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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.

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applied research in financial reporting text and cases

Applied Research in Financial Reporting: Text and Cases

Chapter 5

Issue-Based Accounting Research

chapter issues
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
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
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
inductive ground up logic exhibit 5 1
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
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
Capital Markets Research
  • Dividend Policy Decision Models
  • Valuation Models
  • Mix and Cost of Capital
  • Option Pricing Models
dividend policy decision 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 models
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
valuation models11
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.

mix and cost of capital
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
mix and cost of capital13
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
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
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 hypothesis16
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 hypothesis17
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

option pricing model
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 model19
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 model20
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
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)
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