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 domainTheory describes the underlying reality of that domain through input (observations) and outputs (predictions)

Very little behavior is explained through existing accounting theoryTheory vs theorizingChapter 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

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

The

The Supply and Demand Model

Supply

Demand

Price

Price

QuantityQuantity

The Supply and Demand Model

Best illustrated in the securities marketInformation available from many sources including:1 Published financial reports2 Quarterly earnings reports3 News reports4 Published competitor information5 Contract awardings6 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

Weak FormAn 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 returnsMost available evidence suggest that this form of the EMH is not valid Implications

The Capital Asset Pricing Model

Risk:The possibility that actual returns will deviate from expected returns

U. S. treasury billsA risk free investment

Return on these investments is the risk free return

DiversificationStocks can be combined into a portfolio that is less risky than any of the individual stocks

The Capital Asset Pricing Model

Types of risk are company specific and environmental

Unsystematic riskThe risk that is company specific and can be diversified away

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

The Capital Asset Pricing Model

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

Positive Theory

Agency theoryBased on economic theories of

Prices

Agency relationships

Public choice

Economic regulation

Positive TheoryAgency 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 principles1 Monitoring expenditures by the

principal

2 Bonding expenses by the agent

3 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 informationResults - 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

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

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

Critical Perspectives Research

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’t

2 Human action can help this process

3 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?

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.

Prepared by Kathryn Yarbrough, MBA