Escolar Documentos
Profissional Documentos
Cultura Documentos
Access to this document was granted through an Emerald subscription provided by emerald-srm:173272 []
For Authors
If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service
information about how to choose which publication to write for and submission guidelines are available for all. Please
visit www.emeraldinsight.com/authors for more information.
About Emerald www.emeraldinsight.com
Emerald is a global publisher linking research and practice to the benefit of society. The company manages a portfolio of
more than 290 journals and over 2,350 books and book series volumes, as well as providing an extensive range of online
products and additional customer resources and services.
Emerald is both COUNTER 4 and TRANSFER compliant. The organization is a partner of the Committee on Publication
Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation.
Purpose: The study analyzes whether and how a set of financial ratios calculated on the basis
of financial statement information would allow auditors of Italian Local Governments (ILGs)
to get an indication of LGs financial distress risk and, hence, to support politicians and
managers in promptly detecting financial distress.
Design: A model comprising a set of financial indicators that would distinguish distressed
from non-distressed LGs through a logistic regression approach has been estimated and
applied to Italian LGs. The model is built on the basis of information pertaining to 44
distressed and 53 non-distressed LGs for up to five years prior to bankruptcy and covers the
period 2003-2012.
Findings: The model reveals that the percentage of personnel expenses over revenues, the
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
turnover ratio of short-term liabilities over current revenues and the reliance on subsidies
(calculated as subsidies per capita) are factors discriminating non-distressed LGs from the
distressed ones.
Practical implications: The model could have political and practical implications. The
possible use of this model as a complementary tool in auditing activities might be helpful for
auditors in detecting financial distress promptly, thus potentially enabling politicians and
managers to search for different ways to manage public resources in order to avoid the
detrimental consequences related to the declaration of distress.
Originality/value: This model, contrary to existing models that use accrual accounting data,
applicable to LGs that adopt a modified cash accounting basis.
Keywords:
1
1. Introduction
All over the world local governments (LGs) are experiencing financial difficulties due to the
global financial crisis; at the same time their citizens ask for the sustainability of basic
services provision and the improvement of their efficiency and effectiveness. The eroding tax
bases and transfer reductions from central governments to LGs have contributed in several
LGs becoming financially distressed. In some countries, like Italy, the introduction of a
central government transfers, has shifted the responsibility of managing financial resources
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
from central government to local authorities. Also, the focus of control has changed from the
correct use of governmental grants to the efficient and effective use of citizens' local taxes
(Caperchione and Mussari, 2000). Having New Public Management (NPM) approach as a
starting point which emphasizes private sector management styles coupled with output
controls (Hood, 1995), higher levels of accountability have been progressively required and as
a result the importance of the audit function has been stressed in the public sector (Gendron et
al., 2007). In particular, legislators and standard setters both at national and international level
as well as citizens, taxpayers and other external stakeholders have started paying increasing
al., 2002; Steccolini, 2004). Consequently, provided that financial reporting is a tool used by
stakeholders to evaluate how politicians and managers administer public resources, the role of
reliable and relevant (Gendron et al., 2007). Moreover, the financial audit performed by
Researchers and practitioners have largely investigated the factors affecting the financial
position of LGs and they have provided empirical evidence that this is the outcome of a
combination of internal and external factors (Brown, 1993; Carmeli and Cohen,
when financial distress occurs, both citizens and the entire local community have to endure a
detrimental impact. Also, the future development of the LG is compromised (Pagano and
The aim of this study is to analyze whether and how a set of financial ratios calculated on
the basis of financial statement information would allow auditors of LGs to get an indication
of LGs financial distress risk and, hence, to support politicians and managers in promptly
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
detecting financial distress. Therefore in this study a model based on accounting data having
the power to discriminate LGs which are bankruptcy prone from the healthy ones has been
Scholars and practitioners have developed so far a large set of models that assess the
financial condition of LGs aiming at getting early signals of possible future financial distress
(e.g. Kloha et al. 2005; Murray and Dollery, 2005; Zafra-Gomez et al., 2009; Cohen et al.
2012; Doumpos and Cohen, 2014; Garcia-Sanchez et al., 2012; Navarro-Galera et al., 2015b).
However, no study so far, to the best of our knowledge, has considered how these models
could be adopted by auditors. Professional auditors are ‘naturally’ prone to adopt tools for
rating the financial condition of LGs. This is highly related to a going concern assessment.
Moreover, in some countries, auditors are specifically requested to give an opinion on local
finances (e.g. the UK and Italy) and sometimes their role in LGs overcomes the typical
borders of accounting auditing, as they are required to support politicians and managers in
getting the most out of the scarce resources available. Therefore a tool providing signals of
financial distress could facilitate them in their work. The distinctiveness of the proposed
approach lies in the possibility of exploiting financial performance indicators of LGs derived
from modified cash-basis financial data rather than from accrual accounting data as most of
3
the models already developed. This is an interesting issue as in several European countries
accounting data are still recorded following modified cash accounting (Brusca et al., 2015),
In this paper, a model comprising a set of financial indicators that would distinguish
distressed from non-distressed LGs through a logistic regression approach has been created
and applied to Italian Local Governments (ILGs, henceforth). ILGs are an interesting and
unusual case in which budgetary accounting (i.e. modified cash accounting) is adopted both
for budget and for accounting purposes during the year, while measurements under the
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
accrual basis only occur for preparing financial statements and for reporting purposes at the
end of the year. Thus, accrual accounting information is not available during the year but is
calculated only as a snapshot. Moreover, auditing is significant in Italy as the Italian law asks
auditors to be highly involved in the financial reporting process. The law mandates the
performance of audits by professional auditors with a high level of experience who are totally
independent of politicians. At the same time, however, auditors should support politicians to
make better use of public resources. In this context, a model able to estimate the probability of
an ILG to become financially distressed built by using information prior to this incidence
To carry out the study a panel of 97 Italian LGs split into two groups according to their
financial status has been considered. In particular, information pertaining to 44 distressed and
53 non-distressed LGs for up to five years prior to bankruptcy have been extracted from the
(http://finanzalocale.interno.it). The time period chosen for the collection of LGs information
is relevant to the research question as from year 2003 due to a change in the regime regarding
the treatment of financial costs related to the repayment of the debt of the distressed entities
there was a drastic reduction in the number of entities declaring financial distress. This change
4
motivated several LGs to try to hide their financial difficulties by reporting improper data
(Cortedei Conti, 2014; Anessi Pessina et al., 2008).In this context the importance of the audit
opinion on the true representation of the financial reports and the going concern of the LG
The paper has the following structure: the next section provides a literature review on
financial distress and refers to models developed to identify financial crises in LGs. In the
third section, the role played by auditors as well as features and legislation regulating ILGs
are presented. Section 4 sketches the main assumptions of the proposed model in light of the
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
available data. Section 5 discusses the main results of the analysis. Conclusions, future
developments of the research and possible implications are presented in the last section.
2. Literature Review
Financial distress in the public sector has captured the attention of scholars and
practitioners in the ’70s when some major metropolitan areas in the United States declared
their financial distress (the most famous one was New York in 1975). The concept of
financial distress has also been captured under the terms fiscal crisis, fiscal distress, financial
Since then, a vast literature has developed, aiming to individuate what causes financial
distress. For instance, some authors considered the imbalance between revenue capacity and
expenditure needs as the critical condition (Pagano and Moore, 1985; Inman, 1995). Others
have pinpointed problems related to the short-run solvency (i.e. the ability to pay current
liabilities) as well as the long-run solvency (i.e. the ability of future resources to face long-
term obligations) (Groves et al., 2003; Padovani and Scorsone, 2012). In any case, solvency
has been related to the tax base (Kloha et al., 2005). Wilson (1984) has detected some signs
which could preannounce financial stress: current expenditures exceeding current revenues by
5
a significant amount; continuous deficit spending by small amounts; and current liabilities
exceeding current assets on the financial statements of LGs. Bradbury (1982) analyses fiscal
distress as budgetary fiscal distress and citizen fiscal distress: the former occurs when
municipalities encounter difficulties in balancing their budgets, the latter occurs when citizens
have levied high taxes and fees for municipal services or when the quality of municipal
services is low.
Part of the literature has focused on local management and political context by considering
and dishonesty by the municipal leadership (Martin, 1982; Park, 2004; Landry, 2007; Spiotto,
2008). Also,, exogenous factors have been largely considered by literature, as possible factors
dictating LG financial decisions recognizing in this way that the appropriate fiscal structure
for a government is contingent upon its environment (Howell and Stamm 1979; Skidmore and
Scorsone, 2011). In this realm, some studies on the relationship between the measures of
fiscal distress and local responses strategies have been conducted (Pammer, 1990; Maher and
have also been investigated as potential source of fiscal stress in LGs (Honadle, 2003;
Therefore, it is possible to detect two main strands already considered in the literature: a
‘socioeconomic-decline approach’ when scholars pinpoint external factor as the main causes
of financial distress, and a ‘local-management approach’ when they consider that the
Scholars and practitioners have developed so far a large set of models to control for
financial equilibrium and to avoid bankruptcy: Brown (1993) proposed the famous 10-point
test, later updated by Maher and Nollenberg (2009). Hendrick (2004) views governments as
an ‘open system’ identifying three different dimensions of fiscal health: properties of the
6
government’s environment; balance of fiscal structure with the environment; and properties of
the government’s fiscal structure. Other scholars (Honadle, 2003; Kloha et al., 2005) have
audit reports, while others seem to prefer statistical modeling approaches (Murray and
Dollery, 2005). Practitioners have largely adopted the ICMA Financial Trend Monitoring
monitoring their financial condition. The fil rouge which links all these models is the attempt
to forecast, therefore, prevent financial distress by presenting early signals that would trigger
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
timely government action (Maher and Deller, 2011). Nevertheless, which are the best
indicators suitable for this purpose and how they should be employed is an empirical question
still open.
The majority of relevant studies until recently has been almost limited to the United States
and Australia (Kloha et al. 2005; Murray and Dollery, 2005). Nevertheless, especially thanks
to the financial crisis started in 2008, studies aiming at developing adequate tools to assess the
relationship between financial indicators and local response strategies started to be also
performed in Europe. However, European studies based on statistical modeling are still quite
scanty, and they are related to LGs adopting accrual accounting systems (Zafra-Gomez et al.,
2009; Cohen et al., 2012; Garcia-Sanchez et al., 2012; Cabaleiro et al., 2013; Navarro-Galera,
2015a). It is worth noting the increasing attention put on possible models based on financial
Italy is a country with a long tradition in the public sector, where the State used to have for
more than a century a strong role in the country’s socio-economic life. This tradition has been
radically changed from the early 1990s when the financial and political crisis, coupled with
the pressure exercised both by the European Union and by the citizens started pushing
7
towards more effective and efficient public administration. These pressures have caused a
shift towards federalization and an increasing trend towards the distinction between political
choices and administrative ones, despite the culture of governance remained highly legalistic
(Ongaro and Vallotti, 2008; Turrini et al., 2010). In Italy, there are 8,147 LGs (8,047
reform process, have gained the power to levy taxes - even if in most of the cases under a
predetermined range set by the central government - and they have an obligation to provide a
certain array of public services. The Italian central government typically requires ILGs to
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
follow accounting rules defined by law. The annual budget should be balanced, and its
development and follow-up should follow recommended cash and debt management
procedures. At the end of each financial year, ILGs are required to publish a report which
included three documents: the Financial Statement prepared according to the modified cash
accounting basis, and the Assets and Liability Statement plus the Income statement, prepared
by reclassifying financial data in accordance with the accrual accounting principles. All
questionnaire prepared by the National Audit Court in which, among other assertions, they
have to certify the financial health of the local government based on a set of ten indicators, as
discussed below. Additionally, auditors have the duty to signal to the City Council whenever
The declaration of distress in ILGs is governed by D.Lgs. 267 issued in 1989. According to
art.244 financial distress occurs when the entity, municipality or province, is no longer able
to perform its essential functions and deliver due services, or when it is no longer able to meet
debt with third parties through the ordinary means of restoring fiscal balance or after
recognizing the debts that have not been included in the balance sheet. The City Council is
8
responsible to officially declare that the LG has entered in a condition of financial distress.
appointed by the central government (based on suggestions from the Ministry of the Interior).
Board's task is to prepare a plan to repay overdue debt. At the same time, the municipality’s
institutional bodies have to act towards achieving a stable financial condition by removing the
‘structural causes’ of financial destabilization. In addition, the financial condition of the ILG
is kept under observation by three public institutions: the Ministry of Interior, the National
Audit Court and the State General Accounting Department (which belongs to the Ministry of
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
Economy).
The year 2003 signaled a change on LGs' distress declaration. There was a change in the
regime regarding the treatment of financial costs related to the repayment of the debt of the
distressed entities. While before that law, the financial costs related to loans were assumed by
the central government, the new legislation obliged ILGs to repay on their own and in full, all
costs related to financial distress. The new regulation while drastically reduced the number of
entities declaring financial distress at the same time gave rise to an unanticipated result; many
LGs started to try to hide their financial difficulties by reporting improper data (Corte dei
Moreover, since 2011 a different procedure has been introduced. In case the National
Audit Court identifies any financial difficulties or irregularities, and the LG does not proceed
in any measure to overcome these shortcomings, the Court officially asks for the adoption of
actions necessary to recover the financial equilibrium. In case the situation persists, and the
conditions required by the law are met (the aforementioned art. 244), the Council of the entity
should declare distress within a strict deadline of 20 days. If the described procedure is not
attended, the Council is dissolved and a special Commissioner is appointed directly by the
9
Finally, a further possibility has been recently introduced by the Italian law, the so-called
pluriannual financial re-equilibrium procedure. Under this provision, the Council would start
working in order to regain the financial equilibrium avoiding that the National Audit Court
declares that the LG is in financial distress. Nevertheless, the Council needs to obtain the
positive judgment of the National Audit Court before starting this procedure.
The declaration of financial distress has a strong impact on the local community. Tax and
services fees have to be raised to the maximum levels allowed by the Italian law while
managers and politicians are required to cut off expenses and to proceed in all actions
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
necessary to remove the causes of insolvency. Financial distress has effects on municipal
employees as well. The number of employees must be reduced to certain levels defined by
law and new recruitments are not allowed before the complete restoration of the financial
equilibrium.
The Ministry of the Interior in order to periodically assess the financial health of LGs has
developed with the cooperation of the LGs’ association a set of ten financial indicators (which
have to be updated every three years) to identify whether the LGs are showing any signals of
financial distress. The last such set was issued in February 2013 and has no material
differences compared to the previous one. In case the values of more than the half of these ten
parameters of a given ILG are out of the ranges provided by the law, the LG is included in a
‘watching list’. As a result of that, the LG is found under the close supervision of the Ministry
of Interior and it has to increase its local taxes and tariffs for public services.
The criteria chosen by the Ministry of Interior to monitor the financial condition of the ILGs
are the following. Exceeding the defined threshold per criterion means failure in meeting it.
1) Negative financial results up to2.5% of the current revenues where financial results
stand for the algebraic sum of cash, receivables and payables at the year-end;
10
2) Unpaid operating expenses of the current year up to 50% of the ascertainment of
operating expenses;
3) Total amount of expenses for employees higher than 38% of the current revenues;
4) Financial debts up to 160% of the current revenue for entities presenting positive
financial result (up to 140% of the current revenue for entities presenting negative
financial result);
5) Unrecorded debts up to 1% ascertained current revenues in all the last three financial
years;
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
7) The total amount due for forced execution procedures of payment up to 0.5% of
operating expenses;
8) The total amount of assets to be sold or the use of financial results up to 5% of the
The model developed in this study albeit aiming at predicting LGs financial failure does
not use any of the predictors listed above for two main reasons. Firstly, as the ILGs know that
they are assessed against these benchmarks, they are expected to try to keep their scores
within the eligible ranges at least for a significant number of them. Secondly, LGs reporting a
negative operating result are more likely to declare bankruptcy by definition. Therefore,
Since 1989 and until 2013, 495 ILG (Corte dei Conti, 2014) declared financial distress.
The majority of the financial distressed ILGs are located in the south of Italy, which is the less
economically developed area of the country (Tabellini, 2010). Actually, 239 distressed
municipalities which constitute the 55% out of the total cases are located in two Italian
southern regions (Campania and Calabria). Small ILGs are more failure-prone: in fact, 318
ILGs of the total failed have less than 5,000 inhabitants, while only 5 LGs have more than
11
60,000 inhabitants. Data highlights how reduced financial resources and poor management in
money collection and payments (Manes Rossi, 2011) coupled with difficulties in attracting
new financial resources or adopt structural changes do not allow small LGs to cope with
extraordinary events and as a result push them towards financial distress. Figure 1 shows the
number of ILGs failed per year starting from 2003 up to the year 2012.
Since 1990 in all ILGs an independent audit board composed of professionals has to be
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
appointed. In particular, one auditor is required in entities with less than 15,000 inhabitants
while a committee of three auditors is necessary for municipalities with more than 15,000
inhabitants. Their duty is to audit the accounting data during the year, the budget and all other
documents that are part of the financial reports. Auditors have to prepare an Audit Report that
is annexed to the Statement of Accounts, in which they make remarks and proposals aiming at
the improvement of LGs' efficiency as well as productivity and performances (Bisogno et al.,
2014). The legislation referring to the auditors was updated in 2000 (D. Lgs. 267, art. 234-
241), and it requires auditors to closely cooperate with the City’s Council, according to the
City’s Statute and internal rules, in order to support the ILGs’ Council in attempting the goals
of efficiency, effectiveness and good performances in LGs' management. Also, the Board of
Auditors has to control for both reliability and adequacy of revenues during the year, as well
as for the consistency of expenses, in order to ensure financial equilibrium. Quarterly audits
on cash are also compulsory. Last, but not least, auditors, while supervising the management
of the ILGs, should signal to the City Council serious irregularities. By the same token, City
Councils have to abide by the suggestions postulated by the auditors. In this framework, it is
obvious that the auditors in the ILGs have increased responsibilities that go beyond the
traditional financial audit of the published financial statements. They are supposed to act as
12
objective watchdogs of good financial governance providing indications of financial distress
The role of auditors concerning the declaration of financial distress is even important. They
are involved just from the beginning in the process as they are entrusted with the task to
postponed. They also get active immediately after the declaration of distress, as they are
supposed to provide the necessary support to politicians and managers in regaining LGs'
financial equilibrium. In this setting, having a reliable model able to characterize the tendency
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
of LGs towards financial distress would be useful not only to support managers and
politicians in the adoption of appropriate strategies to regain financial equilibrium but also to
The present study aims at developing a model that could support auditors to promptly
recognize whether there are signals of LGs bankruptcy. The ratios selected are based on both
Italian practice on assessing financial condition of ILGs ( i.e. the Rating system of the Bureau
van Dick for the Italian Local Governments (https://aidapa.bvdinfo.com/)) and international
literature (Zafra-Gómez et al., 2009, Cabaleiro et al., 2013; Cohen et al., 2012; Brusca et al.,
2015; Navarro-Galera et al. 2015a). They account for solvency (i.e. the capability to respond
to obligations) the ability to cover expenses for which the LG is committed to (e.g. personnel
expenses) (Groves et al., 2003), financial autonomy that decreases the possibility of default
(Cabaleiro et al., 2013) as well as financial and economic equilibrium. All ratios are measured
possible to expect that the increase of current revenues in relation to both financial liabilities
and operating expenses would lead to a lower uncertainty in LGs financial conditions because
13
of their relative stability during the medium term, which would support financial
sustainability. Furthermore, since own revenues are directly dependent upon decisions taken
by LGs, they can be maintained over the years, thus reducing the risk of default.
Table 1reports the calculation and the description of the indicators exploited in this study to
analyze the ILGs risk of financial failure. In Table 1 the column referring to the expected sign
for each indicator corresponds to the expected relation with the default risk predicted by the
(INSERT TABLE 1)
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
The study covers the period 2003-2012. The time period is relevant to the research
question as from the year 2003 the law N.289/2002 changed the regime regarding the
repayment of the debt of distressed entities. Before that law, the financial costs related to
loans were assumed by the central government while the new legislation obliged ILGs to
repay on their own and in full, all costs related to financial distress. The new regulation had,
as a result, the number of entities declaring financial distress to reduce. However, it gave rise
to the phenomenon of LGs trying to hide their financial difficulties by reporting improper data
Collecting information about all the 58 distressed LGs in the period 2003-2012 has not been
possible due to the lack of available data. Thus, the final sample is a panel of 97 ILGs divided
covering the period 2003-2012. For each ILG financial information have been collected for up
to five years prior to the declaration of distress. The total sample is 485 ILG observations. To
reduce differences as a source of variation, the non-distressed LGs have been matched from
the population of LGs on the basis of some covariate values one year prior to bankruptcy. In
particular, the geographical region (provinces) was considered as the matching covariate for
the non-distressed group (Heckman et al., 1998) as it condenses many dimensions of interest.
14
In fact, as regards the Italian context, the geographical location tends to incorporate
neighboring areas and so on (Goff et al., 2008). Our matching criterion approach is based on
selecting all contiguous pairs of non-distressed LGs that share a common geographic
relationship within the interquartile range of population size1 and within the interquartile
range of per-capita GDP of the distressed group. In this process, 290 unique paired non-
distressed LGs were obtained among which 44 observations have been randomly selected.
Table 2 reports group statistics of the financial indicators exploited in this study.
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
(INSERT TABLE 2)
The main summaries confirm the expected direction of the indicators' values for distressed
and non-distressed LGs. More specifically, distressed LGs have a higher contribution of
personnel cost to total revenues (meand = 0.376 and meannd = 0.329), they pay more interest
as a proportion of their revenues (meand = 0.066 and meannd = 0.052). Also, short term
(meand = 0.8808 and meannd = 0.485) while their operating expenses are higher than operating
revenues, a phenomenon that is not encountered in the non-distressed group (meand = 1.025
and meannd = 0.934). Similarly, the higher average value assumed by the SUB_P indicator for
distressed LGs compared to the non-distressed group confirms our theoretical reasoning that
the proportion of LGs operating in a poor environment are granted with higher subsidies
(meand = 959.46 and meannd = 270.35). The former group of LGs might be facing difficulties
in obtaining own revenues which raises the probability of default. On the contrary, the
average value of the indicator CR_FL is larger for non-distressed LGs indicating that their
financial burden as a percentage of their revenues compared to the distressed group is lower
15
4.1 Methodology
In this study, a logistic regression (LR, henceforth) approach has been exploited in order to
predict the LGs risk of financial distress. The generic form of the model can be expressed as
follows:
= ( , ;
) (1)
estimated and is i.i.d. (independent and identically distributed) and logistically distributed.
The response variable is dichotomous coded 1 for distress condition and 0 otherwise.
Differently from other parametric classification methods (e.g. discriminant analysis, DA), LR
does not have requirements for data normality and equal dispersion of covariance matrices of
Following Altman (1968) the logit function has been estimated on the training set consisting
of LGs data referring to one year prior the declaration of distress. On the other hand, to
evaluate the long-range predictive power of the estimated model LGs data from the second up
to the fifth year prior bankruptcy has been considered as a validation set. The analysis was
carried out in steps. Starting from the training sample, the probability of bankruptcy has been
estimated. In order to attain the “best” set of bankruptcy predictors, stepwise analysis has
been exploited as a criterion for ranking importance. The significance of each coefficient was
tested using the Wald statistic, while the overall significance of the logistic regression was
The predictive ability of the estimated model is tested by using data up to five years prior to
LGs financial distress. In this framework, the resulting LGs probabilities of failure might be
16
considered as a measure of the management effectiveness on a yearly basis providing auditors
with a complementary tool to investigate and prevent the risk of financial failure.
The final logit model is reported in Table 3. It illustrates the estimated coefficients, Coef (),
their standard errors, . , and the associated p-values. The variables RPER and SUB_P
significant level (p-value < 0.05, = 5%) while the variable STL_CR is statistically
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
significant at 1% (p-value < 0.000, = 1%). The other variables are not statistically
significant.
(INSERT TABLE 3)
The correlation matrix in Table 4 illustrates the relationships among the involved financial
predictors. While the association between the variables SAT and CR_FL and OP_CR and
RPER is not negligible. Overall, the estimates provided by the model can be considered
(INSERT TABLE 4)
In logistic regression, the estimated coefficients give the change in the log odds of the
outcome for a one-unit increase in the predictor variable (Scott, 2005). In such a case, for one
unit increase in RPER, the log odds of going bankrupt increases by about 6.8, while for one
unit increase in STL_CR the log odds of being distressed increases by about 2.6. The variable
SUB_P seems to be not particularly important regarding the effect on the probability of
financial failure. This is a variable associated with subsidies received to compensate poor or
disadvantaged economic condition affecting the entity; but, it is worth noting that in
accordance with the progressive federalism adopted by the Italian Government, subsidies are
17
Besides, in order to determine whether a particular exposure is a risk factor for LGs
bankruptcy, and to compare the magnitude of various risk factors on the financial distress
conditions the results are presented in terms of odd ratios, Exp ().
In this case, the model suggests that for one unit increase in the value of STL_CR the risk of
being distressed increases by a factor of 14%. The results confirm previous researches
undertaken in different countries estimating the effect of short and long-term liabilities on the
likelihood of default (Cabaleiro et al., 2013; Navarro Galera et al., 2015a). On the other hand,
the risk of distress increases enormously as the value of RPER indicator increases by one. The
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
findings are consistent with results reported by research already undertaken in the public
The predictive ability of the estimated model has been tested through the sensitivity and the
(INSERT TABLE 5)
The fitted model correctly predicted 75% of all distressed LGs and 77.1% of all non-
distressed observations. The secondary diagonal illustrates the miss-rate (i.e. the percentage of
false positive LGs of all distressed LGs) and the fall-out rate (i.e. the percentage of false
negative LGs of all non-distressed units), respectively. The fall-out rate is about 25% while
the miss rate is about 23%. The overall predictive accuracy of the model is about 77%.
Lastly, the long range predictive power of the estimated model has been estimated by
exploiting data collected up to five years prior the bankruptcy (test set) and via bootstrapping
procedures2of the training sample. The prediction accuracy of the estimated model is
illustrated in Table 6.
(INSERT TABLE 6)
2
Five replications of the analysis on five bootstrap sampling from the training set. The predictive ability along
time appears not so different from the results reported in Table 4. Results not tabulated as they are
qualitatively the same to the ones reported in Table 6.
18
As expected, the overall predictive power decreases as long as data from two to five years
before the declaration of financial distress are considered. Notwithstanding, the model appears
more suitable to correctly detect non-distressed LGs rather than distressed ones. In other
words, it preserves a better sensitivity (i.e. correctly categorizing non-distressed LGs as non-
distressed ones) than specificity (i.e. correctly categorizing distressed LGs as distressed ones),
Therefore, the application of the model would provide auditors with early signals about the
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
possibility of a LG to run bankrupt in the short run. On the other hand, the model would
provide supportive evidence in favor of LGs that do not exhibit signs of future distress.
6. Final Remarks
ILGs face several critical situations which can result in a distress condition: improper
management of resources, delay in the payment of debts, high level of personnel expenses,
difficulties in cashing receivables (especially those related to tax), to name a few. Moreover,
the coexistence of those factors, coupled with other environmental factors such as the
federalization of taxes and services which have reduced governmental grants for ILGs, often
Literature has already highlighted that financial distress is a multidimensional concept and
that financial dimensions are related to each other (Wang et al., 2007). Some studies
performed by rating agencies (e.g. Fitch, Moody’s, Standards & Poor’s) as well as scholars
(Capaldo et al. 2011, Navarro-Galera et al., 2015b) have related economic and social
conditions to financial distress. We also acknowledge that financial distress does not evolve
only for one single reason. LGs’ financial vulnerability is affected by diverse and interacting
approach" which focuses on the actions of internal management of LGs which is reflected on
19
More specifically, the present study – aiming at developing a model which could be used by
auditors in order to assist them in supporting LGs in preventing financial distress - belongs to
the strand of literature which measures financial condition solely on the basis of accounting
data. Therefore the model is strictly constrained to accounting data availability (Altman,
1968; Zafra-Gomez et al., 2009; Cohen et al., 2012; Padovani and Scorsone, 2012). We
consider this to be a merit of the model as it is self-sufficient and it does not depend on
ILGs provide an excellent sample to assess bankruptcy prediction models, as LGs in Italy
actually declare bankruptcy in contrary to LGs in other European countries. The proposed
model, based on logistic regression approach, allows asserting that a set of indicators built on
the basis of accounting data (measured under modified cash basis information) can assist
auditors in Italian LGs in detecting financial distress promptly, thus potentially enabling
politicians and managers to search for different ways to manage public resources in order to
avoid the detrimental consequences related to the declaration of distress. The model revealed
that the percentage of personnel expenses over revenues, the turnover ratio of short-term
liabilities over current revenues and the reliance on subsidies (calculated as subsidies per
capita) are factors discriminating non-distressed ILS from the distressed ones.
Nevertheless, there are some limitations in our study. Firstly, the model progressively loses its
predictive power in the medium term. However, this is a limitation inherent in all predictive
models. Second, the model is solely based on accounting data. This makes the model easy to
apply but on the other hand, it cannot encapsulate information about the quality of municipal
services. Thirdly, the sample size is rather small because it aimed at covering a homogeneous
period regarding bankruptcy policy. However, it includes the 75% of the bankrupt ILGs for
20
The model developed could also be applied to other countries where modified cash
accounting is adopted, and it provides an easy tool to monitor and signal financial distress.
Nevertheless, our research does not offer an exhaustive set of measures detecting financial
distress. It would be rather considered as a useful starting point for future analysis aiming at
supporting auditors to early diagnose LGs in financial distress. Further studies would add to
the financial distress detection models indicators related to outcomes that would be useful to
policy makers and financial stakeholders to assess the financial condition of LGs. Moreover,
the models could be enhanced by the inclusion of other demographic and socioeconomic
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
factors such as population density, immigration and unemployment rates. From another point
of view, investigating the reasons why LGs go bankrupt despite the application of monitoring
tools enforced by law aiming at preventing this exact event, could help auditors and, in turn,
REFERENCES
Abdesselam, R. (2006), "Mixed principal component analysis", in Nadif, M. and Jollois, F.X. (Ed.), Actes des
XIIIe`mes Rencontres SFC-2006, Metz, France, pp. 27-31.
Agresti, A. (1996),An introduction to categorical data analysis, John Wiley, New York.
Altman, E.I. (1968), Financial ratios, discriminant analysis and the prediction of corporate bankruptcy. The
Journal of Finance, Vol 23, No. 4, pp. 589-609.
Anessi Pessina, E., Nasi, G. and Steccolini I. (2008), "Accounting reforms: determinants of local governments’
choices." Financial Accountability& Management, Vol. 24, No. 3 pp. 321-342.
Bisogno, M., Manes Rossi, F. and Tartaglia Polcini, P. (2014), “ La qualità della revisione negli enti locali
italiani”, Azienda Pubblica, No. 3, pp.278-294.
Bradbury, K.L (1982),“Fiscal Distress in large U.S.”, New England Economic Review, (January /February), pp.
33-43.
Brown, K. W (1993),“The 10-Point Test of Financial Condition: Toward an Easy-to-Use Assessment Tool for
Smaller Cities”, Government Finance Review,Vol. 9, No. 6, pp. 21–26.
Brusca I., Caperchione E., Cohen S. and Manes Rossi F. (2015), Public Sector Accounting and Auditing in
Europe. The Challenge of Harmonization. Palgrave Macmillan, Hampshire, England.
Brusca, I., Manes Rossi, F. and Aversano, N. (2015), Drivers for the financial condition of Local Government: a
comparative study between Italy and Spain”,LexLocalis, Vol. 13, No.2, pp.161-184.
Cabaleiro R, Buch E. andVaamonde A. (2013), “ Developing a method to assessing the municipal financial
health”, The American Review of Public Administration, Vol. 43, No. 6, pp. 729–751.
Capaldo, E., Grossi, G. Ianni, L. and ,Sargiacomo, M. (2011) Financial Distress in the Italian Local
Governments in Yearbook of Swiss Society of Administrative Sciences, SGVW,Zurich,pp.81-92.
Caperchione, E. and Mussari, R. (2000),Comparative issues in LG accounting, Kluwer Academic Publishers,
Norwell, Massachussets.
Carmeli, A. (2007), “The Effect of Fiscal Conditions of LG Authorities on Their Economic
Development”,Economic Development Quarterly, Vol. 21, pp. 1-8.
Carmeli, A. (2008), “The fiscal distress of LG in Israel”, Administration & Society, Vol. 30, No. 8, pp. 984-1007.
21
Carmeli, A., and Cohen, A. (2001), “The financial crisis of the local authorities in Israel: A resource-based
analysis”, Public Administration, Vol. 79, No. 4, pp. 893–913.
Cohen, S.,Doumpos, M., Neofytou, E., and Zopounidis, C. (2012), “Assessing financial distress where
bankruptcy is not an option: An alternative approach for local municipalities”, European Journal of
Operational Research, Vol. 218, No. 1, pp. 270-279.
Corte dei Conti (2013), Relazione sulla gestione finanziaria degli Enti Locali - esercizi 2011 – 2012.
Corte dei Conti (2014),Audizione sul D.D.L. disposizioni urgenti in materia di finanza
locale,availableathttp://www.corteconti.it/export/sites/portalecdc/_documenti/controllo/sez_autonomie/201
4/audizione_21_marzo_2014.pdf (last visit20/03/2016)
Doumpos, M. and S. Cohen (2014), “Applying data envelopment analysis on accounting data to assess and
optimize the efficiency of Greek local governments”, Omega, Vol. 46, pp. 74-85.
García-Sánchez, I.M., Cuadrado-Ballesteros, B., Frías-Aceituno, J.V.andMordan, N. (2012),“A New Predictor of
Local Financial Distress”, International Journal of Public Administration, Vol. 35, No. 11, pp.739-748.
Gendron, Y., D. J. Cooper and B. Townley, (2007), The Construction of Auditing Expertise in Measuring
Government Performance. Accounting, Organizations and Society, Vol. 32, No. 1, pp. 101-129.
Groves, S.M. and Valente, M.G. (2003),Evaluatingfinancial Condition: a handbook for LG, 4th ed., International
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
22
Maher, C.S. and Déller, S. C. (2007), “Municipal Responses to Fiscal Stress”, International Journal of Public
Administration, Vol.30, pp.1549-1572.
Manes Rossi, F. (2011), “Analysis of solvency in Italian LG: the impact of Basel II”, The IUP Journal of
Financial Risk Management –The Icfai University Press. Vol. 8, No. 3, pp. 17-42.
Martin, J. K. (1982), Urban financial stress – Why cities go broke, Auburn House Publishing CompanyBoston,
Massachusetts.
McDougall, A. and O’Connor, K., (2005), “The Importance of Proximity in Economic Competitiveness:
Rethinking the Role of Clusters in Local Economic Development Policy”, Australasian Journal of
Regional Studies, Vol. 11, No. 1, pp. 3-24.
Murray, D. and Dollery, B. (2005),“Local council performance monitoring in New South Wales: Are ‘at risk’
councils really at risk?”, Economic Papers, Vol. 24, pp. 332–345.
Navarro-Galera, A., Lara-Rubio, J., Buendía-Carrillo, D., and Rayo-Cantón, S. (2015a), "What can increase the
default risk in local governments?",International Review of Administrative Sciences, 0020852315586308 -
first published on 29 December 2016.
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
Navarro-Galera, A., Rayo-Cantón, S., Lara-Rubio, J. and Buendía-Carrillo, D., (2015b), "Loan price modelling
for local governments using risk premium analysis", Applied Economics, Vol. 47:58, pp 6257-6276.
Ongaro, E. and Valotti, G. (2008), “Public management reform in Italy: explaining the implementation gap”,
International Journal of Public Sector Management, Vol. 21, No. 2, pp.174-204.
Padovani, E. and Scorsone, E. (2012), “Measuring financial health of LG: a comparative framework”,
Management of crisis situations by the state and the administration- The Swiss society of administrative
sciences yearbook.
Pagano, M. and Moore, R. J. T., (1985), Cities and fiscal choices: a new model of urban public investment,
Duke University Press, Durham.
Pammer, W. J. (1990), Managing Fiscal Strain in Major American Cities: Understanding Retrenchment in the
Public Sector. Greenwood Press,New York.
Park, K. (2004),“To file or not to file: the causes of municipal bankruptcy in the United States”, Journal of
Public Budgeting, Accounting and Financial Management, Vol.16, No. 2, pp.228-256.
Puntillo P. (2012), “Predictive models of default risk in LG. A logistic regression”, In Financial Reporting
Workshop, Naples (Italy), 14-15 June 2012.
Ryan, C., Dunstan, K. and Brown, J., (2002),“The value of public sector annual reports and annual reporting
awards in organizational legitimacy”,Accounting, Accountability and Performance,Vol. 8, No. 1, pp. 61-76.
Skidmore, M. and Scorsone, E. (2011),“Causes and consequences of fiscal stress in Michigan Cities”,Regional
Science and Urban Economics, Vol. 41, No. 4, pp. 360-371.
Spiotto, J.E. (2008),“Chapter 9: The last resort for financially distressed municipalities”, in Feldstein S.G.,
Fabozzi F.J., The Handbook of Municipal Bonds, John Wiley & Sons.
Steccolini, I. (2004),“Is the Annual Report an Accountability Medium? An Empirical Investigation into Italian
LG”, Financial Accountability & Management, Vol. 20, pp. 327–350.
Tabachnick, B.G. and Fidell, L.S. (1996),Using Multivariate Statistics. Harper Collins College Publishers.
Tabellini, G. (2010), “Culture and institutions: economic development in the regions of Europe”, Journal of the
European Economic Association, Vol. 8, No. 4, pp. 677-716.
Turrini A., Cristofoli, D., Nasi, G. &Soscia, I., (2010), “Lifting the veil of Maya: Measuring the implementation
gap of public management reforms in Italy”, International Journal of Public Sector Management, Vol. 23,
No. 1, pp. 5 – 21.
Wang, X., Dennis, L. &Tu, Y. S. (2007), “Measuring Financial Condition: A Study of U.S. States”, Public
Budgeting & Finance, Vol. 27, No. 2, pp. 1–21.
Watson, D. J., Handley, D.M. and Hassett, W.L. (2005), “Financial distress and municipal bankruptcy: The case
of Prichard, Alabama”, Journal of Public Budgeting, Accounting and Financial Management, Vol. 17, No.
2, pp.129-150.
23
Wilson, R.A. (1984),Allocating and reallocating financial resources in an environment of fiscal stress,
University of Arizona, Center for Study of Higher Education, Tucson, Arizona.
Wilson, S. (1978), “Choosing between Logistic Regression and Discriminant Analysis”, Journal of the American
Statistical Association, Vol.73, No. 364, pp. 699-705.
Zafra-Gómez, J. L., López-Hernández, L. M., and Hernández-Bastida, A. (2009), “Developing a Model to
Measure Financial Condition in LG: Evaluating Service Quality and Minimizing the Effects of the
Socioeconomic Environment: An Application to Spanish Municipalities”, The American Review of Public
Administration, Vol. 39, No. 4, pp. 425-449.
Francesca Manes Rossi is Associate Professor in the Department of Management and Information Technology
Downloaded by University of Newcastle At 11:28 24 January 2017 (PT)
at the University of Salerno where she teaches, researches and consults on public accounting, auditing and
performance measurement in public entities. Her research work has been published in several ranked journals
and has been presented in several international conferences.
Antonella Costanzo is Ph.D.in Economics and Quantitative Methods at the University of Cassino and Southern
Lazio. She works as jr. Researcher (CTER) at National Institute for the Evaluation of the Education and Training
(INVALSI). She researches on statistical modelling, applied statistics in economics and educational fields.
Sandra Cohen is an Associate Professor of Accounting in the Department of Business Administration at Athens
University of Economics and Business. Her research interests lie in the fields of "Public Sector Accounting",
"Management accounting" and “Intellectual Capital”. Her research work has been published in several ranked
journals and has been presented in several international conferences.
24
Auditors and early signals of financial distress in Local Governments
0
Table 1.Description of the ratios selected for the model
1
Table 3. ILGs bankruptcy status: estimates
ᇱ ଶ ሺ1973ሻ
ܴ݀ݑ݁ݏܲݏ ݊݁݀݀ܽܨܿܯ = 0.28, ݂݀ = 7;
Sign. Code *** p<0.001, ** p<0.01, *p<0.05, ‘p<0.1
2
Table 5. Predictive power of the estimated model