Journal of Business and Behavioral Sciences Volume 23, Number 1 issn 1946-8113 Spring 2011 inthis issue

The PCAOB was arguably created in response to an increasing lack of confidence on the part of investors. However, questioning the value of the PCAOB, a retired audit partner argues that ―the cost to business of this de facto governmental agency yields little to no benefit to investors‖ (Hill et al, 2007). Investor confidence arguably is influenced by perceived auditor independence or the perception of quality corporate governance since the investing public has no ability to assess the real state of these matters first hand. Does existence of PCAOB oversight influence investor confidence in audit reports?

There are a wide variety of investors, from institutional to individual investors. Some are more informed than others. We define a well-informed investor is someone who stays current with business news, pays attention to news about the state of the economy, earning trends, business related regulation and so on. There are investors who may not view themselves as such. In a survey 58% reported owning a 401K but did not see themselves as belonging to the investor class (Zogby, 2009). Zogby calls them the ―invisible stockholder next door‖ (2009). We sought to obtain opinions of individual investors regarding their awareness of PCAOB, their views on increased regulation, auditing standards, their confidence in audited financial statements and the information furnished by companies. We also solicited their opinion on expanding PCAOB‘s jurisdiction to include regulating the currently un-regulated segment of financial sector: private funds including hedge funds and private equity. Both are pools of money used to invest in different opportunities, not unlike mutual funds. The difference is mainly in the types of investors and the types of companies these funds invest in.

A Pew Research survey conducted in October 2008 finds that the public is divided about the efficacy of government regulation in general: only 46% of the respondents said that weak governmental regulation of financial institutions contributed a lot to the recent problems; 50% believed regulation is necessary to protect the public interest (Pew, 2008). Given this ambivalence, would expansion of PCAOB jurisdiction or creation of yet another agency to monitor financial sector (particularly hedge funds and private equity) help restore public confidence?

We surveyed 138 individuals representing a convenience sample of patrons at two health clubs. Tabulation of demographic measures revealed that 53

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We asked respondent how informed they considered themselves on economic and financial matters. 37 percent checked themselves as well informed, 48.6 percent somewhat informed, and 14.5 percent uninformed. Only 6.7 percent of the well and somewhat informed respondents (85.6% of total respondents) had even heard of PCAOB, let alone know or understand what it does. A far greater number (46.4%) were aware of SOX but not necessarily what it entails.

Respondents were also asked their views on who should set accounting rules. A slim majority (51.4%) believed that accounting rules ought to be set by experts in the field, only 27.5 percent indicating a preference for the government. However, this preference dropped sharply if ―government‖ meant ―political appointees without appropriate background‖. Expressing an often debated sentiment of business knows best, a small percentage (9%) indicated that corporations should set standards (11.6% checked ―other‖ but without elaborating). Many respondents were skeptical of the information companies furnish and of government‘s ability to be an effective watchdog.

As seen in Table 1 below, respondents expressed little or no confidence in (1) auditors objectively auditing financial statements), (2) information provided by companies is not misleading, and (3) government‘s ability to be an effective watchdog.

regulations with respect to these financial instruments and practices. Since most respondents did not know anything about the PCAOB in the first place, asking them about expanding the board‘s mandate becomes meaningless. An overwhelming majority did not believe that the financial sector (e.g., Wall Street) was adequately regulated (73.2%); however, a majority considered the accounting profession to be adequately regulated (54.3%).

Interestingly, a majority of respondents wanted government oversight of hedge funds (69.6%) but not private equity (33.3%). It seems respondents considered anything ―private‖ as off limit. This underscores the fact the most respondents (68%) did not understand the nature of private equity or hedge funds and the negative consequences they may pose for the public.

SUMMARY

A string of accounting scandals and irregularities over the past ten years resulted in loss of investor confidence and invited increased regulation. The accounting profession contributed its share of ―crisis of confidence‖ which led to the Sarbanes Oxley Act of 2002. No one wants to return to the pre-SOX system of self-regulation but it is not clear if a quasi-governmental accounting oversight body, the PCAOB, is the answer.

Our review revealed that the PCAOB‘s operating expenses grew from modest 29 million in 2003 to budgeted 183 million in 2010. Besides the 5 board members, the PCAOB has 35 top management positions. The Board issued six auditing standards, five remain in effect. The Board has been busy carrying out inspections of registered firms, large and small. The number of firms registered to date total 2,349, the number of inspection reports issued to date total 1156; number of reports disclosing quality control criticisms total 79, and number of disciplinary action cases settled to date total 32.

In the standard setting arena, the PCAOB does not seem equipped to be an effective and efficient standard setter. Many firms registered with the PCAOB (70%) did not issue an audit report and therefore were not required to be registered. However, these firms apparently believed that there was some value to be seen as a PCAOB registrant. It is one indicator that suggests that the marketplace (firms, clients, investors) perceives that the PCAOB provides a level of assurance of quality. Other than that and some anecdotal evidence of improved internal controls, the benefits of PCAOB are not clear, especially in terms of investor confidence. Since the SEC is responsible for maintaining investor confidence, it is difficult to gauge the direct impact of PCAOB. Majority of respondents in our survey were skeptical of information companies furnish including audited financial statements. Respondents also expressed doubt in government‘s ability to be an effective watchdog. This is not surprising in light of recent financial/banking crisis. However, it is not PCAOB‘s charge to

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Unfortunately regulation per se may not be sufficient as individual integrity is often suspect in corporate failure. No matter how far the pendulum swings towards regulation as a matter of public interest, there will always be a risk of management fraud and abuse for even the so called informed investors. A system that privatizes gains, socializes losses cannot just be mended. For public confidence in the capital markets and the information released by various providers (companies produce financial statement; auditors certify those statements), a complete overhaul may be necessary.

Our survey revealed considerable skepticism in the government‘s ability to institute meaningful regulatory reforms. However, regulation aimed at protecting investors as well as protecting the financial system from systemic risk will go a long way towards diminishing this skepticism. Regulations in the area of transparency (increased disclosure requirements), leverage and plugging financial sector loopholes would be most consequential in protecting public interest. Limitations associated with the study include lack of benchmark as to what investor confidence was prior to the establishment of the PCAOB and use of a convenience sample. Many challenges PCAOB including hiring and staff training, acquiring ability to assess risks, and ensuring that auditors understand clients business and transactions. Other complex issues on the Board‘s agenda in the foreseeable future might include assurance of XBRL data, monitoring work of IAASB and IAS to leverage auditing standards, possible standard setting and inspection of firms with broker-dealer clients.

REFERENCES

Glover, S. M., Prawitt, D. F. & Taylor, M. H. (2009) Audit Standard Setting and

Inspection for U.S. Public Companies: A Critical Assessment and

Recommendations for Fundamental Change in Accounting Horizons.

June. Vol. 23, Iss. 2; pg. 221, 17 pgs. Hill, N.T, McEnroe, J. E. & Stevens, K. T. (2007). Auditors‘ reactions to

Sarbanes Oxley, CPA Journal. July 2007: 6-11. Kranacher, M. (2008). The PCAOB‘s Primary Mission: Improving Confidence in

Financial Reporting, CPA Journal. January: 14-20. Lennox, C., & Pittman, J. (2008). Auditing the auditors: Evidence on the recent

reforms to the external monitoring of audit firms. Working paper, Hong

Kong University of Science and Technology, 2008 Palmrose, Z. (2006). Maintaining the value and viability of auditors as

gatekeepers under SOX: An auditing master proposal, Financial

Gatekeepers: Can They Protect Investors, edited by U. Fuchita and R.

Litan, 103-135. Baltimore, MD: The Brookings Institute.

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PCAOB, Release 2008-008: Report on the PCAOB's 2004, 2005, 2006, and 2007

Finances, http://people-press.org/report/458/economic-crisis October 15.

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Longwood University

Insider trading is defined as the trading of a corporation's stock or other securities such as bonds by individuals with potential access to non-public information about the company. Legal trades by insiders are common, as employees of publicly-traded corporations often hold stock or stock options. For example, if a corporate insider plans on retiring after a period of time and, as part of his or her retirement planning, adopts a written, binding plan to sell a specific amount of the company's stock every month for the next two years, and during this period the insider comes into possession of material nonpublic information about the company, any subsequent trades based on the original plan might not constitute prohibited insider trading. This type of trading would be considered legal insider trading. On the contrary, if individuals like Galleon Group founder

Asbell and Bacon

Raj Rajaratnam trade on insider information to get an improper edge on other investors, this is classified as illegal insider trading.

How fast does the stock market react to insider purchase announcements? According to Fama (1970), market efficiency can take on three forms: weak, semi-strong, and strong form efficiency. It follows that the information embedded in insider purchase announcements could be tested to determine how fast stock price reacts to this news and whether the reaction is weak, semi-strong, or strong form efficient. This study investigates whether an investor can achieve an above normal return by trading on insider purchase information.

The purpose of this study is to test the semi-strong form efficient market hypothesis by analyzing the effects of insider trading announcements on the risk adjusted rate of return of the firms‘ stock prices. Specifically, how fast will a firm‘s stock price react to the insider purchase announcements examined? This study tests whether insider purchase announcements directly incorporate the strong form, semi-strong form, or weak form of the efficient market hypothesis based on the timing of insider purchases. Using the standard event study methodology, this research tests the effects of a random sample of insider purchase announcements on the risk adjusted rate of return of the firms‘ stock prices. If a semi-strong efficiency is observed, then no investor can earn an above normal return by acting on this information on the announcement date.

Eugene Fama (1970) defined market efficiency in terms of how fast the stock market reacts to information. He suggested three kinds of market efficiency: weak form, semi-strong form, and strong form efficiency. According to weak form efficiency (Fama et. als, 1969), historical price information cannot be used to achieve excess returns. If the market is weak form efficient, then stock price reacts so fast to all past information that no investor can earn an above normal return by acting on this type of information. For example, if an investor receives the firm‘s annual accounting report and buys the firm‘s stock after discovering the firm had high earnings for the period and then stock price does not rise, the market is said to be efficient with respect to past information and is weak form efficient.

Semi-strong form efficiency states that no investor can earn excess returns from trading rules based on publicly available information. If the market is semi-strong form efficient, then stock price reacts so fast to all public information that no investor can earn an above normal return by acting on this type of information. Tests of semi-strong form efficiency (Patell and Wolfson, 1979; Fama et. als 1969) have shown that no investor can earn an above normal return by acting on publicly available information such as annual accounting

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Fama et. als claim that strong form efficiency rules out excess returns based on any information, whether private or public. If the market is strong form efficient, then stock price reacts so fast to all information (public or private) that no investor can earn an above normal return by acting on this type of information (Finnerty, 1976; Givoly and Palmon, 1985). In this case, the market reacts to an event within the confines of the firm (or secret information) when it occurs even before it is publically announced. For this to occur, investors must act on inside information, which is illegal. For example, if an individual buys the stock on the event and still does not make an above normal return, the market is said to be strong form efficient.

Weak form efficiency states that the historical price information cannot be used to achieve excess returns, while strong form efficiency states that the price is a reflection of all information, public or private (Ross, Westfield, and Jaffe, 2005). This study tests insider purchases with respect to semi-strong form efficiency, which purports that all public information determines the price of the stock.

METHODOLOGY AND STUDY SAMPLE

In order to test the level of market efficiency surrounding a sample of insider purchases, this study will use the standard event study methodology from the finance literature. The study sample includes companies that have announced an insider purchase from http://finance.yahoo.com/ or other business and finance sources. This study sample includes 25 randomly selected insider purchases made on November 26, 2008. The random sample was selected from insider purchases of stocks traded either on the NYSE or NASDAQ. Table 1 describes the sample.

To test semi-strong form market efficiency with respect to public announcements of insider purchases and to examine the effect of insider purchases on stock return before, on, and after the purchase date, this study tests following null and alternate hypotheses:

H1₀: The risk adjusted return of the stock price of the sample of firms with announced insider purchases is not significantly affected by this type of information on the purchase date.

H1₁: The risk adjusted return of the stock price of the sample of firms with announced insider purchases is significantly positively affected by this type of information on the purchase date.

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Asbell and Bacon