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 15 16

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 16 17

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 17 18

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 18 19

The Scientific Method Involves the following steps: Draw a tentative conclusion Analyze and evaluate data Collect data necessary to test the hypotheses State the hypotheses to be tested Identify and state the problem to be studied Most accounting research found in academic journals uses the scientific method 19 20

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 20 21

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 21 22

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 22 23

The Efficient Market Hypothesis 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 22 23

The The Supply and Demand Model Price Demand Quantity 23 24

The Supply and Demand Model Best illustrated in the securities market Information available from many sources including: Published financial reports Quarterly earnings reports News reports Published competitor information Contract awardings Stockholder meetings

The Efficient Market Hypothesis 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 Efficient Market Hypothesis 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 24 25

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 25 26

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 26 27

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 28 29

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 27 28

The Capital Asset Pricing Model 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 29 30

The Capital Asset Pricing Model 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 30 31

The Capital Asset Pricing Model Assumption is that investors are risk aversive and will demand higher returns for taking greater risks Beta (b) 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 higher bs offer greater returns than securities with relatively lower bs 31 32

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 bs (higher risk) will be priced relatively lower than securities offering less risk Research has indicated that past bs are a good predictor of future stock prices Criticized because it causes managers to seek only safe investments

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 other Inherent in this theory is that there is a conflict of interest between the shareholders and the managers of a corporation 32 33

Positive Theory Agency relationships involve costs to the principles Monitoring expenditures by the principal Bonding expenses by the agent 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 33 34

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 perception Difficulty in making optimal decisions Sequential processing Implications - extensive disclosures now required may be having opposite effect 34 35

Critical Perspectives Research Previous theories assumed that knowledge of facts can be gained by observation This area of research contests the view that knowledge of accounting is grounded in objective principles Belief in indeterminacy - the history of accounting is a complex web of economic, political and accidental consequences 35 36

Critical Perspectives Research 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 36 37

Critical Perspectives Research Critical perspective research concerns itself with the ways societies and institutions have emerged. Three assumptions: Society has the potential to be what it isn’t Human action can help this process Critical theory can assist human action 37 38

Accounting Research Education and Practice How are research, education and practice related in most disciplines? For example, medicine? How are they related in accounting? 38 39

Prepared by Kathryn Yarbrough, MBA End of Chapter 4 Prepared by Kathryn Yarbrough, MBA Copyright © 2005 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.