A comparison of nearest neighbours, discriminant and logit models for auditing decisions

Abstract

This study investigates the efficiency of k-Nearest Neighbours (k-NN) in developing models for estimating auditors' opinion, as opposed to models developed with discriminant and logit analyses. The sample consists of 5,276 financial statements, out of which 980 received a qualified audit opinion, obtained from 1,455 private and public UK companies operating in the manufacturing and trade sectors. We develop two industry-specific models and a general one using data from the period 1998-2001, which are then tested over the period 2002-2003. In each case, two versions of the models are developed. The first includes only financial variables. The second includes both financial and non-financial variables. The results indicate that the inclusion of credit rating in the models results in a considerable increase both in terms of goodness of fit and classification accuracies. The comparison of the methods reveals that the k-NN models can be more efficient, in terms of average classification accuracy, than the discriminant and logit models. Finally, the results are mixed as it concerns the development of industry-specific models as opposed to general ones.