Accounting Theory-Ch04

FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:

TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
Chapter 4
Research Methodology And
Theories On The Uses Of
Accounting Information
Ch04
CH04: Research Methodology And Theories

On The Uses Of Accounting Information
I. Research Methodology
• Deductive approach
• Inductive approach
• Pragmatic Approach
• Scientific Method
• Other
II. The Outcomes of Providing Accounting Information

• Fundamental Analysis
• The Efficient Market Hypothesis (EMH)
• The Capital Asset Pricing Model (CAPM)
• Normative vs Positive Accounting Theory
• Agency Theory
• Human Information Processing (HIP)
Ch04
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)
INPUTS OUTPUTS
OBSERVATIONS PREDICTIONS
 Very little behavior is explained through existing accounting theory

 Chapter introduces methods of developing theory and some theories on
outcomes of providing accounting information
Ch04
1. Deductive approach
2. Inductive approach
3. Pragmatic Approach
4. Scientific Method
5. Other
Ch04
1. Deductive Approach
 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
 This methodology is often described as “going from the
general to the specific|
 Validity of this approach lies in the researcher’s ability to
relate components
 If researcher is in error, conclusions will also be erroneous
Ch04
2. Inductive Approach
 Making observations and drawing
conclusions from those observations
 Generalizations are made about the
universe based upon limited observations.
 This method is described as “going from the
specific to the general”
Ch04
3. 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
Ch04
4. 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
Ch04
5. 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
Ch04
II. The Outcomes of Providing

Accounting Information
1. Fundamental analysis
2. The efficient market hypothesis (EMH)
3. The capital asset pricing model
4. Normative vs positive accounting theory
5. Agency theory
6. Human information processing
7. Critical perspective research
Ch04
1. Fundamental Analysis
 Investor decisions
Buy
Hold
Sell
 Fundamental analysis is an attempt to identify individual securities
that are mispriced by reviewing all available financial information
 These data are then used to estimate the amount & timing of future
cash flows offered by investment opportunities and to incorporate the
associated degree of risk to arrive at an expected current market price
for a security.
 This expected price is than compared to the current market price of
the security
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2. The Efficient Market Hypothesis (EMH)

 Holds that fundamental analysis is not a useful tool…
 Because individual investors are not able to identify mispriced
securities
 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
Ch04

The Supply and Demand Model
Supply
Price
Demand
Quantity
Ch04

The Supply and Demand Model
 Best illustrated in the securities market
 Information available from many sources including:
1 Published financial reports
2 Quarterly earnings reports
3 News reports
4 Published competitor information
5 Contract awards
6 Stockholder meetings
 According to the supply and demand model, the price is determined by

the consensus of purchasers’ knowledge of relevant information about
the product
 The securities market is viewed as efficient if it reflects all available

information and reacts immediately to new information
Ch04

 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 Form:
 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
Ch04

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
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
Ch04
3. The Capital Asset Pricing Model

 The goal of investors is to minimize risk and maximize returns.
 Riskier investment must offer higher rates of return in order to attract
investors
 The rate of return on stock is calculated:
Dividends + increases (or - decreases) in value

Purchase Price
 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
Ch04
4. 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
Ch04
5. Agency 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
 Agency relationships involve costs to the principles
1. 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
Ch04
6. Human Information Processing (HIP)

 Annual reports provide vast amounts of information
 Disclosure of information is intended to help investors make buy - hold
- sell decisions
 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

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FINANCIAL ACCOUNTING

THEORY AND ANALYSIS:

CH04: Research Methodology And Theories

II. The Outcomes of Providing Accounting Information

 Very little behavior is explained through existing accounting theory

Draw a tentative conclusion

Analyze and evaluate data

Collect data necessary to test the hypotheses

State the hypotheses to be tested

II. The Outcomes of Providing

II. The Outcomes of Providing Accounting Information

II. The Outcomes of Providing Accounting Information

2. The Efficient Market Hypothesis (EMH)

2. The Efficient Market Hypothesis (EMH)

2. The Efficient Market Hypothesis (EMH)

 According to the supply and demand model, the price is determined by

 The securities market is viewed as efficient if it reflects all available

2. The Efficient Market Hypothesis (EMH)

2. The Efficient Market Hypothesis (EMH)

3. The Capital Asset Pricing Model

Dividends + increases (or - decreases) in value

4. Normative vs. Positive theory

 Normative theory – based upon a set of goals that its

6. Human Information Processing (HIP)

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