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Table of Contents for

Financial Accounting Theory and Analysis:
Text and Cases, 11th Edition

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CHAPTER 3: International Accounting

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CHAPTER 5: Income Concepts
To have a science is to have recognized a domain and a set of phenomena in that domain,
and next to have defined a theory whose inputs and outputs are descriptions of phenomena
(the first are observations, the second are predictions), whose terms describe the underlying
reality of the domain.1 In Chapter 2, the FASB's Conceptual Framework Project was
introduced as the state-of-the-art theory of accounting. However, this theory does not
explain how accounting information is used, because very little predictive behavior is
explained by existing accounting theory. Over the years, accountants have done a great deal
of theorizing, providing new insights and various ways of looking at accounting and its
outcomes. A distinction can be made between theorizing and theory construction.
Theorizing is the first step to theory construction, but it is often lacking because its results
are untested or untestable value judgments.2
In the following pages, we first introduce several research methods that might be used to
develop theories of accounting and its uses. Next we discuss the use of accounting
information by investors and a number of theories on the outcomes of the use of accounting
information, including fundamental analysis, the efficient market hypothesis, the capital asset
pricing model, agency theory, human information processing, and critical perspective
research. None of these theories is completely accepted; consequently, each of them is
somewhere along the path between theorizing and theory.

Research Methodology
Accounting theory can be developed by using several research methodologies. Among the
more commonly identified methodologies are the deductive approach, the inductive
approach, the pragmatic approach, the ethical approach, and the behavioral approach. In this
section we briefly describe each of these research approaches. In addition, we present the
scientific method of inquiry, which is essentially a combination of deductive and inductive
reasoning, as a guide to research in accounting theory development.

Deductive Approach
The deductive approach to the development of theory begins with identifying objectives.
Once the objectives are identified, certain key definitions and assumptions must be stated.
The researcher must then develop a logical structure for accomplishing the objectives, based
on the definitions and assumptions. This methodology is often described as “going from the
general to the specific.” If accounting theory is to be developed using the deductive
approach, the researcher must develop a structure that includes the objectives of accounting,
the environment in which accounting is operating, the definitions and assumptions of the
system, and the procedures and practices, all of which follow a logical pattern.
The deductive approach is essentially a mental or “armchair” type of research. The
validity of any accounting theory developed through this process is highly dependent on the
researcher's ability to correctly identify and relate the various components of the accounting
process in a logical manner. To the extent that the researcher is in error as to the objectives,
the environment, or the ability of the procedures to accomplish the objectives, the
conclusions reached will also be in error.

Inductive Approach
The inductive approach to research emphasizes making observations and drawing
conclusions from those observations. Thus this method is described as “going from the
specific to the general” because the researcher generalizes about the universe on the basis of
limited observations of specific situations.
Accounting Principles Board Statement No. 4 is an example of inductive research.3 The
generally accepted accounting principles (GAAP) described in the statement were based
primarily on observation of current practice. In addition, the APB acknowledged that the
then-current principles had not been derived from the environment, objectives, and basic
features of financial accounting. Thus the study was essentially inductive in approach.

Pragmatic Approach
The pragmatic approach to theory development is based on the concept of utility or
usefulness. Once the problem has been identified, the researcher attempts to find a utilitarian
solution—that is, one that will resolve the problem. This does not suggest that the optimum
solution has been found or that the solution will accomplish some stated objective.
(Actually, the only objective may be to find a workable solution to a problem.) Thus any
answers obtained through the pragmatic approach should be viewed as tentative solutions to
problems.
Unfortunately, in accounting, most of the current principles and practices have resulted
from the pragmatic approach, and the solutions have been adopted as GAAP rather than as
an expedient resolution to a problem. As noted in Chapter 2, the Sanders, Hatfield, and
Moore study, A Statement of Accounting Principles, was a pragmatic approach to theory
construction. Unfortunately, much subsequent theory development also used this approach.
As a result, the accounting profession must frequently admit that a certain practice is
followed merely because “that is the way we have always done it,” which is a most
unsatisfactory reason, particularly when such questions arise in legal suits.

Scientific Method of Inquiry

The scientific method of inquiry, as the name suggests, was developed for the natural and
physical sciences and not specifically for social sciences such as accounting. There are some
clear limitations on the application of this research methodology to accounting; for example,
the influence of people and the economic environment make it impossible to hold the
variables constant. Nevertheless, an understanding of the scientific method can provide
useful insights into how research should be conducted.
Conducting research by the scientific method involves five major steps, which may also
have several substeps:
 1. Identify and state the problem to be studied.
2. State the hypotheses to be tested.
3. Collect the data that seem necessary for testing the hypotheses.
4. Analyze and evaluate the data in relation to the hypotheses.
5. Draw a tentative conclusion.

Although the steps are listed sequentially, there is considerable back-and-forth movement
between the steps. For example, at the point of stating the hypotheses, it may be necessary to
go back to step 1 and state the problem more precisely. Again, when collecting data, it may
be necessary to clarify the problem or the hypotheses, or both. This back-and-forth motion
continues throughout the process and is a major factor in the strength of the scientific
method.
The back-and-forth movement involved in the scientific method also suggests why it is
difficult to do purely deductive or inductive research. Once the problem has been identified,
the statement of hypotheses is primarily a deductive process, but the researcher must have
previously made some observations in order to formulate expectations. The collection of data
is primarily an inductive process, but determining what to observe and which data to collect
will be influenced by the hypotheses. Thus the researcher may, at any given moment,
emphasize induction or deduction, but each is influenced by the other, and the emphasis is
continually shifting so that the two approaches are coordinated aspects of one method.
Unfortunately, the scientific method of inquiry has received only limited attention in
accounting research. Those procedures found to have utility have become generally accepted
regardless of whether they were tested for any relevance to a particular hypothesis.

Other Research Approaches

Various writers have also discussed the ethical and behavioral approaches to research as
being applicable to the development of accounting theory. Others view these approaches as
supportive rather than as specific methods for research; that is, they can, and should,
influence the researcher's attitude but cannot by themselves lead to tightly reasoned
conclusions.
The ethical approach, which is attributed to DR Scott,4 emphasizes the concepts of truth,
justice, and fairness. No one would argue with these concepts as guides to actions by the
researcher, but there is always the question of fair to whom, for what purpose, and under
what circumstances. Because of such questions, this approach may be difficult to use in the
development of accounting theory, but it has gained renewed stature owing to the emergence
of a new school of accounting theory development, critical perspective research, which is
discussed later in the chapter.
Accounting is recognized as a practice whose consequences are mediated by the human
and social contexts in which it operates and the ways it intersects with other organizational
and social phenomena. As a consequence, both the behavioral and the economic functioning
of accounting are now of interest, and questions are being asked about how accounting
information is actually used and how it sometimes seems to generate seemingly undesirable
and often unanticipated consequences.5 From this realization has come the school of
accounting research and theory development known as behavioral accounting research
(BAR). BAR is the study of the behavior of accountants or the behavior of others as they are
influenced by accounting functions and reports,6 and it is based on research activities in the
behavioral sciences. Because the purpose of accounting is to provide information for
decision makers, it seems appropriate to be concerned with how preparers and users react to
information. BAR has been seen as studying relevant issues but as not having the impact on
practice that it should, given the importance of these issues.7

The Outcomes of Providing Accounting Information

The development of a theory of accounting will not solve all the needs of the users of
accounting information. Theories must also be developed that predict market reactions to
accounting information and how users react to accounting data. The following section
describes the use of accounting and other information by individuals and presents several
theories on how users react to accounting data.

Fundamental Analysis
Chapter 2 noted that the FASB has indicated that the primary goal of accounting information
is to provide investors with information that is relevant and that faithfully represents
economic phenomena so they can make informed investment decisions. Individual investors
make the following investment decisions:

• Buy—a potential investor decides to purchase a particular security on the

basis of available information.
• Hold—an actual investor decides to retain a particular security on the basis
of available information.
• Sell—an actual investor decides to dispose of a particular security on the
basis of available information.

Individual investors use all available financial information to assist in acquiring or

disposing of the securities contained in their investment portfolios that are consistent with
their risk preferences and the expected returns offered by their investments. One of the
methods available to investors to make these decisions is fundamental analysis. Fundamental
analysis is an attempt to identify individual securities that are mispriced by reviewing all
available financial information. These data are then used to estimate the amount and timing
of future cash flows offered by investment opportunities and to incorporate the associated
degree of risk to arrive at an expected share price for a security. This discounted share price
is then compared to the current market price of the security, thereby allowing the investor to
make buy–hold–sell decisions.
Investment analysis may be performed by investors themselves or by securities analysts.
Because of their training and experience, securities analysts are able to process and
disseminate financial information more accurately and economically than are individual
investors. Securities analysts and individual investors use published financial statements,
quarterly earnings reports, and the information contained in the Management Discussion and
Analysis section of the annual report, particularly those sections containing forward-looking
information and the company's plans. Upon review of these information sources, securities
analysts often make their own quarterly earnings estimates for the most widely held
companies. Subsequently, as company quarterly information is released, securities analysts
comment on the company's performance and may make buy–hold–sell recommendations.
Security analysts' estimates and recommendations can affect the market price of a
company's stock. For example, on April 17, 2000, IBM released its quarterly earnings report
after the stock market had closed. The report indicated that IBM's first-quarter performance
had been better than anticipated. Nevertheless, the company's stock dropped $6.50 from
$111.50 to $105 because several securities analysts had lowered their ratings on the stock
based on IBM's lowered revenue expectations for the second quarter of 2000. The decline in
the value of IBM's stock was probably influenced by the fact that the overall stock market
also declined on April 18, 2000, but this example illustrates how investors' perceptions of
future expectations can affect stock prices.
One school of thought, the efficient market hypothesis, holds that fundamental analysis is
not a useful investment decision tool because a stock's current price reflects the market's
consensus of its value. As a result, individual investors are not able to identify mispriced
securities. The effect of market forces on the price of securities and the efficient market
hypothesis are discussed in the following sections.

The Efficient Market Hypothesis

Economists have argued for many years that in a free-market economy with perfect
competition, price is determined by the availability of the product (supply) and the desire to
possess that product (demand). Accordingly, the price of a product is determined by the
consensus in the marketplace. This process is generally represented by Figure 4.1.
Economists also argue that this model is not completely operational in the marketplace,
because the following assumptions about the perfectly competitive market are routinely
violated by the nature of our economic system.

1. All economic units possess complete knowledge of the economy.

2. All goods and services in the economy are completely mobile and can be
easily shifted within the economy.
3. Each buyer and seller must be so small in relation to the total supply and
demand that neither has an influence on the price or demand in total.
4. There are no artificial restrictions placed on demand, supply, or prices of
goods and services.

The best example of the supply and demand model may be in the securities market,
particularly when we consider that stock exchanges provide a relatively efficient distribution
system and that information concerning securities is available through many outlets.
Examples of these information sources are

• Published financial statements from the companies

• Quarterly earnings reports released by the corporation through the news
media
• Reports of management changes released through the news media
• Competitor financial information released through financial reports or the
news media

FIGURE 4.1 Supply and Demand Curves

 • Contract awards announced by the government or private firms
• Information disseminated to stockholders at annual stockholders' meetings

Under the supply and demand model, price is determined by the consensus of purchasers'
knowledge of relevant information about the product. This model has been refined in the
securities market to become known as the efficient market hypothesis (EMH). The issues
addressed by the EMH are as follow: What information about a company is of value to
investors? Does the form of the disclosure of various types of corporate information affect
the understandability of that information?
Proponents of this theory claim that financial markets price assets at their intrinsic worth,
given all publicly available information. Therefore the price of a company's stock accurately
reflects the company's value after incorporating the information available on company
earnings, business prospects, and other relevant information. Discussions of the EMH in
academic literature have defined all available information in three different ways, resulting in
three separate forms of the EMH: the weak form, the semistrong form, and the strong form.
The EMH holds that an investor cannot make an excess return (a return above what should
be expected for a group of securities, given market conditions and the risk associated with
the securities) by knowledge of particular pieces of information. The three forms of the EMH
differ with respect to their definitions of available information.

Weak Form
The weak form of the EMH is essentially an extension of the random walk theory expressed
in the financial management literature.8 According to this theory, the historical price of a
stock provides an unbiased estimate of its future price. Several studies have supported this
argument.9,10 However, the argument that stock prices are random does not mean that
fluctuation takes place without cause or reason. On the contrary, it suggests that price
changes take place because of investor knowledge about perceived earnings potential or
alternative investment opportunities.
According to the weak form of the EMH, an investor cannot make excess returns simply
on the basis of knowledge of past prices. For example, suppose a certain group of securities
with a known risk yields an average return on investment of 10 percent (this average is
composed of returns above and below that figure). According to the weak form of the EMH,
the stock market incorporates all information on past prices into the determination of the
current price. Therefore the charting of the trends of securities prices provides no additional
information for the investor. If this form of the EMH is correct, an investor could do just as
well by randomly selecting a portfolio of securities as he or she could by charting the past
prices of securities and selecting the portfolio on that basis. (It is important to note that the
EMH is based on a portfolio of securities and average returns on investments, not on
individual purchases of securities.) The implication of the weak form of the EMH is that
some of the information provided by securities analysts is useless. That is, securities analysts
have maintained that trends in prices are good indicators of future prices. However,
knowledge of this information does not aid an investor, because it has already been
incorporated into the price-determination process in the marketplace.

Semistrong Form
The difference between the weak, semistrong, and strong forms of the EMH lies in the
amount of information assumed to be incorporated into the determination of security prices.
Under the semistrong form of the EMH, all publicly available information, including past
stock prices, is assumed to be important in determining securities prices. In other words, if
this form of the EMH is correct, no investor can make an excess return by use of publicly
available information because this information has already been considered by the
marketplace in establishing securities prices. The implication of the semistrong form of the
EMH for accountants is that footnote disclosure is just as relevant as information in the body
of financial statements. In addition, it suggests that the accounting procedures adopted by a
particular organization will have no effect if an investor can convert to the desired method.
The results of studies on this form of the EMH have been generally supportive.11

Strong Form
According to the strong form of the EMH, all information, including price trends of
securities, publicly available information, and insider information, is impounded into
securities prices in such a way as to leave no opportunity for excess returns. The implication
of this form of the EMH for accountants is that the marketplace considers all information
available, whether external or internal. That is, as soon as anyone in a corporation knows a
piece of information, that information is immediately incorporated into determining a
security's price in the market. In effect, the strong form implies that published accounting
information is no more valuable than any other type of available information, whether or not
it is publicly available.
Most of the evidence testing this form of the EMH suggests that it is not valid. 12 However,
one study of mutual funds, whose managers are more likely to have insider information,
indicated that such funds did no better than an individual investor could expect to do if he or
she had purchased a diversified portfolio with similar risk. In fact, many did worse than
randomly selected portfolios would have done.13 This study tends to support the strong form
of the EMH.

Research Challenges of the Efficient Market Hypothesis

The EMH presents an interesting research challenge for accountants. The financial crisis of
2007–2009 suggests that the market failed to incorporate some pieces of information such as
the housing bubble or the unsustainable levels of risk offered by mortgage-backed securities
and has led to additional criticism. One market strategist even maintained that the EMH is
responsible for the financial crisis, asserting that belief in the hypothesis caused the
investment community to underestimate the dangers of asset bubbles
breaking.14 Additionally, noted financial journalist Roger Lowenstein attacked the theory,
stating “The upside of the current Great Recession is that it could drive a stake through the
heart of the academic nostrum known as the efficient-market hypothesis.”15 Finally, former
Federal Reserve chairman Paul Volcker said “It's clear that among the causes of the recent
financial crisis was an unjustified faith in rational expectations [and] market efficiencies.”16
Others disagree with these assessments. Eugene Fama, who first developed the theory,
said that the EMH held up well during the crisis and maintained that the markets were a
casualty of the recession, not the cause of it.17 Despite this, he had conceded earlier that
“poorly informed investors could theoretically lead the market astray” and that stock prices
could become “somewhat irrational” as a result.18 Critics have also suggested that financial
institutions and corporations have been able to reduce the efficiency of financial markets by
creating private information and reducing the accuracy of conventional disclosures, as well
as by developing new and complex products that are challenging for most market
participants to evaluate and correctly price.19
On balance, it has become conventional wisdom that the 2007–2009 financial crisis
discredited the EMH, but to assess the validity of EMH it is important to remember that it
has three forms, and as a result, it is virtually impossible to discredit or uphold EMH in
general terms. Each form of the EMH must be addressed specifically. However, in all of its
forms, EMH simply states that investors cannot consistently produce excess returns given
that stock prices reflect all publicly available information. EMH does not talk about the
ability of stock prices to accurately predict future events.
Research strategies must continue to be designed to test each of the EMH forms so that
more solid conclusions can be drawn. This research is important because it provides
evidence on the way information about business enterprises is incorporated into the price of
corporate securities, and it might allow investor-oriented accounting principles to be
developed.

The Implications of Efficient Market Research

The EMH has implications for the development of accounting theory. Some critics of
accounting have argued that the lack of uniformity in accounting principles has allowed
corporate managers to manipulate earnings and mislead investors.20 This argument is based
on the assumption that accounting reports are a primary source of information on a business
organization. The results of EMH research suggest that stock prices are not determined
solely by accounting reports. This conclusion has led researchers to investigate how
accounting earnings are related to stock prices.
The results of these investigations imply that accounting earnings are correlated with
securities returns. Other accounting research relies on research findings that support the
EMH to test market perceptions of accounting numbers and financial disclosures. This
research is based on the premise that an efficient market implies that the market price of a
firm's shares reflects the consensus of investors regarding the value of the firm. Thus, if
accounting information or other financial disclosures incorporate items that affect a firm's
value, they should be reflected in the firm's security price.21
An additional issue is the relationship between EMH and the economic consequences
argument introduced in Chapter 1. The EMH holds that stock prices will not be influenced
by accounting practices that do not affect profitability or cash flows. However, history
indicates that various stakeholders have attempted to lobby the FASB over such changes.
Examples of these efforts include accounting for the investment tax credit and accounting for
foreign currency translation (discussed in Chapter 16). Some accountants claim that this is an
example of existing theory failing to fully explain current practice and is consistent with
steps 3 and 4 of the Kuhnian approach to scientific progress discussed by SATTA and
reviewed in Chapter 2. If so, an existing paradigm is found to be deficient and the search for
a new paradigm begins. These accountants generally maintain that the positive theory of
accounting (discussed later in the chapter) provides a better description of existing
accounting practice.

Behavioral Finance
The efficient market hypothesis became more than a theory of finance in the period
following its introduction by Eugene Fama in 1970. The EMH became the foundation for
what became known as the rational market theory. This theory held that as more and more
financial instruments were developed and traded, they would bring more rationality to
economic activity. The theory maintained that financial markets possessed superior
knowledge and regulated economic activity in a manner the government couldn't match. The
rational market theory became the cornerstone of national economic policy during the tenure
of Federal Reserve Chairman Alan Greenspan, who led this agency from 1986 to 2009. Its
approach, which opposed government intervention in markets, helped reshape the 1980s and
1990s by encouraging policymakers to open their economies to market forces, and resulted
in an era of deregulation. However, this all changed in 2007.
In the years before 2007, the easy availability of credit in the United States led to a
housing construction boom and facilitated debt-financed consumer spending. Lax lending
standards and rising real estate prices also contributed to a real estate bubble, and loans of
various types were easy to obtain. As a result, consumers assumed an unprecedented debt
load. As part of the housing and credit booms, the number of financial agreements such as
mortgage-backed securities (MBS), which derived their value from mortgage payments and
housing prices, greatly increased. These agreements enabled institutions and investors
around the world to invest in the U.S. housing market.
Beginning in 2007, housing prices declined and major global financial institutions that had
borrowed and invested heavily in MBS reported significant losses. Falling prices also
resulted in homes' being worth less than their mortgage loans, providing a financial incentive
to enter foreclosure. The resulting foreclosure epidemic eroded the financial strength of
banking institutions. Defaults and losses on other loan types also increased significantly as
the crisis expanded from the housing market to other parts of the economy.
While the housing and credit bubbles were building, a series of other factors caused the
financial system to become increasingly fragile. As noted earlier, U.S. government policy
from the 1970s onward had emphasized deregulation to encourage business, which resulted
in less oversight of activities and less disclosure of information about new activities
undertaken by banks and other evolving financial institutions. Thus, policymakers did not
immediately recognize the increasingly important role played by financial institutions such
as investment banks and hedge funds. The U.S. Financial Crisis Inquiry Commission was
created in 2009 by Congress as a bipartisan panel that would investigate the causes of the
country's financial meltdown, much as the 9/11 Commission examined the background of the
attacks. It reported its findings in January 2011, and a majority of the members concluded
that the crisis was avoidable and was caused by “Widespread failures in financial regulation,
including the Federal Reserve's failure to stem the tide of toxic mortgages.”22
In October 2008, former Federal Reserve Chairman Alan Greenspan appeared before the
United States House of Representatives Oversight Committee and acknowledged that he had
made a mistake in believing that banks, operating in their own self-interest, would do what
was necessary to protect their shareholders and institutions. Greenspan called that “a flaw in
the model . . . that defines how the world works.”23 He also acknowledged that he had been
wrong in rejecting fears that the five-year housing boom was turning into an unsustainable
speculative bubble that could harm the economy when it burst. Greenspan had previously
maintained during that period that home prices were unlikely to post a significant decline
nationally because housing was a local market. His later view was an admission that the
rational market theory was flawed.
Criticisms of EMH and the rational market theory were not new in 2008. As far back as
the early 1970s, critics were noting events that could not be explained by the EMH.24 These
unexplainable results were termed anomalies. According to finance theory, a financial
market anomaly occurs when the performance of a stock or a group of stocks deviates from
the assumptions of the efficient market hypothesis. Katz classified anomalies into four basic
types: calendar anomalies, value (fundamental) anomalies, technical anomalies, and other
anomalies.25
Examples of these four types of anomalies are listed in Box 4.1. Calendar anomalies are
related to particular time periods, such as movement in stock prices from day to day, month
to month, or year to year. As for value anomalies, for many years, it has been argued that
value strategies outperform the market. Value strategies consist of buying stocks that have
low prices relative to earnings, dividends, the book value of assets, or other measures of
value. Technical analysis is a general term for a number of investing techniques that attempt
to forecast security prices by studying past prices and other related statistics. Common
technical analysis techniques include strategies based on relative strength, moving averages,
and support and resistance. Several other types of anomalies cannot be easily categorized.
These include announcement-based effects, IPOs, and insider transactions, among others.
Contemporaneously with the identification of financial market anomalies, a new theory of
financial markets espouses what has been termed behavioral finance.
Box 4.1 Financial Market Anomalies
Examples of Calendar Anomalies
Weekend Effect
Stock prices are likely to fall on Monday; consequently, the Monday closing price is less
than the closing price of previous Friday.
Turn-of-the-Month Effect
The prices of stocks are likely to increase on the last trading day of the month, and the
first three days of next month.
Turn-of-the-Year Effect
The prices of stocks are likely to increase during the last week of December and the first
half month of January
January Effect
Small-company stocks tend to generate greater returns than other asset classes and the
overall market in the first two to three weeks of January.
Examples of Value Anomalies
Low Price-to-Book Ratio
Stocks with a low ratio of market price to book value generate greater returns than stocks
having a high ratio of book value to market value.
High Dividend Yield
Stocks with high dividend yields tend to outperform low dividend yield stocks.
Low Price-to-Earnings Ratio (P/E)
 Stocks with low price-to-earnings ratios are likely to generate higher returns and
outperform the overall market, whereas the stocks with high market price-to-earnings
ratios tend to underperform the overall market.
Neglected Stocks
Prior neglected stocks tend to generate higher returns than the overall market in
subsequent periods, and the prior best performers tend to underperform the overall
market.
Examples of Technical Anomalies
Moving Average
Moving average is a trading strategy that involves buying stocks when short-term
averages are higher than long-term averages and selling stocks when short-term averages
fall below their long-term averages.
Trading Range Break
Trading range break is a trading strategy based upon resistance and support levels. A buy
signal is created when the prices reaches a resistance level. A sell signal is created when
prices reach the support level.
Examples of Other Anomalies
The Size Effect
Small firms tend to outperform larger firms.
Announcement-Based Effects and Post-Earnings Announcement Drift
Price changes tend to persist after initial announcements. Stocks with positive surprises
tend to drift upward, and those with negative surprises tend to drift downward.
IPOs, Seasoned Equity Offerings, and Stock Buybacks
Stocks associated with initial public offerings (IPOs) tend to underperform the market,
and there is evidence that secondary offerings also underperform, whereas stocks of firms
announcing stock repurchases outperform the overall market in the following years.
Insider Transactions
There is a relationship between transactions by executives and directors in their firm's
stock and the stock's performance. These stocks tend to outperform the overall market.
The S&P Game
Stocks rise immediately after being added to the S&P 500.
The theory of behavioral finance arose from studies undertaken by Kahneman and Tversky,
and Thaler.
Kahneman and Tversky termed their study of how people manage risk and
uncertainty prospect theory,26 which is a theory about how people make choices between
different options or prospects. It is designed to better describe, explain, and predict the
choices that the typical person makes, especially in a world of uncertainty. Prospect theory is
characterized by the following:

• Certainty: People have a strong preference for certainty and are willing to
sacrifice income to achieve more certainty. For example, if option A is a
guaranteed win of $1000, and option B is an 80 percent chance of winning
 $1400 but a 20 percent chance of winning nothing, people tend to prefer
option A.
• Loss aversion: People tend to give losses more weight than gains: They're
loss-averse. So, if you gain $100 and lose $80, it may be considered a
net loss in terms of satisfaction, even though you came out $20 ahead,
because you tend to focus on how much you lost, not on how much you
gained.
• Relative positioning: People tend to be most interested in their relative gains
and losses as opposed to their final income and wealth. If your relative
position doesn't improve, you won't feel any better off, even if your income
increases dramatically. In other words, if you get a 10 percent raise and your
neighbor gets a 10 percent raise, you won't feel better off. But if you get a
10 percent raise and your neighbor doesn't get a raise at all, you'll feel rich.
• Small probabilities: People tend to underreact to low-probability events. For
example, you might completely discount the probability of losing all your
wealth if the probability is very small. This tendency can result in people
making very risky choices.

Thaler investigated the implications of relaxing the standard economic assumption that
everyone in the economy is rational and selfish, instead entertaining the possibility that some
of the agents in the economy are sometimes human.27 These studies laid the groundwork for
a new field of study, termed behavioral finance. Behavioral finance explores the proposition
that investors are often driven by emotion and cognitive psychology rather than rational
economic behavior. It suggests that investors use imperfect rules of thumb, preconceived
notions, and bias-induced beliefs, and that they behave irrationally. Consequently, behavioral
finance theories attempt to blend cognitive psychology with the tenets of finance and
economics to provide a logical and empirically verifiable explanation for the often-observed
irrational behavior exhibited by investors. The fundamental tenet of behavioral finance is that
psychological factors, or cognitive biases, affect investors, which limits and distorts their
information and can cause them to reach incorrect conclusions even if the information is
correct.
Some of the most the most common cognitive biases in finance include the following:

• Mental accounting: The majority of people perceive a dividend dollar

differently from a capital gains dollar. Dividends are perceived as an
addition to disposable income; capital gains usually are not.
• Biased expectations: People tend to be overconfident in their predictions of
the future. If security analysts believe with 80 percent confidence that a
certain stock will go up, they are right about 40 percent of the time. Between
1973 and 1990, earnings forecast errors have been anywhere between 25
percent and 65 percent of actual earnings.
• Reference dependence: Investment decisions seem to be affected by an
investor's reference point. If a certain stock was once trading for $20, then
dropped to $5 and finally recovered to $10, the investor's propensity to
increase holdings of this stock depends on whether the previous purchase
was made at $20 or at $5.
 • Representativeness heuristic: In cognitive psychology this term means
simply that people tend to judge Event A to be more probable than Event B
when A appears more representative than B. In finance, the most common
instance of the representativeness heuristic is that investors mistake good
companies for good stocks. Good companies are well known and in most
cases fairly valued. Their stocks thus might not have a significant upside
potential.

Although behavioral finance is a relatively new field, Barberis and Thaler28 suggest that
substantial progress has been made. Points of progress include the following:

• Empirical investigation of apparently anomalous facts: When De Bondt and

Thaler's paper29 was published, many thought that the best explanation for
their findings was a programming error. Since then their results have been
replicated numerous times by researchers both sympathetic to their view and
holding alternative views. The evidence suggests that most of the empirical
data are agreed upon, although the interpretation of those data is still in
dispute.
• Limits to arbitrage: In the 1990s, many financial economists thought that
the EMH had to be true because of the forces of arbitrage.30 We now
understand that this was a naive view, and that the limits to arbitrage can
permit substantial mispricing. Most researchers also agree that the absence
of a profitable investment strategy does not imply the absence of mispricing.
Prices can be very wrong without creating profit opportunities.
• Understanding bounded rationality: Owing to the work of cognitive
psychologists such as Kahneman and Tversky, we now have a large group
of empirical findings that catalogue some of the ways humans actually form
expectations and make choices. There has also been progress in developing
formal models of these processes, with prospect theory being the most
notable. Economists once thought that behavior was either rational or
impossible to formalize. Most economists now accept the fact that models of
bounded rationality are both possible and more accurate descriptions of
behavior than purely rational models.
• Behavioral finance theory building: There has been a growth of theoretical
work modeling financial markets with less than fully rational agents. These
studies relax the assumption of individual rationality either through the
belief-formation process or through the decision-making process. Like the
work of the psychologists, these papers are important proofs, showing that it
is possible to think coherently about asset pricing while incorporating salient
aspects of human behavior.
• Investor behavior: The important job of trying to document and understand
how investors—both amateurs and professionals—make their portfolio
choices has begun. Until recently, such research was notably absent from the
study of financial economics.
 Nevertheless, not all economists are convinced of the value of prospect theory and
behavioral finance theory. Critics continue to support the EMH. They contend that
behavioral finance is more a collection of anomalies than a true branch of finance and that
these anomalies are either quickly priced out of the market or explained by appealing to
market microstructure arguments. Additionally they maintain that individual cognitive biases
are distinct from social biases; the former can be averaged out by the market, and the other
can create positive feedback loops that drive the market further and further from a fair price
equilibrium. Similarly, for an anomaly to violate market efficiency, an investor must be able
to trade against it and earn abnormal profits; this is not the case for many anomalies.
Eugene Fama, for example, regards behavioral finance as just storytelling that is very good
at describing individual behavior. Although he concedes that some sorts of professionals are
inclined toward the same sort of biases as others, he asserts that the jumps that behaviorists
make from there to markets are not validated by the data.31 Another critic states,
Pointing out all the ways that real life behavior doesn't bear out the predictions of
traditional economics and finance is interesting—even fascinating, at times—but it's
not an alternative theory. “People aren't rational” isn't a theory: it's an empirical
observation. An alternative theory would need to offer an explanation, including
causal processes, underlying mechanisms and testable propositions.”32
In summary, over the last few decades, our understanding of finance has increased a great
deal, yet there are many questions to be answered. On the whole, financial decision making
remains a gray area waiting for researchers to shed additional light on it; however, a major
paradigm shift is under way. Hopefully the new paradigm will combine neoclassical and
behavioral elements and will replace unrealistic assumptions about the optimality of
individual behavior with descriptive insights tested by laboratory experiments. History
requires economic and financial systems to be continually updated, and it requires that they
be intelligently redesigned to meet social changes and to take advantage of technological
progress. If behavioral finance is to be successful in understanding financial institutions and
participants, and if individuals and policymakers want to make better decisions, they must
take into account the true nature of people with their imperfections and bounded rationality.

The Capital Asset Pricing Model

As indicated earlier in the chapter, investors often wish to use accounting information in an
attempt to minimize risk and maximize returns. It is generally assumed that rational
individual investors are risk averse. Consequently, riskier investments must offer higher
rates of return to attract investors. From an accounting standpoint, this means investors need
information on expected risks and returns. The capital asset pricing model (CAPM) is an
attempt to deal with both risks and returns. CAPM was first introduced by financial
economist (and, later, Nobel laureate in economics) William Sharpe and described in his
1970 book Portfolio Theory and Capital Markets.33
The actual rate of return to an investor from buying a common stock and holding it for a
period of time is calculated by adding the dividends to the increase (or decrease) in value of
the security during the holding period and dividing this amount by the purchase price of the
security, or

Because stock prices fluctuate in response to changes in investor expectations about the
firm's future cash flows, common stocks are considered risky investments. In contrast, U.S.
Treasury notes are not considered risky investments, because the expected and stated rates of
return are equal (assuming the T-bill is held to maturity). Risk is defined as the possibility
that actual returns will deviate from expected returns, and the amount of potential fluctuation
determines the degree of risk.
A basic assumption of the CAPM is that risky stocks can be combined into a portfolio that
is less risky than any of the individual common stocks that make up that portfolio. This
diversification attempts to match the common stocks of companies in such a manner that
environmental forces causing a poor performance by one company will simultaneously cause
a good performance by another—for example, purchasing the common stock of an oil
company and an airline company. Although such negative relationships are rare in our
society, diversification reduces risk.

Types of Risk
Some risk is peculiar to the common stock of a particular company. For example, the value
of a company's stock might decline when the company loses a major customer, as when the
Ford Motor Company lost Hertz as a purchaser of rental cars. On the other hand, overall
environmental forces cause fluctuations in the stock market that affect all stock prices, such
as the oil crisis in 1974.
These two types of risk are termed unsystematic risk and systematic risk. Unsystematic
risk is the portion of a company's particular risk that can be diversified away. Systematic
risk is the nondiversifiable portion that is related to overall movements in the stock market
and is consequently unavoidable. Earlier in the chapter, we indicated that the EMH suggests
that investors cannot discover undervalued or overvalued securities, because the market
consensus will quickly incorporate all available information into a firm's stock price.
However, financial information about a firm can help determine the amount of systematic
risk associated with a particular stock.
As securities are added to a portfolio, unsystematic risk is reduced. Empirical research has
demonstrated that unsystematic risk is virtually eliminated in portfolios of thirty to forty
randomly selected stocks. However, if a portfolio contains many common stocks in the same
or related industries, a much larger number of stocks must be acquired, because the rate of
returns on such stocks are positively correlated and tend to increase or decrease in the same
direction. The CAPM also assumes that investors are risk averse; consequently, investors
demand additional returns for taking additional risks. As a result, high-risk securities must be
priced to yield higher expected returns than lower-risk securities in the marketplace.
A simple equation can be formulated to express the relationship between risk and return.
This equation uses the risk-free return (the T-bill rate) as its foundation and is stated as

where

Rs = the expected return on a given risky security

Rf = the risk-free rate

Rp = the risk premium

Because investors can eliminate the risk associated with acquiring a particular company's
common stock by purchasing diversified portfolios, they are not compensated for bearing
unsystematic risk. And because well-diversified investors are exposed to systematic risk
only, investors using the CAPM as the basis for acquiring their portfolios are subject only to
systematic risk. Consequently, systematic risk is the only relevant type, and investors are
rewarded with higher expected returns for bearing market-related risk that will not be
affected by company-specific risk.
The measure of the parallel relationship of a particular common stock with the overall
trend in the stock market is termed beta (β). β may be viewed as a gauge of a particular
stock's volatility to the total stock market.
A stock with a β of 1.00 has a perfect relationship to the performance of the overall market
as measured by a market index such as the Dow–Jones Industrials or the Standard & Poor's
500-stock index. Stocks with a β of greater than 1.00 tend to rise and fall by a greater
percentage than the market, whereas stocks with a β of less than 1.00 tend to rise and fall by
a smaller percentage than the market over the selected period of analysis. Therefore β can be
viewed as a stock's sensitivity to market changes and as a measure of systematic risk.34
A company's risk premium (the risk adjustment for the amount by which a company's
return is expected to exceed that of a risk-free security) is equivalent to its β multiplied by
the difference between the market return and the risk-free rate. The risk-return equation can
thus be restated to incorporate β, by replacing the risk premium, Rp, with its
equivalent, βs(Rm − Rf), as follows:

where

Rs = the stock's expected return

Rf = the risk-free rate

Rm = the expected return on the stock market as a whole

β= the stock's β, which is calculated over some historical period

The final component of the CAPM reflects how the risk–expected return relationship and
securities prices are related. As indicated above, the expected return on a security equals the
risk-free rate plus a risk premium. In the competitive and efficient financial markets assumed
by the CAPM, no security will be able to sell at low prices to yield more than its appropriate
return, nor will a security be able to sell at higher than market price and offer a low return.
Consequently, the CAPM holds that a security's price will not be affected by unsystematic
risk and that securities offering relatively higher risk (higher βs) will be priced relatively
lower than securities offering relatively lower risk.
The CAPM has come under attack over the last several years because it does not explain
returns the way it was intended to—that is, a higher acceptance of systematic risk leads to
higher returns. An additional concern over the use of the CAPM is the relationship of past
and future βs. Researchers question whether past βs can be used to predict future risk and
return relationships. One notable study that examined this issue was conducted by Fama and
French, who examined share returns on the New York Stock Exchange, the American Stock
Exchange, and NASDAQ between 1963 and 1990. They found that differences in βs over
that lengthy period did not explain the performance of different stocks.35 This finding
suggests that CAPM may be incorrect; however, subsequent research has questioned this
conclusion.36
The CAPM has also been criticized for contributing to the United States' competitiveness
problem. According to critics, U.S. corporate managers using the CAPM are forced into
making safe investments with predictable short-term returns instead of investing for the long
term. This is particularly true when companies with higher βs attempt to invest in new
ventures. Because a high β is seen as evidence of a risky investment, these companies are
forced to accept only new projects that promise high rates of return. As a result, researchers
have been attempting to develop new models that view the markets as complex and evolving
systems that will enable business managers to adopt a more long-range viewpoint.
In summary, there are many detractors who question the validity of the CAPM, and we
can accept the contention that a model created about 40 years ago can fall short of explaining
reality. Many of the issues the critics have with CAPM are valid, but it still can be a useful
tool for explaining how accounting information is used and the relationship between risk and
return. The concepts associated with the CAPM can also be used to make the asset allocation
decisions that will provide a significant chance of successfully outperforming the market
over the long term because the theory demonstrates that portfolio diversification can reduce
investment risk.

Normative versus Positive Accounting Theory

Financial accounting theory attempts to specify which events to record, how the recorded
data should be summarized, and how the data should be presented. As discussed earlier,
accounting theory has developed pragmatically. If a practice or method has been used in the
past by a large number of accountants to satisfy a particular reporting need, its continued use
is acceptable. Also, as noted in Chapter 2, few attempts to develop a comprehensive theory
of accounting were made before World War II. Since then, there has been an increasing
demand for a theory of accounting. In recent decades, efforts to satisfy this demand have
permeated accounting literature. These efforts rely heavily on theories developed in
mathematics, economics, and finance.
Recall from Chapter 1 that there are two basic types of theory: normative and positive.
Normative theories are based on sets of goals that proponents maintain prescribe the way
things should be. However, no set of goals is universally accepted by accountants. As a
consequence, normative accounting theories are usually acceptable only to those who agree
with the assumptions on which they are based. Nevertheless, most accounting theories are
normative, because they are based on certain objectives of financial reporting.
Positive theories attempt to explain observed phenomena. They describe what is without
indicating how things should be. The extreme diversity of accounting practices and
application has made development of a comprehensive description of accounting difficult.
Concurrently, to become a theory, description must have explanatory value. For example, not
only must the use of historical cost be observed, but under positive theory that use must also
be explained. Positive accounting theory has arisen because existing theory does not fully
explain accounting practice. For example, the EMH indicates that knowledge of all publicly
available information will not give an investor an advantage, because the market has
compounded the information into current security prices. If so, the market should react only
to information that reflects or is expected to affect a company's cash flows. Yet various
interest groups continue to lobby the FASB and Congress over accounting policy changes
that do not have cash-flow consequences.
Agency Theory
Attempts to describe financial statements and the accounting theories from which they
originate, as well as to explain their development based on the economic theories of prices,
agency, public choice, and economic regulation, have been categorized as agency
theory. Agency theory is a positive accounting theory that attempts to explain accounting
practices and standards. This research takes the EMH as a given and views accounting as the
supplier of information to the capital markets.
The basic assumption of agency theory is that individuals maximize their own expected
utilities and are resourceful and innovative in doing so. Therefore the issue raised by agency
theory is as follows: What is an individual's expected benefit from a particular course of
action? Stated differently, how might a manager or stockholder benefit from a corporate
decision? It should also be noted that the interests of managers and stockholders are often not
the same.
An agency is defined as a consensual relationship between two parties, whereby one party
(agent) agrees to act on behalf of the other party (principal). For example, the relationship
between shareholders and managers of a corporation is an agency relationship, as is the
relationship between managers and auditors and, to a greater or lesser degree, that between
auditors and shareholders.
An agency relationship exists between shareholders and managers because the owners
don't have the training or expertise to manage the firm themselves, have other occupations,
and are scattered around the country and the world. Consequently, the stockholders must
employ someone to represent them. These employees are agents who are entrusted with
making decisions in the shareholders' best interests. However, the shareholders cannot
observe all of the actions and decisions made by the agents, so a threat exists that the agents
will act to maximize their own wealth rather than that of the stockholders. This is the major
agency theory issue—the challenge of ensuring that the manager/agent operates on behalf of
the shareholders/principals and maximizes their wealth rather than his or her own.
Inherent in agency theory is the assumption that a conflict of interest exists between the
owners (shareholders) and the managers. The conflict occurs when the self-interest of
management is not aligned with the interests of shareholders. Shareholders desire to
maximize profits on their investment in the company; instead, managers may be maximizing
their own utilities at the expense of the shareholders. Under this scenario, shareholder wealth
is not maximized. For example, a manager might choose accounting alternatives that
increase accounting earnings when a management compensation scheme is tied to those
earnings. Because such choices affect only how financial information is measured and thus
the amount of reported earnings, they have no real economic effect in and of themselves and
thus provide no benefit to the shareholder. At the same time, shareholder wealth declines as
management compensation increases.
Agency relationships involve costs to the principals. The costs of an agency relationship
have been defined as the sum of monitoring expenditures by the principal, bonding
expenditures by the agent, and the residual loss.37 Monitoring expenditures are defined as
expenditures by the principal to control the agent's behavior, for example, the costs of
measuring and observing the agent's behavior or the costs of establishing compensation
policies. Bonding costs are defined as expenditures to guarantee that the agent will not take
certain actions to harm the principal's interest. Finally, even with monitoring and bonding
expenditures, the actions taken by the agent will differ from the actions the principal would
take the wealth effect of this divergence in actions is defined as residual loss.
Examples of monitoring costs are external and internal auditors, the SEC, capital markets
including underwriters and lenders, boards of directors, and dividend payments. Examples of
bonding costs include managerial compensation, including stock options and bonuses and the
threat of a takeover if mismanagement causes a reduction in stock prices. Residual losses are
the extent to which returns to the owners fall below what they would be if the principals and
the owners exercised direct control of the corporation.
Because agency theory holds that all individuals act to maximize their own utility,
managers and shareholders would be expected to incur bonding and monitoring costs as long
as those costs are less than the reduction in the residual loss. For instance, a management
compensation plan that ties management wealth to shareholder wealth will reduce the agency
cost of equity, or a bond covenant that restricts dividend payments will reduce the agency
costs of debt. Examples of this latter type of costs were included in corporate charters as
early as the 1600s. According to agency theory, in an unregulated economy, the preparation
of financial statements is determined by the effect of such statements on agency costs. That
is, financial statements would tend to be presented more often by companies with many bond
covenants (e.g., restrictions on dividends or relatively more outside debt). Similarly, the
greater the value of a company's fixed assets, the more likely a charge for maintenance,
repair, or depreciation will be included in the financial statements.
The conclusion drawn by agency theory is that multiple methods of accounting for similar
circumstances have developed from the desires of various individuals, such as managers,
shareholders, and bondholders, to minimize agency costs.
Because private-sector regulations and federal legislation help determine the items
disclosed in financial statements, the effects of regulation and the political process must be
added to the results of agency relationships. However, the regulation process is affected by
external pressures. Groups of individuals might have incentives to band together to cause the
government to transfer wealth, as in farm subsidies. The justification for these transfers is
that they are “in the public interest.” In addition, elected officials and special interest groups
might use the believed high profits of corporations to create crises, which are solved by
wealth transfers “in the public interest.” A prime example is the “windfall profits” tax
enacted at the time of the 1974 oil crisis.
Additionally, the larger a corporation is, the more susceptible it is to political scrutiny and
subsequent wealth transfers. Therefore the larger a company is, the more likely it is to choose
accounting alternatives that minimize net income; this is termed the visibility theory of
accounting.38 Conversely, small companies often have incentives to show greater net income
in order to increase borrowing potential and available capital. Agency theory holds that these
varying desires are a reason for the diversity of acceptable accounting practices.
Agency theory also attributes the preponderance of normative theories of accounting to the
influence of the political processes. When a crisis develops, elected officials base their
positions on “public interest” arguments. These positions are often grounded in the notion
that the problem is caused by an inefficiency in the market that can be remedied only by
government intervention. Elected officials then seek justification of their position in the form
of normative theories supporting that position. They also tend to look for theories prescribing
accounting procedures that should be used to increase the information available to investors
or make the market more efficient.
The advocates of agency theory maintain that it helps explain financial statements and the
absence of a comprehensive theory of accounting. However, the basic assumption that
everyone acts to maximize his or her own expected utility causes this theory to be politically
and socially unacceptable. Agency theory advocates maintain that this is true regardless of
how logically sound the theory may be, or even how well it may stand up to empirical
testing. For example, if an elected official supported a theory that explained his or her actions
as those that maximize his or her own utility, rather than the public good, the official would
not be maximizing his or her own utility.
 Agency theory can help explain the lack of a comprehensive accounting theory. It implies
that because of the diverse interests involved in financial reporting, a framework of
accounting theory cannot be developed. However, there is an even more basic reason that
agency theory has limited direct impact on financial accounting. Agency theory is a
descriptive theory in that it helps to explain why a diversity of accounting practices exists.
Therefore, even if subsequent testing supports this theory, it will not identify the correct
accounting procedures to be used in various circumstances, and as a result, accounting
practice will not be changed.

Human Information Processing

The annual reports of large corporations provide investors with vast amounts of information.
These reports can include a balance sheet, an income statement, a statement of cash flows,
numerous footnotes to the financial statements, a five-year summary of operations, a
description of the various activities of the corporation, a message to the stockholders from
the top management of the corporation, a discussion and analysis by management of the
annual operations and the company's plans for the future, and the report of the company's
independent certified public accountant.
The disclosure of all this information is intended to aid investors and potential investors in
making buy–hold–sell decisions about the company's securities. Studies attempting to assess
an individual's ability to use information have been broadly classified as human information
processing (HIP) research. The issue addressed by these studies is: How do individuals use
available information? Consequently, HIP research can be used to determine how individual
investors make decisions.
In general, HIP research has indicated that people have a limited ability to process large
amounts of information.39 This finding has three main consequences:

1. An individual's perception of information is quite selective. That is, because

people are capable of comprehending only a small part of their environment,
their anticipation of what they expect to perceive about a particular situation
will determine to a large extent what they do perceive.
2. Because people make decisions on the basis of a small part of the total
information available, they do not have the capacity to make optimal
decisions.
3. Because people are incapable of integrating a great deal of information, they
process information in a sequential fashion.

In summary, people use a selective, stepwise information processing system. This system
has limited capacity, and any uncertainty that arises is often ignored.40
These findings can have far-reaching disclosure implications for accountants. The current
trend of the FASB and SEC is to require the disclosure of more and more information. But if
the tentative conclusions of the HIP research are correct, these additional disclosures might
have an effect opposite to that intended. The goal of the FASB and SEC is to provide all
relevant information so that people can make informed decisions about a company.
However, the annual reports might already contain more information than can be adequately
and efficiently processed by their readers.
Research is needed to determine how the selective processing of information by
individuals is transformed into the marketplace consensus described by the EMH and to
determine the most relevant information to include in corporate annual reports. Once these
goals have been accomplished, accountants will have taken a giant step in determining what
information to disclose about accounting entities.

Critical Perspective Research

Our earlier discussion of EMH, behavioral finance, CAPM, agency theory, and HIP includes
references to research studies that attempted to test the hypotheses on which these theories
were built. Such testing carries the assumptions that knowledge of facts can be gained by
observation and that accounting research is completely objective. Critical perspective
research rejects the view that knowledge of accounting is grounded in objective principles.
Rather, researchers adopting this viewpoint share a belief in the indeterminacy of knowledge
claims. Their indeterminacy view rejects the notion that knowledge is externally grounded
only through systems of rules that are superior to other ways of understanding phenomena.
Critical perspective researchers attempt to interpret the history of accounting as a complex
web of economic, political, and accidental co-occurrences.41 They have also argued that
accountants have been unduly influenced by one particular viewpoint in economics (utility-
based, marginalist economics). The economic viewpoint holds that business organizations
trade in markets that form part of a society's economy. Profit is the result of these activities
and indicates the organization's efficiency in using society's scarce resources. In addition,
critical perspective researchers maintain that accountants also take as given the current
institutional framework of government, markets, prices, and organizational forms,42 with the
result that accounting serves to aid certain interest groups in society to the detriment of other
interest groups.43
Critical perspective research views mainstream accounting research as being based on the
view that a world of objective reality exists independently of human beings, has a
determinable nature, and can be observed and known through research. Consequently, people
are not seen as makers of their social reality; instead, they are viewed as possessing attributes
that can be objectively described (i.e., leadership styles or personalities).44 The critical
perspectivists maintain that mainstream accounting research equates normative and positive
theory—that is, what is and what ought to be are the same. They also maintain that
mainstream accounting research theories are put forth as attempts to discover an objective
reality, and there is an expressed or implied belief that the observed phenomena are not
influenced by the research methodology. In summary, this branch of accounting theory,
mainstream accounting research, is based on a belief in empirical testability.
In contrast, critical perspective research is concerned with the ways societies, and the
institutions that make them up, have emerged and can be understood.45 Research from this
viewpoint is based on three assumptions:

1. Society has the potential to be what it is not.

2. Conscious human action is capable of molding the social world to be
something different or better.
3. Assumption 2 can be promoted by using critical theory.46

Using these assumptions, critical theory views organizations in both a historic and a
societal context. It seeks to detect any hidden meanings that reside in these contexts, and it is
concerned with the power of multinational corporations and the resultant distributions of
benefits and costs to societies. Critical theory also does not accept the belief of mainstream
accounting theories that organizations survive because they are maximally efficient; rather, it
maintains that the methods of research are biased in favor of achieving that conclusion.47
The Relationship among Research, Education, and Practice
Research is necessary for effective theory development. In most professional disciplines,
when research indicates that a preferable method has been found to handle a particular
situation, the new method is taught to students, who then implement the method as they
enter their profession. Simply stated, research results in education that influences practice.
For example, physicians once believed that patients undergoing major surgery needed long
periods of bed rest for effective recovery. However, subsequent research indicated that
immediate activity and exercise improved recovery rates. Consequently, it is now common
practice for doctors to encourage their surgery patients to begin walking and exercising as
soon as it is feasible to do so.
The accounting profession has been criticized for not following this model.48 In fact,
before the FASB's development of the conceptual framework, research and normative theory
had little impact on accounting education. During this previous period, students were taught
current accounting practice as the desired state of affairs, and theoretically preferred methods
were rarely discussed in accounting classrooms. As a result, the use of historical cost
accounting received little criticism from accounting educators, because it was the accepted
method of practice, even though it has little relevance to current decision making. Think
about where the medical profession might be today if it had adopted a similar policy—
doctors might still be using the practice of bloodletting to cure diseases.
The development of the conceptual framework and the refinements of the various theories
on the outcomes of accounting are serving to elevate the relationship of research, education,
and practice to a more desirable state. For example, historical cost accounting has been
openly referred to in a disparaging manner as “once-upon-a-time accounting.”
Subsequently, SFAS No. 115 (see FASB ASC 320 and SFAS No. 157) required certain
marketable securities to be valued at their market values (see Chapters 7, 8, and 9). The
recent highly publicized accounting frauds, such as that perpetrated by Enron, have resulted
in new schools of thought, such as those advocated by the critical perspective theorists, and
are forcing both educators and practitioners to rethink previously unquestioned
practices.49 Nevertheless, additional progress is still needed, traditions are difficult to
overcome, and accountants as a group are not known to advocate a great deal of rapid
change.

Cases

Case 4-1 Capital Asset Pricing Model

The capital asset pricing model illustrates how risk is incorporated into user decision
models.

Required:
Discuss the capital asset pricing model, including systematic and unsystematic risk, β, the
relationship between risk and return, how to avoid risk, and the relationship of β to stock
prices.

• These meetings may include discussion of issues that the Monitoring Board
has referred for timely consideration to the IFRS Foundation or the IASB,
and of any proposed resolution of those issues by the IFRS Foundation or
IASB.
 Case 4-2 Supply and Demand
The efficient market hypothesis is an extension of the supply and demand model.

Required:

a. Discuss the assumptions of the supply and demand model inherent in the
EMH.
b. Why is the securities market viewed as a good example of the supply and
demand model?
c. Discuss the three forms of the EMH.

Case 4-3 Behavioral Finance

Criticisms of the EMH and the rational market theory were arising as far back as the early
1970s. These critics were noting events that could not be explained by the EMH. These
unexplainable results were termed anomalies. Four basic types of anomalies have been
identified: calendar anomalies, value (fundamental) anomalies, technical anomalies, and
other anomalies. Contemporaneously with the identification of financial market anomalies, a
new theory of financial markets arose that has been termed behavioral finance.

Required:

a. Discuss the four basic types of anomalies.

b. Define the concept of behavioral finance.
c. What are some of the most the most common cognitive biases in finance?

Case 4-4 Research Methodology

Various research methodologies are available with which to study the development of
accounting theory.

Required:
Discuss the deductive, inductive, and pragmatic research methods. Include in your
discussion examples of accounting research that used each method.

Case 4-5 Agency Theory

Agency theory provides an explanation for the development of accounting theory.

Required:
Discuss agency theory, including its basic assumptions, agency relationships, why the
political process affects agency relationships, and why it does or does not explain
accounting theory.

Case 4-6 Human Information Processing

The study of the ability of individuals to interpret information is classified as human
information processing research.

Required:
Discuss human information processing research. What is the general finding of this
research? What are the consequences of this finding? What effect do these consequences
have on accounting?

Case 4-7 Critical Perspective Research

Critical perspective research views accounting in a manner somewhat different from
traditional accounting research.

Required:

a. What is critical perspective research?

b. How does it differ from traditional accounting research?
c. What are the three assumptions of critical perspective research?

Case 4-8 Economic Consequences

• The FASB has issued SFAS No. 106, “Employers' Accounting for
Postretirement Benefits Other Than Pensions” (see FASB ASC 715)
and SFAS No. 112, “Employers' Accounting for Postemployment Benefits”
(see FASB ASC 712). These pronouncements required companies to change
from accounting for benefits, such as health care, that are paid to former
employees during retirement on a pay-as-you-go basis to recognizing the
expected cost of benefits during employment. As a result, companies must
accrue and report expenses today, thereby reducing income and increasing
liabilities.

Some have argued that these pronouncements will cause employers to reduce or eliminate
postretirement and postemployment benefits. It is not necessary for you to know the
particulars of implementing either of these standards to address the issues described below.

Required:

a. Should financial reporting requirements affect management's decision-

making process? Discuss. Should management reduce or eliminate
postretirement or postemployment benefits simply because of the new
pronouncement? Discuss.
b. Are there social costs associated with these pronouncements? Explain.
c. What would critical perspective proponents say about the potential and/or
actual impact of these pronouncements?
d. What would mainstream accounting proponents say about the potential
and/or actual impact of these pronouncements?

Case 4-9 Financial Statement Disclosure

Current accounting for leases requires that certain leases be capitalized. For capital leases,
an asset and the associated liability are recorded. Whether or not the lease is capitalized, the
cash flows are the same. The rental payments are set by contract and are paid over time at
equally spaced intervals.
Required:

a. If one of the objectives of financial reporting is to enable investors,

creditors, and other users to project future cash flows, what difference does
it make whether we report the lease as a liability or simply describe its terms
in footnotes? Discuss.
b. The efficient market hypothesis states that all available information is
impounded in security prices. In an efficient capital market, would it make
a difference whether the lease is reported as a liability or simply described in
footnotes? Explain.
c. When there are debt covenants that restrict a company's debt-to-equity ratio
and when debt levels rise relative to equity, management may be motivated
to structure leasing agreements so that they are not recorded as capital
leases. Discuss this motivation in terms of agency theory.

FASB ASC Research

FASB ASC 4-1 Employee Stock Options
According to agency theory, linking management pay to stock price changes through stock
option plans and other forms of stock-based compensation should better align management's
goals with those of stockholders. At the same time, if stock options are measured at their fair
value, an expense would be recorded and any portion of management's bonus that is based
on accounting earnings may be negatively affected. Search the FASB ASC database to
determine whether companies are required to report an expense for employee stock options
measured at the option's fair value. Copy and paste your findings, citing the source. Then
write a brief summary of what you found.

Room for Debate

Debate 4-1 The Efficient Market Hypothesis and Accounting Information
It has been argued that by the time financial statements are issued, the market price of shares
already reflects the information contained in them; hence, accounting information is not
relevant. The arguments for both debate teams should address all three forms of the EMH.

Team Debate

Team 1: Present arguments that given the EMH, accounting information is relevant.

Team 2: Present arguments that given the EMH, accounting information is irrelevant.

Debate 4-2 Critical Perspective versus Mainstream Accounting

Proponents of critical perspectives research believe that mainstream accounting research
relies on assumptions that are considered in a vacuum, which does not mirror reality.

Team Debate:
Team 1: Present arguments supporting critical perspective research.

Team 2: Present arguments supporting traditional, mainstream accounting research.

Debate 4-3 Positive versus Normative Accounting Theory

A comprehensive theory of accounting has yet to be developed.

Team Debate

Team Present arguments that support reliance on positive theory to develop a general
1: theory of accounting.

Team Present arguments that support reliance on normative theory to develop a general
2: theory of accounting.
1. Peter Caws, “Accounting Research—Science or Methodology,” in Research Methodology in
Accounting, ed. Robert R. Sterling (Lawrence, KS: Scholars Book Co., 1972), 71.
2. Edwin H. Caplan, “Accounting Research as an Information Source for Theory Construction,” in
Sterling (ed.), Research Methodology in Accounting, 46.
3. This statement was an attempt by the APB to develop a theory of accounting.
4. DR Scott, “The Basis for Accounting Principles,” The Accounting Review (December 1941): 341–
349.
5. Anthony G. Hopwood, “Behavioral Accounting in Retrospect and Prospect,” Behavioral Research
in Accounting (1989): 2.
6. Thomas R. Hofstedt and James C. Kinard, “A Strategy for Behavioral Accounting Research,” The
Accounting Review (January 1970): 43.
7. Edwin H. Caplan, “Behavioral Accounting—A Personal View,” Behavioral Research in
Accounting (1989): 115.
8. Random walk is a term used to characterize a price series where all subsequent price changes
represent random departures from previous prices. The logic of the random walk idea is that if the
flow of information is unimpeded and information is immediately reflected in stock prices, then
tomorrow's price change will react only to tomorrow's news and will be independent of the price
changes today.
9. See, for example, E. Fama, “The Behavior of Stock Market Prices,” Journal of Business (January
1965): 285–299.
10. All tests of the EMH try to demonstrate that using a particular source of information allows an
investor to consistently earn “abnormal” returns. Abnormal returns are percentage returns that are
greater than a buy-and-hold strategy where the investor buys a market index portfolio such as the
S&P/TSX 60 composite index.
11. Research on the semistrong form of the EMH often is conducted as “event studies” that examine
stock returns to determine the impact of a particular event on stock prices. For example, what happens
to the stock price before, during, and after the event? Events include company-specific
announcements such as stock splits, takeover announcements, dividend changes, accounting changes,
and economy-wide changes such as unexpected interest rate changes.
12. Tests of this form of the EMH involve determining whether any group of investors has
information that allows them to earn abnormal profits consistently.
13. See, for example, J. Williamson, “Measuring Mutual Fund Performance,” Financial Analyst's
Journal (November–December 1972): 78–84.
14. Jeremy Grantham, GMO Quarterly Letter (April
2010), http://www.gmo.com/America (Subscription required).
15. Lowenstein, Roger, “Book Review: ‘The Myth of the Rational Market’ by Justin
Fox,” Washington Post, 7 June
2009, http://www.washingtonpost.com/wpdyn/content/article/2009/06/05/AR2009060502053.html.
16. Paul Volcker, “Financial Reform: Unfinished Business,” New York Review of Books (27 October
2011), http://www.nybooks.com/articles/archives/2011/nov/24/financial-reform-unfinished-business/.
17. John Cassidy, “Interview with Eugene Fama,” Rational Irrationality, 13 January
2010, http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-
fama.html.
18. Jon E. Hilsenrath, “Stock Characters: As Two Economists Debate Markets, the Tide Shifts,” Wall
Street Journal, 18 October 2004, A1.
19. See, for example, Michael Simkovic, “Secret Liens and the Financial Crisis of 2008,” American
Bankruptcy Law Journal 83, no. 2 (2009): 253–295.
20. Raymond J. Ball and Philip R. Brown, “An Empirical Evaluation of Accounting Income
Numbers,” Journal of Accounting Research (Autumn 1968): 159–178.
21. Examples of this type of research include G. Peter Wilson, “The Incremental Information Content
of the Accrual and Funds Components of Earnings after Controlling for Earnings,” The Accounting
Review (April 1987), 293–321; Thomas L. Stober, “The Incremental Information Content of Financial
Statement Disclosures: The Case of LIFO Inventory Liquidations,” Journal of Accounting
Research (Supplement, 1986): 138–160; and Bruce Bublitz and Michael Ettredge, “The Information
in Discretionary Outlays: Advertising, Research, and Development,” The Accounting Review (January
1989), 108–124.
22. Financial Crisis Inquiry Commission. “Final Report of The National Commission on the Causes
of the National and Economic Crisis in the United States,” 2011. The report was adopted along
partisan lines. Of the ten commission members, only the six appointed by Democrats endorsed the
final report. Three Republican members prepared a dissent, and a fourth Republican wrote a dissent,
calling government policies to promote homeownership the primary culprit for the crisis.
23. Associated Press, “Greenspan Admits ‘Mistake’ That Helped Crisis,”
NBC News.com. http://www.msnbc.msn.com/id/27335454/ns/business-
stocks_and_economy/t/greenspan-admits-mistake-helped-crisis/.
24. See, for example, S. Basu, “The Investment Performance of Common Stocks in Relation to Their
Price to Earnings Ratios: A Test of the Efficient Market Hypothesis,” The Journal of Finance 32, no.
3 (1977): 663–682.
25. G. Karz, “Historical Stock Market Anomalies,” Investor Home (27 May
2010), http://www.investorhome.com/anomaly.htm.
26. D. Kahneman and A. Tversky, “Prospect Theory: An Analysis of Decision Under
Risk,” Econometrica 47, no. 2 (1979): 263–292.
27. Richard Thaler, “Transaction Utility Theory,” Advances in Consumer Research 10 (1983), 229–
232.
28. N. Barberis and R. Thaler, “A Survey of Behavioral Finance,” in Handbook of the Economics of
Finance, ed. 1, vol. 1B, ed. G. M. Constantinides, M. Harris, and R. M. Stulz (Amsterdam: Elsevier,
2003), 1053–1128.
29. W. De Bondt and R. Thayer, “Does the Stock Market Overreact?” Journal of Finance 40, no. 3
(1985): 793–805. The results of this study suggest that investors overreact to unexpected news and
found substantial weak form EMH inefficiencies.
30. Arbitrage is the practice of taking advantage of a price difference between two or more markets by
striking a combination of matching deals that capitalize upon the imbalance, the profit being the
difference between the market prices.
31. M. Harrison, “Unapologetic after All These Years: Eugene Fama Defends Investor Rationality
and Market Efficiency,” 10 May 2012. http://annual.cfainstitute.org/2012/05/14/eugene-fama-
defends-investor-rationality-and-market-efficiency/.
32. B Harrington. “On the Limitations of Behavioral Finance,” Economic Sociology, 31 October
2010. http://thesocietypages.org/economicsociology/2010/10/31/on-the-limitations-of-behavioral-
finanance/.
33. William F. Sharpe Portfolio Theory and Capital Markets, McGraw-Hill, 1970.
34. Some authors have questioned the contention that volatility and risk are the same.
35. E. Fama and K. French, “The Capital Asset Pricing Model: Theory and Evidence,” Journal of
Economic Perspectives 18, no. 3 (Summer 2004): 25–46.
36. See for example, M. Ferguson and R. Shockley, “Equilibrium ‘Anomalies,’” Journal of
Finance 58, no. 6 (2003): 2549–2580; A. C. MacKinlay, “Multifactor Models Do Not Explain
Deviations from the CAPM,” Journal of Financial Economics 35 (1995): 3–38; and F. Black, “Beta
and Returns,” Journal of Portfolio Management 20 (1993), 8–18.
37. M. Johnson and W. H. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs and
Ownership Structures,” Journal of Financial Economics (October 1976): 308.
38. See, for example, J. R. Hand and T. R. Skantz, “The Economic Determinants of Accounting
Choices: The Unique Case of Equity Carve-outs under SAB No. 51,” Journal of Accounting and
Economics 24, no. 2 (1998): 175–203.
39. See, for example, R. Libby and B. Lewis, “Human Information Processing Research in
Accounting: The State of the Art,” Accounting Organizations and Society 2, no. 3 (1977): 245–268.
40. For a more thorough discussion, see R. M. Hogarth, “Process Tracing in Clinical
Judgments,” Behavioral Science (September 1974): 298–313.
41. C. Edward Arrington and Jere R. Francis, “Letting the Chat Out of the Bag: Deconstruction,
Privilege and Accounting Research,” Accounting, Organizations and Society (1989): 1.
42. Wai Fong Chua, “Radical Development in Accounting Thought,” The Accounting
Review (October 1986): 610.
43. Anthony M. Tinker, Barbara D. Merino, and Marilyn D. Neimark, “The Normative Origins of
Positive Theories, Ideology and Accounting Thought,” Accounting Organizations and Society (1982):
167.
44. See, for example, the discussion of J. Young, “Making Up Users,” in Chapter 2.
45. Richard C. Laughlin, “Accounting Systems in Organizational Contexts: A Case for Critical
Theory,” Accounting, Organizations and Society (1987): 482.
46. Ibid., 483.
47. Walter R. Nord, “Toward an Optimal Dialectical Perspective: Comments and Extensions on
Neimark and Tinker,” Accounting, Organizations and Society (1986): 398.
48. See, for example, Robert R. Sterling, “Accounting Research, Education and Practice,” Journal of
Accountancy (September 1973): 44–52.
49. Richard C. Breeden, chairman of the SEC, in testimony before the U.S. Senate Committee on
Banking, Housing, and Urban Affairs, September 1990.
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