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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

Chapter 5

Issue-Based Accounting Research

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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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A General Framework for Applied Accounting Research

  • Definition of Applied Accounting Research

  • Hypothetico-Deductive: Top down

  • Inductive-Ground up: Bottom up

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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

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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.

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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)

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Capital Markets Research

  • Dividend Policy Decision Models

  • Valuation Models

  • Mix and Cost of Capital

  • Option Pricing Models

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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

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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

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Valuation Models

The Fundamental Valuation Model: Book value and future abnormal earnings:


Vt = bvt + S (1 + r)-GEt[xt+G- rbvt+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.

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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

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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

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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

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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

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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

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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

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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

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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.

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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

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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)