Financial

Accounting
Theory and Analysis:
Text and Cases

12th Edition
Richard G. Schroeder
Myrtle W. Clark
Jack M. Cathey
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 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
 Theory versus theorizing
 This chapter 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
 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
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:

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
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
 Behavioral finance
 The capital asset pricing model
 Normative versus positive accounting theory
 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…

(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 Supply and Demand Model

Supply
Price

Demand
Quantity
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 awardings
6. 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 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
 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
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?
Behavioral 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 markets
▪ Helped 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

Easy Credit and
the Real Estate Bubble
▪ 2007
▪ Housing prices declined
▪ Major global financial institutions that had borrowed and invested heavily in
subprime MBS reported significant losses

▪ Houses under water

▪ Foreclosure epidemic eroded the financial strength of banking institutions

▪ Crisis expanded from housing market to other parts of the economy

▪ Defaults and losses on other loan types also increased significantly
October 2008
▪ Greenspan appeared before the US House Oversight
Committee
▪ Acknowledged 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
Criticisms of EMH and
Rational Market Theory
▪ Not new in 2008
▪ Early 1970s: critics noted 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:
1. Calendar
2. Fundamental
3. Technical
4. Other
 Calendar Anomalies

▪ Related with particular time periods (i.e.; movement in stock prices

from day to day, month to month, year to year, etc.)

▪ Weekend Effect:
▪ Stock prices are likely to fall on Monday; consequently, 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 Effect
▪ The prices of stocks are likely to increase during the last week of December and the first half
month of January

▪ January 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
Value Anomalies
▪ Value 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 Book

▪ Stocks with low market price to book value ratios generate greater returns than stocks
having high book value to market value ratios
▪ High Dividend Yield
▪ Stocks 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 Stocks
▪ Prior 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
Technical Anomalies
▪ Technical analysis is
a general term for a number of
investing techniques

▪ Attempt to forecast security prices

by studying past prices and other
related statistics

▪ Common techniques include

▪ Strategies based on relative strength
▪ Moving averages
▪ Support and resistance
Technical Anomalies
▪ Moving Average
▪ Buying stocks when short-term averages
are higher than long-term averages
▪ Selling stocks when short-term averages
fall below their long-term averages

▪ Trading Range Break

▪ Based 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
Other Anomalies
▪ The size effect
▪ Small firms tend to outperform larger firms

▪ Announcement Based Effects and

Post-earnings announcement drift
▪ Price changes tend to persist after initial
announcements
▪ Stocks with positive surprises tend to drift
upward, those with negative surprises tend to
drift downward
Other Anomalies
▪ IPO's, Seasoned Equity Offerings, and Stock Buybacks
▪ Stocks associated with initial public offerings (IPOs) tend to underperform
the market
▪ Secondary offerings also tend to underperform
▪ Whereas, stocks of firms announcing stock repurchases outperform the
overall market in the following years

▪ Insider Transactions
▪ 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 Game

▪ Stocks rise immediately after being added to S&P 500
 Behavioral Finance
▪ New theory of financial markets
▪ Contemporaneous with the identification of financial
market anomalies
▪ Arose from studies undertaken by
Kahneman and Tversky
▪ They termed their study of how people manage risk and uncertainty
Prospect Theory
Prospect Theory Characteristics
▪ Certainty:
▪ People have a strong preference for certainty
▪ Willing to sacrifice income to achieve more certainty

Option A: Guaranteed win of $1,000

Option B:
80% chance of winning of $1,400
20% chance of winning nothing

People tend to prefer option A

Prospect Theory Characteristics
▪ Loss aversion:
▪ People tend to give losses more weight than gains

Gain = $100

Loss = $80

Net Loss in satisfaction

Prospect 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 dramatically
▪ YOU get a 10 percent raise
▪ YOUR NEIGHBOR gets a 10 percent raise Blah!

10% 10%

Your
You
neighbor
Prospect Theory Characteristics
▪ Relative positioning:
▪ But if you get a 10 percent raise and your
neighbor doesn’t get a raise at all, you feel rich

10%
0%

Your
You neighbor
Prospect 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

Subsequent Research
▪ Later, research began to focus on the study of the time
series properties of prices, dividends, and earnings
▪ Shiller
▪ Thaler
▪ Thaler and de Bondt
Behavioral Finance
▪ These studies laid the groundwork for additional
study of behavioral finance
▪ Explores proposition that investors are often driven
by emotion and cognitive psychology rather than
rational economic behavior
▪ Suggests that investors use:
▪ Imperfect rules of thumb
▪ Preconceived notions, bias-induced beliefs
▪ And behave irrationally
Behavioral Finance

▪ Theories attempt
▪ To blend cognitive psychology with the tenets of
finance and economics
▪ To provide a logical and empirically verifiable
explanation for the often observed irrational behavior
exhibited by investors
Behavioral Finance
▪ Fundamental tenet :
▪ Psychological factors, or cognitive biases, affect investors
▪ These limit and distort their information

Result  incorrect conclusions reached

even if the information is correct
 Cognitive Biases in Finance
▪ Mental accounting
▪ Majority perceives a dividend dollar differently
from a capital gains dollar

▪ Dividends are perceived as an addition to disposable income

×
▪ But capital gains usually are not

≠
Dividends Capital Gains
Cognitive Biases in Finance

▪ Biased expectations
▪ People 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 were anywhere between
25% and 65% of actual earnings
Cognitive Biases in Finance
▪ Reference dependence
▪ Investment decisions seem to be affected by an
investor’s reference point

▪ If a certain stock was traded 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
Cognitive Biases in Finance
▪ Representativeness Heuristic
▪ In cognitive psychology, this term simply means 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 heuristics is that
investors mistake good companies for good stocks
▪ Good companies are well-known and usually fairly valued
▪ Therefore, their stocks may not have a significant
upside potential
Progress to Date
▪ Although behavioral finance is a relatively new field,
Barberis and Thaler suggested that substantial
progress has been made including:

▪ Empirical investigation of apparently anomalous facts

▪ Limits to arbitrage
▪ Understanding bounded rationality
▪ Behavioral finance theory building
▪ Investor behavior
Not All Economists Are Convinced
about Behavioral Finance
▪ Critics continue to support the EMH
▪ Contend that behavioral finance is more a collection of
anomalies than a true branch of finance
▪ Believe 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 profits
▪ This is not the case for many anomalies
Not All Economists Are Convinced
about Behavioral Finance

▪ Eugene Fama
▪ Regards behavioral finance as just story-telling
that is very good at describing individual behavior

▪ He concedes that some sorts of professionals are

inclined toward the same sort of biases as others but…
▪ Asserts that jumps behaviorists make from there to
markets aren’t validated by the data
Not All Economists Are Convinced
about Behavioral Finance
▪ 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
 Conclusions
▪ Major paradigm shift is underway which
will hopefully
▪ Combine neoclassical and behavioral elements
▪ 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…
 Must take into account the true nature of people
with their imperfections and bounded rationality
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
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
 The Capital Asset Pricing Model
▪ Types of risk are company specific and environmental

▪ Unsystematic risk
▪ Risk that is company specific and can be diversified away

▪ Systematic risk
▪ 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
The Capital Asset Pricing Model
▪ Assumption is that investors are risk averse and
will demand higher returns for taking greater risks

▪ Beta (β)
▪ 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 a higher beta offer greater returns

than securities with a relatively lower beta
The Relationship Between
Risk and Return

Rs = Rf + Rp

Where:
Rs = Expected return on a given risky security

Rf = 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

▪ 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
Incorporating Risk Into the Equation

β = Rs = Rf + βs (Rm - Rf)
Where:
Rs = the stock’s expected return

Rf = the risk-free return rate

Rm = the expected market rate as a whole
β = the stock’s beta calculated over some historical period
Implications of CAPM
▪ A security’s price will not be
impacted by unsystematic risk
▪ Securities with a higher β (higher risk) will be priced relatively
lower than securities offering less risk

▪ Research has indicated that past βs are a good

predictor of future stock prices
▪ Criticized because it causes managers to seek only
safe investments
Normative versus 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

Positive Theory
▪ Agency Theory
▪ Based on economic theories of:
▪ Prices
▪ Agency relationships
▪ Public choice
▪ Economic regulation
 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
Positive Theory
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
▪ 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
▪ Research Studies
▪ Attempt 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
Critical Perspectives Research
▪ Previous theories assumed that knowledge
of facts can be gained by observation

 This area of research contests the view that

knowledge of accounting is grounded in
objective principles

 Belief in indeterminacy - the history of

accounting is a complex web of economic,
political and accidental consequences
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?
▪ Recent frauds have resulted in new schools of
thought
 End of Chapter 4
Prepared by Suzanne Sevin, CPA, and Kathryn Yarbrough, MBA

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