Analyzing Expected Accounting Losses in the Context of Bankruptcy Prediction

We investigate the role of expected accounting losses in bankruptcy prediction. To form expectations, we estimate firm-specific expected profitability distributions following Chang et al. (2021). We find that i) an expected loss dummy, ii) the expected probability to realize future losses, and iii) the expected probability of future losses to consume current cash balances (i.e., illiquidity proxy) significantly improve bankruptcy prediction accuracy. Moreover, we provide evidence for a size effect in the relation between expected accounting losses and bankruptcy risk. Our study has implications to whomever facing counterparty risk, especially banks and investors. Also, standard setters working on regulatory frameworks for banks (Basel III) and insurance companies (Solvency II) should consider the insights expected accounting losses reveal about a firm’s bankruptcy risk