Improving the effectiveness of predictors in accounting-based models

Purpose Financial ratios are routinely used as predictors in modelling tasks where accounting information is required. The purpose of this paper is to discuss such use, showing how to improve the effectiveness of ratio-based models. Design/methodology/approach First, the paper exposes the inadequacies of ratios when used as multivariate predictors. It then develops a theoretical foundation and methodology to build accounting-based models. Experiments then verify that this methodology outperforms the conventional methodology. Findings From plausible assumptions about the cross-sectional behaviour of accounting data, the paper shows that the effect of size, which ratios remove, can also be removed by modelling algorithms, which facilitates the discovery of meaningful predictors and leads to markedly more effective models. Originality/value The paper provides a solid foundation for accounting-based modelling, by developing a whole new methodology that can end the uncritical use of modelling remedies currently prevailing and release the full relevance of accounting information when utilised to support investments and other value-bearing decisions.