Presentation on theme: "RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY"— Presentation transcript:
1RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY FINANCIAL ACCOUNTINGTHEORY AND ANALYSIS: TEXT AND CASES11TH EDITIONRICHARD G. SCHROEDERMYRTLE W. CLARKJACK M. CATHEY4
2Chapter 4Research Methodology And Theories On The Uses Of Accounting Information
3IntroductionTo 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 informationINPUTSOBSERVATIONSOUTPUTSPREDICTIONS
5Deductive Approach Essentially an “armchair” approach Going from the general to the specificBegins with the establishment of objectivesNext definitions and assumptions are statedA logical structure for accomplishing the objectives based on the definitions and assumptions is developedAttempts to “theorize are generally based on the deductive approachValidity of this approach lies in the researcher’s ability to relate componentsIf researcher is in error, conclusions will also be erroneous1617
6Inductive Approach Making observations and drawing conclusions Generalizations are made about the universe based upon limited observationsAPB Statement No. 4 utilized the inductive approach1718
7Pragmatic Approach Based upon the concept of utility or usefulness When a problem is found…an attempt to find a solution is undertakenMost accounting theory was developed using this approachA Statement of Accounting Principles was a pragmatic approach1819
8The Scientific Method Involves the following steps: Draw a tentative conclusionAnalyze and evaluate dataCollect data necessary to test the hypothesesState the hypotheses to be testedIdentify and state the problem to be studiedMost accounting research found in academic journals uses the scientific method1920
9Other Research Approaches Ethical approachDeveloped by DR Scott and involves the concepts of truth, justice and fairnessBehavioral approachThe study of how accounting information affects the behavior of users2021
10The Outcomes of Providing Accounting Information Fundamental analysisThe efficient market hypothesisBehavioral financeThe capital asset pricing modelNormative vs positive accounting theoryAgency theoryHuman information processingCritical perspective research2122
11Fundamental Analysis Investor decisions BuyHoldSellThe goal of fundamental analysisInvestment analysis
12The Efficient Market Hypothesis Holds that fundamental analysis is not a useful tool…Because individual investors are not able to identify mispriced securities2223
13The Efficient Market Hypothesis Based on the free market supply and demand model with the following assumptions:All economic units have complete knowledge of the economyAll goods and services are completely mobileAll buyers and sellers are so small in relation to total supply and demand that neither has an influence on supply or demandNo artificial restrictions on demand, supply or prices of goods and services2223
14The The Supply and Demand Model PriceDemandQuantity2324
15The Supply and Demand Model Best illustrated in the securities marketInformation available from many sources including:Published financial reportsQuarterly earnings reportsNews reportsPublished competitor informationContract awardingsStockholder meetings
16The Efficient Market Hypothesis According to the supply and demand model, the price of a product is determined by knowledge of relevant informationThe securities market is viewed as efficient if it reflects all available information and reacts immediately to new information
17The Efficient Market Hypothesis The EMH indicates that an investor with a diversified portfolio cannot make an excess return by knowledge of available informationThere are three forms of the EMH which differ in respect to the definition of available informationWeak formSemi-strong formStrong form2425
18Weak FormAn extension of the random walk theory in the financial management literatureThe historical price of a stock provides an unbiased estimated of its future priceConsequently, an investor cannot make an excess return by knowledge of past pricesThis form of the EMH has been supported by several studies2526
19Semi-Strong FormAll publicly available information including past prices is assumed to be incorporated into the determination of security pricesAn investor cannot make an excess return by knowledge of any publicly available informationImplication is that the form of disclosure, whether in the financial statements, the footnotes, or financial press information is not importantThis form of the EMH has been generally supported in the literature2627
20Strong FormAll 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 validChallenges2008 market crash2728
21Efficient Market Hypothesis: Implications Lack of uniformity in accounting principles may have allowed corporate managers to manipulate earnings and mislead investors.How are earnings and stock prices related?Do changes in accounting principles affect stock prices?2425
22Behavioral Finance EMH: foundation for rational market theory. As more and more financial instruments were developed and traded, they would bring more rationality to economic activity.Financial markets possessed superior knowledge and regulated economic activity in a manner the government couldn’t match.Became the cornerstone of national economic policy during the tenure of Federal Reserve Chairman Alan Greenspan.Opposed government intervention in marketsHelped reshape the 1980s and 1990s by encouraging policy makers to open their economies to market forces and resulted in an era of deregulation.However, this all changed in 2007.
23Easy Credit and the Real Estate Bubble 2007Housing prices declinedMajor global financial institutions that had borrowed and invested heavily in subprime MBS reported significant losses.Houses under waterForeclosure epidemic eroded the financial strength of banking institutions.Crisis expanded from the housing market to other parts of the economyDefaults and losses on other loan types also increased significantly
24October 2008Greenspan appeared before the US House Oversight CommitteeAcknowledged mistake in believing that banks, operating in their own self-interest, would do what was necessary to protect their shareholders and institutions.“A flaw in the model “... that defines how the world works.”Acknowledged that he had been wrong in rejecting fears that the five-year housing boom was turning into an unsustainable speculative bubble that could harm the economy when it burst.Had previously maintained home prices unlikely to post significant decline nationally because housing was a local market
25Criticisms of EMS and Rational Market Theory Not new in 2008.Early 1970s: critics were noting events that could not be explained by the EMH.Unexplainable results were termed anomalies.“Financial market anomaly” occurs when the performance of a stock or a group of stocks deviates from the assumptions of the efficient market hypothesis.Katz classified anomalies into four basic types:CalendarFundamentalTechnicalOther
26Calendar anomaliesRelated with particular time periods; i.e. movement in stock prices from day to day, month to month, year to year etcWeekend Effect:Stock prices are likely to fall on Monday; consequently, the Monday closing price is less than the closing price of previous Friday.Turn-of-the-Month Effect:The prices of stocks are likely to increase on the last trading day of the month, and the first three days of next month.Turn-of-the-Year EffectThe prices of stocks are likely to increase during the last week of December and the first half month of JanuaryJanuary Effect:Small-company stocks tend to generate greater returns than other asset classes and the overall market in the first two to three weeks of January.
27Value anomaliesValue strategies: buying stocks that have low prices relative to earnings, dividends, the book value of assets or other measures of value.Do value strategies outperform the market?Low Price to BookStocks with low market price to book value ratios generate greater returns than stocks having high book value to market value ratios.High Dividend YieldStocks with high dividend yields tend to outperform low dividend yield stocks.Low Price to Earnings (P/E)Stocks with low price to earnings ratios likely to generate higher returns and outperform the overall market, while the stocks with high market price to earnings ratios tend to underperform the overall market.Neglected StocksPrior neglected stocks tend to generate higher returns than the overall market in subsequent periods of time.Prior best performers tend to underperform the overall market.
28Technical anomaliesTechnical analysis is a general term for a number of investing techniquesAttempt to forecast security prices by studying past prices and other related statistics.Common techniques includeStrategies based on relative strengthMoving averagesSupport and resistance.
29Technical anomalies Moving Average Trading Range Break Buying stocks when short-term averages are higher than long-term averagesSelling stocks when short-term averages fall below their long-term averages.Trading Range BreakBased upon resistance and support levels.Buy signal is created when the prices reaches a resistance level.Selling signal is created when prices reach the support level.
30Other Anomalies The size effect Small firms tend to outperform larger firms.Announcement Based Effects and Post-earnings announcement driftPrice changes tend to persist after initial announcements.Stocks with positive surprises tend to drift upward, those with negative surprises tend to drift downward.
31Other Anomalies IPO's, Seasoned Equity Offerings, and Stock Buybacks Stocks associated with initial public offerings (IPOs) in tend to underperform the market and there is also evidence that secondary offerings also underperform. Whereas, stocks of firms announcing stock repurchases outperform the overall market in the following years.Insider TransactionsThere is a relationship between transactions by executives and directors in their firm's stock and the stock's performance. These stocks tend to outperform the overall market.The S&P GameStocks rise immediately after being added to S&P 500
32Behavioral Finance New theory of financial markets Contemporaneous with the identification of financial market anomaliesArose from studies undertaken by Kahneman and Tversky, and Thaler.
33Prospect Theory Characteristics Certainty:People have a strong preference for certaintyWilling to sacrifice income to achieve more certainty.Option A: Guaranteed win of $1,000Option B:80% chance of winning of $1,40020% chance of winning nothingPeople tend to prefer option A
34Prospect Theory Characteristics Loss aversion:People tend to give losses more weight than gainsGain = $100Loss = $80Net Loss in satisfaction
35Prospect Theory Characteristics Relative positioning:People tend to be most interested in their relative gains and losses as opposed to their final income and wealth.If your relative position doesn’t improve, you won’t feel any better off, even if your income increases dramaticallyYOU get a 10 percent raiseYOUR NEIGHBOR gets a 10 percent raiseBlah!10%You10%Your neighbor
36Prospect Theory Characteristics Relative positioningBut if you get a 10 percent raise and your neighbor doesn’t get a raise at all, you’ll feel rich.10%You0%Your neighbor
37Prospect Theory Characteristics Small probabilities:People tend to under-react to low-probability events.You may completely discount the probability of losing all your wealth if the probability is very small.This tendency can result in people making super-risky choices.
38Behavioral FinanceExplores the proposition that investors are often driven by emotion and cognitive psychology rather than rationale economic behavior.It suggests that investors useImperfect rules of thumb,Preconceived notions, bias-induced beliefsAnd behave irrationally.
39Behavioral Finance Theories attempt To blend cognitive psychology with the tenets of finance and economicsTo provide a logical and empirically verifiable explanation for the often observed irrational behavior exhibited by investors.
40Behavioral Finance Fundamental tenet : Psychological factors, or cognitive biases, affect investors,These limit and distort their informationCause them to reach incorrect conclusions even if the information is correct.
41Cognitive Biases in Finance Mental accountingThe majority of people perceive a dividend dollar differently from a capital gains dollar.Dividends are perceived as an addition to disposable income; capital gains usually are not.×≠DividendsCapital Gains
42Cognitive Biases in Finance Biased expectationsPeople tend to be overconfident in their predictions of the future.If security analysts believe with an 80% confidence that a certain stock will go up, they are right about 40% of the time.Between 1973 and 1990, earnings forecast errors have been anywhere between 25% and 65% of actual earnings.
43Cognitive Biases in Finance Reference dependenceInvestment decisions seem to be affected by an investor’s reference point.If a certain stock was once trading for $20, then dropped to $5 and finally recovered to $10, the investor’s propensity to increase holdings of this stock will depend on whether the previous purchase was made at $20 or $5
44Cognitive Biases in Finance Representativeness heuristic.In cognitive psychology this term means simply that people tend to judge “Event A” to be more probable than “Event B” when A appears more representative than B.In finance, the most common instance of representativeness heuristic is that investors mistake good companies for good stocks.Good companies are well-known and in most cases fairly valued.Their stocks, therefore, may not have a significant upside potential.
45Not All Economists Are Convinced Critics continue to support the EMH.Contend that behavioral finance is more a collection of anomalies than a true branch of financeBelieve that these anomalies are either quickly priced out of the market or explained by appealing to market microstructure arguments.Critics maintain that for an anomaly to violate market efficiency, an investor must be able to trade against it and earn abnormal profitsThis is not the case for many anomalies.
46Not All Economists Are Convinced Eugene FamaRegards behavioral finance as just story-telling that is very good at describing individual behavior.Although he concedes that some sorts of professionals are inclined toward the same sort of biases as others, he asserts that the jumps that behaviorists make from there to markets aren’t validated by the data.
47Not All Economists Are Convinced Another critic states that “…pointing out all the ways that real life behavior doesn’t bear out the predictions of traditional economics and finance is interesting—even fascinating, at times—but it’s not an alternative theory.”“People aren’t rational” isn’t a theory: it’s an empirical observation.An alternative theory would need to offer an explanation, including causal processes, underlying mechanisms and testable propositions
48ConclusionsOver the last few decades, our understanding of finance has increased a great dealStill many questions to be answered.On the whole, financial decision making remains a grey area waiting for researchers to shed light on it.However, a major paradigm shift is underway.Hopefully the new paradigm will combine neoclassical and behavioral elements and will replace unrealistic, assumptions about the optimality of individual behavior with descriptive insights, tested by laboratory experiments.If behavioral finance is to be successful in understanding financial institutions and participants, and if individuals and policy-makers, want to make better decisions, they must take into account the true nature of people with their imperfections and bounded rationality
49Conclusions Major paradigm shift is underway. Hopefully the new paradigm willCombine neoclassical and behavioral elementsWill replace unrealistic, assumptions about the optimality of individual behavior with descriptive insights, tested by laboratory experiments.If behavioral finance is to be successful in understanding financial institutions and participants, and if individuals and policy-makers, want to make better decisions, they must take into account the true nature of people with their imperfections and bounded rationality
50The 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 valuePurchase Price2829
51The Capital Asset Pricing Model Risk:The possibility that actual returns will deviate from expected returnsU. S. treasury billsA risk free investmentReturn on these investments is the risk free returnDiversificationStocks can be combined into a portfolio that is less risky than any of the individual stocks2930
52The Capital Asset Pricing Model Types of risk are company specific and environmentalUnsystematic riskThe risk that is company specific and can be diversified awaySystematic riskThe nondiversifiable risk that is related to overall movements in the stock marketFinancial information about a firm can help determine the amount of systematic risk associated with a particular stock3031
53The Capital Asset Pricing Model Assumption is that investors are risk aversive and will demand higher returns for taking greater risksBeta (b)The measure of the relationship of a particular stock with the overall movement of the stock marketViewed as a measure of volatility - a measure of riskSecurities with higher bs offer greater returns than securities with relatively lower bs3132
54The Relationship Between Risk and Return Rs = Rf + RpWhere:Rs = Expected return on a given risky securityRf = The risk free return rateRp = The risk premium
55The Relationship Between Risk and Return Investors will not be compensated for bearing unsystematic risk since it can be diversified awayThe only relevant risk is systematic riskβ = measure of the parallel relationship of a particular common stock with the overall trend in the stock marketStock’s sensitivity to market changesMeasure of systematic risk
56Incorporating Risk Into the Equation β = :Rs = Rf + βs (Rm - Rf)Where:Rs = The stock’s expected returnRf = The risk-free return rateRm = The expected market rate as a wholeβ = The stock’s betacalculated over some historical period
57Implications of CAPMA security’s price will not be impacted by unsystematic riskSecurities with higher bs (higher risk) will be priced relatively lower than securities offering less riskResearch has indicated that past bs are a good predictor of future stock pricesCriticized because it causes managers to seek only safe investments
58Normative 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 usefulPositive theory – attempts to explain observed phenomenaOne positive theory is termed agency theory
59Positive Theory Agency theory Based on economic theories of: Prices Agency relationshipsPublic choiceEconomic regulation
60Positive 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 corporation3233
61Positive Theory Agency relationships involve costs to the principles Monitoring expenditures by the principalBonding expenses by the agentResidual lossAgency theory holds that all individuals will act to maximize their own utilityMonitoring and bonding costs will be incurred as long as they are less than the residual loss3334
62Human Information Processing Annual reports provide vast amounts of informationDisclosure of information is intended to help investors make buy - hold - sell decisions
63Human Information Processing HIP studiesStudies attempting to assess an individual’s ability to use accounting informationResults - individuals have limited ability to process large amounts of informationConsequences:Selective perceptionDifficulty in making optimal decisionsSequential processingImplications - extensive disclosures now required may be having opposite effect3435
64Critical Perspectives Research Previous theories assumed that knowledge of facts can be gained by observationThis area of research contests the view that knowledge of accounting is grounded in objective principlesBelief in indeterminacy - the history of accounting is a complex web of economic, political and accidental consequences3536
65Critical Perspectives Research Accountants have been unduly influenced by utility based marginal economics that holds:Profit = efficiency in using scarce resourcesConventional accounting theory equates normative and positive theory.What should be and what is are the same3637
66Critical 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’tHuman action can help this processCritical theory can assist human action3738
67Accounting Research, Education and Practice How are research, education and practice related in most disciplines?For example, medicine?How are they related in accounting?Recent frauds have resulted in new schools of thought3839