Answers to Chapter 3 Review Questions

Question 1
A theory can be defined as “a set of statements or principles devised to explain a
group of facts or phenomena, especially one that has been repeatedly tested or is
widely accepted and can be used to make predictions”. In other words, it can be
employed to either explain something that has already happened or to predict what
may happen.

A theory’s capacity in this regard will, however, be directly related to the degree to
which it describes the “real” world. Herein lies one of the problems with theories:
many incorporate such a range of assumptions that they no longer approximate to the
reality they are trying to describe.

Question 2
The three dominant theoretical paradigms in accounting over recent decades have
been:

1. Classical Theory: The Classical (or Normative) approach, dominant in the

academic accounting community particularly during the 1960s and early 1970s,
reflected this perspective. This approach assumes that it is possible to identify and
measure the intrinsic value of a firm and evaluate the efficacy of the accounting
function with that in mind. In other words, accounting practices are gauged in
terms of how close they come to reporting the “true” economic reality about the
firm. Because there was a presumption that accounting can, in some sense,
measure and report the “true” situation about a firm, the research emphasis was
primarily on determining those accounting practices best suited to achieving this
end. As a consequence a dynamic developed in which a preconceived notion of
the intrinsic value of a firm was constructed that was in turn confirmed by
techniques that it was assumed could measure this value. Academic energy was
devoted therefore to developing and promulgating accounting practices that were
presumed to be correct, rather than to testing these assumptions by means of
empirical research.
2. Market-Based Theory: While the Classical approach assumes that an underlying
reality exists that accounting can best capture, market-based theory sees reality as
something that the market determines, and in which process the accounting
alternatives adopted make no difference. This approach posits that information
can only be evaluated in the context of its effect upon users of that information,
rather than in terms of any implicit reality that it purports to describe. One of its
more obvious manifestations is Efficient Market Hypothesis (EMH), a dominant
paradigm with traders, and one that has been implicated strongly in the various
collapses that accompanied the recent financial crisis.
3. Positive Accounting Theory: The third main stream of accounting theory to have
had a strong influence over the course of recent decades has been Positive
Accounting Theory, sometimes called “contracting theory”. The central
hypothesis of Positive Accounting Theory is that accounting arose, not in response
to market demands for information, but as a device by which the contracts that
mediate relationships within a firm could be monitored. In contrast to the
Classical approach, which is predicated upon the notion of accounting as the best
 mechanism by which to capture the “correct” value of a firm, the Positive
approach assumes that there is no such “correct” value.

Question 3
Over the course of the middle decades of the twentieth century, a number of
fundamental developments in finance theory began to impact upon the broader
academic world in general and upon the accounting domain in particular.

Principal amongst these was the change in perspective from the preparers of
information to the decision needs of users. This reflected the view promoted by
market-based theory that the users determine “reality”. In other words, the focus
moved away from attempts to capture reality promoted by the Classical view, to the
more modernist paradigm of evaluating information in terms of the experience and
perspective of information consumers.

This perspective has had a number of fundamental implications for accounting and
accounting research:

 One of the criticisms of the Classical approach was that it could not be tested.
Market-based theory, by definition, was based on an empirical testing of the
actual usefulness of the information content of accounting disclosures.
 The focus was on the needs of users – as distinct from preparers – of accounting
information.
 Rather than presuming the existence of “correct” accounting practices, it was
now possible to test how different practices impacted upon the usefulness of the
accounting information and whether specific accounting practices existed that
most suited user needs.

Question 4

1. Diversification: A process of portfolio management and development

predicated on the belief that a portfolio should comprise a range of investments
straddling securities in various industries and sectors.
2. Efficient Market: An efficient market is defined as one where “stocks are
valued fairly in the light of all available information”. Such a market is assumed
to immediately and rationally impound information relevant to the security. For
example, as information that suggests increased profits becomes available the
share price should increase to a level where the yield would be equivalent to that
expected for shares with a similar risk profile. Likewise, information suggesting a
decrease should lead to a drop in share price to a level that would yield an amount
equivalent to that expected for shares with a similar risk profile.
3. Portfolio: A portfolio is basically a combination of various investments. A
portfolio of shares may commence with just one security, but the usual pattern
will be for additional securities to be added over time.

4. Beta: This is a measure of the volatility, or systematic risk, of a security or a

portfolio in comparison to the market as a whole. Every security will have a beta.
It will usually be expressed against a numeric base.
5. Riskiness: This relates to volatility.  is the riskiness of the security relative to
the market.

Question 5
According to portfolio theory, as the number of securities in the portfolio increases
the standard deviation (the measure of risk) decreases. In other words, the relevant
risk to be considered when deciding whether or not to incorporate a security into a
portfolio is not the total risk associated with it, but the effect its incorporation would
have on the riskiness of the portfolio as a whole.

CAPM (Capital Asset Pricing Model) is a technique that allows this marginal effect to
be measured by subdividing the risk element of a security into its component parts:

 The element that can be diversified away, i.e., unsystematic risk, for example, the
risks particular to that firm such as its susceptibility to strikes. This will be
diversified away by the fact that the portfolio will include other securities that will
not be susceptible to such risk.
 The element that cannot be diversified away, i.e., the systematic (or market) risk.
This is the element of risk deriving from considerations common to all firms in the
market such as macro-economic issues, inflation, etc.

Because unsystematic risk will be diversified away in any balanced portfolio, CAPM
posits that the only element of risk that needs to be assessed when deciding whether
or not to include a security in a portfolio is its systematic risk. This is because it is the
only element of risk that the portfolio will be rewarded for taking.

The method used by CAPM to properly quantify the systematic risk element of a
security, i.e., the degree of correlation to variations in the market, is an index,
normally referred to as the beta () of a security.

Question 6
Unlike the single-index CAPM, APT (arbitrage pricing theory) is a multi-index
model. Thus the APT model can incorporate a far greater range of risk factors, for
instance, interest rates and industry-specific indices.

Question 7
The basic tenet of EMH (efficient market hypothesis) is that a market is efficient if
share prices fully reflect all information available. In other words, it does not allow
anyone to profit further from such information as it is assumed that the market has
immediately and rationally impounded the implications of that information into the
price of the share. Consequently, any new or additional information is quickly
absorbed by the market and used to determine the appropriate value of the shares.

The agreed price for a security is seen to be set by the market, therefore, in a manner
that represents some form of weighted consensus as to the value of a share on a given
day, since the market, if it is efficient, will fully reflect all available and relevant
information. Thus, there is an assumption that the market will only react in an extreme
manner to surprise announcements. In short, EMH considers the stock market the
most efficient mechanism for determining value.
These insights impact how accounting information, particularly as disseminated by
means of the Annual Report, is perceived:

 EMH recognizes that accounting information is not the only information source
used for decision-making.
 EMH presumes, contrary to the Classical approach, that the market is a more
efficient arbiter of value than accounting.
 EMH assumes that accounting information will be impounded in the share price
when that information becomes available. By virtue of interim reports,
preliminary announcements, profit warnings/forecasts, press briefings, leaks,
insider information, insider trading and other means, such information will usually
become available to the market prior to the publication of the Annual Report.

EMH raises fundamental questions, therefore, about the usefulness and timeliness of
many accounting statements, such as the Annual Report – one of the most important
(and lucrative) documents produced by the accounting process. Obviously, by
extension, it questions the usefulness of any analysis of the information contained in
an Annual Report.

Question 8
By seeming to confirm that the market impounds all information immediately and
fairly, the ascendancy for several decades of the market-based approach, particularly
as manifested by EMH, posed great challenges for accountants and financial analysts.
Essentially the usefulness of analyzing accounting data was being fundamentally
questioned.

However, the validity of fundamental analysis as a legitimate exercise has been

reasserted in recent years as it has gradually dawned on those championing the
market-based approach that various anomalies, coupled with the failure of empirical
studies to confirm EMH in its strong form, as well as the insights of behavioural
finance, demonstrate that it is not capable of capturing all of the dynamics at work in
a market.

Similarly, the global financial crisis has prompted many to consider the practical
implications of EMH. One immediate result has been a recoiling from the “soft-
touch” regulation of earlier years with a more proactive and assertive pattern of
regulation across society, a process that has directly impacted accounting.

Question 9
Although EMH has proven a remarkably robust theory, recent challenges to it have
exposed some significant issues:

1. First of all, it is important to remember that EMH can be considered under a

number of thresholds: weak, semi-strong and strong. Implicit in this gradation is
an acknowledgement that, particularly in the first two forms, the claims made are
neither universal in application, nor complete in extent.
2. As with many market-based theories, EMH is based on a number of assumptions.
In recent years research in some of the behaviourist sciences have allowed a more
holistic appreciation of the limitations inherent in such assumptions. In the case of
 EMH, developments in economics, behavioural finance and cognitive psychology
have identified significant challenges for the proponents of EMH.
3. Research has also identified certain anomalies in the EMH model, for example,
the small-firm-in-January effect. Proponents respond, however, that the very act
of identifying such anomalies has the effect of highlighting and thereby
eliminating such inefficiencies.

The credibility and broad applicability of EMH has been challenged as a result of
market failures accompanying the global financial crisis. The short-termism that EMH
was believed to foster was identified as a particular weakness that exacerbated an
already precarious scenario.

Question 10
Positive Accounting Theory (PAT) views accounting information primarily as a
means by which to monitor contracts that define and mediate corporate relationships.
It is closely related to contracting theory.

Unlike the Classical approach, PAT views accounting as a vibrant element of the firm
that helps to define and shape it. In other words, accounting data and systems are seen
as a means of exerting control. Management, for example, can be employed on
contracts that incorporate accounting measures such as profit as the basis for the
bonus element of their remuneration packages. In this scenario, accounting methods
and systems act as mechanisms by which resources are allocated within a firm.

From this understanding of the key role of accounting information within a firm it is
postulated that managers have a vested interest in the effect of their actions on
accounting information and disclosures. In other words, they will have incentives to
change either their decisions or the firm's accounting policies in order to influence the
accounting numbers. This will be most likely in circumstances where their
remuneration is tied to performance. The effect of this insight has been to move the
focus away from testing market reaction to accounting disclosures, and onto the study
and observation of management behaviour in relation to the incentives underlying
their choice of alternative accounting policies.