DCAA believes a bankruptcy prediction model is another key tool that provides insight into a contractor’s financial health. Auditors are instructed to use one of the three "Z-Score" prediction models developed by Dr. Edward Altman.
A contractor falls into one of the three models. Model l represents publicly traded manufacturing companies (primarily SIC codes 2000 through 3999), Model ll represents all privately held companies while Model lll represents all remaining companies. The bankruptcy models take several variables corresponding to key financial ratios – working capital/total assets, retained earnings/total assets, earnings before interest and taxes/total assets, stockholder equity/total liabilities and sales/total assets – and assigns point scores to each variable and computes a weighted average score that takes into account the contractor’s scores and how they compare against industry averages. (See Figure 14-3-2, The Altman Z-Score Formulas, in a recent DCAA Contract Audit Manual for additional information on the computation of Z-Scores.) DCAA maintains data for publicly traded companies and industry averages which are available at its OTST ??? and also provides software programs for entering financial data and computing the prediction model scores.
Auditors are cautioned against putting excessive reliance on Z-scores but are told to use it as an initial indicator of financial problems. When using the Z-scores, auditors are encouraged to perform trend analysis of the current and previous two years as well as comparisons to industry averages. When the Z-Scores are below certain specified levels auditors are told a financial capability audit may be required. They are told to consider Z-Score trends, ratio analysis, financial statement evaluations and other indicators in deciding whether to go further.
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