1. FINANCIAL ACCOUNTING RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY THEORY AND ANALYSIS: TEXT AND CASES 10 TH EDITION

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

3. 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 INPUTS OBSERVATIONS OUTPUTS PREDICTIONS

4. Research Methodology  Deductive approach  Inductive approach  Pragmatic Approach  Scientific Method  Other

5. Deductive Approach  Essentially an “armchair” approach  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 researcher’s ability to relate components  If researcher is in error, conclusions will also be erroneous

6. 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

7. 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

8. 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 studiedState the hypotheses to be tested Collect data necessary to test the hypotheses Analyze and evaluate data Draw a tentative conclusion

9. 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

10. The Outcomes of Providing Accounting Information  Fundamental analysis  The efficient market hypothesis  The capital asset pricing model  Normative vs positive accounting theory  Agency theory  Human information processing  Critical perspective research

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

12. The Efficient Market Hypothesis  Holds that fundamental analysis is not a useful tool…  because individual investors are not able to identify mispriced securities

13. 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

14. The The Supply and Demand Model Supply Demand Price Quantity

15. The Supply and Demand Model  Best illustrated in the securities market  Information available from many sources including: 1Published financial reports 2Quarterly earnings reports 3News reports 4Published competitor information 5Contract awardings 6Stockholder meetings

16. 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

17. 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

18. 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

19. 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

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  Challenges  2008 market crash

21. Efficient 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?

22. 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

23. 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

24. 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 Financial information about a firm can help determine the amount of systematic risk associated with a particular stock

25. 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 higher  s offer greater returns than securities with relatively lower  s

26. The Relationship Between Risk and Return R s = R f + R p Where: R s = Expected return on a given risky security R f = The risk free return rate R p = The risk premium

27. 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 β = measure of the parallel relationship of a particular common stock with the overall trend in the stock market  Stock’s sensitivity to market changes  Measure of systematic risk

28. Incorporating Risk Into the Equation β = :R s = R f + β s (R m - R f ) Where: R s = the stock’s expected return R f = the risk-free return rate R m = The expected market rate as a whole β = The stock’s beta calculated over some historical period

29. 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

30. Normative 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 useful Positive theory – attempts to explain observed phenomena  One positive theory is termed agency theory

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

32. 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

33. Positive Theory Agency relationships involve costs to the principles 1Monitoring expenditures by the principal 2Bonding expenses by the agent 3Residual 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

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

35. 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

36. 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

37. 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

38. Critical Perspectives Research Critical perspective research concerns itself with the ways societies and institutions have emerged. Three assumptions: 1Society has the potential to be what it isn’t 2Human action can help this process 3Critical theory can assist human action

39. Accounting 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 thought

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