Quis Auditoret Ipsos Auditores? Can Auditors Be Trusted?

This article explores the extent to which the audit profession and its practices promote public trust in audits. Differences between auditors and non‐auditors as to beliefs about the role of a financial report audit have long been discussed under the term ‘expectations gap’. However, this prior debate has tended to focus on non‐auditors’ alleged misunderstanding of audit processes without a corresponding understanding on the part of the profession as to why the public might place its trust in auditors. The study explores the nature of trust in an auditing context and notes that like any profession, auditing faces practical limitations but the inability to directly observe the conduct of audits combined with professional status create an ‘over trust’ expectation in the public. Changes in audit practices and culture have also exposed the profession to criticism. The article seeks to offer one approach by which the auditing profession can restore public confidence; namely, evidence‐based practice, which has proven effective in improving the quality of practice in medicine. Adoption of a reflective evidence‐based approach to audit practice offers the promise of greater audit quality and an improvement in the profession's accountability and public confidence.     

Can Employees Be Used to Overcome Independent Audit Limitations?

Independent financial statement auditors are appointed by shareholders to provide reasonable assurance on the reliability of financial statements published by management of reporting entities. However, in the last two decades questions have been raised concerning the credibility of external audits due to their apparent failure, especially following the spate of corporate collapses. This paper applies a critical review of literature and a multi‐theoretical governance perspective to examine the inherent limitation of independent external audits and argues that employees can contribute to reducing the limitation gap by strengthening governance through a structure that incorporates a board and employee management representation. It is argued that through this arrangement, auditors can benefit as they will be privy to additional information from employees about issues such as irregular matters that impact upon shareholders and other stakeholders, and control weaknesses across governance levels, allowing auditors to establish a broader understanding of organisational information that may otherwise be less readily available. Thus auditors can base their judgements in terms of audit risks, and develop audit plans based on more reliable information. The theoretical proposition emerging from these findings is that the traditional governance model should be refined to include employees as an additional component of governance.     

Can Stock Volatility Be Benign? New Measurements and Macroeconomic Implications

We find nonsynchronized movements of two new measures of financial market uncertainty—good and bad volatility—which are based on the maximum and minimum stock prices within a month. Good (bad) volatility is associated with better (worse) expectations about the future economic situation and clearly signals acceleration (deceleration) in economic activity. The VAR results indicate that (i) output, employment, and stock price plummet rapidly in response to a bad volatility shock, while their responses to a good volatility shock are modest, and (ii) bad volatility shocks explain the bulk of economic activity and stock price fluctuations in the medium run.     

Can Operating Leverage Be the Cause of the Value Premium?

Recent theoretical models (Carlson, Fisher, and Giammarino, 2004) predict an association between the book-to-market equity ratio (BE/ME) and operating leverage in the cross-section. Consistent with these models, we find a positive association between BE/ME and the degree of operating leverage (DOL), between DOL and stock returns, and between DOL and systematic risk. Overall, our findings provide support for a risk-based explanation for the value premium that is consistent with existing theoretical models. The evolution of systematic risk associated with firm-level investment activity, rather than financial distress, seems to be the main determinant of the value premium.     

Can the Gains from International Diversification Be Achieved without Trading Abroad?

We examine whether portfolios of domestically traded securities can mimic foreign indices so that investment in assets that trade only abroad is not necessary to exhaust the gains from international diversification. We use monthly data from 1976 to 1993 for seven developed and nine emerging markets. Return correlations, mean-variance spanning, and Sharpe ratio test results provide strong evidence that gains beyond those attainable through home-made diversification have become statistically and economically insignificant. Finally, we show that the incremental gains from international diversification beyond home-made diversification portfolios have diminished over time in a way consistent with changes in investment barriers.     

Valuing Loss Firms: What Can Be Learned From Analysts' Forecasts?

Prior research documents an anomalous negative price–earnings relation when a simple earnings capitalization model is estimated for loss‐making firms. Collins et al. (1999 ) suggest that the model is misspecified due to the omission of book value of equity. However, results from previous studies are confusing. We try to enrich prior literature by focusing on analysts' forecasts. In particular, we assess the role of earnings and book value in valuing loss firms using several measures based on the information provided by analysts. We hypothesize that the role of accounting figures depends on whether the loss firm is supported or not by investors. According to this argument, we construct several measures of investor support based on analysts' forecasts, and then test the value relevance of accounting information depending on the degree of support. Our results confirm the usefulness of the notion of ‘investor support’. For those loss firms that are expected to liquidate, we find that the inclusion of book value of equity in the model removes the negative sign on the earnings coefficient. However, for those loss firms that are expected to reverse current losses, we find that the coefficient on earnings remains negative despite the inclusion of book value.     

The Long‐Run Fisher Effect: Can It Be Tested?

In this paper, I provide a plausible explanation as to why past studies have been unable to find support for the long-run Fisher effect. My argument is that exogenous shocks to the inflation rates in industrialized economies have not produced the permanent change to inflation necessary for testing the Fisher effect. Instead of finding a nonstationary, unit-root process for inflation like previous Fisher effect studies, here each country's inflation rate is found to follow a mean-reverting, fractionally integrated, long-memory process. Applying a bivariate, maximum likelihood estimator to a multivariate, fractionally integrated model of inflation and nominal interest, I find that the estimated inflation rates in 17 developed countries are highly persistent, fractionally integrated, mean-reverting processes with order of integration parameters significantly less than one. Since a permanent change to inflation has not occurred, a test of whether a permanent change to inflation affects the nominal interest rate one-for-one will be uninformative as to the truth or fallacy of the Fisher effect hypothesis.     

Can News Be a Major Source of Aggregate Fluctuations? A Bayesian DSGE Approach

We examine whether the news shocks, as explored in Beaudry and Portier (2004) , can be a major source of aggregate fluctuations. For this purpose, we extend a standard dynamic stochastic general equilibrium model of Christiano, Eichenbaum, and Evans (2005) and Smets and Wouters (2003, 2007) by allowing news shocks on the total factor productivity (TFP), and estimate the model using Bayesian methods. Estimation results on the U.S. and Japanese economies suggest that (i) news shocks play a relatively more important role in the United States than in Japan, (ii) a news shock with a longer forecast horizon has larger effects on nominal variables, and (iii) the overall effect of the TFP on hours worked becomes ambiguous in the presence of news shocks.     

Saving the Euro: Mitigating Financial or Trade Spillovers?

This paper analyzes through what channels the euro crisis affected firms and the efficacy of policies to mitigate the crisis. It analyzes stock price responses for 3,045 nonfinancial firms in 16 countries to four key policy events during 2010–11. Using precrisis benchmarks, it separates financial effects from trade effects and examines how bank and trade linkages propagated shocks. It finds that policy measures affected financially dependent firms more, particularly in creditor countries with greater bank exposure to peripheral euro countries, in statistically and economically significant ways. Trade linkages with peripheral countries played little role, although euro movements meant some differential effects.     

Should Derivatives Be Privileged in Bankruptcy?

Derivatives enjoy special status in bankruptcy: they are exempt from the automatic stay and effectively senior to virtually all other claims. We propose a corporate finance model to assess the effect of these exemptions on a firm's cost of borrowing and incentives to engage in derivative transactions. While derivatives are value‐enhancing risk management tools, seniority for derivatives can lead to inefficiencies: it transfers credit risk to debtholders, even though this risk is borne more efficiently in the derivative market. Seniority for derivatives is efficient only if it provides sufficient cross‐netting benefits to derivative counterparties that provide hedging services.     

Can regulation de-bias appraisers?

This paper examines the effect of a regulatory action (the Home Valuation Code of Conduct) that was designed to reduce the incidence of inflated collateral valuations. We identify the impact of the regulation using a difference-in-difference identification strategy. Our baseline results confirm that the regulation reduced inflated valuations in refinance transactions by 16% in the large lender sample, compared to small lenders and a placebo sample. The effect is most significant in low-liquidity and low-distress markets, but not in other markets. We find that the regulation had a significant impact on loan to value ratio and interest rate, and it also led to a significant increase in defaults but a decrease in prepayments.     

Can you handle failure?

Handling failure and blame is key to managerial success. But roughly 70 % of Americans have a personality type that tends to react inappropriately when things go wrong. Some people are extrapunitive, always pointing a finger at someone else. Others are impunitive, denying there's a problem or that they played any role. And still others are intrapunitive, heaping too much blame on themselves and seeing disasters where none exist. Fortunately, there are ways to fix such flawed responses. The first step is to cultivate self-awareness; several personality tests can help you assess your interaction style. Next, deepen your political awareness to better understand what messages others are receiving. Once you've identified your bad habits, you can move toward more-adaptive responses. Dattner and Hogan describe several strategies that can benefit any of the personality types. You should make sure to listen and communicate well, reflect on the situation and the people involved, think carefully before acting, and look for lessons when mistakes do happen. Using detailed examples, the authors illustrate how people with the various personality types are apt to react to specific failures and explain what they might do differently. They also offer insights to help you recognize when your bosses, peers, or subordinates fit into one of the problematic categories and suggest ways to influence their behavior. The taxonomy and tactics they present will help you approach failure with an open mind and react in a balanced, constructive way.     

Are Happy Investors Likely to Be Overconfident?

This study investigates the relationship of investors' happy sentiment and overconfidence effect. Sunshine, temperature, former returns, and margin loan change rate are used as proxies for happy sentiment. Using data from Taiwan Stock Exchange and principal component analysis, the happy sentiment index is divided into two categories: "natural environment happiness" and "investment atmosphere happiness." The results suggest that when natural environment happiness is stronger, investors are less likely to have overconfidence. On the contrary, when investment atmosphere happiness is stronger, investors are more likely to have overconfidence.     

Can learnability save new-Keynesian models?

McCallum (2009) argues that “learnability” can save new-Keynesian models from indeterminacies. He claims the unique bounded equilibrium is learnable, and the explosive equilibria are not. However, he assumes that agents can directly observe the monetary policy shock. Reversing this assumption, I find the opposite: the bounded equilibrium is not learnable and the unbounded equilibria are learnable. More generally, I argue that a threat by the Fed to move to an “unlearnable” equilibrium for all but one value of inflation is a poor foundation for choosing the bounded equilibrium of a new-Keynesian model.     

Can Relationship Banking Survive Competition?

How will banks evolve as competition increases from other banks and from the capital market? Will banks become more like capital market underwriters and offer passive transaction loans or return to their roots as relationship lending experts? These are the questions we address. Our key result is that as interbank competition increases, banks make more relationship loans, but each has lower added value for borrowers. Capital market competition reduces relationship lending (and bank lending shrinks), but each relationship loan has greater added value for borrowers. In both cases, welfare increases for some borrowers but not necessarily for all.     

Can CEO dismissals be proactive?

We find significant variation in the prior stock returns of firms that dismiss their CEOs between 1996 and 2008. 49% of firms that dismiss their CEOs do so in the absence of negative industry-adjusted stock returns prior to dismissal (37% dismiss in the absence of negative raw returns). We find evidence for two reasons why boards may dismiss CEOs early, i.e., in the absence of significant poor prior stock performance. First, we find that early dismissals are more likely to be associated with corporate scandals, suggesting that CEOs that are found to engage in unethical or illegal activities are dismissed although their actions may not have a significant adverse impact on firm value. Second, we find support for the argument that early dismissals are proactive actions by boards to dismiss low ability CEOs. We find that firms with more equity-based compensation for directors and higher independent director ownership are more likely to dismiss their CEOs early. Boards with strong incentives are more likely to be proactive and act on their private information about the CEO than boards with poor incentives. Early dismissal firms experience a short-lived decline in operating performance around the date of CEO dismissal, and their operating performance recovers immediately after the CEO is replaced. On the other hand, the operating performance of late dismissal firms declines significantly prior to dismissal and improves substantially after dismissal. We also find that CEOs that are dismissed early are not more likely to find new CEO positions than CEOs that are dismissed late, supporting the idea that early dismissal CEOs may not have different ability than late dismissal CEOs.     

Can CoCo-bonds mitigate systemic risk?

After the 2008 financial crisis, the idea of contingent convertible (CoCo) capital was revived as a means to stabilize individual banks, and hence the entire banking system. The purpose of this paper is to empirically test, whether CoCo-bonds indeed improve the stability of the banking system and reduce systemic risk. Using the broadly applied SRISK metric, we obtain contradicting results, which are based on the accounting of the CoCo-bond as debt or equity. This observation is problematic, as CoCo-bonds generally increase the loss-absorbing capacity of a bank. We remedy this shortcoming by proposing an adjustment to the original SRISK formula. Using empirical tests, we show that the undue disparity has been solved by our adjustment, and that CoCo-bonds reduce systemic risk, irrespective of their accounting. Our results are robust to different parametrizations and accounting standards, as well as issuance effects.     

Can herding improve investment decisions?

Existing models show that herding in decisions can cause significant information loss, inferior information aggregation, and impaired decision making. However, we show that in a multistage decision setting with endogenous information production, herding on the initial decision can actually result in superior aggregate information and improved decisions. This is because the possibility of herding by a follower incentivizes the leader to increase its ex ante information production to an extent that it can dominate the information loss from herding. Examples include decisions to enter new markets, fund R&D, and provide early‐stage venture capital.