LITIGATION RISK FOR AUDITORS AND THE RISK SOCIETY

The auditing industry has mounted a global campaign to reduce its liability. In Canada, it is attempting to change from a doctrine of joint and several liability to proportionate liability, to have the Federal government legislate a statutory cap on liability, or to have the Provincial governments approve the establishment of Limited Liability Partnerships. These initiatives are consistent with the proposals of the CPA firms in the US and the CA firms in the UK. This cross-national trend suggests that a global theory of society is needed to analyze the consequences of audit risk. This paper uses the “risk society” model proposed by Beck to understand why the audit industry focuses on reducing exposure to liability, rather than on improving the quality of audits. Beck's theory of “reflexive modernization” provides an analysis of the so-called “liability crisis” that attempts to overcome the institutional construction offered by the auditing industry. The paper recognizes that it is very difficult for observers outside of the large auditing firms to judge the real risks of audits and to develop alternative public policy options. Ideally, we should be able to evaluate litigation in a modern audit environment. However, the audit firms are not required to disclose sufficient information about their costs to determine the real impact. Meanwhile, professional groups are lobbying hard for changes that will reduce auditors risk without addressing the root causes of audit failures.     

STOCK MARKET REACTION TO GOOD AND BAD INFLATION NEWS

This article shows that differentiating between good and bad inflation news is important to understanding how inflation affects stock market returns. Summing positive and negative inflation shocks as in previous studies tends to wash out or mute the effects of inflation news on stock returns. More specifically, we find that, depending on the economic state, positive and negative inflation shocks can produce a variety of stock market reactions. We conclude that the effect of inflation on stock returns is conditional on whether investors perceive inflation shocks as good or bad news in different economic states.     

STOCK MARKET REACTION TO ETHICAL INITIATIVES OF DEFENSE CONTRACTORS: THEORY AND EVIDENCE

This paper offers an Investor Decision Framework (IDF) to describe and measure investor behavior toward social responsibility information. This framework seeks to explain how investors perceive the effects of social responsibility information on firm value. The formation in 1986 by 32 major defense contractors of the Defense Industries Initiative (DII) provides an ideal example to assess stock market reaction to an ethical initiative. The performance of the DII firms was compared with that of a control group of non-DII defense firms, which did not sign the agreement, in order to measure and determine the extent to which the market placed substance on the DII as a public commitment to ethics. We initially posited that the DII firms stock price would move in a significantly positive direction. However, when our analysis revealed a significant negative impact not only on DII, but also on non-DII defense stock prices, we were forced to reject thisa priorihypothesis. The market interpreted this ethical initiative as (i) a precursor of future sanctions towards firms engaged in defense contracting or (ii) as a penalty for social irresponsibility imposed by socially conscious investors. Either way, it would have a negative impact upon future cash flows.     

SENSITIVITY OF INVESTOR REACTION TO MARKET DIRECTION AND VOLATILITY: DIVIDEND CHANGE ANNOUNCEMENTS

We examine whether investor reactions are sensitive to the recent direction or volatility of underlying market movements. We find that dividend change announcements elicit a greater change in stock price when the nature of the news (good or bad) goes against the grain of the recent market direction during volatile times. For example, announcements to lower dividends elicit a significantly greater decrease in stock price when market returns have been up and more volatile. Similarly, announcements to raise dividends tends to elicit a greater increase in stock price when market returns have been normal or down and more volatile, although this latter tendency lacks statistical significance. We suggest an explanation for these results that combines the implications of a dynamic rational expectations equilibrium model with behavioral considerations that link the responsiveness of investors to market direction and volatility.     

STOCK MARKET REACTION TO ANTICIPATED VERSUS SURPRISE RATING CHANGES

I examine whether bond rating changes can be anticipated by investors and test whether the stock price reaction to the eventual change varies as a result. All else equal, the market reaction to changes that could have been easily predicted should be significantly smaller than the reaction to changes that are largely a surprise. Although rating upgrades prove difficult to predict, approximately 20% of downgrades can be correctly predicted using a relatively small number of publicly available variables. There is no significant difference between the stock price reaction to anticipated versus unanticipated rating changes.     

THE EFFECT OF MARKET CONDITIONS AND RISK CLASSIFICATIONS ON MARKET MODEL PARAMETERS

This article reports the results of tests used to detect shifts in market model parameters during bull and bear market conditions. The evidence indicates that the parameters exhibit nonstationarity during market advances and market declines for certain predetermined stock groups. Specifically, the parameters of stocks in high-risk and low-risk classifications behave as if they are affected by the alternating forces of bull and bear markets.     

MARKET REACTION TO NATIONAL DISCRETION IN IMPLEMENTING THE BASLE ACCORD

We report the wealth effects among banks in the United States, Japan, Canada, and the United Kingdom in reaction to public announcements concerning their respective national implementation of the 1988 Basle Accord, an international risk-based capital regulatory agreement. Previous survey findings indicate bankers in different countries perceive that national discretion could threaten the competitive equity goals of the new risk-based capital rules. Based on a multivariate regression model using seemingly unrelated equations, we find significantly positive and negative market reactions by bank investors to individual announcements of different countries' post-Accord capital rules. However, no particular country's banks were systematically advantaged or disadvantaged with national discretion announcements viewed in aggregate. Although national discretion does affect bank wealth, the evidence does not suggest that national implementation compromises the competitive goals of the Accord.