Applied Research in Financial Reporting: Text and Cases

1. Applied Research in Financial Reporting: Text and Cases Chapter 5 Issue-Based Accounting Research

2. Chapter issues • A General Framework for Applied Accounting Research • Contemporary Accounting Research Models • Focus on Capital Markets Research Models in this Chapter

3. A General Framework for Applied Accounting Research • Definition of Applied Accounting Research • Hypothetico-Deductive: Top down • Inductive-Ground up: Bottom up

4. 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

5. Hypothetico-Deductive Logic (Exhibit 5-1)

6. 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.

7. 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)

8. Capital Markets Research • Dividend Policy Decision Models • Valuation Models • Mix and Cost of Capital • Option Pricing Models

9. 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

10. Valuation Models The Traditional Valuation Model: A stream of future dividends: ¥ Vt = S (1 + r)-GEt[dt+G] G=1 • Vt is the value of the firm at time t • r is the discount rate • Et[dt+G] is dividend at time t+G expected at time t

11. Valuation Models The Fundamental Valuation Model: Book value and future abnormal earnings: ¥ Vt = bvt + S (1 + r)-GEt[xt+G- rbvt+G-1] G=1 bvt is book value at time t r is the discount rate Et[xt+G- rbvt+G-1] is the discounted future expected abnormal earnings at time t.

12. Mix and Cost of Capital • Issue: Debt to Equity Ratio COC = [(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

13. 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

14. 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

15. 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

16. 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

17. 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 information can produce abnormal returns

18. 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

19. 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.

20. 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

21. 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)