Financial

Accounting
Theory and Analysis:
Text and Cases

13th 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

 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
 Value Creation Reporting
Fundamental Analysis
Investor decisions
 Buy
 Hold
 Sell

 The goal of fundamental analysis

 Investment analysis
 P/E ratio
 Dividend Yield
 BTM ratio
 The Efficient Market Hypothesis (EMH)

Holds that fundamental analysis is not a useful tool…

(Individual investors are not able to identify mispriced securities)
The Efficient Market Hypothesis (EMH)
 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 Efficient Market Hypothesis (EMH)
 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
Forms of EMH

Weak Form Sem-Strong Strong

Historical price is All public All public and
unbiased estimate information is private information
for future price incorporated into is incorporated into
price price
No excess return No excess return No excess return
based on past based on public based on
prices information information
Disclosure is not
important
Supported by Generally Evidence suggests
several studies supported in the that this form is
literature NOT valid
Research Challenges of the EMH
▪ The financial crisis of 2007-2009 and the EMH
▪ Were markets a cause or a casualty of the recession?
▪ Does private information reduce the accuracy of
conventional disclosures?

▪ New research strategies must be developed

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
▪ Low Price to Book / Underperformed Stock
▪ 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
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
▪ Announcement effects
 Behavioral Finance
▪ New theory of financial markets
▪ Contemporaneous with the identification of financial
market anomalies
▪ Arose from studies undertaken by
Kahneman and Tversky (Nobel Prize 2002)
▪ 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
▪ Loss aversion:
▪ People tend to give losses more weight than gains
▪ Relative positioning:
▪ People tend to be most interested in their relative gains
and losses as opposed to their final income and wealth
▪ Small probabilities:
▪ People tend to under-react to low-probability events
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

What would you choose?

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, Yale; Fama, U of Chicago
▪ Nobel Prize - 2013
▪ Thaler, U of Chicago
▪ Nobel Prize - 2017
▪ 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
 Cognitive Biases in Finance
▪ Mental accounting
▪ Majority perceives a dividend dollar differently
from a capital gains dollar

▪ Biased expectations
▪ People tend to be overconfident in their predictions of the future

▪ Reference dependence
▪ Investment decisions seem to be affected by an investor’s reference point

▪ Representativeness Heuristic
▪ In finance, the most common instance of representativeness heuristics
is that investors mistake good companies for good stocks
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
▪ 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
▪ Originated with Markowitz’s “portfolio theory’
in the 1950s
▪ Sharpe built on this work and developed CAPM
▪ Attempts to deal with both risks and returns
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
▪ Assumption is that investors are risk averse and will demand
higher returns for taking greater risks (Beta β)
▪ 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

Diversification
▪ Stocks can be combined into a portfolio that is less risky than any
of the individual stocks
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
Implications and Criticism 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
▪ Doesn’t explain risk-return relationship the way it was
intended to
▪ Fama and French
▪ Subsequent research
▪ Research has indicated that past βs are not
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 –
Watts and Zimmerman, 1990
▪ Contractual view of the firm
▪ Accounting mitigates the contracting
costs by establishing agreements
(contracts) among parties
▪ The foundation in the contract market,
including executive compensation,
political costs, and lender debt contracts
▪ Accounting information is useful in
managing behaviors between parties in
a contract, such as allocation of
resources
Agency Theory –
Eisenhardt, 1989

▪ An “agency” is a consensual relationship between two

parties whereby one agrees to act on behalf of the other
▪ Based on the assumption that individuals act to
maximize their own expected utilities
▪ Inherent in this theory is a conflict of interest between
the shareholders and the managers of a corporation in
risk preference and goals
▪ Agency relationship involves costs of monitoring,
bonding expenses, & residual loss
Positive Theory
▪ Agency Theory
▪ Based on economic theories of:
▪ Prices
▪ Agency relationships
▪ Public choice
▪ Economic regulation
▪ Propositions Discussion
 Human Information Processing
▪ Human information processing theory (HIP) deals with
how people receive, store, integrate, retrieve and use
information
▪ Annual reports provide vast amounts of information
▪ Disclosure of information is intended to help investors
make buy - hold - sell decisions
 Human Information Processing Model

Stimulus
Input
Processes Storage
Processes Output
Processes Response

▪ Input processes are concerned with the analysis of the stimuli

▪ Storage processes cover everything that happens to stimuli
internally in the brain, and can include coding and
manipulation of the stimuli
▪ Output processes are responsible for preparing an
appropriate response to a stimulus
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
Value Creation Reporting
▪ The global economic crisis of 2007–2008 provides a reminder that
financial reporting alone cannot provide sufficient insight into
business performance
▪ Stakeholders want more holistic picture
▪ Is accounting information useful?
▪ Questions about the information content of balance sheets
▪ New reporting measures:
▪ Intellectual Capital Reports
▪ Enhanced Business Reporting Model
▪ Integrated Reporting
▪ These techniques have not gained a great deal of traction primarily
due to the lack of a widespread recognition that the current
accounting model is deficient
Take Home Test Expectations

▪ Your test assignment is based on your student ID.

▪ Work on your own, not a group project.
▪ Use complete sentences.
▪ Use proper references as needed (e.g., SFAC No. 6 or ASC 820)
▪ Define a term before using the acronyms. For example, the
Financial Accounting Standards Board (FASB)…
▪ Also prepare to defend your answer in class next week in a form
of a debate.
 End of Chapter 4

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