Academic journal article Academy of Accounting and Financial Studies Journal

Weak-Form Market Inefficiency and Fraudulent Financial Reporting

Academic journal article Academy of Accounting and Financial Studies Journal

Weak-Form Market Inefficiency and Fraudulent Financial Reporting

Article excerpt

INTRODUCTION

The purpose of this study is to determine if the security prices of firms that are revealed to have engaged in fraudulent financial reporting (FFR) are weak-form inefficient. The incentives of institutional investors to incur information processing costs that can reveal biases (including fraud) in reported accounting information provide a rationale for hypothesizing weak-form inefficiency for FFR firms.

This study examines how the bias in accounting data due to FFR can prevent the contemporaneous impounding of accurate information in the security prices of FFR firms prior to the revelation of FFR. The bias effect is observed in a failure on the part of firms engaging in FFR to achieve weak-form market efficiency. This study tests for this failure in the year prior and the year following the public announcement of FFR for firms accused of fraud by the Securities and Exchange Commission (SEC) during 1998-2002.

Two factors motivate this study. First, Kothari (2001) asserts that the prices of securities establish the wealth that is allocated to both firms and individuals. Kothari (2001), like Lee (2001), considers the primary goal of market efficiency research to be the improvement of the market's allocation efficiency. Lee argues that accounting researchers have a distinct advantage in the arena of market efficiency research because this efficiency can be accomplished through the better application of accounting information to solve existing problems. Since accounting data affect the valuation of securities, the examination of abnormal market behavior associated with fraudulent accounting information adds value by increasing knowledge of the wealth allocation process and the process by which accounting information is impounded in security prices. In particular, it is important to understand the extent to which fraudulent accounting information is impounded in security prices prior to public revelation of fraud and the extent to which investors who have incentives to process information are able to detect biases in the information prior to revelation of the fraud. Second, Bloomfield's (2002) Incomplete Revelation Hypothesis takes a cost-benefit approach to market efficiency. He suggests that investors will weigh the costs of becoming more informed against the anticipated benefits of trading with superior information. This study tests the implications of the Incomplete Revelation Hypothesis.

This research study makes a number of contributions that incorporate and extend the current literature. Fama (1991) believes that contributions to the market efficiency body of literature must be rated on their capacity to explain securities' time-series and cross-section performance. He contends that daily stock price data provide precise measurement of market efficiency while avoiding the joint hypothesis problem. This study extends the literature as Fama recommends. The joint hypothesis problem is avoided by the use of daily stock price data. It moves beyond current market efficiency literature by testing price response on an individual stock basis. Given that researchers (Chan, 1993; Sias and Starks, 1997) have concluded that individual stock autocorrelations are statistically insignificant, finding significant autocorrelations for FFR firms provides stronger evidence that these firms' behavior is unique with respect to market efficiency. Bushee (1998) supports research that focuses on a small, distinct sample of firms. This study does that with its examination of market inefficiency for firms accused of FFR by the SEC. To increase the validity of significant market inefficiency for FFR firms, a matching sample is employed that can be compared to conclusions of previous literature and the FFR sample.

The results of this study support both H1 and H2, which posit that the security prices of firms accused of FFR are weak-form market inefficient both before and after the public announcement of fraud. …

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