Legal Case Study 3: Lawsuit Regression

Executive Summary:

We have analyzed the data on the prediction of lawsuits when expanding companies hire one of the Big Five auditing firms (PricewaterhouseCoopers, Deloitte & Touche, KPMG Peat Marwick, Arthur Anderson, and Ernst & Young).

The following supports our recommendation that the firm should be indifferent re the hiring of a BIG5 auditing firm.  Generally, there are other factors such as the size of the firm, the type of industry that a firm is in and a firm’s own activities that may determine the potential for a lawsuit.

  1. Regression Variables and Descriptive Statistics

The following variables were provided and are described below:

  • Lawsuit Dummy variable = 1 if the firm has been sued during a firm-year, 0 otherwise
  • Big5 Dummy variable =1 if the firm’s auditor was a BIG FIVE, and 0 otherwise.
  • Beta Undiversified relative risk of the company’s stock from the market model regression.
  • Sigmaret Undiversified relative risk of the company’s stock from the market model regression (the standard error of the regression.
  • Cumret Undiversified relative risk of the company’s stock, the sum of the residuals from the market model regression, for the year.
  • Sales Annual sales revenue in millions of dollars.
  • Logsales The natural log of sales.
  • Chemdum Dummy variable =1 if the firm is in the chemical industry, 0 otherwise.
  • Compdum Dummy variable =1 if the firm is in the computer industry, 0 otherwise.
  • Elecdum Dummy variable =1 if the firm is in the electronics industry, 0 otherwise.

The data set consists of 1,988 obervations of firm-years between 1988 through 1991 compiled by Jennifer Francis, Donna Philbrick and Katherine Schipper.  A firm-year is defined as one firm in one year.

According to the outcome of their study, the probability of being sued given that the firm had a Big 5 auditor was nearly 4 times greater than firms that did not have a Big 5 auditor.  This can be seen from the regression below, the probability of having a Lawsuit given that a firm employs a Big 5 auditor is approximately 6.25% vs. 1.7% without a Big 5 auditor. (Denis this should be the probability of being sued if represented by big5 firm increases by 4.5%).

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