FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
10TH 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
OBSERVATIONS
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
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
The capital asset pricing model
Normative vs 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…
 because 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
Price
Supply
Demand
Quantity
The Supply and Demand Model
Best illustrated in the securities market
Information available from many
sources including:
1
2
3
4
5
6
Published financial reports
Quarterly earnings reports
News reports
Published competitor information
Contract awardings
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?
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
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
The Capital Asset Pricing Model
 Assumption is that investors are risk
aversive and will demand higher returns
for taking greater risks
 Beta (b)
 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 bs offer greater returns than
securities with relatively lower bs
The Relationship Between
Risk and Return
Rs = R f + 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 higher bs (higher risk) will be priced relatively
lower than securities offering less risk
 Research has indicated that past
bs are a good predictor of future
stock prices
 Criticized because it causes
managers to seek only safe
investments
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
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
 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
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 Kathryn Yarbrough, MBA
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