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Chapter 4

Research Methodology And Theories On The Uses Of

Accounting Information

Introduction To have a science is to have a recognized domain and a set of

phenomena in that domain Theory describes the underlying reality of that domain through input

(observations) and outputs (predictions)

Very little behavior is explained through existing accounting theory Theory vs theorizing Chapter introduces methods of developing theory and some theories on

outcomes of providing accounting information

Research Methodology Deductive approach Inductive approach Pragmatic Approach Scientific Method Other

Deductive Approach It is essentially an “armchair” approach which is described from

going from the general to the specific Begins with the establishment of objectives Next definitions and assumptions are stated A logical structure for accomplishing the objectives based on

the definitions and assumptions is developed Attempts to “theorize are generally based on the deductive

approach Validity of this approach lies in the ability to relate components

Inductive Approach Making observations and

drawing conclusions Generalizations are made about

the universe based upon limited observations

APB Statement No. 4 utilized the inductive approach

Pragmatic Approach

Based upon the concept of utility or usefulness When a problem is found… an attempt to find a solution is undertaken

Most accounting theory was developed using this approach

A Statement of Accounting Principles was a pragmatic approach

The Scientific Method

Involves the following steps:

Most accounting research found in academic journals uses the scientific method

Identify and state the problem to be studied

State the hypotheses to be tested

Collect data necessary to test the hypotheses

Analyze and evaluate data

Draw a tentative conclusion

Other Research Approaches

Ethical approach– Developed by DR Scott and involves the

concepts of truth, justice and fairness

Behavioral approach– The study of how accounting information

affects the behavior of users

The Outcomes of Providing Accounting Information

Fundamental analysis The efficient market hypothesis The capital asset pricing model Agency theory Human information processing Critical perspective research

Fundamental Analysis

Investor decisions Buy Hold Sell

The goal of fundamental analysis Investment analysis

The Efficient Market Hypothesis

Holds that Fundamental analysis is not a useful tool…

because individual investors are not able to identify mispriced securities


Based on the free market supply and demand model with the following assumptions:– All economic units have complete knowledge of the

economy– All goods and services are completely mobile– All buyers and sellers are so small in relation to total

supply and demand that neither has an influence on supply or demand

– No artificial restrictions on demand, supply or prices of goods and services

The

The Supply and Demand Model

Supply

Demand

Pri

cePri

ce

QuantityQuantity

The Supply and Demand Model

Best illustrated in the securities market Information available from many

sources including:1 Published financial reports2 Quarterly earnings reports3 News reports4 Published competitor information5 Contract awardings6 Stockholder meetings


According to the supply and demand model, the price of a product is determined by knowledge of relevant information

The securities market is viewed as efficient if it reflects all available information and reacts immediately to new information


The EMH indicates that an investor with a diversified portfolio cannot make an excess return by knowledge of available information

There are three forms of the EMH which differ in respect to the definition of available information– Weak form– Semi-strong form– Strong form

Weak Form An extension of the random walk theory in the

financial management literature The historical price of a stock provides an unbiased

estimated of its future price Consequently, an investor cannot

make an excess return by knowledge of past prices

This form of the EMH has been supported by several studies

Semi-Strong Form

All publicly available information including past prices is assumed to be incorporated into the determination of security prices

An investor cannot make an excess return by knowledge of any publicly available information

Implication is that the form of disclosure, whether in the financial statements, the footnotes, or financial press information is not important

This form of the EMH has been generally supported in the literature

The Capital Asset Pricing Model

The goal of investors is to minimize risk and maximize returns.

The rate of return on stock is calculated:

Dividends + increases (or - decreases) in value

Purchase Price

Strong Form All available information,

including insider information is immediately incorporated into the price of securities as soon as it is known leaving no room for excess returns

Most available evidence suggest that this form of the EMH is not valid

Implications


Risk: The possibility that actual returns will deviate from expected

returns U. S. treasury bills

A risk free investment Return on these investments is the risk free return

Diversification Stocks can be combined into a portfolio that is less risky than any

of the individual stocks


Types of risk are company specific and environmental

Unsystematic risk The risk that is company specific

and can be diversified away Systematic risk

The nondiversifiable risk that is related to overall movements in the stock market


Assumption is that investors are risk aversive and will demand higher returns for taking greater risks

Beta ( The measure of the relationship of a particular stock with the

overall movement of the stock market viewed as a measure of volatility - a measure of risk

Securities with highers offer greater returns than securities with relatively lower s

The Relationship Between Risk and Return

Rs = Rt + Rp

Where:

Rs = Expected return on a given risky security

Rt = The risk free return rate

Rp = The risk premium

The Relationship Between Risk and Return

Investors will not be compensated for bearing unsystematic risk since it can be diversified away

The only relevant risk is systematic risk

Incorporating Risk Into the Equation

Rs = Rt + Ps (Rm - Rt)

Where:

Rs = Expected return on a given risky security

Rt = The risk free return rate

Rm = The expected market rate as a whole

Ps = The stock’s beta

Implications of CAPM

A security’s price will not be impacted by unsystematic risk Securities with higher s (higher risk) will be priced relatively

lower than securities offering less risk Research has indicated that past

s are a good predictor of future stock prices

Criticized because it causes managers to seek only safe investments

Normative vs. Positive theory

Normative theory – based upon a set of goals that its proponents maintain prescribe the ways things should be. Must be accepted by the entire universe to be

useful Positive theory – attempts to explain

observed phenomena One positive theory is termed agency theory

Positive Theory

Agency theory Based on economic theories of

Prices Agency relationships Public choice Economic regulation

Positive Theory Agency theory is based on the

assumption that individuals act to maximize their own expected utilities.

As a result the relevant question is:

What is a particular individual’s expected benefit from a particular course of action?

An agency is a consensual relationship between two parties whereby one agrees to act on behalf of the otherInherent in this theory is that there is a conflict of interest between the shareholders and the managers of a corporation

Positive Theory Agency relationships involve costs to the principles

1 Monitoring expenditures by the principal

2 Bonding expenses by the agent3 Residual loss

Agency theory holds that all individuals will act to maximize their own utility Monitoring and bonding costs will be incurred as long as they

are less than the residual loss

Human Information Processing

Annual reports provide vast amounts of information Disclosure of information is intended to help

investors make buy - hold - sell decisions

Human Information Processing

HIP studies Studies attempting to assess an individual’s ability to use

accounting information Results - individuals have limited ability to process large

amounts of information Consequences:

Selective perceptionDifficulty in making optimal decisionsSequential processing

Implications - extensive disclosures now required may be having opposite effect

Critical Perspectives Research

Previous theories assumed that knowledge of facts can be gained by observation

Belief in indeterminacy - the history of accounting is a complex web of economic, political and accidental consequences

This area of research contests the view that knowledge of accounting is grounded in objective principles


Accountants have been unduly influenced by utility based marginal economics that holds:

Profit = efficiency in using scarce resources

Conventional accounting theory equates normative and positive theory.

What should be and what is are the same


Critical perspective research concerns itself with the ways societies and institutions have emerged.

Three assumptions:1 Society has the potential to be what

it isn’t2 Human action can help this process3 Critical theory can assist human action

Accounting Research Education and Practice How are research, education and practice

related in most disciplines? For example, medicine?

How are they related in accounting?

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Prepared by Kathryn Yarbrough, MBA

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