1. Applied Research in Financial Reporting: Text and Cases
Chapter 5
Issue-Based Accounting Research

2. Chapter issues A General Framework for Applied Accounting Research
Contemporary Accounting Research Models
Focus on Capital Markets Research Models in this Chapter

3. A General Framework for Applied Accounting Research
Definition of Applied Accounting Research
Hypothetico-Deductive: Top down
Inductive-Ground up: Bottom up

4. Definition of Applied Accounting Research
Applied accounting research is a systematic process by which defensible answers to specific accounting issues are identified and communicated;
Key words: systematic process & defensible
Requirements: efficiency of the process & generalizeability of the results

5. Hypothetico-Deductive Logic (Exhibit 5-1)

6. Inductive-Ground up Logic (Exhibit 5-1)
From evidence to theory refinement or generation of new theories
Not an objective of applied professional research, but a by-product
Generally requires additional evidence before an existing theory is refined or a new theory is generated.

7. Contemporary Accounting Research Models
Capital Markets Research (this chapter)
Judgment and Decision Making (Ch. 7)
Critical and Creative Thinking and Problem solving (Ch. 8)
Ethics (Ch. 9)
Other Models (this chapter)

8. Capital Markets Research
Dividend Policy Decision Models
Valuation Models
Mix and Cost of Capital
Option Pricing Models

9. Dividend Policy Decision Models
Linkage between dividend, stock price, and earnings
Dividend policy has an effect on market capitalization (i.e., it affects stock price)
Pay out: how much?
Do not pay out: reinvest?
Dividend policy sends signal to the stockholder
Fluctuations are not good signals

10. Valuation Models
The Traditional Valuation Model: A stream of future dividends:
Vt = S (1 + r)-GEt[dt+G] G=1
Vt is the value of the firm at time t
r is the discount rate
Et[dt+G] is dividend at time t+G expected at time t

11. Valuation Models
The Fundamental Valuation Model: Book value and future abnormal earnings:
Vt = bvt + S (1 + r)-GEt[xt+G - rbvt+G-1]
G=1
bvt is book value at time t
r is the discount rate
Et[xt+G - rbvt+G-1] is the discounted future expected abnormal earnings at time t.

12. Mix and Cost of Capital Issue: Debt to Equity Ratio
COC = [(1-t) * iD + rE] / TA
t = tax rate; i = interest rate, D = debt; E = Equity
r = expected rate of return by stockholders
TA = total assets
What is the limit of borrowing?
What are the effects of liability like equities?
Keep ROA = COC: stable stock price

13. Mix and Cost of Capital Issue: ROA Models:
Problems with numerator & denominator:
CPI for adjustment of BS & Income statement numbers
Capital Assets Pricing Model (CAPM)
Arbitrage Pricing Model
Efficient Market Hypothesis

14. Capital Asset Pricing Model
Unobservable future returns are discounted to arrive at assets prices
It is based on portfolio theory
Risk premium (difference between an asset’s beta and the risk-free rate of Treasury Bills) of the asset must be measured
Earnings, capital assets, and cost of capital are formulated using the risk premium

15. Efficient Market hypothesis
Efficiency in capturing and impounding information in stock prices to mitigate arbitrage trading:
Especially important in today’s day trading practices
Weak form: historical information only
Semi-strong: Historical & other Publicly available information
Strong:
Historical, other Publicly available, and private information

16. Efficient Market hypothesis
Assumptions:
Equal access to information for all stock exchanges
No single trader can affect prices
Investors invest in Portfolios, so a single stock may not have an ability to greatly influence the market

17. Efficient Market hypothesis
EMH indicates that arbitrage trading will not produce abnormal returns
What is the value of accounting information?
Knowledge of accounting
Cognitive complexity to understand information
can produce abnormal returns

18. Option Pricing Model
Definition: "a contract that gives the holder the right, but not the obligation, either to purchase or to sell a certain number of shares of stock at the predetermined price for a specified period of time."
Option Price = stock price - exercise price at the grant time?
Call and Put options

19. Option Pricing Model Black and Scholes model:
Call Option Cost = f (S, T, R, V, X, P)
S is stock price at grant time;
T is time to maturity
R is the risk-free rate of return;
V is the variability or volatility (i.e., risk);
X is the option's exercise price;
P is the price of the call option at the issue date.

20. Option Pricing Model
SFAS 123 considered and then abandoned Black and Scholes model:
Complexity of V measurement was a culprit
Opted for disclosure instead of recognition
Option price is determined by the company in any way it deems appropriate

21. Other Models Positive accounting theory Agency models
Information economics
Economic consequences of FASB standards
Accounting History
e.g., fundamental valuation models of 1920s, but formulation in the 1990s
Responsibility for detection of fraud of 1800s, but adoption in 1990s (SAS No. 82)