Knowledge that Transforms

This article analyzes the impacts that three alternative damage apportionment rules have on an owner's financial-reporting decision, an auditor's audit-quality choice, and investors' pricing decisions within the context of a perfectly competitive securities market and owner solvency constraints. The strategic interactions between the players' strategies are analyzed within a setting where payoffs are endogenously determined and vary with the damage apportionment rule. These comparisons speak to potential changes resulting from the Private Securities Litigation Reform Act of 1995 which replaced joint-and-several liability with a proportionate liability rule. The main finding is that the audit failure rate can decrease when there is a switch from a joint-and-several to a proportional liability rule despite the fact that audit quality has also declined. This result occurs when there are strategic interactions between the owner's reporting strategy and the auditor's quality decision.

The paper provides early evidence on the informativeness of commodity price risk measures required by the Securities and Exchange Commission's new market risk disclosure rules (SEC 1997). I use existing disclosures of oil and gas producers (O&G) to obtain proxies for the tabular and sensitivity analysis disclosures required by the new SEC rules. I find that proxies for the tabular and the sensitivity analysis format are significantly associated with O&G firms' stock return sensitivities to oil and gas price movements. This finding casts doubt on claims that the new market risk disclosures do not reflect firms' risk exposures. The proxies for the tabular format and sensitivity format disclosures are not substitutable explanations of firms' risk exposures. This evidence suggests that disclosures from one disclosure format are not comparable to those from the other reporting format.

Theory suggests that earnings response coefficients (ERCs) are positively associated with expected earnings growth and negatively associated with equity risk. Dhaliwal and Reynolds (1994) (DR) hypothesize that equity beta fails to capture a default risk component of equity risk and demonstrate that ERCs are negatively associated with two measures of default risk—bond ratings and debt/equity ratios—in a regression model that contains equity beta. Bond ratings and debt/equity ratios are associated with expected earnings growth. This paper examines how the association between ERCs and default risk is impacted by the inclusion of expected earnings growth in the model. The relation between ERCs and bond ratings is not significant, while the association between ERCs and debt/equity ratios is weakened but is still significant. These findings suggest part of the reason for the negative association between ERCs and default risk in DR is that their default risk proxies also reflect expected earnings growth. In fact, there is no incremental association between ERCs and default risk when equity beta, bond ratings, and expected earnings growth are in the model.