Accounting Scandal Announcements: A Test Of Market Efficiency

Abstract

This paper examines the hypothesis that the stock market overreacted to accounting scandals during 2002, resulting in extensive drops in share value followed by return reversals that reveal market inefficiencies. Data are gathered for nine firms directly involved in an accounting scandal, as well as the major competitors of those firms. An empirical test of returns for all thirty-three firms reveals that an investment strategy of selling short scandal firms and their competitors, followed by a contrarian investment strategy of buying those same stocks, resulted in risk-adjusted returns well above those expected for a period of one year after the scandal. These results reveal stock market inefficiencies and a potential to realize abnormal returns by capitalizing on investor overreaction.