1. Chapter 4
Research Methodology And Theories On The Uses Of Accounting Information

2. 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

3. Research Methodology Deductive approach Inductive approach
Pragmatic Approach
Scientific Method
Other 15 16

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. Fundamental Analysis Investor decisions
Buy
Hold
Sell
The goal of fundamental analysis
Investment analysis

11. 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

12. 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

13. The The Supply and Demand Model
Price
Demand
Quantity 23 24

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. Positive Theory Agency theory Based on economic theories of Prices
Agency relationships
Public choice
Economic regulation

29. 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

30. 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

31. Human Information Processing
Annual reports provide vast amounts of information
Disclosure of information is intended to help investors make buy - hold - sell decisions

32. 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

33. 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

34. 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

35. 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

36. 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

37. Prepared by Kathryn Yarbrough, MBA
End of Chapter 4
Prepared by Kathryn Yarbrough, MBA
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