Applied Research in Financial Reporting: Text and Cases

Chapter 5

Issue-Based Accounting Research

Chapter issues

• A General Framework for Applied Accounting Research

• Contemporary Accounting Research Models

• Focus on Capital Markets Research Models in this Chapter

A General Framework for Applied Accounting Research

• Definition of Applied Accounting Research

• Hypothetico-Deductive: Top down

• Inductive-Ground up: Bottom up

Definition of Applied Accounting Research

• Applied accounting research is a systematic process by which defensible answers to specific accounting issues are identified and communicated;

• Key words: systematic process & defensible– Requirements: efficiency of the process &

generalizeability of the results

Hypothetico-Deductive Logic (Exhibit 5-1)

Exhibit 5-1A General Research Framework

Identify theory

Hypotheses

Consequences

Analysis

Synthesis

Interpretation

Research design:

Database search

Data collection

Library search

Improves old theories or generates new ones

Theory refinement

Documentation & filing

Communication

ImplementationPlan

Conclusions

Inductive-Ground up Logic(Exhibit 5-1)

• From evidence to theory refinement or generation of new theories

• Not an objective of applied professional research, but a by-product

• Generally requires additional evidence before an existing theory is refined or a new theory is generated.

Contemporary Accounting Research Models

• Capital Markets Research (this chapter)• Judgment and Decision Making (Ch. 7)• Critical and Creative Thinking and

Problem solving (Ch. 8)• Ethics (Ch. 9)• Other Models (this chapter)

Capital Markets Research

• Dividend Policy Decision Models

• Valuation Models

• Mix and Cost of Capital

• Option Pricing Models

Dividend Policy Decision Models

• Linkage between dividend, stock price, and earnings– Dividend policy has an effect on market

capitalization (i.e., it affects stock price)• Pay out: how much?

• Do not pay out: reinvest?

– Dividend policy sends signal to the stockholder• Fluctuations are not good signals

Valuation ModelsThe Traditional Valuation Model: A stream

of future dividends:

Vt = (1 + r)-Et[dt+] =1

– Vt is the value of the firm at time t

– r is the discount rate

– Et[dt+] is dividend at time t+ expected at time t

Valuation ModelsThe Fundamental Valuation Model: Book value

and future abnormal earnings:

Vt = bvt + (1 + r)-Et[xt+ - rbvt+-1]

=1

bvt is book value at time t

r is the discount rate

Et[xt+ - rbvt+-1] is the discounted future expected abnormal

earnings at time t.

Mix and Cost of Capital

• Issue: Debt to Equity RatioCOC = [(1-t) * iD + rE] / TA

t = tax rate; i = interest rate, D = debt; E = Equity

r = expected rate of return by stockholders

TA = total assets

– What is the limit of borrowing?

– What are the effects of liability like equities?

– Keep ROA = COC: stable stock price

Mix and Cost of Capital

• Issue: ROA Models:

– Problems with numerator & denominator:

• CPI for adjustment of BS & Income statement numbers

• Capital Assets Pricing Model (CAPM)

• Arbitrage Pricing Model

–Efficient Market Hypothesis

Capital Asset Pricing Model

• Unobservable future returns are discounted to arrive at assets prices

• It is based on portfolio theory• Risk premium (difference between an asset’s

beta and the risk-free rate of Treasury Bills) of the asset must be measured

• Earnings, capital assets, and cost of capital are formulated using the risk premium

Efficient Market hypothesis

• Efficiency in capturing and impounding information in stock prices to mitigate arbitrage trading:– Especially important in today’s day trading practices– Weak form: historical information only– Semi-strong: Historical & other Publicly available

information– Strong: – Historical, other Publicly available, and private information

Efficient Market hypothesis

• Assumptions:– Equal access to information for all stock

exchanges– No single trader can affect prices– Investors invest in Portfolios, so a single stock

may not have an ability to greatly influence the market

Efficient Market hypothesis

• EMH indicates that arbitrage trading will not produce abnormal returns

• What is the value of accounting information?– Knowledge of accounting – Cognitive complexity to understand

informationcan produce abnormal returns

Option Pricing Model

• Definition: "a contract that gives the holder the right, but not the obligation, either to purchase or to sell a certain number of shares of stock at the predetermined price for a specified period of time."

• Option Price = stock price - exercise price at the grant time?

• Call and Put options

Option Pricing Model

• Black and Scholes model:Call Option Cost = f (S, T, R, V, X, P)– S is stock price at grant time;– T is time to maturity – R is the risk-free rate of return;– V is the variability or volatility (i.e., risk);– X is the option's exercise price;– P is the price of the call option at the issue date.

Option Pricing Model

• SFAS 123 considered and then abandoned Black and Scholes model:– Complexity of V measurement was a culprit– Opted for disclosure instead of recognition– Option price is determined by the company in

any way it deems appropriate

Other Models

• Positive accounting theory• Agency models• Information economics

– Economic consequences of FASB standards

• Accounting History– e.g., fundamental valuation models of 1920s, but

formulation in the 1990s

– Responsibility for detection of fraud of 1800s, but adoption in 1990s (SAS No. 82)