Exam 4: Research Methodology and Theories on the Uses of Accounting Information

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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,there is no set of goals that is universally accepted by accountants.As a consequence,normative accounting theories are usually acceptable only to those individuals 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.

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The capital asset pricing model CAPM)is an attempt to deal with both risks and returns.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 Since 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 bills 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 will reduce risk. Some risk is peculiar to the common stock of a particular company.On the other hand,overall environmental forces cause fluctuations in the stock market that affect all stock prices. These two types of risk are termed unsystematic risk and systematic risk.Unsystematic risk is that portion of risk peculiar to a company 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. Since 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 since well-diversified investors are exposed only to systematic risk,investors using the CAPM as the basis for acquiring their portfolios will be subject only to systematic risk.Consequently,systematic risk is the only relevant and investors will be 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 are less likely to rise and fall than the general market index 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