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)

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

It is essentially an armchair approach which is described from

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 ability to relate components

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
Fundamental analysis
Information

The efficient market hypothesis

The capital asset pricing model
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

Price

Supply

Demand

The Supply and Quantity

Demand

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

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

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
Implications

The Capital Asset Pricing

Model

Risk:

U. S. treasury bills

The possibility that actual returns will deviate from expected

returns
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

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 highers offer greater returns than

securities with relatively lower s

The Relationship
Between Risk and
Return
Rs = R t + Rp
Where:
Rs = Expected return on a given risky
security
Rt = 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

Incorporating Risk Into the

Equation
Rs = Rt + Ps (Rm - Rt)
Where:
Rs = Expected return on a given risky security
Rt = The risk free return rate
Rm = The expected market rate as a whole
Ps = The stocks beta

Implications of
CAPM

A securitys 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

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 individuals 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

2
3

Monitoring expenditures by the

principal
Bonding expenses by the agent
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 individuals 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

2
3

Society has the potential to be what

it isnt
Human action can help this process
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?

Prepared by Kathryn Yarbrough, MBA

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