 97.06 % 0.00 % 2.94 %
LPGQ 34 0 0 34 100.00 % 0.00 % 0.00 %
Kohonen 24 3 7 34 70.59 % 8.82 % 20.59 %
Summary of classifications
(Holdout sample)

Correct Errors Total Percents

Method
class SW NE number Correct SW NE
RPA 27 2 3 32 84.38 % 6.25 % 9.38 %
MDA 25 4 3 32 78.13 % 12.50 % 9.38 %
MDA-Q 20 7 5 32 62.50 % 21.88 % 15.63 %
MDA-W 25 5 2 32 78.13 % 15.63 % 6.25 %
LogR 28 3 1 32 87.50 % 9.38 % 3.13 %
LP 24 5 3 32 75.00 % 15.63 % 9.38 %
LP-Q 21 7 4 32 65.63 % 21.88 % 12.50 %
LPG 25 4 3 32 78.13 % 12.50 % 9.38 %
LPGQ 21 7 4 32 65.63 % 21.88 % 12.50 %
Kohonen 16 4 12 32 50.00 % 12.50 % 37.50 %
Factor analysis
 A statistical method used to describe variability
among observed variables in terms of fewer
unobserved variables called factors
 The observed variables are modeled as linear
combinations of the factors plus error terms
 The information gained about the
interdependencies can be used later to reduce the
set of variables in a dataset
Factor analysis

Variables Factors

X1 Factor 1
X2
X3
Factor 2
X4

Factor k < p
Xp
Factor analysis - an example: Financial
ratios

Variables Factors

Sales
Assets Growth

EBIT-%
ROI
ROE Profitability

CF/Sales
Equity Ratio
QR Solidity

CR
Factor analysis - an example: Financial
Ratios for Finnish listed companies

9 variables
 Sales, Assets, EBIT-%, ROI, ROE, Cash
Flow(Operations)/Sales, Equity Ratio, Quick
Ratio Current Ratio
 Fixed number of factors: 3
 Predefined assumption on three factors:
Growth, Profitability and Solidity
 Extraction method: Principal Components
Analysis
 Rotation method: Varimax
Factor analysis: Varimax-rotated
component matrix

Component
1 2 3
DSales (%) ,132 -,055 ,953
DAssets (%) ,100 -,048 ,960
EBIT-% ,869 ,344 ,128
CF(Oper)/Sales ,671 ,183 ,248
ROI ,875 ,177 ,003
ROE ,834 ,037 ,031
Equity Ratio ,274 ,795 -,086
Quick Ratio ,173 ,911 ,011
Current Ratio ,111 ,911 -,042
Factor analysis - an example: Financial
ratios for Finnish listed companies§

 The three pre-assumed factors – Growth,

Profitability and Solidity - may be clearly identified
in the rotated component matrix
 For example Growth is represented by component 3
combining the major part of ratios Sales and
Assets with minor influences from the other seven
variables
 In the same manner Profitability is represented by
component 1 and Solidity by component 2
 The component matrix may be further transformed
into a Component score coefficient matrix to be
used to create new ratios X§describing the factors
Linear Structural Relationships - Lisrel
 Lisrel-modeling combines underlying factor
analyses with simultaneous estimation of structural
relationship between the extracted latent factors
 The general form basic Lisrel model consists of
 Observed explanatory variables (X)
 Observed dependent variables (Y)
 Latent explanatory factors ( )
 Latent dependent factors ( )
 Error (residual) terms ( and ) for each X- and Y-variable
respectively
connected to each other as shown in the next page
Basic Lisrel model
Error X Observed X Latent X Latent Y Observed Y Error Y

eps1 X1

eps2 X2 xi3
Y1 delta1
eps3 X3
eta1 Y2 delta2
eps4 X4
Y3 delta3
eps5 X5 xi2
Y4 delta4
eps6 X6
eta2 Y5 delta5
eps7 X7
Y6 delta6
eps8 X8 xi3

eps9 X9
In order to learn more about
applying statistical methods...
 Participate in the course ”Advanced
Financial Accounting (AFA) II”
 Lectures on statistical methods suitable
for analyzing financial data and adapted
to accounting terminology
 Practical assignments on each method,
useful for your career
References
 Jarque, Carlos M. & Anil K. Bera (1980). “Efficient tests for
normality, homoscedasticity and serial independence of
regression residuals”. Economics Letters 6(3): 255–259
 Massey, Frank J. Jr. (1951). “The Kolmogorov-Smirnov test
for goodness of fit”, Journal of the American Statistical
Association 46(253): 68-78
 Pearson, Karl (1900). “On the criterion that a given system
of deviations from the probable in the case of correlated
system of variables is such that it can be reasonably
supposed to have arisen from random sampling”,
Philosophical Magazine 50: 157-175
 Shapiro, S. S. & M. B. Wilk (1965). “An analysis of variance
test for normality”, Biometrika, 52(3): 591-599